Risk Mitigation Techniques for Uncleared Security-Based Swaps, 4614-4675 [2018-27979]

Download as PDF 4614 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules Comments may be submitted by any of the following methods: ADDRESSES: SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 240 [Release No. 34–84861; File No. S7–28–18] RIN 3235–AL83 Risk Mitigation Techniques for Uncleared Security-Based Swaps Securities and Exchange Commission. ACTION: Proposed rule. AGENCY: The Securities and Exchange Commission (‘‘SEC’’ or ‘‘Commission’’) is proposing rules that would require the application of specific risk mitigation techniques to portfolios of security-based swaps not submitted for clearing. In particular, the proposal would establish requirements for each registered security-based swap dealer (‘‘SBS dealer’’) and each registered major security-based swap participant (‘‘major SBS participant’’) (each SBS dealer and each major SBS participant hereafter referred to as an ‘‘SBS Entity’’ and together referred to as ‘‘SBS Entities’’) with respect to, among other things, reconciling outstanding securitybased swaps with applicable counterparties on a periodic basis, engaging in certain forms of portfolio compression exercises, as appropriate, and executing written security-based swap trading relationship documentation with each of its counterparties prior to, or contemporaneously with, executing a security-based swap transaction. In addition, the Commission is proposing an interpretation to address the application of the portfolio reconciliation, portfolio compression, and trading relationship documentation requirements to cross-border securitybased swap activities and is proposing to amend Rule 3a71–6 to address the potential availability of substituted compliance in connection with those requirements. Moreover, the proposed rules would make corresponding changes to the recordkeeping, reporting, and notification requirements applicable to SBS Entities. Finally, the Commission is requesting comment on how certain aspects of the proposed rules address how a security-based swap data repository (‘‘SDR’’) could potentially satisfy its obligation to verify the terms of each security-based swap with both counterparties to the transaction. amozie on DSK3GDR082PROD with PROPOSALS2 SUMMARY: Comments should be received on or before April 16, 2019. DATES: VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 Electronic Comments • Use the Commission’s internet comment form (https://www.sec.gov/ rules/proposed.shtml); or • Send an email to rule-comments@ sec.gov. Please include File Number S7– 28–18 on the subject line; or Paper Comments • Send paper comments to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–1090. All submissions should refer to File Number S7–28–18. This file number should be included on the subject line if email is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission’s internet website (https://www.sec.gov/rules/ proposed.shtml). Comments are also available for website viewing and printing in the Commission’s Public Reference Room, 100 F Street NE, Washington, DC 20549 on official business days between the hours of 10:00 a.m. and 3:00 p.m. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make available publicly. Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the SEC’s website. To ensure direct electronic receipt of such notifications, sign up through the ‘‘Stay Connected’’ option at www.sec.gov to receive notifications by email. FOR FURTHER INFORMATION CONTACT: Carol McGee, Assistant Director, or Andrew Bernstein, Senior Special Counsel, at (202) 551–5870, Office of Derivatives Policy, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–8010. SUPPLEMENTARY INFORMATION: The Commission is proposing for public comment the following new rules: Commission reference Securities Exchange Act of 1934 (‘‘Exchange Act’’): 1 Rule 15Fi–3 ................. Rule 15Fi–4 ................. PO 00000 Frm 00002 Fmt 4701 CFR citation (17 CFR) § 240.15Fi–3. § 240.15Fi–4. Sfmt 4702 Commission reference Rule 15Fi–5 ................. CFR citation (17 CFR) § 240.15Fi–5. The Commission also is proposing for comment amendments to: Commission reference CFR citation (17 CFR) Exchange Act: Rule 3a71–6 ................ Rule 15Fi–1 ................. Rule 17a–3 2 ................ Rule 17a–4 .................. Rule 18a–5 (proposed) Rule 18a–6 (proposed) § 240.3a71–6. § 240.15Fi–1. § 240.17a–3. § 240.17a–4. § 240.18a–5 (proposed). § 240.18a–6 (proposed). Finally, the Commission is requesting comment under: Commission reference CFR or U.S.C. citation Exchange Act: Section 13(n)(5)(B) ..... Rule 13n–4(b)(3) ......... 15 U.S.C. 78m(n)(5). 17 CFR 240.13n–4(b)(3). Table of Contents I. Proposed Rules and Rule Amendments A. Background B. Rule 15Fi–3 (Portfolio Reconciliation) 1. Overview of Portfolio Reconciliation 2. Scope of the Portfolio Reconciliation Requirements 3. Proposed Rule 15Fi–3(a): Portfolio Reconciliation With Other SBS Entities 4. Proposed Rule 15Fi–3(a): Resolution of Discrepancies With Other SBS Entities 5. Proposed Rule 15Fi–3(b): Portfolio Reconciliation With Other Counterparties 6. Reporting of Valuation Disputes 7. Application of Proposed Rule 15Fi–3 to Cleared Security-Based Swaps 8. Comments Requested C. Rule 15Fi–4 (Portfolio Compression) 1. Overview of Portfolio Compression 2. Scope of Proposed Rule 15Fi–4— Portfolio Compression Exercises 3. Scope of Proposed Rule 15Fi–4— Bilateral Offset 4. Application of Proposed Rule 15Fi–4 to Cleared Security-Based Swaps 5. Comments Requested D. Rule 15Fi–5 (Trading Relationship Documentation) 1. Overview of Trading Relationship Documentation 2. Scope of Proposed Rule 15Fi–5 3. Proposed Rule 15Fi–5(b)(4): Documenting Valuation Methodologies 1 15 U.S.C. 78a et seq. April 2014, the Commission proposed new Rules 18a–5 and 18a–6, and amendments to existing Rules 17a–3 and 17a–4. See Recordkeeping and Reporting Requirements for Security-Based Swap Dealers, Major Security-Based Swap Participants, and Broker-Dealers; Capital Rule for Certain Security-Based Swap Dealers, Exchange Act Release No. 71958 (Apr. 17, 2014), 79 FR 25194 (May 2, 2014) (‘‘SBS Books and Records Proposing Release’’). Although those proposed rules and rule amendments have not yet been adopted by the Commission, all of the relevant proposals included in this release are based on the proposed regulatory text contained in the SBS Books and Records Proposing Release. 2 In E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules 4. Proposed Rule 15Fi–5(b)(5) and (6): Other Disclosure Requirements 5. Proposed Rule 15Fi–5(c): Audit of Security-Based Swap Trading Relationship Documentation 6. Exceptions to the Trading Relationship Documentation Requirements 7. Comments Requested E. Verification of Transaction Data by SDRs 1. Reconciliation of Terms Submitted to an SDR 2. Documentation of Regulatory Reporting Obligations 3. Comments Requested F. Recordkeeping Requirements 1. Proposed Amendments to Recordkeeping Rules 2. Comments Requested II. Cross-Border Application of Rules 15Fi–3 Through 15Fi–5 A. Background on the Cross-Border Application of Title VII Requirements B. Proposed Cross-Border Interpretation C. Comments Requested III. Availability of Substituted Compliance for Rules 15Fi–3 Through 15Fi–5 A. Existing Substituted Compliance Rule B. Proposed Amendment to Rule 3a71–6 1. Basis for Substituted Compliance in Connection With the Portfolio Reconciliation, Portfolio Compression, and Trading Relationship Documentation Requirements 2. Comparability Criteria, and Consideration of Related Requirements 3. Comments Requested IV. General Request or Comment V. Paperwork Reduction Act A. Summary of Collections of Information 1. Proposed Rule 15Fi–3: Portfolio Reconciliation 2. Proposed Rule 15Fi–4: Portfolio Compression 3. Proposed Rule 15Fi–5: Written Trading Relationship Documentation 4. Proposed Amendments to Rules 17a–3, 17a–4, 18a–5, and 18a–6: Books and Records Requirements 5. Proposed Amendment to Rule 3a71–6: Substituted Compliance B. Proposed Use of Information 1. Proposed Rule 15Fi–3: Portfolio Reconciliation 2. Proposed Rule 15Fi–4: Portfolio Compression 3. Proposed Rule 15Fi–5: Written Trading Relationship Documentation 4. Proposed Amendments to Rules 17a–3, 17a–4, 18a–5, and 18a–6: Books and Records Requirements 5. Proposed Amendment to Rule 3a71–6: Substituted Compliance C. Respondents D. Total Annual Recordkeeping Burden 1. Portfolio Reconciliation Activities Generally 2. Establishing, Maintaining, and Enforcing Written Policies and Procedures 3. Reporting of Certain Valuation Disputes 4. Proposed Rule 15Fi–4: Portfolio Compression 5. Proposed Rule 15Fi–5: Written Trading Relationship Documentation 6. Proposed Amendments to Rules 17a–3, 17a–4, 18a–5, and 18a–6: Books and Records Requirements VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 7. Proposed Amendment to Rule 3a71–6: Substituted Compliance E. Collection of Information Is Mandatory F. Confidentiality G. Request for Comment VI. Economic Analysis A. Broad Economic Considerations B. Economic Baseline 1. Security-Based Swap Market Activity and Participants a. Available Data From the Security-Based Swap Market b. Affected SBS Entities c. Other Market Participants d. Outstanding Positions 2. Current Portfolio Reconciliation Practices 3. Current Portfolio Compression Practices 4. Current Trading Relationship Documentation Practices C. Economic Costs and Benefits, Including Impact on Efficiency, Competition, and Capital Formation 1. Effects on Efficiency, Competition, and Capital Formation a. Broad Market Effects b. Substituted Compliance 2. Portfolio Reconciliation a. Requirements b. Benefits c. Costs d. Alternatives 3. Portfolio Compression a. Requirements b. Benefits c. Costs d. Alternatives 4. Trading Relationship Documentation a. Requirements b. Benefits c. Costs d. Alternatives 5. Recordkeeping Requirements a. Requirements b. Benefits c. Costs d. Alternatives 6. Cross-Border Application of Rules 15Fi– 3 Through 15Fi–5. a. Requirements b. Benefits c. Costs D. Request for Comment VII. Consideration of Impact on the Economy VIII. Regulatory Flexibility Act Certification IX. Statutory Basis and Text of Proposed Rules I. Proposed Rules and Rule Amendments A. Background Section 15F(i)(1) of the Exchange Act, as added by Section 764(a) of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (‘‘DoddFrank Act’’),3 requires each SBS Entity to conform with such standards as may be prescribed by the Commission, by rule or regulation, that relate to timely and accurate confirmation, processing, 3 Public Law 111–203, 124 Stat. 1376 (2010). Unless otherwise indicated, references to ‘‘Title VII’’ in this release are to Subtitle B of Title VII of the Dodd-Frank Act. PO 00000 Frm 00003 Fmt 4701 Sfmt 4702 4615 netting, documentation, and valuation of all security-based swaps.4 Section 15F(i)(2) of the Exchange Act provides that the Commission shall adopt rules governing documentation standards for SBS Entities.5 The Commission previously adopted rules requiring SBS Entities to provide trade acknowledgments and to verify those trade acknowledgments with their counterparties to security-based swap transactions,6 but has not proposed rules concerning portfolio reconciliation, portfolio compression, or trading relationship documentation. By contrast, the Commodity Futures Trading Commission (‘‘CFTC’’) has implemented rules setting forth standards for the timely and accurate confirmation of swaps, addressing the reconciliation and compression of swap portfolios, and setting forth requirements for documenting the swap trading relationship between swap dealers or major swap participants (each swap dealer and each major swap participant hereafter referred to as a ‘‘Swap Entity’’ and together referred to as ‘‘Swap Entities’’) and their counterparties.7 4 15 U.S.C. 78o–10(i)(1). U.S.C. 78o–10(i)(2). 6 See Trade Acknowledgment and Verification of Security-Based Swap Transactions, Exchange Act Release No. 78011 (June 8, 2016), 81 FR 39807 (June 17, 2016) (‘‘Trade Acknowledgment and Verification Adopting Release’’). 7 See Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, 77 FR 55904 (Sept. 11, 2012) (‘‘CFTC Risk Mitigation Adopting Release’’). The European Commission (‘‘EC’’) has implemented similar measures. See Commission Delegated Regulation (EU) No. 149/ 2013 (Dec. 18, 2012) supplementing Regulation (EU) No. 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for over-the-counter (‘‘OTC’’) derivatives contracts not cleared by a central counterparty (Feb. 23, 2013), available at: https://eur-lex.europa.eu/LexUriServ/LexUriServ.do? uri=OJ:L:2013:052:0011:0024:en:PDF. Regulatory authorities in other jurisdictions (e.g., the Hong Kong Monetary Authority and the Monetary Authority of Singapore) have also proposed requirements similar to those adopted by the CFTC and the EC. In addition, the Canadian Securities Administrators (‘‘CSA’’) published a consultation paper in 2016 proposing a requirement that financial institutions enter into a written agreement documenting the material terms and conditions of any non-centrally cleared derivative, including standards related to the maintenance, review, and contents of that documentation. See CSA Consultation Paper 95–401—Margin and Collateral Requirements for Non-Centrally Cleared Derivatives (Jul. 7, 2016), available at: https:// www.osc.gov.on.ca/documents/en/SecuritiesCategory9/csa_20160707_95-401_collateralrequirements-cleared-derivatives.pdf. 5 15 E:\FR\FM\15FEP2.SGM 15FEP2 4616 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 Accordingly, the Commission is today proposing requirements applicable to SBS Entities addressing, among other things, reconciling and compressing portfolios of uncleared security-based swaps and executing written trading relationship documentation with each counterparty prior to or contemporaneously with executing an uncleared security-based swap. In developing this proposal, we have consulted and coordinated with the CFTC, the prudential regulators,8 and foreign regulatory authorities in accordance with the consultation mandate of the Dodd-Frank Act.9 We also have consulted and coordinated with foreign regulatory authorities through Commission staff participation in numerous bilateral and multilateral discussions with foreign regulatory authorities addressing the regulation of OTC derivatives.10 Through these multilateral and bilateral discussions and the Commission staff’s participation in various international task forces and 8 For purposes of this statement, the term ‘‘prudential regulator’’ is defined in Section 1a(39) of the CEA, 7 U.S.C. 1a(39), and that definition is incorporated by reference into Section 3(a)(74) of the Exchange Act, 15 U.S.C. 78c(a)(74). Pursuant to that definition, the Board of Governors of the Federal Reserve System (‘‘Federal Reserve Board’’), the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation (‘‘FDIC’’), the Farm Credit Administration, or the Federal Housing Finance Agency (collectively, the ‘‘prudential regulators’’) is the ‘‘prudential regulator’’ of an SBS Entity if the entity is directly supervised by that regulator. Separately, we are proposing a definition of ‘‘prudential regulator,’’ to be used for purposes of the proposed portfolio reconciliation and trading relationship documentation requirements. See infra note 48. That proposed definition also references Section 3(a)(74) of the Exchange Act and includes the same list of agencies as noted above. 9 Section 712(a)(2) of the Dodd-Frank Act provides in part that the Commission shall ‘‘consult and coordinate to the extent possible with the Commodity Futures Trading Commission and the prudential regulators for the purposes of assuring regulatory consistency and comparability, to the extent possible.’’ In addition, Section 752(a) of the Dodd-Frank Act provides, in part, that ‘‘[i]n order to promote effective and consistent global regulation of swaps and security-based swaps, the Commodity Futures Trading Commission, the Securities and Exchange Commission, and the prudential regulators . . . as appropriate, shall consult and coordinate with foreign regulatory authorities on the establishment of consistent international standards with respect to the regulation (including fees) of swaps.’’ 10 Staff participates in a number of international standard-setting bodies and workstreams working on OTC derivatives reforms. For example, Commission staff participated in the International Organization of Securities Commissions’ (‘‘IOSCO’’) preparation of a report regarding risk mitigation standards for non-centrally cleared OTC derivatives. See Risk Mitigation Standards for Noncentrally Cleared OTC Derivatives (Jan. 28, 2015), available at: https://www.iosco.org/library/pubdocs/ pdf/IOSCOPD469.pdf. IOSCO developed those standards in consultation with the Basel Committee on Banking Supervision and the Committee on Payments and Market Infrastructures. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 working groups, we have gathered information about foreign regulatory reform efforts and their effect on, and relationship with, the U.S. regulatory regime. The Commission has taken, and will continue to take, these discussions into consideration in developing rules, forms, and interpretations for implementing Title VII of the DoddFrank Act. Finally, the Commission recognizes that the CFTC rules pertaining to portfolio reconciliation, portfolio compression, and written trading relationship documentation have been in effect since 2012, and that any SBS Entity that also is registered with the CFTC as a Swap Entity will already have incurred systems and compliance costs in connection with the corresponding CFTC requirements. In order to minimize compliance burdens on such potential dual registrants in connection with the rules we are proposing today, we have attempted to harmonize this proposal with the existing CFTC rules wherever possible. There are, however, a limited number of provisions where we preliminarily believe it is appropriate to diverge from a particular aspect of the CFTC rules. Each of those differences is described below, along with the preliminary reasons for the different approaches. To the extent that no such substantive difference is described, it is because we have preliminarily determined that none exists. However, below we welcome and solicit comment on any potential substantive differences between the proposed rules and the corresponding CFTC rules, as well as on the decision to harmonize with the CFTC, both as an overall approach and with respect to any specific provisions of the proposed rules. B. Rule 15Fi–3 (Portfolio Reconciliation) 1. Overview of Portfolio Reconciliation In the Trade Acknowledgement and Verification Adopting Release, the Commission noted the importance of confirming trades in a timely manner, explaining that the process of confirming the terms of a transaction is essential for SBS Entities ‘‘to effectively measure and manage market and credit risk.’’ 11 The Commission further explained that ‘‘a backlog of unconfirmed trades could hinder the settlement process, particularly if errors go undetected or a counterparty disputes the terms of a transaction.’’ 12 Such disruptions in the settlement process could, in turn, lead to broader 11 Trade Acknowledgement and Verification Adopting release, 81 FR at 39833. 12 Id. PO 00000 Frm 00004 Fmt 4701 Sfmt 4702 market instability in the case of a credit event involving a reference entity on which many different counterparties have, in the aggregate, a large notional outstanding exposure.13 In this regard, portfolio reconciliation addresses many of these same issues, but unlike the confirmation process, which occurs at the outset of a transaction, reconciliation operates throughout the life of the transaction. If a security-based swap transaction is accurately confirmed by both parties during the trade acknowledgement and verification process, reconciliation helps to identify any discrepancies in terms that do not remain constant throughout the life of a trade. Furthermore, if a discrepancy is not identified during the trade acknowledgement and verification process, it could be identified during a subsequent reconciliation exercise. The Commission preliminarily believes that portfolio reconciliation serves as an important mechanism for promoting risk mitigation by requiring security-based swap counterparties to have established processes for identifying and resolving discrepancies involving key terms of their transactions. To illustrate this point, if a term necessary for calculating the market value of a security-based swap is not properly confirmed during the trade acknowledgment and verification process, such as due to some form of systems or human error, that discrepancy could lead to complications at various points throughout the life of the transaction, which could become particularly problematic if it remains undetected until such time as the parties are required to perform on their obligations.14 Thus, portfolio reconciliation could help to mitigate the possibility of a discrepancy unexpectedly affecting performance under the security-based swap transaction by increasing the likelihood 13 Id. 14 See Summary of OTC Commitments, Attachment to the July 31, 2008 letter from the Operations Management Group to Timothy Geithner, President, Federal Reserve Bank of New York (‘‘FRBNY’’), available at: https:// www.newyorkfed.org/medialibrary/media/ newsevents/news/markets/2008/ CommitmentSummaryTable.pdf (‘‘Positive affirmation of trade economics is a key risk mitigation technique for OTC derivatives because it assures that each counterparty’s risk management system accurately reflect the economic details of trades that have not yet been matched.’’). Although this particular commitment was made in the context of the trade affirmation process, we believe that the same basic principle supports the need to reconcile terms throughout the life of a trade, even if a term is accurately reflected in a firm’s system as a result of the affirmation process. This is particularly true for terms that do not remain constant during the life of a trade. E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 that the parties are and remain in agreement with respect to all material terms. This practice is particularly relevant with respect to terms used to perform a valuation of the financial instrument. Specifically, unresolved discrepancies regarding the value of a security-based swap can lead to, among other things, difficulties in the application of any processes that depend on the valuation being accurate, such as determining the amount of margin that must be posted or collected during the life of a securitybased swap transaction. In the aggregate, such errors and other complications could result in significant uncollateralized exposure in the uncleared security-based swap markets (or alternatively, potentially inefficient overcollateralization). In addition, valuation discrepancies identified during reconciliation could help to identify problems with one or both of the counterparties’ internal valuation systems and models, or possibly even with a firm’s internal controls. For example, in a report analyzing federal assistance to American International Group, Inc. (‘‘AIG’’) following the events of September 2008, the General Accountability Office (‘‘GAO’’) noted that in structuring this relief one of the many open issues the FRBNY had to address was the number of collateral disputes AIG had with its counterparties.15 GAO further explained that ‘‘[t]o the extent that lower valuations (more CDO value lost) produced greater collateral postings, counterparties had an interest in seeking lower valuations. Similarly, to the extent that higher valuations (less CDO value lost) meant smaller collateral postings, AIG had an interest in seeking higher valuations.’’ 16 In light of this information, the Commission preliminarily believes that the use of portfolio reconciliation to help maintain an agreed-upon valuation of a security-based swap throughout the lifecycle of a transaction should be a hallmark of prudent risk mitigation practices within the operations of an SBS Entity. Accordingly, the Commission is proposing new Rule 15 See GAO, Financial Crisis: Review of Federal Reserve System Financial Assistance to American International Group, Inc., GAO–11–616 (Sept. 2011), available at https://www.gao.gov/assets/590/ 585560.pdf (‘‘According to information we reviewed, on a [collateralized debt obligation (‘‘CDO’’)] portfolio of $71 billion . . . , AIG and its counterparties had valuation differences totaling $4.3 billion. Among a group of 15 counterparties, 9 had valued their assets differently than AIG.’’). 16 Id. at 82. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 15Fi–3 under the Exchange Act,17 which generally would require those entities, in connection with securitybased swaps not submitted for clearing, to (1) engage in portfolio reconciliation with counterparties who are SBS Entities and (2) establish, maintain, and follow written policies and procedures reasonably designed to ensure that they engage in portfolio reconciliation with counterparties who are not SBS Entities. In both cases, the frequency of the portfolio reconciliation would be based on the number of outstanding transactions with the applicable counterparty. 2. Scope of the Portfolio Reconciliation Requirements For purposes of proposed Rule 15Fi– 3,18 the Commission is proposing to amend existing Rule 15Fi–1 to add a definition of ‘‘portfolio reconciliation.’’ 19 As proposed, this term would be defined to mean any process by which the counterparties to one or more uncleared security-based swaps: (i) Exchange the material terms of all security-based swaps in the securitybased swap portfolio between the counterparties; (ii) Exchange each counterparty’s valuation of each security-based swap in the security-based swap portfolio between the counterparties as of the close of business on the immediately preceding business day; and (iii) Resolve any discrepancy in valuations or material terms. For purposes of this proposed definition, the Commission also is proposing to amend Rule 15Fi–1 to add the terms ‘‘security-based swap portfolio,’’ which would be defined to mean all security-based swaps currently in effect between a particular SBS Entity and a particular counterparty,20 and ‘‘valuation,’’ which would be defined to mean the current market value or net present value of a security-based swap.21 Both of these definitions help to establish the scope of the portfolio 17 Unless otherwise noted, all references to rules (both proposed and existing) without an accompanying statutory reference are to rules adopted (or proposed to be adopted) under the Exchange Act. 18 The corresponding CFTC rule is 17 CFR 23.502. The structure of the CFTC rule, including the subsections, mirrors the structure of proposed Rule 15Fi–3. 19 See proposed Rule 15Fi–1(l). The corresponding CFTC definition is in 17 CFR 23.500(i). 20 See proposed Rule 15Fi–1(o). The corresponding CFTC definition is in 17 CFR 23.500(k) 21 See proposed Rule 15Fi–1(q). The corresponding CFTC definition is in 17 CFR 23.500(m). PO 00000 Frm 00005 Fmt 4701 Sfmt 4702 4617 reconciliation requirements in proposed Rule 15Fi–3, with the former defining which security-based swaps are subject to the rule and the latter defining one of the two categories of information that must be exchanged during a reconciliation (the other being ‘‘material terms’’). Moreover, for consistency with the corresponding CFTC rules applicable to Swap Entities, these definitions are substantively identical to the CFTC’s corresponding definitions, which we preliminarily believe are appropriately scoped and clear for purposes of proposed Rule 15Fi–3. With respect to the phrase ‘‘material terms,’’ the proposed definition would follow a similar approach to the one taken by the CFTC in that it would base the definition on the terms required to be reported to an SDR pursuant to Regulation SBSR.22 Unlike the approach taken by the CFTC, however, which has adopted a single definition of ‘‘material terms,’’ the definition in proposed Rule 15Fi–1(i) would be bifurcated depending on whether a security-based swap transaction had already been included in a security-based swap portfolio and reconciled pursuant to proposed Rule 15Fi–3.23 With respect to any security-based swap that has not yet been reconciled as part of a securitybased swap portfolio, ‘‘material terms’’ would be defined to mean each term that is required to be reported to a registered SDR pursuant to Rule 901 under the Exchange Act.24 With respect to all other security-based swaps within a security-based swap portfolio, the definition of ‘‘material terms’’ would continue to be based on the reporting requirements in Rule 901, but would exclude any term that is not relevant to the ongoing rights and obligations of the 22 17 CFR 242.900 to 242.909. Rule 23.500(g) defines ‘‘material terms’’ to include the minimum primary economic terms (as defined in Appendix 1 of part 45 of the CFTC’s regulations) of a swap, other than the 24 specific data fields identified in that rule. See 17 CFR 23.500(g). Among the excluded fields are: (1) The status of either counterparty as a swap dealer, major swap participant, financial entity, or U.S. person; (2) an indication that the swap will be allocated and certain information regarding the agent and the original swap; (3) an indication that the swap is a multi-asset swap and a further indication of its primary and secondary asset class; (4) an indication that the swap is a mixed swap and the identification of any non-CFTC registered swap data repository to which it is also reported (if applicable); (5) the block trade indicator, execution timestamp, and timestamp for submission to a swap data repository; (6) the clearing indicator and clearing venue; and (7) certain information regarding the application of the end user exception from mandatory clearing. 24 See proposed Rule 15Fi–1(i)(1) (referencing 17 CFR 242.901). 23 CFTC E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 4618 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules parties and the valuation of the securitybased swap.25 The Commission preliminarily believes that the data set submitted to an SDR under Rule 901 is an appropriate measure for determining which terms should be reconciled pursuant to proposed Rule 15Fi–3. As noted above, the Commission believes that one of the fundamental goals of the portfolio reconciliation process is to help ensure that both counterparties to a security-based swap are in agreement on all of the terms necessary for developing a comprehensive understanding of each of their rights and obligations under the security-based swap, and that they remain in such agreement throughout the life of the transaction. To effect that objective, we are proposing that the term ‘‘portfolio reconciliation’’ be defined in part as the exchange of the ‘‘material terms’’ of all security-based swaps in the securitybased swap portfolio between the counterparties. Similarly, in adopting Regulation SBSR the Commission explained that the Title VII regulatory reporting requirement ‘‘is designed to allow the Commission and other relevant authorities to have access to comprehensive information about security-based swap activity in registered SDRs.’’ 26 The Commission therefore preliminarily believes that the terms that must be reported to an SDR under Regulation SBSR are a good proxy for identifying the ‘‘material terms’’ that should be subject to the portfolio reconciliation requirements. The Commission also preliminarily believes that basing the definition of ‘‘material terms’’ on what is required to be reported to an SDR provides certainty for SBS Entities regarding what information must be reconciled, which should in turn reduce the burdens on those entities without lessening the benefits of the proposed rule (which are described earlier in this section and in the Economic Analysis section below). Furthermore, the proposed approach is designed to allow affected counterparties to leverage the same systems used for SDR reporting for purposes of the portfolio reconciliation requirements, should such synergies exist. Moreover, this proposed approach would promote the same policy goals that underpin a particular requirement imposed on SDRs to verify the terms of each security-based swap with both 25 See proposed Rule 15Fi–1(i)(2). Regulation SBSR—Reporting and Dissemination of Security-Based Swap Information; Final Rule, Exchange Act Release No. 74244 (Feb. 11, 2015), 80 FR 14563, 14646 (Mar. 19, 2015) (‘‘Regulation SBSR Adopting Release’’). 26 See VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 counterparties to the transaction, as discussed in detail in Section I.E below. The Commission preliminarily believes that the proposed rule is reasonably tailored to avoid unnecessary burdens while still promoting important risk mitigation goals inherent to the portfolio reconciliation process. That said, certain terms of a security-based swap transaction may be material the first time that a transaction is reconciled, but might not be material during a subsequent reconciliation. This could be true, for example, with respect to any term of a transaction that does not affect any ongoing rights or obligations of the parties and that has no effect on the valuation of the security-based swap. Accordingly, the definition of ‘‘material terms’’ in proposed Rule 15Fi–1(i)(2) provides that with respect to any subsequent reconciliations, SBS Entities may exclude any term that is not relevant to the ongoing rights and obligations of the parties and the valuation of the security-based swap, regardless of the fact that the term was required to be reported to an SDR under Regulation SBSR.27 For example, the Commission preliminarily believes that the 24 terms excluded from the CFTC definition could be excluded from the proposed definition of ‘‘material terms’’ in the context of security-based swaps that have previously been reconciled.28 Finally, the Commission recognizes that our proposed definition of ‘‘material terms’’ would differ from the corresponding CFTC definition in that Swap Entities would never need to reconcile the 24 terms excluded from the definition of ‘‘material terms’’ in 27 The Commission does not, however, believe that a term would be appropriately excluded from the definition of ‘‘material terms’’ if it was resubmitted to an SDR because of an error in how it was initially reported or due to a lifecycle event. In those circumstances, the Commission preliminarily believes that such term would continue to be material for the same reasons that every term subject to a reporting requirement under Rule 901 would be material the first time that a transaction is reconciled. Once the updated term is reconciled, however, an SBS Entity would be able to exclude that term from subsequent reconciliations to the extent that it determines that it is not relevant to the ongoing rights and obligations of the parties and the valuation of the security-based swap. 28 See supra note 23 (discussing CFTC Rule 23.500(g)). We further recognize that when the CFTC adopted amendments to Rule 23.500(g) to exclude these terms, it noted that ‘‘removal of these terms from reconciliations would alleviate the burden of resolving discrepancies in terms of a swap that are not relevant to the ongoing rights and obligations of the parties and the valuation of the swap without impairing the [CFTC’s] regulatory mission.’’ See Definitions of ‘‘Portfolio Reconciliation’’ and ‘‘Material Terms’’ for Purposes of Swap Portfolio Reconciliation, 81 FR 27309, 27311 (May 6, 2016). PO 00000 Frm 00006 Fmt 4701 Sfmt 4702 CFTC Rule 23.500(g). Nevertheless, we are proposing to require all reported terms to be reconciled at least initially because, among other things, such requirement could potentially help to address an issue related to how registered SDRs can verify the information that they receive, as discussed in detail in Section I.E below. However, below we solicit comment on our approach, and particularly welcome comments on any trade-offs that may exist as between our efforts to address the SDR-related issue and any additional burdens resulting from a definition of ‘‘material terms’’ that departs from the corresponding CFTC rule, particularly in the context of CFTC-regulated Swap Entities that also may register with the Commission as SBS Entities. 3. Proposed Rule 15Fi–3(a): Portfolio Reconciliation With Other SBS Entities The Commission is proposing to bifurcate proposed Rule 15Fi–3 based on the particular type of counterparty with which the SBS Entity transacts. For transactions between two SBS Entities, proposed Rule 15Fi–3(a) would require the two sides to engage in portfolio reconciliation at frequencies that are based on the size of the security-based swap portfolio between the two parties, expressed in ranges (or tiers).29 Under this tiered approach, if the two SBS Entity counterparties maintain a security-based swap portfolio that includes 500 or more security-based swaps, portfolio reconciliation would need to occur once each business day for as long as the portfolio exceeds this threshold. If a security-based swap portfolio between two SBS Entities includes more than 50 but fewer than 500 security-based swaps on any business day during a week, portfolio reconciliation would be required to occur on a weekly basis. For a securitybased swap portfolio between two SBS Entities that includes no more than 50 security-based swaps at any time during the calendar quarter, portfolio reconciliation would be required on a quarterly basis.30 29 See proposed Rule 15Fi–3(a). proposed Rule 15Fi–3(a)(3). For the avoidance of doubt, if a security-based swap portfolio between two SBS Entity counterparties crosses from one threshold to another, both sides would be required to comply with the proposed rule as of the date that the requirement applies. For example, if two SBS Entities that have long maintained a portfolio of 50 or fewer security-based swaps (and accordingly reconcile on a quarterly basis) exceed the 50 transaction threshold, the two sides would become subject to the weekly reconciliation requirement as of the first day that the portfolio exceeds 50 security-based swaps (or the daily reconciliation requirement if the portfolio increases to 500 or more security-based swaps). By 30 See E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 The Commission preliminarily believes that the proposed tiering of obligations, whereby the frequency of the portfolio reconciliation would be based on the number of outstanding transactions with the applicable counterparty, represents a reasonable attempt to calibrate the costs to the benefits expected from reconciling a person’s security-based swap portfolio at regular intervals. All other things being equal, a larger and more complex portfolio represents a greater potential for loss than a smaller, less complex portfolio. Therefore, the proposed rule would require more frequent reconciliation of the larger, more complex portfolio. We also note that the CFTC has adopted rules that utilize identical levels as our proposal, and that divergence from those thresholds could lead to additional costs and other inefficiencies for SBS Entities that are also registered with the CFTC as Swap Entities.31 In addition to the requirements regarding the frequency of the reconciliation, proposed Rule 15Fi– 3(a)(1) would require SBS Entities to agree in writing with each of their counterparties on the terms of the portfolio reconciliation including, if applicable, agreement on the selection of any third party service provider who contrast, if two SBS Entities that maintain a security-based swap portfolio of more than 500 transactions fall below that threshold, they could begin reconciling on a weekly basis as of the first business day after the date on which they were able to verify that their security-based swap portfolio has fallen below 500 transactions. 31 When it adopted the same numerical thresholds in 2012, the CFTC noted that the requirement to reconcile portfolios with 500 or more swaps on a daily basis was consistent with the commitments made by the OTC Derivatives Steering Group’s 14 major dealers (‘‘G–14 dealers’’) in December 2008 as well as international regulatory efforts underway at the time of the CFTC’s release. See CFTC Risk Mitigation Adopting Release, 77 FR at 55928 nn. 35 and 36. See also Summary of OTC Commitments, Attachment to the June 2, 2009 letter from G–14 dealers and certain buy-side participants to William C. Dudley, President, FRBNY, available at: https:// www.newyorkfed.org/medialibrary/media/ newsevents/news/markets/2009/060209table.pdf (committing, ‘‘[b]y June 30, 2009, [to] execute daily collateralized portfolio reconciliations for collateralized portfolios in excess of 500 trades between [Operations Management Group] dealers as detailed in the December 31, 2008 Collateral Update letter’’). See also Attachment to the Mar. 31, 2011 letter from the G–14 dealers and certain buy-side participants to William C. Dudley, President, FRBNY, available at: https://www.newyorkfed.org/ medialibrary/media/newsevents/news/markets/ 2011/SCL0331.pdf (‘‘We commit to reduce the threshold for routine portfolio reconciliation of collateralized portfolios from those exceeding 1,000 transactions to those exceeding 500 transactions starting June 30, 2011. These portfolios will be reconciled at least monthly.’’) (internal citation omitted). VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 may be performing the reconciliation.32 In practice, the Commission notes that an SBS Entity could satisfy such requirement by including the terms governing the portfolio reconciliation process in the written security-based swap trading relationship documentation that the SBS Entity executes with its counterparty which, pursuant to proposed Rule 15Fi–5 would be required to be executed prior to, or contemporaneously with, the two parties executing any new securitybased swap transaction.33 This practice should help to ensure that portfolio reconciliation begins without delay after execution of the transaction and is designed to minimize the number of disagreements regarding the portfolio reconciliation process itself. Finally, the Commission has preliminarily determined not to propose the CFTC’s definition of ‘‘business day’’ and to rely on the definition in existing Rule 15Fi–1, which was adopted in 2016 in connection with the trade acknowledgement and verification requirements in Rule 15Fi–2. That definition includes ‘‘any day other than a Saturday, Sunday, or legal holiday.’’ 34 Specifically, we believe that the existing definition of ‘‘business day’’ is broadly consistent with other uses of the term within the Commission’s rules.35 We 32 Proposed Rule 15Fi–3(a)(2) provides that portfolio reconciliation may be performed either on a bilateral basis by the counterparties or by a third party selected by the counterparties in accordance with paragraph (a)(1) of the proposed rule. The Commission notes that CFTC Rule 23.502(a)(2), which is comparable to proposed Rule 15Fi–3(a)(2), uses the term ‘‘qualified third party.’’ When it adopted the above provision in 2012, the CFTC explained that it ‘‘expects that parties will determine if the third-party is qualified based on their own policies.’’ See CFTC Risk Mitigation Release, 77 FR at 55929. In addition, the CFTC’s portfolio reconciliation requirements for transactions between Swap Entities and counterparties that are not Swap Entities do not require the relevant third party to be ‘‘qualified’’ and, instead, provide that ‘‘[t]he portfolio reconciliation may be performed on a bilateral basis by the counterparties or by one or more third parties selected by the counterparties.’’ See 17 CFR 23.502(b)(2) (emphasis added). Accordingly, the Commission has decided not to refer to a ‘‘qualified third party’’ and, instead, uses the term ‘‘third party selected by the counterparties’’ for purposes of proposed Rule 15Fi–3(a)(2). We preliminarily believe that it is sufficient for our purposes to refer solely to the fact that a third party has been selected. 33 Once the two parties have agreed in writing on the terms of the portfolio reconciliation for the first time, the requirement could then be satisfied in connection with any new security-based swap transaction executed by the two sides merely by agreeing in writing to abide by the existing agreement regarding the reconciliation process. 34 Under this proposal, the definition of ‘‘business day’’ currently in Rule 15Fi–1(a) would be renumbered as proposed Rule 15Fi–1(b). 35 See, e.g., 17 CFR 270.2a–7(a)(4) (‘‘Business day means any day other than Saturday, Sunday, or any PO 00000 Frm 00007 Fmt 4701 Sfmt 4702 4619 also do not believe it necessary to have two different definitions of the same term promulgated under the same legal authority (i.e., Section 15F(i) of the Exchange Act), one for purposes of the portfolio reconciliation rules and the other for purposes of the trade acknowledgement and verification rules.36 Moreover, we believe that this definition provides market participants with the flexibility to determine which holidays are ‘‘legal holidays’’ for purposes of the portfolio reconciliation requirements in proposed Rule 15Fi–3, which should be particularly useful given the cross-border nature of the OTC derivatives market.37 However, below we solicit comment on our approach. 4. Proposed Rule 15Fi–3(a): Resolution of Discrepancies With Other SBS Entities Proposed Rule 15Fi–3(a) also would require each SBS Entity to take additional actions in the event of a discrepancy with a counterparty that is an SBS Entity. First, proposed Rule 15Fi–3(a)(4) would require the two SBS Entities to resolve immediately any discrepancy in a material term, whether identified directly as part of the portfolio reconciliation or otherwise. We preliminarily believe that this timeframe is appropriate given the ongoing nature of security-based swap transactions, as well as the potential for disagreements between the counterparties regarding the terms of a transaction to compound over the course of the security-based swap transaction. We have not, however, proposed a fixed definition of ‘‘immediately’’ as we believe that the amount of time that will be needed to resolve a discrepancy will depend on the particular facts and circumstances involved, including the complexity of the material term in question and the customary business holiday.’’) and 17 CFR 230.261(b) (‘‘Business day [means] [a]ny day, except Saturdays, Sundays or United States federal holidays.’’). 36 By contrast, the applicable definition of ‘‘business day’’ for purposes of the CFTC’s portfolio reconciliation rules is contained in CFTC Rule 1.3(b), and includes ‘‘any day other than a Sunday or holiday.’’ That definition also provides instructions for computing time periods for CFTC rules that include notice requirements. 37 As a reminder, the proposal would require SBS entities to agree in writing with each of their counterparties on the terms of the portfolio reconciliation pursuant to proposed Rule 15Fi– 3(a)(1) (in the case of security-based swap portfolios with other SBS Entities) and Rule 15Fi–3(b)(1) (in the case of security-based swap portfolios with all other counterparties). Accordingly, such agreement between an SBS Entity and its counterparty could include a determination as to which holidays would be considered ‘‘legal holidays’’ for purposes of any applicable portfolio reconciliation exercises involving those two parties. E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 4620 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules magnitude of the discrepancy. We have, however, solicited comment on this approach. At the same time, we also recognize that discrepancies related to the valuation of a security-based swap could be particularly difficult to resolve in a short period of time. Accordingly, proposed Rule 15Fi–3(a)(5) would require SBS Entities to have policies and procedures reasonably designed to resolve valuation discrepancies no later than five business days from the date they were discovered, which we preliminarily believe to be both a reasonable and appropriate amount of time to resolve such discrepancies. As a condition to this requirement, however, proposed Rule 15Fi–3(a)(5) would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to identify how it will comply with any variation margin requirements under Section 15F(e) of the Exchange Act 38 and any related regulations pending resolution of the valuation discrepancy. Although we preliminarily believe that counterparties should be given sufficient time to resolve valuation discrepancies, we also believe it to be important for those counterparties to take reasonable steps during the pendency of the resolution to ensure that they are continuing to manage their credit risk to each other by way of exchanging variation margin. Moreover, proposed Rule 15Fi–3(a)(5) provides that for purposes of the requirement to resolve valuation discrepancies within five business days of being identified, a difference between the lower valuation and the higher valuation of less than 10% of the higher valuation need not be deemed a discrepancy. This 10% threshold would apply on a transaction-by-transaction basis and not on a portfolio level. As discussed in the immediately preceding paragraph, the Commission recognizes that valuation discrepancies could be challenging and costly to resolve. Accordingly, we preliminarily believe that providing SBS Entities with a clear understanding of exactly which valuation discrepancies would need to be resolved within five business days will help focus the internal resources of both counterparties on the largest discrepancies. At the same time, however, the Commission believes that, in most cases, prudent risk mitigation of a firm’s security-based swap portfolio and proper governance over an entity’s operations would involve ensuring that, at least to a certain degree, most 38 15 U.S.C. 78o–10(e). VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 valuation discrepancies are ultimately resolved.39 5. Proposed Rule 15Fi–3(b): Portfolio Reconciliation With Other Counterparties Proposed Rule 15Fi–3(b) would establish reconciliation requirements for security-based swap portfolios between an SBS Entity and a counterparty that is not an SBS Entity. Although there is some broad similarity between proposed Rule 15Fi–3(b) and the rules applicable to security-based swap portfolios between two SBS Entities, we have preliminarily determined to take a more streamlined approach with respect to security-based swaps between an SBS Entity and its non-SBS Entity counterparties, similar to the CFTC’s approach. This approach reflects our preliminary view that a dealer-to-dealer portfolio may be associated with a degree of market interconnectedness and volume that could potentially carry considerable market-wide risks, at least as compared to a security-based swap portfolio that involves only one SBS Entity. Moreover, the Commission preliminarily believes it to be appropriate to impose more prescriptive requirements in cases where both entities are subject to the SEC’s requirements for registered entities. Accordingly, there are differences in both the application of the portfolio reconciliation requirements with nonSBS Entity counterparties as well as in the thresholds governing the frequency of the required reconciliation exercises. Specifically, the proposal would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to ensure that it engages in portfolio reconciliation with non-SBS Entity counterparties as set forth in the rule.40 This is in contrast to proposed Rule 15Fi–3(a), which expressly requires portfolio reconciliation with respect to transactions where both counterparties are SBS Entities. In addition, the policies and procedures would require 39 For the avoidance of doubt, an SBS Entity that identifies a valuation discrepancy in excess of 10% would be in compliance with the proposed rule if it resolves such discrepancy to a level below 10%, even if the entire discrepancy is not completely eliminated. Thus, an SBS Entity would not be required to reduce an 11% valuation discrepancy down to zero, in contrast to an SBS Entity with a 9% valuation discrepancy, who would have no further obligations under proposed Rule 15Fi– 3(a)(5). 40 See proposed Rule 15Fi–3(b). Additionally, proposed Rule 15Fi–3(b) contains a slight deviation from corresponding CFTC Rule 23.502(b) to eliminate language that we believe to be redundant. We do not intend for such clarification to signify any substantive differences between proposed rule Rule15Fi–3(b) and CFTC Rule 23.502(b). PO 00000 Frm 00008 Fmt 4701 Sfmt 4702 that the portfolio reconciliation be performed no less frequently than: (1) Once each calendar quarter for each security-based swap portfolio that includes more than 100 security-based swaps at any time during the calendar quarter and (2) once annually for each security-based swap portfolio that includes no more than 100 securitybased swaps at any time during the calendar year.41 As we previously explained, the Commission preliminarily believes that basing the required frequency of the portfolio reconciliation on the number of outstanding transactions with the applicable counterparty represents a reasonable attempt to calibrate the costs to the benefits expected from reconciling a person’s security-based swap portfolio at regular intervals. As we also noted above, all other things being equal a larger and more complex portfolio represents a greater potential for loss than a smaller, less complex portfolio. As before, in selecting the specific levels we recognize that the CFTC has adopted rules with identical thresholds and frequencies and that divergence from those thresholds could lead to additional costs and other inefficiencies for SBS Entities that are also registered with the CFTC as Swap Entities.42 In addition, paragraph (b)(1) of proposed Rule 15Fi–3 would require that the applicable policies and procedures be reasonably designed to ensure that each SBS Entity agrees in writing with each of its non-SBS Entity counterparties on the terms of the portfolio reconciliation including, if applicable, agreement on the selection of any third party service provider who may be performing the reconciliation, and paragraph (b)(2) provides that under such required policies and procedures, the portfolio reconciliation may be performed on a bilateral basis by the counterparties or by one or more third parties selected by the counterparties.43 To the extent that the counterparties elect to use a third party to provide these services, the policies and procedures should be reasonably designed to ensure that the SBS Entity and its counterparty agree on the selection of that third party in writing in accordance with the requirements set forth in proposed Rule 15Fi–3(b)(1).44 41 See proposed Rule 15Fi–3(b)(3). supra note 31 (discussing how the CFTC arrived at setting the numerical thresholds for the requirement to engage in portfolio reconciliation as between two Swap Entities.). 43 See proposed Rules 15Fi–3(b)(1) and (2). 44 See proposed Rule 15Fi–3(b)(2). As noted in the discussion of the corresponding provision in Rule 15Fi–3(a)(1), an SBS Entity could in practice 42 See E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules Finally, proposed Rule 15Fi–3(b)(4) would require each SBS Entity to establish, maintain, and follow written procedures reasonably designed to resolve any discrepancies in the valuation or a material term of each security-based swap identified as part of a portfolio reconciliation or otherwise with a non-SBS Entity counterparty in a timely fashion.45 We are reluctant to provide a fixed definition of ‘‘timely fashion’’ in the context of resolving discrepancies with counterparties who are not SBS Entities due to the fact that such counterparties may vary considerably in terms of their size, sophistication, and background. Although it may be possible to resolve most valuation discrepancies with large hedge funds and pension funds within the five-business-day period applicable to transactions between two SBS Entities, that timeframe may be much more challenging with respect to transactions with smaller buy-side firms. Accordingly, below we request comment on the amount of time SBS Entities should be provided to resolve discrepancies in the valuation or a material term with respect to transactions with a non-SBS Entity counterparty. Commenters are particularly encouraged to explain how any recommended time period appropriately balances the importance of quickly resolving valuation discrepancies to the greatest extent possible, with an understanding that more complex discrepancies could involve the need for additional discussion and time for resolution. amozie on DSK3GDR082PROD with PROPOSALS2 6. Reporting of Valuation Disputes Valuation is one of the most fundamental elements for determining the economic rights and obligations of each of the counterparties to a securitysatisfy such requirement by including the terms governing the portfolio reconciliation process in the written security-based swap trading relationship documentation that it executes with its counterparty which, pursuant to proposed Rule 15Fi–5 would be required to be executed prior to, or contemporaneously with, the two parties executing any new security-based swap transaction. In addition, once the two parties have agreed in writing on the terms of the portfolio reconciliation for the first time, the requirement could then be satisfied in connection with any new security-based swap transaction executed by the two sides merely by agreeing in writing to abide by the existing agreement regarding the reconciliation process. See supra notes 32 and 33 and accompanying text. 45 Similar to the requirement in paragraph (a) of the proposed rule for portfolio reconciliation with counterparties that are also SBS Entities, proposed Rule 15Fi–3(b)(4) provides that a difference between the lower valuation and the higher valuation of less than 10% of the higher valuation need not be deemed a discrepancy for purposes of that paragraph. See supra note 39 and accompanying text (discussing the 10% threshold in the context of Rule 15Fi–3(a)(5)). VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 based swap transaction. For example, market participants manage their credit risks to their counterparties by exchanging margin with each other in an amount determined using the value of the underlying security-based swap. If those valuations are not accurate for any reason, such as human or system errors, problems with the valuation methodology, or an issue affecting the timeliness of the calculation, that error could result in one of the counterparties having an uncollaterialized credit exposure and a potential for loss in the event of a default. Given those risks, proposed Rule 15Fi–3(c) would require each SBS Entity to promptly notify the Commission of any security-based swap valuation dispute in excess of $20,000,000 (or its equivalent in any other currency), at either the transaction or portfolio level,46 if not resolved within: (1) Three business days, if the dispute is with a counterparty that is an SBS Entity; or (2) five business days, if the dispute is with a counterparty that is not an SBS Entity. Such notification would be required to be in a form and manner acceptable to the Commission,47 and would also be required to be sent to any applicable prudential regulator (i.e., in the case of any SBS Entity that is also a bank).48 46 The language ‘‘at either the transaction or portfolio level’’ is not included in CFTC Rule 23.502(c), which is the corresponding requirement applicable to Swap Entities. The specific requirements as to the operation of CFTC Rule 23.502(c) are contained in the rules of the National Futures Association (‘‘NFA’’), which the CFTC has authorized to, among other things, receive and review notices of reportable swap valuation disputes. See Performance of Certain Functions by the National Futures Association Related to Notices of Swap Valuation Disputes Filed by Swap Dealers and Major Swap Participants, 81 FR 3390 (Jan. 21, 2016). A detailed discussion of the NFA requirements, including with respect to whether notices of swap valuation disputes should be filed at either the transaction or portfolio level, is set forth at the end of this Section I.B.6. 47 With respect to the language addressing the form and manner of submitting such notices, our intention is to provide SBS Entities with flexibility to determine the most efficient and cost-effective means of making such submissions, so long as it is deemed to be acceptable by the Commission. At the same time, we also understand that SBS Entities may prefer to have more specific direction as to how to report these disputes to the Commission (and any applicable prudential regulator). Accordingly, below we solicit comment on the form of notice that would be required to be submitted pursuant to the proposal. 48 Additionally, the Commission is proposing to amend Rule 15Fi–1 to add the term ‘‘prudential regulator,’’ which would be defined to have the same meaning given to the term in Section 3(a)(74) of the Exchange Act, 15 U.S.C. 78c(a)(74), and would include the Federal Reserve Board, the Office of the Comptroller of the Currency, the FDIC, the Farm Credit Association, and the Federal Housing Finance Agency, as applicable to the specific type of SBS Entity. See proposed Rule 15Fi–1(m). PO 00000 Frm 00009 Fmt 4701 Sfmt 4702 4621 We note that the CFTC has adopted a nearly identical requirement with the same $20,000,000 threshold and timeframes, and that divergence from those requirements could lead to additional costs and other inefficiencies for SBS Entities that are also registered with the CFTC as Swap Entities.49 In addition, when the CFTC adopted this requirement, it explained that ‘‘the $20,000,000 materiality threshold for reporting is sufficiently high to eliminate unnecessary ‘noise’ from overreporting, but not so high as to eliminate reporting that the [CFTC] may find of regulatory value, such as a large number of relatively small disputes that in aggregate could provide the [CFTC] with information regarding a widespread market disruption.’’ 50 We preliminarily concur with that justification, and also note that such notifications could assist the Commission in identifying potential issues with respect to an SBS Entity’s internal valuation methodology. That said, we also invite public comment as to whether the dollar threshold or reporting periods should be modified in any way.51 Finally, the Commission notes that on January 2, 2018, the NFA’s Interpretive Notice entitled, ‘‘NFA Compliance Rule 2–49: Swap Valuation Dispute Filing Requirements’’ went into effect.52 Among other things, that interpretive notice describes the types of disputes that would trigger a notice requirement. Specifically, if the swap dealer and its counterparty exchange collateral, NFA 49 See CFTC Risk Mitigation Adopting Release 77 FR at 55914. 50 Id. The CFTC has a nearly identical requirement in its Rule 23.502(c), except that it also requires Swap Entities to send such notices to the Commission when the dispute involves a swap that is also a security-based swap agreement, of which a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein. See 17 CFR 23.502(c) (citing the inclusion of security-based swap agreements in the definition of ‘‘swap’’ in 7 U.S.C. 1a(47)(v)). Because there is no corresponding inclusion of swap agreements in the definition of ‘‘security-based swap agreement’’ in Section 3(a)(68) of the Exchange Act (15 U.S.C. 78c(a)), proposed Rule 15Fi–3(c) does not contain a requirement to provide notices of any securitybased swap valuation disputes to the CFTC. 51 We have preliminarily determined not to provide a fixed definition of the term ‘‘promptly’’ in the context of when the SBS Entity would need to provide the Commission of an applicable security-based swap valuation dispute. Although we would expect that SBS Entities would be able to provide these notices to the Commission as soon as the disputes exceed the applicable timeframes (e.g., the beginning of fourth business day in the case of a dispute between two SBS Entities), we also understand that some notices may take longer to prepare, such as in cases when the counterparties are unable to agree even on the size of the dispute. 52 See NFA Interpretive Notice to Rule 2–49, available at: https://www.nfa.futures.org/rulebook/ rules.aspx?Section=9&RuleID=9072. E:\FR\FM\15FEP2.SGM 15FEP2 4622 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 Interpretive Notice to Rule 2–49 provides that the swap dealer would be required to file notice of any dispute regarding (1) the amount of initial margin to be posted or collected pursuant to a collateralized eligible master netting agreement 53 if the dispute exceeds the $20 million reporting threshold and (2) the amount of variation margin to be posted or collected pursuant to such master netting agreement if the dispute exceeds the $20 million reporting threshold. Because master netting agreements by definition operate at the portfolio level, such notices also would apply to the relevant swap portfolio. To the extent that a swap dealer and its counterparty do not exchange collateral, NFA Interpretive Notice to Rule 2–49 requires the swap dealer to submit a notice to the NFA upon being notified by its counterparty that such counterparty is disputing any valuation provided by the swap dealer if the dispute exceeds the $20 million reporting threshold. Such notices would either be at the portfolio or transaction level, depending on the particular valuation in question. That is, if the counterparty disputes a valuation provided by the swap dealer related to a particular transaction, the notice provided by the swap dealer to the NFA also would need to be at the transaction level. By contrast, if the counterparty disputes a portfolio valuation provided by the swap dealer, the notice provided by the swap dealer to the NFA also would need to be at the portfolio level.54 NFA Interpretive Notice to Rule 2–49 also provides that swap dealers should not file a daily notice of a previously reported dispute even if the valuation dispute amount changes. Instead, swap dealers are required to notify the NFA of certain changes to the dispute amount on the 15th (or the following business day if the 15th is a weekend or holiday) and last business day of each month by amending any previously filed notice where the dispute amount has increased in $20 million incremental bands.55 53 NFA Interpretive Notice to Rule 2–49 defines ‘‘collateralized eligible master netting agreement’’ to include an eligible master agreement, including any applicable schedule and credit support annex. 54 See id. See also Transcript of the NFA Swap Valuation Dispute Notices and Swap Dealer Risk Data Reports Webinar (Oct. 12, 2017), available at: https://www.nfa.futures.org/members/memberresources/files/transcripts/svdwebinar-transcript oct2017.pdf. 55 See NFA Interpretive Notice to Rule 2–49, supra note 52. NFA Interpretive Notice to Rule 2– 49 provided an example of a swap dealer that filed a notice of a $30 million dispute, noting that an amended notice updating the dispute amount would be required if that dispute increases to $40 million or more and each subsequent $20 million increment (i.e., the dispute amount increases to $60 VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 NFA Notice to Interpretive Rule 2–49 also requires swap dealers to file termination notices of disputes that are no longer reportable under CFTC Rule 23.502(c).56 In addition, on July 20, 2017, NFA issued a Notice to Members (I–17–13) outlining the types of disputes that must be reported under the Interpretive Notice to Rule 2–49 and specifying the information that will be required in NFA’s dispute form.57 Below we solicit comment on whether the Commission should incorporate some or all of the NFA’s approach, including with respect to any of the specific requirements described above, directly into proposed Rule 15Fi–3(c). 7. Application of Proposed Rule 15Fi– 3 to Cleared Security-Based Swaps Pursuant to proposed Rule 15Fi–3(d), the new requirements regarding portfolio reconciliation would not apply to a ‘‘clearing transaction’’ which, pursuant to existing Rule 15Fi–1(c) under the Exchange Act, is defined as a security-based swap that has a clearing agency as a direct counterparty.58 Notwithstanding this provision, the Commission understands that some parties may offer portfolio reconciliation services with respect to OTC derivative transactions novated to a clearing agency. Although the Commission recognizes the importance of reconciling million or more, $80 million or more, etc.), or if the amount decreases at these $20 million increments. 56 See id. Under NFA Interpretive Notice to Rule 2–49, the termination notice would be due on the 15th (or the following business day if the 15th is a weekend or holiday) and the last business day of the month based on the dispute amount on the reporting date. 57 See NFA Notice to Members I–17–30, available at https://www.nfa.futures.org/news/ newsNotice.asp?ArticleID=4827. That notice provided that all swap valuation disputes must include: (1) The swap dealer’s NFA ID and legal entity identifier (‘‘LEI’’), (2) the dispute reportable date, (3) the dispute type, (4) the dispute termination date, (5) the receiver/payer, (6) the disputed amount, in U.S. Dollars (‘‘USD’’), (7) the counterparty name, and (8) counterparty LEI or Privacy Law Identifier. For initial and variation margin disputes, the swap dealer would also be required to provide (1) the unique swap identifier, (2) the base currency notional amount, (3) the base currency code, (4) the notional value USD equivalent, (5) the asset type, and (6) the product type. For disputes where no collateral is exchange, the notice also would need to include the credit support annex/netting agreement ID. 58 See proposed Rule 15Fi–3(d). Under existing Rule 15Fi–1(b) under the Exchange Act (which would be renumbered as Rule 15Fi–1(c) under the proposed rules), the term ‘‘clearing agency’’ means a clearing agency registered with the Commission pursuant to Section 17A of the Exchange Act and provides central counterparty services for securitybased swap transactions. See also Trade Acknowledgement and Verification Adopting release, 81 FR at 39820–21 (explaining the agency and principal models of clearing in the context of providing a comparable exception from the trade acknowledgement and verification requirements). PO 00000 Frm 00010 Fmt 4701 Sfmt 4702 the terms of security-based swap transactions between a clearing member (either acting on its own behalf or for the benefit of a customer) and the clearing agency, we preliminarily believe that the issue of reconciling the terms of cleared trades is more appropriately addressed by the rules governing a clearing agency’s risk management practices, as well as by the documentation governing the relationship between a clearing agency and its members. 8. Comments Requested The Commission generally requests comments on all aspects of proposed Rule 15Fi–3, as well as any definitions in Rule 15Fi–1 that are used in proposed Rule 15Fi–3. In addition, the Commission requests comments on the following specific issues: • Do commenters agree with the three activities comprising the scope of the Commission’s proposed definition of ‘‘portfolio reconciliation’’? Why or why not? • Do you agree that the scope of the proposed definition of ‘‘material terms’’ for purposes of the portfolio reconciliation requirements in proposed Rule 15Fi–3 should be coterminous with the terms of a security-based swap that must be reported to an SDR under Regulation SBSR? Why or why not? Do you believe that there are any terms that must be reported to an SDR that should not be subject to the proposed portfolio reconciliation requirements? If so, which term(s) and why? • As opposed to using a fixed definition of ‘‘material terms,’’ should the Commission adopt a more flexible definition? For example, are there other uses of materiality, such as with regard to the disclosure of information in registration statements (including accounting statements) or proxy solicitations that would be useful to include? Why or why not? • Do you agree with the Commission’s preliminary approach of allowing SBS Entities to exclude certain information from the definition of ‘‘material terms’’ after a transaction is reconciled the first time so long as the excluded terms are not relevant to the ongoing rights and obligations of the parties and the valuation of the securitybased swap? Alternatively, should the definition be revised to conform to the corresponding CFTC definition, which excludes certain terms for purposes of all portfolio reconciliations? Why or why not? With respect to either approach, which terms should be excluded and why? For example, should the final definition include as rule text some or all of the specific data elements E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules excluded from the CFTC’s definition? Which ones and why? By contrast, are there any terms that would be excluded for purposes of subsequent reconciliations under the proposed approach that should also be excluded from the initial reconciliation? Which ones and why? • Do commenters agree with the decision to use the existing definition of ‘‘business day’’ (as currently in effect for the security-based swap trade acknowledgement and verification requirements) for purposes of the portfolio reconciliation requirements in proposed Rule 15Fi–3? If not, why not and how should that definition be modified for purposes of the proposed portfolio reconciliation requirements? For example, should the definition specify which jurisdiction’s legal holidays are the default for specifying which holidays are not included in the definition of ‘‘business days’’? Would the differences between the proposed definition of ‘‘business day’’ and the corresponding CFTC definition (which includes ‘‘any day other than a Sunday or holiday’’) create any practical difficulties for dual SEC–CFTC registrants? If so, what are they? Should the Commission instead adopt a definition of ‘‘business day’’ that mirrors the CFTC definition? Why or why not? • Do commenters agree with the proposed approach of basing the required frequency of portfolio reconciliation in proposed Rule 15Fi–3 on the type of counterparty involved (i.e., its status as an SBS Entity) and on the size of the security-based swap portfolio? If not, why not? If commenters believe that the proposed approach should be retained, should any of the particular frequencies proposed (e.g., daily, weekly, quarterly, or annually) be modified to be either more or less frequent? • Proposed Rule 15Fi–3 permits the portfolio reconciliation exercises required thereunder to be performed by a third party, with the only qualification being that the selection of that third party has been agreed to by both of the parties in writing. As an alternative approach, should the Commission instead establish specific requirements for qualifying third parties that offer portfolio reconciliation services used for compliance with the rule? If so, how should a third party be deemed to be qualified to provide portfolio reconciliation services and who should make such a determination? • Should the Commission’s rules require two SBS Entities to resolve a discrepancy in a material term ‘‘immediately’’? Why or why not? VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 Should the Commission define or provide an interpretation of the term ‘‘immediately,’’ such as ‘‘without undue delay,’’ or, as an alternative, specify a fixed period of time in the rule text within which SBS Entities would be required to comply with proposed Rule 15Fi–3(a)(4)? Why or why not and, if so, how much time should be provided? • Are there any current industry practices that relate to how counterparties to swaps and securitybased swaps resolve discrepancies in a material term in the case of a dealer-todealer transaction? If any such practices exist, please describe them, including with regard to the length of time that it typically takes to resolve these types of discrepancies. Are there particular material terms for which a discrepancy typically takes a longer (or shorter) amount of time to resolve? If so, which ones? • Should the Commission require SBS Entities to have policies and procedures reasonably designed to resolve any discrepancy in a valuation (with another SBS Entity) identified as part of a portfolio reconciliation or otherwise as soon as possible, but in any event within five business days after the date on which the discrepancy is first identified? Why or why not? Should SBS Entities be provided with more days to resolve these discrepancies? Should they have fewer days? • Are there any current industry practices that relate to how counterparties to swaps and securitybased swaps resolve valuation discrepancies in the case of a dealer-todealer transaction? If any such practices exist, please describe them, including with regard to the length of time that it typically takes to resolve these types of discrepancies. Are there particular circumstances that typically make valuation disputes more (or less) difficult and time-consuming to resolve? If so, which ones? • Should the Commission require SBS Entities to have policies and procedures reasonably designed to resolve any discrepancy in a valuation or material term with a counterparty that is not an SBS Entity (identified either as part of a portfolio reconciliation or otherwise) in a timely fashion? Why or why not? Should the Commission define or provide an interpretation of the term ‘‘timely fashion,’’ or, as an alternative, specify a fixed period of time in the rule text within which SBS Entities would be required to comply with proposed Rule 15Fi–3(b)(4)? Why or why not and, if so, how much time should be provided? In suggesting potential timeframes, we note that the period for resolving PO 00000 Frm 00011 Fmt 4701 Sfmt 4702 4623 discrepancies in a valuation or material term with non-SBS Entities should likely not be shorter than the five business days provided in the parallel requirement applicable to valuation discrepancies between two SBS Entities. Should the Commission look at any other similar provisions under the federal securities laws addressing dispute resolution procedures as a guide for determining the amount of time that an SBS Entity should be provided to resolve discrepancies pursuant to proposed Rule 15Fi–3(b)(4)? If so, which ones? • Are there any current industry practices that relate to how counterparties to swaps and securitybased swaps resolve discrepancies in a valuation or material term in the case of a transaction between a dealer and a non-dealer? If any such practices exist, please describe them, including with regard to the length of time that it typically takes to resolve these types of discrepancies. Are there particular terms for which a discrepancy typically takes a longer (or shorter) amount of time to resolve? If so, which ones? In this context, should valuation discrepancies be treated differently than discrepancies in some (or all) material terms? If so, which ones and why? • Do you agree with the Commission’s proposed approach of deeming valuation differences of less than 10% not to be discrepancies for purposes of requiring resolution under either proposed Rule 15Fi–3(a)(5) or (b)(4)? If not, why not and how should the rules address the resolution of valuation differences? Should the threshold be based on the actual dollar amount of the valuation difference (or the related currency equivalent) instead of being expressed as a percentage of the difference of the two amounts? • How has the 10% threshold functioned in the context of CFTC rules applicable to Swap Entities? Has that threshold been under-inclusive, in the sense that it may not identity a sufficient number of swap valuation discrepancies that could affect performance under the swap transaction? Why or why not? By contrast, has the CFTC’s 10% threshold been over-inclusive, in the sense that it has captured swap valuation discrepancies that typically would not affect performance under the swap transaction? Why or why not? • Proposed Rule 15Fi–3(c) would require SBS Entities to promptly notify the Commission, in a form and manner acceptable to the Commission, and any applicable prudential regulator of any security-based swap valuation dispute in excess of $20,000,000 (or its E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 4624 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules equivalent in any other currency) if not resolved within either three business days, if the dispute is with a counterparty that is an SBS Entity, or five business days, if the dispute is with a counterparty that is not an SBS Entity. Do commenters agree with this requirement? Why or why not? As an alternative, should the Commission instead require SBS Entities to make and keep records of these unresolved disputes? Why or why not? Is $20,000,000 the appropriate threshold for notifying the Commission of unresolved disputes? If not, should the threshold be higher or lower? Should the threshold instead be expressed as a percentage? Do commenters agree with the proposed timeframes for submitting such a report? If not, should they be increased or decreased? • Should the Commission establish a specific process for how SBS Entities would need to provide notices of valuation disputes to the Commission pursuant to proposed Rule 15Fi–3(c)? If so, how should such notices be provided? For example, should the Commission require that such notices be submitted in electronic format through the EDGAR system (or any successor system thereto, as designated by the Commission)? Why or why not? Alternatively, should the Commission create a dedicated email box to accept such notices in letter format? Why or why not? Should these notices be submitted on a confidential basis? If so, how would that affect the potential delivery options? • As discussed above, the NFA has issued an interpretive notice to NFA Compliance Rule 2–49 and a separate notice to its members that, together, specify the timing, frequency, and contents for submitting notices of swap valuation disputes pursuant to CFTC Rule 23.502(c).59 Should the Commission consider incorporating some or all of those requirements into proposed Rule 15Fi–3(c) at adoption? If so, which ones and why, and should any of the requirements promulgated by the NFA be modified as part of the process of incorporating them into the Commission’s rules to account for differences between the swap and security-based swap markets? • Do commenters agree with the proposed exception from the reconciliation requirement for clearing transactions? Why or why not? Because the definition of ‘‘clearing transactions’’ only includes transactions cleared at a clearing agency registered with the Commission pursuant to Section 17A of the Exchange Act, security-based swaps 59 See supra notes 52–57 and accompanying text. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 cleared at a foreign clearing agency that is not registered with the Commission would not be deemed to be ‘‘cleared’’ for these purposes, and would therefore be subject to proposed Rule 15Fi–3. Should the Commission modify the scope of the exception for cleared security-based swaps, such as by including transactions that are cleared at a clearing agency that is not registered with the Commission pursuant to Section 17A of the Exchange Act, whether because of an applicable exemption from registration or because the Exchange Act does not cover the activities of the clearing agency? Why or why not? • With respect to any Swap Entity that could potentially register with the Commission as an SBS Entity, would the portfolio reconciliation protocols (or any other applicable documentation) already in existence with respect to CFTC Rule 23.502 satisfy the requirements in proposed Rule 15Fi–3? Why or why not? Should proposed Rule 15Fi–3 be modified to account for the way that market participants have designed their existing protocols (or any other applicable documentation) to be compliant with the CFTC’s rules? Why or why not? For the purposes of compliance with the proposed portfolio reconciliation rules, should the Commission allow compliance with the CFTC’s parallel requirements for some period of time to allow dual SEC–CFTC registrants to conform their existing portfolio reconciliation protocols (or any other applicable documentation) following the adoption of proposed Rule 15Fi–3? If so, on what factors should that reliance be conditioned and how long of a compliance period should be provided? In the alternative, should the Commission delay compliance with, or establish phased compliance deadlines for, some or all of these requirements? Please explain the nature of any compliance challenges (including any additional documentation requirements), and the basis for any suggested compliance period. • As previously noted, proposed Rule 15Fi–3 has been designed to be as consistent as possible with CFTC Rule 23.502, which imposes portfolio reconciliation requirements on Swap Entities, in order to avoid requiring dual SEC–CFTC registrants to incur additional systems or compliance costs due to differences between the two agencies’ approaches. To the extent that any such differences remain, should the Commission consider, for any firm dually-registered as both an SBS Entity and Swap Entity (regardless of whether such firm is also registered with the Commission as a broker-dealer or with PO 00000 Frm 00012 Fmt 4701 Sfmt 4702 the CFTC as a futures commission merchant), permitting such firm to comply with proposed Rule 15Fi–3 on an ongoing basis by complying with CFTC Rule 23.502, as if such rule applied to security-based swaps? If so, what conditions, if any, should be placed on such reliance? • Should SBS dealers and major SBS participants be treated the same for purposes of the portfolio reconciliation requirements in proposed Rule 15Fi–3? Why or why not? C. Rule 15Fi–4 (Portfolio Compression) 1. Overview of Portfolio Compression Portfolio compression generally refers to a post-trade processing exercise that allows two or more market participants to eliminate redundant derivatives transactions within their portfolios in a manner that does not change their net exposure. Compression exercises typically take place in ‘‘cycles,’’ whereby each participating counterparty designates particular contracts within its portfolio as being eligible for compression and specifies its risk tolerances with respect to the composition of its derivatives portfolio following completion of the cycle.60 Following an analysis of the submitted contracts, counterparties may be provided with the option of terminating or modifying those contracts and replacing them with a smaller number of substantially similar contracts. In most cases, the gross notional value of the replacement and remaining contracts is reduced, although the counterparty’s net exposure typically remains the same.61 By reducing the total number of open contracts, portfolio compression is intended to help market participants manage their post-trade risks in a number of important ways. For example, two or more counterparties 60 See, e.g., ISDA Study, Interest Rate Swaps Compression: A Progress Report, (Feb. 2012), available at: https://www2.isda.org/attachment/ NDAzMw==/IRS%20compression %20progress%20report%20-%20Feb%202012.pdf. 61 In 2011, the Commission issued an order granting temporary exemptions from the requirement to register as a clearing agency under Section 17A of the Exchange Act for entities providing certain clearing services for securitybased swaps including, among other things, tear-up and compression services. That order contains general descriptions of the portfolio compression process, based on discussions between Commission staff and market participants prior to the issuance of the exemptive order. See Order Pursuant to Section 36 of the Securities Exchange Act of 1934 Granting Temporary Exemptions from Clearing Agency Registration Requirements under Section 17A(b) of the Exchange Act for Entities Providing Certain Clearing Services for Security-Based Swaps, Exchange Act Release No. 64796 (Jul. 1, 2011), 76 FR 39963 (Jul. 7, 2011) (‘‘Clearing Services Exemptive Order’’). E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 that are active in the OTC derivatives markets might have built up positions in the same (or comparable) products that, when analyzed at the portfolio level across all applicable counterparties, offset each other. Eliminating these offsetting and redundant uncleared derivatives transactions through compression—as measured both by the number of contracts and total notional value—reduces a market participant’s gross exposure to its direct counterparties, including by eliminating all exposure to certain counterparties.62 Reducing the total number of outstanding contracts within a derivatives portfolio also provides important operational benefits and efficiencies for market participants in that there are fewer open contracts to manage, maintain, and settle, resulting in fewer opportunities for processing errors, failures, or other problems that could develop throughout the lifecycle of a transaction.63 Accordingly, the Commission preliminarily believes that the use of portfolio compression by SBS Entities, where appropriate given the circumstances (and to the extent that such activity is not already occurring), should provide important processing improvements consistent with the overall framework of Section 15F(i) of the Exchange Act.64 62 See Darrell Duffie, Ada Li, and Theo Lubke, Policy Perspectives of OTC Derivatives Market Infrastructure, FRBNY Staff Report No. 424, dated Jan. 2010, as revised Mar. 2010, available at: https:// www.newyorkfed.org/research/staff_reports/ sr424.pdf (‘‘FRBNY OTC Derivatives Report’’) (‘‘In some types of derivatives that are not cleared, major market participants tend to build offsetting positions with different counterparties, long with one set of counterparties, and short with the others. In many cases, these offsetting positions are redundant. They serve no useful business purpose and create counterparty risk. Market participants should continue to engage in regular market-wide portfolio compression exercises in order to eliminate these redundant positions.’’). See also, John Kiff, et al., Credit Derivatives: Systemic Risks and Policy Options, IMF Working Paper No. 254 (Nov. 2009), available at: https://www.imf.org/ external/pubs/ft/wp/2009/wp09254.pdf (‘‘Multilateral netting, typically operationalized via ‘tear-up’ or ‘compression’ operations that eliminate redundant contracts, reduces both individual and system counterparty credit risk.’’). 63 See Portfolio compression platform launched to reduce CDS operational risk, Hedgeweek (Sept. 8, 2008) (explaining that a portfolio compression platform ‘‘reduces operational risk while leaving market risk profiles unchanged,’’ which is achieved ‘‘by terminating existing trades and replacing them with a smaller number of new replacement trades that carry the same risk profile and cash flows as the initial portfolio but have less capital exposure’’). 64 See 15 U.S.C. 78o–8 (requiring SBS Entities to ‘‘conform with such standards as may be prescribed by the Commission, by rule or regulation, that relate to timely and accurate confirmation, processing, netting, documentation, and valuation of all security-based swaps’’). VerDate Sep<11>2014 22:29 Feb 14, 2019 Jkt 247001 2. Scope of Proposed Rule 15Fi–4— Portfolio Compression Exercises For purposes of proposed Rule 15Fi– 4 under the Exchange Act, the phrase ‘‘portfolio compression exercise’’ would generally refer to an exercise by which security-based swap counterparties wholly terminate or change the notional value of some or all of the securitybased swaps submitted by the counterparties for inclusion in the portfolio compression exercise and, depending on the methodology employed, replace the terminated security-based swaps with other security-based swaps whose combined notional value (or some other measure of risk) is less than the combined notional value (or some other measure of risk) of the terminated security-based swaps in the exercise.65 In order to incorporate that concept into the proposal, the Commission is proposing to amend Rule 15Fi–1 to create definitions for both ‘‘bilateral portfolio compression exercise’’ 66 and ‘‘multilateral portfolio compression exercise.’’ 67 These two definitions are nearly identical, with the sole difference being that the former would apply to a portfolio compression exercise that includes only two security-based swap counterparties, while the latter would refer to a portfolio compression exercise that includes more than two securitybased swap counterparties.68 Under proposed Rule 15Fi–4(a), SBS Entities would be required to establish, maintain, and follow written policies and procedures for periodically engaging in both bilateral portfolio compression exercises and multilateral portfolio compression exercises, in each case when appropriate, with any counterparties that are SBS Entities.69 To the extent that an SBS Entity transacts with counterparties that are not SBS Entities, proposed Rule 15Fi– 4(b) provides that the policies and procedures required under the proposed rule would require that portfolio compression exercises occur when 65 The corresponding CFTC rule is 17 CFR 23.503. The structure of the CFTC rule, including the subsections, mirrors the structure of proposed Rule 15Fi–4. 66 See proposed Rule 15Fi–1(a). The corresponding CFTC definition is in 17 CFR 23.500(b). 67 See proposed Rule 15Fi–1(j). The corresponding CFTC definition is in 17 CFR 23.500(h). 68 As noted below in Section I.C.4, proposed Rule 15Fi–4 is applicable only to uncleared securitybased swaps. 69 See proposed Rules 15Fi–4(a)(2) and (3). PO 00000 Frm 00013 Fmt 4701 Sfmt 4702 4625 appropriate 70 and only to the extent requested by any such counterparty.71 The proposed definitions of ‘‘bilateral portfolio compression exercise’’ and ‘‘multilateral portfolio compression exercise’’ are designed to be sufficiently broad as to provide market participants with maximum flexibility when complying with proposed Rule 15Fi–4, while also retaining the key elements necessary to achieve the important risk reducing benefits previously discussed—namely the reduction of counterparty and operational risk achieved by terminating offsetting security-based swap transactions. Accordingly, we are not proposing specific requirements as to the contents of the policies and procedures created to comply with these rules.72 In addition, for consistency with the rules applicable to Swap Entities, these definitions are substantively identical to the CFTC’s corresponding definitions, which we preliminarily believe are appropriately scoped and clear for purposes of proposed Rule 15Fi–4. 70 CFTC Rule 23.503(b), which is the corresponding CFTC compression rule applicable to transactions with counterparties that are not SBS Entities does not contain the caveat that the compression or offset covered by the applicable policies and procedures would only need to occur ‘‘when appropriate.’’ Rather, we preliminarily believe it to be prudent to allow an SBS Entity to engage in bilateral offset or compression exercises (to the extent requested by its non-SBS Entity counterparty) only in circumstances when doing so was appropriate for the SBS Entity in light of the particular facts and circumstances involved, recognizing of course that such discretion should not be used by the SBS Entity arbitrarily not to honor the request by its counterparty. Below we solicit comment on this difference. 71 See proposed Rule 15Fi–4(b). As we noted in discussing the proposed portfolio reconciliation requirements, the Commission preliminarily believes it to be appropriate to impose more prescriptive requirements in cases where both entities are subject to the SEC’s requirements for registered entities. 72 The one exception to this statement is the requirement in both proposed Rules 15Fi–4(a)(2) and (a)(3) that such policies and procedures address the evaluation of portfolio compression exercises that are initiated, offered, or sponsored by any third party. The Commission preliminarily believes that the decision of which party to use (or not use) to conduct a compression exercise is of critical importance to the overall determination of whether to participate in compression. Although the Commission takes no position with respect to the type or identity of the party used to conduct a compression exercise, we recognize that a number of parties are currently offering such services, including third-party vendors and some selfregulatory organizations (e.g., clearing agencies). The Commission also understands that there may be some instances where compression could be performed without the use of a third-party service provider. E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 4626 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules Rather, the Commission recognizes that a decision to engage in a process that could ultimately result in the termination or modification of existing contracts, and the potential entry into new ones, should be made in accordance with policies and procedures that are tailored to the specific risks and operations of the relevant SBS Entity. Such policies and procedures should, in the Commission’s view, be permitted to take into account the specific risk tolerances of the regulated entity, including with respect to such areas as operational, funding, liquidity, and credit risk, and also reflect the possibility that firms may have legitimate business reasons for maintaining certain offsetting securitybased swap positions, even if in theory they could be compressed. For example, the Commission understands that an SBS Entity might be unable to participate in a particular portfolio compression exercise that could result in it transacting with certain counterparties (e.g., because a counterparty poses an unacceptable level of credit risk), or in certain types of transactions. To the extent that such limitations exist and are reflected in the policies and procedures required pursuant to proposed Rules 15Fi–4(a) and (b), an SBS Entity would be in compliance with the proposed rules so long as it follows those policies and procedures, even if it determines not to engage in a particular compression exercise. Finally, in comparing the requirements we are proposing today with respect to bilateral and multilateral compression exercises with those previously adopted by the CFTC, we note two differences that we believe to be minor and technical in nature. First, CFTC Rule 23.503(a)(3)(i) requires that any policies and procedures related to multilateral portfolio compression address, among other things, participation in all multilateral portfolio compression exercises required by CFTC regulation or order. We have preliminarily determined not to include a comparable requirement in proposed Rule 15Fi–4(a)(3). Although the Commission would expect that any comprehensive policy or procedure would, as a matter of course, reflect any applicable laws and regulations expressly mandating participation in certain types of portfolio compression exercises, there are currently no Commission regulations or orders mandating participation in any particular type of portfolio compression exercise, and we are reluctant to include a requirement that could lead to VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 confusion by suggesting that such regulations or orders exist. Second, CFTC Rule 23.503(a)(3)(ii) requires that any policies and procedures related to multilateral portfolio compression exercises evaluate, among other things, any services that are initiated, offered, or sponsored by any third party.73 The CFTC did not, however, include such a requirement in the corresponding requirement related to policies and procedures addressing bilateral portfolio compression exercises.74 Although the inclusion of a specific requirement in the rule should not be interpreted as creating an exhaustive list of what we would expect to see included in the policies and procedures, we understand that bilateral portfolio compression services are currently being offered by third-party vendors. Evaluating those services would seem to be a natural part of the process of broadly analyzing the applicability of bilateral compression in general. Therefore, we are proposing to expressly include a similar requirement in both proposed Rules 15Fi–4(a)(2) (policies and procedures regarding bilateral compression) and 15Fi–4(a)(3) (policies and procedures regarding multilateral compression). 3. Scope of Proposed Rule 15Fi–4— Bilateral Offset As we previously noted, the Commission has preliminarily made the determination not to suggest a preference as to the use of any particular type of compression, or as to the type or identity of the party conducting the exercise and has, instead, proposed broad definitions of the terms ‘‘bilateral portfolio compression exercise’’ and ‘‘multilateral portfolio compression exercise.’’ In addition, the Commission recognizes that there may be other ways for market participants to reduce the size of their derivatives portfolios that may not be considered to be ‘‘portfolio compression exercises’’ for purposes of those two proposed definitions. In light of those considerations, proposed Rule 15Fi–4(a)(1) would require each SBS Entity to establish, maintain, and follow written policies and procedures for terminating each ‘‘fully offsetting security-based swap’’ that it maintains with another SBS Entity in a timely fashion, when appropriate.75 To the extent that an SBS 73 See 17 CFR 23.503(a)(3)(ii). 17 CFR 23.503(a)(2). 75 The Commission also is proposing to amend Rule 15Fi–1 to add the term ‘‘fully offsetting security-based swaps,’’ which would be defined as ‘‘security-based swaps of equivalent terms where no net cash flow would be owed to either counterparty 74 See PO 00000 Frm 00014 Fmt 4701 Sfmt 4702 Entity transacts with a counterparty that is not an SBS Entity, the requirements of proposed Rule 15Fi–4(b) would be identical to those in proposed Rule 15Fi–4(a)(1), except that the required policies and procedures would only need to address engaging in bilateral offset when appropriate and to the extent requested by the counterparty. The Commission preliminarily believes that by not proposing prescriptive requirements as to the form of bilateral offset that would need to be reflected in an SBS Entity’s policies and procedures, the proposed rule would allow the counterparties flexibility in the manner in which they reduce the size of their security-based swap portfolios in light of each counterparty’s unique risks and operations. In addition, the proposed rules regarding bilateral offset have been designed to reflect the Commission’s understanding that firms may have legitimate business reasons for maintaining fully offsetting securitybased swap transactions. As such, proposed Rules 15Fi–4(a)(1) and (b) would require a firm’s policies and procedures to address the termination of fully offsetting security-based swaps only ‘‘when appropriate.’’ Finally, for purposes of proposed Rules 15Fi–4(a)(1) and (b), the Commission would generally consider an SBS Entity to have terminated each fully offsetting security-based swap in a ‘‘timely fashion’’ so long as (1) termination of the offsetting securitybased swaps occurs within a period that is reasonable in light of the circumstances of each particular transaction and (2) the relevant SBS Entity is otherwise in compliance with its policies and procedures regarding bilateral offset. 4. Application of Proposed Rule 15Fi– 4 to Cleared Security-Based Swaps Pursuant to proposed Rule 15Fi–4(c), the new requirements regarding portfolio compression would not apply to a ‘‘clearing transaction’’ which, pursuant to existing Rule 15Fi–1(c) under the Exchange Act, is defined as a security-based swap that has a clearing agency as a direct counterparty.76 Notwithstanding this provision, the Commission recognizes that portfolio compression is not limited to uncleared after the offset of payment obligations thereunder.’’ See proposed Rule 15Fi–1(h). For consistency with the rules applicable to Swap Entities, this definition is substantively identical to the CFTC’s corresponding definition in 17 CFR 23.500(f), which we preliminarily believe is appropriately scoped and clear for purposes of proposed Rule 15Fi–4. 76 See supra note 58 and accompanying text. E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules swaps and that compression services may be offered either by a clearing agency itself or by a third-party vendor that works collaboratively with the clearing agency.77 Although the riskreducing benefits that could be realized through the compression of cleared security-based swaps, we preliminarily believe that the issue of whether and when compression should occur within a clearing agency is best addressed by the rules governing the clearing agency’s risk management practices, as well as by the documentation governing the relationship between the clearing agency and its members.78 amozie on DSK3GDR082PROD with PROPOSALS2 5. Comments Requested The Commission generally requests comments on all aspects of Proposed Rule 15Fi–4 (and any related definitions). In addition, the Commission requests comments on the following specific issues: • Do commenters agree with the scope of the Commission’s approach of proposing broad definitions of ‘‘bilateral portfolio compression exercise’’ and ‘‘multilateral portfolio compression exercise’’? Why or why not? • Should SBS Entities be required to have policies and procedures in place for terminating fully offsetting securitybased swaps in a timely fashion? Why or why not? Do you agree with the proposed interpretation of the term ‘‘timely fashion’’ to mean that the relevant security-based swaps should be terminated within a period that is reasonable in light of the circumstances of each particular transaction (so long as the relevant SBS Entity is otherwise in compliance with its policies and procedures regarding bilateral offset)? Why or why not? Should the Commission instead specify a fixed period of time for the required termination of these security-based swaps? Why or why not? • With respect to any Swap Entity that could potentially register with the Commission as an SBS Entity, would the portfolio compression protocols (or 77 Notwithstanding the applicability of the requirements of proposed Rule 15Fi–4, the Commission reminds any third parties performing compression or offset services to keep in mind any potential requirements under other provisions of the securities laws. For example, the Commission has stated that the provision of tear-up and compression services for security-based swaps would qualify these participants as clearing agencies and therefore trigger the statutory requirement to register as clearing agencies pursuant to Section 17A of the Exchange Act, absent exemptive relief (which the Commission provided on a conditional temporary basis in July 2011). See Clearing Services Exemptive Order, 76 FR at 39964. 78 The corresponding CFTC rule is 17 CFR 23.503(c). VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 any other applicable documentation) already in existence with respect to CFTC Rule 23.503 satisfy the requirements in proposed Rule 15Fi–4? Why or why not? Should proposed Rule 15Fi–4 be modified to account for the way that market participants have designed their existing protocols (or any other applicable documentation) to be compliant with the CFTC’s rules? Why or why not? For the purposes of compliance with the proposed portfolio compression rules, should the Commission allow compliance with the CFTC’s parallel requirements for some period of time to allow dual SEC–CFTC registrants to conform their existing portfolio compression protocols (or any other applicable documentation) following the adoption of proposed Rule 15Fi–4? If so, on what factors should that reliance be conditioned and how long of a compliance period should be provided? In the alternative, should the Commission delay compliance with, or establish phased compliance deadlines for, some or all of these requirements? Please explain the nature of any compliance challenges (including any additional documentation requirements), and the basis for any suggested compliance period. • As previously noted, proposed Rule 15Fi–4 has been designed to be as consistent as possible with CFTC Rule 23.503, which imposes portfolio compression requirements on Swap Entities, in order to avoid requiring dual SEC–CFTC registrants to incur additional systems or compliance costs due to differences between the two agencies’ approaches. To the extent that any such differences remain, should the Commission consider, for any firm dually-registered as both an SBS Entity and Swap Entity (regardless of whether such firm is also registered with the Commission as a broker-dealer or with the CFTC as a futures commission merchant), permitting such firm to comply with proposed Rule 15Fi–4 on an ongoing basis by complying with CFTC Rule 23.503, as if such rule applied to security-based swaps? If so, what conditions, if any, should be placed on such reliance? • Do commenters agree with the proposed exception from the compression requirements in proposed Rule 15Fi–4 for clearing transactions? Why or why not? Because the definition of ‘‘clearing transactions’’ only includes transactions cleared at a clearing agency registered with the Commission pursuant to Section 17A of the Exchange Act, security-based swaps cleared at a foreign clearing agency that is not registered with the Commission would not be deemed to be ‘‘cleared’’ PO 00000 Frm 00015 Fmt 4701 Sfmt 4702 4627 for these purposes, and would therefore be subject to proposed Rule 15Fi–4. Should the Commission modify the scope of the exception for cleared security-based swaps, such as by including transactions that are cleared at a clearing agency that is not registered with the Commission pursuant to Section 17A of the Exchange Act, whether because of an applicable exemption from registration or because the Exchange Act does not cover the activities of the clearing? Why or why not? • Proposed Rule 15Fi–4(b) requires each 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 respect to security-based swaps in which its counterparty is an entity other than an SBS Entity, ‘‘when appropriate’’ and to the extent requested by any such counterparty. CFTC Rule 23.503(b) does not contain the ‘‘when appropriate’’ qualifier and provides only that a Swap Entity’s policies and procedures address engaging in bilateral offset or compression exercises ‘‘to the extent requested’’ by a counterparty that is not a Swap Entity. Would the Commission’s proposed approach create any practical difficulties for dual SEC– CFTC registrants? If so, what are they? Should the Commission instead strike the ‘‘when appropriate’’ qualifier in order to mirror the corresponding CFTC requirement? Why or why not? To the extent that the Commission were to follow the approach of CFTC Rule 23.503(b), should there be a reasonableness standard to address situations when a request by a non-SBS Entity counterparty to engage in bilateral offset or compression exercises would be not be reasonable, such as a situation when doing so could be detrimental to the SBS Entity? If so, under what conditions should an SBS Entity be able to refuse a request from a non-SBS Entity counterparty to engage in such activity pursuant to proposed Rule 15Fi–4(b)? • What practices, if any, are currently being used (or are currently under consideration) by market participants with respect to the use of portfolio compression across asset classes? For example, could a compression exercise occur with respect to two or more counterparties maintaining portfolios of both single-name credit default swaps (‘‘CDS’’) and index CDS? If so, should the Commission modify proposed Rule 15Fi–4, or provide related interpretive guidance to accommodate portfolio compression across asset classes? E:\FR\FM\15FEP2.SGM 15FEP2 4628 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules • Should SBS dealers and major SBS participants be treated the same for purposes of the portfolio compression requirements in proposed Rule 15Fi–4? Why or why not? D. Rule 15Fi–5 (Trading Relationship Documentation) 1. Overview of Trading Relationship Documentation Section 15F(i)(2) of the Exchange Act provides that the Commission shall adopt rules governing documentation standards for SBS Entities. Just as portfolio reconciliation is designed to allow counterparties to manage their internal risks by better ensuring agreement with respect to the terms of the transaction (and thereby avoiding complications at various points throughout the life of the transaction),79 requiring each SBS Entity to document the terms of the trading relationship with each of its counterparties before executing a new security-based swap transaction should promote sound collateral and risk management practices by enhancing transparency and legal certainty regarding each party’s rights and obligations under the transaction. This, in turn, should help to reduce counterparty credit risk and promote certainty regarding the agreedupon valuation and other material terms of a security-based swap.80 Having adequate written documentation prior to, or contemporaneously with, executing a security-based swap should also facilitate the ability of the counterparties to engage in portfolio reconciliation, as would be required under these proposed rules, in an efficient and cost-effective manner. 2. Scope of Proposed Rule 15Fi–5 In light of the important risk mitigating factors described above, the Commission is proposing Rule 15Fi–5, which establishes certain requirements for SBS Entities related to the use of written trading relationship documentation in connection with their security-based swap transactions.81 Specifically, proposed Rule 15Fi–5(a)(2) would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably 79 See supra Section I.B.1. e.g., Sylvie A. Durham, Terminating Derivatives Transactions: Risk Mitigation and Close-Out Netting § 8:1 (Nov. 2010) (‘‘[L]egal contractual provisions are the foundation on which the rights and obligations of the parties are based, and sound collateral and risk management practices may be ineffective if the legal rights of the parties are not clearly set forth.’’). 81 The corresponding CFTC rule is 17 CFR 23.504. The structure of the CFTC rule, including the subsections, mirrors the structure of proposed Rule 15Fi–5. amozie on DSK3GDR082PROD with PROPOSALS2 80 See, VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 designed to ensure that it executes written security-based swap trading relationship documentation with each of its counterparties prior to, or contemporaneously with, executing a security-based swap with any counterparty.82 The proposed rule would further require that the policies and procedures required thereunder be approved in writing by a senior officer of the SBS Entity, and that a record of the approval be retained.83 Pursuant to proposed Rule 15Fi– 5(b)(1), the required policies and procedures would require that the security-based swap trading relationship documentation be in writing. The policies and procedures would also require that the documentation 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.84 For purposes of Rule 15Fi–5(b)(2), all trade acknowledgements and verifications of security-based swap 82 Among other exceptions discussed below in Section I.D.6, proposed Rule 15Fi–5 is applicable only to uncleared security-based swaps. 83 See proposed Rule 15Fi–5(b)(2). For purposes of this requirement, the Commission preliminarily views the term ‘‘senior officer’’ as covering only the most senior executives in the organization, such as a firm’s chief executive officer, chief financial officer, chief legal officer, chief compliance officer, president, or other person at a similar level. This approach is similar to how the Commission has previously interpreted the term in the context of other requirements applicable to SBS Entities. See Registration Process for Security-Based Swap Dealers and Major Security-Based Swap Participants, Exchange Act Release No. 75611 (Aug. 5, 2015), 80 FR 48964, 48968 n. 29 (Aug.14, 2015) (‘‘SBS Entity Registration Adopting Release’’). By contrast, CFTC Rule 23.504 uses the term ‘‘senior management,’’ which is not further defined in either CFTC Rules 23.500 or 23.504. We preliminarily view this difference as a clarification and do not believe that it represents a substantive difference between the two sets of rules, but below we solicit comment on this issue. 84 We note that CFTC Rule 23.504 does not contain a comparable provision to the requirement in proposed Rule 15Fi–5(b)(1) that the trading relationship documentation address ‘‘applicable regulatory reporting obligations (including pursuant to Regulation SBSR).’’ The Commission is proposing this requirement not only because of our view that reporting arrangements should be clarified in advance, due to the importance of ensuring that the transaction is reported accurately and in a timely manner, but also because the inclusion of such provision could potentially help to address an issue related to how SDRs can verify the information that they receive, as discussed in detail in Section I.E below. PO 00000 Frm 00016 Fmt 4701 Sfmt 4702 transactions required under Rule 15Fi– 2 would be deemed to be security-based swap trading relationship documentation, as they often may contain one or more terms contemplated by the policies and procedures required by proposed Rule 15Fi–5. Further, the Commission understands that in some transactions, the parties may choose to document their trading relationship by using a stand-alone ‘‘long-form confirmation’’ that includes all of the terms governing the relationship. The proposed rule is not intended to interfere with this practice. Accordingly, we preliminarily believe that the use of a ‘‘long-form confirmation’’ would comply with proposed Rule 15Fi–5 so long as such document is: (1) In written form and includes all of the elements of the trading relationship required under the rule (whether by incorporating them by reference from a standard master agreement or by expressly restating them in the confirmation) and (2) executed prior to, or contemporaneously with, the execution of each relevant security-based swap. The policies and procedures required by the proposed rule also would require that the security-based swap trading relationship documentation include credit support arrangements.85 Such credit support would be required to contain, among other things and in accordance with applicable requirements under regulations adopted by the Commission or any prudential regulators,86 and without limitation, the following: • Initial and variation margin requirements, if any; • types of assets that may be used as margin and asset valuation haircuts, if any; • investment and re-hypothecation terms for assets used as margin for uncleared security-based swaps, if any; and • custodial arrangements for margin assets, including whether margin assets are to be segregated with an independent third party, in accordance with Section 3E(f) of the Exchange Act, if any.87 As the Commission has previously explained, ensuring that uncleared OTC derivatives transactions are appropriately collateralized was one of the key elements of the Title VII reforms.88 Accordingly, we preliminarily believe that policies and procedures requiring counterparties to 85 See proposed Rule 15Fi–5(b)(3). supra note 48. 87 15 U.S.C. 78c–5(f). 88 See supra Section I.B.1. 86 See E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules clearly document the applicable processes and requirements for calculating and exchanging margin in connection with a security-based swap transaction is an important step in achieving this broader regulatory objective. 3. Proposed Rule 15Fi–5(b)(4): Documenting Valuation Methodologies As mentioned throughout this release, ensuring that security-based swaps are accurately valued throughout the duration of a contract should play an important role in protecting the integrity of the OTC derivatives market, both at the level of an individual participant and systemically across the broader financial market.89 Accordingly, proposed Rule 15Fi–5(b)(4) would require that the applicable policies and procedures provide that the relevant swap trading relationship documentation between certain types of 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 securitybased swap at any time from execution to the termination, maturity, or expiration of such security-based swap for the purposes of complying with the margin requirements under Section 15F(e) of the Exchange Act (and applicable regulations),90 and the risk management requirements under Section 15F(j) of the Exchange Act (and applicable regulations).91 To the maximum extent practicable, such valuations would need to be based on recently-executed transactions, valuations provided by independent third parties, or other objective criteria.92 The requirements in proposed Rule 15Fi–5(b)(4) regarding valuation methodology would apply to securitybased swap trading relationship documentation entered into between: (1) Two SBS Entities; (2) an SBS Entity and a ‘‘financial counterparty;’’ and (3) an SBS Entity and any other counterparty, if requested by such counterparty. Accordingly, we are also proposing to 89 See id. 15 U.S.C. 78o–10(e). For the avoidance of doubt, the requirements in proposed Rule 15Fi– 5(b)(4) are intended to facilitate agreement between an SBS Entity and its counterparty as to how they will determine the value of a security-based swap in order to, among other things, comply with the margin requirements promulgated by either the Commission or, with respect to an SBS Entity that is a bank, the applicable prudential regulator. These requirements are not intended in any way to supersede those underlying margin requirements. 91 See 15 U.S.C. 78o–10(j). 92 See proposed Rule 15Fi–5(b)(4)(i). amozie on DSK3GDR082PROD with PROPOSALS2 90 See VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 amend Rule 15Fi-1 to add a definition of ‘‘financial counterparty,’’ which would include any counterparty that is not an SBS Entity and that is one of the following: • A swap dealer; • a major swap participant; • a commodity pool as defined in Section 1a(10) of the Commodity Exchange Act (7 U.S.C. 1a(10)); • a private fund as defined in Section 202(a)(29) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–2(a)); • an employee benefit plan as defined in paragraphs (3) and (32) of Section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002); and • a person predominantly engaged in activities that are in the business of banking or, in activities that are financial in nature, as defined in Section 4(k) of the Bank Holding Company Act of 1956 (12 U.S.C. 1843k).93 Further, proposed Rule 15Fi– 5(b)(4)(ii) has been designed to help ensure that the required valuation documentation between SBS Entities and their counterparties contains sufficient guidance and information in the event of a problem with determining the value of a security-based swap. Specifically, the documentation required by the applicable policies and procedures must include either: (1) Alternative methods for determining the value of the security-based swap for the purposes of complying with proposed Rule 15Fi–5(b)(4) in the event of the unavailability or other failure of any input required to value the securitybased swap for such purposes; or (2) a valuation dispute resolution process by which the value of the security-based swap shall be determined for the purposes of complying with the rule.94 To the extent that the prescribed valuation documentation needs to be updated, revised, or otherwise modified, 93 See proposed Rule 15Fi–1(g). The corresponding definition in CFTC Rule 23.500(e) is referred to as a ‘‘financial entity.’’. We replaced the word ‘‘entity’’ with ‘‘counterparty’’ to avoid any confusion due to the fact that there are other definitions of ‘‘financial entity’’ within the Exchange Act and its implementing regulations. For example, term ‘‘financial entity’’ is used in Section 3C(g) of the Exchange Act for purposes of the statutory exception to the mandatory clearing requirement in Title VII. See 15 U.S.C. 78c–3(g)(3). Similarly, there is a definition of ‘‘financial entity’’ in Rule 3a67–6 under the Exchange Act, which is used for one of the tests for determining a person’s status under the definition of ‘‘major security-based swap participant’’ in Section 3(a)(67) of the Exchange Act. See 15 U.S.C. 78. Other than the different titles, we do not believe that there are any substantive differences between the CFTC’s definition of ‘‘financial entity’’ and the proposed definition of ‘‘financial counterparty.’’ 94 See proposed Rule 15Fi–5(b)(4)(ii). PO 00000 Frm 00017 Fmt 4701 Sfmt 4702 4629 proposed Rule 15Fi–5(b)(4)(iv) provides that the parties may agree on changes or procedures for modifying or amending such documentation at any time.95 Finally, in recognition of the fact that valuation data and methodologies often include, or may be based on, private information, proposed Rule 15Fi– 5(b)(4)(iii) makes clear that an SBS Entity is not required to disclose to the counterparty confidential, proprietary information about any model it may use to value a security-based swap. 4. Proposed Rule 15Fi–5(b)(5) and (6): Other Disclosure Requirements Proposed Rule 15Fi–5 also would require that the policies and procedures governing the applicable trading relationship documentation require an SBS Entity and its counterparty to disclose to each other certain information regarding their legal and bankruptcy status, and to include a statement regarding the status of a security-based swap if accepted for clearing by a CCP. The first requirement relates to whether the SBS Entity or its counterparty is subject to a particular legal regime in the event of its failure, such as FDIC receivership for banks or orderly liquidation for certain financial companies that meet the requirements set forth in Title II of the Dodd-Frank Act.96 As background, Title II of the Dodd-Frank Act provides for an alternative insolvency regime for the ‘‘orderly liquidation’’ of large financial companies,97 including broker-dealers, 95 The text of CFTC Rule 23.504(b)(4)(iv), which is the corresponding subsection under CFTC rules, provides that ‘‘[t]he parties may agree on changes or procedures for modifying or amending the documentation required by this paragraph at any time.’’ Proposed Rule 15Fi–5(b)(4)(iv) does not contain the phrase ‘‘required by this paragraph.’’ We view this to be solely a technical change and do not intend for it to represent a substantive deviation from the corresponding CFTC rule. Rather, the difference is intended to avoid any suggestion that the parties could amend the underlying requirements contained in proposed Rule 15Fi–5(b)(4). 96 See 12 U.S.C. 5382; 12 U.S.C. 5383. 97 The term ‘‘financial company’’ is defined in 12 U.S.C. 5381(a)(11) to include any company (as defined in 12 U.S.C. 5381(a)(5)) that— (A) is incorporated or organized under any provision of Federal law or the laws of any State; (B) is— (i) a bank holding company (as defined in 12 U.S.C. 1841(a)); (ii) a nonbank financial company supervised by the Federal Reserve Board; (iii) any company that is predominantly engaged in activities that the Federal Reserve Board has determined are financial in nature or incidental thereto for purposes of 12 U.S.C. 1843(k) (other than a company described in clause (i) or (ii)); or (iv) any subsidiary of any company described in any of clauses (i) through (iii) that is predominantly engaged in activities that the Federal Reserve Board has determined are financial in nature or incidental E:\FR\FM\15FEP2.SGM Continued 15FEP2 4630 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 that meet specified criteria (each a ‘‘covered financial company’’) as set forth in Title II of the Dodd-Frank Act.98 If the covered financial company is (1) a broker or dealer and (2) a member of the Securities Investor Protection Corporation (‘‘SIPC’’), such ‘‘covered broker or dealer’’ would be placed into an orderly liquidation proceeding with the FDIC appointed as receiver.99 Because this orderly liquidation process, which was modeled on the receivership process used for failed banks, is different from the liquidation regimes established under the Securities Investor Protection Act of 1970 100 or by the U.S. Bankruptcy Code,101 the Commission preliminarily believes it to be appropriate to require counterparties to a security-based swap transaction to disclose to each other whether this alternative regime may potentially apply in the event of an insolvency. Accordingly, proposed Rule 15Fi– 5(b)(5) would require that each SBS Entity’s policies and procedures require that the security-based swap trading relationship documentation contain a statement as to whether it or its counterparty is an insured depository institution or financial company. Further, the documentation also would need to contain a statement that the orderly liquidation provisions of the Dodd-Frank Act and the Federal Deposit Insurance Act 102 may limit the rights of thereto for purposes of 12 U.S.C. 1843(k) (other than a subsidiary that is an insured depository institution or an insurance company); and (C) is not a Farm Credit System institution chartered under and subject to the provisions of the Farm Credit Act of 1971, as amended (12 U.S.C. 2001 et seq.), a governmental entity, or a regulated entity, as defined under 12 U.S.C. 4502(20). 98 Section 203 of the Dodd-Frank Act sets forth the process for designating a financial company as a ‘‘covered financial company.’’ In the case of a broker-dealer, or when a financial company’s largest U.S. subsidiary is a broker-dealer, Section 203(a)(1)(B) provides that the Federal Reserve Board and the Commission (in each case subject to the approval of a two-thirds majority of each agency’s members), in consultation with the FDIC, may, either on their own initiative or at the request of the Secretary of the U.S. Treasury (‘‘Secretary’’), issue a written orderly liquidation recommendation to the Secretary. See 12 U.S.C. 5383(a). Section 203(b) requires the Secretary (after consultation with the President) to take action on the recommendation upon an affirmative determination that, among other things, the failure of a financial company would have serious adverse effects on financial stability in the United States and that taking action under the orderly liquidation authority with respect to that company would avoid or mitigate such adverse effects. See 12 U.S.C. 5383(b). 99 See 12 U.S.C. 5384. Section 205(a) of the DoddFrank Act requires the FDIC, as the appointed receiver for any covered broker or dealer, to appoint SIPC as trustee for the liquidation. See 12 U.S.C. 5385(a). 100 15 U.S.C. 78aaa et seq. 101 11 U.S.C. 101 et seq. 102 12 U.S.C. 1811 et seq. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 the parties under their trading relationship documentation should either party be deemed a ‘‘covered financial company’’ or is otherwise subject to having the FDIC appointed as a receiver. The documentation would further be required to state that such limitations relate to the right of the noncovered party to terminate, liquidate, or net any security-based swap by reason of the appointment of the FDIC as receiver, notwithstanding the agreement of the parties in the security-based swap trading relationship documentation, and of certain rights of the FDIC to transfer security-based swaps of the covered party. Finally, the policies and procedures would require that the trading relationship documentation contain an agreement between the SBS Entity and its counterparty to provide notice if either it or its counterparty becomes or ceases to be an insured depository institution or a financial company.103 Second, the policies and procures required pursuant to proposed Rule 15Fi–5(b)(6) would require the securitybased swap trading relationship documentation of each SBS Entity disclose certain information regarding the status of a security-based swap accepted for clearing by a clearing agency. Specifically, such documentation would need to contain a notice that, upon acceptance of a security-based swap by a clearing agency: 103 Specifically, proposed Rule 15Fi–5(b)(5) would require that an SBS Entity’s policies and procedures require that the applicable securitybased swap trading relationship documentation contain: (A) A statement of whether the SBS Entity is an insured depository institution (as defined in 12 U.S.C. 1813) or a financial company (as defined in Section 201(a)(11) of the Dodd-Frank Act, 12 U.S.C. 5381(a)(11)); (B) A statement of whether the counterparty is an insured depository institution or financial company; (C) A statement that in the event either the SBS Entity or its counterparty becomes a covered financial company (as defined in 12 U.S.C. 5381(a)(8)) or is an insured depository institution for which the FDIC has been appointed as a receiver (the ‘‘covered party’’), certain limitations under Title II of the Dodd-Frank Act or the Federal Deposit Insurance Act may apply to the right of the non-covered party to terminate, liquidate, or net any security-based swap by reason of the appointment of the FDIC as receiver, notwithstanding the agreement of the parties in the security-based swap trading relationship documentation, and that the FDIC may have certain rights to transfer security-based swaps of the covered party under Section 210(c)(9)(A) of the Dodd-Frank Act, 12 U.S.C. 5390(c)(9)(A), or 12 U.S.C. 1821(e)(9)(A); and (D) An agreement between the SBS Entity and its counterparty to provide notice if either it or its counterparty becomes or ceases to be an insured depository institution or a financial company. PO 00000 Frm 00018 Fmt 4701 Sfmt 4702 • The original security-based swap is extinguished; • The original security-based swap is replaced by equal and opposite securitybased swaps with the clearing agency; and • All terms of the security-based swap shall conform to the product specifications of the cleared securitybased swap established under the clearing agency’s rules. The Commission preliminarily believes that this disclosure should provide important information to counterparties regarding the effects of clearing a trade at a clearing agency and clarify the status of the contract following its acceptance and novation at the clearing agency. 5. Proposed Rule 15Fi–5(c): Audit of Security-Based Swap Trading Relationship Documentation 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. The proposal also would require that a record of the results of each audit be retained for a period of three years after the conclusion of the audit.104 The Commission preliminarily believes that requiring periodic audits of a firm’s security-based swap trading relationship documentation is consistent with sound risk mitigation practices and is designed to reduce the prevalence of discrepancies during the course of these transactions. This proposed requirement differs slightly from CFTC Rule 23.504(c), which references an independent ‘‘internal or external’’ auditor.105 104 The three year holding period for these records is contained in the applicable recordkeeping, reporting, and notification requirements for SBS Entities, as opposed to in proposed Rule 15Fi–5(c) itself. 105 See 17 CFR 23.504(c). In the Commission’s experience overseeing accounting and auditing standards in the context of certain disclosure requirements under the federal securities laws, an internal auditor typically reports to the management of the applicable entity, which would be inconsistent with the Commission’s auditor independence rules. See Rule 2–01(c)(2) of Regulation S–X (Employment Relationships). 17 CFR 210.2–01(c). At the same time, we are not foreclosing the possibility that there could be alternative structures to the typical ‘‘internal’’ auditor employment relationship that could, if structured properly, not be inconsistent with the Commission’s auditor independence rules and request comment below identifying and describing such potential structures. E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 6. Exceptions to the Trading Relationship Documentation Requirements Proposed Rule 15Fi–5(a)(1) would establish three different exceptions from the basic requirement that each SBS Entity establish, maintain, and follow written policies and procedures reasonably designed to ensure that it executes written security-based swap trading relationship documentation with each of its counterparties prior to, or contemporaneously with, executing a security-based swap with any counterparty. First, proposed Rule 15Fi– 5(a)(1)(i) would provide an exception for security-based swaps executed prior to the date on which an SBS Entity is required to be in compliance with the documentation rule. Although the Commission recognizes the significant risk mitigation benefits associated with ensuring that all transactions are supported by comprehensive and accurate documentation, we also understand that it may be impractical to require SBS Entities to have policies and procedures to bring existing transactions into compliance with these proposed rules, particularly when weighing any potential benefits of doing so against the potential costs. Accordingly, we preliminarily believe that those transactions should be excepted from the proposed documentation requirements.106 To the extent that an SBS Entity maintains an existing security-based swap portfolio with a counterparty that pre-dates the compliance date, proposed Rule 15F–5(a)(1)(i) would provide an exception from the documentation requirements only with respect to those existing transactions. This means that the SBS Entity would not be in violation of Rule 15Fi–5 solely as a result of having policies and procedures that do not require such SBS Entity to have executed written security-based swap trading relationship documentation with any counterparty with respect to those existing transactions, or if the existing documentation that it maintains with the counterparty does not otherwise comply with the requirements 106 As discussed in detail in Section I.F.1 of this release, the Commission also is proposing amendments to Rule 17a–4 and to proposed Rule 18a–6 that would, among other things, require SBS Entities to retain all security-based swap trading relationship documentation with counterparties required to be created under proposed Rule 15Fi– 5. Because security-based swaps executed prior to the date on which an SBS Entity is required to be in compliance with proposed Rule 15Fi–5 would be exempt from the underlying documentation requirement, any trading relationship documentation voluntarily entered into in respect of those transactions would not be deemed to have been created pursuant to proposed Rule 15Fi–5. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 of the rule. However, if the SBS Entity enters into new security-based swap transactions with the counterparty, the exception would not apply to those new trades, even if trading relationship documentation already existed. Under those circumstances, the SBS Entity’s policies and procedures would be need to be reasonably designed to ensure that the existing documentation complies with the proposed rule before using it as the basis to enter into any new securitybased swaps with that counterparty. Second, proposed Rule 15Fi– 5(a)(1)(ii) would provide an exception for any ‘‘clearing transaction’’ which, pursuant to existing Rule 15Fi–1(c), is defined as a security-based swap that has a clearing agency as a direct counterparty.107 This exception is intended to recognize the fact that once a security-based swap is cleared, the transaction is governed primarily by the terms of the agreements in effect between the clearing member and the clearing agency (as well as between the clearing member and its customer, if applicable). Finally, proposed Rule 15Fi– 5(a)(1)(iii) would provide an exception for security-based swaps executed anonymously on a national securities exchange or a security-based swap execution facility (‘‘SBSEF’’), provided that: • Such security-based swaps are intended to be cleared and are actually submitted for clearing to a clearing agency; • All terms of such security-based swaps conform to the rules of the clearing agency; and • Upon acceptance of such securitybased swap by the clearing agency: (1) The original security-based swap is extinguished; (2) the original securitybased swap is replaced by equal and opposite security-based swaps with the clearing agency; and (3) all terms of the security-based swap shall conform to the product specifications of the cleared security-based swap established under the clearing agency’s rules. The exception in proposed Rule 15Fi– 5(a)(1)(iii) is intended to recognize the fact that the documentation requirements may be largely impossible to comply with in the context of cleared anonymous transactions by virtue of the fact that, by definition, the parties to these transactions would not know the identity their counterparties. Therefore, trading relationship documentation with any such counterparty would be unnecessary and impractical. The exception provided for in proposed Rule 15Fi–5(a)(1)(iii) is 107 See PO 00000 supra note 58 and accompanying text. Frm 00019 Fmt 4701 Sfmt 4702 4631 limited—and therefore distinguishable from the exception for cleared securitybased swap transactions—in one important respect to account for instances where a transaction is not accepted for clearing following its submission. For example, an SBS Entity may enter into a security-based swap transaction on an anonymous basis on a national securities exchange or an SBSEF, fully intending for the transaction to be submitted to, and cleared by, a clearing agency. In some cases, the transaction may be rejected by the clearing agency for reasons which the SBS Entity did not know (or had no reasonable basis to know) prior to its submission, such as possible operational or clerical errors or if one of the clearing members unintentionally exceeded its clearing limits. If a bilateral transaction continues to exist between the two counterparties (who would no longer be unknown to each other), written trading relationship documentation governing that transaction might not exist between them. Under those circumstances, the Commission preliminarily believes that the objectives of Rule 15Fi–5 would not be satisfied if the SBS Entity and its counterparty did not ultimately have written agreement on the terms of the remaining security-based swap transaction. At the same time, however, because the transaction was initially entered into on an anonymous basis, the two sides might need additional time to agree to the terms of the trading relationship documentation, particularly if they previously had not engaged in any other transactions. Accordingly, the Commission is proposing that if an SBS Entity that is relying on the exception in proposed Rule 15Fi–5(a)(1)(iii) subsequently receives notice that the relevant security-based swap transaction has not been accepted for clearing by a clearing agency, the applicable policies and procedures would need to require that the SBS Entity be in compliance with the requirements of proposed Rule 15Fi–5 in all respects promptly after receipt of such notice.108 The Commission notes that whether a contract that has not been accepted for 108 The provisions in proposed Rule 15Fi–5(a)(iii) to account for cleared anonymous transactions that are submitted for clearing, but ultimately not accepted, are not included in CFTC Rule 23.504. We have included this provision to account for situations when an SBS Entity could be otherwise deemed to be not in compliance with proposed Rule 15Fi–5 due to a transaction being rejected for clearing for reasons which the SBS Entity did not know (or have a reasonable basis to know) prior to when the transaction was submitted to the clearing agency. E:\FR\FM\15FEP2.SGM 15FEP2 4632 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 clearing by a clearing agency continues to exist may depend on the rules of the particular SBSEF, national securities exchange, or clearing agency, or the agreement of the counterparties. If the end result is that a security-based swap continues to exist despite being rejected by the clearing agency, then the policies and procedures would need to require that the SBS Entity be in compliance with the requirements of Rule 15Fi–5 with respect to that transaction. If the rejection from clearing results in a termination or voiding of the original security-based swap, then there is no security-based swap for which it is necessary to comply with Rule 15Fi–5. 7. Comments Requested The Commission generally requests comments on all aspects of Proposed Rule 15Fi–5 (and any related definitions). In addition, the Commission requests comments on the following specific issues: • Do commenters agree with the scope of the proposed exception from the trading relationship documentation requirements in proposed Rule 15Fi–5 for clearing transactions? Why or why not? Because the definition of ‘‘clearing transactions’’ only includes transactions cleared at a clearing agency registered with the Commission pursuant to Section 17A of the Exchange Act, security-based swaps cleared at a foreign clearing agency that is not registered with the Commission would not be deemed to be ‘‘cleared’’ for these purposes, and would therefore be subject to proposed Rule 15Fi–5. Should the Commission modify the scope of the exception for cleared security-based swaps, such as by including transactions that are cleared at a clearing agency that is not registered with the Commission pursuant to Section 17A of the Exchange Act, whether because of an applicable exemption from registration or because Exchange Act does not cover the activities of the clearing agency? Why or why not? • Do commenters agree with the proposed exception from the trading relationship documentation requirements for security-based swaps executed anonymously on a national securities exchange or an SBSEF? Is it sufficiently comprehensive? Why or why not? The proposed exception also provides that if a security-based swap executed anonymously on a platform is subsequently rejected for clearing, the SBS Entity would then be required to come into compliance with the documentation requirements ‘‘promptly’’ after receipt of the notice of rejection. Do you agree with this VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 approach? Why or why not? Should the Commission define or provide an interpretation of the word ‘‘promptly’’ for these purposes or, as an alternative, specify a fixed period of time in the rule text in which SBS Entities would be required to comply with proposed Rule 15Fi–5? Why or why not and, if so, how much time should be provided? • Are there any current industry practices that relate to how counterparties to swaps and securitybased swaps treat transactions executed anonymously on a trading platform, but subsequently rejected for clearing? If any such practices exist, please describe them, including with regard to the length of time that it typically takes to document these transactions, if they remain in effect. • With respect to any Swap Entity that could potentially register with the Commission as an SBS Entity, would the documentation protocols (or any other applicable documentation) already in existence with respect to CFTC Rule 23.504 satisfy the requirements in proposed Rule 15Fi–5? Why or why not? Should proposed Rule 15Fi–5 be modified to account for the way that market participants have designed their existing protocols (or any other applicable documentation) to be compliant with the CFTC’s rules? Why or why not? For the purposes of compliance with the proposed documentation rules, should the Commission allow compliance with the CFTC’s parallel documentation rules for some period of time to allow dual SEC– CFTC registrants to conform their existing documentation protocols (or any other applicable documentation) following the adoption of proposed Rule 15Fi–5? If so, on what factors should that reliance be conditioned and how long of a compliance period should be provided? In the alternative, should the Commission delay compliance with, or establish phased compliance deadlines for, some or all of these requirements? Please explain the nature of any compliance challenges (including any additional documentation requirements), and the basis for any suggested compliance period. • As previously noted, proposed Rule 15Fi–5 has been designed to be as consistent as possible with CFTC Rule 23.504, which imposes trading relationship documentation requirements on Swap Entities, in order to avoid requiring dual SEC–CFTC registrants to incur additional systems or compliance costs due to differences between the two agencies’ approaches. To the extent that any such differences remain, should the Commission consider, for any firm dually-registered PO 00000 Frm 00020 Fmt 4701 Sfmt 4702 as both an SBS Entity and Swap Entity (regardless of whether such firm is also registered with the Commission as a broker-dealer or with the CFTC as a futures commission merchant), permitting such firm to comply with proposed Rule 15Fi–5 on an ongoing basis by complying with CFTC Rule 23.504, as if such rule applied to security-based swaps? If so, what conditions, if any, should be placed on such reliance? • In addition to the exceptions set forth in the proposed rule, are there other types of security-based swaps that should not be subject to the underlying trading relationship documentation requirements? • Should the Commission require that the policies and procedures governing the required written security-based swap trading relationship documentation be approved by a senior officer of the SBS Entity, as is currently contemplated pursuant to proposed Rule 15Fi–5? Why or why not? As an alternative to requiring action by a senior officer, should such approval come instead from the governing body of the SBS Entity? Why or why not? As an additional alternative, should the Commission consider requiring approval of those policies and procedures by someone below the senior officer level? If so, who within an SBS Entity should approve them? • For purposes of the requirement that a senior officer approve the policies and procedures required by proposed Rule 15Fi–5, the Commission has preliminarily interpreted the term ‘‘senior officer’’ as covering only the most senior executives in the organization, such as a firm’s chief executive officer, chief financial officer, chief legal officer, chief compliance officer, president, or other person at a similar level. Do commenters agree with such interpretation? Why or why not? Does the proposed interpretation create any differences with respect to the manner in which Swap Entities are required to comply with CFTC Rule 23.504(a)(2), which uses the term ‘‘senior management’’? Should the explanation included in the Commission’s proposed interpretation instead be included in the rule text? • Proposed Rule 15Fi–5 does not contain a comprehensive list of all of the terms that should be addressed in the required security-based swap trading relationship documentation. Rather, it provides that the documentation must include ‘‘all terms governing the trading relationship’’ between the SBS Entity and its counterparty and also contains a nonexclusive list of terms that must be E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules included. Do commenters agree with that approach? Why or why not? Should the Commission consider modifying the list of terms specifically identified in proposed Rule 15Fi–5(b)(1)? • Should the Commission provide any additional specificity and/or guidance as it relates to one or more of the terms identified in proposed Rule 15Fi–5(b)(1) as required to be included in the trading relationship documentation? For example, should the rule specify the types of payment obligation terms that should be addressed in the documentation? Are there any particular details regarding potential events of default or termination events that should be specified in the documentation? Should the information requirements regarding the terms of the credit support arrangements between the two parties be modified in any way? In each case, why or why not and what additional details or guidance should be provided? • Proposed Rule 15Fi–5(b)(1) requires that the security-based swap trading relationship documentation that SBS Entities execute with the counterparties include terms addressing dispute resolution. Should the Commission provide any additional specificity with respect to this proposed requirement, including by identifying what particular aspects of the dispute resolution process should be addressed in the documentation? For example, should the documentation include specific requirements regarding the methods for identifying, recording, and monitoring disputes? Should the terms governing dispute resolution identify specific time periods applicable to the process? Are there particular aspects regarding communications between the counterparties that should be specified in connection with the terms related to dispute resolution, such as the method for providing notice of a potential or actual dispute? In each case, why or why not, and what additional details or guidance should be provided? • Proposed Rule 15Fi–5(b)(4) would require SBS Entities to include in their security-based swap trading relationship documentation with certain counterparties written agreement on the terms for valuing security-based swaps for the purposes of complying with the margin and risk management requirements. Do you agree with the scope of that requirement? Why or why not? Should these requirements apply to an SBS Entity’s transactions with all counterparties, including non-financial counterparties, without regard to whether they are requested? Why or why not? Is there any additional information that should be included in VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 this requirement, or should any of the proposed requirements be modified or deleted? Do the provisions related to valuation discrepancies provide a sufficient basis for helping to ensure that disputes related to the value of a security-based swap are resolved in as efficient a manner as possible, or should any changes be made to these requirements? Should the requirements regarding valuation be modified in any way to account for the use of internal and/or proprietary inputs and models? In each case, why or why not, and how and why should the proposed rule be modified? • Are the protections in the proposed rule regarding the treatment of confidential, proprietary information in connection with the required valuation agreement sufficient to meet the needs of both the party providing the information and the party receiving it? If not, how should the proposal be revised to address any such concerns? • In addition to the terms governing the valuation agreement in proposed Rule 15Fi–5(b)(4), are there any other requirements that should be limited to, or modified for, certain types of counterparties (e.g., financial counterparties)? If so, which ones, and what particular requirements should apply? • Do the disclosure requirements in paragraphs (5) and (6) of proposed Rule 15Fi–5(b), as they relate to the ‘‘insured depository institution’’ or ‘‘financial company’’ status of the SBS Entity or its counterparty and to the status of a security-based swap accepted for clearing, respectively, provide useful and relevant information to counterparties to security-based swaps? Why or why not? Should any other disclosure requirements be modified or deleted? If so, which ones and how? Should any additional disclosure requirements be added to the proposed rule? If so, what should be added and why? • Do commenters agree with the scope of the proposed definition of ‘‘financial counterparty’’ in proposed Rule 15Fi–1(g), which is used for determining when the required securitybased swap trading relationship documentation would need to include the valuation methodology set forth in proposed Rule 15Fi–5(b)(4)? Should that definition be expanded to include other types of financial entities, such as SECregistered broker-dealers, investment companies, or investment advisers? If so, which types of entities should be added to the definition and why? • Do commenters agree with the proposed requirements related to the performance of periodic audits of the PO 00000 Frm 00021 Fmt 4701 Sfmt 4702 4633 SBS Entity’s security-based swap relationship documentation, as set forth in proposed Rule 15Fi–5(c)? Why or why not? If not, how should they be clarified? Should the Commission provide any additional specificity regarding what constitutes ‘‘independence’’ for these purposes? If so, how should that standard be measured and evaluated? For example, the Commission has extensive experience with respect to determining what constitutes ‘‘independence’’ in the context of accountants that audit and review financial statements and prepare attestation reports filed with the Commission, including in connection with rules adopted pursuant to Title II of the Sarbanes-Oxley Act of 2002. Should the Commission consider leveraging particular aspects of that experience in connection with refining the requirements in proposed Rule 15Fi–5(c)? If so, please explain. • Are there any circumstances under which an internal auditor could be considered to be ‘‘independent’’ for purposes of proposed Rule 15Fi–5(c)? If so, please explain. If not, should the Commission consider eliminating the requirement that the auditor be independent in order to allow for internal audits of the SBS Entity’s security-based swap relationship documentation? If so, are there particular conditions that should be included in the requirement in order to maintain the integrity of the audit process? • Should the person performing the audit of the SBS Entity’s security-based swap relationship documentation pursuant to proposed Rule 15Fi–5(c) be subject to any qualification requirements, such as the requirement to be registered with the Public Company Accounting Oversight Board (‘‘PCAOB’’)? If so, which qualifications should be required and why? If not, should proposed Rule 15Fi–5(c) be clarified to state explicitly that PCAOB registration is not a condition of the rule? • Should SBS dealers and major SBS participants be treated the same for purposes of the portfolio reconciliation requirements in proposed Rule 15Fi–5? Why or why not? E. Verification of Transaction Data by SDRs In light of certain of the rules we are proposing today, the Commission believes it to be an appropriate time to revisit and request comment on an issue previously identified in connection with the rules applicable to the registration and ongoing regulation of SDRs. As background, Section 13(n) of the E:\FR\FM\15FEP2.SGM 15FEP2 4634 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 Exchange Act establishes a regulatory regime for the operation of and governance of SDRs.109 Among other things, Section 13(n)(5)(B) requires each registered SDR to ‘‘confirm with both counterparties to the security-based swap the accuracy of the data that was submitted.’’ 110 On February 15, 2015, the Commission adopted Rules 13n–1 to 13n–12, which govern the SDR registration process, duties, and core principles.111 Among other core principles governing the registration and ongoing obligations of SDRs, Rule 13n–4(b)(3) implements the statutory requirement set forth in Section 13(n)(5)(B) by requiring SDRs to confirm, as prescribed in Rule 13n–5, with both counterparties to the securitybased swap the accuracy of the data that was submitted.112 As part of the process of implementing the SDR rules, at least one former SDR applicant expressed reservations and concerns about the burdens of requiring SDRs to reach out to counterparties who are not its members to verify accuracy of the data.113 The Commission understands these concerns and the difficulty SDRs could face when attempting to contact counterparties to a security-based swap transaction with whom the SDR has no existing relationship. At the same time, however, the Commission also recognizes the importance of ensuring that the security-based swap data reported to an SDR is complete and accurate. 109 Section 3(a)(75) of the Exchange Act defines the term ‘‘security-based swap data repository’’ to mean ‘‘any person that collects and maintains information or records with respect to transactions or positions in, or the terms and conditions of, security-based swaps entered into by third parties for the purpose of providing a centralized recordkeeping facility for security-based swaps.’’ 15 U.S.C. 78c(a)(75). 110 See 15 U.S.C. 78m(n)(5). 111 See Security-Based Swap Data Repository Registration, Duties, and Core Principles, Exchange Act Release No. 74246 (Feb. 11, 2015), 80 FR 14437 (Mar. 19, 2015) (‘‘SDR Adopting Release’’). 112 See 17 CFR 240.13n–4(b)(3). 113 See, e.g., Letter from Michael C. Bodson, President and Chief Executive Officer, The Depository Trust & Clearing Corporation, and Larry E. Thompson, Chairman, DTCC Data Repository (U.S.) LLC (‘‘DDR’’), Managing Director and Vice Chairman, The Depository Trust & Clearing Corporation, dated Sept. 22, 2017, regarding DDR’s application for registration as an SDR (withdrawn on Mar. 27, 2018), available at: https:// www.sec.gov/comments/sbsdr-2016-02/ sbsdr201602-2590214-161092.pdf (noting the difficulty an SDR faces with respect to outreach to the non-reporting side of a security-based swap when that non-reporting counterparty is not a member of an SDR and proposing that Section 13(n)(5)(B) and corresponding Rule 13n–4(b)(3) be interpreted as requiring SDRs to confirm the accuracy of the security-based swap solely with counterparties who are its members). VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 Accordingly, the Commission preliminarily believes that certain provisions in proposed Rules 15Fi–3 and 15Fi–5, if adopted and taken together, could be relevant to SDRs in seeking to meet their obligations under Section 13(n)(5)(B) and Rule 13n– 4(b)(3). As we explained in connection with adopting the SDR rules, SDRs may be able to reasonably rely on certain third parties to address the accuracy of the transaction data.114 For example, the Commission previously stated that if an SDR develops reasonable policies and procedures that rely on confirmations completed by another entity, such as a third-party confirmation provider, as long as such reliance is reasonable the SDR could use such confirmation to fulfill its obligations under certain SDR rules.115 Because the two relevant provisions that we are proposing today generally relate to the obligation of SBS Entities to take certain steps in the reconciliation and documentation processes related specifically to the reporting of the relevant security-based swap data to an SDR, including by clarifying the reporting obligations of the counterparties, the Commission believes that, like the previous example, these measures, taken together, could provide an SDR with a set of factors to assess the reasonableness of relying on an SBS Entity’s ability to independently provide the definitive report of a given security-based swap position, thereby providing a basis for the SDR to satisfy its statutory and regulatory obligations to verify the accuracy of the reported data when the SBS Entity’s counterparty is not a member of the SDR. The Commission requests comment on whether this preliminary analysis is accurate. the Exchange Act.116 With respect to all other security-based swaps within a security-based swap portfolio, the definition of ‘‘material terms’’ would exclude any term that is not relevant to the ongoing rights and obligations of the parties and the valuation of the securitybased swap. As we also previously noted in Section I.B.2, the Commission preliminarily believes that there are potential benefits, both to SBS Entities and potentially to the security-based swap market as a whole, of requiring firms to initially reconcile all of the information required to be reported to an SDR. Specifically, doing so helps to ensure that the data reported to an SDR, and ultimately disseminated to the public, is accurate and complete. Section 13(n)(5)(B) of the Exchange Act and Rule 13n–4(b)(3) are both intended to accomplish the same objective of transparency regarding complete and accurate security-based swap data. Accordingly, like the previous example involving the third-party confirmation process, it may be appropriate to allow an SDR to meet its obligations by reasonably relying on an SBS Entity. Such reliance could be based, at least in part, on that fact that the SBS Entity would be subject to the portfolio reconciliation requirements in proposed Rule 15Fi–3 using the proposed definition of ‘‘material terms’’ in Rule 15Fi–1(i), were it to be adopted, to initially reconcile all of the terms of a transaction required to be reported to an SDR or the Commission pursuant to Rule 901, particularly in cases when the SBS Entity’s counterparty is not onboarded to the SDR.117 The Commission seeks comment on whether this preliminary analysis is accurate. 1. Reconciliation of Terms Submitted to an SDR As described above in Section I.B.2, the definition of ‘‘material terms’’ in proposed Rule 15Fi–1(i), which identifies the information that SBS Entities would be required to reconcile with their counterparties, differs based on whether a security-based swap transaction had previously been included in a security-based swap portfolio for purposes of the portfolio reconciliation requirements in proposed Rule 15Fi–3. With respect to any security-based swap that has not yet been reconciled as part of, a securitybased swap portfolio, ‘‘material terms’’ would be defined to mean each term that is required to be reported to a registered SDR under Rule 901 under 2. Documentation of Regulatory Reporting Obligations As discussed above in Section I.D, proposed Rule 15Fi–5 would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to ensure that it executes written security- 114 Cf. SDR Adopting Release, 80 FR at 14491. id. 115 See PO 00000 Frm 00022 Fmt 4701 Sfmt 4702 116 See proposed Rule 15Fi–1(i)(1) (referencing 17 CFR 242.901). 117 The Commission also notes that Rule 905(a) of Regulation SBSR, which was adopted in 2015, generally imposes a duty to correct on any counterparty to a security-based swap (or any other person having a duty to report the security-based swap) that discovers an error in the information reported with respect to that security-based swap. See 17 CFR 242.905(a). Accordingly, if any discrepancies are identified in the course of satisfying the portfolio reconciliation requirements contained in proposed Rule 15F–3 that resulted in incorrect information having been reported to an SDR, then the SBS Entity would be required to follow the procedures set forth in Rule 905(a) to correct any erroneous information with the SDR. E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 based swap trading relationship documentation with each of its counterparties prior to, or contemporaneously with, executing a security-based swap with any counterparty. Paragraph (b)(1) of that rule requires that the trading relationship documentation be in writing and also sets forth the minimum set of items that must be addressed by the documentation including, among other things, the allocation of any applicable regulatory reporting obligations (including pursuant to Regulation SBSR).118 Rule 901(a) of Regulation SBSR establishes a ‘‘reporting hierarchy’’ that specifies which counterparty to a security-based swap has the duty to report the transaction. Where possible, the rule assigns the reporting duty to the side that is registered with the Commission as an SBS Entity. Thus, if only one of the counterparties to a security-based swap transaction is an SBS Entity, then such SBS Entity will be the reporting side. In addition, if one counterparty to a security-based swap transaction is an SBS dealer and the other is a major SBS participant, the SBS dealer will be the reporting side. However, if both counterparties to a security-based swap transaction are SBS dealers (or both are major SBS participants), the sides are required to select the reporting side. The selection of the reporting side is an example of the type of ‘‘applicable reporting obligation’’ that proposed Rule 15Fi– 5(b)(1) would cover. Accordingly, the Commission preliminarily believes that requiring SBS Entities to address any applicable regulatory reporting obligations in the written trading relationship documentation that it executes with their counterparties also could be relevant to SDRs in seeking to meet their obligations under Section 13(n)(5)(B) and Rule 13n–4(b)(3). For example, to the extent that only one counterparty to a security-based swap is an SBS Entity, the trading relationship documentation could be used to memorialize the fact that the SBS Entity is the reporting party for purposes of Rule 901(a), and that such SBS Entity will be responsible for verifying the accuracy of each securitybased swap transaction with the SDR. 3. Comments Requested The Commission generally requests comments on the issues described above. In addition, the Commission requests comments on the following specific issues: 118 See 17 CFR 242.901(a). VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 • Do you agree with the analysis described above, particularly as to how parts of proposed Rules 15Fi–3 (including the definition of ‘‘material terms’’ in proposed Rule 15Fi–1(i)) and 15Fi–5 could help address the concerns raised by former SDR applicants with respect to their obligations, pursuant to Section 13(n)(5)(B) of the Exchange Act and Rule 13n–4(b)(3), to confirm with both counterparties to a security-based swap the accuracy of the data that was submitted to the SDR? Æ Specifically, do those aspects of the proposed rules provide a sufficient basis, in whole or in part, for an SDR to assess whether it can reasonably rely on a SBS Entity’s verification of transaction data as the basis to meet the requirements of Section 13(n)(5)(B) and Rule 13n–4(b)(3)? Why or why not? Æ If not, should the Commission provide an exemption from the verification requirements described above to SDRs that reasonably rely on SBS Entities? Why or why not? If so, what specific terms and conditions should be included in such exemption and why? Æ Are there other regulatory actions the Commission should consider to address the issue? If so, which ones and why? • Should any aspect of the proposed analysis be modified in any way to account for other situations that may not be fully addressed here? If so, how and why? For example, would an SDR be able to reasonably rely on an SBS Entity to independently provide the definitive report of a given security-based swap position for both counterparties in situations when the SBS Entity is acting as agent for one of the two counterparties and is not itself a counterparty? Why or why not, and how should the analysis be revised to address that situation? F. Recordkeeping Requirements 1. Proposed Amendments to Recordkeeping Rules The Commission also is proposing rule amendments that would modify certain proposed requirements contained in its April 2014 release proposing rules for the recordkeeping, reporting, and notification requirements applicable to SBS Entities.119 Those rule amendments would require each SBS Entity to make and keep current 119 See supra note 2. Although we are proposing books and records requirements that would be additive to an existing proposal, we are not reopening the comment period for the entirety of the SBS Books and Records Proposing Release. Rather, our request for comment in this section is limited solely to the recordkeeping requirements related to the rules we are proposing today. PO 00000 Frm 00023 Fmt 4701 Sfmt 4702 4635 information relevant to each portfolio reconciliation and portfolio compression exercise in which it participates, and to retain a record of each valuation dispute notification required pursuant to proposed Rule 15Fi–3(c), all security-based swap trading relationship documentation required to be created under proposed Rule 15Fi–5, a record of the results of each audit of the SBS Entity’s securitybased swap trading relationship documentation policies and procedures, as required pursuant to proposed Rule 15Fi–5(c), and each policy and procedure created pursuant to proposed Rules 15Fi–3 through 15Fi–5. Specifically, the Commission is proposing to amend: (1) Existing Rule 17a–3 under the Exchange Act, which applies to SBS Entities that are also registered with the Commission as broker-dealers under Section 15(b) of the Exchange Act (‘‘broker-dealer SBS Entities’’), and (2) proposed Rule 18a–5 under the Exchange Act, which applies to SBS Entities that are not also registered with the Commission as broker-dealers under Section 15(b) of the Exchange Act (‘‘stand-alone and bank SBS Entities’’). These proposed amendments would require each SBS Entity to make and keep current records of each security-based swap portfolio reconciliation, whether conducted pursuant to proposed Rule 15Fi–3 or otherwise,120 a copy of each valuation dispute notification required to be provided to the Commission pursuant to proposed Rule15Fi–3(c),121 and a record of each bilateral offset and each bilateral portfolio compression exercise or multilateral portfolio compression exercise in which it participates, whether conducted pursuant to proposed Rule 15Fi–4 or otherwise.122 With respect to the reconciliation requirement, the proposed rules would require that these records include the dates of the security-based swap portfolio reconciliation, the number of portfolio reconciliation discrepancies, the number of security-based swap valuation disputes (including the timeto-resolution of each valuation dispute and the age of outstanding valuation disputes, categorized by transaction and counterparty), and the name of the third-party entity performing the security-based swap portfolio 120 See proposed amendments to Rules 17a– 3(a)(31)(i), 18a–5(a)(18)(i), and 18a–5(b)(14)(i). 121 See proposed amendments to Rules 17a– 3(a)(31)(ii), 18a–5(a)(18)(ii), and 18a–5(b)(14)(ii). 122 See proposed amendments to Rules 17a– 3(a)(31)(iii), 18a–5(a)(18)(iii), and 18a–5(b)(14)(iii). E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 4636 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules reconciliation, if any.123 With respect to the valuation notification requirement, the proposed rules would require the retention of each notification required to be provided to the Commission pursuant to proposed Rule 15Fi–3(c).124 With respect to compression, the proposed rules would require that these records include the dates of the offset or compression, the security-based swaps included in the offset or compression, the identity of the counterparties participating in the offset or compression, the results of the compression, and the name of the thirdparty entity performing the offset or compression, if any.125 The Commission preliminarily believes that requiring SBS Entities to make and retain such records will, among other things, promote compliance with proposed Rules 15Fi–3 and 15Fi–4, assist SBS Entities in the event that they need to resolve problems that relate to a previous reconciliation or compression, and assist Commission examiners in reviewing compliance with those rules. In addition, the Commission is proposing to amend (1) existing Rule 17a–4 under the Exchange Act, which requires each applicable broker-dealer, including broker-dealer SBS Entities, to preserve certain records if the brokerdealer makes or receives the type of record and (2) proposed Rule 18a–6 under the Exchange Act, which imposes parallel preservation requirements on stand-alone and bank SBS Entities. In particular, the proposed amendments to Rule 17a–4 and to proposed Rule 18a– 6 would require SBS Entities to retain all of the records required to be made and kept under the proposed amendments to Rule 17a–3 and proposed Rule 18a–5 for at least three years, the first two years in an easily accessible place.126 The proposed amendments also would require each SBS Entity to retain the following: • the written policies and procedures required pursuant to proposed Rules 15Fi–3 through 15Fi–5 until three years after termination of the use of the policies and procedures; 127 • each written agreement with counterparties on the terms of portfolio reconciliation with those counterparties as required to be created under proposed Rules 15Fi–3(a)(1) and (b)(1) until three years after the termination of the agreement and all transactions governed thereby; 128 • security-based swap trading relationship documentation with counterparties required to be created under proposed Rule 15Fi–5 until three years after the termination of such documentation and all transactions governed thereby; 129 and • a record of the results of each audit required to be performed pursuant to proposed Rule 15Fi–5(c) until three years after the completion of the audit.130 The Commission preliminarily believes that requiring the retention of the above records in accordance with the applicable rules will help ensure that those records are retained in a manner that would allow them to be readily accessible for Commission examiners. 123 See proposed amendments to Rules 17a– 3(a)(31)(i), 18a–5(a)(18)(i), and 18a–5(b)(14)(i). 124 See proposed amendments to Rules 17a– 3(a)(31)(ii), 18a–5(a)(18)(ii), and 18a–5(b)(14)(ii). 125 See proposed amendments to Rules 17a– 3(a)(31)(iii), 18a–5(a)(18)(iii), and 18a–5(b)(14)(iii). 126 See proposed amendments to Rules 17a– 4(b)(1), 18a–6(b)(1)(i), and 18a–6(b)(2)(i). 127 See proposed amendments to Rules 17a– 4(e)(10) and 18a–6(d)(4). 128 See proposed amendments to Rules 17a– 4(e)(11)(i) and 18a–6(d)(5)(i). 129 See proposed amendments to Rules 17a– 4(e)(11)(ii) and 18a–6(d)(5)(ii). 130 See proposed amendments to Rules 17a– 4(e)(11)(iii) and 18a–6(d)(5)(iii). 131 See Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 2. Comments Requested The Commission generally requests comments on all aspects of the proposed amendments to Rules 17a–3 and 17a–4 and to proposed Rules 18a–5, and 18a– 6. In addition, the Commission requests comments on the following specific issues: • Has the Commission provided sufficient guidance regarding the scope of the proposed recordkeeping amendments? Are there aspects of the proposed amendments for which the Commission should consider providing additional guidance? If so, please explain. • How do the types of records that would need to be made and kept current under Rule 17a–3 and proposed Rule 18a–5, in each case as proposed to be amended in this release, align with the types of records that a futures commission merchant or a swap dealer is required to make pursuant to CFTC regulations? II. Cross-Border Application of Rules 15Fi–3 Through 15Fi–5. A. Background on the Cross-Border Application of Title VII Requirements In 2013, the Commission proposed rules and interpretive guidance to address the cross-border application of Title VII, including requirements applicable to SBS Entities.131 In that PO 00000 Frm 00024 Fmt 4701 Sfmt 4702 proposal, the Commission preliminarily interpreted the Title VII requirements associated with registration to apply generally to the activities of registered entities.132 The Commission further proposed a taxonomy to classify requirements under Section 15F of the Exchange Act as applying at either the transaction-level or at the entitylevel.133 The Commission took the preliminary view that transaction-level requirements under Section 15F of the Exchange Act are those that primarily focus on protecting counterparties to security-based swap transactions by requiring SBS dealers to, among other things, provide certain disclosures to counterparties, adhere to certain standards of business conduct, and segregate customer funds, securities, and other assets.134 In contrast to transaction-level requirements, the Commission preliminarily took the view that entitylevel requirements under Section 15F of the Exchange Act are those that are expected to play a role in ensuring the safety and soundness of the entity and thus relate to the SBS Entity as a whole.135 Entity-level requirements include capital and margin requirements, as well as other requirements relating to a firm’s identification and management of its risk exposure, such as the requirements in Section 15F(i) of the Exchange Act, which provides the statutory basis for the rules the Commission is proposing in this release.136 Because these requirements relate to the entire entity, the Commission proposed to apply them to SBS Entities on a firm-wide basis, without exception.137 Major Security-Based Swap Participants, Exchange Act Release No. 69490 (May 1, 2013), 78 FR 30968 (May 23, 2013) (‘‘Cross-Border Proposing Release’’) (discussing joint rulemaking to further define various Title VII terms). 132 See id. at 30986 (‘‘We are proposing to apply the Title VII requirements associated with registration (including, among others, capital and margin requirements and external business conduct requirements) to the activities of registered entities to the extent we have determined that doing so advances the purposes of Title VII.’’) (footnotes omitted). 133 See id. at 31009–10. 134 Id. 135 See id. at 31011. 136 See id. at 31011–16 (addressing the classification of capital and margin requirements, as well as of the documentation standard requirements of Section 15F(i) of the Exchange Act and other risk management requirements applicable to SBS dealers). 137 See id. at 31011, 31024–25. See also id. at 31035 (applying the analysis to major SBS participants). In reaching this conclusion, the Commission explained that it ‘‘preliminarily believes that entity-level requirements are core requirements of the Commission’s responsibility to ensure the safety and soundness of registered security-based swap dealers,’’ and that ‘‘it would E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules The Commission first applied this taxonomy with respect to the rules adopted pursuant to Section 15F(i) of the Exchange Act in 2016 when we adopted rules to implement business conduct standards for SBS Entities.138 The Commission subsequently determined that the trade acknowledgment and verification rules would apply at the entity-level.139 The Commission has not, however, proposed or adopted a cross-border interpretation with respect to the portfolio reconciliation, portfolio compression, and trading relationship documentation requirements that we are now proposing. amozie on DSK3GDR082PROD with PROPOSALS2 B. Proposed Cross-Border Interpretation Consistent with its approach in both the Cross-Border Proposing Release and the Trade Acknowledgement and Verification Adopting Release, the Commission believes that the requirements being proposed in this release pursuant to Section 15F(i) of the Exchange Act—as they relate to portfolio reconciliation, portfolio compression, and trading relationship documentation—should be treated 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. The Commission preliminarily believes that the requirements referenced above play an important role in addressing risks to the SBS Entity as a whole, including risks related to the entity’s safety and soundness. As we have noted throughout this release in connection with describing each of the proposed rules, providing SBS Entities not be consistent with this mandate to provide a blanket exclusion to foreign security-based swap dealers from entity-level requirements applicable to such entities.’’ Id. at 31024 (footnotes omitted). The Commission further expressed the preliminary view that concerns regarding the application of entitylevel requirements to foreign SBS dealers would largely be addressed through the proposed approach to substituted compliance. See id. 138 See Business Conduct Standards for SecurityBased Swap Dealers and Major Security-Based Swap Participants, Release No. 77617 (Apr. 14, 2016), 81 FR 29960, 30061–69 (May 13, 2016) (‘‘Business Conduct Standards Adopting Release’’). Under this framework, rules relating to diligent supervision pursuant to Section 15F(h)(1)(B), those relating to the chief compliance officer under Section 15F(k) of the Exchange Act, and those relating to certain risk management requirements under Section 15F(j) of the Exchange Act were determined to be entity-level requirements that apply to an SBS Entity’s business with foreign counterparties to the same extent that they apply to the SBS dealer’s or major SBS participant’s U.S. business. The remaining rules were determined to apply at the transaction-level. 139 See Trade Acknowledgment and Verification Adopting Release, 81 FR at 39826. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 and their counterparties to securitybased swap transactions with the ability to identify and resolve discrepancies involving key terms of their transactions—which is a key consideration underpinning both the proposed portfolio reconciliation and trading relationship documentation requirements—serves as an important mechanism for allowing SBS Entities and their counterparties to manage their internal risks.140 Similarly, portfolio compression is intended to help SBS Entities and their counterparties in security-based swap transactions manage their post-trade risks in a number of important ways, including by eliminating redundant uncleared derivatives transactions (as measured both by the number of contracts and total notional value) and potentially reducing a market participant’s credit risk to its direct counterparties, including by eliminating all outstanding transactions with some counterparties, without affecting the market participant’s overall economic position.141 An alternative approach that does not require an SBS Entity to take steps to manage its internal risk using portfolio reconciliation, compression, or standards governing trading relationship documentation could be expected to contribute to operational risk and legal uncertainty throughout the firm’s entire security-based swap business, affecting the entity’s business as a whole, and not merely specific security-based swap transactions. For example, as we have previously noted, inaccurate or incomplete trading relationship documentation could lead to, among other things, a collateral dispute between the counterparties to a securitybased swap transaction. The larger the dispute, even if confined to a single counterparty, the greater the risk that an SBS Entity could experience liquidity problems on a firmwide basis. Moreover, to the extent that these risks affect the safety and soundness of the SBS Entity, they also may affect the firm’s counterparties and the functioning of the broader securitybased swap market. Continuing with the previous example, if a collateral dispute with a foreign counterparty creates liquidity issues throughout an SBS Entity, the firm could experience difficulty making payments or posting collateral to its other counterparties, which may include U.S. persons. Accordingly, the Commission preliminarily believes that it is appropriate to apply the proposed 140 See 141 See PO 00000 supra note 14 and accompanying text. supra notes 62–63 and accompanying text. Frm 00025 Fmt 4701 Sfmt 4702 4637 requirements to the entirety of an SBS Entity’s security-based swap business.142 C. Comments Requested The Commission generally requests comments on its interpretative guidance regarding the cross-border application of Proposed Rules15Fi–3 through 15Fi–5. In addition, the Commission requests comments on the following specific issues: • Does the proposed approach appropriately treat the proposed portfolio reconciliation, portfolio compression, and trading relationship documentation requirements as entitylevel requirements applicable to the entire business conducted by foreign SBS Entities? If not, please identify any particular aspects of those proposed rules that should not be applied to a foreign SBS Entity, or applied only to specific transactions, and explain how such an approach would be consistent with the goals of Title VII. • Should the Commission apply the same cross-border approach to the application of the proposed portfolio reconciliation, portfolio compression, and trading relationship documentation requirements for both SBS dealers and major SBS participants? If you believe that the approach should vary based on the type of SBS Entity involved, please describe how the cross-border approach for SBS dealers should differ from the cross-border approach for major SBS participants, and explain the justification for any potential differences in approach. • What types of conflicts might a foreign SBS Entity face if subjected to the proposed portfolio reconciliation, portfolio compression, and trading relationship documentation requirements in more than one jurisdiction? In what situations would compliance with more than one of these requirements be difficult or impossible? • As an alternative to treating the proposed requirements as entity-level requirements, should the Commission instead follow the approach taken by the CFTC and treat the proposed portfolio reconciliation, portfolio compression, and trading relationship documentation requirements (or some combination of the three) as transactionlevel requirements? If so, to which cross-border security-based swap 142 We recognize that the CFTC has taken a different position with regard to corresponding requirements pursuant to the CEA, classifying them as what the CFTC has termed ‘‘Category A’’ transaction-level requirements. See CFTC Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations, 78 FR 45292, 45334 (Jul. 26, 2013). E:\FR\FM\15FEP2.SGM 15FEP2 4638 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules transactions should these requirements apply and why? Please describe how these requirements would apply differently if classified as transactionlevel requirements instead of as entitylevel requirements. Please also describe any practical challenges that would be presented by classifying them differently from the CFTC. III. Availability of Substituted Compliance for Rules 15Fi–3 Through 15Fi–5 A. Existing Substituted Compliance Rule amozie on DSK3GDR082PROD with PROPOSALS2 In 2016, the Commission adopted Rule 3a71–6 under the Exchange Act to provide that non-U.S. SBS Entities could satisfy applicable business conduct requirements under Section 15F by complying with comparable regulatory requirements of a foreign jurisdiction, subject to certain conditions. The rule in part provides that the Commission shall not make a determination providing for substituted compliance unless the Commission determines, among other things, that the foreign regulatory requirements are comparable to otherwise applicable requirements.143 In adopting that substituted compliance rule, the Commission addressed a range of issues and concerns that commenters had raised in response to the substituted compliance proposal that was set forth in the Cross-Border Proposing Release. When the Commission adopted this substituted compliance rule that solely addressed the business conduct rules, it stated that it expected to assess the potential availability of substituted compliance in connection with other requirements when the Commission considers final rules to implement those requirements.144 Consistent with that statement, the Commission subsequently amended Rule 3a71–6 in the Trade Acknowledgment and Verification Adopting Release to provide SBS Entities with the potential to avail themselves of substituted compliance to satisfy the Title VII trade 143 See Business Conduct Standards Adopting Release, 81 FR at 30074. 144 The Commission first addressed the potential for allowing market participants to satisfy certain Title VII requirements by complying with comparable foreign rules as a substitute in 2013 as part of the Cross-Border Proposing Release. Pursuant to that release, the Commission proposed making substituted compliance potentially available in connection with the requirements applicable to SBS dealers pursuant to Section 15F of the Exchange Act, other than the registration requirements applicable to dealers. See CrossBorder Proposing Release, 78 FR at 31088, 31207– 08 (proposed Rule 3a71–5). VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 acknowledgment and verification requirements.145 B. Proposed Amendment to Rule 3a71– 6 The Commission is proposing to further amend Rule 3a71–6 to provide SBS Entities that are not U.S. persons (as defined in Rule 3a71–3(a)(4) of the Exchange Act) with the potential to avail themselves of substituted compliance to satisfy the Title VII portfolio compression, portfolio reconciliation, and trading relationship documentation requirements. In proposing to amend the rule, the Commission has preliminarily concluded that the principles associated with substituted compliance, as previously adopted in connection with both the business conduct requirements and the trade acknowledgement and verification requirements, in large part should similarly apply to the portfolio compression, portfolio reconciliation, and trading relationship documentation requirements we are proposing today. Accordingly, except as discussed below, the proposed substituted compliance rule would apply to the portfolio compression, portfolio reconciliation, and trading relationship documentation requirements in the same manner as it already applies to the business conduct requirements and the trade acknowledgement and verification requirements.146 1. Basis for Substituted Compliance in Connection With the Portfolio Reconciliation, Portfolio Compression, and Trading Relationship Documentation Requirements In light of the global nature of the security-based swap market and the prevalence of cross-border transactions within that market, there is the potential that the application of the Title VII portfolio compression, portfolio reconciliation, and trading relationship documentation requirements may lead to requirements that are duplicative of, or in conflict with, applicable foreign requirements, even when the two sets of requirements implement similar goals and lead to similar results. Those results have the potential to disrupt existing business relationships and, more 145 See Trade Acknowledgment and Verification Adopting Release, 81 FR at 39827–28. 146 The discussions in the Business Conduct Standards Adopting Release, including those regarding consideration of supervisory and enforcement practices (see id. at 30079), regarding certain multi-jurisdictional issues (see id. at 30079– 80), and regarding application procedures (see id. at 30080–81) are applicable to the proposed portfolio compression, portfolio reconciliation, and trading relationship documentation requirements. PO 00000 Frm 00026 Fmt 4701 Sfmt 4702 generally, to reduce competition and market efficiency.147 To address those effects, the Commission preliminarily believes that under certain circumstances it may be appropriate to allow the possibility of substituted compliance, whereby market participants may satisfy the proposed portfolio compression, portfolio reconciliation, and trading relationship documentation requirements by complying with comparable foreign requirements. Allowing for the possibility of substituted compliance in this manner may be expected to help achieve the benefits of those particular risk mitigation requirements—helping to curb legal uncertainty and reduce credit and operational risk for participants in security-based swap transactions and in the broader market—in a way that helps avoid regulatory conflict and minimizes duplication, thereby promoting market efficiency, enhancing competition, and contributing to the overall functioning of the global security-based swap market. Accordingly, the Commission is proposing to amend paragraph (d) of Rule 3a71–6 to identify the portfolio compression, portfolio reconciliation, and trading relationship documentation requirements of Title VII as being potentially eligible for substituted compliance.148 2. Comparability Criteria, and Consideration of Related Requirements As discussed when we first adopted Rule 3a71–6—and reiterated when we amended the rule pursuant to the Trade Acknowledgement and Verification Adopting Release—the Commission will endeavor to take a holistic approach in determining the comparability of foreign requirements for substituted compliance purposes, focusing on regulatory outcomes as a whole, rather than on a requirement-by-requirement comparison.149 Under the proposed rule, the Commission’s comparability assessments associated with the 147 See generally Business Conduct Standards Adopting Release, 81 FR at 30073–74 (addressing the basis for making substituted compliance available in the context of the business conduct requirements). 148 Paragraph (a)(1) of the rule provides that the Commission may, conditionally or unconditionally, by order, make a determination with respect to a foreign financial regulatory system that compliance with specified requirements under the foreign financial system by an SBS dealer and/or by a registered major SBS swap participant, or class thereof, may satisfy the corresponding requirements identified in paragraph (d) of the rule that would otherwise apply. 149 See Business Conduct Standards Adopting Release, 81 FR at 30078–79. See also Trade Acknowledgment and Verification Adopting Release, 81 FR at 39828. E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules portfolio compression, portfolio reconciliation, and trading relationship documentation rules accordingly will consider whether, in the Commission’s view, the foreign regulatory system achieves regulatory outcomes that are comparable to the regulatory outcomes associated with those Exchange Act requirements. Proposed new paragraph (d)(4) of Rule 3a71–6 would also provide that prior to making a substituted compliance determination in connection with the portfolio reconciliation, portfolio compression, and trading relationship documentation requirements, the Commission intends to consider whether the requirements of the foreign financial regulatory system, the duties imposed by the foreign financial regulatory system, and the information that is required to be provided to counterparties pursuant to the requirements of the foreign financial regulatory system, are comparable to those required pursuant to the applicable Exchange Act provisions. In application, the Commission may determine to conduct its comparability analyses regarding the portfolio reconciliation, portfolio compression, and trading relationship documentation requirements in conjunction with comparability analyses regarding other Exchange Act requirements that, like the requirements we are proposing today, promote risk mitigation in connection with SBS Entities. Accordingly, depending on the applicable facts and circumstances, the comparability assessment associated with the portfolio reconciliation, portfolio compression, and trading relationship documentation requirements may constitute part of a broader assessment of Exchange Act risk mitigation requirements, and the applicable comparability decisions may be made at the level of those risk mitigation requirements as a whole.150 amozie on DSK3GDR082PROD with PROPOSALS2 3. Comments Requested The Commission generally requests comments on all aspects of the proposed amendment to Rule 3a71–6. In addition, 150 We have not proposed rules making substituted compliance available specifically with respect to the amendments we are proposing to proposed Rules 18a–5 and 18a–6, which specify the recordkeeping, reporting, and notification requirements applicable to SBS Entities. Rather, to the extent that substituted compliance is made available with respect to those rules, we would anticipate that any determination made with respect to the comparability of the foreign financial regulatory system would address all aspects of the Commission recordkeeping, reporting, and notification requirements for SBS Entities including any amendments that we ultimately adopt with respect to the portfolio reconciliation, portfolio compression, and trading relationship document requirements. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 the Commission requests comments on the following specific issues: • Should the Commission provide SBS Entities with the potential to avail themselves of substituted compliance to satisfy the Title VII portfolio reconciliation, portfolio compression, and trading relationship requirements? Why or why not? If you believe that substituted compliance should not be available with respect to these requirements, how would you distinguish this policy decision from the Commission’s previous determination to make substituted compliance potentially available with respect to other Title VII requirements (i.e., the business conduct rules and the trade acknowledgment and verification rules)? • Do commenters agree with the scope and language of the proposed amendment to Rule 3a71–6? Why or why not? Are there aspects of the scope of the proposed rule for which the Commission should consider providing additional guidance? If so, what additional guidance should be provided and why? • Are the items identified in the proposed amendment to Rule 3a71–6 as factors the Commission will consider prior to making a substituted compliance determination in connection with the portfolio reconciliation, portfolio compression, and trading relationship documentation requirements appropriate? Why or why not? Should any of those items be modified or deleted? Should additional considerations be added? If so, please explain. IV. General Request for Comment We request and encourage any interested person to submit comments regarding the proposed rules, specific issues discussed in this release, and other matters that may have an effect on the proposed rules. With regard to any comments, we note that such comments are of particular assistance to our rulemaking initiative if accompanied by supporting data and analysis of the issues addressed in those comments. In addition, we would appreciate any comments related to the comparability of the rules we are proposing today and the corresponding CFTC rules already in effect, including whether certain aspects of the proposed rules should be modified to more fully conform to the CFTC’s rules. In comparing the two sets of rules, commenters are encouraged to identify any areas where the proposed rules may not be sufficiently aligned with the corresponding CFTC rules, such that they could impose unnecessary burdens (with respect to PO 00000 Frm 00027 Fmt 4701 Sfmt 4702 4639 documentation or otherwise) on persons likely to register with the Commission as SBS Entities who are also registered with the CFTC as Swap Entities. V. Paperwork Reduction Act The Paperwork Reduction Act of 1995 (‘‘PRA’’) 151 imposes certain requirements on federal agencies in connection with the conducting or sponsoring of any ‘‘collection of information.’’ 152 For example, 44 U.S.C. 3507(a)(1)(D) provides that before adopting (or revising) a collection of information requirement, an agency must, among other things, publish a notice in the Federal Register stating that the agency has submitted the proposed collection of information to the Office of Management and Budget (‘‘OMB’’) and setting forth certain required information, including: (1) A title for the collection information; (2) a summary of the collected information; (3) a brief description of the need for the information and the proposed use of the information; (4) a description of the likely respondents and proposed frequency of response to the collection of information; (5) an estimate of the paperwork burden that shall result from the collection of information; and (6) notice that comments may be submitted to the agency and director of OMB.153 Certain provisions of the proposed rules contain ‘‘collection of information’’ requirements within the meaning of the PRA. The Commission is submitting these collections of information to OMB for review in accordance with 44 U.S.C. 3507 and 5 CFR 1320.11. An agency may not conduct or sponsor, and a person is not required to respond to, a collection of information unless it displays a currently valid control number. Specifically, proposed Rules 15Fi–3, 15Fi–4, and 15Fi–5 would impose new collection of information requirements. The title of these new collections of information is, collectively, ‘‘Rules 15Fi–3—15Fi–5—Risk Mitigation Techniques for Uncleared SecurityBased Swaps.’’ OMB has not yet assigned a control number to these new collections of information. In addition, the proposals to amend Rules 3a71–6, 17a–3 and 17a–4 would amend alreadyexisting collection of information requirements. Finally, the proposals to amend proposed Rules 18a–5 and 18a– 6 would amend proposed collection of information requirements that were previously submitted to OMB for review 151 44 U.S.C. 3501 et seq. 44 U.S.C. 3502(3). 153 See 44 U.S.C. 3507(a)(1)(D); see also 5 CFR 1320.5(a)(1)(iv). 152 See E:\FR\FM\15FEP2.SGM 15FEP2 4640 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules in connection with the SBS Books and Records Proposing Release. The titles and control numbers for these collections of information are as follows: (1) Rule 17a–3—Records to be made by certain brokers and dealers (OMB control number 3235–0033); (2) Rule 17a–4—Records to be preserved by certain brokers and dealers (OMB control number 3235–0279); (3) Rule 18a–5—Records to be made by certain security-based swap dealers and major security-based swap participants (OMB control number 3235–0745); (4) Rule 18a–6—Records to be preserved by certain security-based swap dealers and major security-based swap participants (OMB control number 3235–0751); and (5) Rule 3a71–6—Substituted Compliance for Foreign Security-Based Swap Dealers (OMB control number 3235–0715). amozie on DSK3GDR082PROD with PROPOSALS2 A. Summary of Collections of Information 1. Proposed Rule 15Fi–3: Portfolio Reconciliation Proposed Rule 15Fi–3 generally would require SBS Entities to (1) engage in periodic portfolio reconciliation activities with counterparties who are also SBS Entities, and (2) establish, maintain, and follow written policies and procedures reasonably designed to ensure that they engage in periodic portfolio reconciliation with counterparties who are not SBS Entities.154 Among other things, proposed Rule 15Fi–3 would specify the requirements applicable to an SBS Entity for purposes of engaging in portfolio reconciliation with either type of counterparty (as well as the applicable definitions), with regard to (1) the information that the two sides would be required to exchange as part of the reconciliation process,155 (2) the frequency by which an SBS Entity would be required to reconcile its security-based swap portfolios with its counterparties,156 (3) the required policies and procedures specifying the means and timeframes by which an SBS Entity would be required to resolve discrepancies with respect to either the valuation or a material term of a security-based swap,157 and (4) the requirement that an SBS Entity agree in writing with each of its counterparties 154 Proposed Rule 15Fi–3 would not apply to any security-based swap that has a clearing agency as a direct counterparty. 155 See supra Section I.B.2. 156 See supra Sections I.B.3 and I.B.5. 157 See supra Sections I.B.4 and I.B.5. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 on the terms of the portfolio reconciliation, including agreement of the selection of any third-party service provider.158 Finally, proposed Rule 15Fi–3(c) would require an SBS Entity to promptly notify the Commission of any security-based swap valuation dispute in excess of $20,000,000 (or its equivalent in any other currency) if not resolved within: (1) Three business days, if the dispute is with a counterparty that is an SBS Entity; or (2) five business days, if the dispute is with a counterparty that is not an SBS Entity.159 2. Proposed Rule 15Fi–4: Portfolio Compression Proposed Rule 15Fi–4 would require SBS Entities to establish, maintain, and follow written policies and procedures related to bilateral offsetting of securitybased swaps, and periodic bilateral and multilateral compression exercises. Specifically, proposed Rules 15Fi– 4(a)(2) and (3) would require each SBS Entity to establish, maintain, and follow written policies and procedures for periodically engaging in both bilateral portfolio compression exercises and multilateral portfolio compression exercises, in each case when appropriate, with each counterparty that is an SBS Entity.160 Similarly, proposed Rule 15Fi–4(a)(1) would require each SBS Entity to establish, maintain, and follow written policies and procedures for terminating each ‘‘fully offsetting security-based swap’’ that it maintains with another SBS Entity in a timely fashion, when appropriate.161 To the extent that an SBS Entity transacts with a counterparty that is not an SBS Entity, proposed Rule 15Fi–4(b) provides that such policies and procedures would only need to address terminating each ‘‘fully offsetting security-based swap’’ or engaging in a bilateral or multilateral portfolio compression exercise, when appropriate and to the extent requested by any such counterparty.162 3. Proposed Rule 15Fi–5: Written Trading Relationship Documentation Proposed Rule 15Fi–5 would require that each SBS Entity enter into written trading relationship documentation with each of its counterparties, subject to certain exceptions, prior to, or contemporaneously with, executing a security-based swap transaction, in each case in the manner as provided for in 158 See supra Sections I.B.3 and I.B.5. supra Section I.B.6. 160 See supra Section I.C.2. 161 See supra Section I.C.3. 162 See supra Section I.C.2 and I.C.3. 159 See PO 00000 Frm 00028 Fmt 4701 Sfmt 4702 the rule.163 The proposed rule also requires that the trading relationship documentation include (1) credit support arrangements addressing certain specified items related to, among other things, margin haircuts, and custody of margin assets 164 and (2) agreements regarding the means by which the counterparties would determine the value of each security-based swap.165 The proposal also contains requirements for SBS Entities and their counterparties to disclose to each other certain information regarding their legal and bankruptcy status, and to include a statement regarding the status of a security-based swap if accepted for clearing by a CCP.166 Finally, the proposal 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.167 4. Proposed Amendments to Rules 17a– 3, 17a–4, 18a–5, and 18a–6: Books and Records Requirements Rule 17a–3 requires a broker-dealer to make and keep current certain records, and Rule 17a–4 requires a broker-dealer to preserve certain records if it makes or receives them.168 The Commission is proposing to amend these existing rules to account for the security-based swap risk mitigation activities of brokerdealers, including broker-dealer SBS Entities, by requiring the making and preserving of any required records regarding portfolio reconciliation, bilateral offsets, bilateral or multilateral portfolio compression, valuation disputes, and written trading relationship documentation. With respect to stand-alone SBS Entities, the Commission is proposing to amend proposed Rules 18a–5 and 18a–6— which were first proposed in 2014 and are themselves modeled on Rule 17a–3 and 17a–4—to account for these same risk mitigation requirements.169 163 See supra Section I.D.2. The proposed rule would require that the security-based swap trading relationship documentation address, among other things, 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, governing law, valuation and dispute resolution. 164 See id. 165 See supra Section I.D.3. 166 See supra Section I.D.4. 167 See supra Section I.D.5. 168 17 CFR 240.17a–3; 17 CFR 240.17a–4. 169 See supra Section I.F.1. E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules 5. Proposed Amendment to Rule 3a71– 6: Substituted Compliance The proposed amendment to Rule 3a71–6 would permit non-U.S. SBS Entities to comply with the proposed portfolio reconciliation, portfolio compression, and written trading relationship documentation requirements by following the comparable regulatory requirements of a foreign financial regulatory system. Specifically, the proposal would add proposed Rules 15Fi–3 through 15Fi–5 to the list of Commission requirements eligible for a substituted compliance determination and would set forth the standard by which the Commission would make such determination.170 amozie on DSK3GDR082PROD with PROPOSALS2 B. Proposed Use of Information 1. Proposed Rule 15Fi–3: Portfolio Reconciliation As previously noted, the Commission preliminarily believes that the information shared by counterparties to a security-based swap transaction periodically during the portfolio reconciliation process, as contemplated by proposed Rule 15Fi–3, will play an important role in assisting those counterparties in identifying and resolving discrepancies involving key terms of their transactions on an ongoing basis. This information also should allow those counterparties to improve their management of internal risks related to the enforcement of their rights and the performance of their obligations under a security-based swap. For example, the information obtained and provided in the course of portfolio reconciliation should help ensure that the counterparties to a security-based swap are and remain in agreement with respect to all material terms throughout the life of the transaction, thereby mitigating the possibility that a discrepancy could unexpectedly affect either side’s ability to perform any or all of its obligations under the contract, including those obligations related to the posting of collateral. Moreover, requiring SBS Entities to agree in writing with each of their counterparties on the terms of the portfolio reconciliation (including, if applicable, agreement on the selection of any third party service provider who may be performing the reconciliation) should help to minimize any discrepancies regarding the portfolio reconciliation process itself, thereby ensuring that it operates in as efficient and cost-effective means possible. Finally, the requirement to report certain unresolved valuation disputes to the Commission 170 See supra Sections III.B.1 and III.B.2. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 should assist the Commission in identifying potential issues with respect to an SBS Entity’s internal valuation methodology and also could serve as an indication of a widespread market disruption in cases where the Commission receives a large number of such notices from multiple firms. 2. Proposed Rule 15Fi–4: Portfolio Compression As previously discussed, the Commission preliminarily believes that proposed Rule 15Fi–4 would help market participants by eliminating redundant uncleared derivatives contracts, thereby potentially reducing a market participant’s credit risk to its direct counterparties, including by eliminating all outstanding contracts with some counterparties, without affecting the market participant’s overall economic position. In addition, we preliminarily believe that the proposed collection of information is expected to lead to processing improvements for market participants, as envisioned by Section 15F(i) of the Exchange Act, by virtue of the fact that both SBS Entities and their counterparties should ultimately have fewer trades to manage, maintain, and settle, resulting in fewer opportunities for processing errors, failures, or other problems that could develop throughout the lifecycle of a transaction. 3. Proposed Rule 15Fi–5: Written Trading Relationship Documentation The Commission preliminarily believes that the information required to be contained in the written trading relationship documentation pursuant to proposed Rule 15Fi–5 should help ensure that each SBS Entity mitigates risk with respect to its security-based swap portfolio by, among other things, enhancing clarity and legal certainty from the outset of a transaction regarding each party’s rights and obligations. This outcome should help to reduce exposure to, among other things, counterparty credit risk and promote agreement regarding the proper valuation and other material terms of a security-based swap. 4. Proposed Amendments to Rules 17a– 3, 17a–4, 18a–5, and 18a–6: Books and Records Requirements The Commission preliminarily expects that the information contained in the records required to be made and kept pursuant to the proposed amendments to Rules 17a–3, 17a–4, 18a–5, and 18a–6 would be used to assist the Commission in conducting effective examinations and oversight of SBS Entities. In addition, records PO 00000 Frm 00029 Fmt 4701 Sfmt 4702 4641 regarding portfolio reconciliation, bilateral offsets, bilateral or multilateral portfolio compression, valuation disputes, and written trading relationship documentation should help to provide SBS Entities and their counterparties to security-based swaps with an ability to identify and resolve discrepancies involving key terms of their transactions on an ongoing basis, allowing for better management of internal risks related to performance of obligations, valuation, margin obligations, internal valuation systems and models, or internal controls. 5. Proposed Amendment to Rule 3a71– 6: Substituted Compliance Under the proposed amendment to Rule 3a71–6 under the Exchange Act, the Commission would use the information collected to evaluate requests for substituted compliance with respect to the portfolio reconciliation, portfolio compression, and written trading relationship documentation requirements applicable to SBS Entities. C. Respondents Proposed Rules 15Fi–3 through 15Fi– 5 and Rules 17a–3, 17a–4, 18a–5, and 18a–6 would apply only to SBS Entities, each of which will be registered with the Commission. In a number of prior releases, including the release adopting the rules by which SBS Entities can register (and withdraw from registration) with the Commission, we estimated that approximately 50 entities may meet the definition of SBS dealer, and up to five entities may meet the definition of major SBS participant.171 The Commission continues to believe that these estimates are appropriate. Thus, the Commission preliminarily believes that approximately 55 entities will be required to register with the Commission under either category, and will therefore be subject to Rules 15Fi– 3 through 15Fi–5. With regard to the requirements under Rule 3a71–6, as proposed to be amended, requests for a substituted compliance determination with respect to the portfolio reconciliation, portfolio compression, and written trading relationship documentation requirements may be filed by foreign financial authorities, or by non-U.S. SBS Entities. Consistent with prior estimates, the Commission expects that there may be approximately 22 non-U.S. entities that may potentially register as SBS dealers, out of approximately 50 total 171 See SBS Entity Registration Adopting Release, 80 FR at 48990. See also Trade Acknowledgement and Verification Adopting Release, 81 FR at 39830. E:\FR\FM\15FEP2.SGM 15FEP2 4642 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules entities that may register as SBS dealers.172 Potentially, all such non-U.S. SBS dealers, or some subset thereof, may seek to rely on a substituted compliance determination in connection with these portfolio reconciliation, portfolio compression, and written trading relationship documentation requirements.173 In practice, however, the Commission expects that the greater portion of any such requests will be submitted by foreign financial authorities, given their expertise in connection with the relevant substantive requirements, and in connection with their supervisory and enforcement oversight with regard to SBS dealers and their activities. D. Total Annual Recordkeeping Burden 1. Portfolio Reconciliation Activities Generally Under proposed Rule 15Fi–3(a), the approximately 55 respondent SBS Entities would be required to reconcile security-based swap portfolios with other SBS Entities on a daily, weekly, or quarterly basis, depending upon the size of the portfolio. For purposes of this requirement, the Commission preliminarily estimates that each SBS Entity will engage in security-based swap transactions with approximately one-third of the other 54 SBS Entities, meaning that an SBS Entity will maintain security-based swap portfolios with approximately 18 SBS Entities. Of this total, we preliminarily believe that, on average, two SBS Entity counterparty portfolios will require daily reconciliation (i.e., a portfolio consisting of 500 or more uncleared security-based swaps), four SBS Entity counterparty portfolios will require weekly reconciliation (i.e., a portfolio of more than 50 but fewer than 500 uncleared security-based swaps), and the remaining 12 SBS Entity counterparty portfolios will require quarterly reconciliation (i.e. a portfolio of no more than 50 uncleared security-based swaps).174 The Commission therefore estimates that each SBS Entity will engage in an average of 760 portfolio reconciliations with other SBS Entities per year.175 The Commission preliminarily believes that each portfolio reconciliation is likely to be conducted through an automated process.176 As a result, we preliminarily believe that each reconciliation will require an average of 30 minutes to complete in total (which is the combined estimate for both counterparties), regardless of the size of the security-based swap portfolio with the applicable counterparty.177 Using these figures, the Commission preliminarily estimates that compliance with proposed Rule 15Fi–3(a), as it relates to engaging in portfolio reconciliation with other SBS Entities, will impose an average annual burden of approximately 190 hours per year on each of the respondent 55 SBS Entities, for an estimated average annual burden of 10,450 hours in the aggregate. These calculations are summarized in PRA Table 1, below. amozie on DSK3GDR082PROD with PROPOSALS2 PRA TABLE 1—PROPOSED RULE 15i–3(a): PORTFOLIO RECONCILIATIONS WITH OTHER SBS ENTITIES Hourly burden per reconciliation (hours) Total annual burden (hours) Number of counterparties per respondent Number of annual reconciliations 2 (≥500 transactions) .................................................................... 4 (>50<500 transactions) .............................................................. 12 (≤50 transactions) .................................................................... 252 (daily) ..................................................................................... 52 (weekly) .................................................................................... 4 (quarterly) ................................................................................... .25 .25 .25 126 52 12 Total per respondent .............................................................. ........................................................................................................ ........................ 190 Total Aggregate Annual Burden for all 55 respondents ........ ........................................................................................................ ........................ 10,450 In addition, proposed Rule 15Fi–3(b) would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to ensure that it engages in portfolio reconciliation for all securitybased swaps (other than security-based swaps that will be cleared by a clearing agency) in which its counterparty is not an SBS Entity.178 In calculating the burden of performing the portfolio reconciliations required by these policies and procedures, the Commission preliminarily estimates that (1) there are currently 13,082 market participants in security-based swaps who will not be required to register as SBS Entities,179 and (2) each SBS Entity will have an average of approximately 350 of these non-SBS Entity market participants as counterparties.180 Further, the Commission preliminarily believes that reconciliations with these parties will 172 See Application of the Title VII Security-Based Swap Dealer De Minimis Counting Requirements to Activity in the United States,’’ Exchange Act Release No. 77104 (Feb. 10, 2016), 81 FR 8598, 8605 (Feb. 19, 2016) (‘‘U.S. Activity Adopting Release’’); see also Business Conduct Standards Adopting Release, 81 FR at 30090. 173 Consistent with prior estimates, the Commission further believes that there may up to five major SBS participants. See SBS Entity Registration Adopting Release, 80 FR at 49000; see also Business Conduct Standards Adopting Release, 81 FR at 30089. It is possible that some subset of those entities will be non-U.S. major SBS participants that will seek to rely on substituted compliance in connection with the applicable portfolio reconciliation, portfolio compression, and written trading relationship documentation requirements. 174 These estimates are consistent with those used by the CFTC in connection with its portfolio reconciliation rule. See Confirmation, Portfolio Reconciliation, and Portfolio Compression Requirements for Swap Dealers and Major Swap Participants, 75 FR 81519, 81528 (Dec. 28, 2010). 175 This estimate uses 252 business days for purposes of the daily portfolio reconciliation requirement, which is consistent with the definition of ‘‘business day’’ in proposed Rule 15Fi–1(b). 176 The Commission recognizes that some respondents may choose to engage a third-party vendor to conduct portfolio reconciliations. For simplicity, however, the Commission’s burden estimate is based upon SBS Entities conducting these activities internally, without the use of thirdparty vendors. The Commission welcomes comments on this approach, including regarding the likelihood and cost of using third-party providers. 177 Because the 30 minute estimate is for the entire reconciliation process, without respect to how that time is allocated between the two parties, to avoid double-counting we have divided it by one-half in the context of security-based swap portfolios between two SBS Entities, resulting in an estimate of 15 minutes per reconciliation per counterparty for those portfolios. 178 The Commission’s estimate for the hourly burden for preparing these policies and procedures is discussed below. 179 In the Economic Analysis, the Commission estimates that there are approximately 13,137 market participants in the security-based swap market. See infra Section VI.B.1.c (Table 2). Subtracting the estimated 55 SBS Entities from this figure results in an estimated 13,082 non-SBS Entities. 180 This estimate is based upon the assumption that each non-SBS Entity market participant will do business with, on average, between one or two SBS Entities and is calculated as follows: ((13,082 nonSBS Entity market participants/55 SBS Entities) × 1.5 SBS Entities per non-SBS market participants) = approximately 350 non-SBS Entity counterparties per SBS Entity. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 PO 00000 Frm 00030 Fmt 4701 Sfmt 4702 E:\FR\FM\15FEP2.SGM 15FEP2 4643 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules be conducted on a quarterly basis for 10% of these portfolios (i.e., portfolios with more than 100 uncleared securitybased swaps), and on an annual basis for the remaining 90% of these portfolios (i.e., portfolios that do not involve 100 or more uncleared securitybased swaps).181 The Commission further estimates that each portfolio reconciliation between an SBS Entity and a non-SBS Entity will require an average of 30 minutes to complete (which is the combined estimate for both counterparties).182 Using these figures, the Commission preliminarily estimates that compliance with proposed Rule 15Fi–3(b), as it relates to conducting portfolio reconciliations with non-SBS Entities, will impose an annual hourly burden of approximately 227.5 hours per SBS Entity, for an estimated average annual burden of approximately 12,512.5 hours in the aggregate for all 55 SBS Entity respondents. These calculations are summarized in PRA Table 2, below. PRA TABLE 2—PROPOSED RULE 15i–3(b): PORTFOLIO RECONCILIATIONS WITH NON-SBS ENTITIES Total annual burden (hours) Number of annual reconciliations 35 (>100 transactions) .................................................................. 315 (≤100 transactions) ................................................................ 4 (quarterly) ................................................................................... 1 (annual) ...................................................................................... .5 .5 70 157.5 Total per respondent .............................................................. ........................................................................................................ ........................ 227.5 Total Aggregate Annual Burden for all 55 respondents ........ ........................................................................................................ ........................ 12,512.5 Proposed Rule 15Fi–3 also contains policies and procedures requirements applicable to SBS Entities in connection with engaging in portfolio reconciliation with both SBS Entities and other counterparties. As the Commission explained in the Business Conduct Standards Adopting Release, the Commission estimates that of the estimated 55 persons that may register with the Commission as SBS Entities, approximately 35 will be duallyregistered with the CFTC as Swap Entities.183 In addition, other than as expressly noted above in Section I.B, the CFTC’s adopted final rules on portfolio reconciliation written policies and procedures are substantively identical to those proposed by Rule 15Fi–3. Accordingly, these 35 dually-registered entities are already required to establish, maintain, and follow written policies and procedures as they relate to the reconciliation of their swap portfolios, and these policies and procedures would be expected to be largely consistent with those that would be required with respect to their securitybased swap portfolios. Assuming that these existing policies and procedures would simply need to be amended to apply to security-based swap transactions upon adoption of proposed Rule 15Fi–3, we preliminarily estimate that the initial burden of revising these policies and procedures would be one hour per respondent, for an estimated one-time initial burden of 35 hours in the aggregate. With respect to the remaining 20 SBS Entities that will not be dually-registered with the CFTC, the Commission preliminarily estimates, based on prior estimates in earlier Dodd-Frank rulemakings, that these policies and procedures would require an average of 80 hours per non-duallyregistered respondent to initially prepare and implement, for an estimated one-time initial burden of 1,600 hours in the aggregate.184 Once these policies and procedures are established, the Commission estimates that it will take an average of 40 hours annually to revise and maintain these policies and procedures per respondent (including both dually-registered and non-dually-registered SBS Entities),185 3. Reporting of Certain Valuation Disputes Proposed Rule 15Fi–3(c) would require each SBS Entity to promptly notify the Commission (and any applicable prudential regulator for an SBS Entity that is also a bank), in a form and manner acceptable to the Commission, of any security-based swap valuation dispute in excess of $20,000,000 (or its equivalent in any other currency) if not resolved within a prescribed time period. As previously noted, we crafted the rule in this way to provide SBS Entities with flexibility to determine the most efficient and costeffective form and manner of making such submissions, so long as it is deemed to be acceptable by the Commission.187 Accordingly, we preliminarily do not expect there to be any initial burden of designing a system for submitting these notices.188 We also preliminarily believe that the associated ongoing hourly burden of preparing and submitting such notices would be minimal. In addition, until SBS Entities 181 Accordingly, of the estimated 350 securitybased swap portfolios that an SBS Entity maintains with non-SBS Entities, 90% (or 315) will require only one portfolio reconciliation each year, and 10% (or 35) will require quarterly portfolio reconciliations, resulting in a total of 455 portfolio reconciliations per SBS Entity per year. 182 This figure is identical to the estimate used for reconciliations between two SBS Entities (before dividing by one-half to avoid double-counting) and is consistent with the estimate used by the CFTC, which used an estimate of six minutes (or .10 hours) in connection with its portfolio reconciliation requirements. See supra notes 174 and 177 and accompanying text. 183 See Business Conduct Standards Adopting Release, 81 FR at 30098. 184 This estimate is based on Commission staff discussions with market participants and is calculated as follows: [((Compliance Attorney at 40 hours) + (Director of Compliance at 20 hours) + (Deputy General Counsel at 20 hours))] = 80 hours per SBS Entity. See Trade Acknowledgment and Verification Adopting Release, 81 FR at 39831 n. 242. 185 Although dually-registered SBS Entities would technically need to revise and maintain their policies and procedures to ensure compliance with both the Commission’s and CFTC’s rules, we have preliminarily decided to conservatively assume that all of the estimated hours would be incurred in connection with compliance with the collection of information associated with proposed Rule 15Fi–3. 186 This estimate is based on Commission staff discussions with market participants and is calculated as follows: [((Compliance Attorney at 20 hours) + (Director of Compliance at 10 hours) + (General Counsel at 10 hours))] = 40 hours per SBS Entity. See Trade Acknowledgment and Verification Adopting Release, 81 FR at 39831 n. 243. 187 See supra note 47. 188 In the request for comments, we asked whether we should require such notices to be submitted in a particular manner, such as having them sent to a dedicated email box or using the EDGAR system (or any successor system thereto, as designated by the Commission). As SBS Entities will already have access to EDGAR (and a Form ID) by virtue of having used the system to register with the Commission, we would not expect there to be any initial burden associated with either approach. 2. Establishing, Maintaining, and Enforcing Written Policies and Procedures amozie on DSK3GDR082PROD with PROPOSALS2 Hourly burden per reconciliation Number of counterparties per respondent VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 PO 00000 Frm 00031 Fmt 4701 Sfmt 4702 for an estimated average annual burden of 2,200 hours in the aggregate for all 55 respondents.186 E:\FR\FM\15FEP2.SGM 15FEP2 4644 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules are registered with the Commission, it is difficult for us to determine the typical number of valuation disputes meeting the applicable thresholds that SBS Entities would be required to submit on an annual basis. As such, and consistent with the estimate the CFTC provided when it first proposed a similar requirement, we preliminarily estimate that each SBS Entities will spend on average of 24 hours each year complying with this requirement, for an estimated average annual burden of 1,320 hours in the aggregate for all 55 respondents.189 We also recognize, however, that there are differences between the markets for swaps and security-based swaps and welcomes comment from the public on this estimate. Combining all of the estimated burdens described above, the Commission preliminarily estimates that proposed Rule 15Fi–3 would impose an estimated one-time initial burden of 1,635 hours in the aggregate for all SBS Entities to prepare new written policies and procedures or to bring existing ones into compliance. The Commission also preliminarily estimates that proposed Rule 15Fi–3 would impose an estimated ongoing burden of 26,482.5 hours each year in the aggregate for all SBS Entities, which is composed of (1) an estimated annual burden of 10,450 hours in the aggregate for all SBS Entities to engage in portfolio reconciliation with SBS Entities; (2) an estimated annual burden of 12,512.5 hours in the aggregate for all SBS Entities to engage in portfolio reconciliation with non-SBS Entities; (3) an estimated annual burden of 2,200 hours in the aggregate for all SBS Entities to revise and maintain the written policies and procedures required pursuant to the rule; and (4) 1,320 hours for all SBS Entities to report certain large valuation disputes to the Commission and any applicable prudential regulator.190 These calculations are summarized in PRA Tables 3 and 4, below. PRA TABLE 3—PROPOSED RULE 15Fi–3: TOTAL ESTIMATED INITIAL BURDENS Hourly burden Total one-time burden (hours) Preparation of New Written Policies and Procedures (35 dual SEC-CFTC registrants) ......................................................................... Preparation of New Written Policies and Procedures (20 SEC-only registrants) .................................................................................... 1 80 35 1,600 Total Aggregate One-Time Burden for all 55 respondents ............................................................................................................... ........................ 1,635 Requirement PRA TABLE 4—PROPOSED RULE 15Fi–3: SUMMARY OF ANNUAL BURDENS Aggregate hourly burden (all 55 respondents) Requirement Portfolio Reconciliations with Other SBS Entities ............................................................................................................................. Portfolio Reconciliations with Non-SBS Entities ............................................................................................................................... Revise and Maintain Written Policies and Procedures ..................................................................................................................... Prepare and Submit Notices of Valuation Disputes >$20 million ..................................................................................................... 10,450 12,512.5 2,200 1,320 Total Aggregate Annual Burden for all 55 respondents ............................................................................................................ 26,482.5 With regard to the written policies and procedures, the Commission continues to believe that of the estimated 55 persons that may register with the Commission as SBS Entities, approximately 35 will be duallyregistered with the CFTC as Swap Entities. In addition, and as we previously noted, the CFTC’s adopted final rules requiring Swap Entities to establish, maintain, and follow written policies and procedures on bilateral offsets and portfolio compression exercises are, other than as expressly noted above in Section I.C, substantively identical to those proposed by Rule 15Fi–4. Accordingly, these 35 entities are already required to establish, maintain, and follow relevant written policies and procedures related to bilateral offsets and portfolio compression exercises involving their swap portfolios, and these policies and procedures would be expected to be largely consistent with those that would be required with respect to their security-based swap portfolios. Assuming that these existing policies and procedures would simply need to be amended to apply to security-based swap transactions upon adoption of proposed Rule 15Fi–4, we preliminarily estimate that the initial burden of revising these policies and procedures would be one hour per respondent, for an estimated one-time initial burden of 35 hours in the aggregate. With respect to the remaining 20 SBS Entities that are not dually-registered with the CFTC, the Commission preliminarily estimates, based on prior estimates in earlier Dodd-Frank rulemakings, that these policies and procedures would require an average of 80 hours per non-dually-registered respondent to initially prepare and implement, for an estimated average annual burden of 1,600 hours in the aggregate.191 Once these policies and procedures are established, the Commission estimates that it will take an average of 40 hours annually to revise and maintain these policies and procedures per respondent (including both dually-registered and non-duallyregistered SBS Entities), for an estimated average annual burden of 2,200 hours in the aggregate for all 55 respondents. In addition, the respondents will incur additional hourly burdens as they undertake bilateral offsets and portfolio compression exercises consistent with these written policies and procedures. As noted above the Commission estimates that each of the 55 estimated 189 See Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, 76 FR 6715, 6723 (Feb. 8, 2011). 190 Rule 15Fi–3(a)(1) and 15Fi–3(b)(1) also require an SBS Entity to agree in writing with each of its counterparties on the terms of the portfolio reconciliation including, if applicable, agreement on the selection of any third party service provider who may be performing the reconciliation. The Commission expects SBS Entities to undertake this agreement as part of the written trading relationship documentation each is required to enter into with its counterparties as a result of proposed Rule 15Fi– 5. Thus, the estimate here does not account for this burden, which is instead assumed to form part of the burden of complying with Rule 15Fi–5. 191 See supra note 184. amozie on DSK3GDR082PROD with PROPOSALS2 4. Proposed Rule 15Fi–4: Portfolio Compression VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 PO 00000 Frm 00032 Fmt 4701 Sfmt 4702 E:\FR\FM\15FEP2.SGM 15FEP2 4645 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules SBS Entities will be counterparty to an average of 18 other SBS Entities and 350 non-SBS Entities, for a total of 368 counterparties. For purposes of conducting bilateral offsets and portfolio compression exercises, the Commission preliminarily estimates that (1) each SBS Entity will have an average of one set of security-based swaps that are eligible for annual bilateral offset with each of these 368 counterparties, (2) each SBS Entity will conduct an annual bilateral compression exercise with one-third, or six of its 18 SBS Entity counterparties, (3) each SBS Entity will conduct an annual bilateral compression exercise with each of its 350 non-SBS Entity counterparties, and (4) each SBS Entity will engage in multilateral compression exercises at an average rate of 12 exercises per year. The Commission preliminarily believes that each bilateral offset and portfolio compression exercise is likely to be conducted through an automated process. As a result, we preliminarily believe that (1) each bilateral offset will require on average five minutes of respondent time to complete with each of the 350 non-SBS Entity counterparties, (2) each bilateral offset will require on average 2.5 minutes of respondent time to complete with each of the 18 SBS Entity counterparties,192 (3) each bilateral compression will require an average of 15 minutes of respondent time to complete with each of the 350 non-SBS Entity counterparties, (4) each bilateral compression will require an average of 7.5 minutes with each of the six SBS Entity counterparties,193 and (5) each multilateral compression exercise will require an average of 30 minutes of respondent time to complete 12 times annually. In each of those hourly burdens, the figure used is the combined estimate for both counterparties. Based on these estimates, the Commission estimates the average annual hourly burden for these activities at 124.16 hours per respondent, an estimated average annual burden of 6,828.8 hours in the aggregate. These calculations are summarized in PRA Table 5, below. PRA TABLE 5—PORTFOLIO COMPRESSION WITH ALL ENTITIES Number of counterparties Type of exercise Number of annual exercises Hourly burden per exercise (hours) Total annual burden (hours) Bilateral Offset (w/non-SBS Entities) ................................................................................................ Bilateral Offset (w/SBS Entities) ....................................................................................................... Bilateral Compression (w/non SBS-Entities) .................................................................................... Bilateral Compression (w/SBS Entities) ............................................................................................ Multilateral Compression ................................................................................................................... 350 18 350 6 N/A 1 1 1 1 12 .0833 .0417 .25 .125 .5 29.16 .75 87.5 .75 6 Total per respondent .................................................................................................................. ........................ ........................ ........................ 124.16 Total Aggregate Annual Burden for all 55 respondents ............................................................ ........................ ........................ ........................ 6,828.8 Combining all of the estimated burdens described above, the Commission preliminarily estimates that proposed Rule 15Fi–4 would impose an estimated one-time initial burden of 1,635 hours in the aggregate for all SBS Entities to prepare new written policies and procedures or to bring existing ones into compliance. The Commission also preliminarily estimates that proposed Rule 15Fi–4 would impose an estimated ongoing burden of 9,028.8 hours each year in the aggregate for all SBS Entities, which is composed of (1) an estimated annual burden of 1,603.8 hours in the aggregate to conduct bilateral offsets with nonSBS Entities; (2) an estimated annual burden of 41.25 hours in the aggregate to conduct bilateral offsets with SBS Entities; (3) an estimated annual burden of 4,812.5 hours in the aggregate to participate in bilateral compression exercises with non-SBS Entities; (4) an estimated annual burden of 41.25 hours in the aggregate to participate in bilateral compression exercises with SBS Entities; (5) an estimated annual burden of 330 hours in the aggregate to participate in multilateral compression exercises; and (6) an estimated annual burden of 2,200 hours in the aggregate for all SBS Entities to revise and maintain written policies and procedures. These calculations are summarized in PRA Tables 6 and 7, below. PRA TABLE 6—PROPOSED RULE 15Fi–4: TOTAL ESTIMATED INITIAL BURDEN Hourly burden (hours) Total one-time burden (hours) Preparation of New Written Policies and Procedures (35 dual SEC–CFTC registrants) ........................................................................ Preparation of New Written Policies and Procedures (20 SEC-only registrants) .................................................................................... 1 80 35 1,600 Total Aggregate One-Time Burden for all 55 respondents ............................................................................................................... ........................ 1,635 amozie on DSK3GDR082PROD with PROPOSALS2 Activity 192 Similar to our estimates in the context of the portfolio reconciliation requirements, because the five minute estimate is for the entire bilateral offset process, without respect to how that time is allocated between the two parties, to avoid doublecounting we have divided it by one-half in the VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 context of security-based swap portfolios between two SBS Entities, resulting in an estimate of 2.5 minutes per bilateral offset for those portfolios. 193 Again, we have divided the 15 minute estimate to complete the bilateral compression PO 00000 Frm 00033 Fmt 4701 Sfmt 4702 exercise by one-half in the context of security-based swap portfolios between two SBS Entities, resulting in an estimate of 7.5 minutes per bilateral compression for those portfolios. E:\FR\FM\15FEP2.SGM 15FEP2 4646 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules PRA TABLE 7—PROPOSED RULE 15Fi–3: SUMMARY OF ANNUAL BURDENS Aggregate hourly burden (hours) (all 55 respondents) Requirement Bilateral Offsets with non-SBS Entities ................................................................................................................................................................................. Bilateral Offsets with SBS Entities ........................................................................................................................................................................................ Bilateral Compression with non-SBS Entities ....................................................................................................................................................................... Bilateral Compression with SBS Entities .............................................................................................................................................................................. Multilateral Compression ....................................................................................................................................................................................................... Revise and Maintain Written Policies and Procedures ........................................................................................................................................................ 1,603.8 41.25 4,812.5 41.25 330 2,200 Total Aggregate Annual Burden for all 55 respondents ................................................................................................................................................ 9,028.8 5. Proposed Rule 15Fi–5: Written Trading Relationship Documentation amozie on DSK3GDR082PROD with PROPOSALS2 As previously noted, the Commission estimates that each SBS Entity will have 18 SBS Entity counterparties and 350 non-SBS Entity counterparties, for a total of 368 counterparties per SBS Entity. For the purposes of the underlying documentation requirements, and based on staff discussions with market participants, the Commission understands that many SBS Entities already have in place industry-standard written trading relationship documentation that is likely to contain many of the elements required by this proposed rule. With this in mind, the Commission preliminarily estimates that (1) the initial burden per respondent to negotiate and draft written trading relationship documentation with nonSBS Entities that is compliant with proposed Rule 15Fi–5 will be approximately 30 hours (which is the combined estimate for both counterparties), and (2) the initial burden per respondent to negotiate and draft written trading relationship documentation with SBS Entities that is compliant with proposed Rule 15Fi–5 will be approximately 15 hours.194 These estimates are averages, and both account for the fact that some SBS Entities may lack appropriate documentation in certain respects and will need to enter into new documentation with counterparties, while in other cases existing documentation will need only to be modified to be brought into compliance. The Commission’s estimates are further based on an assumption that, in each 194 As was the case in calculating the PRA estimates for the portfolio reconciliation and portfolio compression requirements, because the 30 hours estimate is for the entire process of negotiating and executing written trading relationship documentation, without respect to how that time is allocated between the two parties, to avoid double-counting we have divided it by onehalf in the context of counterparties that are also SBS Entities, resulting in an estimate of 15 hours to negotiate and execute such documentation. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 case, the written documentation will always include the valuation agreements set forth in proposed Rule 15Fi–5(b)(4), notwithstanding the fact that the rule only requires this information in certain circumstances. Based on these estimates and assumptions, the Commission preliminarily believes that the requirement to prepare written relationship documentation in accordance with proposed Rule 15Fi–5 will result in an estimated one-time initial burden of 9,540 hours for each of the 55 SBS Entity respondents, for an estimated average one-time burden of 524,700 hours in the aggregate. The Commission also preliminarily believes that there will be little need to modify the written trading relationship documentation on an ongoing basis once it is in place, and therefore is not estimating any additional annual hourly burden for ongoing modifications. With regard to the written policies and procedures required pursuant to proposed Rule 15Fi–5, the Commission continues to believe that of the estimated 55 persons that may register with the Commission as SBS Entities, approximately 35 will be duallyregistered with the CFTC as Swap Entities. In addition, and as we previously noted, the CFTC’s adopted final rules requiring Swap Entities to establish, maintain, and follow written policies and procedures requiring the execution of written trading relationship documentation are, other than as expressly noted above in Section I.D, substantively identical to those proposed by Rule 15Fi–5. Accordingly, these 35 entities are already required to establish, maintain, and follow relevant written policies as they relate to the execution of written trading relationship documentation involving their swap portfolios, and these policies and procedures would be expected to be largely consistent with those that would be required with respect to their security-based swap portfolios. Assuming that these existing policies PO 00000 Frm 00034 Fmt 4701 Sfmt 4702 and procedures would simply need to be amended to apply to security-based swap transactions upon adoption of proposed Rule 15Fi–5, we preliminarily estimate that the average initial burden of revising these policies and procedures would be one hour per respondent, for an estimated one-time burden of 35 hours in the aggregate. With respect to the remaining 20 SBS Entities that are not dually-registered with the CFTC, the Commission preliminarily estimates, based on prior estimates in earlier Dodd-Frank rulemakings, that these policies and procedures would require an average of 80 hours per non-dually-registered respondent to initially prepare and implement, for an estimated average annual burden of 1,600 hours in the aggregate.195 Once these policies and procedures are established, the Commission estimates that it will take an average of 40 hours annually to revise and maintain these policies and procedures per respondent (including both dually-registered and non-duallyregistered SBS Entities), for an estimated average annual burden of 2,200 hours in the aggregate for all 55 respondents. With regard to having an independent auditor conduct the required periodic audit of written trading relationship documentation and the requirement to retain a record of each such audit, the Commission estimates that it will take an average of 10 hours to audit an SBS Entity’s documentation with each of its 368 counterparties, for a total of 3,680 hours per SBS Entity, or 202,400 hours for all 55 SBS Entity respondents. Combining all of the estimated burdens described above, the Commission preliminarily estimates that proposed Rule 15Fi–5 would impose an estimated one-time initial burden of 593,985 hours in the aggregate for all SBS Entities, which consists of (1) 1,635 hours in the aggregate for all SBS Entities to prepare new written policies and procedures or to bring 195 See E:\FR\FM\15FEP2.SGM supra note 184. 15FEP2 4647 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules existing ones into compliance, (2) 577,500 hours in the aggregate for SBS Entities to negotiate and execute trading relationship documentation with 350 non-SBS Entity counterparties, and (3) 14,850 hours in the aggregate for SBS Entities to negotiate and execute trading relationship documentation with 18 SBS Entity counterparties. The Commission also preliminarily estimates that proposed Rule 15Fi–5 would impose an estimated ongoing burden of 204,600 hours each year in the aggregate for all SBS Entities, which is composed of: (1) An estimated annual burden of 2,200 hours in the aggregate for all SBS Entities to revise and maintain written policies and procedures and (2) an estimated annual burden of 202,400 hours in the aggregate for all SBS Entities to conduct the required periodic audits. These calculations are summarized in PRA Tables 8 and 9, below. PRA TABLE 8—PROPOSED RULE 15Fi–5: TOTAL ESTIMATED INITIAL BURDENS Hourly burden (hours) Total one-time burden (hours) Preparation of New Written Policies and Procedures (35 dual SEC–CFTC registrants) ........................................................................ Preparation of New Written Policies and Procedures (20 SEC-only registrants) .................................................................................... Negotiate and Execute Trading Relationship Documentation with 350 non-SBS Entities (all 55 respondents) ..................................... Negotiate and Execute Trading Relationship Documentation with 18 SBS Entities (all 55 respondents) .............................................. 1 80 30 15 35 1,600 577,500 14,850 Total Aggregate One-Time Burden for all 55 respondents ............................................................................................................... ........................ 593,985 Activity PRA TABLE 9—PROPOSED RULE 15Fi–3: SUMMARY OF ANNUAL BURDENS Aggregate hourly burden (hours) (all 55 respondents) Requirement Audit of Written Trading Relationship Documentation .......................................................................................................................................................... Revise and Maintain Written Policies and Procedures ........................................................................................................................................................ 202,400 2,200 Total Aggregate Annual Burden for all 55 respondents ................................................................................................................................................ 204,600 amozie on DSK3GDR082PROD with PROPOSALS2 6. Proposed Amendments to Rules 17a– 3, 17a–4, 18a–5, and 18a–6: Books and Records Requirements The proposed amendments to Rules 17a–3, 17a–4, 18a–5, and 18a–6 would impose collection of information requirements that result in initial and annual time burdens for SBS Entities. The proposed amendments to Rules 17a–3 and 18a–5 would require three additional types of records to be made and kept current by SBS Entities— records regarding portfolio reconciliations, valuation disputes, and portfolio compressions. Because the burden to make these records is accounted for in the PRA estimates for proposed Rules 15Fi–3 and 15Fi–4, the burden imposed by these proposed new requirements is the requirement in Rules 17a–4 and 18a–6 to maintain and preserve a written record of these tasks, as well as the additional requirements in those provisions to maintain and preserve records of policies and procedures required by Rules 15Fi–3 through 15Fi–5 and written agreements with counterparties regarding the terms of portfolio reconciliation. The Commission estimates that these recordkeeping requirements, as proposed to be amended, would impose an initial burden of 60 hours per firm for updating the applicable policies and systems required to account for capturing the additional records made VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 pursuant to proposed Rule 15Fi–3 through 15Fi–5, and an ongoing annual burden of 75 hours per firm for maintaining such records as well as to make additional updates to the applicable recordkeeping policies and systems to account for the proposed rules. As noted previously, the Commission estimates that there are 55 SBS Entity respondents, for a total average initial annual burden for all respondents of 3,300 hours and a total ongoing average annual burden of 4,125 hours. 7. Proposed Amendment to Rule 3a71– 6: Substituted Compliance Proposed amended Rule 3a71–6 would require submission of certain information to the Commission to the extent SBS Entities elect to request a substituted compliance determination with respect to the proposed portfolio reconciliation, portfolio compression, and written trading relationship documentation requirements. The Commission expects that registered SBS Entities will seek to rely on substituted compliance upon registration, and that it is likely that the majority of such requests will be made during the first year following the effective date. Requests would not be necessary with regard to applicable rules and regulations of a foreign financial regulatory system that have previously been the subject of a substituted PO 00000 Frm 00035 Fmt 4701 Sfmt 4702 compliance determination in connection with the applicable rules. The Commission expects that the great majority of substituted compliance applications will be submitted by foreign authorities, and that very few substituted compliance requests will come from SBS Entities. For purposes of this assessment, the Commission estimates that three such SBS Entities will submit such an application.196 The Commission has previously estimated that the paperwork burden associated with making each such substituted compliance request would be approximately 80 hours of in-house counsel time, plus $80,000 for the services of outside professionals (based on 200 hours of outside time × $400 per hour).197 The Commission is currently of the belief that this prior estimate is sufficient to cover a combined substituted compliance request that also seeks a determination for the portfolio reconciliation, portfolio compression, and written trading relationship documentation rules proposed in this release. This estimate results in an aggregate total of 240 internal hours, plus $240,000 for outside services. Therefore, the Commission estimates that the total paperwork burden incurred by such entities associated 196 See Business Conduct Standards Adopting Release, 81 FR at 30097 n. 1582. 197 See Business Conduct Standards Adopting Release, 81 FR at 30097 n. 1583. E:\FR\FM\15FEP2.SGM 15FEP2 4648 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules with preparing and submitting a request for a substituted compliance determination in connection with the portfolio reconciliation, portfolio compression, and written trading relationship documentation requirements will be approximately 240 hours per applicant, plus $240,000 for the services of outside professionals for all three requests. amozie on DSK3GDR082PROD with PROPOSALS2 E. Collection of Information Is Mandatory Each collection of information for proposed Rules 15Fi–3 through 15Fi–5 and for the proposed amendments to Rules 17a–3, 17a–4, 18a–5, and 18a–6 is a mandatory collection of information. With respect to the proposed amendment to Rule 3a71–6, the application for substituted compliance is mandatory for all foreign financial authorities or SBS Entities that seek a substituted compliance determination. F. Confidentiality Proposed Rule 15Fi–3(c) would require an SBS Entity to promptly notify the Commission of any security-based swap valuation dispute in excess of $20,000,000 (or its equivalent in any other currency) if not resolved within: (1) Three business days, if the dispute is with a counterparty that is an SBS Entity; or (2) five business days, if the dispute is with a counterparty that is not an SBS Entity. We have requested comment as to whether these notices should be submitted to the Commission on a confidential basis. No other information would be submitted directly to the Commission under proposed Rules 15Fi–3 through 15Fi–5 or under the proposed amendments to Rules 17a–3, 17a–4, 18a–5, and 18a–6. To the extent that the Commission receives confidential information pursuant to this collection of information that is otherwise not publicly available, including in connection with examinations or investigations, that information will be kept confidential, subject to applicable law. With regard to the proposed amendment to Rule 3a71–6, the Commission generally will make requests for a substituted compliance determination public, subject to requests for confidential treatment being submitted pursuant to any applicable provisions governing confidentiality under the Exchange Act. G. Request for Comment We request comment on whether our estimates for burden hours and any external costs as described above are reasonable. Pursuant to 44 U.S.C. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 3506(c)(2)(B), the Commission solicits comments in order to: (1) Evaluate whether the proposed collections of information are necessary for the proper performance of the functions of the Commission, including whether the information will have practical utility; (2) evaluate the accuracy of the Commission’s estimate of the burden of the proposed collections of information; (3) determine whether there are ways to enhance the quality, utility, and clarity of the information to be collected; and (4) determine whether there are ways to minimize the burden of the collections of information on those who are to respond, including through the use of automated collection techniques or other forms of information technology. In addition, would we would appreciate any comments related to our Paperwork Reduction Act estimates with respect to the following: • The number of counterparties with whom an SBS Entity would maintain a security-based swap portfolio. • The number and proportion of security-based swap portfolios that would fall under each of the proposed thresholds for determining the frequency of the required portfolio reconciliations, with respect to both SBS Entity and non-SBS Entity counterparties. • The hourly burden of conducting each portfolio reconciliation and the use of automated systems to perform this function, including those offered by third parties. • The use of third parties to perform portfolio reconciliation and portfolio compression exercises, any upfront burdens associated with engaging a third party to perform these services, and the ongoing burdens associated with each exercise. • The burdens associated with establishing and routinely updating all required policies and procedures. The agency has submitted the proposed collections of information to OMB for approval.Persons wishing to submit comments on the collection of information requirements should direct the comments to the Office of Management and Budget, Attention: Desk Officer for the Securities and Exchange Commission, Office of Information and Regulatory Affairs, Washington, DC 20503, and send a copy to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549–1090, with reference to File No. S7–28–18. OMB is required to make a decision concerning the collection of information between 30 and 60 days after publication of this release. Consequently, a comment to OMB is best assured of having its full PO 00000 Frm 00036 Fmt 4701 Sfmt 4702 effect if OMB receives it within 30 days of publication. Requests for materials submitted to OMB by the Commission with regard to these collections of information should be in writing, refer to File No. S7–28–18, and be submitted to the Securities and Exchange Commission, Office of FOIA Services, 100 F Street NE, Washington, DC 20549–2736. VI. Economic Analysis The Commission is sensitive to the economic effects of its rules, including the costs and benefits and the effects of its rules on efficiency, competition, and capital formation. Section 3(f) 198 of the Exchange Act requires the Commission, whenever it engages in rulemaking pursuant to the Exchange Act and is required to consider or determine whether an action is necessary or appropriate in the public interest, also to consider, in addition to the protection of investors, whether the action would promote efficiency, competition, and capital formation. In addition, Section 23(a)(2) 199 of the Exchange Act requires the Commission, when promulgating rules under the Exchange Act, to consider the impact such rules would have on competition. Section 23(a)(2) also provides that the Commission shall not adopt any rule which would impose a burden on competition that is not necessary or appropriate in furtherance of the purposes of the Exchange Act.200 A. Broad Economic Considerations Unlike some other types of securities transactions, a security-based swap typically gives rise to ongoing obligations between transaction counterparties during the life of the transaction, including payments contingent on specific events, such as a corporate default or a change in the price of an underlying reference asset (e.g., changes in price to the floating leg of a total return swap). Consequently, certain risk mitigation techniques, such as engaging in portfolio reconciliation at periodic intervals, exercising opportunities for portfolio compression, and ensuring that the terms of a transaction are fully documented, are important practices for assisting SBS Entities in effectively measuring and managing market and credit risk. Credit risk refers to the probability of a financial loss due to a counterparty to a transaction failing to fulfill its financial obligations. In order to manage credit risk in the security-based swap context properly, a market participant 198 15 U.S.C. 78c(f). U.S.C. 78w(a)(2). 200 See id. 199 15 E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 should know the identity of each of its counterparties, the details of the obligations of each counterparty in each transaction into which the two have entered, and the value of those obligations (including for purposes of calculating margin or measuring outstanding exposure for risk management). The greater the number of counterparties and transactions, the complexity of those transactions, and the value of the outstanding obligations, the more important it becomes for each counterparty to have well-documented credit risk management policies. The risks of the counterparties’ failure to manage credit risk adequately may not become apparent until the onset of a financial crisis. Such a crisis occurred in the fall of 2008, when certain events threatened to freeze U.S. and global credit markets. The severity of that crisis has been partially attributed to poor risk management practices of financial firms and flawed supervisory oversight for certain financial institutions.201 Shortcomings in credit risk management and documentation may be unobservable to counterparties and other market participants until a crisis occurs as it did in 2008; thus some benefits of compliance will accrue to the financial system as a whole while the ongoing direct costs are borne by the institution. If firms do not fully internalize the benefits of risk management, then they may underinvest. For example, shortcomings in documentation were reported to have created significant problems during the financial crisis that immediately preceded passage of the Dodd-Frank Act in connection with efforts by Barclays PLC to take over a portion of Lehman Brothers Holdings Inc.’s derivatives trades.202 Shortcomings in the documentation of portfolio valuation methods and reconciliation of portfolio values were also exposed when, during bankruptcy proceedings, counterparties’ valuations differed by hundreds of millions of dollars from the value of those same positions on the bankrupt entity’s books.203 201 See Lessons of the Financial Crisis for Future Regulation of Financial Institutions, at 3–4, IMF Policy Paper (Feb. 4, 2009), available at: https:// www.imf.org/external/np/pp/eng/2009/020409.pdf; see also Sewall Chan, Financial Crisis Was Avoidable, Inquiry Finds, N.Y. Times (Jan. 25, 2011), available at: https://www.nytimes.com/2011/ 01/26/business/economy/26inquiry.html?_r=1;. 202 See Linda Sandler, Lehman Derivatives Records a ‘Mess,’ Barclays Executive Says, Bloomberg (Aug. 30, 2010), available at: https:// www.bloomberg.com/news/articles/2010-08-30/ lehman-derivatives-records-a-mess-barclaysexecutive-says. 203 See Satyajit Das, In the Matter of Lehman Brothers, 59 Wilmott 20–29 (May 2012). VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 Among other things, effective risk management requires the existence of sound documentation, periodic reconciliation of portfolios, rigorously tested valuation methodologies, and sound collateralization practices.204 More broadly, the President’s Working Group on Financial Policy (‘‘PWG’’) noted shortcomings in the OTC derivatives market as a whole during the financial crisis that immediately preceded passage of the Dodd-Frank Act. The PWG identified the need for an improved integrated operational structure supporting OTC derivatives, specifically highlighting the need for an enhanced ability to manage counterparty risk through ‘‘netting and collateral agreements by promoting portfolio reconciliation and accurate valuation of trades.’’ 205 The rules we are proposing today are designed to ensure that SBS Entities implement certain risk mitigation techniques by engaging in periodic portfolio reconciliation, maintaining policies and procedures for engaging in certain forms of portfolio compression exercises with each of their counterparties, and maintaining policies and procedures reasonably designed to ensure that they execute written trading relationship documentation with each of their counterparties prior to executing a security-based swap transaction. The proposed rules also would set minimum standards with respect to identifying the matters that must be addressed in the security-based swap trading documentation, and outline certain requirements related to the resolution of discrepancies, particularly those involving differences in the valuation of security-based swaps.206 In proposing Disagreement over CDO valuation between AIG and its counterparties was also an issue around the same time. See supra note 15 and accompanying text. 204 See PriceWaterhouseCoopers, Lehman Brothers’ Bankruptcy: Lessons learned for the survivors, Informational presentation for clients, (Aug. 2009), at 12–24, available at: https:// www.pwc.com/en_JG/jg/events/Lessons-learned-forthesurvivors.pdf.2009), at 12–24, available at https:// www.pwc.com/en_JG/jg/events/Lessons-learned-forthesurvivors.pdf. 205 See The President’s Working Group on Financial Markets, Policy Statements on Financial Market Developments, (Mar. 2008) (‘‘PWG Report’’), available at: https://www.treasury.gov/resourcecenter/fin-mkts/Documents/pwgpolicystatemkt turmoil_03122008.pdf.2008) (‘‘PWG Report’’), available at https://www.treasury.gov/resourcecenter/fin-mkts/Documents/pwgpolicy statemktturmoil_03122008.pdf. 206 The proposed rules also would (1) address the potential availability of substituted compliance in connection with those portfolio reconciliation, portfolio compression, and trading relationship documentation requirements and (2) add corresponding requirements to the Commission’s recordkeeping rules that would require SBS Entities to make and keep records demonstrating PO 00000 Frm 00037 Fmt 4701 Sfmt 4702 4649 these rules, the Commission preliminarily believes that they will promote effective risk management practiced by security-based swap market participants in a number of important ways, which we discuss in greater detail below. The Commission notes that, where possible, it has attempted to quantify the costs, benefits, and effects on efficiency, competition, and capital formation expected to result from adopting these rules. In certain cases, however, the Commission is unable to quantify the economic effects. Crucially, many of the relevant economic effects, such as improved risk management and the value of Commission enforcement and oversight, are inherently difficult to quantify. In other cases, we lack the information necessary to provide reasonable estimates. For example, we lack data on prices charged by certain third-party service providers, current trading relationship documentation practices for entities and transactions not already subject to similar rules from other regulators, the fraction of outstanding positions that when reconciled will result in a dispute and the costs incurred by the participants in resolving the dispute. To the best of our knowledge, no such data is publicly available. Where the Commission is unable to quantify the economic effects, the discussion is qualitative in nature and includes, where possible, descriptions of the direction of these effects. The Commission requests data from commenters to help quantify these effects. B. Economic Baseline To assess the economic impact of the proposed risk mitigation rules, the Commission is using as a baseline the security-based swap market as it exists today, including applicable rules that have already been adopted, and excluding rules that have been proposed but not yet finalized. The analysis includes the statutory and regulatory provisions that currently govern the security-based swap market pursuant to the Dodd-Frank Act, as well as rules adopted in, among others, the Business Conduct Standards Adopting Release 207 and the Trade Acknowledgment and Verification Adopting Release.208 Moreover, because participants in the security-based swap market may also operate in other markets, particularly the swaps market, we have considered both the direct and indirect impact of compliance with the new risk mitigation requirements. 207 See supra note 138. 208 See supra note 6. E:\FR\FM\15FEP2.SGM 15FEP2 4650 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules rules that have been adopted by other regulators (e.g., the CFTC as well as foreign regulatory bodies) in formulating the baseline. Our understanding of the market is informed by available data on security-based swap transactions, though we acknowledge the data available to us limits the extent to which we can quantitatively characterize the market. Because this data does not cover the entire market, we have developed an understanding of market activity using a sample that includes only certain portions of the market. Furthermore, the overall Title VII regulatory framework will have consequences for the ways in which security-based swaps are transacted which, in turn, will affect the activities addressed by these proposed rules. For example, the proposed rules generally do not apply to security-based swaps cleared through a registered clearing agency. Therefore, the scope of future mandatory clearing requirements may affect the overall level of security-based swap activity subject to the final rules ultimately adopted under the proposal, as well as the overall costs borne by SBS Entities. amozie on DSK3GDR082PROD with PROPOSALS2 1. Security-Based Swap Market Activity and Participants a. Available Data From the SecurityBased Swap Market The Commission’s understanding of the market is informed, in part, by available data on security-based swap transactions, though the Commission acknowledges that limitations in the data limit the extent to which it is possible to quantitatively characterize the market. Since this data does not cover the entire market, the Commission has analyzed market activity using a sample of transactions that includes only certain segments of the market. The Commission believes, however, that the data underlying this analysis provides reasonably comprehensive information regarding single-name CDS transactions and the composition of the participants in the single-name CDS market. Specifically, the analysis of the state of the current security-based swap market is based on data obtained from the Depository Trust and Clearing Corporation (‘‘DTCC’’) Derivatives Repository Limited Trade Information Warehouse (‘‘DTCC–TIW’’), especially data regarding the activity of market participants in the single-name CDS market during the period from 2006 to 2017.209 Although the definition of 209 In prior releases, the Commission has examined data for other time periods. For example, in the Business Conduct Standards Adopting VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 ‘‘security-based swap’’ is not limited to single-name CDS,210 single-name CDS contracts make up a majority of security-based swaps, and we believe that the single-name CDS data is sufficiently representative of the market to inform our analysis of the current security-based swap market. According to data published by the Bank for International Settlements (‘‘BIS’’), the global notional amount outstanding in single-name CDS was approximately $4.6 trillion,211 in multi-name index CDS was approximately $4.4 trillion, and in multi-name, non-index CDS was approximately $343 billion.212 The total gross market value outstanding in single-name CDS was approximately $130 billion, and in multi-name CDS instruments was approximately $174 billion.213 The global notional amount outstanding in equity forwards and swaps as of December 2017 was $3.21 trillion, with total gross market value of $197 billion.214 Release, the Commission presented an analysis of TIW data for November 2006 through December 2014. While the exact numbers of various groups of transacting agents and account holders in that analysis differ from the figures reported in this section (for a longer time period), we do not observe significant structural differences in market participation. Compare 81 FR at 30102 (Tables 1 and 2) with Tables 1 and 2 below. 210 While other repositories may collect data on transactions in total return swaps on equity and debt, we do not currently have access to such data for these products (or other products that are security-based swaps). Additionally, the Commission explains below that data related to single-name CDS provides reasonably comprehensive information for the purpose of this analysis. 211 The global notional amount outstanding represents the total face amount used to calculate payments under outstanding contracts. The gross market value is the cost of replacing all open contracts at current market prices. 212 See BIS, Semi-annual OTC derivatives statistics at December 2017, Table 10.1, available at: https://www.bis.org/statistics/d10_1.pdf (last accessed May 18, 2018). 213 See id. 214 These totals include swaps and security-based swaps, as well as products that are excluded from the definition of ‘‘swap,’’ such as certain equity forwards. See OTC, Equity-Linked Derivatives Statistics, Table D8, available at: https:// www.bis.org/statistics/d8.pdf (last accessed May 18, 2018). For the purposes of this analysis, the Commission assumes that multi-name index CDS are not narrow-based index CDS and therefore, do not fall within the security-based swap definition. See 15 U.S.C. 78c(a)(68)(A). See also Further Definition of ‘‘Swap,’’ ‘‘Security-Based Swap,’’ and ‘‘Security-Based Swap Agreement’’; Mixed Swaps; Security-Based Swap Agreement Recordkeeping, 77 FR 48208. The Commission also assumes that all instruments reported as equity forwards and swaps are security-based swaps, potentially resulting in underestimation of the proportion of the securitybased swap market represented by single-name CDS. Therefore, when measured on the basis of gross notional outstanding single-name CDS contracts appear to constitute roughly 59% of the security-based swap market. Although the BIS data reflects the global OTC derivatives market, and not PO 00000 Frm 00038 Fmt 4701 Sfmt 4702 The Commission further notes that the data available from TIW does not encompass those CDS transactions that both: (i) Do not involve U.S. counterparties; 215 and (ii) are based on non-U.S. reference entities. Notwithstanding this limitation, the TIW single-name CDS data should provide sufficient information to permit the Commission to identify the types of market participants active in the security-based swap market and the general pattern of dealing within that market.216 b. Affected SBS Entities Final SBS Entity registration rules have been adopted, but compliance is not yet required. Therefore, we do not have data on the actual number of SBS Entities that will register with the Commission, or the number of persons associated with registered SBS Entities. The Commission has elsewhere estimated that up to 50 entities may register with the Commission as security-based swap dealers, and up to five additional entities may register as major security-based swap participants,217 and these estimates remain unchanged. Firms that act as dealers play a central role in the security-based swap market. Based on an analysis of 2017 singlename CDS data in TIW, accounts of those firms that are likely to exceed the just the U.S. market, the Commission has no reason to believe that these ratios differ significantly in the U.S. market. 215 Following publication of the Warehouse Trust Guidance on CDS data access, TIW surveyed market participants, asking for the physical address associated with each of their accounts (i.e., where the account is organized as a legal entity). This physical address is designated the registered office location by TIW. When an account reports a registered office location, we have assumed that the registered office location reflects the place of domicile for the fund or account. When an account does not report a registered office location, we have assumed that the settlement country reported by the investment adviser or parent entity to the fund or account is the place of domicile. Thus, for purposes of this analysis, the Commission has classified accounts as ‘‘U.S. counterparties’’ when they have reported a registered office location in the United States. The Commission notes, however, that this classification is not necessarily identical in all cases to the definition of U.S. person under Rule 3a71– 3(a)(4). 216 The challenges the Commission faces in estimating measures of current market activity stem, in part, from the absence of comprehensive reporting requirements for security-based swap market participants. The Commission has adopted rules regarding trade reporting, data elements, and public reporting for security-based swaps that are designed to, when fully implemented, provide the Commission with additional measures of market activity that will allow us to better understand and monitor activity in the security-based swap market. See Regulation SBSR Adopting Release, 81 FR at 53545. 217 See, e.g., Registration Adopting Release, 80 FR at 49000. E:\FR\FM\15FEP2.SGM 15FEP2 4651 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules security-based swap dealer de minimis thresholds and trigger registration requirements for intermediated transactions with a gross notional amount of approximately $2.9 trillion, approximately 55% of the gross notional intermediated by the top five dealer accounts.218 These dealers transact with hundreds or thousands of counterparties. Approximately 21% of accounts of firms expected to register as security-based dealers and observable in TIW have entered into security-based swaps with over 1,000 unique counterparty accounts as of year-end 2017.219 Another 25% of these accounts transacted with 500 to 1,000 unique counterparty accounts; 29% transacted with 100 to 500 unique accounts; and 25% of these accounts intermediated security-based swaps with fewer than 100 unique counterparties in 2017. The median dealer account transacted with 495 unique accounts (with an average of approximately 570 unique accounts). Non-dealer counterparties transacted almost exclusively with these dealers. The median non-dealer counterparty transacted with two dealer accounts (with an average of approximately three dealer accounts) in 2017. c. Other Market Participants In addition to dealers, thousands of other participants appear as counterparties to security-based swap contracts in our sample, and include, but are not limited to, investment companies, pension funds, private funds, sovereign entities, and industrial companies. We observe that most nondealer users of security-based swaps do not engage directly in the trading of swaps, but trade through banks, investment advisers, or other types of firms acting as dealers or agents. Based on an analysis of the counterparties to trades reported to the TIW, there are 2,110 entities that engaged directly in trading between November 2006 and December 2017.220 As shown in Table 1 below, close to three-quarters of these entities (DTCCdefined ‘‘firms’’ shown in TIW, which we refer to here as ‘‘transacting agents’’) were identified as investment advisers, of which approximately 40% (about 30% of all transacting agents) were registered as investment advisers under the Advisers Act.221 Although investment advisers are the vast majority of transacting agents, the transactions they executed account for only 12.8% of all single-name CDS trading activity reported to the TIW, measured by number of transactionsides (each transaction has two transaction sides, i.e., two transaction counterparties). The vast majority of transactions (83.3%) measured by number of transaction-sides were executed by ISDA-recognized dealers. TABLE 1—THE NUMBER OF TRANSACTING AGENTS BY COUNTERPARTY TYPE AND THE FRACTION OF TOTAL TRADING ACTIVITY, FROM NOVEMBER 2006 THROUGH DECEMBER 2017, REPRESENTED BY EACH COUNTERPARTY TYPE amozie on DSK3GDR082PROD with PROPOSALS2 Transacting agents Number Percent Transaction share (percent) Investment Advisers ...................................................................................................................................................... -SEC registered ..................................................................................................................................................... Banks ............................................................................................................................................................................ Pension Funds .............................................................................................................................................................. Insurance Companies ................................................................................................................................................... ISDA-Recognized Dealers 222 ....................................................................................................................................... Other ............................................................................................................................................................................. 1635 658 262 29 42 17 125 77.5 31.2 12.4 1.4 2.0 0.8 5.9 12.8 8.6 3.4 0.1 0.2 83.3 0.2 Total ................................................................................................................................................................ 2,110 100.0 100 Principalholders of CDS risk exposure are represented by ‘‘accounts’’ in the TIW.223 The staff’s analysis of these accounts in TIW shows that the 2,110 transacting agents classified in Table 1 represent 13,137 principal risk holders. Table 2, below, classifies these principal risk holders by their counterparty type and whether they are represented by a registered or unregistered investment adviser.224 For instance, banks in Table 1 allocated transactions across 349 accounts, of which 20 were represented by investment advisers. In the remaining instances, banks traded for their own accounts. Meanwhile, ISDA- recognized dealers in Table 1 allocated transactions across 91 accounts. Private funds are the largest type of account holders that we were able to classify, and although not verified through a recognized database, most of the funds 218 The Commission staff analysis of DTCC Derivatives Repository Limited Trade Information Warehouse transaction records indicates that approximately 99% of single-name CDS priceforming transactions in 2017 involved an ISDArecognized dealer. 219 Many dealer entities and financial groups transact through numerous accounts. Given that individual accounts may transact with hundreds of counterparties, the Commission may infer that entities and financial groups may transact with at least as many counterparties as the largest of their accounts. 220 These 2,110 entities, which are presented in more detail in Table 1, infra, include all DTCCdefined ‘‘firms’’ shown in TIW as transaction counterparties that report at least one transaction to TIW as of December 2017. The staff in the Division of Economic and Risk Analysis classified these firms, which are shown as transaction counterparties, by machine matching names to known third-party databases and by manual classification. See, e.g., Dealing Activity Adopting Release, 81 FR 8602, fn.43. Manual classification was based in part on searches of the EDGAR and Bloomberg databases, the SEC’s Investment Adviser Public Disclosure database, and a firm’s public website or the public website of the account represented by a firm. The staff also referred to ISDA protocol adherence letters available on the ISDA website. 221 See 15 U.S.C. 80b1–80b21. Transacting agents participate directly in the security-based swap market, without relying on an intermediary, on behalf of principals. For example, a university endowment may hold a position in a security-based swap that is established by an investment adviser that transacts on the endowment’s behalf. In this case, the university endowment is a principal that uses the investment adviser as its transacting agent. 222 For the purpose of this analysis, the ISDArecognized dealers are those identified by ISDA as belonging to the G14 or G16 dealer group during the period: JP Morgan Chase NA (and Bear Stearns), Morgan Stanley, Bank of America NA (and Merrill Lynch), Goldman Sachs, Deutsche Bank AG, Barclays Capital, Citigroup, UBS, Credit Suisse AG, RBS Group, BNP Paribas, HSBC Bank, Lehman Brothers, Socie´te´ Ge´ne´rale, Credit Agricole, Wells Fargo and Nomura. See, e.g., https://www.isda.org/ a/5eiDE/isda-operations-survey-2010.pdf. 223 ‘‘Accounts’’ as defined in the TIW context are not equivalent to ‘‘accounts’’ in the definition of ‘‘U.S. person’’ provided by Exchange Act rule 3a71– 3(a)(4)(i)(C). They also do not necessarily represent separate legal persons. One entity or legal person may have multiple accounts. For example, a bank may have one DTCC account for its U.S. headquarters and one DTCC account for one of its foreign branches. 224 Unregistered investment advisers include all investment advisers not registered under the Investment Advisers Act and may include investment advisers registered with a state or a foreign authority as well as investment advisers that are exempt reporting advisers under Section 203(l) or 203(m) of the Investment Advisers Act. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 PO 00000 Frm 00039 Fmt 4701 Sfmt 4702 E:\FR\FM\15FEP2.SGM 15FEP2 4652 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules we were not able to classify appear to be private funds.225 TABLE 2—THE NUMBER AND PERCENTAGE OF ACCOUNT HOLDERS—BY TYPE—WHO PARTICIPATE IN THE SECURITYBASED SWAP MARKET THROUGH A REGISTERED INVESTMENT ADVISER, AN UNREGISTERED INVESTMENT ADVISER, OR DIRECTLY AS A TRANSACTING AGENT, FROM NOVEMBER 2006 THROUGH DECEMBER 2017 Account holders by type Number Represented by an unregistered investment dviser Participant is transacting agent 226 Private Funds ........................................... DFA Special Entities ................................ Registered Investment Companies .......... Banks (non-ISDA-recognized dealers) ..... Insurance Companies .............................. ISDA-Recognized Dealers ....................... Foreign Sovereigns .................................. Non-Financial Corporations ...................... Finance Companies ................................. Other/Unclassified .................................... 3,857 1,319 1,159 349 301 91 83 75 20 5,883 1,973 1,262 1,082 20 196 0 63 52 11 3,745 51% 96% 93% 6% 65% 0% 76% 69% 55% 64% 1,859 37 73 8 34 0 3 4 0 1,887 48% 3% 6% 2% 11% 0% 4% 5% 0% 32% 25 20 4 321 71 91 17 19 9 251 1% 2% 0% 92% 24% 100% 20% 25% 45% 4% All ...................................................... 13,137 8,404 64% 3,905 30% 828 6% Our analysis here focuses on outstanding positions in single-name CDS. As we have previously noted, although the definition of a securitybased swap is not limited to singlename CDS, we believe that the singlename CDS data is sufficiently representative of the market and therefore can directly inform the analysis of the state of the current security-based swap market.227 In 2017, there were 1,534,753 single-name CDS transactions reported to DTCC–TIW, of which 1,036,155 were transactions with a clearing agency as a counterparty.228 Currently, security-based swap transactions are generally negotiated and executed bilaterally, typically with a dealer as one of the counterparties. Indeed, based on our analysis of DTCC– TIW data for 2017, more than 99% of single-name CDS transactions have an ISDA-recognized dealer as a counterparty, and 31% of transactions are between two ISDA-recognized dealers.229 As of December 30, 2017 there were 360,473 outstanding positions (with a gross notional value of $4.196 trillion) in single-name corporate CDS of which 252,108 positions ($2.095 trillion) did not include a central counterparty (‘‘CCP’’) as one of the counterparties. Of the 252,108 positions, 158,674 positions ($1.383 trillion) were between two market participants the Commission expects will register as SBS Entities, based on an analysis of DTCC–TIW data.230 In addition, 90,559 positions ($0.684 trillion) were between an expected SBS Entity and a market participant not expected to register as an SBS Entity and 2,875 ($0.028 trillion) were between two participants not expected to register as SBS Entities. If transactions are examined instead, there were 383,212 price-forming transactions in calendar-year 2017 (with an aggregate gross trade size of $5.304 trillion) in single-name corporate CDS of which 175,600 transactions ($4.321 trillion) did not include a CCP as one of the counterparties. Of those 175,660 225 For the purposes of this discussion, ‘‘private fund’’ encompasses various unregistered pooled investment vehicles, including hedge funds, private equity funds, and venture capital funds. There remain over 5,800 DTCC accounts unclassified by type. Although unclassified, each account was manually reviewed to verify that it was not likely to be a special entity within the meaning of the Dodd-Frank Act and instead was likely to be an entity such as a corporation, an insurance company, or a bank. 226 This column reflects the number of participants who are also trading for their own accounts. 227 While other repositories may collect data on transactions in total return swaps on equity and debt, we do not currently have access to such data for these products (or other products that are security-based swaps). In the Cross-Border Proposing Release, we explained that we believed that data related to single-name CDS was reasonable for purposes of this analysis; such transactions appear to constitute roughly 82% of the securitybased swap market as measured on a notional basis. See Cross-Border Proposing Release, 78 FR at 31120 n. 1301. None of the commenters to that release disputed these assumptions, and we therefore continue to believe that, although the BIS data reflect the global OTC derivatives market, and not just the U.S. market, these ratios are an adequate representation of the U.S. market. Also consistent with our approach in that release, with the exception of the analysis regarding the degree of overlap between participation in the single-name CDS market and the index CDS market (cross-market activity), our analysis below does not include data regarding index CDS (including CDS based on narrow-based security indices) as we do not currently have sufficient information to identify the relative volumes of index CDS that are either swaps or security-based swaps. 228 For the purposes of this analysis, we estimate there were approximately 1.53 million single-name CDS transactions in 2017, of which approximately 1.04 million were transactions with a clearing agency as a counterparty. In addition to CDS, security-based swap products include equity swaps, such as total return swaps on single names and swaps based on narrow-based security indices. The Commission currently lacks comprehensive data on equity swaps, including data on transaction volumes and notional amounts. While there were more than 1.53 million security-based swap transactions in 2017, we do not currently have sufficient information to precisely identify the number of transactions beyond those that were single-name CDS. However, while recognizing that average notional transaction amounts for equity and multi-name CDS may differ from average notional transaction amounts for CDS, our estimate (using data from 2015) that single-name CDS constitute roughly 82% of the security-based swap market implies that there were approximately 337,000 security-based swap transactions in 2017 in addition to the approximately 1.53 million singlename CDS transactions we identify in the DTCC– TIW data, or 1.87 million total security-based swap transactions. Note that our estimate that singlename CDS constitutes roughly 82% of the securitybased swap market is based on notional transaction amounts rather than transaction counts; in using this figure to estimate the total number of securitybased swap transactions, we have assumed that the average notional amount is the same across singlename CDS, multi-name CDS, and equity swaps. 229 For the purpose of this analysis, the reference to ‘‘ISDA-recognized dealers’’ means those dealers identified by ISDA as belonging to the G14 or G16 dealer group during the period. This group includes: JP Morgan Chase NA (and Bear Stearns), Morgan Stanley, Bank of America NA (and Merrill Lynch), Goldman Sachs, Deutsche Bank AG, Barclays Capital, Citigroup, UBS, Credit Suisse AG, RBS Group, BNP Paribas, HSBC Bank, Lehman Brothers, Socie´te´ Ge´ne´rale, Credit Agricole, Wells Fargo and Nomura. See, e.g., https://www.isda.org/ a/5eiDE/isda-operations-survey-2010.pdf. See also Aldasoro, Inaki, and Torsten Ehlers, 2018, The Credit Default Swap Market: What a Difference a Decade Makes, BIS Quarterly Review June 2018, Graph 2, available at: https://www.bis.org/publ/ qtrpdf/r_qt1806b.pdf. https://www.bis.org/publ/ qtrpdf/r_qt1806b.pdf. https://www.bis.org/publ/ qtrpdf/r_qt1806b.pdf, Graph 2. 230 See supra Section VI.B.1.b for current estimates of the number of SBS Entities. d. Outstanding Positions amozie on DSK3GDR082PROD with PROPOSALS2 Represented by a registered investment adviser VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 PO 00000 Frm 00040 Fmt 4701 Sfmt 4702 E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules transactions, 75,119 transactions ($1.695 trillion) were between two expected SBS Entities, 99,370 transactions ($2.245 trillion) were between an expected SBS Entity and a participant not expected to register, and 1,171 transactions ($0.382 trillion) were between two participants not expected to register as SBS Entities. Further analysis of the data reveals that of the 24 expected SBS Entities with outstanding positions as of December 30, 2017, 10 are not U.S. persons and may be subject to similar requirements as those being proposed here by foreign regulators. We note that the data available to us from DTCC–TIW does not encompass those CDS positions that both: (i) Do not involve U.S. counterparties; 231 and (ii) are based on non-U.S. reference entities. Notwithstanding this limitation, we believe that the DTCC–TIW data provides sufficient information to identify the types of market participants active in the security-based swap market and the general pattern of transactions within that market.232 We find that of the outstanding positions on December 30, 2017, 317,854 positions ($1.661 trillion) include at least one expected SBS Entity, 3,037 ($0.018 trillion) are between non-U.S. domiciled expected SBS Entities and 60,948 ($0.489 trillion) are between a non-U.S, domiciled expected SBS Entity and a participant not expected to register as an SBS Entity. amozie on DSK3GDR082PROD with PROPOSALS2 2. Current Portfolio Reconciliation Practices While the Commission does not have data on current portfolio reconciliation practices of security-based swap market participants,233 certain market 231 We note that DTCC–TIW’s determinations as to the domicile of a counterparty or reference entity may not reflect our definition of ‘‘U.S. person’’ in all cases. Our definition of ‘‘U.S. person’’ follows the definition used in the Commission’s June 2014 release where it, among other things, adopted rules and guidance regarding the application of the certain Title VII definitions in the cross-border context. See Application of ‘‘Security-Based Swap Dealer’’ and ‘‘Major-Security-Based Swap Participant’’ Definitions to Cross-Border SecurityBased Swap Activities, Exchange Act Release No. 72472 (June 25, 2014), 79 FR 47277, 47303 (Aug. 12, 2014 (republication)) (‘‘Cross-Border Adopting Release’’). 232 The challenges we face in estimating measures of current market activity stems, in part, from the absence of comprehensive reporting requirements for security-based swap market participants. The Commission has adopted rules regarding trade reporting, data elements, and public reporting for security-based swaps that are designed to, when fully implemented, provide us with appropriate measures of market activity. See Regulation SBSR Adopting Release, 80 FR at 14699–700. 233 Although the Commission does not have information on the number of valuation discrepancies between counterparties in SBS VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 participants we expect will register as SBS Entities are already subject to similar requirements from other regulators. In particular, those entities that are also registered with the CFTC as Swap Entities are subject to CFTC rules on portfolio reconciliation. These rules require Swap Entities to reconcile their swap portfolios with one another and to provide counterparties who are not registered as Swap Entities with regular opportunities for portfolio reconciliation.234 The Commission has reviewed these rules and preliminarily believes that, other than as expressly noted above in Section I.B, they are substantively identical to the rules we are proposing today.235 Further, SBS Entities that are domiciled outside of the U.S. may be subject to similar requirements of regulators from their home jurisdiction. For example, entities subject to Chapter VII, Article 13 of EU Regulation No 149/ 2013 already must comply with portfolio reconciliation requirements similar to those under the proposed rules. The EU regulations require all counterparties to agree on arrangements under which portfolios shall be reconciled before entering into an OTC derivative contract. Furthermore, the frequency of portfolio reconciliation under those regulations depends on both whether either counterparty is a ‘‘financial counterparty’’ or a ‘‘nonfinancial counterparty’’ (each as defined in European regulations), and the number of outstanding contracts between the counterparties. In addition to regulations that may apply to certain SBS Entities that are either dually registered with the CFTC as Swap Entities or subject to similar portfolio reconciliation rules in other jurisdictions, portfolio reconciliation forms a part of current market practices. In particular, ISDA publishes a set of ‘best practices’ for its members for the OTC derivatives collateral process that markets, a June 2017 survey on dealer financing noted that two-fifths of survey respondents reported that the volume of valuation disputes increased somewhat over the September 2016 to June 2017 period. Small net fractions of dealers responded that the volume, duration, and persistence of mark and collateral disputes had increased in OTC derivatives, especially in foreign exchange and interest rate contracts. Three-fifths of dealers responded that, on average, it takes more than two days but less than a week to resolve a mark and collateral dispute on VM. One-third indicated two days or fewer. See Yesol Huh, Division of Research and Statistics, Federal Reserve Board, The June 2017 Senior Credit Officer Opinion Survey on Dealer Financing Terms, available at: https:// www.federalreserve.gov/data/scoos/files/scoos_ 201706.pdf. 234 See 17 CFR 23.502 (Portfolio reconciliation). 235 See, e.g., supra Section I.B.2 for a discussion of similarities and differences in approach to the definition of material terms that must be reconciled. PO 00000 Frm 00041 Fmt 4701 Sfmt 4702 4653 addresses, among other things, portfolio reconciliation of non-cleared OTC derivatives.236 These ‘best practices’ include written agreement between counterparties as to the terms of the reconciliation and reconciliation tolerances, and also recognize both the CFTC and EU rules pertaining to portfolio reconciliation. 3. Current Portfolio Compression Practices While the Commission does not have data on current portfolio compression practices of security-based swap market participants, certain SBS Entities are already subject to similar compression requirements in other contexts similar to the situation involving portfolio reconciliation. Specifically, SBS Entities that are also registered with the CFTC as Swap Entities are subject to CFTC rules on portfolio compression. As discussed above, the Commission has reviewed those rules and preliminarily believes that they are, other than as expressly noted above in Section I.C, substantively identical to the rules we are proposing today. Further, SBS Entities that are domiciled outside of the U.S. may be subject to similar requirements from regulators in their home jurisdiction. For example, entities subject to Chapter VII, Article 14 of EU Regulation No 149/ 2013 already must comply with portfolio compression requirements. Under these requirements any entity that has 500 or more non-cleared OTC derivative contracts with any one counterparty must have procedures in place to regularly (at least twice a year) analyze the possibility of conducting a portfolio compression exercise in order to reduce their counterparty credit risk and engage in such a portfolio compression exercise. The EU regulations differ from these proposed rules in a few important ways, including their application to all OTC derivative positions, not just security-based swaps, as well as the minimum frequency of compression exercises. Moreover, both financial and non-financial counterparties are required under the EU regulations to ensure that they are able to provide ‘‘a reasonable and valid explanation to the relevant competent authority for concluding that a portfolio compression exercise is not appropriate.’’ 236 See ISDA, 2013 Interim Updated Best Practices for the OTC Derivatives Collateral Process, Best Practices 10.1—10.6 (Oct. 23, 2013), available at: https://www2.isda.org/attachment/NjA3NQ==/ 2013%20ISDA%20Best%20Practices%20for% 20the%20OTC%20Derivatives%20Collateral% 20Process%20-%20FINAL.pdf (‘‘ISDA Collateral Best Practices’’). E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules In addition to regulations that may apply to certain SBS Entities that are either dually registered with the CFTC as Swap Entities or subject to similar portfolio compression rules in other jurisdictions, portfolio compression forms a part of current market practices. The ISDA Collateral Best Practices also includes a best practice that addresses portfolio compression, explaining that trades that are subject to industry-wide trade-reducing events should be removed from the portfolio on the day the trade-reducing event occurs and that this should be in agreement with governing documentation for the applicable risk reducing process.237 Although we lack data on current portfolio compression practices of individual SBS market participants, the importance of portfolio compression is illustrated by the scope of its use among security-based swap market participants.238 In March 2010, DTCC explicitly attributed the reduction in the gross notional value of the credit derivatives in its warehouse to industry supported portfolio compression.239 Using data from TriOptima, the BIS reports CDS portfolio compression rates as high as 25% of notional outstanding in the first half of 2008.240 Compression volumes fell steadily over the following years due, in part, to falling transaction volumes and the rise of central clearing.241 TriOptima, as well as other firms, continue to offer compression services, and the Commission preliminarily believes that the fact that market participants continue to find it worthwhile to pay for such services lends support to the argument that market participants view portfolio compression as a valuable tool. The chart below illustrates the opportunities for portfolio compression between 2010 and 2017 for single-name security-based swaps.242 As the gap between gross and net notional values widens, the opportunities for portfolio compression increase. Over our reference period, however, the difference between gross and net notional values has declined. For instance, in 2010, the percentage, which captures the ratio of net to gross notional value, was 11.0%, but this number has been gradually increasing through December 30, 2018 when it was 15.2%. Smaller ratios indicate greater opportunities for portfolio compression; however, as shown in the chart below, based on changes in gross and net notional value over time, unexploited opportunities for compression are diminishing.243 237 See ISDA Collateral Best Practices, supra note 236, Best Practice 8.4. 238 The data available to the Commission with respect to portfolio compression does not allow for enumeration of the actual participants which participate in such practices; however, inferences regarding the scope can be drawn from the magnitude of the reduction in the gross notional value of the credit derivatives. 239 See DTCC Press Release, DTCC Trade Information Warehouse Completes Record Year Processing OTC Credit Derivatives, (Mar. 11, 2010). Notably, beginning in August 2008, ISDA encouraged compression exercises for CDS by selecting the service provider and defining the terms of service. 240 See Aldasoro, Inaki, and Torsten Ehlers, 2018, The Credit Default Swap Market: What a Difference a Decade Makes, BIS Quarterly Review June 2018, Graph 1 panel 2 and accompanying text, available at: https://www.bis.org/publ/qtrpdf/r_qt1806b.pdf. In March of 2010, the staff of the FRBNY estimated that since 2008 nearly $50 trillion gross notional of CDS positions has been eliminated through portfolio compression. See FRBNY OTC Derivatives Report, supra note 62. 241 Id. 242 The chart below includes only gross and net notional of single-name security-based swaps. The inclusion of index security-based swaps could expand potential compression opportunities available to SBS Entities. 243 The result is likely driven by banks and securities firms. See Aldasoro, Inaki, and Torsten Ehlers, 2018, supra note 240, Graph 5. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 PO 00000 Frm 00042 Fmt 4701 Sfmt 4725 E:\FR\FM\15FEP2.SGM 15FEP2 EP15FE19.000</GPH> amozie on DSK3GDR082PROD with PROPOSALS2 4654 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules It is possible that market participants may already be taking advantage of portfolio compression opportunities. However, the Commission does not infer that the entirety of the reduction in the gap between gross and net notional values is due to portfolio compression exercises. Other plausible explanations for the reduction in the gross notional value of security-based swaps include both fewer and/or smaller new transactions, expiration of existing positions without rollover into new positions, and loss or consolidation of market participants throughout time. Due to limitations of the data available to the Commission, it is infeasible to distinguish the overall effect of portfolio compression exercises on the reduction in the gross notional value of the security-based swap market from the alternative explanations presented above. amozie on DSK3GDR082PROD with PROPOSALS2 4. Current Trading Relationship Documentation Practices Memorializing the specific terms of the security-based swap trading relationship and security-based swap transactions between counterparties is prudent business practice and, in fact, many market participants already use standardized documentation. Examination of the use of ISDA Master Agreements (the measure of trading relationship documentation available to the Commission in the data provided by DTCC–TIW) shows that the percentage of transactions with these agreements declines from 78.2% in 2008 to 34.1% in 2017, with the peak occurring in 2010 (96.1%). However, as trading relationship documentation may be different when the counterparty is a CCP, an analysis of documentation on aggregate security-based swap transactions (both cleared and uncleared) may be misleading. With the introduction of ICE Clear Credit in 2009, the percentage of cleared transactions has increased over time, thus a seemingly more relevant measure to look at is the frequency of use of ISDA Master Agreements for uncleared transactions. Approximately 99% of all uncleared transactions are reported (by DTCC–TIW) as using trading relationship documentation (in the form of ISDA Master Agreements) in 2017 compared to 78.2% in 2008. Accordingly, the Commission generally believes that many, if not most, market participants currently execute and maintain trading relationship documentation of the type required by the proposed rules in the ordinary course of their businesses, including documentation that contains several of VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 the terms that would be required by the proposed rules. Finally, and similar to the discussion regarding the reconciliation and compression, SBS Entities that are also registered with the CFTC as Swap Entities are subject to CFTC rules requiring the use of trading relationship documentation. As discussed above, the Commission has reviewed those rules and preliminarily believes that they are, other than as expressly noted above in Section I.D, substantively identical to the rules we are proposing today. C. Economic Costs and Benefits, Including Impact on Efficiency, Competition, and Capital Formation In this section we first discuss the expected effects of the proposed rules on efficiency, competition, and capital formation, focusing particularly on the risk-mitigation benefits that stem from the use of portfolio reconciliation, expanding opportunities for portfolio compression, and improvements in documentation. We then turn our discussion to additional costs and benefits, including compliance costs and alternatives considered of the proposed rules. 1. Effects on Efficiency, Competition, and Capital Formation Risk mitigation rules have the potential to affect efficiency, competition, and capital formation in the security-based swap market, primarily through a reduction in operational, market, and credit risks that accompany outstanding security-based swap positions. In addition, the substituted compliance framework may provide additional effects that are distinct from the broader market impacts that are described below. As with the benefits and costs, we believe that several of the effects described below only occur to the extent that current market practices do not already conform to our proposed rules. a. Broad Market Effects In the release adopting final rules requiring SBS Entities to provide trade acknowledgments and to verify those trade acknowledgments with their counterparties to security-based swap transactions, the Commission explained the importance of confirming trades in a timely manner, noting that confirmation of the terms of a transaction is essential for SBS Entities ‘‘to effectively measure and manage market and credit risk.’’ 244 245 In this 244 See Trade Acknowledgment and Verification Adopting Release, 81 FR at 39833. 245 See supra Section I.B.1. PO 00000 Frm 00043 Fmt 4701 Sfmt 4702 4655 regard, portfolio reconciliation addresses many of these same issues, but unlike the confirmation process, which occurs at the outset of a transaction, reconciliation operates throughout the life of the transaction.246 Failure to periodically conduct portfolio reconciliation may cause errors and disputes over the terms of a transaction that may exist to go undetected, leading to errors in measurement and management of market and credit risks associated with particular transactions. More generally, timely portfolio reconciliation will provide counterparties with accurate information that will enable them to evaluate their own risk exposure in a timely manner. Efficient and costeffective risk management may conserve resources and free up capital that can be deployed in other asset classes, promoting risk-sharing and efficient capital allocation. In addition, costeffective risk management may reduce the overall costs of financial intermediation, allowing market participants to increase lending and other capital formation activities. Similarly, periodic portfolio reconciliation and improved standards for transaction documentation may contribute to broader market stability, particularly during periods of distress. Disagreement as to one or more material terms of a transaction or inadequate documentation could hinder timely and efficient settlement of security-based swap transactions, particularly in the case of a credit event on a reference entity on which many different counterparties have, in the aggregate, a large notional outstanding exposure. During periods of financial distress, uncertainty about terms, value, and documentation of outstanding transactions could contribute to liquidity and cash shortfalls that threaten the stability of the financial system. Thus, to the extent that the proposed rules reduce uncertainty about outstanding transactions, we expect reduced risk of uncertainty about the credit risk of potential counterparties, particularly during a financial crisis. Finally, to the extent that portfolio reconciliation requirements differ from current market practices, the proposed rules have the potential to affect competition across multiple dimensions. If the costs of portfolio reconciliation, portfolio compression, and complying with transaction documentation rules for security-based swap transactions are largely fixed (i.e., the costs come from establishing infrastructure and systems necessary to 246 See E:\FR\FM\15FEP2.SGM id. 15FEP2 4656 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules perform portfolio reconciliation and portfolio compression and comply with documentation requirements) rather than varying with the number of transactions or positions outstanding, smaller dealers intermediating a smaller number of trades may have a larger burden placed on them; larger dealers, on the other hand, may be able to spread the costs over a greater number of trades or positions, with a lower average cost of complying with these rules. Similarly, the costs of establishing an infrastructure to comply with these requirements may create a barrier to entry for market participants wishing to establish a SBS dealer business.247 b. Substituted Compliance amozie on DSK3GDR082PROD with PROPOSALS2 As discussed above, if the Commission has made a positive substituted compliance determination with respect to a particular foreign regulatory regime, SBS Entities operating in that jurisdiction may be able to satisfy their Title VII risk mitigation requirements by complying with similar requirements of the foreign financial regulatory system. Substituted compliance would be available only for SBS Entities who are not U.S. persons. The Commission is proposing to amend its rules to make substituted compliance potentially available to the portfolio reconciliation, portfolio compression, and trading relationship documentation requirements in order to minimize the likelihood that SBS dealers are subjected to potentially duplicative or conflicting regulation. The Commission preliminarily believes that duplicative regulations that achieve comparable regulatory outcomes increase the compliance burdens on market participants without corresponding increases in benefits. By decreasing the compliance burden for foreign SBS dealers active in the U.S. market, the availability of substituted compliance could encourage foreign firms’ participation in the U.S. market, increasing the ability of U.S. firms to access global liquidity, and reducing the likelihood that liquidity would fragment along jurisdictional lines. Such participation and access to liquidity 247 The Commission does not expect that this effect would extend to major SBS participants, which are by definition the largest non-dealer participants in the security-based swap market. As described in the economic baseline, out of more than 4,000 security-based swap market participants, we expect at most five to register as major SBS participants. These entities maintain substantial positions in security-based swaps, as defined in the Intermediary Definitions Adopting Release, and the Commission expects these entities have sufficient resources and infrastructure to comply with portfolio reconciliation and documentation requirements. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 might result in increased competition between both U.S. and foreign intermediaries without compromising the regulatory benefits intended by the applicable risk mitigation rules. 2. Portfolio Reconciliation Disputes related to confirming the terms of a swap, as well as swap valuation disputes, have long been recognized as a significant problem in the OTC derivatives market. The Commission preliminarily believes that the ability to determine definitively the value of a security-based swap at any given time is an important component of many of the OTC derivatives market reforms contained in the Dodd-Frank Act and is a component of sound risk management practices.248 Securitybased swap valuation is also crucial for determining capital and margin requirements applicable to SBS Entities and therefore plays a primary role in risk mitigation for uncleared securitybased swaps. Portfolio reconciliation is considered an effective means of identifying and resolving these disputes at a time and in a manner that will be least disruptive to the counterparties and the broader financial system. Parties may dispute valuations of thinly traded security-based swaps where there is not agreement on valuation methodologies or the source for formula inputs. Many of these security-based swaps are thinly traded either because of their limited liquidity or because they are simply too customized to have comparable counterparts in the market. As many of these security-based swaps are valued by dealers internally by ‘‘marking-tomodel,’’ their counterparties may dispute the inputs and methodologies used in the model. As uncleared security-based swaps are bilateral, privately negotiated contracts, on-going security-based swap valuation for purposes of initial and variation margin calculation and security-based swap terminations or novations, also has been largely a process of on-going negotiation between the parties. The inability to agree on the value of a security-based swap became especially acute during the financial crisis that immediately preceded passage of the Dodd-Frank Act when there was widespread failure of the market inputs needed to value many security-based swaps.249 248 See ISDA Collateral Best Practices, supra note 236, Section 10. 249 The lack of liquidity in markets for mortgagebacked securities led to wide disparities in the valuation of CDS referencing mortgage-backed securities (especially collateralized debt obligations). Such wide disparities led to large collateral calls from dealers on AIG, hastening its PO 00000 Frm 00044 Fmt 4701 Sfmt 4702 a. Requirements The Commission is proposing rules and interpretations that generally would require each SBS Entity (1) to engage in portfolio reconciliation with counterparties who are also SBS Entities at periodic intervals based on the number of outstanding transactions with the counterparty and (2) to establish, maintain, and follow written policies and procedures reasonably designed to ensure that it engages in portfolio reconciliation with counterparties who are not SBS Entities, also at periodic intervals based on the number of outstanding transactions with the counterparty.250 The Commission is proposing to vary the proposed portfolio reconciliation requirement based on the particular type of counterparty with which the SBS Entity transacts. For transactions between two SBS Entities, the proposed rules would require the two sides to engage in portfolio reconciliation at frequencies that are based on the size of the security-based swap portfolio between the two parties.251 In addition to the requirements regarding the frequency of the reconciliation, proposed Rule 15Fi–3(a)(1) would require the two SBS Entities to agree in writing with each of their counterparties on the terms of the portfolio reconciliation including, if applicable, agreement on the selection of any third party service provider who may be performing the reconciliation. To the extent that the two SBS Entities identify a discrepancy, the proposed rule would require the parties to take certain steps. First, proposed Rule 15Fi–3(a)(4) would require the two sides to resolve immediately any discrepancy in a material term, whether identified directly as part of the portfolio reconciliation or otherwise. Second, proposed Rule 15Fi–3(a)(5) would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to resolve any discrepancy in a valuation identified as part of a downfall. See CBS News, ‘‘Calling AIG? Internal Docs Reveal Company Silent About Dozens of Collateral Calls,’’ June 23, 2009, available at: https:// www.cbsnews.com/stories/2009/06/23/cbsnews_ investigates/main5106672.shtml; See also Financial Crisis Inquiry Commission, The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, Chapter 8, available at: https://www.gpo.gov/fdsys/pkg/GPOFCIC/pdf/GPO-FCIC.pdf. 250 Pursuant to proposed Rule 15Fi–3(d), the new requirements regarding portfolio reconciliation would not apply to a clearing transaction (i.e., a security-based swap that has a clearing agency as a direct counterparty). See supra note 58 and accompanying text. 251 See proposed Rule 15Fi–3(a). E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules portfolio reconciliation or otherwise as soon as possible, but in any event within five business days after the date on which the discrepancy is first identified. As a condition to this requirement, however, proposed Rule 15Fi–3(a)(5) would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to identify how the SBS Entity will comply with any variation margin requirements under Section 15F(e) of the Exchange Act 252 and any related regulations pending resolution of the valuation discrepancy. Finally, proposed Rule 15Fi–3(a)(5) would clarify that for purposes of the requirement to resolve valuation discrepancies within five business days of being identified, a difference between the lower valuation and the higher valuation of less than 10% of the higher valuation need not be deemed a discrepancy.253 Separately, with respect to transactions between an SBS Entity and a counterparty that is not an SBS Entity, proposed Rule 15Fi–3(b) would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to ensure that it engages in portfolio reconciliation as set forth in the rule.254 This is in contrast to proposed Rule 15Fi–3(a), which expressly requires portfolio reconciliation with respect to transactions where both counterparties are SBS Entities. Proposed Rule 15Fi–3(b) contains a number of requirements regarding the contents of the policies and procedures required therein, as they relate to reconciliation with non-SBS Entities, which are largely consistent with the requirements imposed directly on the parties under proposed Rule 15Fi–3(a). Specifically, proposed Rule 15Fi–3(b)(3) provides that such policies and procedures must require that the portfolio reconciliation be performed no less frequently than: (1) Once each calendar quarter for each security-based swap portfolio that includes more than 100 security-based swaps at any time during the calendar quarter and (2) once annually for each security-based swap portfolio that includes no more than 100 security-based swaps at any time during the calendar year. In addition, proposed Rule 15Fi– 3(b)(4) requires each SBS Entity to establish, maintain, and follow written procedures reasonably designed to 252 15 U.S.C. 78o–10(e). 10% threshold would apply on a transaction-by-transaction basis, and not on a portfolio level. 254 See proposed Rule 15Fi–3(b). 253 This VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 resolve any discrepancies in the valuation or a material term of each security-based swap identified as part of a portfolio reconciliation or otherwise with a counterparty that is not an SBS Entity within five days.255 Finally, proposed Rule 15Fi–3(c) would require each SBS Entity to promptly notify the Commission of any security-based swap valuation dispute in excess of $20,000,000 (or its equivalent in any other currency) if not resolved within: • three business days, if the dispute is with a counterparty that is an SBS Entity, or • five business days, if the dispute is with a counterparty that is not an SBS Entity. Such notification would be required to be in a form and manner acceptable to the Commission, and would also be required to be sent to any applicable prudential regulator (i.e., for any SBS Entity that is also a bank, to its bank regulator).256 For the security-based swap market to operate efficiently and to reduce credit and operational risk between counterparties, the Commission preliminarily believes that, although the frequency of portfolio reconciliation depends on the number of positions with a counterparty, reconciliation should occur by position because terms may vary across positions with the same counterparty. By identifying and managing mismatches in key economic terms and valuation for individual transactions across an entire portfolio, these rules are intended to require a process in which risk between counterparties can be identified and reduced. b. Benefits Reconciliation is beneficial not only to the parties involved but also to the markets as a whole. By identifying and managing disputed key economic terms or valuation for each transaction across a portfolio, an entity’s counterparty credit risk and operational risk can be diminished. By requiring a systematic reconciliation process, as well as policies and procedures related to portfolio reconciliation between counterparties, SBS Entities will be able 255 Similar to the requirement in paragraph (a) of the proposed rule for portfolio reconciliation with counterparties that are either SBS dealers or major SBS participants, proposed Rule 15Fi–3(b)(4) provides that a difference between the lower valuation and the higher valuation of less than 10% of the higher valuation need not be deemed a discrepancy for purposes of that paragraph. See supra note 39 and accompanying text (discussing the 10% threshold in the context of Rule 15Fi– 3(a)(5)). 256 See supra Section I.B.6. PO 00000 Frm 00045 Fmt 4701 Sfmt 4702 4657 to better identify and correct problems in a timely manner in their postexecution processes (including confirmation) in order to reduce the number of disputes and improve the integrity and efficiency of their internal processes. Accordingly, expanding the universe of participants subject to the reconciliation requirements can help to reduce the risk bilateral markets may pose to the broader financial system. As discussed above, because shortcomings in credit risk management and documentation may only become evident during a crisis, some benefits of portfolio reconciliation will accrue to the financial system as a whole while the ongoing direct costs are borne by the individual market participant. Therefore, in the absence of these rules, the level and frequency of portfolio reconciliation chosen by individual market participants may be less than what would be desired by all market participants in order to properly manage risks to the financial system. In addition, the Commission preliminarily believes that the proposed tiering of obligations, whereby the frequency of the portfolio reconciliation would be based on the number of outstanding transactions with the applicable counterparty, represents a reasonable attempt to calibrate the costs to the benefits expected from reconciling a person’s security-based swap portfolio at regular intervals. In this respect, those benefits would be expected to rise for larger—and often more complex—portfolios that may represent a greater potential for loss than a smaller, less complex portfolio. The Commission preliminarily believes that, given the expected benefits of making the frequency of portfolio reconciliation a function of the size of a portfolio with a particular counterparty, setting the frequency of reconciliation identical to that adopted by the CFTC will provide additional benefit for SBS Entities that are also registered with the CFTC as Swap Entities. In particular, harmonizing the frequency of reconciliation for swaps and SBS should reduce implementation cost and reduce operational complexity. Similarly, the Commission notes that the EC has adopted portfolio reconciliation requirements for the EU that are similar to those proposed by the Commission in this release. The Commission preliminarily believes that aligning its portfolio reconciliation requirements with those in other major security-based swap markets will benefit SBS Entities by avoiding the imposition of disparate compliance and operational policies and procedures. E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 4658 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules Moreover, proposed Rule 15Fi–3(a)(2) provides that portfolio reconciliation may be performed either on a bilateral basis by the counterparties or by a third party selected by the counterparties in accordance with paragraph (a)(1) of the proposed rule. Under this approach, the process for selecting a third-party service provider—or the actual identity of the service provider—should be included in the written agreement between the two sides setting forth the terms of the portfolio reconciliation process. In the absence of periodic portfolio reconciliation, if the counterparties to a security-based swap transaction are not in agreement with respect to each of the terms of the transaction that may affect each party’s rights and obligations, any such difference could lead to complications at various points throughout the trade.257 These discrepancies could be exacerbated if they remain undetected until such times as the parties become obligated to perform on their requirements under the contract. Such discrepancies could be particularly problematic if they are discovered during a period of financial stress for the market participant.258 Thus, portfolio reconciliation may help to mitigate the possibility of a discrepancy unexpectedly affecting performance by ensuring that the parties are and remain in agreement with respect to all of the material terms of the security-based swap transaction. Regular reconciliation of all portfolios is a process to reduce counterparty credit exposure and operational risk and help prevent disputes from arising. The rule should promote market integrity and reduce risk by establishing procedures that will promote legal certainty concerning security-based swap transactions, assist with the early resolution of valuation disputes, reduce operational risk, and increase operational efficiency. The proposed rules may have differential benefits for smaller market participants. Smaller market participants may not have the bargaining power necessary to compel larger counterparties to coordinate on portfolio reconciliation. Since SBS Entities, absent a mandate, are likely to focus risk management resources on larger counterparties, the ability of smaller counterparties to require the necessary cooperation from their counterparties who are SBS Entities will be improved. Reduced uncertainty concerning material terms and valuation methodologies could reduce the risks to 257 See 258 See supra note 14. supra note 203. VerDate Sep<11>2014 22:04 Feb 14, 2019 these smaller participants for using SBS for hedging market risk to which they may be exposed. Portfolio reconciliation is particularly relevant with respect to terms related to the valuation of the instrument. Unresolved discrepancies regarding the value of a security-based swap can lead to, among other things, active disputes between counterparties with respect to the amount of margin that must be posted or collected, as well as errors and other complications that may result in significant uncollateralized exposure in the uncleared security-based swap markets (or alternately, potentially inefficient overcollateralization). Accordingly, we preliminarily believe that requiring counterparties to clearly document the applicable processes and requirements for calculating and exchanging margin in connection with a security-based swap transaction is an important step in achieving this broader regulatory objective. The notification requirement of proposed Rule 15Fi–3(c) would provide the Commission with information about disagreements over position values between counterparties. Valuation is one of the most fundamental elements for determining the economic rights and obligations of each of the counterparties to a security-based swap transaction. For example, market participants manage credit risks to their counterparties by exchanging margin with each other in an amount determined using the value of the underlying security-based swap. If those valuations are not accurate for any reason, such as human or system errors, problems with the valuation methodology, or an issue affecting the timeliness of the calculation, that error could result in one of the counterparties having an uncollateralized credit exposure and a potential for loss in the event of a default. We therefore expect that the notification requirement could assist the Commission in anticipating potential valuation problems that could ultimately lead to market disruption, and in identifying potential issues with respect to an SBS Entity’s internal valuation methodology. As noted above, the CFTC has adopted a nearly identical requirement with the same $20,000,000 threshold, and the Commission believes that divergence from that requirement could lead to additional costs for SBS Entities that are also registered with the CFTC as Swap Entities.259 Finally, as discussed above, the Commission preliminarily believes reconciliation may provide indirect benefits by 259 See Jkt 247001 PO 00000 supra Section I.B.6. Frm 00046 Fmt 4701 Sfmt 4702 improving the accuracy of SDR data.260 As described above in Section I.B.2, the information that SBS Entities would initially be required to reconcile with their counterparties would include each term that is required to be reported to a registered SDR under Rule 901 under the Exchange Act.261 c. Costs The portfolio reconciliation rules the Commission is proposing today are similar to the corresponding CFTC rules for Swap Entities. As a result, the onetime costs to develop, test, and implement new procedures and technology that may be required in order to be compliant with the proposed rules are mitigated by the fact that many SBS Entities also are likely to be Swap Entities. These dually registered entities are likely to be familiar with these general requirements and have the infrastructure in place to comply with similar rules that apply to their swap business. SBS Entities that are not also CFTCregulated Swap Entities and that do not currently use an electronic platform or vendor service to conduct portfolio reconciliation will need to expend significant time and resources to modify the necessary systems to comply with proposed Rule 15Fi–3. Even those SBS Entities that do use electronic platforms or vendors services may find it necessary to make significant adjustments to comply with the rules. The Commission estimates a one-time upfront cost of approximately $5–10 million for an SBS Entity that is not also a Swap Entity.262 Although the Commission does not currently have cost data for either reconciliation performed in-house or by third-party service providers, and therefore cannot quantify these costs, the Commission preliminarily believes that the ongoing portfolio reconciliation cost would likely be a function of portfolio size and the availability of third party service providers. In contrast, when commenting on the CFTC’s then-proposed portfolio reconciliation rule, a third party provider of multilateral compression services stated that a large number of Swap Entities already regularly reconcile their portfolios with each other and with other entities and that 260 See SDR Adopting Release, 80 FR at 14528– 48, for a discussion of the expected economic benefits accurate SBS data held at SDRs. 261 See proposed Rule 15Fi–1(i)(1) (referencing 17 CFR 242.901). 262 This estimate is based on an estimate supplied by ISDA to the CFTC in response to their proposed portfolio reconciliation rule. See CFTC Risk Mitigation Adopting Release 77 FR at 55952–3. E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules the increased frequency and inclusion of smaller portfolios as proposed should prove no obstacle to such entities.263 If SBS Entities have similar business practices, then this comment suggests start-up and on-going portfolio reconciliation costs could be small. The Commission preliminarily believes that certain costs will arise despite the fact that an SBS Entity also may be registered with the CFTC as a Swap Entity, and therefore subject to similar rules already adopted by the CFTC. Such costs may include (i) increased costs to account for possible differences between the SEC and CFTC related to the terms considered to be material for purposes of the reconciliation requirement; (ii) the additional resources necessary to design, compose, and implement the required policies and procedures; (iii) the additional resources needed to comply with the dispute resolution timeframes; and (iv) the compilation and maintenance of applicable records. These costs, however, are by nature specific to each entity’s internal operations; absent specific information from commenters, the Commission cannot provide reasonable estimations regarding the resources needed to comply. The proposed rule also requires SBS Entities to agree in writing with each of their counterparties on the terms of the portfolio reconciliation including, if applicable, agreement on the selection of any third party service provider who may be performing the reconciliation. Accordingly, each counterparty to a SBS Entity subject to these rules would incur an upfront cost in implementing this requirement, particularly since the Commission would expect that such terms be agreed to in writing prior to, or contemporaneously with, the two parties executing any new securitybased swap transaction. These costs would be mitigated if, once the parties have agreed in writing on the terms of the portfolio reconciliation for the first time, the two sides comply with this requirement for subsequent transactions by merely agreeing in writing to abide by the existing agreement regarding the reconciliation process. This practice could help to ensure that portfolio reconciliation begins without delay after execution of the transaction and is designed to minimize the number of 263 See Letter from Per Sjo ¨ berg, Executive Vice TriOptima AB to the CFTC, dated Feb. 28, 2011 at 2, available at: https://comments.cftc.gov/ PublicComments/ViewComment.aspx?id=30562& SearchText.28, 2011 at 2, available at https:// comments.cftc.gov/PublicComments/ ViewComment.aspx?id=30562&SearchText. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 disagreements regarding the portfolio reconciliation process itself. The Commission estimates that of the 55 market participants we expect to register as SBS Entities, approximately 35 will be dually-registered with the CFTC and may already have automated portfolio reconciliation systems in place. Thus, for these entities, the costs associated with modifying these existing systems to account for security-based swap reconciliations is expected to be minimal. For the remaining 20 SBS Entities which are not expected be dually-registered with the CFTC, the anticipated personnel costs associated with setting up an automated portfolio reconciliation system per SBS Entity is $58,795, or $1,175,900 in aggregate.264 265 The Commission preliminarily believes that these costs would be a component of the upfront cost estimate of $5–10 million discussed above.266 For each SBS Entity, we anticipate that approximately 190 hours per year will be required for reconciliation or a total of 10,450 hours across the 55 SBS Entities.267 With respect to reconciliations with non-SBS counterparties, the Commission estimates that an additional 227.5 hours per SBS Entity, or 12,512.5 hours in aggregate would be needed for automated portfolio reconciliation with these counterparties.268 264 This estimate is based on the following: [(Sr. Programmer (80 hours) × $314 per hour) + (Sr. Systems Analyst (80 hours) × $269 per hour) + (Compliance Manager (10 hours) × $293 per hour) + (Director of Compliance (5 hours) × $461 per hour) + (Compliance Attorney (20 hours) × $346 per hour)] = $58,795 per SBS Entity, or ($58,795 × 20 SBS Entities) = $1,175,900 in aggregate. 265 The hourly rates for internal professionals used throughout Sections VII.C.2.c, VII.C.3.c, and VII.C.4.c of the release are taken from SIFMA’s Management & Professional Earnings in the Securities Industry 2013, modified to account for an 1800-hour work-year and inflation, and multiplied by 5.35 to account for bonuses, firm size, employee benefits, and overhead. 266 See supra note 262 and associated text. 267 Each SBS Entity is anticipated to have counterparty relationships with approximately onethird of the other SBS market participants (1⁄3 × 55 = 18.333), which is rounded to 18 participants. Of those counterparty relationships, two are expected to have portfolios in excess of 500 positions, which would need to be reconciled daily (252 trading days per year), four would have between 50 and 500 positions, which would need to be reconciled weekly (52 weeks per year), and the remaining 12 would have less than 50 positions, which would need to be reconciled quarterly (four times per year). The Commission estimates that each portfolio reconciliation would require 30 minutes, 15 minutes per counterparty, through an automated system, thus the total anticipated reconciliation time would be [(2 counterparties × 252 trading days × 0.25 hours) + (4 counterparties × 52 weeks × 0.25 hours) + (12 counterparties × 4 quarters × 0.25 hours)] = 190 hours per SBS Entity, or (190 × 55 SBS Entities) = 10,450 hours in aggregate. 268 There are anticipated to be 13,137 total SBS counterparties, of which 55 are registered SBS PO 00000 Frm 00047 Fmt 4701 Sfmt 4702 4659 The Commission further estimates that the development and implementation of written policies and procedures as required under proposed Rule 15Fi–3 would impose an initial cost of $702,232.50. Of the total 55 SBS Entities that would be subject to Rule 15Fi–3, 35 are estimated to be duallyregistered with the CFTC, and are anticipated to already have policies and procedures in place with respect to reconciliation. The expected additional time to revise the existing policies and procedures for these SBS Entities is expected to be one hour per SBS Entity, for a cumulative 35 hours, costing $429.50 per SBS Entity or $15,032.50 in aggregate.269 For the remaining 20 SBS Entities, the Commission estimates that it will take approximately 80 hours per entity to establish the written policies and procedures. The costs for these SBS Entities will be $687,200, or $34,360 per SBS Entity.270 Once established, the Commission estimates that it would cost SBS Entities approximately $944,900 or $17,180 per SBS Entity to revise and maintain these policies and procedures.271 Resolution of valuation discrepancies can be labor intensive. One objective of the proposed rule is to reduce the incidence of valuation discrepancies through the periodic reconciliations between security-based swap counterparties. It is unlikely, however, that the proposed rule will completely eliminate disputes related to Entities, leaving 13,082 non-SBS market participants. See supra note 179. The Commission estimates that each SBS Entity will transact with approximately 350 of these non-registered participants. Of those 350 counterparties, 35 are expected to have portfolio positions in excess of 100 positions, which would require quarterly reconciliations, while the remaining 315 are expected to have positions of less than 100 securitybased swaps, and therefore, would require annual reconciliation. The Commission estimates that each portfolio reconciliation would require 30 minutes through an automated system, thus the total anticipated reconciliation time would be [(35 counterparties × 4 quarters × 0.5 hours) + (315 counterparties × 1 time per year × 0.5 hours)] = 227.5 hours per SBS Entity, or (227.5 × 55 SBS Entities) = 12,512.5 hours in aggregate. 269 The estimate is based on the following: [((Compliance Attorney (30 minutes) at $346 per hour) + ((Director of Compliance (15 minutes) at $461 per hour) + ((Deputy General Counsel (15 minutes) at $565 per hour)] = $429.50 per hour per SBS Entity or ($429.50 per hour × 35 SBS duallyregistered Entities) = $15,032.50. 270 The estimate is based on the following: [((Compliance Attorney (40 hours) at $346 per hour) + ((Director of Compliance (20 hours) at $461 per hour) + ((Deputy General Counsel (20 hours) at $565 per hour)] = $34,360 per SBS Entity or ($34,360 × 20 SBS Entities that are not duallyregistered) = $687,200 in aggregate. 271 The estimate is based on the following: [((Compliance Attorney (20 hours) at $346 per hour) + ((Director of Compliance (10 hours) at $461 per hour) + ((Deputy General Counsel (10 hours) at $565 per hour)] = $17,180 per SBS Entity or ($17,180 × 55 SBS Entities) = $944,900 in aggregate. E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 4660 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules valuation. The Commission lacks data on the fraction of positions that, when reconciled, will result in a dispute as well as the costs likely to be incurred resolving those disputes, and is therefore unable to quantify these costs. However, the Commission recognizes that the costs associated with resolution of these disputes is likely to be higher than costs for reconciliations in which disputes do not arise. However, the Commission preliminarily believes that these costs may be mitigated by only requiring counterparties to address differences in valuation greater than 10%. These costs of reconciliation may be further mitigated by agreement between the counterparties to use a third party service provider to assist in resolving valuation discrepancies. Reconciliation of other terms is likely to be less costly as the terms of the agreement are unlikely to change over the life of the contract. The 10% threshold was designed to both identify large deviations in valuations between SBS Entities, while not requiring those entities to devote significant effort to resolving minor valuation disputes. Further, this threshold is identical to that already adopted by the CFTC.272 The Commission notes, however, that this 10% threshold is at the transaction level, rather than the entity level. While discrepancies could be random in nature, the risk exists that one counterparty could have systemic issues in valuation across its entire portfolio, thereby leading to discrepancies in valuation with one or several counterparties and throughout the portfolio. For example, if an entity’s valuation model consistently undervalued each of its security-based swap positions by 9%, in aggregate, the overall level of risk could be substantial, even though it would not trigger a discrepancy event as currently defined by the 10% transaction level threshold. Further, since the Commission estimates that approximately 35 of the expected 55 SBS Entities are likely to be duallyregistered with the CFTC and active in swap and security-based swap markets, these participants are likely to face higher costs when regulations differ. The costs of resolving valuation disputes are expected to be mitigated, because the reconciliation requirements are expected to prevent disputes from arising in the first instance through the regular comparison of material terms and valuations. The Commission preliminarily believes that by requiring SBS Entities to reach agreement with 272 See 17 CFR 23.502 (portfolio reconciliation). VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 certain counterparties on the methods and inputs for valuation of each security-based swap, as required in connection with the trading relationship documentation requirements in proposed Rule 15Fi–5, the overall framework of these rules should assist SBS Entities in resolving valuation disputes within five business days. In addition, the Commission estimates that SBS Entities will spend an average of 24 hours per year to comply with the notification requirement of proposed Rule 15Fi–3(c) costing $8,304 per SBS Entity or $456,720 in aggregate.273 Lastly, portfolio reconciliation costs are also mitigated by virtue of the fact that cleared security-based swaps are not within the scope of the requirements of these rules. The Commission preliminarily believes that CCPs establish settlement prices for each cleared security-based swap every business day for margining purposes and this process is more appropriately addressed by rules governing a clearing agency’s risk management practices.274 Because a large part of the securitybased swap portfolios of SBS Entities may consist of cleared security-based swaps to which the reconciliation requirements will not apply, the sizes of the bilateral, uncleared portfolios (to which the requirement would apply) may be limited.275 d. Alternatives The proposed rule creates a specific definition of ‘‘material terms’’ for purposes of determining what discrepancies must be resolved in connection with the portfolio reconciliation which includes each term required to be reported to an SDR, but then permits SBS Entities to exclude any term that is not relevant to the ongoing rights and obligations of the parties and the valuation of the securitybased swap during subsequent reconciliations. The Commission considered not providing a specific definition of ‘‘material terms’’ and allowing SBS Entities discretion in determining those terms that are relevant to the ongoing rights or 273 The estimate is based on the following: [Compliance Attorney (24 hours) at $346 per hour] = $8,304 per entity × 55 SBS entities = $456,720. 274 See supra Section I.B.7. 275 Currently, there is no regulatory requirement in the United States to clear security-based swaps. As of December 2015, approximately 56% of the total volume of new trade activity in single-name security-based swap products had been cleared through ICE Clear Credit. Further, approximately 79% of index CDS transactions were centrally cleared as of December 2015 (see https:// www.isda.org/a/kVDDE/swapsinfo-q4-2015-reviewfinal.pdf); therefore, single-name security-based swaps potentially could be cleared at a similar rate. PO 00000 Frm 00048 Fmt 4701 Sfmt 4702 obligations of the parties or affect the valuation of the security-based swap. The Commission has preliminarily concluded that the data required to be submitted to an SDR in connection with regulatory reporting requirements is an appropriate measure for determining which terms should be reconciled pursuant to proposed Rule 15Fi-3. The Commission also preliminarily believes that tying the definition of ‘‘material terms’’ to reporting requirements to an SDR could reduce the burdens on some SBS Entities by potentially allowing them to leverage the same electronic systems used for SDR reporting for purposes of the portfolio reconciliation requirements. The portfolio size breakpoints and frequencies are consistent with those adopted by the CFTC for Swap Entities and are therefore likely to be familiar to those entities that are registered as both an SBS Entity and a Swap Entity. These are also the breakpoints adopted by the EC. Further, the Commission believes that alternative breakpoints based on the number of transactions which deviate from those adopted by the CFTC and the EC would likely impose additional costs on SBS Entities without any corresponding increases in material benefits to those participants. Although the notion of breakpoints based on number of transactions previously has been accepted by the CFTC and other regulatory agencies, the Commission notes that breakpoints based on alternative measures could be considered. In particular, breakpoints for reconciliation could be categorized by either gross (or net) notional amounts of positions or the current market value of positions, and identified as levels or scaled by some measure such as the aggregate notional value of the market (for gross or net notional values) or the assets of the SBS Entity (if market values are used instead). Although the number of security-based swaps between counterparties is easy to capture, it may actually be misleading with respect to the complexity or magnitude of the risk between counterparties. For instance, say two counterparties have over 500 transactions between them, but the average value of each transaction is only $5 million notional value. The total exposure between the two counterparties would only be $2.5 billion, but this portfolio would need to be reconciled daily due to the number of transactions. If, on the other hand, two counterparties have only 40 transactions, but the average value of each transaction is $1 billion notional value, the overall exposure would be $40 billion (16 times greater exposure E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules than the 500 transaction counterparties), but this portfolio would only be reconciled quarterly. Basing breakpoints on some measure other than the number of transactions may enable SBS Entities to better assess the overall level of counterparty credit risk as well as operational risk associated with their security-based swap portfolios. Setting aside these concerns, the Commission believes that breakpoints based on the number of transactions is likely to capture the complexity of SBS Entities’ portfolios, and that reconciliations based on this dimension are likely to identify discrepancies in a timely manner. Further, given that the Commission estimates that approximately 35 of the expected 55 SBS Entities are likely to be duallyregistered with the CFTC and active in both swap and security-based swap markets, this alternative could potentially impose additional costs due to differences in regulatory requirements. The Commission has also considered alternatives to the requirement that valuation discrepancies exceeding 10% must be resolved within five days. The 10% threshold is consistent with the rule adopted by the CFTC for Swap Entities and, as a result, is likely to be familiar to those entities that are registered as both an SBS Entity and a Swap Entity. The Commission preliminarily believes that the proposed 10% threshold is high enough to prevent market participants from incurring costs to resolve small valuation differences that would have only a small effect on margin or other risk management practices, yet low enough to prevent difference in valuation from resulting in significant miscalculations in risk management. As noted above, there are potential economic costs that could accrue to counterparties related to both the 10% threshold and the five business day resolution window. An alternative (albeit supplementary) approach would be an additional requirement of a valuation threshold related to the overall portfolio discrepancies, in aggregate and/or with individual counterparties. For instance, if the aggregate portfolio has valuation discrepancies of 5% or 10%, this could trigger a discrepancy event, even if the individual transaction-level discrepancies fall below the prescribed threshold as documented currently in the proposed rule. Relatedly, while the five business day window is narrow enough to potentially stem valuations from deviating for extended periods of time while still providing a horizon in which parties can work through their VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 valuation disputes, entities can face significant counterparty risk over seemingly short-term horizons. For relatively stable valuation disputes in which the value does not continue to deviate further from the agreed-upon level, then a five business day window is likely to be sufficient; however, a more compressed alternative horizon could be invoked when the discrepancies in value continue to widen between counterparties. The Commission preliminarily believes that the proposed five business day horizon is sufficient and serves as an upperbound for which market participants to address and correct any material discrepancies that arise during reconciliation. Moreover, this approach is consistent with requirements from other regulators, and given the Commission’s estimates on SBS Entities that are likely to be dually-registered with the CFTC, any differences in regulation would likely impose additional costs to those entities. Finally, proposed Rule 15Fi-3(c) would require each SBS Entity to promptly notify the Commission of any security-based swap valuation dispute in excess of $20,000,000 (or its equivalent in any other currency) if not resolved within: • Three business days, if the dispute is with a counterparty that is an SBS Entity, or • five business days, if the dispute is with a counterparty that is not an SBS Entity. Such notification would be required to be in a form and manner acceptable to the Commission, and would also be required to be sent to any applicable prudential regulator (i.e., for any SBS Entity that is also a bank, to its bank regulator).276 The Commission has considered as an alternative, requiring SBS Entities to make and keep records of valuation discrepancies that exceed $20,000,000 rather than requiring that they be reported to the Commission. The Commission preliminarily concluded that the benefit of receiving an early warning of potential problems before they surfaced though an ordinary course of review of books and records justifies any additional cost imposed on SBS entities. Proposed Rule 15Fi-3(d), the new requirements regarding portfolio reconciliation would not apply to a ‘‘clearing transaction’’ which is defined as a security-based swap that has a clearing agency as a direct counterparty.277 A clearing agency 276 See 277 See PO 00000 supra Section I.B.6. supra Section I.B.7. Frm 00049 Fmt 4701 Sfmt 4702 4661 means a clearing agency that is registered with the Commission pursuant to Section 17A of the Exchange Act and that provides central counterparty services for security-based swap transactions. The Commission considered as an alternative including transactions cleared at a foreign clearing agency that is not registered with the Commission within its definition of ‘‘clearing transaction’’ for the purposes of the proposed rule. The Commission preliminarily concluded that an approach that is similar to that taken by the Commission in other rules,278 as well as the approach taken by the CFTC,279 would reduce implementation and compliance costs. The Commission has considered as an alternative, an alternative compliance mechanism that would allow a SBS Entity to be deemed in compliance with certain proposed rules regarding portfolio reconciliation if the SBS Entity is also registered as a swap dealer or major swap participant with the CFTC and is in compliance with the corresponding CFTC portfolio reconciliation rules. The Commission preliminarily concludes that differences between its proposed rules and rules adopted by the CFTC may provide certain benefits to SBS Entities and other market participants that would not be available under a rule that was identical to the corresponding CFTC rule. For example, the requirement in the proposed rule that each term required to be reported to a registered SDR under Rule 901 must be reconciled may facilitate the verification of transaction data by SDRs, which could address concerns raised by market participants and data repositories. Such benefits could be unavailable under an alternative compliance mechanism given that CFTC portfolio reconciliation rules do not require all of this information to be reconciled.280 3. Portfolio Compression Portfolio compression is an important post-trade processing mechanism that can be an effective and efficient tool for the management of risk by securitybased swap market participants. Portfolio compression is a mechanism whereby directionally opposite 278 See, e.g., Trade Acknowledgement and Verification Adopting Release, 81 FR at 39839. 279 Specifically, CFTC Rule 23.502(c) provides that ‘‘[n]othing in this section shall apply to a swap that is cleared by a derivatives clearing organization.’’ 17 CFR 23.502(c). 280 See supra Section I.E for a discussion of the proposed reconciliation rules and the verification of transaction data by SDRs. See also supra note 32 for a discussion of differences between CFTC and proposed Commission requirements concerning third party reconciliation. E:\FR\FM\15FEP2.SGM 15FEP2 4662 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules transactions with substantially similar terms among two or more counterparties are terminated and, if any exposure remains, replaced with a smaller number of transactions of decreased notional value in an effort to reduce the risk, cost, and inefficiency of maintaining offsetting transactions on the counterparties’ books. Because portfolio compression participants are permitted to establish their own credit, market, and cash payment risk tolerances and to establish their own mark-to-market values for the transactions to be compressed, the process does not alter the risk profiles of the individual participants beyond a level acceptable to the participant. Portfolio compression is commonly acknowledged as useful risk management tool.281 amozie on DSK3GDR082PROD with PROPOSALS2 a. Requirements The Commission is proposing rules and interpretations that generally would require each SBS Entity to establish, maintain, and follow written policies and procedures for engaging in certain forms of portfolio compression exercises with each of its counterparties. Depending on the number of counterparties, the portfolio compression exercise would be defined as either a ‘‘bilateral portfolio compression exercise’’ or as a ‘‘multilateral portfolio compression exercise.’’ Under proposed Rule 15Fi–4(a), SBS Entities would be required to establish, maintain, and follow written policies and procedures for periodically engaging in both bilateral portfolio compression exercises and multilateral portfolio compression exercises, when appropriate, with each counterparty that is also an SBS Entity.282 For transactions with non-SBS Entities, the policies and procedures required under the proposed rule would require only that portfolio compression exercise would have to occur when appropriate and only if requested by any such counterparty.283 b. Benefits As a mechanism for post-trade management of risk in security-based swaps, portfolio compression provides benefits not only to the counterparties in each transaction but also to the markets as a whole. A portfolio compression exercise permits firms to identify instances in which 281 See https://www2.isda.org/news/isdapublishes-paper-highlighting-achievements-inportfolio-compression. 282 See proposed Rules 15Fi–4(a)(2) and (3). 283 See proposed Rule 15Fi–4(b). See also supra notes 70 and 71 and associated text. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 directionally opposite transactions with similar terms can be terminated or replaced, with a smaller number of transactions with decreased notional value, reducing the overall risk, cost, and inefficiencies associated with maintaining offsetting transactions. As such, portfolio compression is recognized as an important risk management tool.284 By expanding the universe of participants required to maintain portfolio compression policies and procedures, credit risk in the uncleared security-based swaps market can be reduced and may provide benefits to the entire financial system. Further, the termination of redundant security-based swap transactions through the portfolio compression process is likely to result in the potential reduction of both counterparty and operational risk at the SBS Entity level. The use of portfolio compression also could reduce the overall level of bilateral risk exposures, while leaving the net positions of market participants unaltered, thereby improving operational efficiency. Improvements in operational efficiency may arise due to fewer overall positions for each entity, a reduction in carried margin and variation margin calculations, and fewer (and potentially less frequent) portfolio reconciliations. This would also reduce the number of bilateral positions that would have to be resolved in the event of insolvency of a market participant. These reductions in risk and improvements in operational efficiency of SBS Entities could benefit the financial system as a whole, thereby potentially increasing the number of market participants as well as improving liquidity. Although the costs of participating in portfolio reconciliation are fully internalized by each counterparty, the potential benefits, particularly for multilateral compression exercises, increase with the number of counterparties that participate. Under proposed Rule 15Fi–4(a), SBS Entities would be required to establish, maintain, and follow written policies 284 For example, in 2008, the PWG identified frequent portfolio compression of outstanding trades as a key policy objective in the effort to strengthen the OTC derivatives market infrastructure. See PWG Report, supra note 205. Similarly, the 2010 staff report issued by the FRBNY outlined policy perspectives on OTC derivatives infrastructure and identified trade compression as an element of strong risk management and recommended that market participants engage in regular, market-wide portfolio compression exercises. See FRBNY OTC Derivatives Report, supra note 62. Since the years immediately following the 2008 financial crisis, compression outside of CCPs has been somewhat less common and has declined substantially from its 2008 peak. See supra note 240. PO 00000 Frm 00050 Fmt 4701 Sfmt 4702 and procedures for periodically engaging in both bilateral portfolio compression exercises and multilateral portfolio compression exercises, in each case when appropriate, with counterparties that also are an SBS Entities.285 To the extent that an SBS Entity transacts with a counterparties that are not SBS Entities, the policies and procedures required under the proposed rule would require only that portfolio compression exercises occur when appropriate and only if requested by any such counterparty. In the absence of the proposed rules, some counterparties may not participate in compression activities reducing the potential benefits available to other counterparties and the financial system generally. As noted in the economic baseline, the emergence of third-party vendors has provided portfolio compression services for security-based swaps. SBS Entities may be able to continue to benefit from the services of these thirdparty vendors to provide additional portfolio compression opportunities for these firms. The proposed rule provides flexibility to security-based swap market participants with respect to portfolio compression. The Commission preliminarily believes that by not proposing prescriptive requirements, an SBS Entity would allow the counterparties flexibility in the manner in which they reduce the size of their security-based swap portfolios in light of each counterparty’s unique risks and operations. Moreover, the proposed rules regarding bilateral offset have been designed to reflect the understanding by the Commission that firms may have legitimate economic and business reasons for maintaining fully offsetting security-based swap transactions. Certain portfolio compression exercises could result in adverse credit exposures to certain counterparties. For example, the results of a particular multilateral compression exercise may result in a credit exposure to a particular counterparty that exceeds credit exposure limits for that counterparty. Thus, the Commission preliminarily believes that the policies and procedures should be flexible enough to allow an SBS Entity to take the most appropriate course of action with respect to managing its risks, while at the same time, encouraging SBS Entities to consider the risk mitigation possibilities of portfolio compression in a non-arbitrary manner and consistent with the purposes of Section 15F(i) of the Exchange Act. As such, proposed 285 See E:\FR\FM\15FEP2.SGM supra Section I.C. 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules Rules 15Fi–4(a)(1) and (b) would require a firm’s policies and procedures to address the termination of fully offsetting security-based swaps only ‘‘when appropriate.’’ Finally, the Commission notes that both the CFTC and the EC have adopted portfolio compression requirements that are substantially similar to those being proposed by the Commission in this release.286 By closely aligning portfolio compression requirements through consultation with the CFTC and with ESMA, the Commission preliminarily believes that SBS Entities will benefit from a largely unitary regulatory regime that does not require separate compliance and operational policies and procedures. c. Costs SBS Entities will necessarily have to design, compose, and implement policies and procedures to regularly evaluate compression opportunities with their counterparties as well as those opportunities offered by third parties. However, the Commission preliminarily believes that given the large risk management benefits available from the regular compression of offsetting trades—benefits including reduced risk and enhanced operational efficiency—SBS Entities already undertake regular portfolio compression exercises. For this reason and those discussed below, the Commission preliminarily believes that the relevant costs will primarily be the creation of policies and procedures. The greater the level of standardization in security-based swaps, the less costly it becomes to identify compression opportunities. In April 2009, ISDA announced the implementation of the 2009 ISDA Credit Derivatives Determinations Committees and Auction Settlement CDS Protocol, known colloquially in the industry as the ‘‘Big Bang Protocol,’’ which introduced a number of documentation changes to help standardize single-name CDS contracts.287 Among these changes were the introduction of standard coupon rates and standard effective dates. Following the standardization of single-name CDS, compression in this market segment increased.288 As that amozie on DSK3GDR082PROD with PROPOSALS2 286 See supra note 7 and accompanying text. Press Release, ISDA Announces Successful Implementation of ‘Big Bang’ CDS Protocol; Determinations Committees and Auction Settlement Changes Take Effect (Apr. 8, 2009), available at: https://www.isda.org/a/XS6EE/ISDAAnnounces-Successful-Implementation-of-%E2% 80%98Big-Bang%E2%80%99-CDS-ProtocolDeterminations-Committees-and-AuctionSettlement-Changes-Take-Effect.docx. 288 See Nicholas Vause, Counterparty risk and contract volumes in the credit default swap market, 287 See VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 standardization continues, we would expect that the cost of identifying appropriate compression opportunities should continue to fall. Using singlename corporate CDS data from DTCC– TIW discussed above, we find the percentage of new trades in North American Single-Name Corporate that have standardized coupons has risen from 95.2% in 2012 to 99.8% in 2017. The reduction in the number of rolldates from four to two in order to both improve liquidity as well as to align with updates to CDS indices 289 also may result in increased standardization and therefore may reduce the costs of identifying compression opportunities. The Commission estimates that the development and implementation of written policies and procedures as required under proposed Rule 15Fi–4 would impose an initial cost of $702,232.50 in aggregate. Of the 55 market participants the Commission expects will register as SBS Entities and be subject to Rule 15Fi–4, the Commission estimates that approximately 35 of these market participants are registered with the CFTC, and are anticipated to already have policies and procedures in place with respect to portfolio compression. The expected additional time to revise the existing policies and procedures for these SBS Entities is expected to be one hour per SBS Entity, for a cumulative 35 hours, costing $429.50 per SBS Entity or $15,032.50 in aggregate.290 For the remaining 20 SBS Entities, the Commission estimates that it will take approximately 80 hours per entity to establish the written policies and procedures. The costs for these SBS Entities will be $687,200, or $34,360 per SBS Entity.291 Once established, the Commission estimates that it would cost BIS Quarterly Review (Dec. 2010), available at: https://www.bis.org/publ/qtrpdf/r_qt1012g.pdf (‘‘TriOptima became the first company to offer CDS portfolio compression when it extended its TriReduce service from interest rate swaps to the CDS market in 2005. In the CDS market, TriReduce has compressed mainly portfolios of CDS indices and index tranches, but single names have accounted for an increasing share of its compression volumes since standardisation in 2009.’’). 289 See https://www2.isda.org/asset-classes/creditderivatives/single-name-cds-roll/. 290 The estimate is based on the following: [((Compliance Attorney (30 minutes) at $346 per hour) + ((Director of Compliance (15 minutes) at $461 per hour) + ((Deputy General Counsel (15 minutes) at $565 per hour)] = $429.50 per hour per SBS Entity or ($429.50 per hour × 35 SBS duallyregistered Entities) = $15,032.50. 291 The estimate is based on the following: [((Compliance Attorney (40 hours) at $346 per hour) + ((Director of Compliance (20 hours) at $461 per hour) + ((Deputy General Counsel (20 hours) at $565 per hour)] = $34,360 per SBS Entity or ($34,360 × 20 SBS Entities that are not duallyregistered) = $687,200 in aggregate. PO 00000 Frm 00051 Fmt 4701 Sfmt 4702 4663 SBS Entities approximately $944,900 or $17,180 per SBS Entity to revise and maintain these policies and procedures.292 The Commission further estimates that an SBS Entity will devote approximately 124.17 hours per year for portfolio offsets and compression exercises (6,829.35 aggregate hours), a substantial portion of which will be automated, and some of which may be handled by third-party vendors.293 Similar to our discussion for portfolio reconciliation (Section VIII.C.2.c), the Commission expects that the costs of implementing portfolio compression exercises through an automated process will be minimal for those SBS Entities that are dually-registered with the CFTC, as many of those systems will already be in place. With respect to the remaining 20 SBS Entities that are not dually-registered, the Commission anticipates that any cost associated with implementing the portfolio reconciliation system may also account for the portfolio compression exercises that may periodically take place; therefore, the overall costs of portfolio compression systems should be minimal. In terms of quantification of the costs of compression, the Commission also notes that that there are a number of third-party vendors that provide compression services, and some of these providers may charge fees based on results achieved (such as number of swaps or security-based swaps compressed). Assuming that third-party vendors charge a fee directly related to the outcome of the compression exercise (as opposed to a fixed fee in whole or some portion thereof for portfolio compression activities), the direct costs of portfolio compression by third-party vendors would therefore likely be 292 The estimate is based on the following: [((Compliance Attorney (20 hours) at $346 per hour) + ((Director of Compliance (10 hours) at $461 per hour) + ((Deputy General Counsel (10 hours) at $565 per hour)] = $17,180 per SBS Entity or ($17,180 × 55 SBS Entities) = $944,900 in aggregate. 293 The Commission estimates that each SBS Entity will transact with approximately 368 counterparties (18 SBS Entities and 350 non-SBS market participants). It is estimated that approximately one offset per year will take place between counterparties and it is expected to take five minutes to complete, for a total number of hours of (2.5/60 × 18 + 5/60*350) or 29.92 hours per year per SBS Entity. Further, each SBS Entity is expected to conduct six bilateral compressions with SBS Entities and 350 bilateral compressions with non-SBS counterparties, each taking 15 minutes for total hours of [(7.5/60 × 6) + (15/60 × 350)] = 88.25 hours. Lastly, each SBS Entity is anticipated to complete 12 multilateral compressions each year, each taking 30 minutes for a total of 6 hours. Total time for each SBS Entity for portfolio compression exercises is estimated to be (29.92 + 88.25 + 6) = 124.17 hours, or 6829.35 hours (124.17 hours × 55 SBS Entities). E:\FR\FM\15FEP2.SGM 15FEP2 4664 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 directly related to the economic benefits of reduced counterparty and operational risk realized through the compression exercises. The Commission does not currently have pricing data for thirdparty service providers that offer portfolio compression services and so is unable to quantify the costs to market participants who make use of these services. Many non-SBS Entities typically trade only in small volumes and on one side of a particular security-based swap, to create a synthetic position in the underlying asset or to hedge another position, for example. Such one-sided market positions reduce the opportunities to engage in periodic compression cycles. For SBS Entities that do not currently participate in compression cycles, there could be costs to modify the participant’s risk systems and connectivity enhancements that would allow for sharing the necessary information required to identify compression opportunities and for the booking and processing of a large volume of security-based swaps in a short time period. Multilateral compression cycles are typically managed with automated tools to support tear-up and new trade creation that end-users usually do not possess, and the costs of obtaining such tools cannot be justified by the benefits. The rule does not require market participants to engage in mandatory compression cycles, but only to establish, maintain, and follow written policies and procedures for engaging in certain forms of portfolio compression exercises. d. Alternatives The proposed rule requires that SBS Entities establish, maintain, and follow written policies and procedures as they relate to certain forms of portfolio compression exercises with each of its counterparties. As such, the Commission is not proposing to mandate the specific contents of the policies and procedures created to comply with these rules.294 However, a number of more specific requirements for portfolio compression could be included. For example, the current proposal only requires policies and procedures that address compression to the extent requested by the counterparty rather than a more prescriptive requirement.295 Pursuant to the proposed Rule 15Fi– 4, SBS Entities are required ‘‘periodically’’ to examine the 294 There is one exception to this statement, see supra note 72. 295 See supra Section I.C.3. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 possibility for whether portfolio compression exercises can take place. While this provides flexibility to the counterparties in terms of the frequency with which rebalancing would have to be explored, it leaves open the possibility that market participants will suboptimally select the frequency with which portfolio compression exercises can occur, which could impose externalities on SBS counterparties as well as the financial system as a whole. As an alternative, the Commission has considered requiring a minimum frequency of analysis of portfolio compression exercises. For instance, at least twice a year, SBS Entities could conduct an analysis of the possibility of a portfolio compression exercise in order to reduce their counterparty credit risk and engage in such a portfolio compression exercise, similar to those adopted by the EC.296 Given that portfolio compression has been identified to be a valuable and important tool for risk management, it is likely that many SBS Entities already have in place policies and procedures for periodic evaluation of compression possibilities, thus imposing a minimum standard could be burdensome and costly for firms to implement. Relatedly, the frequency with which SBS Entities evaluate their prospects for portfolio compression opportunities could be related to the number of transactions between counterparties (as is required for portfolio reconciliation in proposed rule 15Fi–3). For instance, if counterparties have portfolios in excess of 500 transactions, an analysis of portfolio compression could be conducted quarterly, while SBS Entities with portfolios between 50 and 500 transactions, portfolio compression exercises could be explored twice a year. For counterparties with fewer than 50 transactions between them (or for portfolios with non-SBS Entities), portfolio compression exercises could be simply ‘‘periodically.’’ This would allow counterparties to assess the counterparty credit risk at frequencies aligned with the complexities of their portfolios without incurring substantive additional costs of this increase in periodic evaluation of portfolio compression opportunities. The Commission has considered the costs and benefits to market participants of imposing policies and procedures related to portfolio compression based on the number of transactions between counterparties. However, it is likely that market participants expected to register as SBS Entities already have policies 296 See EU Regulation 149/2013, art. 14, 2013 O.J. 11, 22. PO 00000 Frm 00052 Fmt 4701 Sfmt 4702 and procedures in place to evaluate portfolio compression opportunities with counterparties, and requiring alterations to these policies could be costly for these entities without corresponding benefits. Proposed Rule 15Fi–4(c), the new requirements regarding portfolio compression, would not apply to a ‘‘clearing transaction’’, which is defined as a security-based swap that has a clearing agency as a direct counterparty.297 A clearing agency means a clearing agency that is registered with the Commission pursuant to Section 17A of the Exchange Act and that provides central counterparty services for security-based swap transactions. The Commission considered as an alternative including transactions cleared at a foreign clearing agency that is not registered with the Commission within its definition of ‘‘clearing transaction’’ for the purposes of the proposed rule. The Commission preliminarily concluded that an approach that is similar to that taken by the Commission in other rules,298 as well as the approach taken by the CFTC,299 would reduce implementation and compliance costs. The Commission has considered as an alternative, an alternative compliance mechanism that would allow a SBS Entity to be deemed in compliance with certain proposed rules regarding portfolio compression if the SBS Entity is also registered as a swap dealer or major swap participant with the CFTC and is in compliance with the corresponding CFTC portfolio compression rules. The Commission preliminarily concludes that, as a practical matter, the rules are nearly equivalent, suggesting that any additional compliance cost arising from differences in these rules for an entity that is registered with both the CFTC and the Commission should be small. The Commission preliminarily believes that the differences that do exist (such as the proposed rule providing that requested compression by an entity that is not a security-based swap dealer or major security-based swap participant need only be conducted if appropriate 300) may provide marginal benefits to SBS market participants (such as by preventing portfolio compression that is not appropriate given the particular circumstances of 297 See supra Section I.C.4. supra note 278. 299 Specifically, CFTC Rule 23.503(c) provides that ‘‘[n]othing in this section shall apply to a swap that is cleared by a derivatives clearing organization.’’ 17 CFR 23.503(c). 300 See supra note 70 and accompanying text. 298 See E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules the trade and the counterparties to that trade).301 4. Trading Relationship Documentation OTC derivatives market participants typically have relied on the use of industry standard legal documentation, including master netting agreements, definitions, schedules, and confirmations, to document their security-based swap trading relationships. This industry standard documentation offers a framework for documenting the transactions between counterparties for OTC derivatives products.302 The standard documentation is designed to set forth the legal, trading, and credit relationship between the parties and to facilitate netting of transactions in the event that parties have to close-out their position with one another or determine credit exposure for margin and collateral management. Notwithstanding the standardization of such documentation, some or all of the terms of the master agreement and other documents are subject to negotiation and modification. amozie on DSK3GDR082PROD with PROPOSALS2 a. Requirements The Commission is proposing rules and interpretations that generally would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to ensure that it executes written trading relationship documentation with its counterparties prior to, or contemporaneously with, executing a security-based swap. The security-based swap trading relationship documentation is required to be in writing and to include all material terms governing the trading relationship between counterparties. Further, the proposed rule would also require that the security-based swap trading relationship documentation include credit support arrangements.303 One of the key elements of Title VII reforms was to ensure that uncleared OTC derivatives were appropriately collateralized, thus the documentation of processes for calculating and 301 The corresponding CFTC compression rule applicable to transactions with counterparties that are not SBS Entities does not contain the caveat that any form of compression or offset covered by the applicable policies and procedures would only need to occur ‘‘when appropriate.’’ See supra note 70. We solicit comment on this difference. See supra Section I.C.5. 302 One commonly used form of the industry standard documentation is the ISDA Master Agreement and related definitions, schedules, and confirmations specific to particular asset classes. As noted in Section VI.B.4, over 99% of uncleared security-based swap transactions use an ISDA Master Agreement as reported in DTCC–TIW. 303 See supra Section I.C.2 VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 exchanging margin in connection with security-based swaps helps to achieve the broader regulatory objective.304 The proposed rules also would establish minimum standards with respect to identifying the matters that must be addressed in the security-based swap trading documentation, and outline certain requirements related to the resolution of discrepancies, particularly those involving differences in the valuation of security-based swaps. In the event that discrepancies in valuation arise, the proposed rule requires that counterparties must provide documentation for either an alternative method for determining value of the security-based swap or documentation on the resolution process for such disputes. The proposed rule also requires that counterparties to the security-based swap provide information on their legal status, particularly in the event of liquidation, as well as to disclose certain information of a security-based swap accepted for clearing by a clearing agency, in order to reduce any potential confusion regarding the status of the trade following its acceptance and novation at the clearing agency. Lastly, proposed Rule 15Fi–5 requires a periodic independent audit to identify any material deficiencies in the trading relationship documentation policies and procedures. b. Benefits Inadequate or incomplete documentation of open security-based swap transactions could, in some cases, result in collateral and legal disputes between the two counterparties, thereby exposing both sides to significant counterparty credit risk. By way of contrast, adequate documentation between counterparties offers a framework for establishing the trading relationship between the parties from the outset of the transaction, which should minimize both the number and magnitude of potential disputes. Further, the proposed rule provides particular guidance with respect to policies and procedures documenting the valuation of security-based swaps. Although having policies and procedures regarding trading relationship documentation in place is important for all aspects of the transaction, the valuation of the transaction and how it affects margin requirements on an on-going basis is critical for managing both counterparty credit as well as operational risk. Pursuant to proposed Rule 15Fi–5, counterparties are required to provide 304 15 PO 00000 U.S.C. 78c–5(f). Frm 00053 Fmt 4701 Sfmt 4702 4665 information on the valuation methods, procedures, rules, and inputs (within limits so as to not reveal private information regarding proprietary valuation models), while further stipulating that either alternative valuation methods or valuation discrepancy resolutions are detailed in the trading relationship documentation. These benefits are both complemented by, and accrue to, the portfolio reconciliation process contemplated by proposed Rule 15Fi–3. That is, comprehensive and accurate documentation of a transaction may contribute to a smoother reconciliation process by reducing the possibility of discrepancies; and any discrepancies that may still arise could subsequently be identified and resolved through reconciliation. As discussed above, because shortcomings in credit risk management and documentation may only become evident during a crisis, some benefits of complying with these rules will accrue to the financial system as a whole while the ongoing direct costs are borne by the individual market participant. Therefore, in the absence of these rules, trading relationship documentation practices employed by individual market participants may be less thorough than would be desired by all market participants in order to properly manage risks to the financial system. However, the widespread use of standard documentation mitigates both the potential benefit and costs of the proposed rule. c. Costs Market participants will likely incur ongoing costs associated with the rules concerning trading relationship documentation. Market participants will have to (1) negotiate and document all terms of each trading relationship; (2) design, compose, and implement policies and procedures reasonably designed to ensure the execution of security-based swap trading relationship documentation, including valuation documentation; (3) obtain documentation from counterparties who are claiming the end user exception to clearing; and (4) periodically audit documentation and keep records and/or make reports as required under these rules. The Commission estimates that the initial burden to negotiate and draft trading relationship documentation will be $4,741,680 per SBS Entity, or $260,792,400 in aggregate across the 55 E:\FR\FM\15FEP2.SGM 15FEP2 4666 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 SBS Entities.305 The Commission further estimates that the development and implementation of written policies and procedures as required under proposed Rule 15Fi–5 would impose an initial cost of $702,232.50 in aggregate. Of the total 55 SBS Entities as expected by the Commission that would be subject to Rule 15Fi–5, 35 are anticipated to be registered concurrently with the CFTC, and are anticipated to already have policies and procedures in place with respect to portfolio compression. The expected additional time to revise the existing policies and procedures for these Entities is expected to be one hour per Entity, for a cumulative 35 hours, costing $429.50 per Entity or $15,032.50 in aggregate.306 For the remaining 20 SBS Entities, the Commission estimates that it will take approximately 80 hours per entity to establish the written policies and procedures. The costs for these SBS Entities will be $687,200, or $34,360 per SBS Entity.307 Once established, the Commission estimates that it would cost SBS Entities approximately $944,900 or $17,180 per SBS Entity to revise and maintain these policies and procedures.308 Lastly, proposed Rule 15Fi–5 requires periodic independent audits of the trading relationship documentation. The Commission estimates that the costs associated with these audits will be $794,880 per SBS Entity, or $43,718,400 in aggregate.309 Memorializing the specific terms of the security-based swap trading 305 Each SBS Entity is anticipated to be counterparty to 18 other SBS Entities and 350 nonSBS market participants, for a total of 368 counterparties. The initial negotiation and draft in expected to take 30 hours per counterparty. The estimation is as follows: [((Compliance Manager (15 hours) × $346) + (Director of Compliance (7.5 hours) × $461) + (Deputy General Counsel (7.5 hours) × $565)) × 368 counterparties] = $4,741,680 per SBS Entity, or ($4,741,680 × 55 SBS Entities) = $260,792,400 in aggregate. 306 The estimate is based on the following: [((Compliance Attorney (30 minutes) at $346 per hour) + ((Director of Compliance (15 minutes) at $461 per hour) + ((Deputy General Counsel (15 minutes) at $565 per hour)] = $429.50 per hour per SBS Entity or ($429.50 per hour × 35 SBS duallyregistered Entities) = $15,032.50. 307 The estimate is based on the following: [((Compliance Attorney (40 hours) at $346 per hour) + ((Director of Compliance (20 hours) at $461 per hour) + ((Deputy General Counsel (20 hours) at $565 per hour)] = $34,360 per SBS Entity or ($34,360 × 20 SBS Entities that are not duallyregistered) = $687,200 in aggregate. 308 The estimate is based on the following: [((Compliance Attorney (20 hours) at $346 per hour) + ((Director of Compliance (10 hours) at $461 per hour) + ((Deputy General Counsel (10 hours) at $565 per hour)] = $17,180 per SBS Entity or ($17,180 × 55 SBS Entities) = $944,900 in aggregate. 309 The estimate is based on the following: [368 counterparties × 10 hours per Audit × Auditor ($216 per hour)] = $794,880 per SBS Entity, or ($794,880 × 55 SBS Entities) = $43,718,400 in aggregate. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 relationship and security-based swap transactions between counterparties is prudent business practice and, in fact, many market participants already use standardized documentation.310 Accordingly, the Commission preliminarily believes that many, if not most, market participants that are expected to register as SBS Entities currently execute and maintain trading relationship documentation of the type required by the proposed rules in the ordinary course of their businesses, including documentation that contains several of the terms that would be required by the proposed rules. Thus, the hour and dollar burdens associated with the security-based swap trading relationship documentation requirements may be limited to amending existing documentation to expressly include any additional terms required by the proposed rules. In addition the Commission anticipates that standardized security-based swap trading relationship documentation will eventually incorporate changes that may be necessary to comply with many of the requirements of this rule reducing the cost to individual security-based swap market participants.311 Proposed Rule 15Fi–5 also includes certain exceptions that are intended to mitigate costs incurred by market participants while preserving the risk mitigating benefits of thorough trading relationship documents. First, the proposed rule would provide an exception for security-based swaps executed prior to the date on which the SBS Entity is required to be in compliance with the trading relationship documentation rule, as it may be costly and impractical to require SBS Entities to bring existing transactions into compliance with the proposed rules. The Commission notes that this exception may increase the likelihood of disputes in valuation with respect to such transactions, which will be subject to the portfolio reconciliation requirement of proposed Rule 15Fi–3 even though they are not subject to the documentation requirements of proposed Rule 15Fi–5. Such disputes could be costly to resolve and may lead to greater uncertainty with respect to counterparty credit risk. 310 As noted in Section VI.B.4, as of 2015, the DTCC–TIW data shows that over 99% of SBS Entities use the ISDA Master Agreement. 311 In response to prior Dodd Frank Act related regulatory requirements, ISDA in partnership with third party providers, has created technology-based solutions enabling counterparties to modify OTC derivatives related documentation quickly and efficiently. See https://www2.isda.org/dodd-frankdocumentation-initiative/. PO 00000 Frm 00054 Fmt 4701 Sfmt 4702 The proposed rule further provides exceptions for any ‘‘clearing transaction’’, which, pursuant to existing Rule 15Fi–1(c) under the Exchange Act, is defined as a securitybased swap that has a clearing agency as a direct counterparty. Once a security is cleared, the transaction is primarily governed by the terms of the agreement between clearing member and the clearing agency. Lastly, the proposed rule would provide an exception for security-based swaps executed anonymously on a national securities exchange or an SBSEF, provided that these security-based swaps are intended to be cleared and are actually submitted for clearing to a clearing agency that provides CCP services. This exception is intended to recognize that documentation requirements may be nearly impossible to fulfill within the context of cleared anonymous transactions.312 d. Alternatives The Commission has evaluated reasonable alternatives to the proposed rule on trading relationship documentation. One alternative would be that all SBS Entities are required to adhere to an industry-accepted standard form of trading documentation, instead of establishing policies and procedures related to documentation. It is unlikely that this alternative would materially alter the primary benefits of the rule, namely that of reducing disputes over documentation that could lead to increased counterparty risk, but could increase overall compliance costs without analogous increases in benefits, due to reduced operational flexibility. Further, the proposed rule requires that SBS Entities undertake a periodic, independent audit to identify material weaknesses in its documentation policies and procedures. As proposed, there is flexibility on behalf of the SBS Entity as to how and when those audits occur. Alternatively, the Commission has considered limiting to only external auditors and requiring a once per year audit of trading relationship documentation. Although this alternative would not materially amend the primary benefits related to the audit of SBS Entities’ policies and procedures related to trading relationship documentation, the Commission anticipates that this alternative could increase compliance costs by reducing operational flexibility. 312 The exception with respect to security-based swap transactions on national exchanges or SBSEF is limited. See Section I.D.6 for a complete discussion of those limitations. E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 Proposed Rule 15Fi–5(a)(1)(ii) would provide an exception to the trading relationship documentations requirements for any ‘‘clearing transaction’’ which is defined as a security-based swap that has a clearing agency as a direct counterparty.313 A clearing agency means a clearing agency that is registered with the Commission pursuant to Section 17A of the Exchange Act and that provides central counterparty services for security-based swap transactions. The Commission considered as an alternative including transactions cleared at a foreign clearing agency that is not registered with the Commission within its definition of ‘‘clearing transaction’’ for the purposes of the proposed rule. The Commission preliminarily concluded that an approach that is similar to that taken by the Commission in other rules,314 as well as the approach taken by the CFTC,315 would reduce implementation and compliance costs. The Commission has considered as an alternative, an alternative compliance mechanism that would allow a SBS Entity to be deemed in compliance with certain proposed rules regarding trading relationship documentation if the SBS Entity is also registered as a swap dealer or major swap participant with the CFTC and is in compliance with the corresponding CFTC trading relationship documentation rules. The Commission preliminarily concludes that, as a practical matter, the rules are nearly equivalent, suggesting that any additional compliance cost arising from differences in these rules for an entity that is registered with both the CFTC and the Commission should be small. The Commission preliminarily believes that differences that do exist are necessary and appropriate. For example, to the extent that a transaction entered into on an anonymous basis on a national securities exchange or SBSEF that is then rejected for clearing but continues to exist, the Commission preliminarily believes that the counterparties to the ongoing securitybased swap should have in place a written agreement on the terms of that transaction.316 5. Recordkeeping Requirements The Commission is also proposing rules that would modify existing Rules 17a–3 and 17a–4, as well as proposed 313 See supra Section I.D.6. supra note 278. 315 Specifically, CFTC Rule 23.504(a)(1)(iii) excludes from the written trading relationship documentation requirements ‘‘swaps cleared by a derivatives clearing organization.’’ 17 CFR 23.504(a)(1)(iii). 316 See supra Section I.D.6. 314 See VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 Rules 18a–5 and 18a–6 for the recordkeeping and reporting requirements applicable to SBS Entities. The proposed amendments would involve requiring each SBS Entity to make and keep current information relevant to portfolio reconciliation and portfolio compression exercises and to retain all security-based swap trading relationship documentation required to be created under proposed Rule 15Fi–5, as well as each policy and procedure created pursuant to proposed Rules 15Fi–3, 15Fi–4, and 15Fi–5. a. Requirements The Commission is proposing to amend Rule 17a–3 (which applies to SBS Entities that are also registered with the Commission as broker-dealers) and proposed Rule 18a–5 (which applies to SBS Entities that are not registered with the Commission as broker-dealers). Under these amendments, each SBS Entity would be required to make and keep records of each security-based swap portfolio reconciliation and portfolio compression exercise, which is believed to promote compliance with proposed Rules 15Fi–3 and 15Fi–4 as well as support SBS Entities in the event that disputes arise in relation to previous reconciliations or compressions. The proposed amendments would also require that SBS Entities make and keep records of valuation disputes in excess of $20 million if not resolved within three (for SBS Entities) or five (for non-SBS counterparties) days. The Commission also is proposing to amend Rule 17a–4 (which applies to SBS Entities that are also registered with the Commission as broker-dealers) and proposed Rule 18a–6 (which applies to SBS Entities that are not registered with the Commission as broker-dealers), which address record retention. All records made and kept under the proposed amendments to Rule 17a–3 and proposed Rule 18a–5 would need to be retained for at least three years. Further, all policies and procedures related to proposed Rules 15Fi–3 through 15Fi–5, all written agreements between counterparties on terms of portfolio reconciliation, and all securitybased swap trading relationship documentation with counterparties would need to be retained until at least three years following the termination of said policies and procedures and/or documentation. b. Benefits In proposing these requirements, the Commission considered the potential benefits of improving the oversight, transparency, and documentation of PO 00000 Frm 00055 Fmt 4701 Sfmt 4702 4667 security-based swap activities. The amendments to Rules 17a–3 and 17a–4, and proposed Rules 18a–5 and 18a–6 are intended to facilitate effective oversight of SBS Entities, thus the benefits associated with the proposed amendments related to recordkeeping are beneficial not only to the SBS Entities, but also are expected to facilitate regulatory oversight. Requiring retention of records related to portfolio reconciliation, portfolio compression, and trading relationship documentation for a minimum of three years provides SBS Entities with a wellestablished track record should disputes about terms of the security-based swap arise. The benefits of these proposed amendments, to the extent that they enhance existing practice, could reduce both counterparty credit risk as well as operational risk for the SBS Entities. Further, the proposed amendments are expected to facilitate examinations by the Commission of SBS Entities. c. Costs The Commission also recognizes that there will be costs associated with the new rules and rule amendments. Those costs include the costs of creating procedures to ensure that records are kept as required by the proposed rule amendments, and costs associated with ongoing record maintenance. As the recordkeeping requirements would be amendments to Rules 17a–3 and 17a–4, and proposed Rules 18a–5 and 18a–6; however, the incremental costs of compliance with these amendments is likely to be minimal. The proposed Rules 15Fi–3 through 15Fi–5 would require that SBS Entities would establish and maintain written policies and procedures related to portfolio reconciliation, portfolio compression exercises, and trading relationship documentation. Further, SBS Entities are already required to comply with the retention of written policies and procedures with respect to Rule 15Fi–2 related to trade acknowledgement and verification, and should have recordkeeping systems previously instituted. Therefore, only minor modifications would need to be made in order to make the systems compliant with the proposed amendments regarding recordkeeping requirements for portfolio reconciliation, portfolio compression exercises, and trading relationship documentation. Generally, the Commission does not expect the amendments to Rules 17a–3 and 17a–4, and proposed Rules 18a–5 and 18a–6 to create material burdens for registrants, although as noted above the Commission does expect that there will E:\FR\FM\15FEP2.SGM 15FEP2 4668 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules be incremental costs related to complying with the proposed rule amendments.317 amozie on DSK3GDR082PROD with PROPOSALS2 d. Alternatives The Commission has considered reasonable alternatives to the proposed amendments. In particular, the costs and benefits associated with the required recordkeeping horizon have been evaluated. Shorter horizons (of less than three years) would lessen the overall recordkeeping burden by reducing the retention requirements and corresponding storage of records. However, as it may take time for disputes, particularly in the event of liquidations to be fully settled, shorter horizons may lead to the elimination of relevant records prior to resolution. On the other hand, longer horizons for maintaining records could be costly with respect to storage and system requirements. However, longer record preservation would reduce the likelihood that historical records are unavailable if needed at some point in the future. Proposed Rule 15Fi–5(c) requires each SBS Entity to have an independent auditor conduct periodic audits sufficient to identify any material weakness in it documentation policies and procedures required by the rule. The Commission considered using the same requirement as that required by the CFTC that the audit be conducted by an independent internal or external auditor. The Commission chose not to follow this approach because in its experience overseeing accounting and auditing standards in the context of certain disclosure requirements under the federal securities laws, an internal auditor typically reports to the management of the applicable entity, which by definition would not satisfy the test for auditor independence under any existing statutory or regulatory provision that the Commission administers.318 However, because the proposed rule would still encompass any auditor, whether external or internal, that is in fact independent, the Commission preliminarily believes that the practical differences between the Commission’s proposed rule and the corresponding CFTC rule are negligible. 6. Cross-Border Application of Rules 15Fi–3 Through 15Fi–5 In early 2016, the Commission adopted Rule 3a71–6 under the Exchange Act, which determined that non-U.S. SBS Entities could satisfy certain requirements of Section 15F by 317 See 318 See supra Section I.F.1. supra Section I.D.5. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 complying with comparable regulatory requirements of a foreign financial regulatory system.319 At the time of the substituted compliance rule, it applied solely to business conduct standards; however, Rule 3a71–6 was amended in the Trade Acknowledgement and Verification Adopting Release to provide foreign SBS Entities with the potential to rely on substituted compliance to satisfy Title VII trade confirmation requirements.320 a. Requirements The Commission is proposing to amend further Rule 3a71–6 to allow non-U.S. SBS Entities to potentially be able to satisfy through substituted compliance the Title VII portfolio reconciliation, portfolio compression, and trading relationship documentation requirements in proposed Rules 15Fi–3 through 15Fi–5. The Commission has preliminarily determined that the principles previously set forth in the Business Conduct Standards Adopting Release and the Trade Acknowledgement and Verification Adopting Release with respect to substituted compliance should in large part similarly pertain to the reconciliation, compression, and documentation requirements proposed herein. b. Benefits The Commission proposed amendments to Rule 3a71–6 permit consideration of substituted compliance in order to reduce the probability that SBS Entities are subject to potentially duplicative or conflicting regulation. Market participants that face duplicative regulatory regimes are likely to attain comparable regulatory outcomes, but at a cost of increased compliance burdens without an analogous increase in benefits. The availability of substituted compliance could decrease the compliance burden for non-U.S. SBS Entities, particularly as it pertains to portfolio reconciliation, portfolio compression, and trading relationship documentation. Allowing for the possibility of substituted compliance may help achieve the risk mitigation requirements set forth in proposed Rules 15Fi–3 through 15Fi–5, in particular as it reduces legal uncertainty, counterparty credit risk exposure, and operational risk for market participants. Further, the Commission anticipates broader market implications of 319 See Business Conduct Standards Adopting Release, 81 FR at 30074. 320 See Trade Acknowledgement and Verification Adopting Release, 81 FR at 39827–28. PO 00000 Frm 00056 Fmt 4701 Sfmt 4702 substituted compliance, as well, namely an increase in foreign SBS dealers’ activity in the U.S. market, the expansion of access by both U.S. and foreign SBS Entities to global liquidity, and a reduction in the possibility of liquidity fragmentation along jurisdictional lines. The availability of substituted compliance for non-U.S. SBS Entities also could promote market efficiency, while enhancing competition in U.S. markets. Increased participation and access to liquidity is likely to improve efficiencies related to hedging and risk sharing, while simultaneously increasing competition between domestic and foreign SBS Entities. c. Costs The Commission preliminarily believes that the availability of substituted compliance for portfolio reconciliation, portfolio compression, and trading relationship documentation would not substantially alter the benefits intended by the proposed Rules 15Fi–3 through 15Fi–5. In particular, it is expected that the availability of substituted compliance will not detract from the risk mitigation benefits that stem from periodic portfolio reconciliation, as well as policies and procedures regarding portfolio compression exercises and trading relationship documentation. To the extent that substituted compliance reduces duplicative compliance costs, non-U.S. SBS Entities entering into transactions in which substituted compliance is available may incur lower overall costs associated with portfolio reconciliation, portfolio compression, and documentation exercises with their counterparties than they would otherwise incur without the option of substituted compliance availability, either because a non-U.S. SBS Entity may have already implemented foreign regulatory requirements which have been deemed comparable by the Commission, or because security-based swap counterparties eligible for substituted compliance do not need to duplicate compliance with two sets of comparable requirements. A substituted compliance request can be made by either a foreign regulatory jurisdiction on behalf of its market participants, or by the registered market participant itself.321 The decision to request substituted compliance is voluntary, and therefore, to the extent that requests are made by individual market participants, such participants would request substituted compliance 321 See Cross-Border Adopting Release, 79 FR at 47277. E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 only if compliance with foreign regulatory requirements was less costly, in their own assessment, than compliance with both the foreign regulatory regime and the relevant Title VII requirements, including portfolio reconciliation, portfolio compression, and trading relationship documentation requirements. Even after a substituted compliance determination is made, market participants would only choose substituted compliance for portfolio reconciliation, compression, and documentation requirements if the benefits that they expect to receive from transacting in the U.S. markets exceed the costs that they expect to bear for doing so. D. Request for Comment The Commission requests comment on all aspects of this initial economic analysis, including whether the analysis has: (i) Identified all benefits and costs, including all effects on efficiency, competition, and capital formation; (ii) given due consideration to each benefit and cost, including each effect on efficiency, competition, and capital formation; and (iii) identified and considered reasonable alternatives to the proposed regulations. We request and encourage any interested person to submit comments regarding the proposed regulations and our analysis of the potential effects of the proposed regulations. We request that commenters identify sources of data and information as well as provide data and information to assist us in analyzing the economic consequences of the proposed rule and proposed amendments. We also are interested in comments on the qualitative benefits and costs we have identified and any benefits and costs we may have overlooked. In addition to our general request for comment on the economic analysis associated with the proposed rule and proposed amendments, we request specific comment on certain aspects of the proposal: • We request comment on our characterization of current portfolio reconciliation practices. Do commenters agree that the proposed portfolio reconciliation rules are similar to current best practices? If not, how are they different? Are there third party service providers that offer portfolio reconciliation services? If so, what are the costs associated with using such services? • We request comment on our characterization of current portfolio compression practices. Do commenters agree that the proposed portfolio compression rules are similar to current best practices? If not, how are they VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 different? The Commission understands that there are third party service providers that offer portfolio compression services. What are the direct and indirect costs of using such service providers? • We request comment on our characterization of current trading relationship documentation practices. Do commenters agree with our characterization? If not, how are they different? • We request comment on our characterization of the benefits of the proposed regulations concerning portfolio reconciliation. The Commission preliminarily believes that the main benefit of portfolio reconciliation is improved management of market and credit risks associated with particular transactions. Do commenters agree with this characterization of the benefits? Are there other benefits of the proposed rule that have not been identified in our discussion and that warrant consideration? Are the assumptions that form the basis of our analysis of the benefits appropriate? Can commenters provide data that supports or opposes these assumptions? Can commenters provide data that would help the Commission quantify the magnitude of the benefits identified in our discussion or other benefits that we did not identify in our discussion and that warrant consideration? • We request comment on our characterization of the costs of the proposed regulations concerning portfolio reconciliation. The Commission preliminarily believes that making its rules as similar as practicable to those of the CFTC will mitigate compliance costs for SBS entities. The Commission also preliminarily believes that ongoing portfolio reconciliation costs would likely be a function of portfolio size and the availability of third party service providers. Do commenters agree with our characterization of the costs? Are there other costs of the proposed rule that have not been identified in our discussion and that warrant consideration? Are the assumptions that form the basis of our analysis of the costs appropriate? Can commenters provide data that supports or opposes these assumptions? Can commenters provide data that would help the Commission quantify the magnitude of the costs identified in our discussion or other costs that we did not identify in our discussion and that warrant consideration? • We request comment on our characterization of the benefits of the proposed rules concerning portfolio PO 00000 Frm 00057 Fmt 4701 Sfmt 4702 4669 compression. The Commission preliminarily believes that the main benefit of the proposed portfolio compression rule is the potential for reducing the overall risk, cost, and inefficiencies associated with maintaining offsetting transactions. Do commenters agree with this characterization of the benefits? Are there other benefits of the proposed rule that have not been identified in our discussion and that warrant consideration? Are the assumptions that form the basis of our analysis of the benefits appropriate? Can commenters provide data that supports or opposes these assumptions? Can commenters provide data that would help the Commission quantify the magnitude of the benefits identified in our discussion or other benefits that we did not identify in our discussion and that warrant consideration? • We request comment on our characterization of the costs of the proposed regulations concerning portfolio compression. The Commission preliminarily believes the making its rules as similar as practicable to those of the CFTC will mitigate compliance costs for SBS entities. Do commenters agree with our characterization of the costs? Are there other costs of the proposed rule that have not been identified in our discussion and that warrant consideration? Are the assumptions that form the basis of our analysis of the costs appropriate? The Commission preliminarily believes third-party service providers often facilitate multilateral portfolio compression but lacks data on the costs to participants of using these services. Can commenters provide data that supports or opposes these assumptions? Can commenters provide data that would help the Commission quantify the magnitude of the costs identified in our discussion or other costs that we did not identify in our discussion and that warrant consideration? • We request comment on our characterization of the benefits of the proposed rules concerning trading relationship documentation. The Commission preliminarily believes that the main benefit of the proposed trading relationship documentation rule is the potential for reducing the likelihood of collateral and legal disputes between counterparties that might expose each side to significant counterparty credit risk. Do commenters agree with this characterization of the benefits? Are there other benefits of the proposed rule that have not been identified in our discussion and that warrant consideration? Are the assumptions that form the basis of our analysis of the E:\FR\FM\15FEP2.SGM 15FEP2 4670 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules amozie on DSK3GDR082PROD with PROPOSALS2 benefits appropriate? Can commenters provide data that supports or opposes these assumptions? Can commenters provide data that would help the Commission quantify the magnitude of the benefits identified in our discussion or other benefits that we did not identify in our discussion and that warrant consideration? • We request comment on our characterization of the costs of the proposed regulations concerning trading relationship documentation. The Commission preliminarily believes the widespread use of standard documentation mitigates the costs of the proposed rule. Do commenters agree with our characterization of the costs? Are there other costs of the proposed rule that have not been identified in our discussion and that warrant consideration? Are the assumptions that form the basis of our analysis of the costs appropriate? Can commenters provide data that would help the Commission quantify the magnitude of the costs identified in our discussion or other costs that we did not identify in our discussion and that warrant consideration? • Are there any effects on efficiency, competition, and capital formation that are not identified or are misidentified in our economic analysis? Please be specific and provide data and analysis to support your views. • Do commenters believe that the alternatives the Commission considered are appropriate? Are there other reasonable alternatives that the Commission should consider? If so, please provide additional alternatives and how their costs and benefits would compare to the proposal. • We request and encourage any interested person to submit comments regarding any aspect of the economic analysis of the proposed rule, specific issues discussed in the economic analysis, and other matters that may have an effect on the costs or benefits of the proposed rule. With regard to any comments, we note that such comments are of particular assistance to our rulemaking initiative if accompanied by supporting data and analysis of the issues addressed in those comments. VII. Consideration of Impact on the Economy For purposes of the Small Business Regulatory Enforcement Fairness Act of 1996 (‘‘SBREFA’’) 322 the Commission requests comment on the potential impact of the proposed rules and 322 Public Law 104–121, Title II, 110 Stat. 857 (1996) (codified in various sections of 5 U.S.C., 15 U.S.C. and as a note to 5 U.S.C. 601). VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 amendments on the economy on an annual basis. The Commission also requests comment on any potential increases in costs or prices for consumers or individual industries, and any potential effect on competition, investment, or innovation. Commenters are requested to provide empirical data and other factual support for their views to the extent possible. VIII. Regulatory Flexibility Act Certification The Regulatory Flexibility Act of 1980 (‘‘RFA’’) 323 requires the Commission, in promulgating rules, to consider the impact of those rules on small entities. Section 603(a) 324 of the Administrative Procedure Act,325 as amended by the RFA, generally requires the Commission to undertake a regulatory flexibility analysis of all proposed rules to determine the impact of such rulemaking on ‘‘small entities.’’ Section 605(b) of the RFA 326 provides that this requirement shall not apply to any proposed rule or proposed rule amendment which, if adopted, would not have a significant economic impact on a substantial number of small entities. For purposes of Commission rulemaking in connection with the RFA,327 a small entity includes: (1) When used with reference to an ‘‘issuer’’ or a ‘‘person,’’ other than an investment company, an ‘‘issuer’’ or ‘‘person’’ that, on the last day of its most recent fiscal year, had total assets of $5 million or less; 328 or (2) a broker-dealer with total capital (net worth plus subordinated liabilities) of less than $500,000 on the date in the prior fiscal year as of which its audited financial statements were prepared pursuant to Rule 17a–5(d) under the Exchange Act,329 or, if not required to file such statements, a broker-dealer with total capital (net worth plus subordinated liabilities) of less than $500,000 on the last day of the preceding fiscal year (or in the time that it has been in business, if shorter); and is not affiliated with any 323 5 U.S.C. 601 et seq. U.S.C. 603(a). 325 5 U.S.C. 551 et seq. 326 5 U.S.C. 605(b). 327 Although Section 601(b) of the RFA defines the term ‘‘small entity,’’ the statute permits agencies to formulate their own definitions. The Commission has adopted definitions for the term ‘‘small entity’’ for the purposes of Commission rulemaking in accordance with the RFA. Those definitions, as relevant to this proposed rulemaking, are set forth in Rule 0–10 under the Exchange Act, 17 CFR 240.0–10. See Exchange Act Release No. 18451 (Jan., 28, 1982), 47 FR 5215 (Feb., 4, 1982) (File No. AS–305). 328 See 17 CFR 240.0–10(a). 329 17 CFR 240.17a–5(d). person (other than a natural person) that is not a small business or small organization.330 Under the standards adopted by the Small Business Administration, small entities in the finance and insurance industry include the following: (i) For entities engaged in credit intermediation and related activities, entities with $175 million or less in assets; 331 (ii) for entities engaged in non-depository credit intermediation and certain other activities, entities with $7 million or less in annual receipts; 332 (iii) for entities engaged in financial investments and related activities, entities with $7 million or less in annual receipts; 333 (iv) for insurance carriers and entities engaged in related activities, entities with $7 million or less in annual receipts; 334 and (v) for funds, trusts, and other financial vehicles, entities with $7 million or less in annual receipts.335 With respect to SBS Entities, based on feedback from market participants and our information about the securitybased swap markets, and consistent with our position in prior Dodd-Frank Act rulemakings, the Commission continues to believe that (1) the types of entities that would engage in more than a de minimis amount of dealing activity involving security-based swaps—which generally would be large financial institutions—would not be ‘‘small entities’’ for purposes of the RFA and (2) the types of entities that may have security-based swap positions above the level required to be ‘‘major securitybased swap participants’’ would not be ‘‘small entities’’ for purposes of the RFA.336 For the foregoing reasons, the Commission certifies that neither proposed Rules 15Fi–3 through 15Fi, nor the proposed amendments to Rules 3a71–6, 15Fi–1, 17a–3, 17a–4, 18a–5 (proposed) and 18a–6 (proposed) would, if adopted, have a significant economic impact on a substantial number of small entities. The Commission encourages written comments regarding this certification. The Commission solicits comment as to whether the proposed rules could have an effect on small 324 5 PO 00000 Frm 00058 Fmt 4701 Sfmt 4702 330 See 17 CFR 240.0–10(c). 13 CFR 121.201 (Subsector 522). 332 See id. at Subsector 522. 333 See id. at Subsector 523. 334 See id. at Subsector 524. 335 See id. at Subsector 525. 336 See SBS Entity Registration Adopting Release, 80 FR at 49013; SBS Books and Records Proposing Release, 79 FR at 25296–97 and n.1441; Intermediary Definitions Adopting Release, 77 FR at 30743. See also Sections V (Paperwork Reduction Act) and VI (Economic Analysis) (discussing, among other things, the economic impact, including the estimated compliance costs and burdens, of the amendments). 331 See E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules entities that has not been considered. The Commission requests that commenters describe the nature of any impact on small entities and provide empirical data to support the extent of such impact. IX. Statutory Basis and Text of Proposed Rules The Commission is proposing to revise Rules 3a71–6, 15Fi–1, 17a–3, and 17a–4 under the Exchange Act (17 CFR 240.3a71–6, 17 CFR 240.15Fi–1, 17 CFR 240.17a–3 [as proposed to be amended at 79 FR 25193, May 2, 2014], and 17 CFR 240.17a–4 [as proposed to be amended at 79 FR 25193, May 2, 2014]), to revise proposed Rules 18a–5 and 18a–6 under the Exchange Act (17 CFR 240.18a–5 [as proposed to be adopted at 79 FR 25193, May 2, 2014] and 17 CFR 240.18a–6 [as proposed to be adopted at 79 FR 25193, May 2, 2014]) and to add new Rules 15Fi–3, 15Fi–4, and 15Fi–5 under the Exchange Act (17 CFR 240.15Fi–3, 17 CFR 240.15Fi–4, and 17 CFR 240.15Fi–5) pursuant to the authority conferred by the Exchange Act, as amended, and particularly sections 3(b), 15F, 17, and 23(a).337 List of Subjects in 17 CFR Part 240 Reporting and recordkeeping requirements, Securities, Security-based swaps, Security-based swap dealers, Major security-based swap participants. Text of the Amendments In accordance with the foregoing, the Securities and Exchange Commission proposes to amend Title 17, chapter II of the Code of Federal Regulations as follows: PART 240—GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 1934 1. The general authority citation for Part 240 continues to read as follows: amozie on DSK3GDR082PROD with PROPOSALS2 ■ Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z–2, 77z–3, 77eee, 77ggg, 77nnn, 77sss,77ttt, 78c, 78c–3, 78c–5, 78d, 78e, 78f, 78g, 78i, 78j, 78j–1, 78k, 78k–1, 78l, 78m, 78n, 78n–1, 78o, 78o–4, 78o–10, 78p, 78q, 78q–1, 78s, 78u–5, 78w, 78x, 78ll, 78mm, 80a–20, 80a–23, 80a–29, 80a–37, 80b–3, 80b– 4, 80b–11, 7201 et seq., and 8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 1350; and Pub. L. 111–203, 939A, 124 Stat. 1376 (2010), unless otherwise noted. 2. Section 240.3a71–6 is amended by adding paragraph (d)(4) to read as follows: ■ 337 15 U.S.C. 78c(b), 78o–10, 78q, 78w(a), and 78mm. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 § 240.3a71–6 Substituted compliance for security-based swap dealers and major security-based swap participants. * * * * * (d) * * * (4) Portfolio reconciliation, portfolio compression, and trading relationship documentation requirements. The portfolio reconciliation, portfolio compression, and trading relationship documentation requirements of section 15F(i) of the Act (15 U.S.C. 78o–10(i)) and §§ 240.15Fi–3 through 15Fi–5; provided, however, that prior to making such a substituted compliance determination the Commission intends to consider whether the requirements of the foreign financial regulatory system for engaging in portfolio reconciliation and portfolio compression and for executing trading relationship documentation with counterparties, the duties imposed by the foreign financial regulatory system, and the information that is required to be provided to counterparties pursuant to the requirements of the foreign financial regulatory system, are comparable to those required pursuant to the applicable provisions arising under the Act and its rules and regulations. ■ 3. Revise § 240.15Fi–1 to read as follows: § 240.15Fi–1 Definitions. For the purposes of § 240.15Fi–1 through § 240.15Fi–5: (a) The term bilateral portfolio compression exercise means an exercise by which two security-based swap counterparties wholly terminate or change the notional value of some or all of the security-based swaps submitted by the counterparties for inclusion in the portfolio compression exercise and, depending on the methodology employed, replace the terminated security-based swaps with other security-based swaps whose combined notional value (or some other measure of risk) is less than the combined notional value (or some other measure of risk) of the terminated security-based swaps in the exercise. (b) The term business day means any day other than a Saturday, Sunday, or legal holiday. (c) The term clearing agency means a clearing agency as defined in section 3(a)(23) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(23)) that is registered pursuant to section 17A of the Securities Exchange Act of 1934 (15 U.S.C. 78q–1) and provides central counterparty services for security-based swap transactions. (d) The term clearing transaction means a security-based swap that has a clearing agency as a direct counterparty. PO 00000 Frm 00059 Fmt 4701 Sfmt 4702 4671 (e) The term day of execution means the calendar day of the counterparty to the security-based swap transaction that ends the latest, provided that if a security-based swap transaction is (1) Entered into after 4:00 p.m. in the place of a counterparty; or (2) Entered into on a day that is not a business day in the place of a counterparty, then such security-based swap transaction shall be deemed to have been entered into by that counterparty on the immediately succeeding business day of that counterparty, and the day of execution shall be determined with reference to such business day. (f) The term execution means the point at which the counterparties become irrevocably bound to a transaction under applicable law. (g) The term financial counterparty means a counterparty that is not a security-based swap dealer or a major security-based swap participant and that is one of the following: (1) A swap dealer; (2) A major swap participant; (3) A commodity pool as defined in section 1a(10) of the Commodity Exchange Act (7 U.S.C. 1a(10)); (4) A private fund as defined in section 202(a)(29) of the Investment Advisers Act of 1940 (15 U.S.C. 80b– 2(a)); (5) An employee benefit plan as defined in paragraphs (3) and (32) of section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002); and (6) A person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 4(k) of the Bank Holding Company Act of 1956 (12 U.S.C. 1843k). (h) The term fully offsetting securitybased swaps means security-based swaps of equivalent terms where no net cash flow would be owed to either counterparty after the offset of payment obligations thereunder. (i) The term material terms means: (1) With respect to any security-based swap that has not yet been included in a security-based swap portfolio and reconciled pursuant to § 240.15Fi–3, each term that is required to be reported to a registered swap data repository or the Commission pursuant to § 242.901 of this chapter; and (2) With respect to all other securitybased swaps within a security-based swap portfolio, each term that is required to be reported to a registered swap data repository or the Commission pursuant to § 242.901 of this chapter; provided, however, that such definition does not include any term that is not E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 4672 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules relevant to the ongoing rights and obligations of the parties and the valuation of the security-based swap. (j) The term multilateral portfolio compression exercise means an exercise by which multiple security-based swap counterparties wholly terminate or change the notional value of some or all of the security-based swaps submitted by the counterparties for inclusion in the portfolio compression exercise and, depending on the methodology employed, replace the terminated security-based swaps with other security-based swaps whose combined notional value (or some other measure of risk) is less than the combined notional value (or some other measure of risk) of the terminated security-based swaps in the exercise. (k) The term national securities exchange means an exchange as defined in section 3(a)(1) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(1)) that is registered pursuant to section 6 of the Securities Exchange Act of 1934 (15 U.S.C. 78f). (l) The term portfolio reconciliation means any process by which the counterparties to one or more securitybased swaps: (1) Exchange the material terms of all security-based swaps in the securitybased swap portfolio between the counterparties; (2) Exchange each counterparty’s valuation of each security-based swap in the security-based swap portfolio between the counterparties as of the close of business on the immediately preceding business day; and (3) Resolve any discrepancy in valuations or material terms. (m) The term prudential regulator has the meaning given to the term in section 3(a)(74) of the Act (15 U.S.C. 78c(a)(74)) and includes the Board of Governors of the Federal Reserve System, the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Association, and the Federal Housing Finance Agency, as applicable to the security-based swap dealer or major security-based swap participant. (n) The term security-based swap execution facility means a securitybased swap execution facility as defined in section 3(a)(77) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(77)) that is registered pursuant to section 3D of the Securities Exchange Act of 1934 (15 U.S.C. 78c–4). (o) The term security-based swap portfolio means all security-based swaps currently in effect between a particular security-based swap dealer or major security-based swap participant and a particular counterparty. VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 (p) The term trade acknowledgment means a written or electronic record of a security-based swap transaction sent by one counterparty of the securitybased swap transaction to the other. (q) The term valuation means the current market value or net present value of a security-based swap. (r) The term verification means the process by which a trade acknowledgment has been manually, electronically, or by some other legally equivalent means, signed by the receiving counterparty. ■ 4. Section 240.15Fi–3 is added to read as follows: § 240.15Fi–3 Security-based swap portfolio reconciliation. (a) Security-based swaps with security-based swap dealers or major security-based swap participants. Each security-based swap dealer and major security-based swap participant shall engage in portfolio reconciliation as follows for all security-based swaps in which its counterparty is also a securitybased swap dealer or major securitybased swap participant. (1) Each security-based swap dealer or major security-based swap participant shall agree in writing with each of its counterparties on the terms of the portfolio reconciliation including, if applicable, agreement on the selection of any third party service provider who may be performing the portfolio reconciliation. (2) The portfolio reconciliation may be performed on a bilateral basis by the counterparties or by a third party selected by the counterparties in accordance with paragraph (a)(1) of this section. (3) The portfolio reconciliation shall be performed no less frequently than: (i) Once each business day for each security-based swap portfolio that includes 500 or more security-based swaps; (ii) Once each week for each securitybased swap portfolio that includes more than 50 but fewer than 500 securitybased swaps on any business day during the week; and (iii) Once each calendar quarter for each security-based swap portfolio that includes no more than 50 security-based swaps at any time during the calendar quarter. (4) Each security-based swap dealer and major security-based swap participant shall resolve immediately any discrepancy in a material term of a security-based swap identified as part of a portfolio reconciliation or otherwise. (5) Each security-based swap dealer and major security-based swap participant shall establish, maintain, PO 00000 Frm 00060 Fmt 4701 Sfmt 4702 and follow written policies and procedures reasonably designed to resolve any discrepancy in a valuation identified as part of a portfolio reconciliation or otherwise as soon as possible, but in any event within five business days after the date on which the discrepancy is first identified, provided that the security-based swap dealer and major security-based swap participant establishes, maintains, and follows written policies and procedures reasonably designed to identify how the security-based swap dealer or major security-based swap participant will comply with any variation margin requirements under section 15F(e) of the Act (15 U.S.C. 78o–10(e)) and regulations thereunder pending resolution of the discrepancy in valuation. For purposes of this paragraph, a difference between the lower valuation and the higher valuation of less than 10 percent of the higher valuation need not be deemed a discrepancy. (b) Security-based swaps with entities other than security-based swap dealers or major security-based swap participants. Each security-based swap dealer and major security-based swap participant shall establish, maintain, and follow written policies and procedures reasonably designed to ensure that it engages in portfolio reconciliation for all security-based swaps in which its counterparty is neither a security-based swap dealer nor a major security-based swap participant as follows. (1) Each security-based swap dealer or major security-based swap participant shall agree in writing with each of its counterparties on the terms of the portfolio reconciliation including, if applicable, agreement on the selection of any third party service provider who may be performing the reconciliation. (2) The portfolio reconciliation may be performed on a bilateral basis by the counterparties or by one or more third parties selected by the counterparties in accordance with paragraph (b)(1) of this section. (3) The portfolio reconciliation will be required to be performed no less frequently than: (i) Once each calendar quarter for each security-based swap portfolio that includes more than 100 security-based swaps at any time during the calendar quarter; and (ii) Once annually for each securitybased swap portfolio that includes no more than 100 security-based swaps at any time during the calendar year. (4) Each security-based swap dealer or major security-based swap participant shall establish, maintain, and follow E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules written procedures reasonably designed to resolve any discrepancies in the valuation or material terms of each security-based swap identified as part of a portfolio reconciliation or otherwise with a counterparty that is neither a security-based swap dealer nor major security-based swap participant in a timely fashion. For purposes of this paragraph, a difference between the lower valuation and the higher valuation of less than 10 percent of the higher valuation need not be deemed a discrepancy. (c) Reporting of Security-Based Swap Valuation Disputes. Each security-based swap dealer and major security-based swap participant shall promptly notify the Commission, in a form and manner acceptable to the Commission, and any applicable prudential regulator of any security-based swap valuation dispute in excess of $20,000,000 (or its equivalent in any other currency), at either the transaction or portfolio level, if not resolved within: (1) Three business days, if the dispute is with a counterparty that is a securitybased swap dealer or major securitybased swap participant; or (2) Five business days, if the dispute is with a counterparty that is not a security-based swap dealer or major security-based swap participant. (d) Reconciliation of cleared securitybased swaps. Nothing in this section shall apply to any clearing transaction. ■ 5. Section 240.15Fi–4 is added to read as follows: amozie on DSK3GDR082PROD with PROPOSALS2 § 240.15Fi–4 Security-based swap portfolio compression. (a) Portfolio compression with security-based swap dealers and major security-based swap participants—(1) Bilateral offset. Each security-based swap dealer and major security-based swap participant shall establish, maintain, and follow written policies and procedures for terminating each fully offsetting security-based swap between a security-based swap dealer or major security-based swap participant and another security-based swap dealer or major security-based swap participant in a timely fashion, when appropriate. (2) Bilateral compression. Each security-based swap dealer and major security-based swap participant shall establish, maintain, and follow written policies and procedures for periodically engaging in bilateral portfolio compression exercises, when appropriate, with each counterparty that is also a security-based swap dealer or major security-based swap participant. Such policies and procedures shall address, among other things, the VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 evaluation of bilateral portfolio compression exercises that are initiated, offered, or sponsored by any third party. (3) Multilateral compression. Each security-based swap dealer and major security-based swap participant shall establish, maintain, and follow written policies and procedures for periodically engaging in multilateral portfolio compression exercises, when appropriate, with each counterparty that is also a security-based swap dealer or major security-based swap participant. Such policies and procedures shall address, among other things, the evaluation of multilateral portfolio compression exercises that are initiated, offered, or sponsored by any third party. (b) Portfolio compression with counterparties other than security-based swap dealers and major security-based swap participants. Each security-based swap dealer and major security-based swap participant shall establish, maintain, and follow written policies and procedures for periodically terminating fully offsetting securitybased swaps and for engaging in bilateral or multilateral portfolio compression exercises with respect to security-based swaps in which its counterparty is an entity other than a security-based swap dealer or major security-based swap participant, when appropriate and to the extent requested by any such counterparty. (c) Portfolio compression of cleared security-based swaps. Nothing in this section shall apply to any clearing transaction. ■ 6. Section 240.15Fi–5 is added to read as follows: § 240.15Fi–5 Security-based swap trading relationship documentation. (a)(1) Applicability. The requirements of this section shall not apply to: (i) Security-based swaps executed prior to the date on which a securitybased swap dealer or major securitybased swap participant is required to be in compliance with this section; (ii) Any clearing transaction; and (iii) Security-based swaps executed anonymously on a national securities exchange or a security-based swap execution facility, Provided that: (A) Such security-based swaps are intended to be cleared and are actually submitted for clearing to a clearing agency; (B) All terms of such security-based swaps conform to the rules of the clearing agency; and (C) Upon acceptance of such securitybased swap by the clearing agency: (1) The original security-based swap is extinguished; (2) The original security-based swap is replaced by equal and opposite PO 00000 Frm 00061 Fmt 4701 Sfmt 4702 4673 security-based swaps with the clearing agency; and (3) All terms of the security-based swap shall conform to the product specifications of the cleared securitybased swap established under the clearing agency’s rules; and Provided further, That if a security-based swap dealer or major security-based swap participant receives notice that a security-based swap transaction has not been accepted for clearing by a clearing agency, the security-based swap dealer or major security-based swap participant shall be required to comply with the requirements of this section in all respects promptly after receipt of such notice. (2) Policies and procedures. Each security-based swap dealer and major security-based swap participant shall establish, maintain, and follow written policies and procedures reasonably designed to ensure that the securitybased swap dealer or major securitybased swap participant executes written security-based swap trading relationship documentation with its counterparty that complies with the requirements of this section. The policies and procedures shall be approved in writing by a senior officer of the security-based swap dealer or major security-based swap participant, and a record of the approval shall be retained. Other than trade acknowledgements and verifications of security-based swap transactions under § 240.15Fi–2, the security-based swap trading relationship documentation shall be executed prior to, or contemporaneously with, executing a security-based swap with any counterparty. (b) Security-based swap trading relationship documentation. (1) The security-based swap trading relationship documentation shall be in writing and shall include all terms governing the trading relationship between the security-based swap dealer or major security-based swap participant 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 §§ 242.900 to 242.909) of this chapter, governing law, valuation, and dispute resolution. (2) The security-based swap trading relationship documentation shall include all trade acknowledgements and verifications of security-based swap transactions under § 240.15Fi–2. (3) The security-based swap trading relationship documentation shall E:\FR\FM\15FEP2.SGM 15FEP2 amozie on DSK3GDR082PROD with PROPOSALS2 4674 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules include credit support arrangements, which shall contain, in accordance with applicable requirements under Commission regulations or regulations adopted by prudential regulators and without limitation, the following: (i) Initial and variation margin requirements, if any; (ii) Types of assets that may be used as margin and asset valuation haircuts, if any; (iii) Investment and re-hypothecation terms for assets used as margin for uncleared security-based swaps, if any; and (iv) Custodial arrangements for margin assets, including whether margin assets are to be segregated with an independent third party, in accordance with section 3E(f) of the Act (15 U.S.C. 78c–5(f)), if any. (4)(i) The security-based swap trading relationship documentation between security-based swap dealers, between major security-based swap participants, between a security-based swap dealer and major security-based swap participant, between a security-based swap dealer or major security-based swap participant and a financial counterparty, and, if requested by any other counterparty, between a securitybased swap dealer or major securitybased swap participant and such counterparty, shall 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 securitybased swap at any time from execution to the termination, maturity, or expiration of such security-based swap for the purposes of complying with the margin requirements under section 15F(e) of the Act (15 U.S.C. 78o–10(e)) and regulations thereunder, and the risk management requirements under section 15F(j) of the Act (15 U.S.C. 78o– 10(j)) of the Act and regulations thereunder. To the maximum extent practicable, the valuation of each security-based swap shall be based on recently-executed transactions, valuations provided by independent third parties, or other objective criteria. (ii) Such documentation shall include either: (A) Alternative methods for determining the value of the securitybased swap for the purposes of complying with this paragraph in the event of the unavailability or other failure of any input required to value the security-based swap for such purposes; or (B) A valuation dispute resolution process by which the value of the security-based swap shall be determined VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 for the purposes of complying with this paragraph (b)(4). (iii) A security-based swap dealer or major security-based swap participant is not required to disclose to the counterparty confidential, proprietary information about any model it may use to value a security-based swap. (iv) The parties may agree on changes or procedures for modifying or amending the documentation at any time. (5) The security-based swap trading relationship documentation of a security-based swap dealer or major security-based swap participant shall include the following: (i) A statement of whether the security-based swap dealer or major security-based swap participant is an insured depository institution (as defined in 12 U.S.C. 1813) or a financial company (as defined in section 201(a)(11) of the Dodd-Frank Act, 12 U.S.C. 5381(a)(11)); (ii) A statement of whether the counterparty is an insured depository institution or financial company; (iii) A statement that in the event either the security-based swap dealer or major security-based swap participant or its counterparty becomes a covered financial company (as defined in section 201(a)(8) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 12 U.S.C. 5381(a)(8)) or is an insured depository institution for which the Federal Deposit Insurance Corporation (FDIC) has been appointed as a receiver (the ‘‘covered party’’), certain limitations under Title II of the DoddFrank Act or the Federal Deposit Insurance Act may apply to the right of the non-covered party to terminate, liquidate, or net any security-based swap by reason of the appointment of the FDIC as receiver, notwithstanding the agreement of the parties in the security-based swap trading relationship documentation, and that the FDIC may have certain rights to transfer securitybased swaps of the covered party under section 210(c)(9)(A) of the Dodd-Frank Wall Street Reform and Consumer Protection Act, 12 U.S.C. 5390(c)(9)(A), or 12 U.S.C. 1821(e)(9)(A); and (iv) An agreement between the security-based swap dealer or major security-based swap participant and its counterparty to provide notice if either it or its counterparty becomes or ceases to be an insured depository institution or a financial company. (6) The security-based swap trading relationship documentation of each security-based swap dealer and major security-based swap participant shall contain a notice that, upon acceptance PO 00000 Frm 00062 Fmt 4701 Sfmt 4702 of a security-based swap by a clearing agency: (i) The original security-based swap is extinguished; (ii) The original security-based swap is replaced by equal and opposite security-based swaps with the clearing agency; and (iii) All terms of the security-based swap shall conform to the product specifications of the cleared securitybased swap established under the clearing agency’s rules. (c) Audit of security-based swap trading relationship documentation. Each security-based swap dealer and major security-based swap participant shall have an independent auditor conduct periodic audits sufficient to identify any material weakness in its documentation policies and procedures required by this section. A record of the results of each audit shall be retained. ■ 7. Section 240.17a–3, as proposed to be amended at 79 FR 25193, May 2, 2014 is further amended by adding paragraph (a)(31) to read as follows: § 240.17a–3 Records to be made by certain brokers and dealers. * * * * * (a) * * * (31)(i) A record of each security-based swap portfolio reconciliation, whether conducted pursuant to § 240.15Fi–3 or otherwise, including the dates of the security-based swap portfolio reconciliation, the number of portfolio reconciliation discrepancies, the number of security-based swap valuation disputes (including the timeto-resolution of each valuation dispute and the age of outstanding valuation disputes, categorized by transaction and counterparty), and the name of the third-party entity performing the security-based swap portfolio reconciliation, if any. (ii) A copy of each notification required to be provided to the Commission pursuant to § 240.15Fi– 3(c). (iii) A record of each bilateral offset and each bilateral portfolio compression exercise or multilateral portfolio compression exercise in which it participates, whether conducted pursuant to § 240.15Fi–4 or otherwise, including the dates of the offset or compression, the security-based swaps included in the offset or compression, the identity of the counterparties participating in the offset or compression, the results of the compression, and the name of the thirdparty entity performing the offset or compression, if any. * * * * * E:\FR\FM\15FEP2.SGM 15FEP2 Federal Register / Vol. 84, No. 32 / Friday, February 15, 2019 / Proposed Rules 8. Section 240.17a–4, as proposed to be amended at 79 FR 25193, May 2, 2014 is amended by revising paragraph (b)(1) and adding paragraphs (e)(10) and (11) to read as follows: ■ § 240.17a–4 Records to be preserved by certain exchange members, brokers and dealers. * * * * * (b) * * * (1) All records required to be made pursuant to § 240.17a–3(a)(4), (a)(6), (a)(7), (a)(8), (a)(9), (a)(10), (a)(11), (a)(16), (a)(18), (a)(19), (a)(20), (a)(24), (a)(25), (a)(26), (a)(27), (a)(28), (a)(29), (a)(30), and (a)(31), and analogous records created pursuant to § 240.17a– 3(e). * * * * * (e) * * * (10) The written policies and procedures required pursuant to §§ 240.15Fi–3, 240.15Fi–4, and 240.15Fi–5 until three years after termination of the use of the policies and procedures. (11) (i) Each written agreement with counterparties on the terms of portfolio reconciliation with those counterparties as required to be created under § 240.15Fi–3(a)(1) and (b)(1) until three years after the termination of the agreement and all transactions governed thereby. (ii) Security-based swap trading relationship documentation with counterparties required to be created under § 240.15Fi–5 until three years after the termination of such documentation and all transactions governed thereby. (iii) A record of the results of each audit required to be performed pursuant to § 240.15Fi–5(c) until three years after the conclusion of the audit. * * * * * ■ 9. Section 240.18a–5, as proposed to be added at 79 FR 25193, May 2, 2014, is further amended by adding paragraphs (a)(18) and (b)(14) to read as follows: § 240.18a–5 Records to be made by certain security-based swap dealers and major security-based swap participants. amozie on DSK3GDR082PROD with PROPOSALS2 * * * * * (a) * * * (18)(i) A record of each security-based swap portfolio reconciliation, whether conducted pursuant to § 240.15Fi–3 or otherwise, including the dates of the security-based swap portfolio reconciliation, the number of portfolio VerDate Sep<11>2014 22:04 Feb 14, 2019 Jkt 247001 reconciliation discrepancies, the number of security-based swap valuation disputes (including the timeto-resolution of each valuation dispute and the age of outstanding valuation disputes, categorized by transaction and counterparty), and the name of the third-party entity performing the security-based swap portfolio reconciliation, if any. (ii) A copy of each notification required to be provided to the Commission pursuant to § 240.15Fi– 3(c). (iii) A record of each bilateral offset and each bilateral portfolio compression exercise or multilateral portfolio compression exercise in which it participates, whether conducted pursuant to § 240.15Fi–4 or otherwise, including the dates of the offset or compression, the security-based swaps included in the offset or compression, the identity of the counterparties participating in the offset or compression, the results of the compression, and the name of the thirdparty entity performing the offset or compression, if any. * * * * * (b) * * * (14)(i) A record of each security-based swap portfolio reconciliation, whether conducted pursuant to § 240.15Fi–3 or otherwise, including the dates of the security-based swap portfolio reconciliation, the number of portfolio reconciliation discrepancies, the number of security-based swap valuation disputes (including the timeto-resolution of each valuation dispute and the age of outstanding valuation disputes, categorized by transaction and counterparty), and the name of the third-party entity performing the security-based swap portfolio reconciliation, if any. (ii) A copy of each notification required to be provided to the Commission pursuant to § 240.15Fi– 3(c). (iii) A record of each bilateral offset and each bilateral portfolio compression exercise or multilateral portfolio compression exercise in which it participates, whether conducted pursuant to § 240.15Fi–4 or otherwise, including the dates of the offset or compression, the security-based swaps included in the offset or compression, the identity of the counterparties participating in the offset or compression, the results of the PO 00000 Frm 00063 Fmt 4701 Sfmt 9990 4675 compression, and the name of the thirdparty entity performing the offset or compression, if any. * * * * * ■ 10. Section 240.18a–6, as proposed to be added at 79 FR 25193, May 2, 2014, is further amended by revising paragraphs (b)(1)(i) and (b)(2)(i) and adding paragraphs (d)(4) and (d)(5) to read as follows: § 240.18a–6 Records to be preserved by certain security-based swap dealers and major security-based swap participants. * * * * * (b) * * * (1) * * * (i) All records required to be made pursuant to §§ 240.18a–5(a)(5), (a)(6), (a)(7), (a)(8), (a)(9), (a)(11), (a)(12), (a)(13), (a)(14), (a)(15), (a)(16), (a)(17), and (a)(18). * * * * * (2) * * * (i) All records required to be made pursuant to § 240.18a–5(b)(4), (b)(5), (b)(6), (b)(7), (b)(9), (b)(10), (b)(11), (b)(12), (b)(13), and (b)(14). * * * * * (d) * * * (4) The written policies and procedures required pursuant to §§ 240.15Fi–3, 240.15Fi–4, and 240.15Fi–5 until three years after termination of the use of the policies and procedures. (5)(i) Each written agreement with counterparties on the terms of portfolio reconciliation with those counterparties as required to be created under § 240.15Fi–3(a)(1) and (b)(1) until three years after the termination of the agreement and all transactions governed thereby. (ii) Security-based swap trading relationship documentation with counterparties required to be created under § 240.15Fi–5 until three years after the termination of such documentation and all transactions governed thereby. (iii) A record of the results of each audit required to be performed pursuant to § 240.15Fi–5(c) until three years after the conclusion of the audit. * * * * * By the Commission. Dated: December 19, 2018. Brent J. Fields, Secretary. [FR Doc. 2018–27979 Filed 2–14–19; 8:45 am] BILLING CODE 8011–01–P E:\FR\FM\15FEP2.SGM 15FEP2

Agencies

SECURITIES AND EXCHANGE COMMISSION

[Federal Register Volume 84, Number 32 (Friday, February 15, 2019)]
[Proposed Rules]
[Pages 4614-4675]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2018-27979]



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Vol. 84

Friday,

No. 32

February 15, 2019

Part II





 Securities and Exchange Commission





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17 CFR Part 240





 Risk Mitigation Techniques for Uncleared Security-Based Swaps; 
Proposed Rule

Federal Register / Vol. 84 , No. 32 / Friday, February 15, 2019 / 
Proposed Rules

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-84861; File No. S7-28-18]
RIN 3235-AL83


Risk Mitigation Techniques for Uncleared Security-Based Swaps

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (``SEC'' or 
``Commission'') is proposing rules that would require the application 
of specific risk mitigation techniques to portfolios of security-based 
swaps not submitted for clearing. In particular, the proposal would 
establish requirements for each registered security-based swap dealer 
(``SBS dealer'') and each registered major security-based swap 
participant (``major SBS participant'') (each SBS dealer and each major 
SBS participant hereafter referred to as an ``SBS Entity'' and together 
referred to as ``SBS Entities'') with respect to, among other things, 
reconciling outstanding security-based swaps with applicable 
counterparties on a periodic basis, engaging in certain forms of 
portfolio compression exercises, as appropriate, and executing written 
security-based swap trading relationship documentation with each of its 
counterparties prior to, or contemporaneously with, executing a 
security-based swap transaction. In addition, the Commission is 
proposing an interpretation to address the application of the portfolio 
reconciliation, portfolio compression, and trading relationship 
documentation requirements to cross-border security-based swap 
activities and is proposing to amend Rule 3a71-6 to address the 
potential availability of substituted compliance in connection with 
those requirements. Moreover, the proposed rules would make 
corresponding changes to the recordkeeping, reporting, and notification 
requirements applicable to SBS Entities. Finally, the Commission is 
requesting comment on how certain aspects of the proposed rules address 
how a security-based swap data repository (``SDR'') could potentially 
satisfy its obligation to verify the terms of each security-based swap 
with both counterparties to the transaction.

DATES: Comments should be received on or before April 16, 2019.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's internet comment form (https://www.sec.gov/rules/proposed.shtml); or
     Send an email to rule-comments@sec.gov. Please include 
File Number S7-28-18 on the subject line; or

Paper Comments

     Send paper comments to Brent J. Fields, Secretary, 
Securities and Exchange Commission, 100 F Street NE, Washington, DC 
20549-1090.

All submissions should refer to File Number S7-28-18. This file number 
should be included on the subject line if email is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
internet website (https://www.sec.gov/rules/proposed.shtml). Comments 
are also available for website viewing and printing in the Commission's 
Public Reference Room, 100 F Street NE, Washington, DC 20549 on 
official business days between the hours of 10:00 a.m. and 3:00 p.m. 
Persons submitting comments are cautioned that we do not redact or edit 
personal identifying information from comment submissions. You should 
submit only information that you wish to make available publicly.
    Studies, memoranda, or other substantive items may be added by the 
Commission or staff to the comment file during this rulemaking. A 
notification of the inclusion in the comment file of any such materials 
will be made available on the SEC's website. To ensure direct 
electronic receipt of such notifications, sign up through the ``Stay 
Connected'' option at www.sec.gov to receive notifications by email.

FOR FURTHER INFORMATION CONTACT: Carol McGee, Assistant Director, or 
Andrew Bernstein, Senior Special Counsel, at (202) 551-5870, Office of 
Derivatives Policy, Division of Trading and Markets, Securities and 
Exchange Commission, 100 F Street NE, Washington, DC 20549-8010.

SUPPLEMENTARY INFORMATION: The Commission is proposing for public 
comment the following new rules:

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           Commission reference                 CFR citation (17 CFR)
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Securities Exchange Act of 1934
 (``Exchange Act''): \1\
  Rule 15Fi-3.............................  Sec.   240.15Fi-3.
  Rule 15Fi-4.............................  Sec.   240.15Fi-4.
  Rule 15Fi-5.............................  Sec.   240.15Fi-5.
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    The Commission also is proposing for comment amendments to:
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    \1\ 15 U.S.C. 78a et seq.

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           Commission reference                 CFR citation (17 CFR)
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Exchange Act:
  Rule 3a71-6.............................  Sec.   240.3a71-6.
  Rule 15Fi-1.............................  Sec.   240.15Fi-1.
  Rule 17a-3 \2\..........................  Sec.   240.17a-3.
  Rule 17a-4..............................  Sec.   240.17a-4.
  Rule 18a-5 (proposed)...................  Sec.   240.18a-5 (proposed).
  Rule 18a-6 (proposed)...................  Sec.   240.18a-6 (proposed).
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    Finally, the Commission is requesting comment under:
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    \2\ In April 2014, the Commission proposed new Rules 18a-5 and 
18a-6, and amendments to existing Rules 17a-3 and 17a-4. See 
Recordkeeping and Reporting Requirements for Security-Based Swap 
Dealers, Major Security-Based Swap Participants, and Broker-Dealers; 
Capital Rule for Certain Security-Based Swap Dealers, Exchange Act 
Release No. 71958 (Apr. 17, 2014), 79 FR 25194 (May 2, 2014) (``SBS 
Books and Records Proposing Release''). Although those proposed 
rules and rule amendments have not yet been adopted by the 
Commission, all of the relevant proposals included in this release 
are based on the proposed regulatory text contained in the SBS Books 
and Records Proposing Release.

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           Commission reference                CFR or U.S.C. citation
------------------------------------------------------------------------
Exchange Act:
  Section 13(n)(5)(B).....................  15 U.S.C. 78m(n)(5).
  Rule 13n-4(b)(3)........................  17 CFR 240.13n-4(b)(3).
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Table of Contents

I. Proposed Rules and Rule Amendments
    A. Background
    B. Rule 15Fi-3 (Portfolio Reconciliation)
    1. Overview of Portfolio Reconciliation
    2. Scope of the Portfolio Reconciliation Requirements
    3. Proposed Rule 15Fi-3(a): Portfolio Reconciliation With Other 
SBS Entities
    4. Proposed Rule 15Fi-3(a): Resolution of Discrepancies With 
Other SBS Entities
    5. Proposed Rule 15Fi-3(b): Portfolio Reconciliation With Other 
Counterparties
    6. Reporting of Valuation Disputes
    7. Application of Proposed Rule 15Fi-3 to Cleared Security-Based 
Swaps
    8. Comments Requested
    C. Rule 15Fi-4 (Portfolio Compression)
    1. Overview of Portfolio Compression
    2. Scope of Proposed Rule 15Fi-4--Portfolio Compression 
Exercises
    3. Scope of Proposed Rule 15Fi-4--Bilateral Offset
    4. Application of Proposed Rule 15Fi-4 to Cleared Security-Based 
Swaps
    5. Comments Requested
    D. Rule 15Fi-5 (Trading Relationship Documentation)
    1. Overview of Trading Relationship Documentation
    2. Scope of Proposed Rule 15Fi-5
    3. Proposed Rule 15Fi-5(b)(4): Documenting Valuation 
Methodologies

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    4. Proposed Rule 15Fi-5(b)(5) and (6): Other Disclosure 
Requirements
    5. Proposed Rule 15Fi-5(c): Audit of Security-Based Swap Trading 
Relationship Documentation
    6. Exceptions to the Trading Relationship Documentation 
Requirements
    7. Comments Requested
    E. Verification of Transaction Data by SDRs
    1. Reconciliation of Terms Submitted to an SDR
    2. Documentation of Regulatory Reporting Obligations
    3. Comments Requested
    F. Recordkeeping Requirements
    1. Proposed Amendments to Recordkeeping Rules
    2. Comments Requested
II. Cross-Border Application of Rules 15Fi-3 Through 15Fi-5
    A. Background on the Cross-Border Application of Title VII 
Requirements
    B. Proposed Cross-Border Interpretation
    C. Comments Requested
III. Availability of Substituted Compliance for Rules 15Fi-3 Through 
15Fi-5
    A. Existing Substituted Compliance Rule
    B. Proposed Amendment to Rule 3a71-6
    1. Basis for Substituted Compliance in Connection With the 
Portfolio Reconciliation, Portfolio Compression, and Trading 
Relationship Documentation Requirements
    2. Comparability Criteria, and Consideration of Related 
Requirements
    3. Comments Requested
IV. General Request or Comment
V. Paperwork Reduction Act
    A. Summary of Collections of Information
    1. Proposed Rule 15Fi-3: Portfolio Reconciliation
    2. Proposed Rule 15Fi-4: Portfolio Compression
    3. Proposed Rule 15Fi-5: Written Trading Relationship 
Documentation
    4. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: 
Books and Records Requirements
    5. Proposed Amendment to Rule 3a71-6: Substituted Compliance
    B. Proposed Use of Information
    1. Proposed Rule 15Fi-3: Portfolio Reconciliation
    2. Proposed Rule 15Fi-4: Portfolio Compression
    3. Proposed Rule 15Fi-5: Written Trading Relationship 
Documentation
    4. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: 
Books and Records Requirements
    5. Proposed Amendment to Rule 3a71-6: Substituted Compliance
    C. Respondents
    D. Total Annual Recordkeeping Burden
    1. Portfolio Reconciliation Activities Generally
    2. Establishing, Maintaining, and Enforcing Written Policies and 
Procedures
    3. Reporting of Certain Valuation Disputes
    4. Proposed Rule 15Fi-4: Portfolio Compression
    5. Proposed Rule 15Fi-5: Written Trading Relationship 
Documentation
    6. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: 
Books and Records Requirements
    7. Proposed Amendment to Rule 3a71-6: Substituted Compliance
    E. Collection of Information Is Mandatory
    F. Confidentiality
    G. Request for Comment
VI. Economic Analysis
    A. Broad Economic Considerations
    B. Economic Baseline
    1. Security-Based Swap Market Activity and Participants
    a. Available Data From the Security-Based Swap Market
    b. Affected SBS Entities
    c. Other Market Participants
    d. Outstanding Positions
    2. Current Portfolio Reconciliation Practices
    3. Current Portfolio Compression Practices
    4. Current Trading Relationship Documentation Practices
    C. Economic Costs and Benefits, Including Impact on Efficiency, 
Competition, and Capital Formation
    1. Effects on Efficiency, Competition, and Capital Formation
    a. Broad Market Effects
    b. Substituted Compliance
    2. Portfolio Reconciliation
    a. Requirements
    b. Benefits
    c. Costs
    d. Alternatives
    3. Portfolio Compression
    a. Requirements
    b. Benefits
    c. Costs
    d. Alternatives
    4. Trading Relationship Documentation
    a. Requirements
    b. Benefits
    c. Costs
    d. Alternatives
    5. Recordkeeping Requirements
    a. Requirements
    b. Benefits
    c. Costs
    d. Alternatives
    6. Cross-Border Application of Rules 15Fi-3 Through 15Fi-5.
    a. Requirements
    b. Benefits
    c. Costs
    D. Request for Comment
VII. Consideration of Impact on the Economy
VIII. Regulatory Flexibility Act Certification
IX. Statutory Basis and Text of Proposed Rules

I. Proposed Rules and Rule Amendments

A. Background

    Section 15F(i)(1) of the Exchange Act, as added by Section 764(a) 
of Title VII of the Dodd-Frank Wall Street Reform and Consumer 
Protection Act (``Dodd-Frank Act''),\3\ requires each SBS Entity to 
conform with such standards as may be prescribed by the Commission, by 
rule or regulation, that relate to timely and accurate confirmation, 
processing, netting, documentation, and valuation of all security-based 
swaps.\4\ Section 15F(i)(2) of the Exchange Act provides that the 
Commission shall adopt rules governing documentation standards for SBS 
Entities.\5\
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    \3\ Public Law 111-203, 124 Stat. 1376 (2010). Unless otherwise 
indicated, references to ``Title VII'' in this release are to 
Subtitle B of Title VII of the Dodd-Frank Act.
    \4\ 15 U.S.C. 78o-10(i)(1).
    \5\ 15 U.S.C. 78o-10(i)(2).
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    The Commission previously adopted rules requiring SBS Entities to 
provide trade acknowledgments and to verify those trade acknowledgments 
with their counterparties to security-based swap transactions,\6\ but 
has not proposed rules concerning portfolio reconciliation, portfolio 
compression, or trading relationship documentation. By contrast, the 
Commodity Futures Trading Commission (``CFTC'') has implemented rules 
setting forth standards for the timely and accurate confirmation of 
swaps, addressing the reconciliation and compression of swap 
portfolios, and setting forth requirements for documenting the swap 
trading relationship between swap dealers or major swap participants 
(each swap dealer and each major swap participant hereafter referred to 
as a ``Swap Entity'' and together referred to as ``Swap Entities'') and 
their counterparties.\7\
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    \6\ See Trade Acknowledgment and Verification of Security-Based 
Swap Transactions, Exchange Act Release No. 78011 (June 8, 2016), 81 
FR 39807 (June 17, 2016) (``Trade Acknowledgment and Verification 
Adopting Release'').
    \7\ See Confirmation, Portfolio Reconciliation, Portfolio 
Compression, and Swap Trading Relationship Documentation 
Requirements for Swap Dealers and Major Swap Participants, 77 FR 
55904 (Sept. 11, 2012) (``CFTC Risk Mitigation Adopting Release''). 
The European Commission (``EC'') has implemented similar measures. 
See Commission Delegated Regulation (EU) No. 149/2013 (Dec. 18, 
2012) supplementing Regulation (EU) No. 648/2012 of the European 
Parliament and of the Council with regard to regulatory technical 
standards on indirect clearing arrangements, the clearing 
obligation, the public register, access to a trading venue, non-
financial counterparties, and risk mitigation techniques for over-
the-counter (``OTC'') derivatives contracts not cleared by a central 
counterparty (Feb. 23, 2013), available at: https://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:052:0011:0024:en:PDF. Regulatory 
authorities in other jurisdictions (e.g., the Hong Kong Monetary 
Authority and the Monetary Authority of Singapore) have also 
proposed requirements similar to those adopted by the CFTC and the 
EC. In addition, the Canadian Securities Administrators (``CSA'') 
published a consultation paper in 2016 proposing a requirement that 
financial institutions enter into a written agreement documenting 
the material terms and conditions of any non-centrally cleared 
derivative, including standards related to the maintenance, review, 
and contents of that documentation. See CSA Consultation Paper 95-
401--Margin and Collateral Requirements for Non-Centrally Cleared 
Derivatives (Jul. 7, 2016), available at: https://www.osc.gov.on.ca/documents/en/Securities-Category9/csa_20160707_95-401_collateral-requirements-cleared-derivatives.pdf.

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    Accordingly, the Commission is today proposing requirements 
applicable to SBS Entities addressing, among other things, reconciling 
and compressing portfolios of uncleared security-based swaps and 
executing written trading relationship documentation with each 
counterparty prior to or contemporaneously with executing an uncleared 
security-based swap. In developing this proposal, we have consulted and 
coordinated with the CFTC, the prudential regulators,\8\ and foreign 
regulatory authorities in accordance with the consultation mandate of 
the Dodd-Frank Act.\9\ We also have consulted and coordinated with 
foreign regulatory authorities through Commission staff participation 
in numerous bilateral and multilateral discussions with foreign 
regulatory authorities addressing the regulation of OTC 
derivatives.\10\ Through these multilateral and bilateral discussions 
and the Commission staff's participation in various international task 
forces and working groups, we have gathered information about foreign 
regulatory reform efforts and their effect on, and relationship with, 
the U.S. regulatory regime. The Commission has taken, and will continue 
to take, these discussions into consideration in developing rules, 
forms, and interpretations for implementing Title VII of the Dodd-Frank 
Act.
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    \8\ For purposes of this statement, the term ``prudential 
regulator'' is defined in Section 1a(39) of the CEA, 7 U.S.C. 
1a(39), and that definition is incorporated by reference into 
Section 3(a)(74) of the Exchange Act, 15 U.S.C. 78c(a)(74). Pursuant 
to that definition, the Board of Governors of the Federal Reserve 
System (``Federal Reserve Board''), the Office of the Comptroller of 
the Currency, the Federal Deposit Insurance Corporation (``FDIC''), 
the Farm Credit Administration, or the Federal Housing Finance 
Agency (collectively, the ``prudential regulators'') is the 
``prudential regulator'' of an SBS Entity if the entity is directly 
supervised by that regulator. Separately, we are proposing a 
definition of ``prudential regulator,'' to be used for purposes of 
the proposed portfolio reconciliation and trading relationship 
documentation requirements. See infra note 48. That proposed 
definition also references Section 3(a)(74) of the Exchange Act and 
includes the same list of agencies as noted above.
    \9\ Section 712(a)(2) of the Dodd-Frank Act provides in part 
that the Commission shall ``consult and coordinate to the extent 
possible with the Commodity Futures Trading Commission and the 
prudential regulators for the purposes of assuring regulatory 
consistency and comparability, to the extent possible.''
    In addition, Section 752(a) of the Dodd-Frank Act provides, in 
part, that ``[i]n order to promote effective and consistent global 
regulation of swaps and security-based swaps, the Commodity Futures 
Trading Commission, the Securities and Exchange Commission, and the 
prudential regulators . . . as appropriate, shall consult and 
coordinate with foreign regulatory authorities on the establishment 
of consistent international standards with respect to the regulation 
(including fees) of swaps.''
    \10\ Staff participates in a number of international standard-
setting bodies and workstreams working on OTC derivatives reforms. 
For example, Commission staff participated in the International 
Organization of Securities Commissions' (``IOSCO'') preparation of a 
report regarding risk mitigation standards for non-centrally cleared 
OTC derivatives. See Risk Mitigation Standards for Non-centrally 
Cleared OTC Derivatives (Jan. 28, 2015), available at: https://www.iosco.org/library/pubdocs/pdf/IOSCOPD469.pdf. IOSCO developed 
those standards in consultation with the Basel Committee on Banking 
Supervision and the Committee on Payments and Market 
Infrastructures.
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    Finally, the Commission recognizes that the CFTC rules pertaining 
to portfolio reconciliation, portfolio compression, and written trading 
relationship documentation have been in effect since 2012, and that any 
SBS Entity that also is registered with the CFTC as a Swap Entity will 
already have incurred systems and compliance costs in connection with 
the corresponding CFTC requirements. In order to minimize compliance 
burdens on such potential dual registrants in connection with the rules 
we are proposing today, we have attempted to harmonize this proposal 
with the existing CFTC rules wherever possible. There are, however, a 
limited number of provisions where we preliminarily believe it is 
appropriate to diverge from a particular aspect of the CFTC rules. Each 
of those differences is described below, along with the preliminary 
reasons for the different approaches. To the extent that no such 
substantive difference is described, it is because we have 
preliminarily determined that none exists. However, below we welcome 
and solicit comment on any potential substantive differences between 
the proposed rules and the corresponding CFTC rules, as well as on the 
decision to harmonize with the CFTC, both as an overall approach and 
with respect to any specific provisions of the proposed rules.

B. Rule 15Fi-3 (Portfolio Reconciliation)

1. Overview of Portfolio Reconciliation
    In the Trade Acknowledgement and Verification Adopting Release, the 
Commission noted the importance of confirming trades in a timely 
manner, explaining that the process of confirming the terms of a 
transaction is essential for SBS Entities ``to effectively measure and 
manage market and credit risk.'' \11\ The Commission further explained 
that ``a backlog of unconfirmed trades could hinder the settlement 
process, particularly if errors go undetected or a counterparty 
disputes the terms of a transaction.'' \12\ Such disruptions in the 
settlement process could, in turn, lead to broader market instability 
in the case of a credit event involving a reference entity on which 
many different counterparties have, in the aggregate, a large notional 
outstanding exposure.\13\
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    \11\ Trade Acknowledgement and Verification Adopting release, 81 
FR at 39833.
    \12\ Id.
    \13\ Id.
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    In this regard, portfolio reconciliation addresses many of these 
same issues, but unlike the confirmation process, which occurs at the 
outset of a transaction, reconciliation operates throughout the life of 
the transaction. If a security-based swap transaction is accurately 
confirmed by both parties during the trade acknowledgement and 
verification process, reconciliation helps to identify any 
discrepancies in terms that do not remain constant throughout the life 
of a trade. Furthermore, if a discrepancy is not identified during the 
trade acknowledgement and verification process, it could be identified 
during a subsequent reconciliation exercise.
    The Commission preliminarily believes that portfolio reconciliation 
serves as an important mechanism for promoting risk mitigation by 
requiring security-based swap counterparties to have established 
processes for identifying and resolving discrepancies involving key 
terms of their transactions. To illustrate this point, if a term 
necessary for calculating the market value of a security-based swap is 
not properly confirmed during the trade acknowledgment and verification 
process, such as due to some form of systems or human error, that 
discrepancy could lead to complications at various points throughout 
the life of the transaction, which could become particularly 
problematic if it remains undetected until such time as the parties are 
required to perform on their obligations.\14\ Thus, portfolio 
reconciliation could help to mitigate the possibility of a discrepancy 
unexpectedly affecting performance under the security-based swap 
transaction by increasing the likelihood

[[Page 4617]]

that the parties are and remain in agreement with respect to all 
material terms.
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    \14\ See Summary of OTC Commitments, Attachment to the July 31, 
2008 letter from the Operations Management Group to Timothy 
Geithner, President, Federal Reserve Bank of New York (``FRBNY''), 
available at: https://www.newyorkfed.org/medialibrary/media/newsevents/news/markets/2008/CommitmentSummaryTable.pdf (``Positive 
affirmation of trade economics is a key risk mitigation technique 
for OTC derivatives because it assures that each counterparty's risk 
management system accurately reflect the economic details of trades 
that have not yet been matched.''). Although this particular 
commitment was made in the context of the trade affirmation process, 
we believe that the same basic principle supports the need to 
reconcile terms throughout the life of a trade, even if a term is 
accurately reflected in a firm's system as a result of the 
affirmation process. This is particularly true for terms that do not 
remain constant during the life of a trade.
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    This practice is particularly relevant with respect to terms used 
to perform a valuation of the financial instrument. Specifically, 
unresolved discrepancies regarding the value of a security-based swap 
can lead to, among other things, difficulties in the application of any 
processes that depend on the valuation being accurate, such as 
determining the amount of margin that must be posted or collected 
during the life of a security-based swap transaction. In the aggregate, 
such errors and other complications could result in significant 
uncollateralized exposure in the uncleared security-based swap markets 
(or alternatively, potentially inefficient overcollateralization).
    In addition, valuation discrepancies identified during 
reconciliation could help to identify problems with one or both of the 
counterparties' internal valuation systems and models, or possibly even 
with a firm's internal controls. For example, in a report analyzing 
federal assistance to American International Group, Inc. (``AIG'') 
following the events of September 2008, the General Accountability 
Office (``GAO'') noted that in structuring this relief one of the many 
open issues the FRBNY had to address was the number of collateral 
disputes AIG had with its counterparties.\15\ GAO further explained 
that ``[t]o the extent that lower valuations (more CDO value lost) 
produced greater collateral postings, counterparties had an interest in 
seeking lower valuations. Similarly, to the extent that higher 
valuations (less CDO value lost) meant smaller collateral postings, AIG 
had an interest in seeking higher valuations.'' \16\
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    \15\ See GAO, Financial Crisis: Review of Federal Reserve System 
Financial Assistance to American International Group, Inc., GAO-11-
616 (Sept. 2011), available at https://www.gao.gov/assets/590/585560.pdf (``According to information we reviewed, on a 
[collateralized debt obligation (``CDO'')] portfolio of $71 billion 
. . . , AIG and its counterparties had valuation differences 
totaling $4.3 billion. Among a group of 15 counterparties, 9 had 
valued their assets differently than AIG.'').
    \16\ Id. at 82.
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    In light of this information, the Commission preliminarily believes 
that the use of portfolio reconciliation to help maintain an agreed-
upon valuation of a security-based swap throughout the lifecycle of a 
transaction should be a hallmark of prudent risk mitigation practices 
within the operations of an SBS Entity. Accordingly, the Commission is 
proposing new Rule 15Fi-3 under the Exchange Act,\17\ which generally 
would require those entities, in connection with security-based swaps 
not submitted for clearing, to (1) engage in portfolio reconciliation 
with counterparties who are SBS Entities and (2) establish, maintain, 
and follow written policies and procedures reasonably designed to 
ensure that they engage in portfolio reconciliation with counterparties 
who are not SBS Entities. In both cases, the frequency of the portfolio 
reconciliation would be based on the number of outstanding transactions 
with the applicable counterparty.
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    \17\ Unless otherwise noted, all references to rules (both 
proposed and existing) without an accompanying statutory reference 
are to rules adopted (or proposed to be adopted) under the Exchange 
Act.
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2. Scope of the Portfolio Reconciliation Requirements
    For purposes of proposed Rule 15Fi-3,\18\ the Commission is 
proposing to amend existing Rule 15Fi-1 to add a definition of 
``portfolio reconciliation.'' \19\ As proposed, this term would be 
defined to mean any process by which the counterparties to one or more 
uncleared security-based swaps:
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    \18\ The corresponding CFTC rule is 17 CFR 23.502. The structure 
of the CFTC rule, including the subsections, mirrors the structure 
of proposed Rule 15Fi-3.
    \19\ See proposed Rule 15Fi-1(l). The corresponding CFTC 
definition is in 17 CFR 23.500(i).
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    (i) Exchange the material terms of all security-based swaps in the 
security-based swap portfolio between the counterparties;
    (ii) Exchange each counterparty's valuation of each security-based 
swap in the security-based swap portfolio between the counterparties as 
of the close of business on the immediately preceding business day; and
    (iii) Resolve any discrepancy in valuations or material terms.
    For purposes of this proposed definition, the Commission also is 
proposing to amend Rule 15Fi-1 to add the terms ``security-based swap 
portfolio,'' which would be defined to mean all security-based swaps 
currently in effect between a particular SBS Entity and a particular 
counterparty,\20\ and ``valuation,'' which would be defined to mean the 
current market value or net present value of a security-based swap.\21\ 
Both of these definitions help to establish the scope of the portfolio 
reconciliation requirements in proposed Rule 15Fi-3, with the former 
defining which security-based swaps are subject to the rule and the 
latter defining one of the two categories of information that must be 
exchanged during a reconciliation (the other being ``material terms''). 
Moreover, for consistency with the corresponding CFTC rules applicable 
to Swap Entities, these definitions are substantively identical to the 
CFTC's corresponding definitions, which we preliminarily believe are 
appropriately scoped and clear for purposes of proposed Rule 15Fi-3.
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    \20\ See proposed Rule 15Fi-1(o). The corresponding CFTC 
definition is in 17 CFR 23.500(k)
    \21\ See proposed Rule 15Fi-1(q). The corresponding CFTC 
definition is in 17 CFR 23.500(m).
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    With respect to the phrase ``material terms,'' the proposed 
definition would follow a similar approach to the one taken by the CFTC 
in that it would base the definition on the terms required to be 
reported to an SDR pursuant to Regulation SBSR.\22\ Unlike the approach 
taken by the CFTC, however, which has adopted a single definition of 
``material terms,'' the definition in proposed Rule 15Fi-1(i) would be 
bifurcated depending on whether a security-based swap transaction had 
already been included in a security-based swap portfolio and reconciled 
pursuant to proposed Rule 15Fi-3.\23\ With respect to any security-
based swap that has not yet been reconciled as part of a security-based 
swap portfolio, ``material terms'' would be defined to mean each term 
that is required to be reported to a registered SDR pursuant to Rule 
901 under the Exchange Act.\24\ With respect to all other security-
based swaps within a security-based swap portfolio, the definition of 
``material terms'' would continue to be based on the reporting 
requirements in Rule 901, but would exclude any term that is not 
relevant to the ongoing rights and obligations of the

[[Page 4618]]

parties and the valuation of the security-based swap.\25\
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    \22\ 17 CFR 242.900 to 242.909.
    \23\ CFTC Rule 23.500(g) defines ``material terms'' to include 
the minimum primary economic terms (as defined in Appendix 1 of part 
45 of the CFTC's regulations) of a swap, other than the 24 specific 
data fields identified in that rule. See 17 CFR 23.500(g). Among the 
excluded fields are: (1) The status of either counterparty as a swap 
dealer, major swap participant, financial entity, or U.S. person; 
(2) an indication that the swap will be allocated and certain 
information regarding the agent and the original swap; (3) an 
indication that the swap is a multi-asset swap and a further 
indication of its primary and secondary asset class; (4) an 
indication that the swap is a mixed swap and the identification of 
any non-CFTC registered swap data repository to which it is also 
reported (if applicable); (5) the block trade indicator, execution 
timestamp, and timestamp for submission to a swap data repository; 
(6) the clearing indicator and clearing venue; and (7) certain 
information regarding the application of the end user exception from 
mandatory clearing.
    \24\ See proposed Rule 15Fi-1(i)(1) (referencing 17 CFR 
242.901).
    \25\ See proposed Rule 15Fi-1(i)(2).
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    The Commission preliminarily believes that the data set submitted 
to an SDR under Rule 901 is an appropriate measure for determining 
which terms should be reconciled pursuant to proposed Rule 15Fi-3. As 
noted above, the Commission believes that one of the fundamental goals 
of the portfolio reconciliation process is to help ensure that both 
counterparties to a security-based swap are in agreement on all of the 
terms necessary for developing a comprehensive understanding of each of 
their rights and obligations under the security-based swap, and that 
they remain in such agreement throughout the life of the transaction. 
To effect that objective, we are proposing that the term ``portfolio 
reconciliation'' be defined in part as the exchange of the ``material 
terms'' of all security-based swaps in the security-based swap 
portfolio between the counterparties. Similarly, in adopting Regulation 
SBSR the Commission explained that the Title VII regulatory reporting 
requirement ``is designed to allow the Commission and other relevant 
authorities to have access to comprehensive information about security-
based swap activity in registered SDRs.'' \26\ The Commission therefore 
preliminarily believes that the terms that must be reported to an SDR 
under Regulation SBSR are a good proxy for identifying the ``material 
terms'' that should be subject to the portfolio reconciliation 
requirements.
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    \26\ See Regulation SBSR--Reporting and Dissemination of 
Security-Based Swap Information; Final Rule, Exchange Act Release 
No. 74244 (Feb. 11, 2015), 80 FR 14563, 14646 (Mar. 19, 2015) 
(``Regulation SBSR Adopting Release'').
---------------------------------------------------------------------------

    The Commission also preliminarily believes that basing the 
definition of ``material terms'' on what is required to be reported to 
an SDR provides certainty for SBS Entities regarding what information 
must be reconciled, which should in turn reduce the burdens on those 
entities without lessening the benefits of the proposed rule (which are 
described earlier in this section and in the Economic Analysis section 
below). Furthermore, the proposed approach is designed to allow 
affected counterparties to leverage the same systems used for SDR 
reporting for purposes of the portfolio reconciliation requirements, 
should such synergies exist. Moreover, this proposed approach would 
promote the same policy goals that underpin a particular requirement 
imposed on SDRs to verify the terms of each security-based swap with 
both counterparties to the transaction, as discussed in detail in 
Section I.E below.
    The Commission preliminarily believes that the proposed rule is 
reasonably tailored to avoid unnecessary burdens while still promoting 
important risk mitigation goals inherent to the portfolio 
reconciliation process. That said, certain terms of a security-based 
swap transaction may be material the first time that a transaction is 
reconciled, but might not be material during a subsequent 
reconciliation. This could be true, for example, with respect to any 
term of a transaction that does not affect any ongoing rights or 
obligations of the parties and that has no effect on the valuation of 
the security-based swap. Accordingly, the definition of ``material 
terms'' in proposed Rule 15Fi-1(i)(2) provides that with respect to any 
subsequent reconciliations, SBS Entities may exclude any term that is 
not relevant to the ongoing rights and obligations of the parties and 
the valuation of the security-based swap, regardless of the fact that 
the term was required to be reported to an SDR under Regulation 
SBSR.\27\ For example, the Commission preliminarily believes that the 
24 terms excluded from the CFTC definition could be excluded from the 
proposed definition of ``material terms'' in the context of security-
based swaps that have previously been reconciled.\28\
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    \27\ The Commission does not, however, believe that a term would 
be appropriately excluded from the definition of ``material terms'' 
if it was resubmitted to an SDR because of an error in how it was 
initially reported or due to a lifecycle event. In those 
circumstances, the Commission preliminarily believes that such term 
would continue to be material for the same reasons that every term 
subject to a reporting requirement under Rule 901 would be material 
the first time that a transaction is reconciled. Once the updated 
term is reconciled, however, an SBS Entity would be able to exclude 
that term from subsequent reconciliations to the extent that it 
determines that it is not relevant to the ongoing rights and 
obligations of the parties and the valuation of the security-based 
swap.
    \28\ See supra note 23 (discussing CFTC Rule 23.500(g)). We 
further recognize that when the CFTC adopted amendments to Rule 
23.500(g) to exclude these terms, it noted that ``removal of these 
terms from reconciliations would alleviate the burden of resolving 
discrepancies in terms of a swap that are not relevant to the 
ongoing rights and obligations of the parties and the valuation of 
the swap without impairing the [CFTC's] regulatory mission.'' See 
Definitions of ``Portfolio Reconciliation'' and ``Material Terms'' 
for Purposes of Swap Portfolio Reconciliation, 81 FR 27309, 27311 
(May 6, 2016).
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    Finally, the Commission recognizes that our proposed definition of 
``material terms'' would differ from the corresponding CFTC definition 
in that Swap Entities would never need to reconcile the 24 terms 
excluded from the definition of ``material terms'' in CFTC Rule 
23.500(g). Nevertheless, we are proposing to require all reported terms 
to be reconciled at least initially because, among other things, such 
requirement could potentially help to address an issue related to how 
registered SDRs can verify the information that they receive, as 
discussed in detail in Section I.E below. However, below we solicit 
comment on our approach, and particularly welcome comments on any 
trade-offs that may exist as between our efforts to address the SDR-
related issue and any additional burdens resulting from a definition of 
``material terms'' that departs from the corresponding CFTC rule, 
particularly in the context of CFTC-regulated Swap Entities that also 
may register with the Commission as SBS Entities.
3. Proposed Rule 15Fi-3(a): Portfolio Reconciliation With Other SBS 
Entities
    The Commission is proposing to bifurcate proposed Rule 15Fi-3 based 
on the particular type of counterparty with which the SBS Entity 
transacts. For transactions between two SBS Entities, proposed Rule 
15Fi-3(a) would require the two sides to engage in portfolio 
reconciliation at frequencies that are based on the size of the 
security-based swap portfolio between the two parties, expressed in 
ranges (or tiers).\29\
---------------------------------------------------------------------------

    \29\ See proposed Rule 15Fi-3(a).
---------------------------------------------------------------------------

    Under this tiered approach, if the two SBS Entity counterparties 
maintain a security-based swap portfolio that includes 500 or more 
security-based swaps, portfolio reconciliation would need to occur once 
each business day for as long as the portfolio exceeds this threshold. 
If a security-based swap portfolio between two SBS Entities includes 
more than 50 but fewer than 500 security-based swaps on any business 
day during a week, portfolio reconciliation would be required to occur 
on a weekly basis. For a security-based swap portfolio between two SBS 
Entities that includes no more than 50 security-based swaps at any time 
during the calendar quarter, portfolio reconciliation would be required 
on a quarterly basis.\30\
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    \30\ See proposed Rule 15Fi-3(a)(3). For the avoidance of doubt, 
if a security-based swap portfolio between two SBS Entity 
counterparties crosses from one threshold to another, both sides 
would be required to comply with the proposed rule as of the date 
that the requirement applies. For example, if two SBS Entities that 
have long maintained a portfolio of 50 or fewer security-based swaps 
(and accordingly reconcile on a quarterly basis) exceed the 50 
transaction threshold, the two sides would become subject to the 
weekly reconciliation requirement as of the first day that the 
portfolio exceeds 50 security-based swaps (or the daily 
reconciliation requirement if the portfolio increases to 500 or more 
security-based swaps). By contrast, if two SBS Entities that 
maintain a security-based swap portfolio of more than 500 
transactions fall below that threshold, they could begin reconciling 
on a weekly basis as of the first business day after the date on 
which they were able to verify that their security-based swap 
portfolio has fallen below 500 transactions.

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[[Page 4619]]

    The Commission preliminarily believes that the proposed tiering of 
obligations, whereby the frequency of the portfolio reconciliation 
would be based on the number of outstanding transactions with the 
applicable counterparty, represents a reasonable attempt to calibrate 
the costs to the benefits expected from reconciling a person's 
security-based swap portfolio at regular intervals. All other things 
being equal, a larger and more complex portfolio represents a greater 
potential for loss than a smaller, less complex portfolio. Therefore, 
the proposed rule would require more frequent reconciliation of the 
larger, more complex portfolio. We also note that the CFTC has adopted 
rules that utilize identical levels as our proposal, and that 
divergence from those thresholds could lead to additional costs and 
other inefficiencies for SBS Entities that are also registered with the 
CFTC as Swap Entities.\31\
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    \31\ When it adopted the same numerical thresholds in 2012, the 
CFTC noted that the requirement to reconcile portfolios with 500 or 
more swaps on a daily basis was consistent with the commitments made 
by the OTC Derivatives Steering Group's 14 major dealers (``G-14 
dealers'') in December 2008 as well as international regulatory 
efforts underway at the time of the CFTC's release. See CFTC Risk 
Mitigation Adopting Release, 77 FR at 55928 nn. 35 and 36. See also 
Summary of OTC Commitments, Attachment to the June 2, 2009 letter 
from G-14 dealers and certain buy-side participants to William C. 
Dudley, President, FRBNY, available at: https://www.newyorkfed.org/medialibrary/media/newsevents/news/markets/2009/060209table.pdf 
(committing, ``[b]y June 30, 2009, [to] execute daily collateralized 
portfolio reconciliations for collateralized portfolios in excess of 
500 trades between [Operations Management Group] dealers as detailed 
in the December 31, 2008 Collateral Update letter''). See also 
Attachment to the Mar. 31, 2011 letter from the G-14 dealers and 
certain buy-side participants to William C. Dudley, President, 
FRBNY, available at: https://www.newyorkfed.org/medialibrary/media/newsevents/news/markets/2011/SCL0331.pdf (``We commit to reduce the 
threshold for routine portfolio reconciliation of collateralized 
portfolios from those exceeding 1,000 transactions to those 
exceeding 500 transactions starting June 30, 2011. These portfolios 
will be reconciled at least monthly.'') (internal citation omitted).
---------------------------------------------------------------------------

    In addition to the requirements regarding the frequency of the 
reconciliation, proposed Rule 15Fi-3(a)(1) would require SBS Entities 
to agree in writing with each of their counterparties on the terms of 
the portfolio reconciliation including, if applicable, agreement on the 
selection of any third party service provider who may be performing the 
reconciliation.\32\ In practice, the Commission notes that an SBS 
Entity could satisfy such requirement by including the terms governing 
the portfolio reconciliation process in the written security-based swap 
trading relationship documentation that the SBS Entity executes with 
its counterparty which, pursuant to proposed Rule 15Fi-5 would be 
required to be executed prior to, or contemporaneously with, the two 
parties executing any new security-based swap transaction.\33\ This 
practice should help to ensure that portfolio reconciliation begins 
without delay after execution of the transaction and is designed to 
minimize the number of disagreements regarding the portfolio 
reconciliation process itself.
---------------------------------------------------------------------------

    \32\ Proposed Rule 15Fi-3(a)(2) provides that portfolio 
reconciliation may be performed either on a bilateral basis by the 
counterparties or by a third party selected by the counterparties in 
accordance with paragraph (a)(1) of the proposed rule. The 
Commission notes that CFTC Rule 23.502(a)(2), which is comparable to 
proposed Rule 15Fi-3(a)(2), uses the term ``qualified third party.'' 
When it adopted the above provision in 2012, the CFTC explained that 
it ``expects that parties will determine if the third-party is 
qualified based on their own policies.'' See CFTC Risk Mitigation 
Release, 77 FR at 55929. In addition, the CFTC's portfolio 
reconciliation requirements for transactions between Swap Entities 
and counterparties that are not Swap Entities do not require the 
relevant third party to be ``qualified'' and, instead, provide that 
``[t]he portfolio reconciliation may be performed on a bilateral 
basis by the counterparties or by one or more third parties selected 
by the counterparties.'' See 17 CFR 23.502(b)(2) (emphasis added). 
Accordingly, the Commission has decided not to refer to a 
``qualified third party'' and, instead, uses the term ``third party 
selected by the counterparties'' for purposes of proposed Rule 15Fi-
3(a)(2). We preliminarily believe that it is sufficient for our 
purposes to refer solely to the fact that a third party has been 
selected.
    \33\ Once the two parties have agreed in writing on the terms of 
the portfolio reconciliation for the first time, the requirement 
could then be satisfied in connection with any new security-based 
swap transaction executed by the two sides merely by agreeing in 
writing to abide by the existing agreement regarding the 
reconciliation process.
---------------------------------------------------------------------------

    Finally, the Commission has preliminarily determined not to propose 
the CFTC's definition of ``business day'' and to rely on the definition 
in existing Rule 15Fi-1, which was adopted in 2016 in connection with 
the trade acknowledgement and verification requirements in Rule 15Fi-2. 
That definition includes ``any day other than a Saturday, Sunday, or 
legal holiday.'' \34\ Specifically, we believe that the existing 
definition of ``business day'' is broadly consistent with other uses of 
the term within the Commission's rules.\35\ We also do not believe it 
necessary to have two different definitions of the same term 
promulgated under the same legal authority (i.e., Section 15F(i) of the 
Exchange Act), one for purposes of the portfolio reconciliation rules 
and the other for purposes of the trade acknowledgement and 
verification rules.\36\ Moreover, we believe that this definition 
provides market participants with the flexibility to determine which 
holidays are ``legal holidays'' for purposes of the portfolio 
reconciliation requirements in proposed Rule 15Fi-3, which should be 
particularly useful given the cross-border nature of the OTC 
derivatives market.\37\ However, below we solicit comment on our 
approach.
---------------------------------------------------------------------------

    \34\ Under this proposal, the definition of ``business day'' 
currently in Rule 15Fi-1(a) would be renumbered as proposed Rule 
15Fi-1(b).
    \35\ See, e.g., 17 CFR 270.2a-7(a)(4) (``Business day means any 
day other than Saturday, Sunday, or any customary business 
holiday.'') and 17 CFR 230.261(b) (``Business day [means] [a]ny day, 
except Saturdays, Sundays or United States federal holidays.'').
    \36\ By contrast, the applicable definition of ``business day'' 
for purposes of the CFTC's portfolio reconciliation rules is 
contained in CFTC Rule 1.3(b), and includes ``any day other than a 
Sunday or holiday.'' That definition also provides instructions for 
computing time periods for CFTC rules that include notice 
requirements.
    \37\ As a reminder, the proposal would require SBS entities to 
agree in writing with each of their counterparties on the terms of 
the portfolio reconciliation pursuant to proposed Rule 15Fi-3(a)(1) 
(in the case of security-based swap portfolios with other SBS 
Entities) and Rule 15Fi-3(b)(1) (in the case of security-based swap 
portfolios with all other counterparties). Accordingly, such 
agreement between an SBS Entity and its counterparty could include a 
determination as to which holidays would be considered ``legal 
holidays'' for purposes of any applicable portfolio reconciliation 
exercises involving those two parties.
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4. Proposed Rule 15Fi-3(a): Resolution of Discrepancies With Other SBS 
Entities
    Proposed Rule 15Fi-3(a) also would require each SBS Entity to take 
additional actions in the event of a discrepancy with a counterparty 
that is an SBS Entity. First, proposed Rule 15Fi-3(a)(4) would require 
the two SBS Entities to resolve immediately any discrepancy in a 
material term, whether identified directly as part of the portfolio 
reconciliation or otherwise. We preliminarily believe that this 
timeframe is appropriate given the ongoing nature of security-based 
swap transactions, as well as the potential for disagreements between 
the counterparties regarding the terms of a transaction to compound 
over the course of the security-based swap transaction. We have not, 
however, proposed a fixed definition of ``immediately'' as we believe 
that the amount of time that will be needed to resolve a discrepancy 
will depend on the particular facts and circumstances involved, 
including the complexity of the material term in question and the

[[Page 4620]]

magnitude of the discrepancy. We have, however, solicited comment on 
this approach.
    At the same time, we also recognize that discrepancies related to 
the valuation of a security-based swap could be particularly difficult 
to resolve in a short period of time. Accordingly, proposed Rule 15Fi-
3(a)(5) would require SBS Entities to have policies and procedures 
reasonably designed to resolve valuation discrepancies no later than 
five business days from the date they were discovered, which we 
preliminarily believe to be both a reasonable and appropriate amount of 
time to resolve such discrepancies. As a condition to this requirement, 
however, proposed Rule 15Fi-3(a)(5) would require each SBS Entity to 
establish, maintain, and follow written policies and procedures 
reasonably designed to identify how it will comply with any variation 
margin requirements under Section 15F(e) of the Exchange Act \38\ and 
any related regulations pending resolution of the valuation 
discrepancy. Although we preliminarily believe that counterparties 
should be given sufficient time to resolve valuation discrepancies, we 
also believe it to be important for those counterparties to take 
reasonable steps during the pendency of the resolution to ensure that 
they are continuing to manage their credit risk to each other by way of 
exchanging variation margin.
---------------------------------------------------------------------------

    \38\ 15 U.S.C. 78o-10(e).
---------------------------------------------------------------------------

    Moreover, proposed Rule 15Fi-3(a)(5) provides that for purposes of 
the requirement to resolve valuation discrepancies within five business 
days of being identified, a difference between the lower valuation and 
the higher valuation of less than 10% of the higher valuation need not 
be deemed a discrepancy. This 10% threshold would apply on a 
transaction-by-transaction basis and not on a portfolio level. As 
discussed in the immediately preceding paragraph, the Commission 
recognizes that valuation discrepancies could be challenging and costly 
to resolve. Accordingly, we preliminarily believe that providing SBS 
Entities with a clear understanding of exactly which valuation 
discrepancies would need to be resolved within five business days will 
help focus the internal resources of both counterparties on the largest 
discrepancies. At the same time, however, the Commission believes that, 
in most cases, prudent risk mitigation of a firm's security-based swap 
portfolio and proper governance over an entity's operations would 
involve ensuring that, at least to a certain degree, most valuation 
discrepancies are ultimately resolved.\39\
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    \39\ For the avoidance of doubt, an SBS Entity that identifies a 
valuation discrepancy in excess of 10% would be in compliance with 
the proposed rule if it resolves such discrepancy to a level below 
10%, even if the entire discrepancy is not completely eliminated. 
Thus, an SBS Entity would not be required to reduce an 11% valuation 
discrepancy down to zero, in contrast to an SBS Entity with a 9% 
valuation discrepancy, who would have no further obligations under 
proposed Rule 15Fi-3(a)(5).
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5. Proposed Rule 15Fi-3(b): Portfolio Reconciliation With Other 
Counterparties
    Proposed Rule 15Fi-3(b) would establish reconciliation requirements 
for security-based swap portfolios between an SBS Entity and a 
counterparty that is not an SBS Entity. Although there is some broad 
similarity between proposed Rule 15Fi-3(b) and the rules applicable to 
security-based swap portfolios between two SBS Entities, we have 
preliminarily determined to take a more streamlined approach with 
respect to security-based swaps between an SBS Entity and its non-SBS 
Entity counterparties, similar to the CFTC's approach. This approach 
reflects our preliminary view that a dealer-to-dealer portfolio may be 
associated with a degree of market interconnectedness and volume that 
could potentially carry considerable market-wide risks, at least as 
compared to a security-based swap portfolio that involves only one SBS 
Entity. Moreover, the Commission preliminarily believes it to be 
appropriate to impose more prescriptive requirements in cases where 
both entities are subject to the SEC's requirements for registered 
entities. Accordingly, there are differences in both the application of 
the portfolio reconciliation requirements with non-SBS Entity 
counterparties as well as in the thresholds governing the frequency of 
the required reconciliation exercises.
    Specifically, the proposal would require each SBS Entity to 
establish, maintain, and follow written policies and procedures 
reasonably designed to ensure that it engages in portfolio 
reconciliation with non-SBS Entity counterparties as set forth in the 
rule.\40\ This is in contrast to proposed Rule 15Fi-3(a), which 
expressly requires portfolio reconciliation with respect to 
transactions where both counterparties are SBS Entities. In addition, 
the policies and procedures would require that the portfolio 
reconciliation be performed no less frequently than: (1) Once each 
calendar quarter for each security-based swap portfolio that includes 
more than 100 security-based swaps at any time during the calendar 
quarter and (2) once annually for each security-based swap portfolio 
that includes no more than 100 security-based swaps at any time during 
the calendar year.\41\
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    \40\ See proposed Rule 15Fi-3(b). Additionally, proposed Rule 
15Fi-3(b) contains a slight deviation from corresponding CFTC Rule 
23.502(b) to eliminate language that we believe to be redundant. We 
do not intend for such clarification to signify any substantive 
differences between proposed rule Rule15Fi-3(b) and CFTC Rule 
23.502(b).
    \41\ See proposed Rule 15Fi-3(b)(3).
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    As we previously explained, the Commission preliminarily believes 
that basing the required frequency of the portfolio reconciliation on 
the number of outstanding transactions with the applicable counterparty 
represents a reasonable attempt to calibrate the costs to the benefits 
expected from reconciling a person's security-based swap portfolio at 
regular intervals. As we also noted above, all other things being equal 
a larger and more complex portfolio represents a greater potential for 
loss than a smaller, less complex portfolio. As before, in selecting 
the specific levels we recognize that the CFTC has adopted rules with 
identical thresholds and frequencies and that divergence from those 
thresholds could lead to additional costs and other inefficiencies for 
SBS Entities that are also registered with the CFTC as Swap 
Entities.\42\
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    \42\ See supra note 31 (discussing how the CFTC arrived at 
setting the numerical thresholds for the requirement to engage in 
portfolio reconciliation as between two Swap Entities.).
---------------------------------------------------------------------------

    In addition, paragraph (b)(1) of proposed Rule 15Fi-3 would require 
that the applicable policies and procedures be reasonably designed to 
ensure that each SBS Entity agrees in writing with each of its non-SBS 
Entity counterparties on the terms of the portfolio reconciliation 
including, if applicable, agreement on the selection of any third party 
service provider who may be performing the reconciliation, and 
paragraph (b)(2) provides that under such required policies and 
procedures, the portfolio reconciliation may be performed on a 
bilateral basis by the counterparties or by one or more third parties 
selected by the counterparties.\43\ To the extent that the 
counterparties elect to use a third party to provide these services, 
the policies and procedures should be reasonably designed to ensure 
that the SBS Entity and its counterparty agree on the selection of that 
third party in writing in accordance with the requirements set forth in 
proposed Rule 15Fi-3(b)(1).\44\
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    \43\ See proposed Rules 15Fi-3(b)(1) and (2).
    \44\ See proposed Rule 15Fi-3(b)(2). As noted in the discussion 
of the corresponding provision in Rule 15Fi-3(a)(1), an SBS Entity 
could in practice satisfy such requirement by including the terms 
governing the portfolio reconciliation process in the written 
security-based swap trading relationship documentation that it 
executes with its counterparty which, pursuant to proposed Rule 
15Fi-5 would be required to be executed prior to, or 
contemporaneously with, the two parties executing any new security-
based swap transaction. In addition, once the two parties have 
agreed in writing on the terms of the portfolio reconciliation for 
the first time, the requirement could then be satisfied in 
connection with any new security-based swap transaction executed by 
the two sides merely by agreeing in writing to abide by the existing 
agreement regarding the reconciliation process. See supra notes 32 
and 33 and accompanying text.

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[[Page 4621]]

    Finally, proposed Rule 15Fi-3(b)(4) would require each SBS Entity 
to establish, maintain, and follow written procedures reasonably 
designed to resolve any discrepancies in the valuation or a material 
term of each security-based swap identified as part of a portfolio 
reconciliation or otherwise with a non-SBS Entity counterparty in a 
timely fashion.\45\ We are reluctant to provide a fixed definition of 
``timely fashion'' in the context of resolving discrepancies with 
counterparties who are not SBS Entities due to the fact that such 
counterparties may vary considerably in terms of their size, 
sophistication, and background. Although it may be possible to resolve 
most valuation discrepancies with large hedge funds and pension funds 
within the five-business-day period applicable to transactions between 
two SBS Entities, that timeframe may be much more challenging with 
respect to transactions with smaller buy-side firms. Accordingly, below 
we request comment on the amount of time SBS Entities should be 
provided to resolve discrepancies in the valuation or a material term 
with respect to transactions with a non-SBS Entity counterparty. 
Commenters are particularly encouraged to explain how any recommended 
time period appropriately balances the importance of quickly resolving 
valuation discrepancies to the greatest extent possible, with an 
understanding that more complex discrepancies could involve the need 
for additional discussion and time for resolution.
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    \45\ Similar to the requirement in paragraph (a) of the proposed 
rule for portfolio reconciliation with counterparties that are also 
SBS Entities, proposed Rule 15Fi-3(b)(4) provides that a difference 
between the lower valuation and the higher valuation of less than 
10% of the higher valuation need not be deemed a discrepancy for 
purposes of that paragraph. See supra note 39 and accompanying text 
(discussing the 10% threshold in the context of Rule 15Fi-3(a)(5)).
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6. Reporting of Valuation Disputes
    Valuation is one of the most fundamental elements for determining 
the economic rights and obligations of each of the counterparties to a 
security-based swap transaction. For example, market participants 
manage their credit risks to their counterparties by exchanging margin 
with each other in an amount determined using the value of the 
underlying security-based swap. If those valuations are not accurate 
for any reason, such as human or system errors, problems with the 
valuation methodology, or an issue affecting the timeliness of the 
calculation, that error could result in one of the counterparties 
having an uncollaterialized credit exposure and a potential for loss in 
the event of a default.
    Given those risks, proposed Rule 15Fi-3(c) would require each SBS 
Entity to promptly notify the Commission of any security-based swap 
valuation dispute in excess of $20,000,000 (or its equivalent in any 
other currency), at either the transaction or portfolio level,\46\ if 
not resolved within: (1) Three business days, if the dispute is with a 
counterparty that is an SBS Entity; or (2) five business days, if the 
dispute is with a counterparty that is not an SBS Entity. Such 
notification would be required to be in a form and manner acceptable to 
the Commission,\47\ and would also be required to be sent to any 
applicable prudential regulator (i.e., in the case of any SBS Entity 
that is also a bank).\48\
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    \46\ The language ``at either the transaction or portfolio 
level'' is not included in CFTC Rule 23.502(c), which is the 
corresponding requirement applicable to Swap Entities. The specific 
requirements as to the operation of CFTC Rule 23.502(c) are 
contained in the rules of the National Futures Association 
(``NFA''), which the CFTC has authorized to, among other things, 
receive and review notices of reportable swap valuation disputes. 
See Performance of Certain Functions by the National Futures 
Association Related to Notices of Swap Valuation Disputes Filed by 
Swap Dealers and Major Swap Participants, 81 FR 3390 (Jan. 21, 
2016). A detailed discussion of the NFA requirements, including with 
respect to whether notices of swap valuation disputes should be 
filed at either the transaction or portfolio level, is set forth at 
the end of this Section I.B.6.
    \47\ With respect to the language addressing the form and manner 
of submitting such notices, our intention is to provide SBS Entities 
with flexibility to determine the most efficient and cost-effective 
means of making such submissions, so long as it is deemed to be 
acceptable by the Commission. At the same time, we also understand 
that SBS Entities may prefer to have more specific direction as to 
how to report these disputes to the Commission (and any applicable 
prudential regulator). Accordingly, below we solicit comment on the 
form of notice that would be required to be submitted pursuant to 
the proposal.
    \48\ Additionally, the Commission is proposing to amend Rule 
15Fi-1 to add the term ``prudential regulator,'' which would be 
defined to have the same meaning given to the term in Section 
3(a)(74) of the Exchange Act, 15 U.S.C. 78c(a)(74), and would 
include the Federal Reserve Board, the Office of the Comptroller of 
the Currency, the FDIC, the Farm Credit Association, and the Federal 
Housing Finance Agency, as applicable to the specific type of SBS 
Entity. See proposed Rule 15Fi-1(m).
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    We note that the CFTC has adopted a nearly identical requirement 
with the same $20,000,000 threshold and timeframes, and that divergence 
from those requirements could lead to additional costs and other 
inefficiencies for SBS Entities that are also registered with the CFTC 
as Swap Entities.\49\ In addition, when the CFTC adopted this 
requirement, it explained that ``the $20,000,000 materiality threshold 
for reporting is sufficiently high to eliminate unnecessary `noise' 
from over-reporting, but not so high as to eliminate reporting that the 
[CFTC] may find of regulatory value, such as a large number of 
relatively small disputes that in aggregate could provide the [CFTC] 
with information regarding a widespread market disruption.'' \50\ We 
preliminarily concur with that justification, and also note that such 
notifications could assist the Commission in identifying potential 
issues with respect to an SBS Entity's internal valuation methodology. 
That said, we also invite public comment as to whether the dollar 
threshold or reporting periods should be modified in any way.\51\
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    \49\ See CFTC Risk Mitigation Adopting Release 77 FR at 55914.
    \50\ Id. The CFTC has a nearly identical requirement in its Rule 
23.502(c), except that it also requires Swap Entities to send such 
notices to the Commission when the dispute involves a swap that is 
also a security-based swap agreement, of which a material term is 
based on the price, yield, value, or volatility of any security or 
any group or index of securities, or any interest therein. See 17 
CFR 23.502(c) (citing the inclusion of security-based swap 
agreements in the definition of ``swap'' in 7 U.S.C. 1a(47)(v)). 
Because there is no corresponding inclusion of swap agreements in 
the definition of ``security-based swap agreement'' in Section 
3(a)(68) of the Exchange Act (15 U.S.C. 78c(a)), proposed Rule 15Fi-
3(c) does not contain a requirement to provide notices of any 
security-based swap valuation disputes to the CFTC.
    \51\ We have preliminarily determined not to provide a fixed 
definition of the term ``promptly'' in the context of when the SBS 
Entity would need to provide the Commission of an applicable 
security-based swap valuation dispute. Although we would expect that 
SBS Entities would be able to provide these notices to the 
Commission as soon as the disputes exceed the applicable timeframes 
(e.g., the beginning of fourth business day in the case of a dispute 
between two SBS Entities), we also understand that some notices may 
take longer to prepare, such as in cases when the counterparties are 
unable to agree even on the size of the dispute.
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    Finally, the Commission notes that on January 2, 2018, the NFA's 
Interpretive Notice entitled, ``NFA Compliance Rule 2-49: Swap 
Valuation Dispute Filing Requirements'' went into effect.\52\ Among 
other things, that interpretive notice describes the types of disputes 
that would trigger a notice requirement. Specifically, if the swap 
dealer and its counterparty exchange collateral, NFA

[[Page 4622]]

Interpretive Notice to Rule 2-49 provides that the swap dealer would be 
required to file notice of any dispute regarding (1) the amount of 
initial margin to be posted or collected pursuant to a collateralized 
eligible master netting agreement \53\ if the dispute exceeds the $20 
million reporting threshold and (2) the amount of variation margin to 
be posted or collected pursuant to such master netting agreement if the 
dispute exceeds the $20 million reporting threshold. Because master 
netting agreements by definition operate at the portfolio level, such 
notices also would apply to the relevant swap portfolio.
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    \52\ See NFA Interpretive Notice to Rule 2-49, available at: 
https://www.nfa.futures.org/rulebook/rules.aspx?Section=9&RuleID=9072.
    \53\ NFA Interpretive Notice to Rule 2-49 defines 
``collateralized eligible master netting agreement'' to include an 
eligible master agreement, including any applicable schedule and 
credit support annex.
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    To the extent that a swap dealer and its counterparty do not 
exchange collateral, NFA Interpretive Notice to Rule 2-49 requires the 
swap dealer to submit a notice to the NFA upon being notified by its 
counterparty that such counterparty is disputing any valuation provided 
by the swap dealer if the dispute exceeds the $20 million reporting 
threshold. Such notices would either be at the portfolio or transaction 
level, depending on the particular valuation in question. That is, if 
the counterparty disputes a valuation provided by the swap dealer 
related to a particular transaction, the notice provided by the swap 
dealer to the NFA also would need to be at the transaction level. By 
contrast, if the counterparty disputes a portfolio valuation provided 
by the swap dealer, the notice provided by the swap dealer to the NFA 
also would need to be at the portfolio level.\54\
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    \54\ See id. See also Transcript of the NFA Swap Valuation 
Dispute Notices and Swap Dealer Risk Data Reports Webinar (Oct. 12, 
2017), available at: https://www.nfa.futures.org/members/member-resources/files/transcripts/svdwebinar-transcriptoct2017.pdf.
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    NFA Interpretive Notice to Rule 2-49 also provides that swap 
dealers should not file a daily notice of a previously reported dispute 
even if the valuation dispute amount changes. Instead, swap dealers are 
required to notify the NFA of certain changes to the dispute amount on 
the 15th (or the following business day if the 15th is a weekend or 
holiday) and last business day of each month by amending any previously 
filed notice where the dispute amount has increased in $20 million 
incremental bands.\55\ NFA Notice to Interpretive Rule 2-49 also 
requires swap dealers to file termination notices of disputes that are 
no longer reportable under CFTC Rule 23.502(c).\56\ In addition, on 
July 20, 2017, NFA issued a Notice to Members (I-17-13) outlining the 
types of disputes that must be reported under the Interpretive Notice 
to Rule 2-49 and specifying the information that will be required in 
NFA's dispute form.\57\ Below we solicit comment on whether the 
Commission should incorporate some or all of the NFA's approach, 
including with respect to any of the specific requirements described 
above, directly into proposed Rule 15Fi-3(c).
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    \55\ See NFA Interpretive Notice to Rule 2-49, supra note 52. 
NFA Interpretive Notice to Rule 2-49 provided an example of a swap 
dealer that filed a notice of a $30 million dispute, noting that an 
amended notice updating the dispute amount would be required if that 
dispute increases to $40 million or more and each subsequent $20 
million increment (i.e., the dispute amount increases to $60 million 
or more, $80 million or more, etc.), or if the amount decreases at 
these $20 million increments.
    \56\ See id. Under NFA Interpretive Notice to Rule 2-49, the 
termination notice would be due on the 15th (or the following 
business day if the 15th is a weekend or holiday) and the last 
business day of the month based on the dispute amount on the 
reporting date.
    \57\ See NFA Notice to Members I-17-30, available at https://www.nfa.futures.org/news/newsNotice.asp?ArticleID=4827. That notice 
provided that all swap valuation disputes must include: (1) The swap 
dealer's NFA ID and legal entity identifier (``LEI''), (2) the 
dispute reportable date, (3) the dispute type, (4) the dispute 
termination date, (5) the receiver/payer, (6) the disputed amount, 
in U.S. Dollars (``USD''), (7) the counterparty name, and (8) 
counterparty LEI or Privacy Law Identifier. For initial and 
variation margin disputes, the swap dealer would also be required to 
provide (1) the unique swap identifier, (2) the base currency 
notional amount, (3) the base currency code, (4) the notional value 
USD equivalent, (5) the asset type, and (6) the product type. For 
disputes where no collateral is exchange, the notice also would need 
to include the credit support annex/netting agreement ID.
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7. Application of Proposed Rule 15Fi-3 to Cleared Security-Based Swaps
    Pursuant to proposed Rule 15Fi-3(d), the new requirements regarding 
portfolio reconciliation would not apply to a ``clearing transaction'' 
which, pursuant to existing Rule 15Fi-1(c) under the Exchange Act, is 
defined as a security-based swap that has a clearing agency as a direct 
counterparty.\58\ Notwithstanding this provision, the Commission 
understands that some parties may offer portfolio reconciliation 
services with respect to OTC derivative transactions novated to a 
clearing agency. Although the Commission recognizes the importance of 
reconciling the terms of security-based swap transactions between a 
clearing member (either acting on its own behalf or for the benefit of 
a customer) and the clearing agency, we preliminarily believe that the 
issue of reconciling the terms of cleared trades is more appropriately 
addressed by the rules governing a clearing agency's risk management 
practices, as well as by the documentation governing the relationship 
between a clearing agency and its members.
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    \58\ See proposed Rule 15Fi-3(d). Under existing Rule 15Fi-1(b) 
under the Exchange Act (which would be renumbered as Rule 15Fi-1(c) 
under the proposed rules), the term ``clearing agency'' means a 
clearing agency registered with the Commission pursuant to Section 
17A of the Exchange Act and provides central counterparty services 
for security-based swap transactions. See also Trade Acknowledgement 
and Verification Adopting release, 81 FR at 39820-21 (explaining the 
agency and principal models of clearing in the context of providing 
a comparable exception from the trade acknowledgement and 
verification requirements).
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8. Comments Requested
    The Commission generally requests comments on all aspects of 
proposed Rule 15Fi-3, as well as any definitions in Rule 15Fi-1 that 
are used in proposed Rule 15Fi-3. In addition, the Commission requests 
comments on the following specific issues:
     Do commenters agree with the three activities comprising 
the scope of the Commission's proposed definition of ``portfolio 
reconciliation''? Why or why not?
     Do you agree that the scope of the proposed definition of 
``material terms'' for purposes of the portfolio reconciliation 
requirements in proposed Rule 15Fi-3 should be coterminous with the 
terms of a security-based swap that must be reported to an SDR under 
Regulation SBSR? Why or why not? Do you believe that there are any 
terms that must be reported to an SDR that should not be subject to the 
proposed portfolio reconciliation requirements? If so, which term(s) 
and why?
     As opposed to using a fixed definition of ``material 
terms,'' should the Commission adopt a more flexible definition? For 
example, are there other uses of materiality, such as with regard to 
the disclosure of information in registration statements (including 
accounting statements) or proxy solicitations that would be useful to 
include? Why or why not?
     Do you agree with the Commission's preliminary approach of 
allowing SBS Entities to exclude certain information from the 
definition of ``material terms'' after a transaction is reconciled the 
first time so long as the excluded terms are not relevant to the 
ongoing rights and obligations of the parties and the valuation of the 
security-based swap? Alternatively, should the definition be revised to 
conform to the corresponding CFTC definition, which excludes certain 
terms for purposes of all portfolio reconciliations? Why or why not? 
With respect to either approach, which terms should be excluded and 
why? For example, should the final definition include as rule text some 
or all of the specific data elements

[[Page 4623]]

excluded from the CFTC's definition? Which ones and why? By contrast, 
are there any terms that would be excluded for purposes of subsequent 
reconciliations under the proposed approach that should also be 
excluded from the initial reconciliation? Which ones and why?
     Do commenters agree with the decision to use the existing 
definition of ``business day'' (as currently in effect for the 
security-based swap trade acknowledgement and verification 
requirements) for purposes of the portfolio reconciliation requirements 
in proposed Rule 15Fi-3? If not, why not and how should that definition 
be modified for purposes of the proposed portfolio reconciliation 
requirements? For example, should the definition specify which 
jurisdiction's legal holidays are the default for specifying which 
holidays are not included in the definition of ``business days''? Would 
the differences between the proposed definition of ``business day'' and 
the corresponding CFTC definition (which includes ``any day other than 
a Sunday or holiday'') create any practical difficulties for dual SEC-
CFTC registrants? If so, what are they? Should the Commission instead 
adopt a definition of ``business day'' that mirrors the CFTC 
definition? Why or why not?
     Do commenters agree with the proposed approach of basing 
the required frequency of portfolio reconciliation in proposed Rule 
15Fi-3 on the type of counterparty involved (i.e., its status as an SBS 
Entity) and on the size of the security-based swap portfolio? If not, 
why not? If commenters believe that the proposed approach should be 
retained, should any of the particular frequencies proposed (e.g., 
daily, weekly, quarterly, or annually) be modified to be either more or 
less frequent?
     Proposed Rule 15Fi-3 permits the portfolio reconciliation 
exercises required thereunder to be performed by a third party, with 
the only qualification being that the selection of that third party has 
been agreed to by both of the parties in writing. As an alternative 
approach, should the Commission instead establish specific requirements 
for qualifying third parties that offer portfolio reconciliation 
services used for compliance with the rule? If so, how should a third 
party be deemed to be qualified to provide portfolio reconciliation 
services and who should make such a determination?
     Should the Commission's rules require two SBS Entities to 
resolve a discrepancy in a material term ``immediately''? Why or why 
not? Should the Commission define or provide an interpretation of the 
term ``immediately,'' such as ``without undue delay,'' or, as an 
alternative, specify a fixed period of time in the rule text within 
which SBS Entities would be required to comply with proposed Rule 15Fi-
3(a)(4)? Why or why not and, if so, how much time should be provided?
     Are there any current industry practices that relate to 
how counterparties to swaps and security-based swaps resolve 
discrepancies in a material term in the case of a dealer-to-dealer 
transaction? If any such practices exist, please describe them, 
including with regard to the length of time that it typically takes to 
resolve these types of discrepancies. Are there particular material 
terms for which a discrepancy typically takes a longer (or shorter) 
amount of time to resolve? If so, which ones?
     Should the Commission require SBS Entities to have 
policies and procedures reasonably designed to resolve any discrepancy 
in a valuation (with another SBS Entity) identified as part of a 
portfolio reconciliation or otherwise as soon as possible, but in any 
event within five business days after the date on which the discrepancy 
is first identified? Why or why not? Should SBS Entities be provided 
with more days to resolve these discrepancies? Should they have fewer 
days?
     Are there any current industry practices that relate to 
how counterparties to swaps and security-based swaps resolve valuation 
discrepancies in the case of a dealer-to-dealer transaction? If any 
such practices exist, please describe them, including with regard to 
the length of time that it typically takes to resolve these types of 
discrepancies. Are there particular circumstances that typically make 
valuation disputes more (or less) difficult and time-consuming to 
resolve? If so, which ones?
     Should the Commission require SBS Entities to have 
policies and procedures reasonably designed to resolve any discrepancy 
in a valuation or material term with a counterparty that is not an SBS 
Entity (identified either as part of a portfolio reconciliation or 
otherwise) in a timely fashion? Why or why not? Should the Commission 
define or provide an interpretation of the term ``timely fashion,'' or, 
as an alternative, specify a fixed period of time in the rule text 
within which SBS Entities would be required to comply with proposed 
Rule 15Fi-3(b)(4)? Why or why not and, if so, how much time should be 
provided? In suggesting potential timeframes, we note that the period 
for resolving discrepancies in a valuation or material term with non-
SBS Entities should likely not be shorter than the five business days 
provided in the parallel requirement applicable to valuation 
discrepancies between two SBS Entities. Should the Commission look at 
any other similar provisions under the federal securities laws 
addressing dispute resolution procedures as a guide for determining the 
amount of time that an SBS Entity should be provided to resolve 
discrepancies pursuant to proposed Rule 15Fi-3(b)(4)? If so, which 
ones?
     Are there any current industry practices that relate to 
how counterparties to swaps and security-based swaps resolve 
discrepancies in a valuation or material term in the case of a 
transaction between a dealer and a non-dealer? If any such practices 
exist, please describe them, including with regard to the length of 
time that it typically takes to resolve these types of discrepancies. 
Are there particular terms for which a discrepancy typically takes a 
longer (or shorter) amount of time to resolve? If so, which ones? In 
this context, should valuation discrepancies be treated differently 
than discrepancies in some (or all) material terms? If so, which ones 
and why?
     Do you agree with the Commission's proposed approach of 
deeming valuation differences of less than 10% not to be discrepancies 
for purposes of requiring resolution under either proposed Rule 15Fi-
3(a)(5) or (b)(4)? If not, why not and how should the rules address the 
resolution of valuation differences? Should the threshold be based on 
the actual dollar amount of the valuation difference (or the related 
currency equivalent) instead of being expressed as a percentage of the 
difference of the two amounts?
     How has the 10% threshold functioned in the context of 
CFTC rules applicable to Swap Entities? Has that threshold been under-
inclusive, in the sense that it may not identity a sufficient number of 
swap valuation discrepancies that could affect performance under the 
swap transaction? Why or why not? By contrast, has the CFTC's 10% 
threshold been over-inclusive, in the sense that it has captured swap 
valuation discrepancies that typically would not affect performance 
under the swap transaction? Why or why not?
     Proposed Rule 15Fi-3(c) would require SBS Entities to 
promptly notify the Commission, in a form and manner acceptable to the 
Commission, and any applicable prudential regulator of any security-
based swap valuation dispute in excess of $20,000,000 (or its

[[Page 4624]]

equivalent in any other currency) if not resolved within either three 
business days, if the dispute is with a counterparty that is an SBS 
Entity, or five business days, if the dispute is with a counterparty 
that is not an SBS Entity. Do commenters agree with this requirement? 
Why or why not? As an alternative, should the Commission instead 
require SBS Entities to make and keep records of these unresolved 
disputes? Why or why not? Is $20,000,000 the appropriate threshold for 
notifying the Commission of unresolved disputes? If not, should the 
threshold be higher or lower? Should the threshold instead be expressed 
as a percentage? Do commenters agree with the proposed timeframes for 
submitting such a report? If not, should they be increased or 
decreased?
     Should the Commission establish a specific process for how 
SBS Entities would need to provide notices of valuation disputes to the 
Commission pursuant to proposed Rule 15Fi-3(c)? If so, how should such 
notices be provided? For example, should the Commission require that 
such notices be submitted in electronic format through the EDGAR system 
(or any successor system thereto, as designated by the Commission)? Why 
or why not? Alternatively, should the Commission create a dedicated 
email box to accept such notices in letter format? Why or why not? 
Should these notices be submitted on a confidential basis? If so, how 
would that affect the potential delivery options?
     As discussed above, the NFA has issued an interpretive 
notice to NFA Compliance Rule 2-49 and a separate notice to its members 
that, together, specify the timing, frequency, and contents for 
submitting notices of swap valuation disputes pursuant to CFTC Rule 
23.502(c).\59\ Should the Commission consider incorporating some or all 
of those requirements into proposed Rule 15Fi-3(c) at adoption? If so, 
which ones and why, and should any of the requirements promulgated by 
the NFA be modified as part of the process of incorporating them into 
the Commission's rules to account for differences between the swap and 
security-based swap markets?
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    \59\ See supra notes 52-57 and accompanying text.
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     Do commenters agree with the proposed exception from the 
reconciliation requirement for clearing transactions? Why or why not? 
Because the definition of ``clearing transactions'' only includes 
transactions cleared at a clearing agency registered with the 
Commission pursuant to Section 17A of the Exchange Act, security-based 
swaps cleared at a foreign clearing agency that is not registered with 
the Commission would not be deemed to be ``cleared'' for these 
purposes, and would therefore be subject to proposed Rule 15Fi-3. 
Should the Commission modify the scope of the exception for cleared 
security-based swaps, such as by including transactions that are 
cleared at a clearing agency that is not registered with the Commission 
pursuant to Section 17A of the Exchange Act, whether because of an 
applicable exemption from registration or because the Exchange Act does 
not cover the activities of the clearing agency? Why or why not?
     With respect to any Swap Entity that could potentially 
register with the Commission as an SBS Entity, would the portfolio 
reconciliation protocols (or any other applicable documentation) 
already in existence with respect to CFTC Rule 23.502 satisfy the 
requirements in proposed Rule 15Fi-3? Why or why not? Should proposed 
Rule 15Fi-3 be modified to account for the way that market participants 
have designed their existing protocols (or any other applicable 
documentation) to be compliant with the CFTC's rules? Why or why not? 
For the purposes of compliance with the proposed portfolio 
reconciliation rules, should the Commission allow compliance with the 
CFTC's parallel requirements for some period of time to allow dual SEC-
CFTC registrants to conform their existing portfolio reconciliation 
protocols (or any other applicable documentation) following the 
adoption of proposed Rule 15Fi-3? If so, on what factors should that 
reliance be conditioned and how long of a compliance period should be 
provided? In the alternative, should the Commission delay compliance 
with, or establish phased compliance deadlines for, some or all of 
these requirements? Please explain the nature of any compliance 
challenges (including any additional documentation requirements), and 
the basis for any suggested compliance period.
     As previously noted, proposed Rule 15Fi-3 has been 
designed to be as consistent as possible with CFTC Rule 23.502, which 
imposes portfolio reconciliation requirements on Swap Entities, in 
order to avoid requiring dual SEC-CFTC registrants to incur additional 
systems or compliance costs due to differences between the two 
agencies' approaches. To the extent that any such differences remain, 
should the Commission consider, for any firm dually-registered as both 
an SBS Entity and Swap Entity (regardless of whether such firm is also 
registered with the Commission as a broker-dealer or with the CFTC as a 
futures commission merchant), permitting such firm to comply with 
proposed Rule 15Fi-3 on an ongoing basis by complying with CFTC Rule 
23.502, as if such rule applied to security-based swaps? If so, what 
conditions, if any, should be placed on such reliance?
     Should SBS dealers and major SBS participants be treated 
the same for purposes of the portfolio reconciliation requirements in 
proposed Rule 15Fi-3? Why or why not?

C. Rule 15Fi-4 (Portfolio Compression)

1. Overview of Portfolio Compression
    Portfolio compression generally refers to a post-trade processing 
exercise that allows two or more market participants to eliminate 
redundant derivatives transactions within their portfolios in a manner 
that does not change their net exposure. Compression exercises 
typically take place in ``cycles,'' whereby each participating 
counterparty designates particular contracts within its portfolio as 
being eligible for compression and specifies its risk tolerances with 
respect to the composition of its derivatives portfolio following 
completion of the cycle.\60\ Following an analysis of the submitted 
contracts, counterparties may be provided with the option of 
terminating or modifying those contracts and replacing them with a 
smaller number of substantially similar contracts. In most cases, the 
gross notional value of the replacement and remaining contracts is 
reduced, although the counterparty's net exposure typically remains the 
same.\61\
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    \60\ See, e.g., ISDA Study, Interest Rate Swaps Compression: A 
Progress Report, (Feb. 2012), available at: https://www2.isda.org/attachment/NDAzMw==/IRS%20compression%20progress%20report%20-%20Feb%202012.pdf.
    \61\ In 2011, the Commission issued an order granting temporary 
exemptions from the requirement to register as a clearing agency 
under Section 17A of the Exchange Act for entities providing certain 
clearing services for security-based swaps including, among other 
things, tear-up and compression services. That order contains 
general descriptions of the portfolio compression process, based on 
discussions between Commission staff and market participants prior 
to the issuance of the exemptive order. See Order Pursuant to 
Section 36 of the Securities Exchange Act of 1934 Granting Temporary 
Exemptions from Clearing Agency Registration Requirements under 
Section 17A(b) of the Exchange Act for Entities Providing Certain 
Clearing Services for Security-Based Swaps, Exchange Act Release No. 
64796 (Jul. 1, 2011), 76 FR 39963 (Jul. 7, 2011) (``Clearing 
Services Exemptive Order'').
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    By reducing the total number of open contracts, portfolio 
compression is intended to help market participants manage their post-
trade risks in a number of important ways. For example, two or more 
counterparties

[[Page 4625]]

that are active in the OTC derivatives markets might have built up 
positions in the same (or comparable) products that, when analyzed at 
the portfolio level across all applicable counterparties, offset each 
other. Eliminating these offsetting and redundant uncleared derivatives 
transactions through compression--as measured both by the number of 
contracts and total notional value--reduces a market participant's 
gross exposure to its direct counterparties, including by eliminating 
all exposure to certain counterparties.\62\ Reducing the total number 
of outstanding contracts within a derivatives portfolio also provides 
important operational benefits and efficiencies for market participants 
in that there are fewer open contracts to manage, maintain, and settle, 
resulting in fewer opportunities for processing errors, failures, or 
other problems that could develop throughout the lifecycle of a 
transaction.\63\ Accordingly, the Commission preliminarily believes 
that the use of portfolio compression by SBS Entities, where 
appropriate given the circumstances (and to the extent that such 
activity is not already occurring), should provide important processing 
improvements consistent with the overall framework of Section 15F(i) of 
the Exchange Act.\64\
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    \62\ See Darrell Duffie, Ada Li, and Theo Lubke, Policy 
Perspectives of OTC Derivatives Market Infrastructure, FRBNY Staff 
Report No. 424, dated Jan. 2010, as revised Mar. 2010, available at: 
https://www.newyorkfed.org/research/staff_reports/sr424.pdf (``FRBNY 
OTC Derivatives Report'') (``In some types of derivatives that are 
not cleared, major market participants tend to build offsetting 
positions with different counterparties, long with one set of 
counterparties, and short with the others. In many cases, these 
offsetting positions are redundant. They serve no useful business 
purpose and create counterparty risk. Market participants should 
continue to engage in regular market-wide portfolio compression 
exercises in order to eliminate these redundant positions.''). See 
also, John Kiff, et al., Credit Derivatives: Systemic Risks and 
Policy Options, IMF Working Paper No. 254 (Nov. 2009), available at: 
https://www.imf.org/external/pubs/ft/wp/2009/wp09254.pdf 
(``Multilateral netting, typically operationalized via `tear-up' or 
`compression' operations that eliminate redundant contracts, reduces 
both individual and system counterparty credit risk.'').
    \63\ See Portfolio compression platform launched to reduce CDS 
operational risk, Hedgeweek (Sept. 8, 2008) (explaining that a 
portfolio compression platform ``reduces operational risk while 
leaving market risk profiles unchanged,'' which is achieved ``by 
terminating existing trades and replacing them with a smaller number 
of new replacement trades that carry the same risk profile and cash 
flows as the initial portfolio but have less capital exposure'').
    \64\ See 15 U.S.C. 78o-8 (requiring SBS Entities to ``conform 
with such standards as may be prescribed by the Commission, by rule 
or regulation, that relate to timely and accurate confirmation, 
processing, netting, documentation, and valuation of all security-
based swaps'').
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2. Scope of Proposed Rule 15Fi-4--Portfolio Compression Exercises
    For purposes of proposed Rule 15Fi-4 under the Exchange Act, the 
phrase ``portfolio compression exercise'' would generally refer to an 
exercise by which security-based swap counterparties wholly terminate 
or change the notional value of some or all of the security-based swaps 
submitted by the counterparties for inclusion in the portfolio 
compression exercise and, depending on the methodology employed, 
replace the terminated security-based swaps with other security-based 
swaps whose combined notional value (or some other measure of risk) is 
less than the combined notional value (or some other measure of risk) 
of the terminated security-based swaps in the exercise.\65\ In order to 
incorporate that concept into the proposal, the Commission is proposing 
to amend Rule 15Fi-1 to create definitions for both ``bilateral 
portfolio compression exercise'' \66\ and ``multilateral portfolio 
compression exercise.'' \67\ These two definitions are nearly 
identical, with the sole difference being that the former would apply 
to a portfolio compression exercise that includes only two security-
based swap counterparties, while the latter would refer to a portfolio 
compression exercise that includes more than two security-based swap 
counterparties.\68\
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    \65\ The corresponding CFTC rule is 17 CFR 23.503. The structure 
of the CFTC rule, including the subsections, mirrors the structure 
of proposed Rule 15Fi-4.
    \66\ See proposed Rule 15Fi-1(a). The corresponding CFTC 
definition is in 17 CFR 23.500(b).
    \67\ See proposed Rule 15Fi-1(j). The corresponding CFTC 
definition is in 17 CFR 23.500(h).
    \68\ As noted below in Section I.C.4, proposed Rule 15Fi-4 is 
applicable only to uncleared security-based swaps.
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    Under proposed Rule 15Fi-4(a), SBS Entities would be required to 
establish, maintain, and follow written policies and procedures for 
periodically engaging in both bilateral portfolio compression exercises 
and multilateral portfolio compression exercises, in each case when 
appropriate, with any counterparties that are SBS Entities.\69\ To the 
extent that an SBS Entity transacts with counterparties that are not 
SBS Entities, proposed Rule 15Fi-4(b) provides that the policies and 
procedures required under the proposed rule would require that 
portfolio compression exercises occur when appropriate \70\ and only to 
the extent requested by any such counterparty.\71\
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    \69\ See proposed Rules 15Fi-4(a)(2) and (3).
    \70\ CFTC Rule 23.503(b), which is the corresponding CFTC 
compression rule applicable to transactions with counterparties that 
are not SBS Entities does not contain the caveat that the 
compression or offset covered by the applicable policies and 
procedures would only need to occur ``when appropriate.'' Rather, we 
preliminarily believe it to be prudent to allow an SBS Entity to 
engage in bilateral offset or compression exercises (to the extent 
requested by its non-SBS Entity counterparty) only in circumstances 
when doing so was appropriate for the SBS Entity in light of the 
particular facts and circumstances involved, recognizing of course 
that such discretion should not be used by the SBS Entity 
arbitrarily not to honor the request by its counterparty. Below we 
solicit comment on this difference.
    \71\ See proposed Rule 15Fi-4(b). As we noted in discussing the 
proposed portfolio reconciliation requirements, the Commission 
preliminarily believes it to be appropriate to impose more 
prescriptive requirements in cases where both entities are subject 
to the SEC's requirements for registered entities.
    \72\ The one exception to this statement is the requirement in 
both proposed Rules 15Fi-4(a)(2) and (a)(3) that such policies and 
procedures address the evaluation of portfolio compression exercises 
that are initiated, offered, or sponsored by any third party. The 
Commission preliminarily believes that the decision of which party 
to use (or not use) to conduct a compression exercise is of critical 
importance to the overall determination of whether to participate in 
compression. Although the Commission takes no position with respect 
to the type or identity of the party used to conduct a compression 
exercise, we recognize that a number of parties are currently 
offering such services, including third-party vendors and some self-
regulatory organizations (e.g., clearing agencies). The Commission 
also understands that there may be some instances where compression 
could be performed without the use of a third-party service 
provider.
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    The proposed definitions of ``bilateral portfolio compression 
exercise'' and ``multilateral portfolio compression exercise'' are 
designed to be sufficiently broad as to provide market participants 
with maximum flexibility when complying with proposed Rule 15Fi-4, 
while also retaining the key elements necessary to achieve the 
important risk reducing benefits previously discussed--namely the 
reduction of counterparty and operational risk achieved by terminating 
offsetting security-based swap transactions. Accordingly, we are not 
proposing specific requirements as to the contents of the policies and 
procedures created to comply with these rules.\72\ In addition, for 
consistency with the rules applicable to Swap Entities, these 
definitions are substantively identical to the CFTC's corresponding 
definitions, which we preliminarily believe are appropriately scoped 
and clear for purposes of proposed Rule 15Fi-4.

[[Page 4626]]

    Rather, the Commission recognizes that a decision to engage in a 
process that could ultimately result in the termination or modification 
of existing contracts, and the potential entry into new ones, should be 
made in accordance with policies and procedures that are tailored to 
the specific risks and operations of the relevant SBS Entity. Such 
policies and procedures should, in the Commission's view, be permitted 
to take into account the specific risk tolerances of the regulated 
entity, including with respect to such areas as operational, funding, 
liquidity, and credit risk, and also reflect the possibility that firms 
may have legitimate business reasons for maintaining certain offsetting 
security-based swap positions, even if in theory they could be 
compressed.
    For example, the Commission understands that an SBS Entity might be 
unable to participate in a particular portfolio compression exercise 
that could result in it transacting with certain counterparties (e.g., 
because a counterparty poses an unacceptable level of credit risk), or 
in certain types of transactions. To the extent that such limitations 
exist and are reflected in the policies and procedures required 
pursuant to proposed Rules 15Fi-4(a) and (b), an SBS Entity would be in 
compliance with the proposed rules so long as it follows those policies 
and procedures, even if it determines not to engage in a particular 
compression exercise.
    Finally, in comparing the requirements we are proposing today with 
respect to bilateral and multilateral compression exercises with those 
previously adopted by the CFTC, we note two differences that we believe 
to be minor and technical in nature. First, CFTC Rule 23.503(a)(3)(i) 
requires that any policies and procedures related to multilateral 
portfolio compression address, among other things, participation in all 
multilateral portfolio compression exercises required by CFTC 
regulation or order. We have preliminarily determined not to include a 
comparable requirement in proposed Rule 15Fi-4(a)(3). Although the 
Commission would expect that any comprehensive policy or procedure 
would, as a matter of course, reflect any applicable laws and 
regulations expressly mandating participation in certain types of 
portfolio compression exercises, there are currently no Commission 
regulations or orders mandating participation in any particular type of 
portfolio compression exercise, and we are reluctant to include a 
requirement that could lead to confusion by suggesting that such 
regulations or orders exist.
    Second, CFTC Rule 23.503(a)(3)(ii) requires that any policies and 
procedures related to multilateral portfolio compression exercises 
evaluate, among other things, any services that are initiated, offered, 
or sponsored by any third party.\73\ The CFTC did not, however, include 
such a requirement in the corresponding requirement related to policies 
and procedures addressing bilateral portfolio compression 
exercises.\74\ Although the inclusion of a specific requirement in the 
rule should not be interpreted as creating an exhaustive list of what 
we would expect to see included in the policies and procedures, we 
understand that bilateral portfolio compression services are currently 
being offered by third-party vendors. Evaluating those services would 
seem to be a natural part of the process of broadly analyzing the 
applicability of bilateral compression in general. Therefore, we are 
proposing to expressly include a similar requirement in both proposed 
Rules 15Fi-4(a)(2) (policies and procedures regarding bilateral 
compression) and 15Fi-4(a)(3) (policies and procedures regarding 
multilateral compression).
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    \73\ See 17 CFR 23.503(a)(3)(ii).
    \74\ See 17 CFR 23.503(a)(2).
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3. Scope of Proposed Rule 15Fi-4--Bilateral Offset
    As we previously noted, the Commission has preliminarily made the 
determination not to suggest a preference as to the use of any 
particular type of compression, or as to the type or identity of the 
party conducting the exercise and has, instead, proposed broad 
definitions of the terms ``bilateral portfolio compression exercise'' 
and ``multilateral portfolio compression exercise.'' In addition, the 
Commission recognizes that there may be other ways for market 
participants to reduce the size of their derivatives portfolios that 
may not be considered to be ``portfolio compression exercises'' for 
purposes of those two proposed definitions.
    In light of those considerations, proposed Rule 15Fi-4(a)(1) would 
require each SBS Entity to establish, maintain, and follow written 
policies and procedures for terminating each ``fully offsetting 
security-based swap'' that it maintains with another SBS Entity in a 
timely fashion, when appropriate.\75\ To the extent that an SBS Entity 
transacts with a counterparty that is not an SBS Entity, the 
requirements of proposed Rule 15Fi-4(b) would be identical to those in 
proposed Rule 15Fi-4(a)(1), except that the required policies and 
procedures would only need to address engaging in bilateral offset when 
appropriate and to the extent requested by the counterparty. The 
Commission preliminarily believes that by not proposing prescriptive 
requirements as to the form of bilateral offset that would need to be 
reflected in an SBS Entity's policies and procedures, the proposed rule 
would allow the counterparties flexibility in the manner in which they 
reduce the size of their security-based swap portfolios in light of 
each counterparty's unique risks and operations.
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    \75\ The Commission also is proposing to amend Rule 15Fi-1 to 
add the term ``fully offsetting security-based swaps,'' which would 
be defined as ``security-based swaps of equivalent terms where no 
net cash flow would be owed to either counterparty after the offset 
of payment obligations thereunder.'' See proposed Rule 15Fi-1(h). 
For consistency with the rules applicable to Swap Entities, this 
definition is substantively identical to the CFTC's corresponding 
definition in 17 CFR 23.500(f), which we preliminarily believe is 
appropriately scoped and clear for purposes of proposed Rule 15Fi-4.
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    In addition, the proposed rules regarding bilateral offset have 
been designed to reflect the Commission's understanding that firms may 
have legitimate business reasons for maintaining fully offsetting 
security-based swap transactions. As such, proposed Rules 15Fi-4(a)(1) 
and (b) would require a firm's policies and procedures to address the 
termination of fully offsetting security-based swaps only ``when 
appropriate.''
    Finally, for purposes of proposed Rules 15Fi-4(a)(1) and (b), the 
Commission would generally consider an SBS Entity to have terminated 
each fully offsetting security-based swap in a ``timely fashion'' so 
long as (1) termination of the offsetting security-based swaps occurs 
within a period that is reasonable in light of the circumstances of 
each particular transaction and (2) the relevant SBS Entity is 
otherwise in compliance with its policies and procedures regarding 
bilateral offset.
4. Application of Proposed Rule 15Fi-4 to Cleared Security-Based Swaps
    Pursuant to proposed Rule 15Fi-4(c), the new requirements regarding 
portfolio compression would not apply to a ``clearing transaction'' 
which, pursuant to existing Rule 15Fi-1(c) under the Exchange Act, is 
defined as a security-based swap that has a clearing agency as a direct 
counterparty.\76\ Notwithstanding this provision, the Commission 
recognizes that portfolio compression is not limited to uncleared

[[Page 4627]]

swaps and that compression services may be offered either by a clearing 
agency itself or by a third-party vendor that works collaboratively 
with the clearing agency.\77\ Although the risk-reducing benefits that 
could be realized through the compression of cleared security-based 
swaps, we preliminarily believe that the issue of whether and when 
compression should occur within a clearing agency is best addressed by 
the rules governing the clearing agency's risk management practices, as 
well as by the documentation governing the relationship between the 
clearing agency and its members.\78\
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    \76\ See supra note 58 and accompanying text.
    \77\ Notwithstanding the applicability of the requirements of 
proposed Rule 15Fi-4, the Commission reminds any third parties 
performing compression or offset services to keep in mind any 
potential requirements under other provisions of the securities 
laws. For example, the Commission has stated that the provision of 
tear-up and compression services for security-based swaps would 
qualify these participants as clearing agencies and therefore 
trigger the statutory requirement to register as clearing agencies 
pursuant to Section 17A of the Exchange Act, absent exemptive relief 
(which the Commission provided on a conditional temporary basis in 
July 2011). See Clearing Services Exemptive Order, 76 FR at 39964.
    \78\ The corresponding CFTC rule is 17 CFR 23.503(c).
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5. Comments Requested
    The Commission generally requests comments on all aspects of 
Proposed Rule 15Fi-4 (and any related definitions). In addition, the 
Commission requests comments on the following specific issues:
     Do commenters agree with the scope of the Commission's 
approach of proposing broad definitions of ``bilateral portfolio 
compression exercise'' and ``multilateral portfolio compression 
exercise''? Why or why not?
     Should SBS Entities be required to have policies and 
procedures in place for terminating fully offsetting security-based 
swaps in a timely fashion? Why or why not? Do you agree with the 
proposed interpretation of the term ``timely fashion'' to mean that the 
relevant security-based swaps should be terminated within a period that 
is reasonable in light of the circumstances of each particular 
transaction (so long as the relevant SBS Entity is otherwise in 
compliance with its policies and procedures regarding bilateral 
offset)? Why or why not? Should the Commission instead specify a fixed 
period of time for the required termination of these security-based 
swaps? Why or why not?
     With respect to any Swap Entity that could potentially 
register with the Commission as an SBS Entity, would the portfolio 
compression protocols (or any other applicable documentation) already 
in existence with respect to CFTC Rule 23.503 satisfy the requirements 
in proposed Rule 15Fi-4? Why or why not? Should proposed Rule 15Fi-4 be 
modified to account for the way that market participants have designed 
their existing protocols (or any other applicable documentation) to be 
compliant with the CFTC's rules? Why or why not? For the purposes of 
compliance with the proposed portfolio compression rules, should the 
Commission allow compliance with the CFTC's parallel requirements for 
some period of time to allow dual SEC-CFTC registrants to conform their 
existing portfolio compression protocols (or any other applicable 
documentation) following the adoption of proposed Rule 15Fi-4? If so, 
on what factors should that reliance be conditioned and how long of a 
compliance period should be provided? In the alternative, should the 
Commission delay compliance with, or establish phased compliance 
deadlines for, some or all of these requirements? Please explain the 
nature of any compliance challenges (including any additional 
documentation requirements), and the basis for any suggested compliance 
period.
     As previously noted, proposed Rule 15Fi-4 has been 
designed to be as consistent as possible with CFTC Rule 23.503, which 
imposes portfolio compression requirements on Swap Entities, in order 
to avoid requiring dual SEC-CFTC registrants to incur additional 
systems or compliance costs due to differences between the two 
agencies' approaches. To the extent that any such differences remain, 
should the Commission consider, for any firm dually-registered as both 
an SBS Entity and Swap Entity (regardless of whether such firm is also 
registered with the Commission as a broker-dealer or with the CFTC as a 
futures commission merchant), permitting such firm to comply with 
proposed Rule 15Fi-4 on an ongoing basis by complying with CFTC Rule 
23.503, as if such rule applied to security-based swaps? If so, what 
conditions, if any, should be placed on such reliance?
     Do commenters agree with the proposed exception from the 
compression requirements in proposed Rule 15Fi-4 for clearing 
transactions? Why or why not? Because the definition of ``clearing 
transactions'' only includes transactions cleared at a clearing agency 
registered with the Commission pursuant to Section 17A of the Exchange 
Act, security-based swaps cleared at a foreign clearing agency that is 
not registered with the Commission would not be deemed to be 
``cleared'' for these purposes, and would therefore be subject to 
proposed Rule 15Fi-4. Should the Commission modify the scope of the 
exception for cleared security-based swaps, such as by including 
transactions that are cleared at a clearing agency that is not 
registered with the Commission pursuant to Section 17A of the Exchange 
Act, whether because of an applicable exemption from registration or 
because the Exchange Act does not cover the activities of the clearing? 
Why or why not?
     Proposed Rule 15Fi-4(b) requires each 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 respect to security-based swaps in which its counterparty is an 
entity other than an SBS Entity, ``when appropriate'' and to the extent 
requested by any such counterparty. CFTC Rule 23.503(b) does not 
contain the ``when appropriate'' qualifier and provides only that a 
Swap Entity's policies and procedures address engaging in bilateral 
offset or compression exercises ``to the extent requested'' by a 
counterparty that is not a Swap Entity. Would the Commission's proposed 
approach create any practical difficulties for dual SEC-CFTC 
registrants? If so, what are they? Should the Commission instead strike 
the ``when appropriate'' qualifier in order to mirror the corresponding 
CFTC requirement? Why or why not? To the extent that the Commission 
were to follow the approach of CFTC Rule 23.503(b), should there be a 
reasonableness standard to address situations when a request by a non-
SBS Entity counterparty to engage in bilateral offset or compression 
exercises would be not be reasonable, such as a situation when doing so 
could be detrimental to the SBS Entity? If so, under what conditions 
should an SBS Entity be able to refuse a request from a non-SBS Entity 
counterparty to engage in such activity pursuant to proposed Rule 15Fi-
4(b)?
     What practices, if any, are currently being used (or are 
currently under consideration) by market participants with respect to 
the use of portfolio compression across asset classes? For example, 
could a compression exercise occur with respect to two or more 
counterparties maintaining portfolios of both single-name credit 
default swaps (``CDS'') and index CDS? If so, should the Commission 
modify proposed Rule 15Fi-4, or provide related interpretive guidance 
to accommodate portfolio compression across asset classes?

[[Page 4628]]

     Should SBS dealers and major SBS participants be treated 
the same for purposes of the portfolio compression requirements in 
proposed Rule 15Fi-4? Why or why not?

D. Rule 15Fi-5 (Trading Relationship Documentation)

1. Overview of Trading Relationship Documentation
    Section 15F(i)(2) of the Exchange Act provides that the Commission 
shall adopt rules governing documentation standards for SBS Entities. 
Just as portfolio reconciliation is designed to allow counterparties to 
manage their internal risks by better ensuring agreement with respect 
to the terms of the transaction (and thereby avoiding complications at 
various points throughout the life of the transaction),\79\ requiring 
each SBS Entity to document the terms of the trading relationship with 
each of its counterparties before executing a new security-based swap 
transaction should promote sound collateral and risk management 
practices by enhancing transparency and legal certainty regarding each 
party's rights and obligations under the transaction. This, in turn, 
should help to reduce counterparty credit risk and promote certainty 
regarding the agreed-upon valuation and other material terms of a 
security-based swap.\80\ Having adequate written documentation prior 
to, or contemporaneously with, executing a security-based swap should 
also facilitate the ability of the counterparties to engage in 
portfolio reconciliation, as would be required under these proposed 
rules, in an efficient and cost-effective manner.
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    \79\ See supra Section I.B.1.
    \80\ See, e.g., Sylvie A. Durham, Terminating Derivatives 
Transactions: Risk Mitigation and Close-Out Netting Sec.  8:1 (Nov. 
2010) (``[L]egal contractual provisions are the foundation on which 
the rights and obligations of the parties are based, and sound 
collateral and risk management practices may be ineffective if the 
legal rights of the parties are not clearly set forth.'').
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2. Scope of Proposed Rule 15Fi-5
    In light of the important risk mitigating factors described above, 
the Commission is proposing Rule 15Fi-5, which establishes certain 
requirements for SBS Entities related to the use of written trading 
relationship documentation in connection with their security-based swap 
transactions.\81\ Specifically, proposed Rule 15Fi-5(a)(2) would 
require each SBS Entity to establish, maintain, and follow written 
policies and procedures reasonably designed to ensure that it executes 
written security-based swap trading relationship documentation with 
each of its counterparties prior to, or contemporaneously with, 
executing a security-based swap with any counterparty.\82\ The proposed 
rule would further require that the policies and procedures required 
thereunder be approved in writing by a senior officer of the SBS 
Entity, and that a record of the approval be retained.\83\
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    \81\ The corresponding CFTC rule is 17 CFR 23.504. The structure 
of the CFTC rule, including the subsections, mirrors the structure 
of proposed Rule 15Fi-5.
    \82\ Among other exceptions discussed below in Section I.D.6, 
proposed Rule 15Fi-5 is applicable only to uncleared security-based 
swaps.
    \83\ See proposed Rule 15Fi-5(b)(2). For purposes of this 
requirement, the Commission preliminarily views the term ``senior 
officer'' as covering only the most senior executives in the 
organization, such as a firm's chief executive officer, chief 
financial officer, chief legal officer, chief compliance officer, 
president, or other person at a similar level. This approach is 
similar to how the Commission has previously interpreted the term in 
the context of other requirements applicable to SBS Entities. See 
Registration Process for Security-Based Swap Dealers and Major 
Security-Based Swap Participants, Exchange Act Release No. 75611 
(Aug. 5, 2015), 80 FR 48964, 48968 n. 29 (Aug.14, 2015) (``SBS 
Entity Registration Adopting Release''). By contrast, CFTC Rule 
23.504 uses the term ``senior management,'' which is not further 
defined in either CFTC Rules 23.500 or 23.504. We preliminarily view 
this difference as a clarification and do not believe that it 
represents a substantive difference between the two sets of rules, 
but below we solicit comment on this issue.
---------------------------------------------------------------------------

    Pursuant to proposed Rule 15Fi-5(b)(1), the required policies and 
procedures would require that the security-based swap trading 
relationship documentation be in writing. The policies and procedures 
would also require that the documentation 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.\84\
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    \84\ We note that CFTC Rule 23.504 does not contain a comparable 
provision to the requirement in proposed Rule 15Fi-5(b)(1) that the 
trading relationship documentation address ``applicable regulatory 
reporting obligations (including pursuant to Regulation SBSR).'' The 
Commission is proposing this requirement not only because of our 
view that reporting arrangements should be clarified in advance, due 
to the importance of ensuring that the transaction is reported 
accurately and in a timely manner, but also because the inclusion of 
such provision could potentially help to address an issue related to 
how SDRs can verify the information that they receive, as discussed 
in detail in Section I.E below.
---------------------------------------------------------------------------

    For purposes of Rule 15Fi-5(b)(2), all trade acknowledgements and 
verifications of security-based swap transactions required under Rule 
15Fi-2 would be deemed to be security-based swap trading relationship 
documentation, as they often may contain one or more terms contemplated 
by the policies and procedures required by proposed Rule 15Fi-5. 
Further, the Commission understands that in some transactions, the 
parties may choose to document their trading relationship by using a 
stand-alone ``long-form confirmation'' that includes all of the terms 
governing the relationship. The proposed rule is not intended to 
interfere with this practice. Accordingly, we preliminarily believe 
that the use of a ``long-form confirmation'' would comply with proposed 
Rule 15Fi-5 so long as such document is: (1) In written form and 
includes all of the elements of the trading relationship required under 
the rule (whether by incorporating them by reference from a standard 
master agreement or by expressly restating them in the confirmation) 
and (2) executed prior to, or contemporaneously with, the execution of 
each relevant security-based swap.
    The policies and procedures required by the proposed rule also 
would require that the security-based swap trading relationship 
documentation include credit support arrangements.\85\ Such credit 
support would be required to contain, among other things and in 
accordance with applicable requirements under regulations adopted by 
the Commission or any prudential regulators,\86\ and without 
limitation, the following:
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    \85\ See proposed Rule 15Fi-5(b)(3).
    \86\ See supra note 48.
---------------------------------------------------------------------------

     Initial and variation margin requirements, if any;
     types of assets that may be used as margin and asset 
valuation haircuts, if any;
     investment and re-hypothecation terms for assets used as 
margin for uncleared security-based swaps, if any; and
     custodial arrangements for margin assets, including 
whether margin assets are to be segregated with an independent third 
party, in accordance with Section 3E(f) of the Exchange Act, if 
any.\87\
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    \87\ 15 U.S.C. 78c-5(f).
---------------------------------------------------------------------------

    As the Commission has previously explained, ensuring that uncleared 
OTC derivatives transactions are appropriately collateralized was one 
of the key elements of the Title VII reforms.\88\ Accordingly, we 
preliminarily believe that policies and procedures requiring 
counterparties to

[[Page 4629]]

clearly document the applicable processes and requirements for 
calculating and exchanging margin in connection with a security-based 
swap transaction is an important step in achieving this broader 
regulatory objective.
---------------------------------------------------------------------------

    \88\ See supra Section I.B.1.
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3. Proposed Rule 15Fi-5(b)(4): Documenting Valuation Methodologies
    As mentioned throughout this release, ensuring that security-based 
swaps are accurately valued throughout the duration of a contract 
should play an important role in protecting the integrity of the OTC 
derivatives market, both at the level of an individual participant and 
systemically across the broader financial market.\89\ Accordingly, 
proposed Rule 15Fi-5(b)(4) would require that the applicable policies 
and procedures provide that the relevant swap trading relationship 
documentation between certain types of 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 for the purposes of complying with the margin requirements 
under Section 15F(e) of the Exchange Act (and applicable 
regulations),\90\ and the risk management requirements under Section 
15F(j) of the Exchange Act (and applicable regulations).\91\ To the 
maximum extent practicable, such valuations would need to be based on 
recently-executed transactions, valuations provided by independent 
third parties, or other objective criteria.\92\
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    \89\ See id.
    \90\ See 15 U.S.C. 78o-10(e). For the avoidance of doubt, the 
requirements in proposed Rule 15Fi-5(b)(4) are intended to 
facilitate agreement between an SBS Entity and its counterparty as 
to how they will determine the value of a security-based swap in 
order to, among other things, comply with the margin requirements 
promulgated by either the Commission or, with respect to an SBS 
Entity that is a bank, the applicable prudential regulator. These 
requirements are not intended in any way to supersede those 
underlying margin requirements.
    \91\ See 15 U.S.C. 78o-10(j).
    \92\ See proposed Rule 15Fi-5(b)(4)(i).
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    The requirements in proposed Rule 15Fi-5(b)(4) regarding valuation 
methodology would apply to security-based swap trading relationship 
documentation entered into between: (1) Two SBS Entities; (2) an SBS 
Entity and a ``financial counterparty;'' and (3) an SBS Entity and any 
other counterparty, if requested by such counterparty. Accordingly, we 
are also proposing to amend Rule 15Fi-1 to add a definition of 
``financial counterparty,'' which would include any counterparty that 
is not an SBS Entity and that is one of the following:
     A swap dealer;
     a major swap participant;
     a commodity pool as defined in Section 1a(10) of the 
Commodity Exchange Act (7 U.S.C. 1a(10));
     a private fund as defined in Section 202(a)(29) of the 
Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a));
     an employee benefit plan as defined in paragraphs (3) and 
(32) of Section 3 of the Employee Retirement Income Security Act of 
1974 (29 U.S.C. 1002); and
     a person predominantly engaged in activities that are in 
the business of banking or, in activities that are financial in nature, 
as defined in Section 4(k) of the Bank Holding Company Act of 1956 (12 
U.S.C. 1843k).\93\
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    \93\ See proposed Rule 15Fi-1(g). The corresponding definition 
in CFTC Rule 23.500(e) is referred to as a ``financial entity.''. We 
replaced the word ``entity'' with ``counterparty'' to avoid any 
confusion due to the fact that there are other definitions of 
``financial entity'' within the Exchange Act and its implementing 
regulations. For example, term ``financial entity'' is used in 
Section 3C(g) of the Exchange Act for purposes of the statutory 
exception to the mandatory clearing requirement in Title VII. See 15 
U.S.C. 78c-3(g)(3). Similarly, there is a definition of ``financial 
entity'' in Rule 3a67-6 under the Exchange Act, which is used for 
one of the tests for determining a person's status under the 
definition of ``major security-based swap participant'' in Section 
3(a)(67) of the Exchange Act. See 15 U.S.C. 78. Other than the 
different titles, we do not believe that there are any substantive 
differences between the CFTC's definition of ``financial entity'' 
and the proposed definition of ``financial counterparty.''
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    Further, proposed Rule 15Fi-5(b)(4)(ii) has been designed to help 
ensure that the required valuation documentation between SBS Entities 
and their counterparties contains sufficient guidance and information 
in the event of a problem with determining the value of a security-
based swap. Specifically, the documentation required by the applicable 
policies and procedures must include either: (1) Alternative methods 
for determining the value of the security-based swap for the purposes 
of complying with proposed Rule 15Fi-5(b)(4) in the event of the 
unavailability or other failure of any input required to value the 
security-based swap for such purposes; or (2) a valuation dispute 
resolution process by which the value of the security-based swap shall 
be determined for the purposes of complying with the rule.\94\
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    \94\ See proposed Rule 15Fi-5(b)(4)(ii).
---------------------------------------------------------------------------

    To the extent that the prescribed valuation documentation needs to 
be updated, revised, or otherwise modified, proposed Rule 15Fi-
5(b)(4)(iv) provides that the parties may agree on changes or 
procedures for modifying or amending such documentation at any 
time.\95\ Finally, in recognition of the fact that valuation data and 
methodologies often include, or may be based on, private information, 
proposed Rule 15Fi-5(b)(4)(iii) makes clear that an SBS Entity is not 
required to disclose to the counterparty confidential, proprietary 
information about any model it may use to value a security-based swap.
---------------------------------------------------------------------------

    \95\ The text of CFTC Rule 23.504(b)(4)(iv), which is the 
corresponding subsection under CFTC rules, provides that ``[t]he 
parties may agree on changes or procedures for modifying or amending 
the documentation required by this paragraph at any time.'' Proposed 
Rule 15Fi-5(b)(4)(iv) does not contain the phrase ``required by this 
paragraph.'' We view this to be solely a technical change and do not 
intend for it to represent a substantive deviation from the 
corresponding CFTC rule. Rather, the difference is intended to avoid 
any suggestion that the parties could amend the underlying 
requirements contained in proposed Rule 15Fi-5(b)(4).
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4. Proposed Rule 15Fi-5(b)(5) and (6): Other Disclosure Requirements
    Proposed Rule 15Fi-5 also would require that the policies and 
procedures governing the applicable trading relationship documentation 
require an SBS Entity and its counterparty to disclose to each other 
certain information regarding their legal and bankruptcy status, and to 
include a statement regarding the status of a security-based swap if 
accepted for clearing by a CCP. The first requirement relates to 
whether the SBS Entity or its counterparty is subject to a particular 
legal regime in the event of its failure, such as FDIC receivership for 
banks or orderly liquidation for certain financial companies that meet 
the requirements set forth in Title II of the Dodd-Frank Act.\96\ As 
background, Title II of the Dodd-Frank Act provides for an alternative 
insolvency regime for the ``orderly liquidation'' of large financial 
companies,\97\ including broker-dealers,

[[Page 4630]]

that meet specified criteria (each a ``covered financial company'') as 
set forth in Title II of the Dodd-Frank Act.\98\ If the covered 
financial company is (1) a broker or dealer and (2) a member of the 
Securities Investor Protection Corporation (``SIPC''), such ``covered 
broker or dealer'' would be placed into an orderly liquidation 
proceeding with the FDIC appointed as receiver.\99\ Because this 
orderly liquidation process, which was modeled on the receivership 
process used for failed banks, is different from the liquidation 
regimes established under the Securities Investor Protection Act of 
1970 \100\ or by the U.S. Bankruptcy Code,\101\ the Commission 
preliminarily believes it to be appropriate to require counterparties 
to a security-based swap transaction to disclose to each other whether 
this alternative regime may potentially apply in the event of an 
insolvency.
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    \96\ See 12 U.S.C. 5382; 12 U.S.C. 5383.
    \97\ The term ``financial company'' is defined in 12 U.S.C. 
5381(a)(11) to include any company (as defined in 12 U.S.C. 
5381(a)(5)) that--
    (A) is incorporated or organized under any provision of Federal 
law or the laws of any State;
    (B) is--
    (i) a bank holding company (as defined in 12 U.S.C. 1841(a));
    (ii) a nonbank financial company supervised by the Federal 
Reserve Board;
    (iii) any company that is predominantly engaged in activities 
that the Federal Reserve Board has determined are financial in 
nature or incidental thereto for purposes of 12 U.S.C. 1843(k) 
(other than a company described in clause (i) or (ii)); or
    (iv) any subsidiary of any company described in any of clauses 
(i) through (iii) that is predominantly engaged in activities that 
the Federal Reserve Board has determined are financial in nature or 
incidental thereto for purposes of 12 U.S.C. 1843(k) (other than a 
subsidiary that is an insured depository institution or an insurance 
company); and
    (C) is not a Farm Credit System institution chartered under and 
subject to the provisions of the Farm Credit Act of 1971, as amended 
(12 U.S.C. 2001 et seq.), a governmental entity, or a regulated 
entity, as defined under 12 U.S.C. 4502(20).
    \98\ Section 203 of the Dodd-Frank Act sets forth the process 
for designating a financial company as a ``covered financial 
company.'' In the case of a broker-dealer, or when a financial 
company's largest U.S. subsidiary is a broker-dealer, Section 
203(a)(1)(B) provides that the Federal Reserve Board and the 
Commission (in each case subject to the approval of a two-thirds 
majority of each agency's members), in consultation with the FDIC, 
may, either on their own initiative or at the request of the 
Secretary of the U.S. Treasury (``Secretary''), issue a written 
orderly liquidation recommendation to the Secretary. See 12 U.S.C. 
5383(a). Section 203(b) requires the Secretary (after consultation 
with the President) to take action on the recommendation upon an 
affirmative determination that, among other things, the failure of a 
financial company would have serious adverse effects on financial 
stability in the United States and that taking action under the 
orderly liquidation authority with respect to that company would 
avoid or mitigate such adverse effects. See 12 U.S.C. 5383(b).
    \99\ See 12 U.S.C. 5384. Section 205(a) of the Dodd-Frank Act 
requires the FDIC, as the appointed receiver for any covered broker 
or dealer, to appoint SIPC as trustee for the liquidation. See 12 
U.S.C. 5385(a).
    \100\ 15 U.S.C. 78aaa et seq.
    \101\ 11 U.S.C. 101 et seq.
---------------------------------------------------------------------------

    Accordingly, proposed Rule 15Fi-5(b)(5) would require that each SBS 
Entity's policies and procedures require that the security-based swap 
trading relationship documentation contain a statement as to whether it 
or its counterparty is an insured depository institution or financial 
company. Further, the documentation also would need to contain a 
statement that the orderly liquidation provisions of the Dodd-Frank Act 
and the Federal Deposit Insurance Act \102\ may limit the rights of the 
parties under their trading relationship documentation should either 
party be deemed a ``covered financial company'' or is otherwise subject 
to having the FDIC appointed as a receiver. The documentation would 
further be required to state that such limitations relate to the right 
of the non-covered party to terminate, liquidate, or net any security-
based swap by reason of the appointment of the FDIC as receiver, 
notwithstanding the agreement of the parties in the security-based swap 
trading relationship documentation, and of certain rights of the FDIC 
to transfer security-based swaps of the covered party. Finally, the 
policies and procedures would require that the trading relationship 
documentation contain an agreement between the SBS Entity and its 
counterparty to provide notice if either it or its counterparty becomes 
or ceases to be an insured depository institution or a financial 
company.\103\
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    \102\ 12 U.S.C. 1811 et seq.
    \103\ Specifically, proposed Rule 15Fi-5(b)(5) would require 
that an SBS Entity's policies and procedures require that the 
applicable security-based swap trading relationship documentation 
contain:
    (A) A statement of whether the SBS Entity is an insured 
depository institution (as defined in 12 U.S.C. 1813) or a financial 
company (as defined in Section 201(a)(11) of the Dodd-Frank Act, 12 
U.S.C. 5381(a)(11));
    (B) A statement of whether the counterparty is an insured 
depository institution or financial company;
    (C) A statement that in the event either the SBS Entity or its 
counterparty becomes a covered financial company (as defined in 12 
U.S.C. 5381(a)(8)) or is an insured depository institution for which 
the FDIC has been appointed as a receiver (the ``covered party''), 
certain limitations under Title II of the Dodd-Frank Act or the 
Federal Deposit Insurance Act may apply to the right of the non-
covered party to terminate, liquidate, or net any security-based 
swap by reason of the appointment of the FDIC as receiver, 
notwithstanding the agreement of the parties in the security-based 
swap trading relationship documentation, and that the FDIC may have 
certain rights to transfer security-based swaps of the covered party 
under Section 210(c)(9)(A) of the Dodd-Frank Act, 12 U.S.C. 
5390(c)(9)(A), or 12 U.S.C. 1821(e)(9)(A); and
    (D) An agreement between the SBS Entity and its counterparty to 
provide notice if either it or its counterparty becomes or ceases to 
be an insured depository institution or a financial company.
---------------------------------------------------------------------------

    Second, the policies and procures required pursuant to proposed 
Rule 15Fi-5(b)(6) would require the security-based swap trading 
relationship documentation of each SBS Entity disclose certain 
information regarding the status of a security-based swap accepted for 
clearing by a clearing agency. Specifically, such documentation would 
need to contain a notice that, upon acceptance of a security-based swap 
by a clearing agency:
     The original security-based swap is extinguished;
     The original security-based swap is replaced by equal and 
opposite security-based swaps with the clearing agency; and
     All terms of the security-based swap shall conform to the 
product specifications of the cleared security-based swap established 
under the clearing agency's rules.
    The Commission preliminarily believes that this disclosure should 
provide important information to counterparties regarding the effects 
of clearing a trade at a clearing agency and clarify the status of the 
contract following its acceptance and novation at the clearing agency.
5. Proposed Rule 15Fi-5(c): Audit of Security-Based Swap Trading 
Relationship Documentation
    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. The proposal also would require that a record of the 
results of each audit be retained for a period of three years after the 
conclusion of the audit.\104\ The Commission preliminarily believes 
that requiring periodic audits of a firm's security-based swap trading 
relationship documentation is consistent with sound risk mitigation 
practices and is designed to reduce the prevalence of discrepancies 
during the course of these transactions. This proposed requirement 
differs slightly from CFTC Rule 23.504(c), which references an 
independent ``internal or external'' auditor.\105\
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    \104\ The three year holding period for these records is 
contained in the applicable recordkeeping, reporting, and 
notification requirements for SBS Entities, as opposed to in 
proposed Rule 15Fi-5(c) itself.
    \105\ See 17 CFR 23.504(c). In the Commission's experience 
overseeing accounting and auditing standards in the context of 
certain disclosure requirements under the federal securities laws, 
an internal auditor typically reports to the management of the 
applicable entity, which would be inconsistent with the Commission's 
auditor independence rules. See Rule 2-01(c)(2) of Regulation S-X 
(Employment Relationships). 17 CFR 210.2-01(c). At the same time, we 
are not foreclosing the possibility that there could be alternative 
structures to the typical ``internal'' auditor employment 
relationship that could, if structured properly, not be inconsistent 
with the Commission's auditor independence rules and request comment 
below identifying and describing such potential structures.

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[[Page 4631]]

6. Exceptions to the Trading Relationship Documentation Requirements
    Proposed Rule 15Fi-5(a)(1) would establish three different 
exceptions from the basic requirement that each SBS Entity establish, 
maintain, and follow written policies and procedures reasonably 
designed to ensure that it executes written security-based swap trading 
relationship documentation with each of its counterparties prior to, or 
contemporaneously with, executing a security-based swap with any 
counterparty. First, proposed Rule 15Fi-5(a)(1)(i) would provide an 
exception for security-based swaps executed prior to the date on which 
an SBS Entity is required to be in compliance with the documentation 
rule. Although the Commission recognizes the significant risk 
mitigation benefits associated with ensuring that all transactions are 
supported by comprehensive and accurate documentation, we also 
understand that it may be impractical to require SBS Entities to have 
policies and procedures to bring existing transactions into compliance 
with these proposed rules, particularly when weighing any potential 
benefits of doing so against the potential costs. Accordingly, we 
preliminarily believe that those transactions should be excepted from 
the proposed documentation requirements.\106\
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    \106\ As discussed in detail in Section I.F.1 of this release, 
the Commission also is proposing amendments to Rule 17a-4 and to 
proposed Rule 18a-6 that would, among other things, require SBS 
Entities to retain all security-based swap trading relationship 
documentation with counterparties required to be created under 
proposed Rule 15Fi-5. Because security-based swaps executed prior to 
the date on which an SBS Entity is required to be in compliance with 
proposed Rule 15Fi-5 would be exempt from the underlying 
documentation requirement, any trading relationship documentation 
voluntarily entered into in respect of those transactions would not 
be deemed to have been created pursuant to proposed Rule 15Fi-5.
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    To the extent that an SBS Entity maintains an existing security-
based swap portfolio with a counterparty that pre-dates the compliance 
date, proposed Rule 15F-5(a)(1)(i) would provide an exception from the 
documentation requirements only with respect to those existing 
transactions. This means that the SBS Entity would not be in violation 
of Rule 15Fi-5 solely as a result of having policies and procedures 
that do not require such SBS Entity to have executed written security-
based swap trading relationship documentation with any counterparty 
with respect to those existing transactions, or if the existing 
documentation that it maintains with the counterparty does not 
otherwise comply with the requirements of the rule. However, if the SBS 
Entity enters into new security-based swap transactions with the 
counterparty, the exception would not apply to those new trades, even 
if trading relationship documentation already existed. Under those 
circumstances, the SBS Entity's policies and procedures would be need 
to be reasonably designed to ensure that the existing documentation 
complies with the proposed rule before using it as the basis to enter 
into any new security-based swaps with that counterparty.
    Second, proposed Rule 15Fi-5(a)(1)(ii) would provide an exception 
for any ``clearing transaction'' which, pursuant to existing Rule 15Fi-
1(c), is defined as a security-based swap that has a clearing agency as 
a direct counterparty.\107\ This exception is intended to recognize the 
fact that once a security-based swap is cleared, the transaction is 
governed primarily by the terms of the agreements in effect between the 
clearing member and the clearing agency (as well as between the 
clearing member and its customer, if applicable).
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    \107\ See supra note 58 and accompanying text.
---------------------------------------------------------------------------

    Finally, proposed Rule 15Fi-5(a)(1)(iii) would provide an exception 
for security-based swaps executed anonymously on a national securities 
exchange or a security-based swap execution facility (``SBSEF''), 
provided that:
     Such security-based swaps are intended to be cleared and 
are actually submitted for clearing to a clearing agency;
     All terms of such security-based swaps conform to the 
rules of the clearing agency; and
     Upon acceptance of such security-based swap by the 
clearing agency: (1) The original security-based swap is extinguished; 
(2) the original security-based swap is replaced by equal and opposite 
security-based swaps with the clearing agency; and (3) all terms of the 
security-based swap shall conform to the product specifications of the 
cleared security-based swap established under the clearing agency's 
rules.
    The exception in proposed Rule 15Fi-5(a)(1)(iii) is intended to 
recognize the fact that the documentation requirements may be largely 
impossible to comply with in the context of cleared anonymous 
transactions by virtue of the fact that, by definition, the parties to 
these transactions would not know the identity their counterparties. 
Therefore, trading relationship documentation with any such 
counterparty would be unnecessary and impractical.
    The exception provided for in proposed Rule 15Fi-5(a)(1)(iii) is 
limited--and therefore distinguishable from the exception for cleared 
security-based swap transactions--in one important respect to account 
for instances where a transaction is not accepted for clearing 
following its submission. For example, an SBS Entity may enter into a 
security-based swap transaction on an anonymous basis on a national 
securities exchange or an SBSEF, fully intending for the transaction to 
be submitted to, and cleared by, a clearing agency. In some cases, the 
transaction may be rejected by the clearing agency for reasons which 
the SBS Entity did not know (or had no reasonable basis to know) prior 
to its submission, such as possible operational or clerical errors or 
if one of the clearing members unintentionally exceeded its clearing 
limits. If a bilateral transaction continues to exist between the two 
counterparties (who would no longer be unknown to each other), written 
trading relationship documentation governing that transaction might not 
exist between them.
    Under those circumstances, the Commission preliminarily believes 
that the objectives of Rule 15Fi-5 would not be satisfied if the SBS 
Entity and its counterparty did not ultimately have written agreement 
on the terms of the remaining security-based swap transaction. At the 
same time, however, because the transaction was initially entered into 
on an anonymous basis, the two sides might need additional time to 
agree to the terms of the trading relationship documentation, 
particularly if they previously had not engaged in any other 
transactions. Accordingly, the Commission is proposing that if an SBS 
Entity that is relying on the exception in proposed Rule 15Fi-
5(a)(1)(iii) subsequently receives notice that the relevant security-
based swap transaction has not been accepted for clearing by a clearing 
agency, the applicable policies and procedures would need to require 
that the SBS Entity be in compliance with the requirements of proposed 
Rule 15Fi-5 in all respects promptly after receipt of such notice.\108\
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    \108\ The provisions in proposed Rule 15Fi-5(a)(iii) to account 
for cleared anonymous transactions that are submitted for clearing, 
but ultimately not accepted, are not included in CFTC Rule 23.504. 
We have included this provision to account for situations when an 
SBS Entity could be otherwise deemed to be not in compliance with 
proposed Rule 15Fi-5 due to a transaction being rejected for 
clearing for reasons which the SBS Entity did not know (or have a 
reasonable basis to know) prior to when the transaction was 
submitted to the clearing agency.
---------------------------------------------------------------------------

    The Commission notes that whether a contract that has not been 
accepted for

[[Page 4632]]

clearing by a clearing agency continues to exist may depend on the 
rules of the particular SBSEF, national securities exchange, or 
clearing agency, or the agreement of the counterparties. If the end 
result is that a security-based swap continues to exist despite being 
rejected by the clearing agency, then the policies and procedures would 
need to require that the SBS Entity be in compliance with the 
requirements of Rule 15Fi-5 with respect to that transaction. If the 
rejection from clearing results in a termination or voiding of the 
original security-based swap, then there is no security-based swap for 
which it is necessary to comply with Rule 15Fi-5.
7. Comments Requested
    The Commission generally requests comments on all aspects of 
Proposed Rule 15Fi-5 (and any related definitions). In addition, the 
Commission requests comments on the following specific issues:
     Do commenters agree with the scope of the proposed 
exception from the trading relationship documentation requirements in 
proposed Rule 15Fi-5 for clearing transactions? Why or why not? Because 
the definition of ``clearing transactions'' only includes transactions 
cleared at a clearing agency registered with the Commission pursuant to 
Section 17A of the Exchange Act, security-based swaps cleared at a 
foreign clearing agency that is not registered with the Commission 
would not be deemed to be ``cleared'' for these purposes, and would 
therefore be subject to proposed Rule 15Fi-5. Should the Commission 
modify the scope of the exception for cleared security-based swaps, 
such as by including transactions that are cleared at a clearing agency 
that is not registered with the Commission pursuant to Section 17A of 
the Exchange Act, whether because of an applicable exemption from 
registration or because Exchange Act does not cover the activities of 
the clearing agency? Why or why not?
     Do commenters agree with the proposed exception from the 
trading relationship documentation requirements for security-based 
swaps executed anonymously on a national securities exchange or an 
SBSEF? Is it sufficiently comprehensive? Why or why not? The proposed 
exception also provides that if a security-based swap executed 
anonymously on a platform is subsequently rejected for clearing, the 
SBS Entity would then be required to come into compliance with the 
documentation requirements ``promptly'' after receipt of the notice of 
rejection. Do you agree with this approach? Why or why not? Should the 
Commission define or provide an interpretation of the word ``promptly'' 
for these purposes or, as an alternative, specify a fixed period of 
time in the rule text in which SBS Entities would be required to comply 
with proposed Rule 15Fi-5? Why or why not and, if so, how much time 
should be provided?
     Are there any current industry practices that relate to 
how counterparties to swaps and security-based swaps treat transactions 
executed anonymously on a trading platform, but subsequently rejected 
for clearing? If any such practices exist, please describe them, 
including with regard to the length of time that it typically takes to 
document these transactions, if they remain in effect.
     With respect to any Swap Entity that could potentially 
register with the Commission as an SBS Entity, would the documentation 
protocols (or any other applicable documentation) already in existence 
with respect to CFTC Rule 23.504 satisfy the requirements in proposed 
Rule 15Fi-5? Why or why not? Should proposed Rule 15Fi-5 be modified to 
account for the way that market participants have designed their 
existing protocols (or any other applicable documentation) to be 
compliant with the CFTC's rules? Why or why not? For the purposes of 
compliance with the proposed documentation rules, should the Commission 
allow compliance with the CFTC's parallel documentation rules for some 
period of time to allow dual SEC-CFTC registrants to conform their 
existing documentation protocols (or any other applicable 
documentation) following the adoption of proposed Rule 15Fi-5? If so, 
on what factors should that reliance be conditioned and how long of a 
compliance period should be provided? In the alternative, should the 
Commission delay compliance with, or establish phased compliance 
deadlines for, some or all of these requirements? Please explain the 
nature of any compliance challenges (including any additional 
documentation requirements), and the basis for any suggested compliance 
period.
     As previously noted, proposed Rule 15Fi-5 has been 
designed to be as consistent as possible with CFTC Rule 23.504, which 
imposes trading relationship documentation requirements on Swap 
Entities, in order to avoid requiring dual SEC-CFTC registrants to 
incur additional systems or compliance costs due to differences between 
the two agencies' approaches. To the extent that any such differences 
remain, should the Commission consider, for any firm dually-registered 
as both an SBS Entity and Swap Entity (regardless of whether such firm 
is also registered with the Commission as a broker-dealer or with the 
CFTC as a futures commission merchant), permitting such firm to comply 
with proposed Rule 15Fi-5 on an ongoing basis by complying with CFTC 
Rule 23.504, as if such rule applied to security-based swaps? If so, 
what conditions, if any, should be placed on such reliance?
     In addition to the exceptions set forth in the proposed 
rule, are there other types of security-based swaps that should not be 
subject to the underlying trading relationship documentation 
requirements?
     Should the Commission require that the policies and 
procedures governing the required written security-based swap trading 
relationship documentation be approved by a senior officer of the SBS 
Entity, as is currently contemplated pursuant to proposed Rule 15Fi-5? 
Why or why not? As an alternative to requiring action by a senior 
officer, should such approval come instead from the governing body of 
the SBS Entity? Why or why not? As an additional alternative, should 
the Commission consider requiring approval of those policies and 
procedures by someone below the senior officer level? If so, who within 
an SBS Entity should approve them?
     For purposes of the requirement that a senior officer 
approve the policies and procedures required by proposed Rule 15Fi-5, 
the Commission has preliminarily interpreted the term ``senior 
officer'' as covering only the most senior executives in the 
organization, such as a firm's chief executive officer, chief financial 
officer, chief legal officer, chief compliance officer, president, or 
other person at a similar level. Do commenters agree with such 
interpretation? Why or why not? Does the proposed interpretation create 
any differences with respect to the manner in which Swap Entities are 
required to comply with CFTC Rule 23.504(a)(2), which uses the term 
``senior management''? Should the explanation included in the 
Commission's proposed interpretation instead be included in the rule 
text?
     Proposed Rule 15Fi-5 does not contain a comprehensive list 
of all of the terms that should be addressed in the required security-
based swap trading relationship documentation. Rather, it provides that 
the documentation must include ``all terms governing the trading 
relationship'' between the SBS Entity and its counterparty and also 
contains a non-exclusive list of terms that must be

[[Page 4633]]

included. Do commenters agree with that approach? Why or why not? 
Should the Commission consider modifying the list of terms specifically 
identified in proposed Rule 15Fi-5(b)(1)?
     Should the Commission provide any additional specificity 
and/or guidance as it relates to one or more of the terms identified in 
proposed Rule 15Fi-5(b)(1) as required to be included in the trading 
relationship documentation? For example, should the rule specify the 
types of payment obligation terms that should be addressed in the 
documentation? Are there any particular details regarding potential 
events of default or termination events that should be specified in the 
documentation? Should the information requirements regarding the terms 
of the credit support arrangements between the two parties be modified 
in any way? In each case, why or why not and what additional details or 
guidance should be provided?
     Proposed Rule 15Fi-5(b)(1) requires that the security-
based swap trading relationship documentation that SBS Entities execute 
with the counterparties include terms addressing dispute resolution. 
Should the Commission provide any additional specificity with respect 
to this proposed requirement, including by identifying what particular 
aspects of the dispute resolution process should be addressed in the 
documentation? For example, should the documentation include specific 
requirements regarding the methods for identifying, recording, and 
monitoring disputes? Should the terms governing dispute resolution 
identify specific time periods applicable to the process? Are there 
particular aspects regarding communications between the counterparties 
that should be specified in connection with the terms related to 
dispute resolution, such as the method for providing notice of a 
potential or actual dispute? In each case, why or why not, and what 
additional details or guidance should be provided?
     Proposed Rule 15Fi-5(b)(4) would require SBS Entities to 
include in their security-based swap trading relationship documentation 
with certain counterparties written agreement on the terms for valuing 
security-based swaps for the purposes of complying with the margin and 
risk management requirements. Do you agree with the scope of that 
requirement? Why or why not? Should these requirements apply to an SBS 
Entity's transactions with all counterparties, including non-financial 
counterparties, without regard to whether they are requested? Why or 
why not? Is there any additional information that should be included in 
this requirement, or should any of the proposed requirements be 
modified or deleted? Do the provisions related to valuation 
discrepancies provide a sufficient basis for helping to ensure that 
disputes related to the value of a security-based swap are resolved in 
as efficient a manner as possible, or should any changes be made to 
these requirements? Should the requirements regarding valuation be 
modified in any way to account for the use of internal and/or 
proprietary inputs and models? In each case, why or why not, and how 
and why should the proposed rule be modified?
     Are the protections in the proposed rule regarding the 
treatment of confidential, proprietary information in connection with 
the required valuation agreement sufficient to meet the needs of both 
the party providing the information and the party receiving it? If not, 
how should the proposal be revised to address any such concerns?
     In addition to the terms governing the valuation agreement 
in proposed Rule 15Fi-5(b)(4), are there any other requirements that 
should be limited to, or modified for, certain types of counterparties 
(e.g., financial counterparties)? If so, which ones, and what 
particular requirements should apply?
     Do the disclosure requirements in paragraphs (5) and (6) 
of proposed Rule 15Fi-5(b), as they relate to the ``insured depository 
institution'' or ``financial company'' status of the SBS Entity or its 
counterparty and to the status of a security-based swap accepted for 
clearing, respectively, provide useful and relevant information to 
counterparties to security-based swaps? Why or why not? Should any 
other disclosure requirements be modified or deleted? If so, which ones 
and how? Should any additional disclosure requirements be added to the 
proposed rule? If so, what should be added and why?
     Do commenters agree with the scope of the proposed 
definition of ``financial counterparty'' in proposed Rule 15Fi-1(g), 
which is used for determining when the required security-based swap 
trading relationship documentation would need to include the valuation 
methodology set forth in proposed Rule 15Fi-5(b)(4)? Should that 
definition be expanded to include other types of financial entities, 
such as SEC-registered broker-dealers, investment companies, or 
investment advisers? If so, which types of entities should be added to 
the definition and why?
     Do commenters agree with the proposed requirements related 
to the performance of periodic audits of the SBS Entity's security-
based swap relationship documentation, as set forth in proposed Rule 
15Fi-5(c)? Why or why not? If not, how should they be clarified? Should 
the Commission provide any additional specificity regarding what 
constitutes ``independence'' for these purposes? If so, how should that 
standard be measured and evaluated? For example, the Commission has 
extensive experience with respect to determining what constitutes 
``independence'' in the context of accountants that audit and review 
financial statements and prepare attestation reports filed with the 
Commission, including in connection with rules adopted pursuant to 
Title II of the Sarbanes-Oxley Act of 2002. Should the Commission 
consider leveraging particular aspects of that experience in connection 
with refining the requirements in proposed Rule 15Fi-5(c)? If so, 
please explain.
     Are there any circumstances under which an internal 
auditor could be considered to be ``independent'' for purposes of 
proposed Rule 15Fi-5(c)? If so, please explain. If not, should the 
Commission consider eliminating the requirement that the auditor be 
independent in order to allow for internal audits of the SBS Entity's 
security-based swap relationship documentation? If so, are there 
particular conditions that should be included in the requirement in 
order to maintain the integrity of the audit process?
     Should the person performing the audit of the SBS Entity's 
security-based swap relationship documentation pursuant to proposed 
Rule 15Fi-5(c) be subject to any qualification requirements, such as 
the requirement to be registered with the Public Company Accounting 
Oversight Board (``PCAOB'')? If so, which qualifications should be 
required and why? If not, should proposed Rule 15Fi-5(c) be clarified 
to state explicitly that PCAOB registration is not a condition of the 
rule?
     Should SBS dealers and major SBS participants be treated 
the same for purposes of the portfolio reconciliation requirements in 
proposed Rule 15Fi-5? Why or why not?

E. Verification of Transaction Data by SDRs

    In light of certain of the rules we are proposing today, the 
Commission believes it to be an appropriate time to revisit and request 
comment on an issue previously identified in connection with the rules 
applicable to the registration and ongoing regulation of SDRs. As 
background, Section 13(n) of the

[[Page 4634]]

Exchange Act establishes a regulatory regime for the operation of and 
governance of SDRs.\109\ Among other things, Section 13(n)(5)(B) 
requires each registered SDR to ``confirm with both counterparties to 
the security-based swap the accuracy of the data that was submitted.'' 
\110\ On February 15, 2015, the Commission adopted Rules 13n-1 to 13n-
12, which govern the SDR registration process, duties, and core 
principles.\111\ Among other core principles governing the registration 
and ongoing obligations of SDRs, Rule 13n-4(b)(3) implements the 
statutory requirement set forth in Section 13(n)(5)(B) by requiring 
SDRs to confirm, as prescribed in Rule 13n-5, with both counterparties 
to the security-based swap the accuracy of the data that was 
submitted.\112\
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    \109\ Section 3(a)(75) of the Exchange Act defines the term 
``security-based swap data repository'' to mean ``any person that 
collects and maintains information or records with respect to 
transactions or positions in, or the terms and conditions of, 
security-based swaps entered into by third parties for the purpose 
of providing a centralized recordkeeping facility for security-based 
swaps.'' 15 U.S.C. 78c(a)(75).
    \110\ See 15 U.S.C. 78m(n)(5).
    \111\ See Security-Based Swap Data Repository Registration, 
Duties, and Core Principles, Exchange Act Release No. 74246 (Feb. 
11, 2015), 80 FR 14437 (Mar. 19, 2015) (``SDR Adopting Release'').
    \112\ See 17 CFR 240.13n-4(b)(3).
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    As part of the process of implementing the SDR rules, at least one 
former SDR applicant expressed reservations and concerns about the 
burdens of requiring SDRs to reach out to counterparties who are not 
its members to verify accuracy of the data.\113\ The Commission 
understands these concerns and the difficulty SDRs could face when 
attempting to contact counterparties to a security-based swap 
transaction with whom the SDR has no existing relationship. At the same 
time, however, the Commission also recognizes the importance of 
ensuring that the security-based swap data reported to an SDR is 
complete and accurate.
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    \113\ See, e.g., Letter from Michael C. Bodson, President and 
Chief Executive Officer, The Depository Trust & Clearing 
Corporation, and Larry E. Thompson, Chairman, DTCC Data Repository 
(U.S.) LLC (``DDR''), Managing Director and Vice Chairman, The 
Depository Trust & Clearing Corporation, dated Sept. 22, 2017, 
regarding DDR's application for registration as an SDR (withdrawn on 
Mar. 27, 2018), available at: https://www.sec.gov/comments/sbsdr-2016-02/sbsdr201602-2590214-161092.pdf (noting the difficulty an SDR 
faces with respect to outreach to the non-reporting side of a 
security-based swap when that non-reporting counterparty is not a 
member of an SDR and proposing that Section 13(n)(5)(B) and 
corresponding Rule 13n-4(b)(3) be interpreted as requiring SDRs to 
confirm the accuracy of the security[hyphen]based swap solely with 
counterparties who are its members).
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    Accordingly, the Commission preliminarily believes that certain 
provisions in proposed Rules 15Fi-3 and 15Fi-5, if adopted and taken 
together, could be relevant to SDRs in seeking to meet their 
obligations under Section 13(n)(5)(B) and Rule 13n-4(b)(3). As we 
explained in connection with adopting the SDR rules, SDRs may be able 
to reasonably rely on certain third parties to address the accuracy of 
the transaction data.\114\ For example, the Commission previously 
stated that if an SDR develops reasonable policies and procedures that 
rely on confirmations completed by another entity, such as a third-
party confirmation provider, as long as such reliance is reasonable the 
SDR could use such confirmation to fulfill its obligations under 
certain SDR rules.\115\ Because the two relevant provisions that we are 
proposing today generally relate to the obligation of SBS Entities to 
take certain steps in the reconciliation and documentation processes 
related specifically to the reporting of the relevant security-based 
swap data to an SDR, including by clarifying the reporting obligations 
of the counterparties, the Commission believes that, like the previous 
example, these measures, taken together, could provide an SDR with a 
set of factors to assess the reasonableness of relying on an SBS 
Entity's ability to independently provide the definitive report of a 
given security-based swap position, thereby providing a basis for the 
SDR to satisfy its statutory and regulatory obligations to verify the 
accuracy of the reported data when the SBS Entity's counterparty is not 
a member of the SDR. The Commission requests comment on whether this 
preliminary analysis is accurate.
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    \114\ Cf. SDR Adopting Release, 80 FR at 14491.
    \115\ See id.
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1. Reconciliation of Terms Submitted to an SDR
    As described above in Section I.B.2, the definition of ``material 
terms'' in proposed Rule 15Fi-1(i), which identifies the information 
that SBS Entities would be required to reconcile with their 
counterparties, differs based on whether a security-based swap 
transaction had previously been included in a security-based swap 
portfolio for purposes of the portfolio reconciliation requirements in 
proposed Rule 15Fi-3. With respect to any security-based swap that has 
not yet been reconciled as part of, a security-based swap portfolio, 
``material terms'' would be defined to mean each term that is required 
to be reported to a registered SDR under Rule 901 under the Exchange 
Act.\116\ With respect to all other security-based swaps within a 
security-based swap portfolio, the definition of ``material terms'' 
would exclude any term that is not relevant to the ongoing rights and 
obligations of the parties and the valuation of the security-based 
swap.
---------------------------------------------------------------------------

    \116\ See proposed Rule 15Fi-1(i)(1) (referencing 17 CFR 
242.901).
---------------------------------------------------------------------------

    As we also previously noted in Section I.B.2, the Commission 
preliminarily believes that there are potential benefits, both to SBS 
Entities and potentially to the security-based swap market as a whole, 
of requiring firms to initially reconcile all of the information 
required to be reported to an SDR. Specifically, doing so helps to 
ensure that the data reported to an SDR, and ultimately disseminated to 
the public, is accurate and complete. Section 13(n)(5)(B) of the 
Exchange Act and Rule 13n-4(b)(3) are both intended to accomplish the 
same objective of transparency regarding complete and accurate 
security-based swap data. Accordingly, like the previous example 
involving the third-party confirmation process, it may be appropriate 
to allow an SDR to meet its obligations by reasonably relying on an SBS 
Entity. Such reliance could be based, at least in part, on that fact 
that the SBS Entity would be subject to the portfolio reconciliation 
requirements in proposed Rule 15Fi-3 using the proposed definition of 
``material terms'' in Rule 15Fi-1(i), were it to be adopted, to 
initially reconcile all of the terms of a transaction required to be 
reported to an SDR or the Commission pursuant to Rule 901, particularly 
in cases when the SBS Entity's counterparty is not onboarded to the 
SDR.\117\ The Commission seeks comment on whether this preliminary 
analysis is accurate.
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    \117\ The Commission also notes that Rule 905(a) of Regulation 
SBSR, which was adopted in 2015, generally imposes a duty to correct 
on any counterparty to a security-based swap (or any other person 
having a duty to report the security-based swap) that discovers an 
error in the information reported with respect to that security-
based swap. See 17 CFR 242.905(a). Accordingly, if any discrepancies 
are identified in the course of satisfying the portfolio 
reconciliation requirements contained in proposed Rule 15F-3 that 
resulted in incorrect information having been reported to an SDR, 
then the SBS Entity would be required to follow the procedures set 
forth in Rule 905(a) to correct any erroneous information with the 
SDR.
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2. Documentation of Regulatory Reporting Obligations
    As discussed above in Section I.D, proposed Rule 15Fi-5 would 
require each SBS Entity to establish, maintain, and follow written 
policies and procedures reasonably designed to ensure that it executes 
written security-

[[Page 4635]]

based swap trading relationship documentation with each of its 
counterparties prior to, or contemporaneously with, executing a 
security-based swap with any counterparty. Paragraph (b)(1) of that 
rule requires that the trading relationship documentation be in writing 
and also sets forth the minimum set of items that must be addressed by 
the documentation including, among other things, the allocation of any 
applicable regulatory reporting obligations (including pursuant to 
Regulation SBSR).\118\
---------------------------------------------------------------------------

    \118\ See 17 CFR 242.901(a).
---------------------------------------------------------------------------

    Rule 901(a) of Regulation SBSR establishes a ``reporting 
hierarchy'' that specifies which counterparty to a security-based swap 
has the duty to report the transaction. Where possible, the rule 
assigns the reporting duty to the side that is registered with the 
Commission as an SBS Entity. Thus, if only one of the counterparties to 
a security-based swap transaction is an SBS Entity, then such SBS 
Entity will be the reporting side. In addition, if one counterparty to 
a security-based swap transaction is an SBS dealer and the other is a 
major SBS participant, the SBS dealer will be the reporting side. 
However, if both counterparties to a security-based swap transaction 
are SBS dealers (or both are major SBS participants), the sides are 
required to select the reporting side. The selection of the reporting 
side is an example of the type of ``applicable reporting obligation'' 
that proposed Rule 15Fi-5(b)(1) would cover.
    Accordingly, the Commission preliminarily believes that requiring 
SBS Entities to address any applicable regulatory reporting obligations 
in the written trading relationship documentation that it executes with 
their counterparties also could be relevant to SDRs in seeking to meet 
their obligations under Section 13(n)(5)(B) and Rule 13n-4(b)(3). For 
example, to the extent that only one counterparty to a security-based 
swap is an SBS Entity, the trading relationship documentation could be 
used to memorialize the fact that the SBS Entity is the reporting party 
for purposes of Rule 901(a), and that such SBS Entity will be 
responsible for verifying the accuracy of each security-based swap 
transaction with the SDR.
3. Comments Requested
    The Commission generally requests comments on the issues described 
above. In addition, the Commission requests comments on the following 
specific issues:
     Do you agree with the analysis described above, 
particularly as to how parts of proposed Rules 15Fi-3 (including the 
definition of ``material terms'' in proposed Rule 15Fi-1(i)) and 15Fi-5 
could help address the concerns raised by former SDR applicants with 
respect to their obligations, pursuant to Section 13(n)(5)(B) of the 
Exchange Act and Rule 13n-4(b)(3), to confirm with both counterparties 
to a security-based swap the accuracy of the data that was submitted to 
the SDR?
    [cir] Specifically, do those aspects of the proposed rules provide 
a sufficient basis, in whole or in part, for an SDR to assess whether 
it can reasonably rely on a SBS Entity's verification of transaction 
data as the basis to meet the requirements of Section 13(n)(5)(B) and 
Rule 13n-4(b)(3)? Why or why not?
    [cir] If not, should the Commission provide an exemption from the 
verification requirements described above to SDRs that reasonably rely 
on SBS Entities? Why or why not? If so, what specific terms and 
conditions should be included in such exemption and why?
    [cir] Are there other regulatory actions the Commission should 
consider to address the issue? If so, which ones and why?
     Should any aspect of the proposed analysis be modified in 
any way to account for other situations that may not be fully addressed 
here? If so, how and why? For example, would an SDR be able to 
reasonably rely on an SBS Entity to independently provide the 
definitive report of a given security-based swap position for both 
counterparties in situations when the SBS Entity is acting as agent for 
one of the two counterparties and is not itself a counterparty? Why or 
why not, and how should the analysis be revised to address that 
situation?

F. Recordkeeping Requirements

1. Proposed Amendments to Recordkeeping Rules
    The Commission also is proposing rule amendments that would modify 
certain proposed requirements contained in its April 2014 release 
proposing rules for the recordkeeping, reporting, and notification 
requirements applicable to SBS Entities.\119\ Those rule amendments 
would require each SBS Entity to make and keep current information 
relevant to each portfolio reconciliation and portfolio compression 
exercise in which it participates, and to retain a record of each 
valuation dispute notification required pursuant to proposed Rule 15Fi-
3(c), all security-based swap trading relationship documentation 
required to be created under proposed Rule 15Fi-5, a record of the 
results of each audit of the SBS Entity's security-based swap trading 
relationship documentation policies and procedures, as required 
pursuant to proposed Rule 15Fi-5(c), and each policy and procedure 
created pursuant to proposed Rules 15Fi-3 through 15Fi-5.
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    \119\ See supra note 2. Although we are proposing books and 
records requirements that would be additive to an existing proposal, 
we are not re-opening the comment period for the entirety of the SBS 
Books and Records Proposing Release. Rather, our request for comment 
in this section is limited solely to the recordkeeping requirements 
related to the rules we are proposing today.
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    Specifically, the Commission is proposing to amend: (1) Existing 
Rule 17a-3 under the Exchange Act, which applies to SBS Entities that 
are also registered with the Commission as broker-dealers under Section 
15(b) of the Exchange Act (``broker-dealer SBS Entities''), and (2) 
proposed Rule 18a-5 under the Exchange Act, which applies to SBS 
Entities that are not also registered with the Commission as broker-
dealers under Section 15(b) of the Exchange Act (``stand-alone and bank 
SBS Entities''). These proposed amendments would require each SBS 
Entity to make and keep current records of each security-based swap 
portfolio reconciliation, whether conducted pursuant to proposed Rule 
15Fi-3 or otherwise,\120\ a copy of each valuation dispute notification 
required to be provided to the Commission pursuant to proposed 
Rule15Fi-3(c),\121\ and a record of each bilateral offset and each 
bilateral portfolio compression exercise or multilateral portfolio 
compression exercise in which it participates, whether conducted 
pursuant to proposed Rule 15Fi-4 or otherwise.\122\
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    \120\ See proposed amendments to Rules 17a-3(a)(31)(i), 18a-
5(a)(18)(i), and 18a-5(b)(14)(i).
    \121\ See proposed amendments to Rules 17a-3(a)(31)(ii), 18a-
5(a)(18)(ii), and 18a-5(b)(14)(ii).
    \122\ See proposed amendments to Rules 17a-3(a)(31)(iii), 18a-
5(a)(18)(iii), and 18a-5(b)(14)(iii).
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    With respect to the reconciliation requirement, the proposed rules 
would require that these records include the dates of the security-
based swap portfolio reconciliation, the number of portfolio 
reconciliation discrepancies, the number of security-based swap 
valuation disputes (including the time-to-resolution of each valuation 
dispute and the age of outstanding valuation disputes, categorized by 
transaction and counterparty), and the name of the third-party entity 
performing the security-based swap portfolio

[[Page 4636]]

reconciliation, if any.\123\ With respect to the valuation notification 
requirement, the proposed rules would require the retention of each 
notification required to be provided to the Commission pursuant to 
proposed Rule 15Fi-3(c).\124\ With respect to compression, the proposed 
rules would require that these records include the dates of the offset 
or compression, the security-based swaps included in the offset or 
compression, the identity of the counterparties participating in the 
offset or compression, the results of the compression, and the name of 
the third-party entity performing the offset or compression, if 
any.\125\ The Commission preliminarily believes that requiring SBS 
Entities to make and retain such records will, among other things, 
promote compliance with proposed Rules 15Fi-3 and 15Fi-4, assist SBS 
Entities in the event that they need to resolve problems that relate to 
a previous reconciliation or compression, and assist Commission 
examiners in reviewing compliance with those rules.
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    \123\ See proposed amendments to Rules 17a-3(a)(31)(i), 18a-
5(a)(18)(i), and 18a-5(b)(14)(i).
    \124\ See proposed amendments to Rules 17a-3(a)(31)(ii), 18a-
5(a)(18)(ii), and 18a-5(b)(14)(ii).
    \125\ See proposed amendments to Rules 17a-3(a)(31)(iii), 18a-
5(a)(18)(iii), and 18a-5(b)(14)(iii).
---------------------------------------------------------------------------

    In addition, the Commission is proposing to amend (1) existing Rule 
17a-4 under the Exchange Act, which requires each applicable broker-
dealer, including broker-dealer SBS Entities, to preserve certain 
records if the broker-dealer makes or receives the type of record and 
(2) proposed Rule 18a-6 under the Exchange Act, which imposes parallel 
preservation requirements on stand-alone and bank SBS Entities. In 
particular, the proposed amendments to Rule 17a-4 and to proposed Rule 
18a-6 would require SBS Entities to retain all of the records required 
to be made and kept under the proposed amendments to Rule 17a-3 and 
proposed Rule 18a-5 for at least three years, the first two years in an 
easily accessible place.\126\ The proposed amendments also would 
require each SBS Entity to retain the following:
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    \126\ See proposed amendments to Rules 17a-4(b)(1), 18a-
6(b)(1)(i), and 18a-6(b)(2)(i).
---------------------------------------------------------------------------

     the written policies and procedures required pursuant to 
proposed Rules 15Fi-3 through 15Fi-5 until three years after 
termination of the use of the policies and procedures; \127\
---------------------------------------------------------------------------

    \127\ See proposed amendments to Rules 17a-4(e)(10) and 18a-
6(d)(4).
---------------------------------------------------------------------------

     each written agreement with counterparties on the terms of 
portfolio reconciliation with those counterparties as required to be 
created under proposed Rules 15Fi-3(a)(1) and (b)(1) until three years 
after the termination of the agreement and all transactions governed 
thereby; \128\
---------------------------------------------------------------------------

    \128\ See proposed amendments to Rules 17a-4(e)(11)(i) and 18a-
6(d)(5)(i).
---------------------------------------------------------------------------

     security-based swap trading relationship documentation 
with counterparties required to be created under proposed Rule 15Fi-5 
until three years after the termination of such documentation and all 
transactions governed thereby; \129\ and
---------------------------------------------------------------------------

    \129\ See proposed amendments to Rules 17a-4(e)(11)(ii) and 18a-
6(d)(5)(ii).
---------------------------------------------------------------------------

     a record of the results of each audit required to be 
performed pursuant to proposed Rule 15Fi-5(c) until three years after 
the completion of the audit.\130\
---------------------------------------------------------------------------

    \130\ See proposed amendments to Rules 17a-4(e)(11)(iii) and 
18a-6(d)(5)(iii).
---------------------------------------------------------------------------

    The Commission preliminarily believes that requiring the retention 
of the above records in accordance with the applicable rules will help 
ensure that those records are retained in a manner that would allow 
them to be readily accessible for Commission examiners.
2. Comments Requested
    The Commission generally requests comments on all aspects of the 
proposed amendments to Rules 17a-3 and 17a-4 and to proposed Rules 18a-
5, and 18a-6. In addition, the Commission requests comments on the 
following specific issues:
     Has the Commission provided sufficient guidance regarding 
the scope of the proposed recordkeeping amendments? Are there aspects 
of the proposed amendments for which the Commission should consider 
providing additional guidance? If so, please explain.
     How do the types of records that would need to be made and 
kept current under Rule 17a-3 and proposed Rule 18a-5, in each case as 
proposed to be amended in this release, align with the types of records 
that a futures commission merchant or a swap dealer is required to make 
pursuant to CFTC regulations?

II. Cross-Border Application of Rules 15Fi-3 Through 15Fi-5.

A. Background on the Cross-Border Application of Title VII Requirements

    In 2013, the Commission proposed rules and interpretive guidance to 
address the cross-border application of Title VII, including 
requirements applicable to SBS Entities.\131\ In that proposal, the 
Commission preliminarily interpreted the Title VII requirements 
associated with registration to apply generally to the activities of 
registered entities.\132\ The Commission further proposed a taxonomy to 
classify requirements under Section 15F of the Exchange Act as applying 
at either the transaction-level or at the entity-level.\133\ The 
Commission took the preliminary view that transaction-level 
requirements under Section 15F of the Exchange Act are those that 
primarily focus on protecting counterparties to security-based swap 
transactions by requiring SBS dealers to, among other things, provide 
certain disclosures to counterparties, adhere to certain standards of 
business conduct, and segregate customer funds, securities, and other 
assets.\134\
---------------------------------------------------------------------------

    \131\ See Cross-Border Security-Based Swap Activities; Re-
Proposal of Regulation SBSR and Certain Rules and Forms Relating to 
the Registration of Security-Based Swap Dealers and Major Security-
Based Swap Participants, Exchange Act Release No. 69490 (May 1, 
2013), 78 FR 30968 (May 23, 2013) (``Cross-Border Proposing 
Release'') (discussing joint rulemaking to further define various 
Title VII terms).
    \132\ See id. at 30986 (``We are proposing to apply the Title 
VII requirements associated with registration (including, among 
others, capital and margin requirements and external business 
conduct requirements) to the activities of registered entities to 
the extent we have determined that doing so advances the purposes of 
Title VII.'') (footnotes omitted).
    \133\ See id. at 31009-10.
    \134\ Id.
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    In contrast to transaction-level requirements, the Commission 
preliminarily took the view that entity-level requirements under 
Section 15F of the Exchange Act are those that are expected to play a 
role in ensuring the safety and soundness of the entity and thus relate 
to the SBS Entity as a whole.\135\ Entity-level requirements include 
capital and margin requirements, as well as other requirements relating 
to a firm's identification and management of its risk exposure, such as 
the requirements in Section 15F(i) of the Exchange Act, which provides 
the statutory basis for the rules the Commission is proposing in this 
release.\136\ Because these requirements relate to the entire entity, 
the Commission proposed to apply them to SBS Entities on a firm-wide 
basis, without exception.\137\
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    \135\ See id. at 31011.
    \136\ See id. at 31011-16 (addressing the classification of 
capital and margin requirements, as well as of the documentation 
standard requirements of Section 15F(i) of the Exchange Act and 
other risk management requirements applicable to SBS dealers).
    \137\ See id. at 31011, 31024-25. See also id. at 31035 
(applying the analysis to major SBS participants). In reaching this 
conclusion, the Commission explained that it ``preliminarily 
believes that entity-level requirements are core requirements of the 
Commission's responsibility to ensure the safety and soundness of 
registered security-based swap dealers,'' and that ``it would not be 
consistent with this mandate to provide a blanket exclusion to 
foreign security-based swap dealers from entity-level requirements 
applicable to such entities.'' Id. at 31024 (footnotes omitted). The 
Commission further expressed the preliminary view that concerns 
regarding the application of entity-level requirements to foreign 
SBS dealers would largely be addressed through the proposed approach 
to substituted compliance. See id.

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[[Page 4637]]

    The Commission first applied this taxonomy with respect to the 
rules adopted pursuant to Section 15F(i) of the Exchange Act in 2016 
when we adopted rules to implement business conduct standards for SBS 
Entities.\138\ The Commission subsequently determined that the trade 
acknowledgment and verification rules would apply at the entity-
level.\139\ The Commission has not, however, proposed or adopted a 
cross-border interpretation with respect to the portfolio 
reconciliation, portfolio compression, and trading relationship 
documentation requirements that we are now proposing.
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    \138\ See Business Conduct Standards for Security-Based Swap 
Dealers and Major Security-Based Swap Participants, Release No. 
77617 (Apr. 14, 2016), 81 FR 29960, 30061-69 (May 13, 2016) 
(``Business Conduct Standards Adopting Release''). Under this 
framework, rules relating to diligent supervision pursuant to 
Section 15F(h)(1)(B), those relating to the chief compliance officer 
under Section 15F(k) of the Exchange Act, and those relating to 
certain risk management requirements under Section 15F(j) of the 
Exchange Act were determined to be entity-level requirements that 
apply to an SBS Entity's business with foreign counterparties to the 
same extent that they apply to the SBS dealer's or major SBS 
participant's U.S. business. The remaining rules were determined to 
apply at the transaction-level.
    \139\ See Trade Acknowledgment and Verification Adopting 
Release, 81 FR at 39826.
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B. Proposed Cross-Border Interpretation

    Consistent with its approach in both the Cross-Border Proposing 
Release and the Trade Acknowledgement and Verification Adopting 
Release, the Commission believes that the requirements being proposed 
in this release pursuant to Section 15F(i) of the Exchange Act--as they 
relate to portfolio reconciliation, portfolio compression, and trading 
relationship documentation--should be treated 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.
    The Commission preliminarily believes that the requirements 
referenced above play an important role in addressing risks to the SBS 
Entity as a whole, including risks related to the entity's safety and 
soundness. As we have noted throughout this release in connection with 
describing each of the proposed rules, providing SBS Entities and their 
counterparties to security-based swap transactions with the ability to 
identify and resolve discrepancies involving key terms of their 
transactions--which is a key consideration underpinning both the 
proposed portfolio reconciliation and trading relationship 
documentation requirements--serves as an important mechanism for 
allowing SBS Entities and their counterparties to manage their internal 
risks.\140\ Similarly, portfolio compression is intended to help SBS 
Entities and their counterparties in security-based swap transactions 
manage their post-trade risks in a number of important ways, including 
by eliminating redundant uncleared derivatives transactions (as 
measured both by the number of contracts and total notional value) and 
potentially reducing a market participant's credit risk to its direct 
counterparties, including by eliminating all outstanding transactions 
with some counterparties, without affecting the market participant's 
overall economic position.\141\
---------------------------------------------------------------------------

    \140\ See supra note 14 and accompanying text.
    \141\ See supra notes 62-63 and accompanying text.
---------------------------------------------------------------------------

    An alternative approach that does not require an SBS Entity to take 
steps to manage its internal risk using portfolio reconciliation, 
compression, or standards governing trading relationship documentation 
could be expected to contribute to operational risk and legal 
uncertainty throughout the firm's entire security-based swap business, 
affecting the entity's business as a whole, and not merely specific 
security-based swap transactions. For example, as we have previously 
noted, inaccurate or incomplete trading relationship documentation 
could lead to, among other things, a collateral dispute between the 
counterparties to a security-based swap transaction. The larger the 
dispute, even if confined to a single counterparty, the greater the 
risk that an SBS Entity could experience liquidity problems on a 
firmwide basis.
    Moreover, to the extent that these risks affect the safety and 
soundness of the SBS Entity, they also may affect the firm's 
counterparties and the functioning of the broader security-based swap 
market. Continuing with the previous example, if a collateral dispute 
with a foreign counterparty creates liquidity issues throughout an SBS 
Entity, the firm could experience difficulty making payments or posting 
collateral to its other counterparties, which may include U.S. persons. 
Accordingly, the Commission preliminarily believes that it is 
appropriate to apply the proposed requirements to the entirety of an 
SBS Entity's security-based swap business.\142\
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    \142\ We recognize that the CFTC has taken a different position 
with regard to corresponding requirements pursuant to the CEA, 
classifying them as what the CFTC has termed ``Category A'' 
transaction-level requirements. See CFTC Interpretive Guidance and 
Policy Statement Regarding Compliance With Certain Swap Regulations, 
78 FR 45292, 45334 (Jul. 26, 2013).
---------------------------------------------------------------------------

C. Comments Requested

    The Commission generally requests comments on its interpretative 
guidance regarding the cross-border application of Proposed Rules15Fi-3 
through 15Fi-5. In addition, the Commission requests comments on the 
following specific issues:
     Does the proposed approach appropriately treat the 
proposed portfolio reconciliation, portfolio compression, and trading 
relationship documentation requirements as entity-level requirements 
applicable to the entire business conducted by foreign SBS Entities? If 
not, please identify any particular aspects of those proposed rules 
that should not be applied to a foreign SBS Entity, or applied only to 
specific transactions, and explain how such an approach would be 
consistent with the goals of Title VII.
     Should the Commission apply the same cross-border approach 
to the application of the proposed portfolio reconciliation, portfolio 
compression, and trading relationship documentation requirements for 
both SBS dealers and major SBS participants? If you believe that the 
approach should vary based on the type of SBS Entity involved, please 
describe how the cross-border approach for SBS dealers should differ 
from the cross-border approach for major SBS participants, and explain 
the justification for any potential differences in approach.
     What types of conflicts might a foreign SBS Entity face if 
subjected to the proposed portfolio reconciliation, portfolio 
compression, and trading relationship documentation requirements in 
more than one jurisdiction? In what situations would compliance with 
more than one of these requirements be difficult or impossible?
     As an alternative to treating the proposed requirements as 
entity-level requirements, should the Commission instead follow the 
approach taken by the CFTC and treat the proposed portfolio 
reconciliation, portfolio compression, and trading relationship 
documentation requirements (or some combination of the three) as 
transaction-level requirements? If so, to which cross-border security-
based swap

[[Page 4638]]

transactions should these requirements apply and why? Please describe 
how these requirements would apply differently if classified as 
transaction-level requirements instead of as entity-level requirements. 
Please also describe any practical challenges that would be presented 
by classifying them differently from the CFTC.

III. Availability of Substituted Compliance for Rules 15Fi-3 Through 
15Fi-5

A. Existing Substituted Compliance Rule

    In 2016, the Commission adopted Rule 3a71-6 under the Exchange Act 
to provide that non-U.S. SBS Entities could satisfy applicable business 
conduct requirements under Section 15F by complying with comparable 
regulatory requirements of a foreign jurisdiction, subject to certain 
conditions. The rule in part provides that the Commission shall not 
make a determination providing for substituted compliance unless the 
Commission determines, among other things, that the foreign regulatory 
requirements are comparable to otherwise applicable requirements.\143\ 
In adopting that substituted compliance rule, the Commission addressed 
a range of issues and concerns that commenters had raised in response 
to the substituted compliance proposal that was set forth in the Cross-
Border Proposing Release.
---------------------------------------------------------------------------

    \143\ See Business Conduct Standards Adopting Release, 81 FR at 
30074.
---------------------------------------------------------------------------

    When the Commission adopted this substituted compliance rule that 
solely addressed the business conduct rules, it stated that it expected 
to assess the potential availability of substituted compliance in 
connection with other requirements when the Commission considers final 
rules to implement those requirements.\144\ Consistent with that 
statement, the Commission subsequently amended Rule 3a71-6 in the Trade 
Acknowledgment and Verification Adopting Release to provide SBS 
Entities with the potential to avail themselves of substituted 
compliance to satisfy the Title VII trade acknowledgment and 
verification requirements.\145\
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    \144\ The Commission first addressed the potential for allowing 
market participants to satisfy certain Title VII requirements by 
complying with comparable foreign rules as a substitute in 2013 as 
part of the Cross-Border Proposing Release. Pursuant to that 
release, the Commission proposed making substituted compliance 
potentially available in connection with the requirements applicable 
to SBS dealers pursuant to Section 15F of the Exchange Act, other 
than the registration requirements applicable to dealers. See Cross-
Border Proposing Release, 78 FR at 31088, 31207-08 (proposed Rule 
3a71-5).
    \145\ See Trade Acknowledgment and Verification Adopting 
Release, 81 FR at 39827-28.
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B. Proposed Amendment to Rule 3a71-6

    The Commission is proposing to further amend Rule 3a71-6 to provide 
SBS Entities that are not U.S. persons (as defined in Rule 3a71-3(a)(4) 
of the Exchange Act) with the potential to avail themselves of 
substituted compliance to satisfy the Title VII portfolio compression, 
portfolio reconciliation, and trading relationship documentation 
requirements. In proposing to amend the rule, the Commission has 
preliminarily concluded that the principles associated with substituted 
compliance, as previously adopted in connection with both the business 
conduct requirements and the trade acknowledgement and verification 
requirements, in large part should similarly apply to the portfolio 
compression, portfolio reconciliation, and trading relationship 
documentation requirements we are proposing today. Accordingly, except 
as discussed below, the proposed substituted compliance rule would 
apply to the portfolio compression, portfolio reconciliation, and 
trading relationship documentation requirements in the same manner as 
it already applies to the business conduct requirements and the trade 
acknowledgement and verification requirements.\146\
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    \146\ The discussions in the Business Conduct Standards Adopting 
Release, including those regarding consideration of supervisory and 
enforcement practices (see id. at 30079), regarding certain multi-
jurisdictional issues (see id. at 30079-80), and regarding 
application procedures (see id. at 30080-81) are applicable to the 
proposed portfolio compression, portfolio reconciliation, and 
trading relationship documentation requirements.
---------------------------------------------------------------------------

1. Basis for Substituted Compliance in Connection With the Portfolio 
Reconciliation, Portfolio Compression, and Trading Relationship 
Documentation Requirements
    In light of the global nature of the security-based swap market and 
the prevalence of cross-border transactions within that market, there 
is the potential that the application of the Title VII portfolio 
compression, portfolio reconciliation, and trading relationship 
documentation requirements may lead to requirements that are 
duplicative of, or in conflict with, applicable foreign requirements, 
even when the two sets of requirements implement similar goals and lead 
to similar results. Those results have the potential to disrupt 
existing business relationships and, more generally, to reduce 
competition and market efficiency.\147\
---------------------------------------------------------------------------

    \147\ See generally Business Conduct Standards Adopting Release, 
81 FR at 30073-74 (addressing the basis for making substituted 
compliance available in the context of the business conduct 
requirements).
---------------------------------------------------------------------------

    To address those effects, the Commission preliminarily believes 
that under certain circumstances it may be appropriate to allow the 
possibility of substituted compliance, whereby market participants may 
satisfy the proposed portfolio compression, portfolio reconciliation, 
and trading relationship documentation requirements by complying with 
comparable foreign requirements. Allowing for the possibility of 
substituted compliance in this manner may be expected to help achieve 
the benefits of those particular risk mitigation requirements--helping 
to curb legal uncertainty and reduce credit and operational risk for 
participants in security-based swap transactions and in the broader 
market--in a way that helps avoid regulatory conflict and minimizes 
duplication, thereby promoting market efficiency, enhancing 
competition, and contributing to the overall functioning of the global 
security-based swap market. Accordingly, the Commission is proposing to 
amend paragraph (d) of Rule 3a71-6 to identify the portfolio 
compression, portfolio reconciliation, and trading relationship 
documentation requirements of Title VII as being potentially eligible 
for substituted compliance.\148\
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    \148\ Paragraph (a)(1) of the rule provides that the Commission 
may, conditionally or unconditionally, by order, make a 
determination with respect to a foreign financial regulatory system 
that compliance with specified requirements under the foreign 
financial system by an SBS dealer and/or by a registered major SBS 
swap participant, or class thereof, may satisfy the corresponding 
requirements identified in paragraph (d) of the rule that would 
otherwise apply.
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2. Comparability Criteria, and Consideration of Related Requirements
    As discussed when we first adopted Rule 3a71-6--and reiterated when 
we amended the rule pursuant to the Trade Acknowledgement and 
Verification Adopting Release--the Commission will endeavor to take a 
holistic approach in determining the comparability of foreign 
requirements for substituted compliance purposes, focusing on 
regulatory outcomes as a whole, rather than on a requirement-by-
requirement comparison.\149\ Under the proposed rule, the Commission's 
comparability assessments associated with the

[[Page 4639]]

portfolio compression, portfolio reconciliation, and trading 
relationship documentation rules accordingly will consider whether, in 
the Commission's view, the foreign regulatory system achieves 
regulatory outcomes that are comparable to the regulatory outcomes 
associated with those Exchange Act requirements.
---------------------------------------------------------------------------

    \149\ See Business Conduct Standards Adopting Release, 81 FR at 
30078-79. See also Trade Acknowledgment and Verification Adopting 
Release, 81 FR at 39828.
---------------------------------------------------------------------------

    Proposed new paragraph (d)(4) of Rule 3a71-6 would also provide 
that prior to making a substituted compliance determination in 
connection with the portfolio reconciliation, portfolio compression, 
and trading relationship documentation requirements, the Commission 
intends to consider whether the requirements of the foreign financial 
regulatory system, the duties imposed by the foreign financial 
regulatory system, and the information that is required to be provided 
to counterparties pursuant to the requirements of the foreign financial 
regulatory system, are comparable to those required pursuant to the 
applicable Exchange Act provisions.
    In application, the Commission may determine to conduct its 
comparability analyses regarding the portfolio reconciliation, 
portfolio compression, and trading relationship documentation 
requirements in conjunction with comparability analyses regarding other 
Exchange Act requirements that, like the requirements we are proposing 
today, promote risk mitigation in connection with SBS Entities. 
Accordingly, depending on the applicable facts and circumstances, the 
comparability assessment associated with the portfolio reconciliation, 
portfolio compression, and trading relationship documentation 
requirements may constitute part of a broader assessment of Exchange 
Act risk mitigation requirements, and the applicable comparability 
decisions may be made at the level of those risk mitigation 
requirements as a whole.\150\
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    \150\ We have not proposed rules making substituted compliance 
available specifically with respect to the amendments we are 
proposing to proposed Rules 18a-5 and 18a-6, which specify the 
recordkeeping, reporting, and notification requirements applicable 
to SBS Entities. Rather, to the extent that substituted compliance 
is made available with respect to those rules, we would anticipate 
that any determination made with respect to the comparability of the 
foreign financial regulatory system would address all aspects of the 
Commission recordkeeping, reporting, and notification requirements 
for SBS Entities including any amendments that we ultimately adopt 
with respect to the portfolio reconciliation, portfolio compression, 
and trading relationship document requirements.
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3. Comments Requested
    The Commission generally requests comments on all aspects of the 
proposed amendment to Rule 3a71-6. In addition, the Commission requests 
comments on the following specific issues:
     Should the Commission provide SBS Entities with the 
potential to avail themselves of substituted compliance to satisfy the 
Title VII portfolio reconciliation, portfolio compression, and trading 
relationship requirements? Why or why not? If you believe that 
substituted compliance should not be available with respect to these 
requirements, how would you distinguish this policy decision from the 
Commission's previous determination to make substituted compliance 
potentially available with respect to other Title VII requirements 
(i.e., the business conduct rules and the trade acknowledgment and 
verification rules)?
     Do commenters agree with the scope and language of the 
proposed amendment to Rule 3a71-6? Why or why not? Are there aspects of 
the scope of the proposed rule for which the Commission should consider 
providing additional guidance? If so, what additional guidance should 
be provided and why?
     Are the items identified in the proposed amendment to Rule 
3a71-6 as factors the Commission will consider prior to making a 
substituted compliance determination in connection with the portfolio 
reconciliation, portfolio compression, and trading relationship 
documentation requirements appropriate? Why or why not? Should any of 
those items be modified or deleted? Should additional considerations be 
added? If so, please explain.

IV. General Request for Comment

    We request and encourage any interested person to submit comments 
regarding the proposed rules, specific issues discussed in this 
release, and other matters that may have an effect on the proposed 
rules. With regard to any comments, we note that such comments are of 
particular assistance to our rulemaking initiative if accompanied by 
supporting data and analysis of the issues addressed in those comments. 
In addition, we would appreciate any comments related to the 
comparability of the rules we are proposing today and the corresponding 
CFTC rules already in effect, including whether certain aspects of the 
proposed rules should be modified to more fully conform to the CFTC's 
rules. In comparing the two sets of rules, commenters are encouraged to 
identify any areas where the proposed rules may not be sufficiently 
aligned with the corresponding CFTC rules, such that they could impose 
unnecessary burdens (with respect to documentation or otherwise) on 
persons likely to register with the Commission as SBS Entities who are 
also registered with the CFTC as Swap Entities.

V. Paperwork Reduction Act

    The Paperwork Reduction Act of 1995 (``PRA'') \151\ imposes certain 
requirements on federal agencies in connection with the conducting or 
sponsoring of any ``collection of information.'' \152\ For example, 44 
U.S.C. 3507(a)(1)(D) provides that before adopting (or revising) a 
collection of information requirement, an agency must, among other 
things, publish a notice in the Federal Register stating that the 
agency has submitted the proposed collection of information to the 
Office of Management and Budget (``OMB'') and setting forth certain 
required information, including: (1) A title for the collection 
information; (2) a summary of the collected information; (3) a brief 
description of the need for the information and the proposed use of the 
information; (4) a description of the likely respondents and proposed 
frequency of response to the collection of information; (5) an estimate 
of the paperwork burden that shall result from the collection of 
information; and (6) notice that comments may be submitted to the 
agency and director of OMB.\153\
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    \151\ 44 U.S.C. 3501 et seq.
    \152\ See 44 U.S.C. 3502(3).
    \153\ See 44 U.S.C. 3507(a)(1)(D); see also 5 CFR 
1320.5(a)(1)(iv).
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    Certain provisions of the proposed rules contain ``collection of 
information'' requirements within the meaning of the PRA. The 
Commission is submitting these collections of information to OMB for 
review in accordance with 44 U.S.C. 3507 and 5 CFR 1320.11. An agency 
may not conduct or sponsor, and a person is not required to respond to, 
a collection of information unless it displays a currently valid 
control number.
    Specifically, proposed Rules 15Fi-3, 15Fi-4, and 15Fi-5 would 
impose new collection of information requirements. The title of these 
new collections of information is, collectively, ``Rules 15Fi-3--15Fi-
5--Risk Mitigation Techniques for Uncleared Security-Based Swaps.'' OMB 
has not yet assigned a control number to these new collections of 
information. In addition, the proposals to amend Rules 3a71-6, 17a-3 
and 17a-4 would amend already-existing collection of information 
requirements. Finally, the proposals to amend proposed Rules 18a-5 and 
18a-6 would amend proposed collection of information requirements that 
were previously submitted to OMB for review

[[Page 4640]]

in connection with the SBS Books and Records Proposing Release. The 
titles and control numbers for these collections of information are as 
follows:
    (1) Rule 17a-3--Records to be made by certain brokers and dealers 
(OMB control number 3235-0033);
    (2) Rule 17a-4--Records to be preserved by certain brokers and 
dealers (OMB control number 3235-0279);
    (3) Rule 18a-5--Records to be made by certain security-based swap 
dealers and major security-based swap participants (OMB control number 
3235-0745);
    (4) Rule 18a-6--Records to be preserved by certain security-based 
swap dealers and major security-based swap participants (OMB control 
number 3235-0751); and
    (5) Rule 3a71-6--Substituted Compliance for Foreign Security-Based 
Swap Dealers (OMB control number 3235-0715).

A. Summary of Collections of Information

1. Proposed Rule 15Fi-3: Portfolio Reconciliation
    Proposed Rule 15Fi-3 generally would require SBS Entities to (1) 
engage in periodic portfolio reconciliation activities with 
counterparties who are also SBS Entities, and (2) establish, maintain, 
and follow written policies and procedures reasonably designed to 
ensure that they engage in periodic portfolio reconciliation with 
counterparties who are not SBS Entities.\154\ Among other things, 
proposed Rule 15Fi-3 would specify the requirements applicable to an 
SBS Entity for purposes of engaging in portfolio reconciliation with 
either type of counterparty (as well as the applicable definitions), 
with regard to (1) the information that the two sides would be required 
to exchange as part of the reconciliation process,\155\ (2) the 
frequency by which an SBS Entity would be required to reconcile its 
security-based swap portfolios with its counterparties,\156\ (3) the 
required policies and procedures specifying the means and timeframes by 
which an SBS Entity would be required to resolve discrepancies with 
respect to either the valuation or a material term of a security-based 
swap,\157\ and (4) the requirement that an SBS Entity agree in writing 
with each of its counterparties on the terms of the portfolio 
reconciliation, including agreement of the selection of any third-party 
service provider.\158\ Finally, proposed Rule 15Fi-3(c) would require 
an SBS Entity to promptly notify the Commission of any security-based 
swap valuation dispute in excess of $20,000,000 (or its equivalent in 
any other currency) if not resolved within: (1) Three business days, if 
the dispute is with a counterparty that is an SBS Entity; or (2) five 
business days, if the dispute is with a counterparty that is not an SBS 
Entity.\159\
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    \154\ Proposed Rule 15Fi-3 would not apply to any security-based 
swap that has a clearing agency as a direct counterparty.
    \155\ See supra Section I.B.2.
    \156\ See supra Sections I.B.3 and I.B.5.
    \157\ See supra Sections I.B.4 and I.B.5.
    \158\ See supra Sections I.B.3 and I.B.5.
    \159\ See supra Section I.B.6.
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2. Proposed Rule 15Fi-4: Portfolio Compression
    Proposed Rule 15Fi-4 would require SBS Entities to establish, 
maintain, and follow written policies and procedures related to 
bilateral offsetting of security-based swaps, and periodic bilateral 
and multilateral compression exercises. Specifically, proposed Rules 
15Fi-4(a)(2) and (3) would require each SBS Entity to establish, 
maintain, and follow written policies and procedures for periodically 
engaging in both bilateral portfolio compression exercises and 
multilateral portfolio compression exercises, in each case when 
appropriate, with each counterparty that is an SBS Entity.\160\ 
Similarly, proposed Rule 15Fi-4(a)(1) would require each SBS Entity to 
establish, maintain, and follow written policies and procedures for 
terminating each ``fully offsetting security-based swap'' that it 
maintains with another SBS Entity in a timely fashion, when 
appropriate.\161\ To the extent that an SBS Entity transacts with a 
counterparty that is not an SBS Entity, proposed Rule 15Fi-4(b) 
provides that such policies and procedures would only need to address 
terminating each ``fully offsetting security-based swap'' or engaging 
in a bilateral or multilateral portfolio compression exercise, when 
appropriate and to the extent requested by any such counterparty.\162\
---------------------------------------------------------------------------

    \160\ See supra Section I.C.2.
    \161\ See supra Section I.C.3.
    \162\ See supra Section I.C.2 and I.C.3.
---------------------------------------------------------------------------

3. Proposed Rule 15Fi-5: Written Trading Relationship Documentation
    Proposed Rule 15Fi-5 would require that each SBS Entity enter into 
written trading relationship documentation with each of its 
counterparties, subject to certain exceptions, prior to, or 
contemporaneously with, executing a security-based swap transaction, in 
each case in the manner as provided for in the rule.\163\ The proposed 
rule also requires that the trading relationship documentation include 
(1) credit support arrangements addressing certain specified items 
related to, among other things, margin haircuts, and custody of margin 
assets \164\ and (2) agreements regarding the means by which the 
counterparties would determine the value of each security-based 
swap.\165\ The proposal also contains requirements for SBS Entities and 
their counterparties to disclose to each other certain information 
regarding their legal and bankruptcy status, and to include a statement 
regarding the status of a security-based swap if accepted for clearing 
by a CCP.\166\ Finally, the proposal 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.\167\
---------------------------------------------------------------------------

    \163\ See supra Section I.D.2. The proposed rule would require 
that the security-based swap trading relationship documentation 
address, among other things, 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, governing law, valuation and dispute 
resolution.
    \164\ See id.
    \165\ See supra Section I.D.3.
    \166\ See supra Section I.D.4.
    \167\ See supra Section I.D.5.
---------------------------------------------------------------------------

4. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: Books 
and Records Requirements
    Rule 17a-3 requires a broker-dealer to make and keep current 
certain records, and Rule 17a-4 requires a broker-dealer to preserve 
certain records if it makes or receives them.\168\ The Commission is 
proposing to amend these existing rules to account for the security-
based swap risk mitigation activities of broker-dealers, including 
broker-dealer SBS Entities, by requiring the making and preserving of 
any required records regarding portfolio reconciliation, bilateral 
offsets, bilateral or multilateral portfolio compression, valuation 
disputes, and written trading relationship documentation. With respect 
to stand-alone SBS Entities, the Commission is proposing to amend 
proposed Rules 18a-5 and 18a-6--which were first proposed in 2014 and 
are themselves modeled on Rule 17a-3 and 17a-4--to account for these 
same risk mitigation requirements.\169\
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    \168\ 17 CFR 240.17a-3; 17 CFR 240.17a-4.
    \169\ See supra Section I.F.1.

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[[Page 4641]]

5. Proposed Amendment to Rule 3a71-6: Substituted Compliance
    The proposed amendment to Rule 3a71-6 would permit non-U.S. SBS 
Entities to comply with the proposed portfolio reconciliation, 
portfolio compression, and written trading relationship documentation 
requirements by following the comparable regulatory requirements of a 
foreign financial regulatory system. Specifically, the proposal would 
add proposed Rules 15Fi-3 through 15Fi-5 to the list of Commission 
requirements eligible for a substituted compliance determination and 
would set forth the standard by which the Commission would make such 
determination.\170\
---------------------------------------------------------------------------

    \170\ See supra Sections III.B.1 and III.B.2.
---------------------------------------------------------------------------

B. Proposed Use of Information

1. Proposed Rule 15Fi-3: Portfolio Reconciliation
    As previously noted, the Commission preliminarily believes that the 
information shared by counterparties to a security-based swap 
transaction periodically during the portfolio reconciliation process, 
as contemplated by proposed Rule 15Fi-3, will play an important role in 
assisting those counterparties in identifying and resolving 
discrepancies involving key terms of their transactions on an ongoing 
basis. This information also should allow those counterparties to 
improve their management of internal risks related to the enforcement 
of their rights and the performance of their obligations under a 
security-based swap. For example, the information obtained and provided 
in the course of portfolio reconciliation should help ensure that the 
counterparties to a security-based swap are and remain in agreement 
with respect to all material terms throughout the life of the 
transaction, thereby mitigating the possibility that a discrepancy 
could unexpectedly affect either side's ability to perform any or all 
of its obligations under the contract, including those obligations 
related to the posting of collateral. Moreover, requiring SBS Entities 
to agree in writing with each of their counterparties on the terms of 
the portfolio reconciliation (including, if applicable, agreement on 
the selection of any third party service provider who may be performing 
the reconciliation) should help to minimize any discrepancies regarding 
the portfolio reconciliation process itself, thereby ensuring that it 
operates in as efficient and cost-effective means possible. Finally, 
the requirement to report certain unresolved valuation disputes to the 
Commission should assist the Commission in identifying potential issues 
with respect to an SBS Entity's internal valuation methodology and also 
could serve as an indication of a widespread market disruption in cases 
where the Commission receives a large number of such notices from 
multiple firms.
2. Proposed Rule 15Fi-4: Portfolio Compression
    As previously discussed, the Commission preliminarily believes that 
proposed Rule 15Fi-4 would help market participants by eliminating 
redundant uncleared derivatives contracts, thereby potentially reducing 
a market participant's credit risk to its direct counterparties, 
including by eliminating all outstanding contracts with some 
counterparties, without affecting the market participant's overall 
economic position. In addition, we preliminarily believe that the 
proposed collection of information is expected to lead to processing 
improvements for market participants, as envisioned by Section 15F(i) 
of the Exchange Act, by virtue of the fact that both SBS Entities and 
their counterparties should ultimately have fewer trades to manage, 
maintain, and settle, resulting in fewer opportunities for processing 
errors, failures, or other problems that could develop throughout the 
lifecycle of a transaction.
3. Proposed Rule 15Fi-5: Written Trading Relationship Documentation
    The Commission preliminarily believes that the information required 
to be contained in the written trading relationship documentation 
pursuant to proposed Rule 15Fi-5 should help ensure that each SBS 
Entity mitigates risk with respect to its security-based swap portfolio 
by, among other things, enhancing clarity and legal certainty from the 
outset of a transaction regarding each party's rights and obligations. 
This outcome should help to reduce exposure to, among other things, 
counterparty credit risk and promote agreement regarding the proper 
valuation and other material terms of a security-based swap.
4. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: Books 
and Records Requirements
    The Commission preliminarily expects that the information contained 
in the records required to be made and kept pursuant to the proposed 
amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6 would be used to 
assist the Commission in conducting effective examinations and 
oversight of SBS Entities. In addition, records regarding portfolio 
reconciliation, bilateral offsets, bilateral or multilateral portfolio 
compression, valuation disputes, and written trading relationship 
documentation should help to provide SBS Entities and their 
counterparties to security-based swaps with an ability to identify and 
resolve discrepancies involving key terms of their transactions on an 
ongoing basis, allowing for better management of internal risks related 
to performance of obligations, valuation, margin obligations, internal 
valuation systems and models, or internal controls.
5. Proposed Amendment to Rule 3a71-6: Substituted Compliance
    Under the proposed amendment to Rule 3a71-6 under the Exchange Act, 
the Commission would use the information collected to evaluate requests 
for substituted compliance with respect to the portfolio 
reconciliation, portfolio compression, and written trading relationship 
documentation requirements applicable to SBS Entities.

C. Respondents

    Proposed Rules 15Fi-3 through 15Fi-5 and Rules 17a-3, 17a-4, 18a-5, 
and 18a-6 would apply only to SBS Entities, each of which will be 
registered with the Commission. In a number of prior releases, 
including the release adopting the rules by which SBS Entities can 
register (and withdraw from registration) with the Commission, we 
estimated that approximately 50 entities may meet the definition of SBS 
dealer, and up to five entities may meet the definition of major SBS 
participant.\171\ The Commission continues to believe that these 
estimates are appropriate. Thus, the Commission preliminarily believes 
that approximately 55 entities will be required to register with the 
Commission under either category, and will therefore be subject to 
Rules 15Fi-3 through 15Fi-5.
---------------------------------------------------------------------------

    \171\ See SBS Entity Registration Adopting Release, 80 FR at 
48990. See also Trade Acknowledgement and Verification Adopting 
Release, 81 FR at 39830.
---------------------------------------------------------------------------

    With regard to the requirements under Rule 3a71-6, as proposed to 
be amended, requests for a substituted compliance determination with 
respect to the portfolio reconciliation, portfolio compression, and 
written trading relationship documentation requirements may be filed by 
foreign financial authorities, or by non-U.S. SBS Entities. Consistent 
with prior estimates, the Commission expects that there may be 
approximately 22 non-U.S. entities that may potentially register as SBS 
dealers, out of approximately 50 total

[[Page 4642]]

entities that may register as SBS dealers.\172\
---------------------------------------------------------------------------

    \172\ See Application of the Title VII Security-Based Swap 
Dealer De Minimis Counting Requirements to Activity in the United 
States,'' Exchange Act Release No. 77104 (Feb. 10, 2016), 81 FR 
8598, 8605 (Feb. 19, 2016) (``U.S. Activity Adopting Release''); see 
also Business Conduct Standards Adopting Release, 81 FR at 30090.
---------------------------------------------------------------------------

    Potentially, all such non-U.S. SBS dealers, or some subset thereof, 
may seek to rely on a substituted compliance determination in 
connection with these portfolio reconciliation, portfolio compression, 
and written trading relationship documentation requirements.\173\ In 
practice, however, the Commission expects that the greater portion of 
any such requests will be submitted by foreign financial authorities, 
given their expertise in connection with the relevant substantive 
requirements, and in connection with their supervisory and enforcement 
oversight with regard to SBS dealers and their activities.
---------------------------------------------------------------------------

    \173\ Consistent with prior estimates, the Commission further 
believes that there may up to five major SBS participants. See SBS 
Entity Registration Adopting Release, 80 FR at 49000; see also 
Business Conduct Standards Adopting Release, 81 FR at 30089. It is 
possible that some subset of those entities will be non-U.S. major 
SBS participants that will seek to rely on substituted compliance in 
connection with the applicable portfolio reconciliation, portfolio 
compression, and written trading relationship documentation 
requirements.
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D. Total Annual Recordkeeping Burden

1. Portfolio Reconciliation Activities Generally
    Under proposed Rule 15Fi-3(a), the approximately 55 respondent SBS 
Entities would be required to reconcile security-based swap portfolios 
with other SBS Entities on a daily, weekly, or quarterly basis, 
depending upon the size of the portfolio. For purposes of this 
requirement, the Commission preliminarily estimates that each SBS 
Entity will engage in security-based swap transactions with 
approximately one-third of the other 54 SBS Entities, meaning that an 
SBS Entity will maintain security-based swap portfolios with 
approximately 18 SBS Entities. Of this total, we preliminarily believe 
that, on average, two SBS Entity counterparty portfolios will require 
daily reconciliation (i.e., a portfolio consisting of 500 or more 
uncleared security-based swaps), four SBS Entity counterparty 
portfolios will require weekly reconciliation (i.e., a portfolio of 
more than 50 but fewer than 500 uncleared security-based swaps), and 
the remaining 12 SBS Entity counterparty portfolios will require 
quarterly reconciliation (i.e. a portfolio of no more than 50 uncleared 
security-based swaps).\174\ The Commission therefore estimates that 
each SBS Entity will engage in an average of 760 portfolio 
reconciliations with other SBS Entities per year.\175\
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    \174\ These estimates are consistent with those used by the CFTC 
in connection with its portfolio reconciliation rule. See 
Confirmation, Portfolio Reconciliation, and Portfolio Compression 
Requirements for Swap Dealers and Major Swap Participants, 75 FR 
81519, 81528 (Dec. 28, 2010).
    \175\ This estimate uses 252 business days for purposes of the 
daily portfolio reconciliation requirement, which is consistent with 
the definition of ``business day'' in proposed Rule 15Fi-1(b).
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    The Commission preliminarily believes that each portfolio 
reconciliation is likely to be conducted through an automated 
process.\176\ As a result, we preliminarily believe that each 
reconciliation will require an average of 30 minutes to complete in 
total (which is the combined estimate for both counterparties), 
regardless of the size of the security-based swap portfolio with the 
applicable counterparty.\177\ Using these figures, the Commission 
preliminarily estimates that compliance with proposed Rule 15Fi-3(a), 
as it relates to engaging in portfolio reconciliation with other SBS 
Entities, will impose an average annual burden of approximately 190 
hours per year on each of the respondent 55 SBS Entities, for an 
estimated average annual burden of 10,450 hours in the aggregate. These 
calculations are summarized in PRA Table 1, below.
---------------------------------------------------------------------------

    \176\ The Commission recognizes that some respondents may choose 
to engage a third-party vendor to conduct portfolio reconciliations. 
For simplicity, however, the Commission's burden estimate is based 
upon SBS Entities conducting these activities internally, without 
the use of third-party vendors. The Commission welcomes comments on 
this approach, including regarding the likelihood and cost of using 
third-party providers.
    \177\ Because the 30 minute estimate is for the entire 
reconciliation process, without respect to how that time is 
allocated between the two parties, to avoid double-counting we have 
divided it by one-half in the context of security-based swap 
portfolios between two SBS Entities, resulting in an estimate of 15 
minutes per reconciliation per counterparty for those portfolios.

             PRA Table 1--Proposed Rule 15i-3(a): Portfolio Reconciliations With Other SBS Entities
----------------------------------------------------------------------------------------------------------------
                                                                                   Hourly burden
                                                                                        per        Total annual
    Number of counterparties per respondent     Number of annual reconciliations  reconciliation  burden (hours)
                                                                                      (hours)
----------------------------------------------------------------------------------------------------------------
2 (>=500 transactions)........................  252 (daily).....................             .25             126
4 (>50<500 transactions)......................  52 (weekly).....................             .25              52
12 (<=50 transactions)........................  4 (quarterly)...................             .25              12
                                                                                 -------------------------------
    Total per respondent......................  ................................  ..............             190
                                                                                 -------------------------------
    Total Aggregate Annual Burden for all 55    ................................  ..............          10,450
     respondents.
----------------------------------------------------------------------------------------------------------------

    In addition, proposed Rule 15Fi-3(b) would require each SBS Entity 
to establish, maintain, and follow written policies and procedures 
reasonably designed to ensure that it engages in portfolio 
reconciliation for all security-based swaps (other than security-based 
swaps that will be cleared by a clearing agency) in which its 
counterparty is not an SBS Entity.\178\ In calculating the burden of 
performing the portfolio reconciliations required by these policies and 
procedures, the Commission preliminarily estimates that (1) there are 
currently 13,082 market participants in security-based swaps who will 
not be required to register as SBS Entities,\179\ and (2) each SBS 
Entity will have an average of approximately 350 of these non-SBS 
Entity market participants as counterparties.\180\ Further, the 
Commission preliminarily believes that reconciliations with these 
parties will

[[Page 4643]]

be conducted on a quarterly basis for 10% of these portfolios (i.e., 
portfolios with more than 100 uncleared security-based swaps), and on 
an annual basis for the remaining 90% of these portfolios (i.e., 
portfolios that do not involve 100 or more uncleared security-based 
swaps).\181\
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    \178\ The Commission's estimate for the hourly burden for 
preparing these policies and procedures is discussed below.
    \179\ In the Economic Analysis, the Commission estimates that 
there are approximately 13,137 market participants in the security-
based swap market. See infra Section VI.B.1.c (Table 2). Subtracting 
the estimated 55 SBS Entities from this figure results in an 
estimated 13,082 non-SBS Entities.
    \180\ This estimate is based upon the assumption that each non-
SBS Entity market participant will do business with, on average, 
between one or two SBS Entities and is calculated as follows: 
((13,082 non-SBS Entity market participants/55 SBS Entities) x 1.5 
SBS Entities per non-SBS market participants) = approximately 350 
non-SBS Entity counterparties per SBS Entity.
    \181\ Accordingly, of the estimated 350 security-based swap 
portfolios that an SBS Entity maintains with non-SBS Entities, 90% 
(or 315) will require only one portfolio reconciliation each year, 
and 10% (or 35) will require quarterly portfolio reconciliations, 
resulting in a total of 455 portfolio reconciliations per SBS Entity 
per year.
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    The Commission further estimates that each portfolio reconciliation 
between an SBS Entity and a non-SBS Entity will require an average of 
30 minutes to complete (which is the combined estimate for both 
counterparties).\182\ Using these figures, the Commission preliminarily 
estimates that compliance with proposed Rule 15Fi-3(b), as it relates 
to conducting portfolio reconciliations with non-SBS Entities, will 
impose an annual hourly burden of approximately 227.5 hours per SBS 
Entity, for an estimated average annual burden of approximately 
12,512.5 hours in the aggregate for all 55 SBS Entity respondents. 
These calculations are summarized in PRA Table 2, below.
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    \182\ This figure is identical to the estimate used for 
reconciliations between two SBS Entities (before dividing by one-
half to avoid double-counting) and is consistent with the estimate 
used by the CFTC, which used an estimate of six minutes (or .10 
hours) in connection with its portfolio reconciliation requirements. 
See supra notes 174 and 177 and accompanying text.

              PRA Table 2--Proposed Rule 15i-3(b): Portfolio Reconciliations With Non-SBS Entities
----------------------------------------------------------------------------------------------------------------
                                                                                   Hourly burden
    Number of counterparties per respondent     Number of annual reconciliations        per        Total annual
                                                                                  reconciliation  burden (hours)
----------------------------------------------------------------------------------------------------------------
35 (>100 transactions)........................  4 (quarterly)...................              .5              70
315 (<=100 transactions)......................  1 (annual)......................              .5           157.5
                                                                                 -------------------------------
    Total per respondent......................  ................................  ..............           227.5
                                                                                 -------------------------------
    Total Aggregate Annual Burden for all 55    ................................  ..............        12,512.5
     respondents.
----------------------------------------------------------------------------------------------------------------

2. Establishing, Maintaining, and Enforcing Written Policies and 
Procedures
    Proposed Rule 15Fi-3 also contains policies and procedures 
requirements applicable to SBS Entities in connection with engaging in 
portfolio reconciliation with both SBS Entities and other 
counterparties. As the Commission explained in the Business Conduct 
Standards Adopting Release, the Commission estimates that of the 
estimated 55 persons that may register with the Commission as SBS 
Entities, approximately 35 will be dually-registered with the CFTC as 
Swap Entities.\183\ In addition, other than as expressly noted above in 
Section I.B, the CFTC's adopted final rules on portfolio reconciliation 
written policies and procedures are substantively identical to those 
proposed by Rule 15Fi-3. Accordingly, these 35 dually-registered 
entities are already required to establish, maintain, and follow 
written policies and procedures as they relate to the reconciliation of 
their swap portfolios, and these policies and procedures would be 
expected to be largely consistent with those that would be required 
with respect to their security-based swap portfolios. Assuming that 
these existing policies and procedures would simply need to be amended 
to apply to security-based swap transactions upon adoption of proposed 
Rule 15Fi-3, we preliminarily estimate that the initial burden of 
revising these policies and procedures would be one hour per 
respondent, for an estimated one-time initial burden of 35 hours in the 
aggregate. With respect to the remaining 20 SBS Entities that will not 
be dually-registered with the CFTC, the Commission preliminarily 
estimates, based on prior estimates in earlier Dodd-Frank rulemakings, 
that these policies and procedures would require an average of 80 hours 
per non-dually-registered respondent to initially prepare and 
implement, for an estimated one-time initial burden of 1,600 hours in 
the aggregate.\184\ Once these policies and procedures are established, 
the Commission estimates that it will take an average of 40 hours 
annually to revise and maintain these policies and procedures per 
respondent (including both dually-registered and non-dually-registered 
SBS Entities),\185\ for an estimated average annual burden of 2,200 
hours in the aggregate for all 55 respondents.\186\
---------------------------------------------------------------------------

    \183\ See Business Conduct Standards Adopting Release, 81 FR at 
30098.
    \184\ This estimate is based on Commission staff discussions 
with market participants and is calculated as follows: [((Compliance 
Attorney at 40 hours) + (Director of Compliance at 20 hours) + 
(Deputy General Counsel at 20 hours))] = 80 hours per SBS Entity. 
See Trade Acknowledgment and Verification Adopting Release, 81 FR at 
39831 n. 242.
    \185\ Although dually-registered SBS Entities would technically 
need to revise and maintain their policies and procedures to ensure 
compliance with both the Commission's and CFTC's rules, we have 
preliminarily decided to conservatively assume that all of the 
estimated hours would be incurred in connection with compliance with 
the collection of information associated with proposed Rule 15Fi-3.
    \186\ This estimate is based on Commission staff discussions 
with market participants and is calculated as follows: [((Compliance 
Attorney at 20 hours) + (Director of Compliance at 10 hours) + 
(General Counsel at 10 hours))] = 40 hours per SBS Entity. See Trade 
Acknowledgment and Verification Adopting Release, 81 FR at 39831 n. 
243.
---------------------------------------------------------------------------

3. Reporting of Certain Valuation Disputes
    Proposed Rule 15Fi-3(c) would require each SBS Entity to promptly 
notify the Commission (and any applicable prudential regulator for an 
SBS Entity that is also a bank), in a form and manner acceptable to the 
Commission, of any security-based swap valuation dispute in excess of 
$20,000,000 (or its equivalent in any other currency) if not resolved 
within a prescribed time period. As previously noted, we crafted the 
rule in this way to provide SBS Entities with flexibility to determine 
the most efficient and cost-effective form and manner of making such 
submissions, so long as it is deemed to be acceptable by the 
Commission.\187\ Accordingly, we preliminarily do not expect there to 
be any initial burden of designing a system for submitting these 
notices.\188\ We also preliminarily believe that the associated ongoing 
hourly burden of preparing and submitting such notices would be 
minimal. In addition, until SBS Entities

[[Page 4644]]

are registered with the Commission, it is difficult for us to determine 
the typical number of valuation disputes meeting the applicable 
thresholds that SBS Entities would be required to submit on an annual 
basis. As such, and consistent with the estimate the CFTC provided when 
it first proposed a similar requirement, we preliminarily estimate that 
each SBS Entities will spend on average of 24 hours each year complying 
with this requirement, for an estimated average annual burden of 1,320 
hours in the aggregate for all 55 respondents.\189\ We also recognize, 
however, that there are differences between the markets for swaps and 
security-based swaps and welcomes comment from the public on this 
estimate.
---------------------------------------------------------------------------

    \187\ See supra note 47.
    \188\ In the request for comments, we asked whether we should 
require such notices to be submitted in a particular manner, such as 
having them sent to a dedicated email box or using the EDGAR system 
(or any successor system thereto, as designated by the Commission). 
As SBS Entities will already have access to EDGAR (and a Form ID) by 
virtue of having used the system to register with the Commission, we 
would not expect there to be any initial burden associated with 
either approach.
    \189\ See Swap Trading Relationship Documentation Requirements 
for Swap Dealers and Major Swap Participants, 76 FR 6715, 6723 (Feb. 
8, 2011).
---------------------------------------------------------------------------

    Combining all of the estimated burdens described above, the 
Commission preliminarily estimates that proposed Rule 15Fi-3 would 
impose an estimated one-time initial burden of 1,635 hours in the 
aggregate for all SBS Entities to prepare new written policies and 
procedures or to bring existing ones into compliance. The Commission 
also preliminarily estimates that proposed Rule 15Fi-3 would impose an 
estimated ongoing burden of 26,482.5 hours each year in the aggregate 
for all SBS Entities, which is composed of (1) an estimated annual 
burden of 10,450 hours in the aggregate for all SBS Entities to engage 
in portfolio reconciliation with SBS Entities; (2) an estimated annual 
burden of 12,512.5 hours in the aggregate for all SBS Entities to 
engage in portfolio reconciliation with non-SBS Entities; (3) an 
estimated annual burden of 2,200 hours in the aggregate for all SBS 
Entities to revise and maintain the written policies and procedures 
required pursuant to the rule; and (4) 1,320 hours for all SBS Entities 
to report certain large valuation disputes to the Commission and any 
applicable prudential regulator.\190\ These calculations are summarized 
in PRA Tables 3 and 4, below.
---------------------------------------------------------------------------

    \190\ Rule 15Fi-3(a)(1) and 15Fi-3(b)(1) also require an SBS 
Entity to agree in writing with each of its counterparties on the 
terms of the portfolio reconciliation including, if applicable, 
agreement on the selection of any third party service provider who 
may be performing the reconciliation. The Commission expects SBS 
Entities to undertake this agreement as part of the written trading 
relationship documentation each is required to enter into with its 
counterparties as a result of proposed Rule 15Fi-5. Thus, the 
estimate here does not account for this burden, which is instead 
assumed to form part of the burden of complying with Rule 15Fi-5.

   PRA Table 3--Proposed Rule 15Fi-3: Total Estimated Initial Burdens
------------------------------------------------------------------------
                                                          Total one-time
               Requirement                 Hourly burden  burden (hours)
------------------------------------------------------------------------
Preparation of New Written Policies and                1              35
 Procedures (35 dual SEC-CFTC
 registrants)...........................
Preparation of New Written Policies and               80           1,600
 Procedures (20 SEC-only registrants)...
                                         -------------------------------
    Total Aggregate One-Time Burden for   ..............           1,635
     all 55 respondents.................
------------------------------------------------------------------------


                          PRA Table 4--Proposed Rule 15Fi-3: Summary of Annual Burdens
----------------------------------------------------------------------------------------------------------------
                       Requirement                             Aggregate hourly burden (all 55 respondents)
----------------------------------------------------------------------------------------------------------------
Portfolio Reconciliations with Other SBS Entities.......  10,450
Portfolio Reconciliations with Non-SBS Entities.........  12,512.5
Revise and Maintain Written Policies and Procedures.....  2,200
Prepare and Submit Notices of Valuation Disputes >$20     1,320
 million.
                                                         -------------------------------------------------------
    Total Aggregate Annual Burden for all 55 respondents  26,482.5
----------------------------------------------------------------------------------------------------------------

4. Proposed Rule 15Fi-4: Portfolio Compression
    With regard to the written policies and procedures, the Commission 
continues to believe that of the estimated 55 persons that may register 
with the Commission as SBS Entities, approximately 35 will be dually-
registered with the CFTC as Swap Entities. In addition, and as we 
previously noted, the CFTC's adopted final rules requiring Swap 
Entities to establish, maintain, and follow written policies and 
procedures on bilateral offsets and portfolio compression exercises 
are, other than as expressly noted above in Section I.C, substantively 
identical to those proposed by Rule 15Fi-4. Accordingly, these 35 
entities are already required to establish, maintain, and follow 
relevant written policies and procedures related to bilateral offsets 
and portfolio compression exercises involving their swap portfolios, 
and these policies and procedures would be expected to be largely 
consistent with those that would be required with respect to their 
security-based swap portfolios. Assuming that these existing policies 
and procedures would simply need to be amended to apply to security-
based swap transactions upon adoption of proposed Rule 15Fi-4, we 
preliminarily estimate that the initial burden of revising these 
policies and procedures would be one hour per respondent, for an 
estimated one-time initial burden of 35 hours in the aggregate.
    With respect to the remaining 20 SBS Entities that are not dually-
registered with the CFTC, the Commission preliminarily estimates, based 
on prior estimates in earlier Dodd-Frank rulemakings, that these 
policies and procedures would require an average of 80 hours per non-
dually-registered respondent to initially prepare and implement, for an 
estimated average annual burden of 1,600 hours in the aggregate.\191\ 
Once these policies and procedures are established, the Commission 
estimates that it will take an average of 40 hours annually to revise 
and maintain these policies and procedures per respondent (including 
both dually-registered and non-dually-registered SBS Entities), for an 
estimated average annual burden of 2,200 hours in the aggregate for all 
55 respondents.
---------------------------------------------------------------------------

    \191\ See supra note 184.
---------------------------------------------------------------------------

    In addition, the respondents will incur additional hourly burdens 
as they undertake bilateral offsets and portfolio compression exercises 
consistent with these written policies and procedures. As noted above 
the Commission estimates that each of the 55 estimated

[[Page 4645]]

SBS Entities will be counterparty to an average of 18 other SBS 
Entities and 350 non-SBS Entities, for a total of 368 counterparties. 
For purposes of conducting bilateral offsets and portfolio compression 
exercises, the Commission preliminarily estimates that (1) each SBS 
Entity will have an average of one set of security-based swaps that are 
eligible for annual bilateral offset with each of these 368 
counterparties, (2) each SBS Entity will conduct an annual bilateral 
compression exercise with one-third, or six of its 18 SBS Entity 
counterparties, (3) each SBS Entity will conduct an annual bilateral 
compression exercise with each of its 350 non-SBS Entity 
counterparties, and (4) each SBS Entity will engage in multilateral 
compression exercises at an average rate of 12 exercises per year.
    The Commission preliminarily believes that each bilateral offset 
and portfolio compression exercise is likely to be conducted through an 
automated process. As a result, we preliminarily believe that (1) each 
bilateral offset will require on average five minutes of respondent 
time to complete with each of the 350 non-SBS Entity counterparties, 
(2) each bilateral offset will require on average 2.5 minutes of 
respondent time to complete with each of the 18 SBS Entity 
counterparties,\192\ (3) each bilateral compression will require an 
average of 15 minutes of respondent time to complete with each of the 
350 non-SBS Entity counterparties, (4) each bilateral compression will 
require an average of 7.5 minutes with each of the six SBS Entity 
counterparties,\193\ and (5) each multilateral compression exercise 
will require an average of 30 minutes of respondent time to complete 12 
times annually. In each of those hourly burdens, the figure used is the 
combined estimate for both counterparties. Based on these estimates, 
the Commission estimates the average annual hourly burden for these 
activities at 124.16 hours per respondent, an estimated average annual 
burden of 6,828.8 hours in the aggregate. These calculations are 
summarized in PRA Table 5, below.
---------------------------------------------------------------------------

    \192\ Similar to our estimates in the context of the portfolio 
reconciliation requirements, because the five minute estimate is for 
the entire bilateral offset process, without respect to how that 
time is allocated between the two parties, to avoid double-counting 
we have divided it by one-half in the context of security-based swap 
portfolios between two SBS Entities, resulting in an estimate of 2.5 
minutes per bilateral offset for those portfolios.
    \193\ Again, we have divided the 15 minute estimate to complete 
the bilateral compression exercise by one-half in the context of 
security-based swap portfolios between two SBS Entities, resulting 
in an estimate of 7.5 minutes per bilateral compression for those 
portfolios.

                              PRA Table 5--Portfolio Compression With All Entities
----------------------------------------------------------------------------------------------------------------
                                                                     Number of     Hourly burden
                Type of exercise                     Number of        annual       per exercise    Total annual
                                                  counterparties     exercises        (hours)     burden (hours)
----------------------------------------------------------------------------------------------------------------
Bilateral Offset (w/non-SBS Entities)...........             350               1           .0833           29.16
Bilateral Offset (w/SBS Entities)...............              18               1           .0417             .75
Bilateral Compression (w/non SBS-Entities)......             350               1             .25            87.5
Bilateral Compression (w/SBS Entities)..........               6               1            .125             .75
Multilateral Compression........................             N/A              12              .5               6
                                                 ---------------------------------------------------------------
    Total per respondent........................  ..............  ..............  ..............          124.16
                                                 ---------------------------------------------------------------
    Total Aggregate Annual Burden for all 55      ..............  ..............  ..............         6,828.8
     respondents................................
----------------------------------------------------------------------------------------------------------------

    Combining all of the estimated burdens described above, the 
Commission preliminarily estimates that proposed Rule 15Fi-4 would 
impose an estimated one-time initial burden of 1,635 hours in the 
aggregate for all SBS Entities to prepare new written policies and 
procedures or to bring existing ones into compliance. The Commission 
also preliminarily estimates that proposed Rule 15Fi-4 would impose an 
estimated ongoing burden of 9,028.8 hours each year in the aggregate 
for all SBS Entities, which is composed of (1) an estimated annual 
burden of 1,603.8 hours in the aggregate to conduct bilateral offsets 
with non-SBS Entities; (2) an estimated annual burden of 41.25 hours in 
the aggregate to conduct bilateral offsets with SBS Entities; (3) an 
estimated annual burden of 4,812.5 hours in the aggregate to 
participate in bilateral compression exercises with non-SBS Entities; 
(4) an estimated annual burden of 41.25 hours in the aggregate to 
participate in bilateral compression exercises with SBS Entities; (5) 
an estimated annual burden of 330 hours in the aggregate to participate 
in multilateral compression exercises; and (6) an estimated annual 
burden of 2,200 hours in the aggregate for all SBS Entities to revise 
and maintain written policies and procedures. These calculations are 
summarized in PRA Tables 6 and 7, below.

    PRA Table 6--Proposed Rule 15Fi-4: Total Estimated Initial Burden
------------------------------------------------------------------------
                                           Hourly burden  Total one-time
                Activity                      (hours)     burden (hours)
------------------------------------------------------------------------
Preparation of New Written Policies and                1              35
 Procedures (35 dual SEC-CFTC
 registrants)...........................
Preparation of New Written Policies and               80           1,600
 Procedures (20 SEC-only registrants)...
                                         -------------------------------
    Total Aggregate One-Time Burden for   ..............           1,635
     all 55 respondents.................
------------------------------------------------------------------------


[[Page 4646]]


      PRA Table 7--Proposed Rule 15Fi-3: Summary of Annual Burdens
------------------------------------------------------------------------
                                                             Aggregate
                                                           hourly burden
                       Requirement                         (hours) (all
                                                                55
                                                           respondents)
------------------------------------------------------------------------
Bilateral Offsets with non-SBS Entities.................         1,603.8
Bilateral Offsets with SBS Entities.....................           41.25
Bilateral Compression with non-SBS Entities.............         4,812.5
Bilateral Compression with SBS Entities.................           41.25
Multilateral Compression................................             330
Revise and Maintain Written Policies and Procedures.....           2,200
                                                         ---------------
    Total Aggregate Annual Burden for all 55 respondents         9,028.8
------------------------------------------------------------------------

5. Proposed Rule 15Fi-5: Written Trading Relationship Documentation
    As previously noted, the Commission estimates that each SBS Entity 
will have 18 SBS Entity counterparties and 350 non-SBS Entity 
counterparties, for a total of 368 counterparties per SBS Entity. For 
the purposes of the underlying documentation requirements, and based on 
staff discussions with market participants, the Commission understands 
that many SBS Entities already have in place industry-standard written 
trading relationship documentation that is likely to contain many of 
the elements required by this proposed rule. With this in mind, the 
Commission preliminarily estimates that (1) the initial burden per 
respondent to negotiate and draft written trading relationship 
documentation with non-SBS Entities that is compliant with proposed 
Rule 15Fi-5 will be approximately 30 hours (which is the combined 
estimate for both counterparties), and (2) the initial burden per 
respondent to negotiate and draft written trading relationship 
documentation with SBS Entities that is compliant with proposed Rule 
15Fi-5 will be approximately 15 hours.\194\ These estimates are 
averages, and both account for the fact that some SBS Entities may lack 
appropriate documentation in certain respects and will need to enter 
into new documentation with counterparties, while in other cases 
existing documentation will need only to be modified to be brought into 
compliance. The Commission's estimates are further based on an 
assumption that, in each case, the written documentation will always 
include the valuation agreements set forth in proposed Rule 15Fi-
5(b)(4), notwithstanding the fact that the rule only requires this 
information in certain circumstances.
---------------------------------------------------------------------------

    \194\ As was the case in calculating the PRA estimates for the 
portfolio reconciliation and portfolio compression requirements, 
because the 30 hours estimate is for the entire process of 
negotiating and executing written trading relationship 
documentation, without respect to how that time is allocated between 
the two parties, to avoid double-counting we have divided it by one-
half in the context of counterparties that are also SBS Entities, 
resulting in an estimate of 15 hours to negotiate and execute such 
documentation.
---------------------------------------------------------------------------

    Based on these estimates and assumptions, the Commission 
preliminarily believes that the requirement to prepare written 
relationship documentation in accordance with proposed Rule 15Fi-5 will 
result in an estimated one-time initial burden of 9,540 hours for each 
of the 55 SBS Entity respondents, for an estimated average one-time 
burden of 524,700 hours in the aggregate. The Commission also 
preliminarily believes that there will be little need to modify the 
written trading relationship documentation on an ongoing basis once it 
is in place, and therefore is not estimating any additional annual 
hourly burden for ongoing modifications.
    With regard to the written policies and procedures required 
pursuant to proposed Rule 15Fi-5, the Commission continues to believe 
that of the estimated 55 persons that may register with the Commission 
as SBS Entities, approximately 35 will be dually-registered with the 
CFTC as Swap Entities. In addition, and as we previously noted, the 
CFTC's adopted final rules requiring Swap Entities to establish, 
maintain, and follow written policies and procedures requiring the 
execution of written trading relationship documentation are, other than 
as expressly noted above in Section I.D, substantively identical to 
those proposed by Rule 15Fi-5. Accordingly, these 35 entities are 
already required to establish, maintain, and follow relevant written 
policies as they relate to the execution of written trading 
relationship documentation involving their swap portfolios, and these 
policies and procedures would be expected to be largely consistent with 
those that would be required with respect to their security-based swap 
portfolios. Assuming that these existing policies and procedures would 
simply need to be amended to apply to security-based swap transactions 
upon adoption of proposed Rule 15Fi-5, we preliminarily estimate that 
the average initial burden of revising these policies and procedures 
would be one hour per respondent, for an estimated one-time burden of 
35 hours in the aggregate.
    With respect to the remaining 20 SBS Entities that are not dually-
registered with the CFTC, the Commission preliminarily estimates, based 
on prior estimates in earlier Dodd-Frank rulemakings, that these 
policies and procedures would require an average of 80 hours per non-
dually-registered respondent to initially prepare and implement, for an 
estimated average annual burden of 1,600 hours in the aggregate.\195\ 
Once these policies and procedures are established, the Commission 
estimates that it will take an average of 40 hours annually to revise 
and maintain these policies and procedures per respondent (including 
both dually-registered and non-dually-registered SBS Entities), for an 
estimated average annual burden of 2,200 hours in the aggregate for all 
55 respondents.
---------------------------------------------------------------------------

    \195\ See supra note 184.
---------------------------------------------------------------------------

    With regard to having an independent auditor conduct the required 
periodic audit of written trading relationship documentation and the 
requirement to retain a record of each such audit, the Commission 
estimates that it will take an average of 10 hours to audit an SBS 
Entity's documentation with each of its 368 counterparties, for a total 
of 3,680 hours per SBS Entity, or 202,400 hours for all 55 SBS Entity 
respondents.
    Combining all of the estimated burdens described above, the 
Commission preliminarily estimates that proposed Rule 15Fi-5 would 
impose an estimated one-time initial burden of 593,985 hours in the 
aggregate for all SBS Entities, which consists of (1) 1,635 hours in 
the aggregate for all SBS Entities to prepare new written policies and 
procedures or to bring

[[Page 4647]]

existing ones into compliance, (2) 577,500 hours in the aggregate for 
SBS Entities to negotiate and execute trading relationship 
documentation with 350 non-SBS Entity counterparties, and (3) 14,850 
hours in the aggregate for SBS Entities to negotiate and execute 
trading relationship documentation with 18 SBS Entity counterparties. 
The Commission also preliminarily estimates that proposed Rule 15Fi-5 
would impose an estimated ongoing burden of 204,600 hours each year in 
the aggregate for all SBS Entities, which is composed of: (1) An 
estimated annual burden of 2,200 hours in the aggregate for all SBS 
Entities to revise and maintain written policies and procedures and (2) 
an estimated annual burden of 202,400 hours in the aggregate for all 
SBS Entities to conduct the required periodic audits. These 
calculations are summarized in PRA Tables 8 and 9, below.

   PRA Table 8--Proposed Rule 15Fi-5: Total Estimated Initial Burdens
------------------------------------------------------------------------
                                           Hourly burden  Total one-time
                Activity                      (hours)     burden (hours)
------------------------------------------------------------------------
Preparation of New Written Policies and                1              35
 Procedures (35 dual SEC-CFTC
 registrants)...........................
Preparation of New Written Policies and               80           1,600
 Procedures (20 SEC-only registrants)...
Negotiate and Execute Trading                         30         577,500
 Relationship Documentation with 350 non-
 SBS Entities (all 55 respondents)......
Negotiate and Execute Trading                         15          14,850
 Relationship Documentation with 18 SBS
 Entities (all 55 respondents)..........
                                         -------------------------------
    Total Aggregate One-Time Burden for   ..............         593,985
     all 55 respondents.................
------------------------------------------------------------------------


      PRA Table 9--Proposed Rule 15Fi-3: Summary of Annual Burdens
------------------------------------------------------------------------
                                                             Aggregate
                                                           hourly burden
                       Requirement                         (hours) (all
                                                                55
                                                           respondents)
------------------------------------------------------------------------
Audit of Written Trading Relationship Documentation.....         202,400
Revise and Maintain Written Policies and Procedures.....           2,200
                                                         ---------------
    Total Aggregate Annual Burden for all 55 respondents         204,600
------------------------------------------------------------------------

6. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: Books 
and Records Requirements
    The proposed amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6 
would impose collection of information requirements that result in 
initial and annual time burdens for SBS Entities. The proposed 
amendments to Rules 17a-3 and 18a-5 would require three additional 
types of records to be made and kept current by SBS Entities--records 
regarding portfolio reconciliations, valuation disputes, and portfolio 
compressions. Because the burden to make these records is accounted for 
in the PRA estimates for proposed Rules 15Fi-3 and 15Fi-4, the burden 
imposed by these proposed new requirements is the requirement in Rules 
17a-4 and 18a-6 to maintain and preserve a written record of these 
tasks, as well as the additional requirements in those provisions to 
maintain and preserve records of policies and procedures required by 
Rules 15Fi-3 through 15Fi-5 and written agreements with counterparties 
regarding the terms of portfolio reconciliation. The Commission 
estimates that these recordkeeping requirements, as proposed to be 
amended, would impose an initial burden of 60 hours per firm for 
updating the applicable policies and systems required to account for 
capturing the additional records made pursuant to proposed Rule 15Fi-3 
through 15Fi-5, and an ongoing annual burden of 75 hours per firm for 
maintaining such records as well as to make additional updates to the 
applicable recordkeeping policies and systems to account for the 
proposed rules. As noted previously, the Commission estimates that 
there are 55 SBS Entity respondents, for a total average initial annual 
burden for all respondents of 3,300 hours and a total ongoing average 
annual burden of 4,125 hours.
7. Proposed Amendment to Rule 3a71-6: Substituted Compliance
    Proposed amended Rule 3a71-6 would require submission of certain 
information to the Commission to the extent SBS Entities elect to 
request a substituted compliance determination with respect to the 
proposed portfolio reconciliation, portfolio compression, and written 
trading relationship documentation requirements. The Commission expects 
that registered SBS Entities will seek to rely on substituted 
compliance upon registration, and that it is likely that the majority 
of such requests will be made during the first year following the 
effective date. Requests would not be necessary with regard to 
applicable rules and regulations of a foreign financial regulatory 
system that have previously been the subject of a substituted 
compliance determination in connection with the applicable rules.
    The Commission expects that the great majority of substituted 
compliance applications will be submitted by foreign authorities, and 
that very few substituted compliance requests will come from SBS 
Entities. For purposes of this assessment, the Commission estimates 
that three such SBS Entities will submit such an application.\196\
---------------------------------------------------------------------------

    \196\ See Business Conduct Standards Adopting Release, 81 FR at 
30097 n. 1582.
---------------------------------------------------------------------------

    The Commission has previously estimated that the paperwork burden 
associated with making each such substituted compliance request would 
be approximately 80 hours of in-house counsel time, plus $80,000 for 
the services of outside professionals (based on 200 hours of outside 
time x $400 per hour).\197\ The Commission is currently of the belief 
that this prior estimate is sufficient to cover a combined substituted 
compliance request that also seeks a determination for the portfolio 
reconciliation, portfolio compression, and written trading relationship 
documentation rules proposed in this release. This estimate results in 
an aggregate total of 240 internal hours, plus $240,000 for outside 
services. Therefore, the Commission estimates that the total paperwork 
burden incurred by such entities associated

[[Page 4648]]

with preparing and submitting a request for a substituted compliance 
determination in connection with the portfolio reconciliation, 
portfolio compression, and written trading relationship documentation 
requirements will be approximately 240 hours per applicant, plus 
$240,000 for the services of outside professionals for all three 
requests.
---------------------------------------------------------------------------

    \197\ See Business Conduct Standards Adopting Release, 81 FR at 
30097 n. 1583.
---------------------------------------------------------------------------

E. Collection of Information Is Mandatory

    Each collection of information for proposed Rules 15Fi-3 through 
15Fi-5 and for the proposed amendments to Rules 17a-3, 17a-4, 18a-5, 
and 18a-6 is a mandatory collection of information. With respect to the 
proposed amendment to Rule 3a71-6, the application for substituted 
compliance is mandatory for all foreign financial authorities or SBS 
Entities that seek a substituted compliance determination.

F. Confidentiality

    Proposed Rule 15Fi-3(c) would require an SBS Entity to promptly 
notify the Commission of any security-based swap valuation dispute in 
excess of $20,000,000 (or its equivalent in any other currency) if not 
resolved within: (1) Three business days, if the dispute is with a 
counterparty that is an SBS Entity; or (2) five business days, if the 
dispute is with a counterparty that is not an SBS Entity. We have 
requested comment as to whether these notices should be submitted to 
the Commission on a confidential basis. No other information would be 
submitted directly to the Commission under proposed Rules 15Fi-3 
through 15Fi-5 or under the proposed amendments to Rules 17a-3, 17a-4, 
18a-5, and 18a-6. To the extent that the Commission receives 
confidential information pursuant to this collection of information 
that is otherwise not publicly available, including in connection with 
examinations or investigations, that information will be kept 
confidential, subject to applicable law.
    With regard to the proposed amendment to Rule 3a71-6, the 
Commission generally will make requests for a substituted compliance 
determination public, subject to requests for confidential treatment 
being submitted pursuant to any applicable provisions governing 
confidentiality under the Exchange Act.

G. Request for Comment

    We request comment on whether our estimates for burden hours and 
any external costs as described above are reasonable. Pursuant to 44 
U.S.C. 3506(c)(2)(B), the Commission solicits comments in order to: (1) 
Evaluate whether the proposed collections of information are necessary 
for the proper performance of the functions of the Commission, 
including whether the information will have practical utility; (2) 
evaluate the accuracy of the Commission's estimate of the burden of the 
proposed collections of information; (3) determine whether there are 
ways to enhance the quality, utility, and clarity of the information to 
be collected; and (4) determine whether there are ways to minimize the 
burden of the collections of information on those who are to respond, 
including through the use of automated collection techniques or other 
forms of information technology.
    In addition, would we would appreciate any comments related to our 
Paperwork Reduction Act estimates with respect to the following:
     The number of counterparties with whom an SBS Entity would 
maintain a security-based swap portfolio.
     The number and proportion of security-based swap 
portfolios that would fall under each of the proposed thresholds for 
determining the frequency of the required portfolio reconciliations, 
with respect to both SBS Entity and non-SBS Entity counterparties.
     The hourly burden of conducting each portfolio 
reconciliation and the use of automated systems to perform this 
function, including those offered by third parties.
     The use of third parties to perform portfolio 
reconciliation and portfolio compression exercises, any upfront burdens 
associated with engaging a third party to perform these services, and 
the ongoing burdens associated with each exercise.
     The burdens associated with establishing and routinely 
updating all required policies and procedures.
    The agency has submitted the proposed collections of information to 
OMB for approval.Persons wishing to submit comments on the collection 
of information requirements should direct the comments to the Office of 
Management and Budget, Attention: Desk Officer for the Securities and 
Exchange Commission, Office of Information and Regulatory Affairs, 
Washington, DC 20503, and send a copy to Brent J. Fields, Secretary, 
Securities and Exchange Commission, 100 F Street NE, Washington, DC 
20549-1090, with reference to File No. S7-28-18. OMB is required to 
make a decision concerning the collection of information between 30 and 
60 days after publication of this release. Consequently, a comment to 
OMB is best assured of having its full effect if OMB receives it within 
30 days of publication. Requests for materials submitted to OMB by the 
Commission with regard to these collections of information should be in 
writing, refer to File No. S7-28-18, and be submitted to the Securities 
and Exchange Commission, Office of FOIA Services, 100 F Street NE, 
Washington, DC 20549-2736.

VI. Economic Analysis

    The Commission is sensitive to the economic effects of its rules, 
including the costs and benefits and the effects of its rules on 
efficiency, competition, and capital formation. Section 3(f) \198\ of 
the Exchange Act requires the Commission, whenever it engages in 
rulemaking pursuant to the Exchange Act and is required to consider or 
determine whether an action is necessary or appropriate in the public 
interest, also to consider, in addition to the protection of investors, 
whether the action would promote efficiency, competition, and capital 
formation. In addition, Section 23(a)(2) \199\ of the Exchange Act 
requires the Commission, when promulgating rules under the Exchange 
Act, to consider the impact such rules would have on competition. 
Section 23(a)(2) also provides that the Commission shall not adopt any 
rule which would impose a burden on competition that is not necessary 
or appropriate in furtherance of the purposes of the Exchange Act.\200\
---------------------------------------------------------------------------

    \198\ 15 U.S.C. 78c(f).
    \199\ 15 U.S.C. 78w(a)(2).
    \200\ See id.
---------------------------------------------------------------------------

A. Broad Economic Considerations

    Unlike some other types of securities transactions, a security-
based swap typically gives rise to ongoing obligations between 
transaction counterparties during the life of the transaction, 
including payments contingent on specific events, such as a corporate 
default or a change in the price of an underlying reference asset 
(e.g., changes in price to the floating leg of a total return swap). 
Consequently, certain risk mitigation techniques, such as engaging in 
portfolio reconciliation at periodic intervals, exercising 
opportunities for portfolio compression, and ensuring that the terms of 
a transaction are fully documented, are important practices for 
assisting SBS Entities in effectively measuring and managing market and 
credit risk.
    Credit risk refers to the probability of a financial loss due to a 
counterparty to a transaction failing to fulfill its financial 
obligations. In order to manage credit risk in the security-based swap 
context properly, a market participant

[[Page 4649]]

should know the identity of each of its counterparties, the details of 
the obligations of each counterparty in each transaction into which the 
two have entered, and the value of those obligations (including for 
purposes of calculating margin or measuring outstanding exposure for 
risk management). The greater the number of counterparties and 
transactions, the complexity of those transactions, and the value of 
the outstanding obligations, the more important it becomes for each 
counterparty to have well-documented credit risk management policies.
    The risks of the counterparties' failure to manage credit risk 
adequately may not become apparent until the onset of a financial 
crisis. Such a crisis occurred in the fall of 2008, when certain events 
threatened to freeze U.S. and global credit markets. The severity of 
that crisis has been partially attributed to poor risk management 
practices of financial firms and flawed supervisory oversight for 
certain financial institutions.\201\
---------------------------------------------------------------------------

    \201\ See Lessons of the Financial Crisis for Future Regulation 
of Financial Institutions, at 3-4, IMF Policy Paper (Feb. 4, 2009), 
available at: https://www.imf.org/external/np/pp/eng/2009/020409.pdf; 
see also Sewall Chan, Financial Crisis Was Avoidable, Inquiry Finds, 
N.Y. Times (Jan. 25, 2011), available at: https://www.nytimes.com/2011/01/26/business/economy/26inquiry.html?_r=1;.
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    Shortcomings in credit risk management and documentation may be 
unobservable to counterparties and other market participants until a 
crisis occurs as it did in 2008; thus some benefits of compliance will 
accrue to the financial system as a whole while the ongoing direct 
costs are borne by the institution. If firms do not fully internalize 
the benefits of risk management, then they may underinvest. For 
example, shortcomings in documentation were reported to have created 
significant problems during the financial crisis that immediately 
preceded passage of the Dodd-Frank Act in connection with efforts by 
Barclays PLC to take over a portion of Lehman Brothers Holdings Inc.'s 
derivatives trades.\202\ Shortcomings in the documentation of portfolio 
valuation methods and reconciliation of portfolio values were also 
exposed when, during bankruptcy proceedings, counterparties' valuations 
differed by hundreds of millions of dollars from the value of those 
same positions on the bankrupt entity's books.\203\
---------------------------------------------------------------------------

    \202\ See Linda Sandler, Lehman Derivatives Records a `Mess,' 
Barclays Executive Says, Bloomberg (Aug. 30, 2010), available at: 
https://www.bloomberg.com/news/articles/2010-08-30/lehman-derivatives-records-a-mess-barclays-executive-says.
    \203\ See Satyajit Das, In the Matter of Lehman Brothers, 59 
Wilmott 20-29 (May 2012). Disagreement over CDO valuation between 
AIG and its counterparties was also an issue around the same time. 
See supra note 15 and accompanying text.
---------------------------------------------------------------------------

    Among other things, effective risk management requires the 
existence of sound documentation, periodic reconciliation of 
portfolios, rigorously tested valuation methodologies, and sound 
collateralization practices.\204\ More broadly, the President's Working 
Group on Financial Policy (``PWG'') noted shortcomings in the OTC 
derivatives market as a whole during the financial crisis that 
immediately preceded passage of the Dodd-Frank Act. The PWG identified 
the need for an improved integrated operational structure supporting 
OTC derivatives, specifically highlighting the need for an enhanced 
ability to manage counterparty risk through ``netting and collateral 
agreements by promoting portfolio reconciliation and accurate valuation 
of trades.'' \205\
---------------------------------------------------------------------------

    \204\ See PriceWaterhouseCoopers, Lehman Brothers' Bankruptcy: 
Lessons learned for the survivors, Informational presentation for 
clients, (Aug. 2009), at 12-24, available at: https://www.pwc.com/en_JG/jg/events/Lessons-learned-for-thesurvivors.pdf.2009), at 12-
24, available at https://www.pwc.com/en_JG/jg/events/Lessons-learned-for-thesurvivors.pdf.
    \205\ See The President's Working Group on Financial Markets, 
Policy Statements on Financial Market Developments, (Mar. 2008) 
(``PWG Report''), available at: https://www.treasury.gov/resource-center/fin-mkts/Documents/pwgpolicystatemktturmoil_03122008.pdf.2008) (``PWG Report''), 
available at https://www.treasury.gov/resource-center/fin-mkts/Documents/pwgpolicystatemktturmoil_03122008.pdf.
---------------------------------------------------------------------------

    The rules we are proposing today are designed to ensure that SBS 
Entities implement certain risk mitigation techniques by engaging in 
periodic portfolio reconciliation, maintaining policies and procedures 
for engaging in certain forms of portfolio compression exercises with 
each of their counterparties, and maintaining policies and procedures 
reasonably designed to ensure that they execute written trading 
relationship documentation with each of their counterparties prior to 
executing a security-based swap transaction. The proposed rules also 
would set minimum standards with respect to identifying the matters 
that must be addressed in the security-based swap trading 
documentation, and outline certain requirements related to the 
resolution of discrepancies, particularly those involving differences 
in the valuation of security-based swaps.\206\ In proposing these 
rules, the Commission preliminarily believes that they will promote 
effective risk management practiced by security-based swap market 
participants in a number of important ways, which we discuss in greater 
detail below.
---------------------------------------------------------------------------

    \206\ The proposed rules also would (1) address the potential 
availability of substituted compliance in connection with those 
portfolio reconciliation, portfolio compression, and trading 
relationship documentation requirements and (2) add corresponding 
requirements to the Commission's recordkeeping rules that would 
require SBS Entities to make and keep records demonstrating 
compliance with the new risk mitigation requirements.
---------------------------------------------------------------------------

    The Commission notes that, where possible, it has attempted to 
quantify the costs, benefits, and effects on efficiency, competition, 
and capital formation expected to result from adopting these rules. In 
certain cases, however, the Commission is unable to quantify the 
economic effects. Crucially, many of the relevant economic effects, 
such as improved risk management and the value of Commission 
enforcement and oversight, are inherently difficult to quantify. In 
other cases, we lack the information necessary to provide reasonable 
estimates. For example, we lack data on prices charged by certain 
third-party service providers, current trading relationship 
documentation practices for entities and transactions not already 
subject to similar rules from other regulators, the fraction of 
outstanding positions that when reconciled will result in a dispute and 
the costs incurred by the participants in resolving the dispute. To the 
best of our knowledge, no such data is publicly available. Where the 
Commission is unable to quantify the economic effects, the discussion 
is qualitative in nature and includes, where possible, descriptions of 
the direction of these effects. The Commission requests data from 
commenters to help quantify these effects.

B. Economic Baseline

    To assess the economic impact of the proposed risk mitigation 
rules, the Commission is using as a baseline the security-based swap 
market as it exists today, including applicable rules that have already 
been adopted, and excluding rules that have been proposed but not yet 
finalized. The analysis includes the statutory and regulatory 
provisions that currently govern the security-based swap market 
pursuant to the Dodd-Frank Act, as well as rules adopted in, among 
others, the Business Conduct Standards Adopting Release \207\ and the 
Trade Acknowledgment and Verification Adopting Release.\208\ Moreover, 
because participants in the security-based swap market may also operate 
in other markets, particularly the swaps market, we have considered 
both the direct and indirect impact of

[[Page 4650]]

rules that have been adopted by other regulators (e.g., the CFTC as 
well as foreign regulatory bodies) in formulating the baseline. Our 
understanding of the market is informed by available data on security-
based swap transactions, though we acknowledge the data available to us 
limits the extent to which we can quantitatively characterize the 
market. Because this data does not cover the entire market, we have 
developed an understanding of market activity using a sample that 
includes only certain portions of the market.
---------------------------------------------------------------------------

    \207\ See supra note 138.
    \208\ See supra note 6.
---------------------------------------------------------------------------

    Furthermore, the overall Title VII regulatory framework will have 
consequences for the ways in which security-based swaps are transacted 
which, in turn, will affect the activities addressed by these proposed 
rules. For example, the proposed rules generally do not apply to 
security-based swaps cleared through a registered clearing agency. 
Therefore, the scope of future mandatory clearing requirements may 
affect the overall level of security-based swap activity subject to the 
final rules ultimately adopted under the proposal, as well as the 
overall costs borne by SBS Entities.
1. Security-Based Swap Market Activity and Participants
a. Available Data From the Security-Based Swap Market
    The Commission's understanding of the market is informed, in part, 
by available data on security-based swap transactions, though the 
Commission acknowledges that limitations in the data limit the extent 
to which it is possible to quantitatively characterize the market. 
Since this data does not cover the entire market, the Commission has 
analyzed market activity using a sample of transactions that includes 
only certain segments of the market. The Commission believes, however, 
that the data underlying this analysis provides reasonably 
comprehensive information regarding single-name CDS transactions and 
the composition of the participants in the single-name CDS market.
    Specifically, the analysis of the state of the current security-
based swap market is based on data obtained from the Depository Trust 
and Clearing Corporation (``DTCC'') Derivatives Repository Limited 
Trade Information Warehouse (``DTCC-TIW''), especially data regarding 
the activity of market participants in the single-name CDS market 
during the period from 2006 to 2017.\209\ Although the definition of 
``security-based swap'' is not limited to single-name CDS,\210\ single-
name CDS contracts make up a majority of security-based swaps, and we 
believe that the single-name CDS data is sufficiently representative of 
the market to inform our analysis of the current security-based swap 
market. According to data published by the Bank for International 
Settlements (``BIS''), the global notional amount outstanding in 
single-name CDS was approximately $4.6 trillion,\211\ in multi-name 
index CDS was approximately $4.4 trillion, and in multi-name, non-index 
CDS was approximately $343 billion.\212\ The total gross market value 
outstanding in single-name CDS was approximately $130 billion, and in 
multi-name CDS instruments was approximately $174 billion.\213\ The 
global notional amount outstanding in equity forwards and swaps as of 
December 2017 was $3.21 trillion, with total gross market value of $197 
billion.\214\
---------------------------------------------------------------------------

    \209\ In prior releases, the Commission has examined data for 
other time periods. For example, in the Business Conduct Standards 
Adopting Release, the Commission presented an analysis of TIW data 
for November 2006 through December 2014. While the exact numbers of 
various groups of transacting agents and account holders in that 
analysis differ from the figures reported in this section (for a 
longer time period), we do not observe significant structural 
differences in market participation. Compare 81 FR at 30102 (Tables 
1 and 2) with Tables 1 and 2 below.
    \210\ While other repositories may collect data on transactions 
in total return swaps on equity and debt, we do not currently have 
access to such data for these products (or other products that are 
security-based swaps). Additionally, the Commission explains below 
that data related to single-name CDS provides reasonably 
comprehensive information for the purpose of this analysis.
    \211\ The global notional amount outstanding represents the 
total face amount used to calculate payments under outstanding 
contracts. The gross market value is the cost of replacing all open 
contracts at current market prices.
    \212\ See BIS, Semi-annual OTC derivatives statistics at 
December 2017, Table 10.1, available at: https://www.bis.org/statistics/d10_1.pdf (last accessed May 18, 2018).
    \213\ See id.
    \214\ These totals include swaps and security-based swaps, as 
well as products that are excluded from the definition of ``swap,'' 
such as certain equity forwards. See OTC, Equity-Linked Derivatives 
Statistics, Table D8, available at: https://www.bis.org/statistics/d8.pdf (last accessed May 18, 2018). For the purposes of this 
analysis, the Commission assumes that multi-name index CDS are not 
narrow-based index CDS and therefore, do not fall within the 
security-based swap definition. See 15 U.S.C. 78c(a)(68)(A). See 
also Further Definition of ``Swap,'' ``Security-Based Swap,'' and 
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap 
Agreement Recordkeeping, 77 FR 48208. The Commission also assumes 
that all instruments reported as equity forwards and swaps are 
security-based swaps, potentially resulting in underestimation of 
the proportion of the security-based swap market represented by 
single-name CDS. Therefore, when measured on the basis of gross 
notional outstanding single-name CDS contracts appear to constitute 
roughly 59% of the security-based swap market. Although the BIS data 
reflects the global OTC derivatives market, and not just the U.S. 
market, the Commission has no reason to believe that these ratios 
differ significantly in the U.S. market.
---------------------------------------------------------------------------

    The Commission further notes that the data available from TIW does 
not encompass those CDS transactions that both: (i) Do not involve U.S. 
counterparties; \215\ and (ii) are based on non-U.S. reference 
entities. Notwithstanding this limitation, the TIW single-name CDS data 
should provide sufficient information to permit the Commission to 
identify the types of market participants active in the security-based 
swap market and the general pattern of dealing within that market.\216\
---------------------------------------------------------------------------

    \215\ Following publication of the Warehouse Trust Guidance on 
CDS data access, TIW surveyed market participants, asking for the 
physical address associated with each of their accounts (i.e., where 
the account is organized as a legal entity). This physical address 
is designated the registered office location by TIW. When an account 
reports a registered office location, we have assumed that the 
registered office location reflects the place of domicile for the 
fund or account. When an account does not report a registered office 
location, we have assumed that the settlement country reported by 
the investment adviser or parent entity to the fund or account is 
the place of domicile. Thus, for purposes of this analysis, the 
Commission has classified accounts as ``U.S. counterparties'' when 
they have reported a registered office location in the United 
States. The Commission notes, however, that this classification is 
not necessarily identical in all cases to the definition of U.S. 
person under Rule 3a71-3(a)(4).
    \216\ The challenges the Commission faces in estimating measures 
of current market activity stem, in part, from the absence of 
comprehensive reporting requirements for security-based swap market 
participants. The Commission has adopted rules regarding trade 
reporting, data elements, and public reporting for security-based 
swaps that are designed to, when fully implemented, provide the 
Commission with additional measures of market activity that will 
allow us to better understand and monitor activity in the security-
based swap market. See Regulation SBSR Adopting Release, 81 FR at 
53545.
---------------------------------------------------------------------------

b. Affected SBS Entities
    Final SBS Entity registration rules have been adopted, but 
compliance is not yet required. Therefore, we do not have data on the 
actual number of SBS Entities that will register with the Commission, 
or the number of persons associated with registered SBS Entities. The 
Commission has elsewhere estimated that up to 50 entities may register 
with the Commission as security-based swap dealers, and up to five 
additional entities may register as major security-based swap 
participants,\217\ and these estimates remain unchanged.
---------------------------------------------------------------------------

    \217\ See, e.g., Registration Adopting Release, 80 FR at 49000.
---------------------------------------------------------------------------

    Firms that act as dealers play a central role in the security-based 
swap market. Based on an analysis of 2017 single-name CDS data in TIW, 
accounts of those firms that are likely to exceed the

[[Page 4651]]

security-based swap dealer de minimis thresholds and trigger 
registration requirements for intermediated transactions with a gross 
notional amount of approximately $2.9 trillion, approximately 55% of 
the gross notional intermediated by the top five dealer accounts.\218\
---------------------------------------------------------------------------

    \218\ The Commission staff analysis of DTCC Derivatives 
Repository Limited Trade Information Warehouse transaction records 
indicates that approximately 99% of single-name CDS price-forming 
transactions in 2017 involved an ISDA-recognized dealer.
---------------------------------------------------------------------------

    These dealers transact with hundreds or thousands of 
counterparties. Approximately 21% of accounts of firms expected to 
register as security-based dealers and observable in TIW have entered 
into security-based swaps with over 1,000 unique counterparty accounts 
as of year-end 2017.\219\ Another 25% of these accounts transacted with 
500 to 1,000 unique counterparty accounts; 29% transacted with 100 to 
500 unique accounts; and 25% of these accounts intermediated security-
based swaps with fewer than 100 unique counterparties in 2017. The 
median dealer account transacted with 495 unique accounts (with an 
average of approximately 570 unique accounts). Non-dealer 
counterparties transacted almost exclusively with these dealers. The 
median non-dealer counterparty transacted with two dealer accounts 
(with an average of approximately three dealer accounts) in 2017.
---------------------------------------------------------------------------

    \219\ Many dealer entities and financial groups transact through 
numerous accounts. Given that individual accounts may transact with 
hundreds of counterparties, the Commission may infer that entities 
and financial groups may transact with at least as many 
counterparties as the largest of their accounts.
---------------------------------------------------------------------------

c. Other Market Participants
    In addition to dealers, thousands of other participants appear as 
counterparties to security-based swap contracts in our sample, and 
include, but are not limited to, investment companies, pension funds, 
private funds, sovereign entities, and industrial companies. We observe 
that most non-dealer users of security-based swaps do not engage 
directly in the trading of swaps, but trade through banks, investment 
advisers, or other types of firms acting as dealers or agents. Based on 
an analysis of the counterparties to trades reported to the TIW, there 
are 2,110 entities that engaged directly in trading between November 
2006 and December 2017.\220\
---------------------------------------------------------------------------

    \220\ These 2,110 entities, which are presented in more detail 
in Table 1, infra, include all DTCC-defined ``firms'' shown in TIW 
as transaction counterparties that report at least one transaction 
to TIW as of December 2017. The staff in the Division of Economic 
and Risk Analysis classified these firms, which are shown as 
transaction counterparties, by machine matching names to known 
third-party databases and by manual classification. See, e.g., 
Dealing Activity Adopting Release, 81 FR 8602, fn.43. Manual 
classification was based in part on searches of the EDGAR and 
Bloomberg databases, the SEC's Investment Adviser Public Disclosure 
database, and a firm's public website or the public website of the 
account represented by a firm. The staff also referred to ISDA 
protocol adherence letters available on the ISDA website.
---------------------------------------------------------------------------

    As shown in Table 1 below, close to three-quarters of these 
entities (DTCC-defined ``firms'' shown in TIW, which we refer to here 
as ``transacting agents'') were identified as investment advisers, of 
which approximately 40% (about 30% of all transacting agents) were 
registered as investment advisers under the Advisers Act.\221\ Although 
investment advisers are the vast majority of transacting agents, the 
transactions they executed account for only 12.8% of all single-name 
CDS trading activity reported to the TIW, measured by number of 
transaction-sides (each transaction has two transaction sides, i.e., 
two transaction counterparties). The vast majority of transactions 
(83.3%) measured by number of transaction-sides were executed by ISDA-
recognized dealers.
---------------------------------------------------------------------------

    \221\ See 15 U.S.C. 80b1-80b21. Transacting agents participate 
directly in the security-based swap market, without relying on an 
intermediary, on behalf of principals. For example, a university 
endowment may hold a position in a security-based swap that is 
established by an investment adviser that transacts on the 
endowment's behalf. In this case, the university endowment is a 
principal that uses the investment adviser as its transacting agent.

 Table 1--The number of Transacting Agents by Counterparty Type and the Fraction of Total Trading Activity, From
                   November 2006 Through December 2017, Represented by Each Counterparty Type
----------------------------------------------------------------------------------------------------------------
                                                                                                    Transaction
                       Transacting agents                             Number          Percent          share
                                                                                                     (percent)
----------------------------------------------------------------------------------------------------------------
Investment Advisers.............................................            1635            77.5            12.8
    - SEC registered............................................             658            31.2             8.6
Banks...........................................................             262            12.4             3.4
Pension Funds...................................................              29             1.4             0.1
Insurance Companies.............................................              42             2.0             0.2
ISDA-Recognized Dealers \222\...................................              17             0.8            83.3
Other...........................................................             125             5.9             0.2
                                                                 -----------------------------------------------
        Total...................................................           2,110           100.0             100
----------------------------------------------------------------------------------------------------------------

    Principal holders of CDS risk exposure are represented by 
``accounts'' in the TIW.\223\ The staff's analysis of these accounts in 
TIW shows that the 2,110 transacting agents classified in Table 1 
represent 13,137 principal risk holders. Table 2, below, classifies 
these principal risk holders by their counterparty type and whether 
they are represented by a registered or unregistered investment 
adviser.\224\ For instance, banks in Table 1 allocated transactions 
across 349 accounts, of which 20 were represented by investment 
advisers. In the remaining instances, banks traded for their own 
accounts. Meanwhile, ISDA-recognized dealers in Table 1 allocated 
transactions across 91 accounts. Private funds are the largest type of 
account holders that we were able to classify, and although not 
verified through a recognized database, most of the funds

[[Page 4652]]

we were not able to classify appear to be private funds.\225\
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    \222\ For the purpose of this analysis, the ISDA-recognized 
dealers are those identified by ISDA as belonging to the G14 or G16 
dealer group during the period: JP Morgan Chase NA (and Bear 
Stearns), Morgan Stanley, Bank of America NA (and Merrill Lynch), 
Goldman Sachs, Deutsche Bank AG, Barclays Capital, Citigroup, UBS, 
Credit Suisse AG, RBS Group, BNP Paribas, HSBC Bank, Lehman 
Brothers, Soci[eacute]t[eacute] G[eacute]n[eacute]rale, Credit 
Agricole, Wells Fargo and Nomura. See, e.g., https://www.isda.org/a/5eiDE/isda-operations-survey-2010.pdf.
    \223\ ``Accounts'' as defined in the TIW context are not 
equivalent to ``accounts'' in the definition of ``U.S. person'' 
provided by Exchange Act rule 3a71-3(a)(4)(i)(C). They also do not 
necessarily represent separate legal persons. One entity or legal 
person may have multiple accounts. For example, a bank may have one 
DTCC account for its U.S. headquarters and one DTCC account for one 
of its foreign branches.
    \224\ Unregistered investment advisers include all investment 
advisers not registered under the Investment Advisers Act and may 
include investment advisers registered with a state or a foreign 
authority as well as investment advisers that are exempt reporting 
advisers under Section 203(l) or 203(m) of the Investment Advisers 
Act.
    \225\ For the purposes of this discussion, ``private fund'' 
encompasses various unregistered pooled investment vehicles, 
including hedge funds, private equity funds, and venture capital 
funds. There remain over 5,800 DTCC accounts unclassified by type. 
Although unclassified, each account was manually reviewed to verify 
that it was not likely to be a special entity within the meaning of 
the Dodd-Frank Act and instead was likely to be an entity such as a 
corporation, an insurance company, or a bank.
    \226\ This column reflects the number of participants who are 
also trading for their own accounts.

    Table 2--The Number and Percentage of Account Holders--by Type--Who Participate in the Security-Based Swap Market Through a Registered Investment
                Adviser, an Unregistered Investment Adviser, or Directly as a Transacting Agent, from November 2006 Through December 2017
--------------------------------------------------------------------------------------------------------------------------------------------------------
 
--------------------------------------------------------------------------------------------------------------------------------------------------------
Account holders by type                                          Number       Represented by a
                                                                           registered investment
                                                                                  adviser
                                                                Represented by an
                                                             unregistered investment
                                                                      dviser
                                                                  Participant is
                                                             transacting agent \226\
--------------------------------------------------------------------------------------------------------------------------------------------------------
Private Funds.............................................        3,857        1,973           51%        1,859           48%           25            1%
DFA Special Entities......................................        1,319        1,262           96%           37            3%           20            2%
Registered Investment Companies...........................        1,159        1,082           93%           73            6%            4            0%
Banks (non-ISDA-recognized dealers).......................          349           20            6%            8            2%          321           92%
Insurance Companies.......................................          301          196           65%           34           11%           71           24%
ISDA-Recognized Dealers...................................           91            0            0%            0            0%           91          100%
Foreign Sovereigns........................................           83           63           76%            3            4%           17           20%
Non-Financial Corporations................................           75           52           69%            4            5%           19           25%
Finance Companies.........................................           20           11           55%            0            0%            9           45%
Other/Unclassified........................................        5,883        3,745           64%        1,887           32%          251            4%
                                                           ---------------------------------------------------------------------------------------------
    All...................................................       13,137        8,404           64%        3,905           30%          828            6%
--------------------------------------------------------------------------------------------------------------------------------------------------------

d. Outstanding Positions
    Our analysis here focuses on outstanding positions in single-name 
CDS. As we have previously noted, although the definition of a 
security-based swap is not limited to single-name CDS, we believe that 
the single-name CDS data is sufficiently representative of the market 
and therefore can directly inform the analysis of the state of the 
current security-based swap market.\227\ In 2017, there were 1,534,753 
single-name CDS transactions reported to DTCC-TIW, of which 1,036,155 
were transactions with a clearing agency as a counterparty.\228\ 
Currently, security-based swap transactions are generally negotiated 
and executed bilaterally, typically with a dealer as one of the 
counterparties. Indeed, based on our analysis of DTCC-TIW data for 
2017, more than 99% of single-name CDS transactions have an ISDA-
recognized dealer as a counterparty, and 31% of transactions are 
between two ISDA-recognized dealers.\229\
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    \227\ While other repositories may collect data on transactions 
in total return swaps on equity and debt, we do not currently have 
access to such data for these products (or other products that are 
security-based swaps). In the Cross-Border Proposing Release, we 
explained that we believed that data related to single-name CDS was 
reasonable for purposes of this analysis; such transactions appear 
to constitute roughly 82% of the security-based swap market as 
measured on a notional basis. See Cross-Border Proposing Release, 78 
FR at 31120 n. 1301. None of the commenters to that release disputed 
these assumptions, and we therefore continue to believe that, 
although the BIS data reflect the global OTC derivatives market, and 
not just the U.S. market, these ratios are an adequate 
representation of the U.S. market.
    Also consistent with our approach in that release, with the 
exception of the analysis regarding the degree of overlap between 
participation in the single-name CDS market and the index CDS market 
(cross-market activity), our analysis below does not include data 
regarding index CDS (including CDS based on narrow-based security 
indices) as we do not currently have sufficient information to 
identify the relative volumes of index CDS that are either swaps or 
security-based swaps.
    \228\ For the purposes of this analysis, we estimate there were 
approximately 1.53 million single-name CDS transactions in 2017, of 
which approximately 1.04 million were transactions with a clearing 
agency as a counterparty. In addition to CDS, security-based swap 
products include equity swaps, such as total return swaps on single 
names and swaps based on narrow-based security indices. The 
Commission currently lacks comprehensive data on equity swaps, 
including data on transaction volumes and notional amounts. While 
there were more than 1.53 million security-based swap transactions 
in 2017, we do not currently have sufficient information to 
precisely identify the number of transactions beyond those that were 
single-name CDS. However, while recognizing that average notional 
transaction amounts for equity and multi-name CDS may differ from 
average notional transaction amounts for CDS, our estimate (using 
data from 2015) that single-name CDS constitute roughly 82% of the 
security-based swap market implies that there were approximately 
337,000 security-based swap transactions in 2017 in addition to the 
approximately 1.53 million single-name CDS transactions we identify 
in the DTCC-TIW data, or 1.87 million total security-based swap 
transactions. Note that our estimate that single-name CDS 
constitutes roughly 82% of the security-based swap market is based 
on notional transaction amounts rather than transaction counts; in 
using this figure to estimate the total number of security-based 
swap transactions, we have assumed that the average notional amount 
is the same across single-name CDS, multi-name CDS, and equity 
swaps.
    \229\ For the purpose of this analysis, the reference to ``ISDA-
recognized dealers'' means those dealers identified by ISDA as 
belonging to the G14 or G16 dealer group during the period. This 
group includes: JP Morgan Chase NA (and Bear Stearns), Morgan 
Stanley, Bank of America NA (and Merrill Lynch), Goldman Sachs, 
Deutsche Bank AG, Barclays Capital, Citigroup, UBS, Credit Suisse 
AG, RBS Group, BNP Paribas, HSBC Bank, Lehman Brothers, 
Soci[eacute]t[eacute] G[eacute]n[eacute]rale, Credit Agricole, Wells 
Fargo and Nomura. See, e.g., https://www.isda.org/a/5eiDE/isda-operations-survey-2010.pdf. See also Aldasoro, Inaki, and Torsten 
Ehlers, 2018, The Credit Default Swap Market: What a Difference a 
Decade Makes, BIS Quarterly Review June 2018, Graph 2, available at: 
https://www.bis.org/publ/qtrpdf/r_qt1806b.pdf. https://www.bis.org/publ/qtrpdf/r_qt1806b.pdf. https://www.bis.org/publ/qtrpdf/r_qt1806b.pdf, Graph 2.
---------------------------------------------------------------------------

    As of December 30, 2017 there were 360,473 outstanding positions 
(with a gross notional value of $4.196 trillion) in single-name 
corporate CDS of which 252,108 positions ($2.095 trillion) did not 
include a central counterparty (``CCP'') as one of the counterparties. 
Of the 252,108 positions, 158,674 positions ($1.383 trillion) were 
between two market participants the Commission expects will register as 
SBS Entities, based on an analysis of DTCC-TIW data.\230\ In addition, 
90,559 positions ($0.684 trillion) were between an expected SBS Entity 
and a market participant not expected to register as an SBS Entity and 
2,875 ($0.028 trillion) were between two participants not expected to 
register as SBS Entities.
---------------------------------------------------------------------------

    \230\ See supra Section VI.B.1.b for current estimates of the 
number of SBS Entities.
---------------------------------------------------------------------------

    If transactions are examined instead, there were 383,212 price-
forming transactions in calendar-year 2017 (with an aggregate gross 
trade size of $5.304 trillion) in single-name corporate CDS of which 
175,600 transactions ($4.321 trillion) did not include a CCP as one of 
the counterparties. Of those 175,660

[[Page 4653]]

transactions, 75,119 transactions ($1.695 trillion) were between two 
expected SBS Entities, 99,370 transactions ($2.245 trillion) were 
between an expected SBS Entity and a participant not expected to 
register, and 1,171 transactions ($0.382 trillion) were between two 
participants not expected to register as SBS Entities.
    Further analysis of the data reveals that of the 24 expected SBS 
Entities with outstanding positions as of December 30, 2017, 10 are not 
U.S. persons and may be subject to similar requirements as those being 
proposed here by foreign regulators. We note that the data available to 
us from DTCC-TIW does not encompass those CDS positions that both: (i) 
Do not involve U.S. counterparties; \231\ and (ii) are based on non-
U.S. reference entities. Notwithstanding this limitation, we believe 
that the DTCC-TIW data provides sufficient information to identify the 
types of market participants active in the security-based swap market 
and the general pattern of transactions within that market.\232\ We 
find that of the outstanding positions on December 30, 2017, 317,854 
positions ($1.661 trillion) include at least one expected SBS Entity, 
3,037 ($0.018 trillion) are between non-U.S. domiciled expected SBS 
Entities and 60,948 ($0.489 trillion) are between a non-U.S, domiciled 
expected SBS Entity and a participant not expected to register as an 
SBS Entity.
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    \231\ We note that DTCC-TIW's determinations as to the domicile 
of a counterparty or reference entity may not reflect our definition 
of ``U.S. person'' in all cases. Our definition of ``U.S. person'' 
follows the definition used in the Commission's June 2014 release 
where it, among other things, adopted rules and guidance regarding 
the application of the certain Title VII definitions in the cross-
border context. See Application of ``Security-Based Swap Dealer'' 
and ``Major-Security-Based Swap Participant'' Definitions to Cross-
Border Security- Based Swap Activities, Exchange Act Release No. 
72472 (June 25, 2014), 79 FR 47277, 47303 (Aug. 12, 2014 
(republication)) (``Cross-Border Adopting Release'').
    \232\ The challenges we face in estimating measures of current 
market activity stems, in part, from the absence of comprehensive 
reporting requirements for security-based swap market participants. 
The Commission has adopted rules regarding trade reporting, data 
elements, and public reporting for security-based swaps that are 
designed to, when fully implemented, provide us with appropriate 
measures of market activity. See Regulation SBSR Adopting Release, 
80 FR at 14699-700.
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2. Current Portfolio Reconciliation Practices
    While the Commission does not have data on current portfolio 
reconciliation practices of security-based swap market 
participants,\233\ certain market participants we expect will register 
as SBS Entities are already subject to similar requirements from other 
regulators. In particular, those entities that are also registered with 
the CFTC as Swap Entities are subject to CFTC rules on portfolio 
reconciliation. These rules require Swap Entities to reconcile their 
swap portfolios with one another and to provide counterparties who are 
not registered as Swap Entities with regular opportunities for 
portfolio reconciliation.\234\ The Commission has reviewed these rules 
and preliminarily believes that, other than as expressly noted above in 
Section I.B, they are substantively identical to the rules we are 
proposing today.\235\
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    \233\ Although the Commission does not have information on the 
number of valuation discrepancies between counterparties in SBS 
markets, a June 2017 survey on dealer financing noted that two-
fifths of survey respondents reported that the volume of valuation 
disputes increased somewhat over the September 2016 to June 2017 
period. Small net fractions of dealers responded that the volume, 
duration, and persistence of mark and collateral disputes had 
increased in OTC derivatives, especially in foreign exchange and 
interest rate contracts. Three-fifths of dealers responded that, on 
average, it takes more than two days but less than a week to resolve 
a mark and collateral dispute on VM. One-third indicated two days or 
fewer. See Yesol Huh, Division of Research and Statistics, Federal 
Reserve Board, The June 2017 Senior Credit Officer Opinion Survey on 
Dealer Financing Terms, available at: https://www.federalreserve.gov/data/scoos/files/scoos_201706.pdf.
    \234\ See 17 CFR 23.502 (Portfolio reconciliation).
    \235\ See, e.g., supra Section I.B.2 for a discussion of 
similarities and differences in approach to the definition of 
material terms that must be reconciled.
---------------------------------------------------------------------------

    Further, SBS Entities that are domiciled outside of the U.S. may be 
subject to similar requirements of regulators from their home 
jurisdiction. For example, entities subject to Chapter VII, Article 13 
of EU Regulation No 149/2013 already must comply with portfolio 
reconciliation requirements similar to those under the proposed rules. 
The EU regulations require all counterparties to agree on arrangements 
under which portfolios shall be reconciled before entering into an OTC 
derivative contract. Furthermore, the frequency of portfolio 
reconciliation under those regulations depends on both whether either 
counterparty is a ``financial counterparty'' or a ``non-financial 
counterparty'' (each as defined in European regulations), and the 
number of outstanding contracts between the counterparties.
    In addition to regulations that may apply to certain SBS Entities 
that are either dually registered with the CFTC as Swap Entities or 
subject to similar portfolio reconciliation rules in other 
jurisdictions, portfolio reconciliation forms a part of current market 
practices. In particular, ISDA publishes a set of `best practices' for 
its members for the OTC derivatives collateral process that addresses, 
among other things, portfolio reconciliation of non-cleared OTC 
derivatives.\236\ These `best practices' include written agreement 
between counterparties as to the terms of the reconciliation and 
reconciliation tolerances, and also recognize both the CFTC and EU 
rules pertaining to portfolio reconciliation.
---------------------------------------------------------------------------

    \236\ See ISDA, 2013 Interim Updated Best Practices for the OTC 
Derivatives Collateral Process, Best Practices 10.1--10.6 (Oct. 23, 
2013), available at: https://www2.isda.org/attachment/NjA3NQ==/2013%20ISDA%20Best%20Practices%20for%20the%20OTC%20Derivatives%20Collateral%20Process%20-%20FINAL.pdf (``ISDA Collateral Best 
Practices'').
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3. Current Portfolio Compression Practices
    While the Commission does not have data on current portfolio 
compression practices of security-based swap market participants, 
certain SBS Entities are already subject to similar compression 
requirements in other contexts similar to the situation involving 
portfolio reconciliation. Specifically, SBS Entities that are also 
registered with the CFTC as Swap Entities are subject to CFTC rules on 
portfolio compression. As discussed above, the Commission has reviewed 
those rules and preliminarily believes that they are, other than as 
expressly noted above in Section I.C, substantively identical to the 
rules we are proposing today.
    Further, SBS Entities that are domiciled outside of the U.S. may be 
subject to similar requirements from regulators in their home 
jurisdiction. For example, entities subject to Chapter VII, Article 14 
of EU Regulation No 149/2013 already must comply with portfolio 
compression requirements. Under these requirements any entity that has 
500 or more non-cleared OTC derivative contracts with any one 
counterparty must have procedures in place to regularly (at least twice 
a year) analyze the possibility of conducting a portfolio compression 
exercise in order to reduce their counterparty credit risk and engage 
in such a portfolio compression exercise. The EU regulations differ 
from these proposed rules in a few important ways, including their 
application to all OTC derivative positions, not just security-based 
swaps, as well as the minimum frequency of compression exercises. 
Moreover, both financial and non-financial counterparties are required 
under the EU regulations to ensure that they are able to provide ``a 
reasonable and valid explanation to the relevant competent authority 
for concluding that a portfolio compression exercise is not 
appropriate.''

[[Page 4654]]

    In addition to regulations that may apply to certain SBS Entities 
that are either dually registered with the CFTC as Swap Entities or 
subject to similar portfolio compression rules in other jurisdictions, 
portfolio compression forms a part of current market practices. The 
ISDA Collateral Best Practices also includes a best practice that 
addresses portfolio compression, explaining that trades that are 
subject to industry-wide trade-reducing events should be removed from 
the portfolio on the day the trade-reducing event occurs and that this 
should be in agreement with governing documentation for the applicable 
risk reducing process.\237\
---------------------------------------------------------------------------

    \237\ See ISDA Collateral Best Practices, supra note 236, Best 
Practice 8.4.
---------------------------------------------------------------------------

    Although we lack data on current portfolio compression practices of 
individual SBS market participants, the importance of portfolio 
compression is illustrated by the scope of its use among security-based 
swap market participants.\238\ In March 2010, DTCC explicitly 
attributed the reduction in the gross notional value of the credit 
derivatives in its warehouse to industry supported portfolio 
compression.\239\ Using data from TriOptima, the BIS reports CDS 
portfolio compression rates as high as 25% of notional outstanding in 
the first half of 2008.\240\ Compression volumes fell steadily over the 
following years due, in part, to falling transaction volumes and the 
rise of central clearing.\241\ TriOptima, as well as other firms, 
continue to offer compression services, and the Commission 
preliminarily believes that the fact that market participants continue 
to find it worthwhile to pay for such services lends support to the 
argument that market participants view portfolio compression as a 
valuable tool.
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    \238\ The data available to the Commission with respect to 
portfolio compression does not allow for enumeration of the actual 
participants which participate in such practices; however, 
inferences regarding the scope can be drawn from the magnitude of 
the reduction in the gross notional value of the credit derivatives.
    \239\ See DTCC Press Release, DTCC Trade Information Warehouse 
Completes Record Year Processing OTC Credit Derivatives, (Mar. 11, 
2010). Notably, beginning in August 2008, ISDA encouraged 
compression exercises for CDS by selecting the service provider and 
defining the terms of service.
    \240\ See Aldasoro, Inaki, and Torsten Ehlers, 2018, The Credit 
Default Swap Market: What a Difference a Decade Makes, BIS Quarterly 
Review June 2018, Graph 1 panel 2 and accompanying text, available 
at: https://www.bis.org/publ/qtrpdf/r_qt1806b.pdf. In March of 2010, 
the staff of the FRBNY estimated that since 2008 nearly $50 trillion 
gross notional of CDS positions has been eliminated through 
portfolio compression. See FRBNY OTC Derivatives Report, supra note 
62.
    \241\ Id.
---------------------------------------------------------------------------

    The chart below illustrates the opportunities for portfolio 
compression between 2010 and 2017 for single-name security-based 
swaps.\242\ As the gap between gross and net notional values widens, 
the opportunities for portfolio compression increase. Over our 
reference period, however, the difference between gross and net 
notional values has declined. For instance, in 2010, the percentage, 
which captures the ratio of net to gross notional value, was 11.0%, but 
this number has been gradually increasing through December 30, 2018 
when it was 15.2%. Smaller ratios indicate greater opportunities for 
portfolio compression; however, as shown in the chart below, based on 
changes in gross and net notional value over time, unexploited 
opportunities for compression are diminishing.\243\
---------------------------------------------------------------------------

    \242\ The chart below includes only gross and net notional of 
single-name security-based swaps. The inclusion of index security-
based swaps could expand potential compression opportunities 
available to SBS Entities.
    \243\ The result is likely driven by banks and securities firms. 
See Aldasoro, Inaki, and Torsten Ehlers, 2018, supra note 240, Graph 
5.

[GRAPHIC] [TIFF OMITTED] TP15FE19.000



[[Page 4655]]


    It is possible that market participants may already be taking 
advantage of portfolio compression opportunities. However, the 
Commission does not infer that the entirety of the reduction in the gap 
between gross and net notional values is due to portfolio compression 
exercises. Other plausible explanations for the reduction in the gross 
notional value of security-based swaps include both fewer and/or 
smaller new transactions, expiration of existing positions without 
rollover into new positions, and loss or consolidation of market 
participants throughout time. Due to limitations of the data available 
to the Commission, it is infeasible to distinguish the overall effect 
of portfolio compression exercises on the reduction in the gross 
notional value of the security-based swap market from the alternative 
explanations presented above.
4. Current Trading Relationship Documentation Practices
    Memorializing the specific terms of the security-based swap trading 
relationship and security-based swap transactions between 
counterparties is prudent business practice and, in fact, many market 
participants already use standardized documentation. Examination of the 
use of ISDA Master Agreements (the measure of trading relationship 
documentation available to the Commission in the data provided by DTCC-
TIW) shows that the percentage of transactions with these agreements 
declines from 78.2% in 2008 to 34.1% in 2017, with the peak occurring 
in 2010 (96.1%). However, as trading relationship documentation may be 
different when the counterparty is a CCP, an analysis of documentation 
on aggregate security-based swap transactions (both cleared and 
uncleared) may be misleading. With the introduction of ICE Clear Credit 
in 2009, the percentage of cleared transactions has increased over 
time, thus a seemingly more relevant measure to look at is the 
frequency of use of ISDA Master Agreements for uncleared transactions. 
Approximately 99% of all uncleared transactions are reported (by DTCC-
TIW) as using trading relationship documentation (in the form of ISDA 
Master Agreements) in 2017 compared to 78.2% in 2008. Accordingly, the 
Commission generally believes that many, if not most, market 
participants currently execute and maintain trading relationship 
documentation of the type required by the proposed rules in the 
ordinary course of their businesses, including documentation that 
contains several of the terms that would be required by the proposed 
rules.
    Finally, and similar to the discussion regarding the reconciliation 
and compression, SBS Entities that are also registered with the CFTC as 
Swap Entities are subject to CFTC rules requiring the use of trading 
relationship documentation. As discussed above, the Commission has 
reviewed those rules and preliminarily believes that they are, other 
than as expressly noted above in Section I.D, substantively identical 
to the rules we are proposing today.

C. Economic Costs and Benefits, Including Impact on Efficiency, 
Competition, and Capital Formation

    In this section we first discuss the expected effects of the 
proposed rules on efficiency, competition, and capital formation, 
focusing particularly on the risk-mitigation benefits that stem from 
the use of portfolio reconciliation, expanding opportunities for 
portfolio compression, and improvements in documentation. We then turn 
our discussion to additional costs and benefits, including compliance 
costs and alternatives considered of the proposed rules.
1. Effects on Efficiency, Competition, and Capital Formation
    Risk mitigation rules have the potential to affect efficiency, 
competition, and capital formation in the security-based swap market, 
primarily through a reduction in operational, market, and credit risks 
that accompany outstanding security-based swap positions. In addition, 
the substituted compliance framework may provide additional effects 
that are distinct from the broader market impacts that are described 
below. As with the benefits and costs, we believe that several of the 
effects described below only occur to the extent that current market 
practices do not already conform to our proposed rules.
a. Broad Market Effects
    In the release adopting final rules requiring SBS Entities to 
provide trade acknowledgments and to verify those trade acknowledgments 
with their counterparties to security-based swap transactions, the 
Commission explained the importance of confirming trades in a timely 
manner, noting that confirmation of the terms of a transaction is 
essential for SBS Entities ``to effectively measure and manage market 
and credit risk.'' ^{244 245} In this regard, portfolio 
reconciliation addresses many of these same issues, but unlike the 
confirmation process, which occurs at the outset of a transaction, 
reconciliation operates throughout the life of the transaction.\246\
---------------------------------------------------------------------------

    \244\ See Trade Acknowledgment and Verification Adopting 
Release, 81 FR at 39833.
    \245\ See supra Section I.B.1.
    \246\ See id.
---------------------------------------------------------------------------

    Failure to periodically conduct portfolio reconciliation may cause 
errors and disputes over the terms of a transaction that may exist to 
go undetected, leading to errors in measurement and management of 
market and credit risks associated with particular transactions. More 
generally, timely portfolio reconciliation will provide counterparties 
with accurate information that will enable them to evaluate their own 
risk exposure in a timely manner. Efficient and cost-effective risk 
management may conserve resources and free up capital that can be 
deployed in other asset classes, promoting risk-sharing and efficient 
capital allocation. In addition, cost-effective risk management may 
reduce the overall costs of financial intermediation, allowing market 
participants to increase lending and other capital formation 
activities.
    Similarly, periodic portfolio reconciliation and improved standards 
for transaction documentation may contribute to broader market 
stability, particularly during periods of distress. Disagreement as to 
one or more material terms of a transaction or inadequate documentation 
could hinder timely and efficient settlement of security-based swap 
transactions, particularly in the case of a credit event on a reference 
entity on which many different counterparties have, in the aggregate, a 
large notional outstanding exposure. During periods of financial 
distress, uncertainty about terms, value, and documentation of 
outstanding transactions could contribute to liquidity and cash 
shortfalls that threaten the stability of the financial system. Thus, 
to the extent that the proposed rules reduce uncertainty about 
outstanding transactions, we expect reduced risk of uncertainty about 
the credit risk of potential counterparties, particularly during a 
financial crisis.
    Finally, to the extent that portfolio reconciliation requirements 
differ from current market practices, the proposed rules have the 
potential to affect competition across multiple dimensions. If the 
costs of portfolio reconciliation, portfolio compression, and complying 
with transaction documentation rules for security-based swap 
transactions are largely fixed (i.e., the costs come from establishing 
infrastructure and systems necessary to

[[Page 4656]]

perform portfolio reconciliation and portfolio compression and comply 
with documentation requirements) rather than varying with the number of 
transactions or positions outstanding, smaller dealers intermediating a 
smaller number of trades may have a larger burden placed on them; 
larger dealers, on the other hand, may be able to spread the costs over 
a greater number of trades or positions, with a lower average cost of 
complying with these rules. Similarly, the costs of establishing an 
infrastructure to comply with these requirements may create a barrier 
to entry for market participants wishing to establish a SBS dealer 
business.\247\
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    \247\ The Commission does not expect that this effect would 
extend to major SBS participants, which are by definition the 
largest non-dealer participants in the security-based swap market. 
As described in the economic baseline, out of more than 4,000 
security-based swap market participants, we expect at most five to 
register as major SBS participants. These entities maintain 
substantial positions in security-based swaps, as defined in the 
Intermediary Definitions Adopting Release, and the Commission 
expects these entities have sufficient resources and infrastructure 
to comply with portfolio reconciliation and documentation 
requirements.
---------------------------------------------------------------------------

b. Substituted Compliance
    As discussed above, if the Commission has made a positive 
substituted compliance determination with respect to a particular 
foreign regulatory regime, SBS Entities operating in that jurisdiction 
may be able to satisfy their Title VII risk mitigation requirements by 
complying with similar requirements of the foreign financial regulatory 
system. Substituted compliance would be available only for SBS Entities 
who are not U.S. persons.
    The Commission is proposing to amend its rules to make substituted 
compliance potentially available to the portfolio reconciliation, 
portfolio compression, and trading relationship documentation 
requirements in order to minimize the likelihood that SBS dealers are 
subjected to potentially duplicative or conflicting regulation. The 
Commission preliminarily believes that duplicative regulations that 
achieve comparable regulatory outcomes increase the compliance burdens 
on market participants without corresponding increases in benefits. By 
decreasing the compliance burden for foreign SBS dealers active in the 
U.S. market, the availability of substituted compliance could encourage 
foreign firms' participation in the U.S. market, increasing the ability 
of U.S. firms to access global liquidity, and reducing the likelihood 
that liquidity would fragment along jurisdictional lines. Such 
participation and access to liquidity might result in increased 
competition between both U.S. and foreign intermediaries without 
compromising the regulatory benefits intended by the applicable risk 
mitigation rules.
2. Portfolio Reconciliation
    Disputes related to confirming the terms of a swap, as well as swap 
valuation disputes, have long been recognized as a significant problem 
in the OTC derivatives market. The Commission preliminarily believes 
that the ability to determine definitively the value of a security-
based swap at any given time is an important component of many of the 
OTC derivatives market reforms contained in the Dodd-Frank Act and is a 
component of sound risk management practices.\248\ Security-based swap 
valuation is also crucial for determining capital and margin 
requirements applicable to SBS Entities and therefore plays a primary 
role in risk mitigation for uncleared security-based swaps. Portfolio 
reconciliation is considered an effective means of identifying and 
resolving these disputes at a time and in a manner that will be least 
disruptive to the counterparties and the broader financial system.
---------------------------------------------------------------------------

    \248\ See ISDA Collateral Best Practices, supra note 236, 
Section 10.
---------------------------------------------------------------------------

    Parties may dispute valuations of thinly traded security-based 
swaps where there is not agreement on valuation methodologies or the 
source for formula inputs. Many of these security-based swaps are 
thinly traded either because of their limited liquidity or because they 
are simply too customized to have comparable counterparts in the 
market. As many of these security-based swaps are valued by dealers 
internally by ``marking-to-model,'' their counterparties may dispute 
the inputs and methodologies used in the model. As uncleared security-
based swaps are bilateral, privately negotiated contracts, on-going 
security-based swap valuation for purposes of initial and variation 
margin calculation and security-based swap terminations or novations, 
also has been largely a process of on-going negotiation between the 
parties. The inability to agree on the value of a security-based swap 
became especially acute during the financial crisis that immediately 
preceded passage of the Dodd-Frank Act when there was widespread 
failure of the market inputs needed to value many security-based 
swaps.\249\
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    \249\ The lack of liquidity in markets for mortgage-backed 
securities led to wide disparities in the valuation of CDS 
referencing mortgage-backed securities (especially collateralized 
debt obligations). Such wide disparities led to large collateral 
calls from dealers on AIG, hastening its downfall. See CBS News, 
``Calling AIG? Internal Docs Reveal Company Silent About Dozens of 
Collateral Calls,'' June 23, 2009, available at: https://www.cbsnews.com/stories/2009/06/23/cbsnews_investigates/main5106672.shtml; See also Financial Crisis Inquiry Commission, The 
Financial Crisis Inquiry Report: Final Report of the National 
Commission on the Causes of the Financial and Economic Crisis in the 
United States, Chapter 8, available at: https://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
---------------------------------------------------------------------------

a. Requirements
    The Commission is proposing rules and interpretations that 
generally would require each SBS Entity (1) to engage in portfolio 
reconciliation with counterparties who are also SBS Entities at 
periodic intervals based on the number of outstanding transactions with 
the counterparty and (2) to establish, maintain, and follow written 
policies and procedures reasonably designed to ensure that it engages 
in portfolio reconciliation with counterparties who are not SBS 
Entities, also at periodic intervals based on the number of outstanding 
transactions with the counterparty.\250\
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    \250\ Pursuant to proposed Rule 15Fi-3(d), the new requirements 
regarding portfolio reconciliation would not apply to a clearing 
transaction (i.e., a security-based swap that has a clearing agency 
as a direct counterparty). See supra note 58 and accompanying text.
---------------------------------------------------------------------------

    The Commission is proposing to vary the proposed portfolio 
reconciliation requirement based on the particular type of counterparty 
with which the SBS Entity transacts. For transactions between two SBS 
Entities, the proposed rules would require the two sides to engage in 
portfolio reconciliation at frequencies that are based on the size of 
the security-based swap portfolio between the two parties.\251\ In 
addition to the requirements regarding the frequency of the 
reconciliation, proposed Rule 15Fi-3(a)(1) would require the two SBS 
Entities to agree in writing with each of their counterparties on the 
terms of the portfolio reconciliation including, if applicable, 
agreement on the selection of any third party service provider who may 
be performing the reconciliation.
---------------------------------------------------------------------------

    \251\ See proposed Rule 15Fi-3(a).
---------------------------------------------------------------------------

    To the extent that the two SBS Entities identify a discrepancy, the 
proposed rule would require the parties to take certain steps. First, 
proposed Rule 15Fi-3(a)(4) would require the two sides to resolve 
immediately any discrepancy in a material term, whether identified 
directly as part of the portfolio reconciliation or otherwise. Second, 
proposed Rule 15Fi-3(a)(5) would require each SBS Entity to establish, 
maintain, and follow written policies and procedures reasonably 
designed to resolve any discrepancy in a valuation identified as part 
of a

[[Page 4657]]

portfolio reconciliation or otherwise as soon as possible, but in any 
event within five business days after the date on which the discrepancy 
is first identified. As a condition to this requirement, however, 
proposed Rule 15Fi-3(a)(5) would require each SBS Entity to establish, 
maintain, and follow written policies and procedures reasonably 
designed to identify how the SBS Entity will comply with any variation 
margin requirements under Section 15F(e) of the Exchange Act \252\ and 
any related regulations pending resolution of the valuation 
discrepancy. Finally, proposed Rule 15Fi-3(a)(5) would clarify that for 
purposes of the requirement to resolve valuation discrepancies within 
five business days of being identified, a difference between the lower 
valuation and the higher valuation of less than 10% of the higher 
valuation need not be deemed a discrepancy.\253\
---------------------------------------------------------------------------

    \252\ 15 U.S.C. 78o-10(e).
    \253\ This 10% threshold would apply on a transaction-by-
transaction basis, and not on a portfolio level.
---------------------------------------------------------------------------

    Separately, with respect to transactions between an SBS Entity and 
a counterparty that is not an SBS Entity, proposed Rule 15Fi-3(b) would 
require each SBS Entity to establish, maintain, and follow written 
policies and procedures reasonably designed to ensure that it engages 
in portfolio reconciliation as set forth in the rule.\254\ This is in 
contrast to proposed Rule 15Fi-3(a), which expressly requires portfolio 
reconciliation with respect to transactions where both counterparties 
are SBS Entities.
---------------------------------------------------------------------------

    \254\ See proposed Rule 15Fi-3(b).
---------------------------------------------------------------------------

    Proposed Rule 15Fi-3(b) contains a number of requirements regarding 
the contents of the policies and procedures required therein, as they 
relate to reconciliation with non-SBS Entities, which are largely 
consistent with the requirements imposed directly on the parties under 
proposed Rule 15Fi-3(a). Specifically, proposed Rule 15Fi-3(b)(3) 
provides that such policies and procedures must require that the 
portfolio reconciliation be performed no less frequently than: (1) Once 
each calendar quarter for each security-based swap portfolio that 
includes more than 100 security-based swaps at any time during the 
calendar quarter and (2) once annually for each security-based swap 
portfolio that includes no more than 100 security-based swaps at any 
time during the calendar year.
    In addition, proposed Rule 15Fi-3(b)(4) requires each SBS Entity to 
establish, maintain, and follow written procedures reasonably designed 
to resolve any discrepancies in the valuation or a material term of 
each security-based swap identified as part of a portfolio 
reconciliation or otherwise with a counterparty that is not an SBS 
Entity within five days.\255\
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    \255\ Similar to the requirement in paragraph (a) of the 
proposed rule for portfolio reconciliation with counterparties that 
are either SBS dealers or major SBS participants, proposed Rule 
15Fi-3(b)(4) provides that a difference between the lower valuation 
and the higher valuation of less than 10% of the higher valuation 
need not be deemed a discrepancy for purposes of that paragraph. See 
supra note 39 and accompanying text (discussing the 10% threshold in 
the context of Rule 15Fi-3(a)(5)).
---------------------------------------------------------------------------

    Finally, proposed Rule 15Fi-3(c) would require each SBS Entity to 
promptly notify the Commission of any security-based swap valuation 
dispute in excess of $20,000,000 (or its equivalent in any other 
currency) if not resolved within:
     three business days, if the dispute is with a counterparty 
that is an SBS Entity, or
     five business days, if the dispute is with a counterparty 
that is not an SBS Entity.
    Such notification would be required to be in a form and manner 
acceptable to the Commission, and would also be required to be sent to 
any applicable prudential regulator (i.e., for any SBS Entity that is 
also a bank, to its bank regulator).\256\
---------------------------------------------------------------------------

    \256\ See supra Section I.B.6.
---------------------------------------------------------------------------

    For the security-based swap market to operate efficiently and to 
reduce credit and operational risk between counterparties, the 
Commission preliminarily believes that, although the frequency of 
portfolio reconciliation depends on the number of positions with a 
counterparty, reconciliation should occur by position because terms may 
vary across positions with the same counterparty. By identifying and 
managing mismatches in key economic terms and valuation for individual 
transactions across an entire portfolio, these rules are intended to 
require a process in which risk between counterparties can be 
identified and reduced.
b. Benefits
    Reconciliation is beneficial not only to the parties involved but 
also to the markets as a whole. By identifying and managing disputed 
key economic terms or valuation for each transaction across a 
portfolio, an entity's counterparty credit risk and operational risk 
can be diminished. By requiring a systematic reconciliation process, as 
well as policies and procedures related to portfolio reconciliation 
between counterparties, SBS Entities will be able to better identify 
and correct problems in a timely manner in their post-execution 
processes (including confirmation) in order to reduce the number of 
disputes and improve the integrity and efficiency of their internal 
processes. Accordingly, expanding the universe of participants subject 
to the reconciliation requirements can help to reduce the risk 
bilateral markets may pose to the broader financial system.
    As discussed above, because shortcomings in credit risk management 
and documentation may only become evident during a crisis, some 
benefits of portfolio reconciliation will accrue to the financial 
system as a whole while the ongoing direct costs are borne by the 
individual market participant. Therefore, in the absence of these 
rules, the level and frequency of portfolio reconciliation chosen by 
individual market participants may be less than what would be desired 
by all market participants in order to properly manage risks to the 
financial system.
    In addition, the Commission preliminarily believes that the 
proposed tiering of obligations, whereby the frequency of the portfolio 
reconciliation would be based on the number of outstanding transactions 
with the applicable counterparty, represents a reasonable attempt to 
calibrate the costs to the benefits expected from reconciling a 
person's security-based swap portfolio at regular intervals. In this 
respect, those benefits would be expected to rise for larger--and often 
more complex--portfolios that may represent a greater potential for 
loss than a smaller, less complex portfolio.
    The Commission preliminarily believes that, given the expected 
benefits of making the frequency of portfolio reconciliation a function 
of the size of a portfolio with a particular counterparty, setting the 
frequency of reconciliation identical to that adopted by the CFTC will 
provide additional benefit for SBS Entities that are also registered 
with the CFTC as Swap Entities. In particular, harmonizing the 
frequency of reconciliation for swaps and SBS should reduce 
implementation cost and reduce operational complexity.
    Similarly, the Commission notes that the EC has adopted portfolio 
reconciliation requirements for the EU that are similar to those 
proposed by the Commission in this release. The Commission 
preliminarily believes that aligning its portfolio reconciliation 
requirements with those in other major security-based swap markets will 
benefit SBS Entities by avoiding the imposition of disparate compliance 
and operational policies and procedures.

[[Page 4658]]

    Moreover, proposed Rule 15Fi-3(a)(2) provides that portfolio 
reconciliation may be performed either on a bilateral basis by the 
counterparties or by a third party selected by the counterparties in 
accordance with paragraph (a)(1) of the proposed rule. Under this 
approach, the process for selecting a third-party service provider--or 
the actual identity of the service provider--should be included in the 
written agreement between the two sides setting forth the terms of the 
portfolio reconciliation process.
    In the absence of periodic portfolio reconciliation, if the 
counterparties to a security-based swap transaction are not in 
agreement with respect to each of the terms of the transaction that may 
affect each party's rights and obligations, any such difference could 
lead to complications at various points throughout the trade.\257\ 
These discrepancies could be exacerbated if they remain undetected 
until such times as the parties become obligated to perform on their 
requirements under the contract. Such discrepancies could be 
particularly problematic if they are discovered during a period of 
financial stress for the market participant.\258\ Thus, portfolio 
reconciliation may help to mitigate the possibility of a discrepancy 
unexpectedly affecting performance by ensuring that the parties are and 
remain in agreement with respect to all of the material terms of the 
security-based swap transaction.
---------------------------------------------------------------------------

    \257\ See supra note 14.
    \258\ See supra note 203.
---------------------------------------------------------------------------

    Regular reconciliation of all portfolios is a process to reduce 
counterparty credit exposure and operational risk and help prevent 
disputes from arising. The rule should promote market integrity and 
reduce risk by establishing procedures that will promote legal 
certainty concerning security-based swap transactions, assist with the 
early resolution of valuation disputes, reduce operational risk, and 
increase operational efficiency.
    The proposed rules may have differential benefits for smaller 
market participants. Smaller market participants may not have the 
bargaining power necessary to compel larger counterparties to 
coordinate on portfolio reconciliation. Since SBS Entities, absent a 
mandate, are likely to focus risk management resources on larger 
counterparties, the ability of smaller counterparties to require the 
necessary cooperation from their counterparties who are SBS Entities 
will be improved. Reduced uncertainty concerning material terms and 
valuation methodologies could reduce the risks to these smaller 
participants for using SBS for hedging market risk to which they may be 
exposed.
    Portfolio reconciliation is particularly relevant with respect to 
terms related to the valuation of the instrument. Unresolved 
discrepancies regarding the value of a security-based swap can lead to, 
among other things, active disputes between counterparties with respect 
to the amount of margin that must be posted or collected, as well as 
errors and other complications that may result in significant 
uncollateralized exposure in the uncleared security-based swap markets 
(or alternately, potentially inefficient overcollateralization). 
Accordingly, we preliminarily believe that requiring counterparties to 
clearly document the applicable processes and requirements for 
calculating and exchanging margin in connection with a security-based 
swap transaction is an important step in achieving this broader 
regulatory objective.
    The notification requirement of proposed Rule 15Fi-3(c) would 
provide the Commission with information about disagreements over 
position values between counterparties. Valuation is one of the most 
fundamental elements for determining the economic rights and 
obligations of each of the counterparties to a security-based swap 
transaction. For example, market participants manage credit risks to 
their counterparties by exchanging margin with each other in an amount 
determined using the value of the underlying security-based swap. If 
those valuations are not accurate for any reason, such as human or 
system errors, problems with the valuation methodology, or an issue 
affecting the timeliness of the calculation, that error could result in 
one of the counterparties having an uncollateralized credit exposure 
and a potential for loss in the event of a default. We therefore expect 
that the notification requirement could assist the Commission in 
anticipating potential valuation problems that could ultimately lead to 
market disruption, and in identifying potential issues with respect to 
an SBS Entity's internal valuation methodology. As noted above, the 
CFTC has adopted a nearly identical requirement with the same 
$20,000,000 threshold, and the Commission believes that divergence from 
that requirement could lead to additional costs for SBS Entities that 
are also registered with the CFTC as Swap Entities.\259\ Finally, as 
discussed above, the Commission preliminarily believes reconciliation 
may provide indirect benefits by improving the accuracy of SDR 
data.\260\ As described above in Section I.B.2, the information that 
SBS Entities would initially be required to reconcile with their 
counterparties would include each term that is required to be reported 
to a registered SDR under Rule 901 under the Exchange Act.\261\
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    \259\ See supra Section I.B.6.
    \260\ See SDR Adopting Release, 80 FR at 14528-48, for a 
discussion of the expected economic benefits accurate SBS data held 
at SDRs.
    \261\ See proposed Rule 15Fi-1(i)(1) (referencing 17 CFR 
242.901).
---------------------------------------------------------------------------

c. Costs
    The portfolio reconciliation rules the Commission is proposing 
today are similar to the corresponding CFTC rules for Swap Entities. As 
a result, the one-time costs to develop, test, and implement new 
procedures and technology that may be required in order to be compliant 
with the proposed rules are mitigated by the fact that many SBS 
Entities also are likely to be Swap Entities. These dually registered 
entities are likely to be familiar with these general requirements and 
have the infrastructure in place to comply with similar rules that 
apply to their swap business.
    SBS Entities that are not also CFTC-regulated Swap Entities and 
that do not currently use an electronic platform or vendor service to 
conduct portfolio reconciliation will need to expend significant time 
and resources to modify the necessary systems to comply with proposed 
Rule 15Fi-3. Even those SBS Entities that do use electronic platforms 
or vendors services may find it necessary to make significant 
adjustments to comply with the rules. The Commission estimates a one-
time upfront cost of approximately $5-10 million for an SBS Entity that 
is not also a Swap Entity.\262\ Although the Commission does not 
currently have cost data for either reconciliation performed in-house 
or by third-party service providers, and therefore cannot quantify 
these costs, the Commission preliminarily believes that the ongoing 
portfolio reconciliation cost would likely be a function of portfolio 
size and the availability of third party service providers.
---------------------------------------------------------------------------

    \262\ This estimate is based on an estimate supplied by ISDA to 
the CFTC in response to their proposed portfolio reconciliation 
rule. See CFTC Risk Mitigation Adopting Release 77 FR at 55952-3.
---------------------------------------------------------------------------

    In contrast, when commenting on the CFTC's then-proposed portfolio 
reconciliation rule, a third party provider of multilateral compression 
services stated that a large number of Swap Entities already regularly 
reconcile their portfolios with each other and with other entities and 
that

[[Page 4659]]

the increased frequency and inclusion of smaller portfolios as proposed 
should prove no obstacle to such entities.\263\ If SBS Entities have 
similar business practices, then this comment suggests start-up and on-
going portfolio reconciliation costs could be small.
---------------------------------------------------------------------------

    \263\ See Letter from Per Sj[ouml]berg, Executive Vice TriOptima 
AB to the CFTC, dated Feb. 28, 2011 at 2, available at: https://comments.cftc.gov/PublicComments/ViewComment.aspx?id=30562&SearchText.28, 2011 at 2, available at 
https://comments.cftc.gov/PublicComments/ViewComment.aspx?id=30562&SearchText.
---------------------------------------------------------------------------

    The Commission preliminarily believes that certain costs will arise 
despite the fact that an SBS Entity also may be registered with the 
CFTC as a Swap Entity, and therefore subject to similar rules already 
adopted by the CFTC. Such costs may include (i) increased costs to 
account for possible differences between the SEC and CFTC related to 
the terms considered to be material for purposes of the reconciliation 
requirement; (ii) the additional resources necessary to design, 
compose, and implement the required policies and procedures; (iii) the 
additional resources needed to comply with the dispute resolution 
timeframes; and (iv) the compilation and maintenance of applicable 
records. These costs, however, are by nature specific to each entity's 
internal operations; absent specific information from commenters, the 
Commission cannot provide reasonable estimations regarding the 
resources needed to comply.
    The proposed rule also requires SBS Entities to agree in writing 
with each of their counterparties on the terms of the portfolio 
reconciliation including, if applicable, agreement on the selection of 
any third party service provider who may be performing the 
reconciliation. Accordingly, each counterparty to a SBS Entity subject 
to these rules would incur an upfront cost in implementing this 
requirement, particularly since the Commission would expect that such 
terms be agreed to in writing prior to, or contemporaneously with, the 
two parties executing any new security-based swap transaction. These 
costs would be mitigated if, once the parties have agreed in writing on 
the terms of the portfolio reconciliation for the first time, the two 
sides comply with this requirement for subsequent transactions by 
merely agreeing in writing to abide by the existing agreement regarding 
the reconciliation process. This practice could help to ensure that 
portfolio reconciliation begins without delay after execution of the 
transaction and is designed to minimize the number of disagreements 
regarding the portfolio reconciliation process itself.
    The Commission estimates that of the 55 market participants we 
expect to register as SBS Entities, approximately 35 will be dually-
registered with the CFTC and may already have automated portfolio 
reconciliation systems in place. Thus, for these entities, the costs 
associated with modifying these existing systems to account for 
security-based swap reconciliations is expected to be minimal. For the 
remaining 20 SBS Entities which are not expected be dually-registered 
with the CFTC, the anticipated personnel costs associated with setting 
up an automated portfolio reconciliation system per SBS Entity is 
$58,795, or $1,175,900 in aggregate.^{264 265} The Commission 
preliminarily believes that these costs would be a component of the 
upfront cost estimate of $5-10 million discussed above.\266\ For each 
SBS Entity, we anticipate that approximately 190 hours per year will be 
required for reconciliation or a total of 10,450 hours across the 55 
SBS Entities.\267\ With respect to reconciliations with non-SBS 
counterparties, the Commission estimates that an additional 227.5 hours 
per SBS Entity, or 12,512.5 hours in aggregate would be needed for 
automated portfolio reconciliation with these counterparties.\268\
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    \264\ This estimate is based on the following: [(Sr. Programmer 
(80 hours) x $314 per hour) + (Sr. Systems Analyst (80 hours) x $269 
per hour) + (Compliance Manager (10 hours) x $293 per hour) + 
(Director of Compliance (5 hours) x $461 per hour) + (Compliance 
Attorney (20 hours) x $346 per hour)] = $58,795 per SBS Entity, or 
($58,795 x 20 SBS Entities) = $1,175,900 in aggregate.
    \265\ The hourly rates for internal professionals used 
throughout Sections VII.C.2.c, VII.C.3.c, and VII.C.4.c of the 
release are taken from SIFMA's Management & Professional Earnings in 
the Securities Industry 2013, modified to account for an 1800-hour 
work-year and inflation, and multiplied by 5.35 to account for 
bonuses, firm size, employee benefits, and overhead.
    \266\ See supra note 262 and associated text.
    \267\ Each SBS Entity is anticipated to have counterparty 
relationships with approximately one-third of the other SBS market 
participants (\1/3\ x 55 = 18.333), which is rounded to 18 
participants. Of those counterparty relationships, two are expected 
to have portfolios in excess of 500 positions, which would need to 
be reconciled daily (252 trading days per year), four would have 
between 50 and 500 positions, which would need to be reconciled 
weekly (52 weeks per year), and the remaining 12 would have less 
than 50 positions, which would need to be reconciled quarterly (four 
times per year). The Commission estimates that each portfolio 
reconciliation would require 30 minutes, 15 minutes per 
counterparty, through an automated system, thus the total 
anticipated reconciliation time would be [(2 counterparties x 252 
trading days x 0.25 hours) + (4 counterparties x 52 weeks x 0.25 
hours) + (12 counterparties x 4 quarters x 0.25 hours)] = 190 hours 
per SBS Entity, or (190 x 55 SBS Entities) = 10,450 hours in 
aggregate.
    \268\ There are anticipated to be 13,137 total SBS 
counterparties, of which 55 are registered SBS Entities, leaving 
13,082 non-SBS market participants. See supra note 179. The 
Commission estimates that each SBS Entity will transact with 
approximately 350 of these non-registered participants. Of those 350 
counterparties, 35 are expected to have portfolio positions in 
excess of 100 positions, which would require quarterly 
reconciliations, while the remaining 315 are expected to have 
positions of less than 100 security-based swaps, and therefore, 
would require annual reconciliation. The Commission estimates that 
each portfolio reconciliation would require 30 minutes through an 
automated system, thus the total anticipated reconciliation time 
would be [(35 counterparties x 4 quarters x 0.5 hours) + (315 
counterparties x 1 time per year x 0.5 hours)] = 227.5 hours per SBS 
Entity, or (227.5 x 55 SBS Entities) = 12,512.5 hours in aggregate.
---------------------------------------------------------------------------

    The Commission further estimates that the development and 
implementation of written policies and procedures as required under 
proposed Rule 15Fi-3 would impose an initial cost of $702,232.50. Of 
the total 55 SBS Entities that would be subject to Rule 15Fi-3, 35 are 
estimated to be dually-registered with the CFTC, and are anticipated to 
already have policies and procedures in place with respect to 
reconciliation. The expected additional time to revise the existing 
policies and procedures for these SBS Entities is expected to be one 
hour per SBS Entity, for a cumulative 35 hours, costing $429.50 per SBS 
Entity or $15,032.50 in aggregate.\269\ For the remaining 20 SBS 
Entities, the Commission estimates that it will take approximately 80 
hours per entity to establish the written policies and procedures. The 
costs for these SBS Entities will be $687,200, or $34,360 per SBS 
Entity.\270\ Once established, the Commission estimates that it would 
cost SBS Entities approximately $944,900 or $17,180 per SBS Entity to 
revise and maintain these policies and procedures.\271\ Resolution of 
valuation discrepancies can be labor intensive. One objective of the 
proposed rule is to reduce the incidence of valuation discrepancies 
through the periodic reconciliations between security-based swap 
counterparties. It is unlikely, however, that the proposed rule will 
completely eliminate disputes related to

[[Page 4660]]

valuation. The Commission lacks data on the fraction of positions that, 
when reconciled, will result in a dispute as well as the costs likely 
to be incurred resolving those disputes, and is therefore unable to 
quantify these costs. However, the Commission recognizes that the costs 
associated with resolution of these disputes is likely to be higher 
than costs for reconciliations in which disputes do not arise.
---------------------------------------------------------------------------

    \269\ The estimate is based on the following: [((Compliance 
Attorney (30 minutes) at $346 per hour) + ((Director of Compliance 
(15 minutes) at $461 per hour) + ((Deputy General Counsel (15 
minutes) at $565 per hour)] = $429.50 per hour per SBS Entity or 
($429.50 per hour x 35 SBS dually-registered Entities) = $15,032.50.
    \270\ The estimate is based on the following: [((Compliance 
Attorney (40 hours) at $346 per hour) + ((Director of Compliance (20 
hours) at $461 per hour) + ((Deputy General Counsel (20 hours) at 
$565 per hour)] = $34,360 per SBS Entity or ($34,360 x 20 SBS 
Entities that are not dually-registered) = $687,200 in aggregate.
    \271\ The estimate is based on the following: [((Compliance 
Attorney (20 hours) at $346 per hour) + ((Director of Compliance (10 
hours) at $461 per hour) + ((Deputy General Counsel (10 hours) at 
$565 per hour)] = $17,180 per SBS Entity or ($17,180 x 55 SBS 
Entities) = $944,900 in aggregate.
---------------------------------------------------------------------------

    However, the Commission preliminarily believes that these costs may 
be mitigated by only requiring counterparties to address differences in 
valuation greater than 10%. These costs of reconciliation may be 
further mitigated by agreement between the counterparties to use a 
third party service provider to assist in resolving valuation 
discrepancies. Reconciliation of other terms is likely to be less 
costly as the terms of the agreement are unlikely to change over the 
life of the contract.
    The 10% threshold was designed to both identify large deviations in 
valuations between SBS Entities, while not requiring those entities to 
devote significant effort to resolving minor valuation disputes. 
Further, this threshold is identical to that already adopted by the 
CFTC.\272\ The Commission notes, however, that this 10% threshold is at 
the transaction level, rather than the entity level. While 
discrepancies could be random in nature, the risk exists that one 
counterparty could have systemic issues in valuation across its entire 
portfolio, thereby leading to discrepancies in valuation with one or 
several counterparties and throughout the portfolio. For example, if an 
entity's valuation model consistently undervalued each of its security-
based swap positions by 9%, in aggregate, the overall level of risk 
could be substantial, even though it would not trigger a discrepancy 
event as currently defined by the 10% transaction level threshold. 
Further, since the Commission estimates that approximately 35 of the 
expected 55 SBS Entities are likely to be dually-registered with the 
CFTC and active in swap and security-based swap markets, these 
participants are likely to face higher costs when regulations differ.
---------------------------------------------------------------------------

    \272\ See 17 CFR 23.502 (portfolio reconciliation).
---------------------------------------------------------------------------

    The costs of resolving valuation disputes are expected to be 
mitigated, because the reconciliation requirements are expected to 
prevent disputes from arising in the first instance through the regular 
comparison of material terms and valuations. The Commission 
preliminarily believes that by requiring SBS Entities to reach 
agreement with certain counterparties on the methods and inputs for 
valuation of each security-based swap, as required in connection with 
the trading relationship documentation requirements in proposed Rule 
15Fi-5, the overall framework of these rules should assist SBS Entities 
in resolving valuation disputes within five business days. In addition, 
the Commission estimates that SBS Entities will spend an average of 24 
hours per year to comply with the notification requirement of proposed 
Rule 15Fi-3(c) costing $8,304 per SBS Entity or $456,720 in 
aggregate.\273\
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    \273\ The estimate is based on the following: [Compliance 
Attorney (24 hours) at $346 per hour] = $8,304 per entity x 55 SBS 
entities = $456,720.
---------------------------------------------------------------------------

    Lastly, portfolio reconciliation costs are also mitigated by virtue 
of the fact that cleared security-based swaps are not within the scope 
of the requirements of these rules. The Commission preliminarily 
believes that CCPs establish settlement prices for each cleared 
security-based swap every business day for margining purposes and this 
process is more appropriately addressed by rules governing a clearing 
agency's risk management practices.\274\ Because a large part of the 
security-based swap portfolios of SBS Entities may consist of cleared 
security-based swaps to which the reconciliation requirements will not 
apply, the sizes of the bilateral, uncleared portfolios (to which the 
requirement would apply) may be limited.\275\
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    \274\ See supra Section I.B.7.
    \275\ Currently, there is no regulatory requirement in the 
United States to clear security-based swaps. As of December 2015, 
approximately 56% of the total volume of new trade activity in 
single-name security-based swap products had been cleared through 
ICE Clear Credit. Further, approximately 79% of index CDS 
transactions were centrally cleared as of December 2015 (see https://www.isda.org/a/kVDDE/swapsinfo-q4-2015-review-final.pdf); 
therefore, single-name security-based swaps potentially could be 
cleared at a similar rate.
---------------------------------------------------------------------------

d. Alternatives
    The proposed rule creates a specific definition of ``material 
terms'' for purposes of determining what discrepancies must be resolved 
in connection with the portfolio reconciliation which includes each 
term required to be reported to an SDR, but then permits SBS Entities 
to exclude any term that is not relevant to the ongoing rights and 
obligations of the parties and the valuation of the security-based swap 
during subsequent reconciliations. The Commission considered not 
providing a specific definition of ``material terms'' and allowing SBS 
Entities discretion in determining those terms that are relevant to the 
ongoing rights or obligations of the parties or affect the valuation of 
the security-based swap.
    The Commission has preliminarily concluded that the data required 
to be submitted to an SDR in connection with regulatory reporting 
requirements is an appropriate measure for determining which terms 
should be reconciled pursuant to proposed Rule 15Fi-3. The Commission 
also preliminarily believes that tying the definition of ``material 
terms'' to reporting requirements to an SDR could reduce the burdens on 
some SBS Entities by potentially allowing them to leverage the same 
electronic systems used for SDR reporting for purposes of the portfolio 
reconciliation requirements.
    The portfolio size breakpoints and frequencies are consistent with 
those adopted by the CFTC for Swap Entities and are therefore likely to 
be familiar to those entities that are registered as both an SBS Entity 
and a Swap Entity. These are also the breakpoints adopted by the EC. 
Further, the Commission believes that alternative breakpoints based on 
the number of transactions which deviate from those adopted by the CFTC 
and the EC would likely impose additional costs on SBS Entities without 
any corresponding increases in material benefits to those participants.
    Although the notion of breakpoints based on number of transactions 
previously has been accepted by the CFTC and other regulatory agencies, 
the Commission notes that breakpoints based on alternative measures 
could be considered. In particular, breakpoints for reconciliation 
could be categorized by either gross (or net) notional amounts of 
positions or the current market value of positions, and identified as 
levels or scaled by some measure such as the aggregate notional value 
of the market (for gross or net notional values) or the assets of the 
SBS Entity (if market values are used instead). Although the number of 
security-based swaps between counterparties is easy to capture, it may 
actually be misleading with respect to the complexity or magnitude of 
the risk between counterparties.
    For instance, say two counterparties have over 500 transactions 
between them, but the average value of each transaction is only $5 
million notional value. The total exposure between the two 
counterparties would only be $2.5 billion, but this portfolio would 
need to be reconciled daily due to the number of transactions. If, on 
the other hand, two counterparties have only 40 transactions, but the 
average value of each transaction is $1 billion notional value, the 
overall exposure would be $40 billion (16 times greater exposure

[[Page 4661]]

than the 500 transaction counterparties), but this portfolio would only 
be reconciled quarterly. Basing breakpoints on some measure other than 
the number of transactions may enable SBS Entities to better assess the 
overall level of counterparty credit risk as well as operational risk 
associated with their security-based swap portfolios. Setting aside 
these concerns, the Commission believes that breakpoints based on the 
number of transactions is likely to capture the complexity of SBS 
Entities' portfolios, and that reconciliations based on this dimension 
are likely to identify discrepancies in a timely manner. Further, given 
that the Commission estimates that approximately 35 of the expected 55 
SBS Entities are likely to be dually-registered with the CFTC and 
active in both swap and security-based swap markets, this alternative 
could potentially impose additional costs due to differences in 
regulatory requirements.
    The Commission has also considered alternatives to the requirement 
that valuation discrepancies exceeding 10% must be resolved within five 
days. The 10% threshold is consistent with the rule adopted by the CFTC 
for Swap Entities and, as a result, is likely to be familiar to those 
entities that are registered as both an SBS Entity and a Swap Entity. 
The Commission preliminarily believes that the proposed 10% threshold 
is high enough to prevent market participants from incurring costs to 
resolve small valuation differences that would have only a small effect 
on margin or other risk management practices, yet low enough to prevent 
difference in valuation from resulting in significant miscalculations 
in risk management.
    As noted above, there are potential economic costs that could 
accrue to counterparties related to both the 10% threshold and the five 
business day resolution window. An alternative (albeit supplementary) 
approach would be an additional requirement of a valuation threshold 
related to the overall portfolio discrepancies, in aggregate and/or 
with individual counterparties. For instance, if the aggregate 
portfolio has valuation discrepancies of 5% or 10%, this could trigger 
a discrepancy event, even if the individual transaction-level 
discrepancies fall below the prescribed threshold as documented 
currently in the proposed rule. Relatedly, while the five business day 
window is narrow enough to potentially stem valuations from deviating 
for extended periods of time while still providing a horizon in which 
parties can work through their valuation disputes, entities can face 
significant counterparty risk over seemingly short-term horizons. For 
relatively stable valuation disputes in which the value does not 
continue to deviate further from the agreed-upon level, then a five 
business day window is likely to be sufficient; however, a more 
compressed alternative horizon could be invoked when the discrepancies 
in value continue to widen between counterparties. The Commission 
preliminarily believes that the proposed five business day horizon is 
sufficient and serves as an upper-bound for which market participants 
to address and correct any material discrepancies that arise during 
reconciliation. Moreover, this approach is consistent with requirements 
from other regulators, and given the Commission's estimates on SBS 
Entities that are likely to be dually-registered with the CFTC, any 
differences in regulation would likely impose additional costs to those 
entities.
    Finally, proposed Rule 15Fi-3(c) would require each SBS Entity to 
promptly notify the Commission of any security-based swap valuation 
dispute in excess of $20,000,000 (or its equivalent in any other 
currency) if not resolved within:
     Three business days, if the dispute is with a counterparty 
that is an SBS Entity, or
     five business days, if the dispute is with a counterparty 
that is not an SBS Entity.
    Such notification would be required to be in a form and manner 
acceptable to the Commission, and would also be required to be sent to 
any applicable prudential regulator (i.e., for any SBS Entity that is 
also a bank, to its bank regulator).\276\
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    \276\ See supra Section I.B.6.
---------------------------------------------------------------------------

    The Commission has considered as an alternative, requiring SBS 
Entities to make and keep records of valuation discrepancies that 
exceed $20,000,000 rather than requiring that they be reported to the 
Commission. The Commission preliminarily concluded that the benefit of 
receiving an early warning of potential problems before they surfaced 
though an ordinary course of review of books and records justifies any 
additional cost imposed on SBS entities.
    Proposed Rule 15Fi-3(d), the new requirements regarding portfolio 
reconciliation would not apply to a ``clearing transaction'' which is 
defined as a security-based swap that has a clearing agency as a direct 
counterparty.\277\ A clearing agency means a clearing agency that is 
registered with the Commission pursuant to Section 17A of the Exchange 
Act and that provides central counterparty services for security-based 
swap transactions. The Commission considered as an alternative 
including transactions cleared at a foreign clearing agency that is not 
registered with the Commission within its definition of ``clearing 
transaction'' for the purposes of the proposed rule. The Commission 
preliminarily concluded that an approach that is similar to that taken 
by the Commission in other rules,\278\ as well as the approach taken by 
the CFTC,\279\ would reduce implementation and compliance costs.
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    \277\ See supra Section I.B.7.
    \278\ See, e.g., Trade Acknowledgement and Verification Adopting 
Release, 81 FR at 39839.
    \279\ Specifically, CFTC Rule 23.502(c) provides that 
``[n]othing in this section shall apply to a swap that is cleared by 
a derivatives clearing organization.'' 17 CFR 23.502(c).
---------------------------------------------------------------------------

    The Commission has considered as an alternative, an alternative 
compliance mechanism that would allow a SBS Entity to be deemed in 
compliance with certain proposed rules regarding portfolio 
reconciliation if the SBS Entity is also registered as a swap dealer or 
major swap participant with the CFTC and is in compliance with the 
corresponding CFTC portfolio reconciliation rules. The Commission 
preliminarily concludes that differences between its proposed rules and 
rules adopted by the CFTC may provide certain benefits to SBS Entities 
and other market participants that would not be available under a rule 
that was identical to the corresponding CFTC rule. For example, the 
requirement in the proposed rule that each term required to be reported 
to a registered SDR under Rule 901 must be reconciled may facilitate 
the verification of transaction data by SDRs, which could address 
concerns raised by market participants and data repositories. Such 
benefits could be unavailable under an alternative compliance mechanism 
given that CFTC portfolio reconciliation rules do not require all of 
this information to be reconciled.\280\
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    \280\ See supra Section I.E for a discussion of the proposed 
reconciliation rules and the verification of transaction data by 
SDRs. See also supra note 32 for a discussion of differences between 
CFTC and proposed Commission requirements concerning third party 
reconciliation.
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3. Portfolio Compression
    Portfolio compression is an important post-trade processing 
mechanism that can be an effective and efficient tool for the 
management of risk by security-based swap market participants. 
Portfolio compression is a mechanism whereby directionally opposite

[[Page 4662]]

transactions with substantially similar terms among two or more 
counterparties are terminated and, if any exposure remains, replaced 
with a smaller number of transactions of decreased notional value in an 
effort to reduce the risk, cost, and inefficiency of maintaining 
offsetting transactions on the counterparties' books. Because portfolio 
compression participants are permitted to establish their own credit, 
market, and cash payment risk tolerances and to establish their own 
mark-to-market values for the transactions to be compressed, the 
process does not alter the risk profiles of the individual participants 
beyond a level acceptable to the participant. Portfolio compression is 
commonly acknowledged as useful risk management tool.\281\
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    \281\ See https://www2.isda.org/news/isda-publishes-paper-highlighting-achievements-in-portfolio-compression.
---------------------------------------------------------------------------

a. Requirements
    The Commission is proposing rules and interpretations that 
generally would require each SBS Entity to establish, maintain, and 
follow written policies and procedures for engaging in certain forms of 
portfolio compression exercises with each of its counterparties. 
Depending on the number of counterparties, the portfolio compression 
exercise would be defined as either a ``bilateral portfolio compression 
exercise'' or as a ``multilateral portfolio compression exercise.''
    Under proposed Rule 15Fi-4(a), SBS Entities would be required to 
establish, maintain, and follow written policies and procedures for 
periodically engaging in both bilateral portfolio compression exercises 
and multilateral portfolio compression exercises, when appropriate, 
with each counterparty that is also an SBS Entity.\282\ For 
transactions with non-SBS Entities, the policies and procedures 
required under the proposed rule would require only that portfolio 
compression exercise would have to occur when appropriate and only if 
requested by any such counterparty.\283\
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    \282\ See proposed Rules 15Fi-4(a)(2) and (3).
    \283\ See proposed Rule 15Fi-4(b). See also supra notes 70 and 
71 and associated text.
---------------------------------------------------------------------------

b. Benefits
    As a mechanism for post-trade management of risk in security-based 
swaps, portfolio compression provides benefits not only to the 
counterparties in each transaction but also to the markets as a whole. 
A portfolio compression exercise permits firms to identify instances in 
which directionally opposite transactions with similar terms can be 
terminated or replaced, with a smaller number of transactions with 
decreased notional value, reducing the overall risk, cost, and 
inefficiencies associated with maintaining offsetting transactions. As 
such, portfolio compression is recognized as an important risk 
management tool.\284\ By expanding the universe of participants 
required to maintain portfolio compression policies and procedures, 
credit risk in the uncleared security-based swaps market can be reduced 
and may provide benefits to the entire financial system.
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    \284\ For example, in 2008, the PWG identified frequent 
portfolio compression of outstanding trades as a key policy 
objective in the effort to strengthen the OTC derivatives market 
infrastructure. See PWG Report, supra note 205. Similarly, the 2010 
staff report issued by the FRBNY outlined policy perspectives on OTC 
derivatives infrastructure and identified trade compression as an 
element of strong risk management and recommended that market 
participants engage in regular, market-wide portfolio compression 
exercises. See FRBNY OTC Derivatives Report, supra note 62. Since 
the years immediately following the 2008 financial crisis, 
compression outside of CCPs has been somewhat less common and has 
declined substantially from its 2008 peak. See supra note 240.
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    Further, the termination of redundant security-based swap 
transactions through the portfolio compression process is likely to 
result in the potential reduction of both counterparty and operational 
risk at the SBS Entity level. The use of portfolio compression also 
could reduce the overall level of bilateral risk exposures, while 
leaving the net positions of market participants unaltered, thereby 
improving operational efficiency. Improvements in operational 
efficiency may arise due to fewer overall positions for each entity, a 
reduction in carried margin and variation margin calculations, and 
fewer (and potentially less frequent) portfolio reconciliations. This 
would also reduce the number of bilateral positions that would have to 
be resolved in the event of insolvency of a market participant. These 
reductions in risk and improvements in operational efficiency of SBS 
Entities could benefit the financial system as a whole, thereby 
potentially increasing the number of market participants as well as 
improving liquidity.
    Although the costs of participating in portfolio reconciliation are 
fully internalized by each counterparty, the potential benefits, 
particularly for multilateral compression exercises, increase with the 
number of counterparties that participate. Under proposed Rule 15Fi-
4(a), SBS Entities would be required to establish, maintain, and follow 
written policies and procedures for periodically engaging in both 
bilateral portfolio compression exercises and multilateral portfolio 
compression exercises, in each case when appropriate, with 
counterparties that also are an SBS Entities.\285\ To the extent that 
an SBS Entity transacts with a counterparties that are not SBS 
Entities, the policies and procedures required under the proposed rule 
would require only that portfolio compression exercises occur when 
appropriate and only if requested by any such counterparty. In the 
absence of the proposed rules, some counterparties may not participate 
in compression activities reducing the potential benefits available to 
other counterparties and the financial system generally.
---------------------------------------------------------------------------

    \285\ See supra Section I.C.
---------------------------------------------------------------------------

    As noted in the economic baseline, the emergence of third-party 
vendors has provided portfolio compression services for security-based 
swaps. SBS Entities may be able to continue to benefit from the 
services of these third-party vendors to provide additional portfolio 
compression opportunities for these firms.
    The proposed rule provides flexibility to security-based swap 
market participants with respect to portfolio compression. The 
Commission preliminarily believes that by not proposing prescriptive 
requirements, an SBS Entity would allow the counterparties flexibility 
in the manner in which they reduce the size of their security-based 
swap portfolios in light of each counterparty's unique risks and 
operations. Moreover, the proposed rules regarding bilateral offset 
have been designed to reflect the understanding by the Commission that 
firms may have legitimate economic and business reasons for maintaining 
fully offsetting security-based swap transactions. Certain portfolio 
compression exercises could result in adverse credit exposures to 
certain counterparties. For example, the results of a particular 
multilateral compression exercise may result in a credit exposure to a 
particular counterparty that exceeds credit exposure limits for that 
counterparty.
    Thus, the Commission preliminarily believes that the policies and 
procedures should be flexible enough to allow an SBS Entity to take the 
most appropriate course of action with respect to managing its risks, 
while at the same time, encouraging SBS Entities to consider the risk 
mitigation possibilities of portfolio compression in a non-arbitrary 
manner and consistent with the purposes of Section 15F(i) of the 
Exchange Act. As such, proposed

[[Page 4663]]

Rules 15Fi-4(a)(1) and (b) would require a firm's policies and 
procedures to address the termination of fully offsetting security-
based swaps only ``when appropriate.''
    Finally, the Commission notes that both the CFTC and the EC have 
adopted portfolio compression requirements that are substantially 
similar to those being proposed by the Commission in this release.\286\ 
By closely aligning portfolio compression requirements through 
consultation with the CFTC and with ESMA, the Commission preliminarily 
believes that SBS Entities will benefit from a largely unitary 
regulatory regime that does not require separate compliance and 
operational policies and procedures.
---------------------------------------------------------------------------

    \286\ See supra note 7 and accompanying text.
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c. Costs
    SBS Entities will necessarily have to design, compose, and 
implement policies and procedures to regularly evaluate compression 
opportunities with their counterparties as well as those opportunities 
offered by third parties. However, the Commission preliminarily 
believes that given the large risk management benefits available from 
the regular compression of offsetting trades--benefits including 
reduced risk and enhanced operational efficiency--SBS Entities already 
undertake regular portfolio compression exercises. For this reason and 
those discussed below, the Commission preliminarily believes that the 
relevant costs will primarily be the creation of policies and 
procedures.
    The greater the level of standardization in security-based swaps, 
the less costly it becomes to identify compression opportunities. In 
April 2009, ISDA announced the implementation of the 2009 ISDA Credit 
Derivatives Determinations Committees and Auction Settlement CDS 
Protocol, known colloquially in the industry as the ``Big Bang 
Protocol,'' which introduced a number of documentation changes to help 
standardize single-name CDS contracts.\287\ Among these changes were 
the introduction of standard coupon rates and standard effective dates. 
Following the standardization of single-name CDS, compression in this 
market segment increased.\288\ As that standardization continues, we 
would expect that the cost of identifying appropriate compression 
opportunities should continue to fall. Using single-name corporate CDS 
data from DTCC-TIW discussed above, we find the percentage of new 
trades in North American Single-Name Corporate that have standardized 
coupons has risen from 95.2% in 2012 to 99.8% in 2017. The reduction in 
the number of roll-dates from four to two in order to both improve 
liquidity as well as to align with updates to CDS indices \289\ also 
may result in increased standardization and therefore may reduce the 
costs of identifying compression opportunities.
---------------------------------------------------------------------------

    \287\ See Press Release, ISDA Announces Successful 
Implementation of `Big Bang' CDS Protocol; Determinations Committees 
and Auction Settlement Changes Take Effect (Apr. 8, 2009), available 
at: https://www.isda.org/a/XS6EE/ISDA-Announces-Successful-Implementation-of-%E2%80%98Big-Bang%E2%80%99-CDS-Protocol-Determinations-Committees-and-Auction-Settlement-Changes-Take-Effect.docx.
    \288\ See Nicholas Vause, Counterparty risk and contract volumes 
in the credit default swap market, BIS Quarterly Review (Dec. 2010), 
available at: https://www.bis.org/publ/qtrpdf/r_qt1012g.pdf 
(``TriOptima became the first company to offer CDS portfolio 
compression when it extended its TriReduce service from interest 
rate swaps to the CDS market in 2005. In the CDS market, TriReduce 
has compressed mainly portfolios of CDS indices and index tranches, 
but single names have accounted for an increasing share of its 
compression volumes since standardisation in 2009.'').
    \289\ See https://www2.isda.org/asset-classes/credit-derivatives/single-name-cds-roll/.
---------------------------------------------------------------------------

    The Commission estimates that the development and implementation of 
written policies and procedures as required under proposed Rule 15Fi-4 
would impose an initial cost of $702,232.50 in aggregate. Of the 55 
market participants the Commission expects will register as SBS 
Entities and be subject to Rule 15Fi-4, the Commission estimates that 
approximately 35 of these market participants are registered with the 
CFTC, and are anticipated to already have policies and procedures in 
place with respect to portfolio compression. The expected additional 
time to revise the existing policies and procedures for these SBS 
Entities is expected to be one hour per SBS Entity, for a cumulative 35 
hours, costing $429.50 per SBS Entity or $15,032.50 in aggregate.\290\ 
For the remaining 20 SBS Entities, the Commission estimates that it 
will take approximately 80 hours per entity to establish the written 
policies and procedures. The costs for these SBS Entities will be 
$687,200, or $34,360 per SBS Entity.\291\ Once established, the 
Commission estimates that it would cost SBS Entities approximately 
$944,900 or $17,180 per SBS Entity to revise and maintain these 
policies and procedures.\292\
---------------------------------------------------------------------------

    \290\ The estimate is based on the following: [((Compliance 
Attorney (30 minutes) at $346 per hour) + ((Director of Compliance 
(15 minutes) at $461 per hour) + ((Deputy General Counsel (15 
minutes) at $565 per hour)] = $429.50 per hour per SBS Entity or 
($429.50 per hour x 35 SBS dually-registered Entities) = $15,032.50.
    \291\ The estimate is based on the following: [((Compliance 
Attorney (40 hours) at $346 per hour) + ((Director of Compliance (20 
hours) at $461 per hour) + ((Deputy General Counsel (20 hours) at 
$565 per hour)] = $34,360 per SBS Entity or ($34,360 x 20 SBS 
Entities that are not dually-registered) = $687,200 in aggregate.
    \292\ The estimate is based on the following: [((Compliance 
Attorney (20 hours) at $346 per hour) + ((Director of Compliance (10 
hours) at $461 per hour) + ((Deputy General Counsel (10 hours) at 
$565 per hour)] = $17,180 per SBS Entity or ($17,180 x 55 SBS 
Entities) = $944,900 in aggregate.
---------------------------------------------------------------------------

    The Commission further estimates that an SBS Entity will devote 
approximately 124.17 hours per year for portfolio offsets and 
compression exercises (6,829.35 aggregate hours), a substantial portion 
of which will be automated, and some of which may be handled by third-
party vendors.\293\ Similar to our discussion for portfolio 
reconciliation (Section VIII.C.2.c), the Commission expects that the 
costs of implementing portfolio compression exercises through an 
automated process will be minimal for those SBS Entities that are 
dually-registered with the CFTC, as many of those systems will already 
be in place. With respect to the remaining 20 SBS Entities that are not 
dually-registered, the Commission anticipates that any cost associated 
with implementing the portfolio reconciliation system may also account 
for the portfolio compression exercises that may periodically take 
place; therefore, the overall costs of portfolio compression systems 
should be minimal.
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    \293\ The Commission estimates that each SBS Entity will 
transact with approximately 368 counterparties (18 SBS Entities and 
350 non-SBS market participants). It is estimated that approximately 
one offset per year will take place between counterparties and it is 
expected to take five minutes to complete, for a total number of 
hours of (2.5/60 x 18 + 5/60*350) or 29.92 hours per year per SBS 
Entity. Further, each SBS Entity is expected to conduct six 
bilateral compressions with SBS Entities and 350 bilateral 
compressions with non-SBS counterparties, each taking 15 minutes for 
total hours of [(7.5/60 x 6) + (15/60 x 350)] = 88.25 hours. Lastly, 
each SBS Entity is anticipated to complete 12 multilateral 
compressions each year, each taking 30 minutes for a total of 6 
hours. Total time for each SBS Entity for portfolio compression 
exercises is estimated to be (29.92 + 88.25 + 6) = 124.17 hours, or 
6829.35 hours (124.17 hours x 55 SBS Entities).
---------------------------------------------------------------------------

    In terms of quantification of the costs of compression, the 
Commission also notes that that there are a number of third-party 
vendors that provide compression services, and some of these providers 
may charge fees based on results achieved (such as number of swaps or 
security-based swaps compressed). Assuming that third-party vendors 
charge a fee directly related to the outcome of the compression 
exercise (as opposed to a fixed fee in whole or some portion thereof 
for portfolio compression activities), the direct costs of portfolio 
compression by third-party vendors would therefore likely be

[[Page 4664]]

directly related to the economic benefits of reduced counterparty and 
operational risk realized through the compression exercises. The 
Commission does not currently have pricing data for third-party service 
providers that offer portfolio compression services and so is unable to 
quantify the costs to market participants who make use of these 
services.
    Many non-SBS Entities typically trade only in small volumes and on 
one side of a particular security-based swap, to create a synthetic 
position in the underlying asset or to hedge another position, for 
example. Such one-sided market positions reduce the opportunities to 
engage in periodic compression cycles. For SBS Entities that do not 
currently participate in compression cycles, there could be costs to 
modify the participant's risk systems and connectivity enhancements 
that would allow for sharing the necessary information required to 
identify compression opportunities and for the booking and processing 
of a large volume of security-based swaps in a short time period. 
Multilateral compression cycles are typically managed with automated 
tools to support tear-up and new trade creation that end-users usually 
do not possess, and the costs of obtaining such tools cannot be 
justified by the benefits. The rule does not require market 
participants to engage in mandatory compression cycles, but only to 
establish, maintain, and follow written policies and procedures for 
engaging in certain forms of portfolio compression exercises.
d. Alternatives
    The proposed rule requires that SBS Entities establish, maintain, 
and follow written policies and procedures as they relate to certain 
forms of portfolio compression exercises with each of its 
counterparties. As such, the Commission is not proposing to mandate the 
specific contents of the policies and procedures created to comply with 
these rules.\294\ However, a number of more specific requirements for 
portfolio compression could be included. For example, the current 
proposal only requires policies and procedures that address compression 
to the extent requested by the counterparty rather than a more 
prescriptive requirement.\295\
---------------------------------------------------------------------------

    \294\ There is one exception to this statement, see supra note 
72.
    \295\ See supra Section I.C.3.
---------------------------------------------------------------------------

    Pursuant to the proposed Rule 15Fi-4, SBS Entities are required 
``periodically'' to examine the possibility for whether portfolio 
compression exercises can take place. While this provides flexibility 
to the counterparties in terms of the frequency with which rebalancing 
would have to be explored, it leaves open the possibility that market 
participants will suboptimally select the frequency with which 
portfolio compression exercises can occur, which could impose 
externalities on SBS counterparties as well as the financial system as 
a whole. As an alternative, the Commission has considered requiring a 
minimum frequency of analysis of portfolio compression exercises. For 
instance, at least twice a year, SBS Entities could conduct an analysis 
of the possibility of a portfolio compression exercise in order to 
reduce their counterparty credit risk and engage in such a portfolio 
compression exercise, similar to those adopted by the EC.\296\ Given 
that portfolio compression has been identified to be a valuable and 
important tool for risk management, it is likely that many SBS Entities 
already have in place policies and procedures for periodic evaluation 
of compression possibilities, thus imposing a minimum standard could be 
burdensome and costly for firms to implement.
---------------------------------------------------------------------------

    \296\ See EU Regulation 149/2013, art. 14, 2013 O.J. 11, 22.
---------------------------------------------------------------------------

    Relatedly, the frequency with which SBS Entities evaluate their 
prospects for portfolio compression opportunities could be related to 
the number of transactions between counterparties (as is required for 
portfolio reconciliation in proposed rule 15Fi-3). For instance, if 
counterparties have portfolios in excess of 500 transactions, an 
analysis of portfolio compression could be conducted quarterly, while 
SBS Entities with portfolios between 50 and 500 transactions, portfolio 
compression exercises could be explored twice a year. For 
counterparties with fewer than 50 transactions between them (or for 
portfolios with non-SBS Entities), portfolio compression exercises 
could be simply ``periodically.'' This would allow counterparties to 
assess the counterparty credit risk at frequencies aligned with the 
complexities of their portfolios without incurring substantive 
additional costs of this increase in periodic evaluation of portfolio 
compression opportunities. The Commission has considered the costs and 
benefits to market participants of imposing policies and procedures 
related to portfolio compression based on the number of transactions 
between counterparties. However, it is likely that market participants 
expected to register as SBS Entities already have policies and 
procedures in place to evaluate portfolio compression opportunities 
with counterparties, and requiring alterations to these policies could 
be costly for these entities without corresponding benefits.
    Proposed Rule 15Fi-4(c), the new requirements regarding portfolio 
compression, would not apply to a ``clearing transaction'', which is 
defined as a security-based swap that has a clearing agency as a direct 
counterparty.\297\ A clearing agency means a clearing agency that is 
registered with the Commission pursuant to Section 17A of the Exchange 
Act and that provides central counterparty services for security-based 
swap transactions. The Commission considered as an alternative 
including transactions cleared at a foreign clearing agency that is not 
registered with the Commission within its definition of ``clearing 
transaction'' for the purposes of the proposed rule. The Commission 
preliminarily concluded that an approach that is similar to that taken 
by the Commission in other rules,\298\ as well as the approach taken by 
the CFTC,\299\ would reduce implementation and compliance costs.
---------------------------------------------------------------------------

    \297\ See supra Section I.C.4.
    \298\ See supra note 278.
    \299\ Specifically, CFTC Rule 23.503(c) provides that 
``[n]othing in this section shall apply to a swap that is cleared by 
a derivatives clearing organization.'' 17 CFR 23.503(c).
---------------------------------------------------------------------------

    The Commission has considered as an alternative, an alternative 
compliance mechanism that would allow a SBS Entity to be deemed in 
compliance with certain proposed rules regarding portfolio compression 
if the SBS Entity is also registered as a swap dealer or major swap 
participant with the CFTC and is in compliance with the corresponding 
CFTC portfolio compression rules. The Commission preliminarily 
concludes that, as a practical matter, the rules are nearly equivalent, 
suggesting that any additional compliance cost arising from differences 
in these rules for an entity that is registered with both the CFTC and 
the Commission should be small. The Commission preliminarily believes 
that the differences that do exist (such as the proposed rule providing 
that requested compression by an entity that is not a security-based 
swap dealer or major security-based swap participant need only be 
conducted if appropriate \300\) may provide marginal benefits to SBS 
market participants (such as by preventing portfolio compression that 
is not appropriate given the particular circumstances of

[[Page 4665]]

the trade and the counterparties to that trade).\301\
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    \300\ See supra note 70 and accompanying text.
    \301\ The corresponding CFTC compression rule applicable to 
transactions with counterparties that are not SBS Entities does not 
contain the caveat that any form of compression or offset covered by 
the applicable policies and procedures would only need to occur 
``when appropriate.'' See supra note 70. We solicit comment on this 
difference. See supra Section I.C.5.
---------------------------------------------------------------------------

4. Trading Relationship Documentation
    OTC derivatives market participants typically have relied on the 
use of industry standard legal documentation, including master netting 
agreements, definitions, schedules, and confirmations, to document 
their security-based swap trading relationships. This industry standard 
documentation offers a framework for documenting the transactions 
between counterparties for OTC derivatives products.\302\ The standard 
documentation is designed to set forth the legal, trading, and credit 
relationship between the parties and to facilitate netting of 
transactions in the event that parties have to close-out their position 
with one another or determine credit exposure for margin and collateral 
management. Notwithstanding the standardization of such documentation, 
some or all of the terms of the master agreement and other documents 
are subject to negotiation and modification.
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    \302\ One commonly used form of the industry standard 
documentation is the ISDA Master Agreement and related definitions, 
schedules, and confirmations specific to particular asset classes. 
As noted in Section VI.B.4, over 99% of uncleared security-based 
swap transactions use an ISDA Master Agreement as reported in DTCC-
TIW.
---------------------------------------------------------------------------

a. Requirements
    The Commission is proposing rules and interpretations that 
generally would require each SBS Entity to establish, maintain, and 
follow written policies and procedures reasonably designed to ensure 
that it executes written trading relationship documentation with its 
counterparties prior to, or contemporaneously with, executing a 
security-based swap. The security-based swap trading relationship 
documentation is required to be in writing and to include all material 
terms governing the trading relationship between counterparties.
    Further, the proposed rule would also require that the security-
based swap trading relationship documentation include credit support 
arrangements.\303\ One of the key elements of Title VII reforms was to 
ensure that uncleared OTC derivatives were appropriately 
collateralized, thus the documentation of processes for calculating and 
exchanging margin in connection with security-based swaps helps to 
achieve the broader regulatory objective.\304\
---------------------------------------------------------------------------

    \303\ See supra Section I.C.2
    \304\ 15 U.S.C. 78c-5(f).
---------------------------------------------------------------------------

    The proposed rules also would establish minimum standards with 
respect to identifying the matters that must be addressed in the 
security-based swap trading documentation, and outline certain 
requirements related to the resolution of discrepancies, particularly 
those involving differences in the valuation of security-based swaps. 
In the event that discrepancies in valuation arise, the proposed rule 
requires that counterparties must provide documentation for either an 
alternative method for determining value of the security-based swap or 
documentation on the resolution process for such disputes.
    The proposed rule also requires that counterparties to the 
security-based swap provide information on their legal status, 
particularly in the event of liquidation, as well as to disclose 
certain information of a security-based swap accepted for clearing by a 
clearing agency, in order to reduce any potential confusion regarding 
the status of the trade following its acceptance and novation at the 
clearing agency. Lastly, proposed Rule 15Fi-5 requires a periodic 
independent audit to identify any material deficiencies in the trading 
relationship documentation policies and procedures.
b. Benefits
    Inadequate or incomplete documentation of open security-based swap 
transactions could, in some cases, result in collateral and legal 
disputes between the two counterparties, thereby exposing both sides to 
significant counterparty credit risk. By way of contrast, adequate 
documentation between counterparties offers a framework for 
establishing the trading relationship between the parties from the 
outset of the transaction, which should minimize both the number and 
magnitude of potential disputes.
    Further, the proposed rule provides particular guidance with 
respect to policies and procedures documenting the valuation of 
security-based swaps. Although having policies and procedures regarding 
trading relationship documentation in place is important for all 
aspects of the transaction, the valuation of the transaction and how it 
affects margin requirements on an on-going basis is critical for 
managing both counterparty credit as well as operational risk. Pursuant 
to proposed Rule 15Fi-5, counterparties are required to provide 
information on the valuation methods, procedures, rules, and inputs 
(within limits so as to not reveal private information regarding 
proprietary valuation models), while further stipulating that either 
alternative valuation methods or valuation discrepancy resolutions are 
detailed in the trading relationship documentation. These benefits are 
both complemented by, and accrue to, the portfolio reconciliation 
process contemplated by proposed Rule 15Fi-3. That is, comprehensive 
and accurate documentation of a transaction may contribute to a 
smoother reconciliation process by reducing the possibility of 
discrepancies; and any discrepancies that may still arise could 
subsequently be identified and resolved through reconciliation.
    As discussed above, because shortcomings in credit risk management 
and documentation may only become evident during a crisis, some 
benefits of complying with these rules will accrue to the financial 
system as a whole while the ongoing direct costs are borne by the 
individual market participant. Therefore, in the absence of these 
rules, trading relationship documentation practices employed by 
individual market participants may be less thorough than would be 
desired by all market participants in order to properly manage risks to 
the financial system. However, the widespread use of standard 
documentation mitigates both the potential benefit and costs of the 
proposed rule.
c. Costs
    Market participants will likely incur ongoing costs associated with 
the rules concerning trading relationship documentation. Market 
participants will have to (1) negotiate and document all terms of each 
trading relationship; (2) design, compose, and implement policies and 
procedures reasonably designed to ensure the execution of security-
based swap trading relationship documentation, including valuation 
documentation; (3) obtain documentation from counterparties who are 
claiming the end user exception to clearing; and (4) periodically audit 
documentation and keep records and/or make reports as required under 
these rules.
    The Commission estimates that the initial burden to negotiate and 
draft trading relationship documentation will be $4,741,680 per SBS 
Entity, or $260,792,400 in aggregate across the 55

[[Page 4666]]

SBS Entities.\305\ The Commission further estimates that the 
development and implementation of written policies and procedures as 
required under proposed Rule 15Fi-5 would impose an initial cost of 
$702,232.50 in aggregate. Of the total 55 SBS Entities as expected by 
the Commission that would be subject to Rule 15Fi-5, 35 are anticipated 
to be registered concurrently with the CFTC, and are anticipated to 
already have policies and procedures in place with respect to portfolio 
compression. The expected additional time to revise the existing 
policies and procedures for these Entities is expected to be one hour 
per Entity, for a cumulative 35 hours, costing $429.50 per Entity or 
$15,032.50 in aggregate.\306\ For the remaining 20 SBS Entities, the 
Commission estimates that it will take approximately 80 hours per 
entity to establish the written policies and procedures. The costs for 
these SBS Entities will be $687,200, or $34,360 per SBS Entity.\307\ 
Once established, the Commission estimates that it would cost SBS 
Entities approximately $944,900 or $17,180 per SBS Entity to revise and 
maintain these policies and procedures.\308\ Lastly, proposed Rule 
15Fi-5 requires periodic independent audits of the trading relationship 
documentation. The Commission estimates that the costs associated with 
these audits will be $794,880 per SBS Entity, or $43,718,400 in 
aggregate.\309\
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    \305\ Each SBS Entity is anticipated to be counterparty to 18 
other SBS Entities and 350 non-SBS market participants, for a total 
of 368 counterparties. The initial negotiation and draft in expected 
to take 30 hours per counterparty. The estimation is as follows: 
[((Compliance Manager (15 hours) x $346) + (Director of Compliance 
(7.5 hours) x $461) + (Deputy General Counsel (7.5 hours) x $565)) x 
368 counterparties] = $4,741,680 per SBS Entity, or ($4,741,680 x 55 
SBS Entities) = $260,792,400 in aggregate.
    \306\ The estimate is based on the following: [((Compliance 
Attorney (30 minutes) at $346 per hour) + ((Director of Compliance 
(15 minutes) at $461 per hour) + ((Deputy General Counsel (15 
minutes) at $565 per hour)] = $429.50 per hour per SBS Entity or 
($429.50 per hour x 35 SBS dually-registered Entities) = $15,032.50.
    \307\ The estimate is based on the following: [((Compliance 
Attorney (40 hours) at $346 per hour) + ((Director of Compliance (20 
hours) at $461 per hour) + ((Deputy General Counsel (20 hours) at 
$565 per hour)] = $34,360 per SBS Entity or ($34,360 x 20 SBS 
Entities that are not dually-registered) = $687,200 in aggregate.
    \308\ The estimate is based on the following: [((Compliance 
Attorney (20 hours) at $346 per hour) + ((Director of Compliance (10 
hours) at $461 per hour) + ((Deputy General Counsel (10 hours) at 
$565 per hour)] = $17,180 per SBS Entity or ($17,180 x 55 SBS 
Entities) = $944,900 in aggregate.
    \309\ The estimate is based on the following: [368 
counterparties x 10 hours per Audit x Auditor ($216 per hour)] = 
$794,880 per SBS Entity, or ($794,880 x 55 SBS Entities) = 
$43,718,400 in aggregate.
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    Memorializing the specific terms of the security-based swap trading 
relationship and security-based swap transactions between 
counterparties is prudent business practice and, in fact, many market 
participants already use standardized documentation.\310\ Accordingly, 
the Commission preliminarily believes that many, if not most, market 
participants that are expected to register as SBS Entities currently 
execute and maintain trading relationship documentation of the type 
required by the proposed rules in the ordinary course of their 
businesses, including documentation that contains several of the terms 
that would be required by the proposed rules. Thus, the hour and dollar 
burdens associated with the security-based swap trading relationship 
documentation requirements may be limited to amending existing 
documentation to expressly include any additional terms required by the 
proposed rules. In addition the Commission anticipates that 
standardized security-based swap trading relationship documentation 
will eventually incorporate changes that may be necessary to comply 
with many of the requirements of this rule reducing the cost to 
individual security-based swap market participants.\311\
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    \310\ As noted in Section VI.B.4, as of 2015, the DTCC-TIW data 
shows that over 99% of SBS Entities use the ISDA Master Agreement.
    \311\ In response to prior Dodd Frank Act related regulatory 
requirements, ISDA in partnership with third party providers, has 
created technology-based solutions enabling counterparties to modify 
OTC derivatives related documentation quickly and efficiently. See 
https://www2.isda.org/dodd-frank-documentation-initiative/.
---------------------------------------------------------------------------

    Proposed Rule 15Fi-5 also includes certain exceptions that are 
intended to mitigate costs incurred by market participants while 
preserving the risk mitigating benefits of thorough trading 
relationship documents. First, the proposed rule would provide an 
exception for security-based swaps executed prior to the date on which 
the SBS Entity is required to be in compliance with the trading 
relationship documentation rule, as it may be costly and impractical to 
require SBS Entities to bring existing transactions into compliance 
with the proposed rules. The Commission notes that this exception may 
increase the likelihood of disputes in valuation with respect to such 
transactions, which will be subject to the portfolio reconciliation 
requirement of proposed Rule 15Fi-3 even though they are not subject to 
the documentation requirements of proposed Rule 15Fi-5. Such disputes 
could be costly to resolve and may lead to greater uncertainty with 
respect to counterparty credit risk.
    The proposed rule further provides exceptions for any ``clearing 
transaction'', which, pursuant to existing Rule 15Fi-1(c) under the 
Exchange Act, is defined as a security-based swap that has a clearing 
agency as a direct counterparty. Once a security is cleared, the 
transaction is primarily governed by the terms of the agreement between 
clearing member and the clearing agency. Lastly, the proposed rule 
would provide an exception for security-based swaps executed 
anonymously on a national securities exchange or an SBSEF, provided 
that these security-based swaps are intended to be cleared and are 
actually submitted for clearing to a clearing agency that provides CCP 
services. This exception is intended to recognize that documentation 
requirements may be nearly impossible to fulfill within the context of 
cleared anonymous transactions.\312\
---------------------------------------------------------------------------

    \312\ The exception with respect to security-based swap 
transactions on national exchanges or SBSEF is limited. See Section 
I.D.6 for a complete discussion of those limitations.
---------------------------------------------------------------------------

d. Alternatives
    The Commission has evaluated reasonable alternatives to the 
proposed rule on trading relationship documentation. One alternative 
would be that all SBS Entities are required to adhere to an industry-
accepted standard form of trading documentation, instead of 
establishing policies and procedures related to documentation. It is 
unlikely that this alternative would materially alter the primary 
benefits of the rule, namely that of reducing disputes over 
documentation that could lead to increased counterparty risk, but could 
increase overall compliance costs without analogous increases in 
benefits, due to reduced operational flexibility.
    Further, the proposed rule requires that SBS Entities undertake a 
periodic, independent audit to identify material weaknesses in its 
documentation policies and procedures. As proposed, there is 
flexibility on behalf of the SBS Entity as to how and when those audits 
occur. Alternatively, the Commission has considered limiting to only 
external auditors and requiring a once per year audit of trading 
relationship documentation. Although this alternative would not 
materially amend the primary benefits related to the audit of SBS 
Entities' policies and procedures related to trading relationship 
documentation, the Commission anticipates that this alternative could 
increase compliance costs by reducing operational flexibility.

[[Page 4667]]

    Proposed Rule 15Fi-5(a)(1)(ii) would provide an exception to the 
trading relationship documentations requirements for any ``clearing 
transaction'' which is defined as a security-based swap that has a 
clearing agency as a direct counterparty.\313\ A clearing agency means 
a clearing agency that is registered with the Commission pursuant to 
Section 17A of the Exchange Act and that provides central counterparty 
services for security-based swap transactions. The Commission 
considered as an alternative including transactions cleared at a 
foreign clearing agency that is not registered with the Commission 
within its definition of ``clearing transaction'' for the purposes of 
the proposed rule. The Commission preliminarily concluded that an 
approach that is similar to that taken by the Commission in other 
rules,\314\ as well as the approach taken by the CFTC,\315\ would 
reduce implementation and compliance costs.
---------------------------------------------------------------------------

    \313\ See supra Section I.D.6.
    \314\ See supra note 278.
    \315\ Specifically, CFTC Rule 23.504(a)(1)(iii) excludes from 
the written trading relationship documentation requirements ``swaps 
cleared by a derivatives clearing organization.'' 17 CFR 
23.504(a)(1)(iii).
---------------------------------------------------------------------------

    The Commission has considered as an alternative, an alternative 
compliance mechanism that would allow a SBS Entity to be deemed in 
compliance with certain proposed rules regarding trading relationship 
documentation if the SBS Entity is also registered as a swap dealer or 
major swap participant with the CFTC and is in compliance with the 
corresponding CFTC trading relationship documentation rules. The 
Commission preliminarily concludes that, as a practical matter, the 
rules are nearly equivalent, suggesting that any additional compliance 
cost arising from differences in these rules for an entity that is 
registered with both the CFTC and the Commission should be small. The 
Commission preliminarily believes that differences that do exist are 
necessary and appropriate. For example, to the extent that a 
transaction entered into on an anonymous basis on a national securities 
exchange or SBSEF that is then rejected for clearing but continues to 
exist, the Commission preliminarily believes that the counterparties to 
the ongoing security-based swap should have in place a written 
agreement on the terms of that transaction.\316\
---------------------------------------------------------------------------

    \316\ See supra Section I.D.6.
---------------------------------------------------------------------------

5. Recordkeeping Requirements
    The Commission is also proposing rules that would modify existing 
Rules 17a-3 and 17a-4, as well as proposed Rules 18a-5 and 18a-6 for 
the recordkeeping and reporting requirements applicable to SBS 
Entities. The proposed amendments would involve requiring each SBS 
Entity to make and keep current information relevant to portfolio 
reconciliation and portfolio compression exercises and to retain all 
security-based swap trading relationship documentation required to be 
created under proposed Rule 15Fi-5, as well as each policy and 
procedure created pursuant to proposed Rules 15Fi-3, 15Fi-4, and 15Fi-
5.
a. Requirements
    The Commission is proposing to amend Rule 17a-3 (which applies to 
SBS Entities that are also registered with the Commission as broker-
dealers) and proposed Rule 18a-5 (which applies to SBS Entities that 
are not registered with the Commission as broker-dealers). Under these 
amendments, each SBS Entity would be required to make and keep records 
of each security-based swap portfolio reconciliation and portfolio 
compression exercise, which is believed to promote compliance with 
proposed Rules 15Fi-3 and 15Fi-4 as well as support SBS Entities in the 
event that disputes arise in relation to previous reconciliations or 
compressions. The proposed amendments would also require that SBS 
Entities make and keep records of valuation disputes in excess of $20 
million if not resolved within three (for SBS Entities) or five (for 
non-SBS counterparties) days.
    The Commission also is proposing to amend Rule 17a-4 (which applies 
to SBS Entities that are also registered with the Commission as broker-
dealers) and proposed Rule 18a-6 (which applies to SBS Entities that 
are not registered with the Commission as broker-dealers), which 
address record retention. All records made and kept under the proposed 
amendments to Rule 17a-3 and proposed Rule 18a-5 would need to be 
retained for at least three years. Further, all policies and procedures 
related to proposed Rules 15Fi-3 through 15Fi-5, all written agreements 
between counterparties on terms of portfolio reconciliation, and all 
security-based swap trading relationship documentation with 
counterparties would need to be retained until at least three years 
following the termination of said policies and procedures and/or 
documentation.
b. Benefits
    In proposing these requirements, the Commission considered the 
potential benefits of improving the oversight, transparency, and 
documentation of security-based swap activities. The amendments to 
Rules 17a-3 and 17a-4, and proposed Rules 18a-5 and 18a-6 are intended 
to facilitate effective oversight of SBS Entities, thus the benefits 
associated with the proposed amendments related to recordkeeping are 
beneficial not only to the SBS Entities, but also are expected to 
facilitate regulatory oversight.
    Requiring retention of records related to portfolio reconciliation, 
portfolio compression, and trading relationship documentation for a 
minimum of three years provides SBS Entities with a well-established 
track record should disputes about terms of the security-based swap 
arise. The benefits of these proposed amendments, to the extent that 
they enhance existing practice, could reduce both counterparty credit 
risk as well as operational risk for the SBS Entities. Further, the 
proposed amendments are expected to facilitate examinations by the 
Commission of SBS Entities.
c. Costs
    The Commission also recognizes that there will be costs associated 
with the new rules and rule amendments. Those costs include the costs 
of creating procedures to ensure that records are kept as required by 
the proposed rule amendments, and costs associated with ongoing record 
maintenance. As the recordkeeping requirements would be amendments to 
Rules 17a-3 and 17a-4, and proposed Rules 18a-5 and 18a-6; however, the 
incremental costs of compliance with these amendments is likely to be 
minimal.
    The proposed Rules 15Fi-3 through 15Fi-5 would require that SBS 
Entities would establish and maintain written policies and procedures 
related to portfolio reconciliation, portfolio compression exercises, 
and trading relationship documentation. Further, SBS Entities are 
already required to comply with the retention of written policies and 
procedures with respect to Rule 15Fi-2 related to trade acknowledgement 
and verification, and should have recordkeeping systems previously 
instituted. Therefore, only minor modifications would need to be made 
in order to make the systems compliant with the proposed amendments 
regarding recordkeeping requirements for portfolio reconciliation, 
portfolio compression exercises, and trading relationship 
documentation.
    Generally, the Commission does not expect the amendments to Rules 
17a-3 and 17a-4, and proposed Rules 18a-5 and 18a-6 to create material 
burdens for registrants, although as noted above the Commission does 
expect that there will

[[Page 4668]]

be incremental costs related to complying with the proposed rule 
amendments.\317\
---------------------------------------------------------------------------

    \317\ See supra Section I.F.1.
---------------------------------------------------------------------------

d. Alternatives
    The Commission has considered reasonable alternatives to the 
proposed amendments. In particular, the costs and benefits associated 
with the required recordkeeping horizon have been evaluated. Shorter 
horizons (of less than three years) would lessen the overall 
recordkeeping burden by reducing the retention requirements and 
corresponding storage of records. However, as it may take time for 
disputes, particularly in the event of liquidations to be fully 
settled, shorter horizons may lead to the elimination of relevant 
records prior to resolution. On the other hand, longer horizons for 
maintaining records could be costly with respect to storage and system 
requirements. However, longer record preservation would reduce the 
likelihood that historical records are unavailable if needed at some 
point in the future.
    Proposed Rule 15Fi-5(c) requires each SBS Entity to have an 
independent auditor conduct periodic audits sufficient to identify any 
material weakness in it documentation policies and procedures required 
by the rule. The Commission considered using the same requirement as 
that required by the CFTC that the audit be conducted by an independent 
internal or external auditor. The Commission chose not to follow this 
approach because in its experience overseeing accounting and auditing 
standards in the context of certain disclosure requirements under the 
federal securities laws, an internal auditor typically reports to the 
management of the applicable entity, which by definition would not 
satisfy the test for auditor independence under any existing statutory 
or regulatory provision that the Commission administers.\318\ However, 
because the proposed rule would still encompass any auditor, whether 
external or internal, that is in fact independent, the Commission 
preliminarily believes that the practical differences between the 
Commission's proposed rule and the corresponding CFTC rule are 
negligible.
---------------------------------------------------------------------------

    \318\ See supra Section I.D.5.
---------------------------------------------------------------------------

6. Cross-Border Application of Rules 15Fi-3 Through 15Fi-5
    In early 2016, the Commission adopted Rule 3a71-6 under the 
Exchange Act, which determined that non-U.S. SBS Entities could satisfy 
certain requirements of Section 15F by complying with comparable 
regulatory requirements of a foreign financial regulatory system.\319\ 
At the time of the substituted compliance rule, it applied solely to 
business conduct standards; however, Rule 3a71-6 was amended in the 
Trade Acknowledgement and Verification Adopting Release to provide 
foreign SBS Entities with the potential to rely on substituted 
compliance to satisfy Title VII trade confirmation requirements.\320\
---------------------------------------------------------------------------

    \319\ See Business Conduct Standards Adopting Release, 81 FR at 
30074.
    \320\ See Trade Acknowledgement and Verification Adopting 
Release, 81 FR at 39827-28.
---------------------------------------------------------------------------

a. Requirements
    The Commission is proposing to amend further Rule 3a71-6 to allow 
non-U.S. SBS Entities to potentially be able to satisfy through 
substituted compliance the Title VII portfolio reconciliation, 
portfolio compression, and trading relationship documentation 
requirements in proposed Rules 15Fi-3 through 15Fi-5. The Commission 
has preliminarily determined that the principles previously set forth 
in the Business Conduct Standards Adopting Release and the Trade 
Acknowledgement and Verification Adopting Release with respect to 
substituted compliance should in large part similarly pertain to the 
reconciliation, compression, and documentation requirements proposed 
herein.
b. Benefits
    The Commission proposed amendments to Rule 3a71-6 permit 
consideration of substituted compliance in order to reduce the 
probability that SBS Entities are subject to potentially duplicative or 
conflicting regulation. Market participants that face duplicative 
regulatory regimes are likely to attain comparable regulatory outcomes, 
but at a cost of increased compliance burdens without an analogous 
increase in benefits. The availability of substituted compliance could 
decrease the compliance burden for non-U.S. SBS Entities, particularly 
as it pertains to portfolio reconciliation, portfolio compression, and 
trading relationship documentation. Allowing for the possibility of 
substituted compliance may help achieve the risk mitigation 
requirements set forth in proposed Rules 15Fi-3 through 15Fi-5, in 
particular as it reduces legal uncertainty, counterparty credit risk 
exposure, and operational risk for market participants.
    Further, the Commission anticipates broader market implications of 
substituted compliance, as well, namely an increase in foreign SBS 
dealers' activity in the U.S. market, the expansion of access by both 
U.S. and foreign SBS Entities to global liquidity, and a reduction in 
the possibility of liquidity fragmentation along jurisdictional lines. 
The availability of substituted compliance for non-U.S. SBS Entities 
also could promote market efficiency, while enhancing competition in 
U.S. markets. Increased participation and access to liquidity is likely 
to improve efficiencies related to hedging and risk sharing, while 
simultaneously increasing competition between domestic and foreign SBS 
Entities.
c. Costs
    The Commission preliminarily believes that the availability of 
substituted compliance for portfolio reconciliation, portfolio 
compression, and trading relationship documentation would not 
substantially alter the benefits intended by the proposed Rules 15Fi-3 
through 15Fi-5. In particular, it is expected that the availability of 
substituted compliance will not detract from the risk mitigation 
benefits that stem from periodic portfolio reconciliation, as well as 
policies and procedures regarding portfolio compression exercises and 
trading relationship documentation.
    To the extent that substituted compliance reduces duplicative 
compliance costs, non-U.S. SBS Entities entering into transactions in 
which substituted compliance is available may incur lower overall costs 
associated with portfolio reconciliation, portfolio compression, and 
documentation exercises with their counterparties than they would 
otherwise incur without the option of substituted compliance 
availability, either because a non-U.S. SBS Entity may have already 
implemented foreign regulatory requirements which have been deemed 
comparable by the Commission, or because security-based swap 
counterparties eligible for substituted compliance do not need to 
duplicate compliance with two sets of comparable requirements.
    A substituted compliance request can be made by either a foreign 
regulatory jurisdiction on behalf of its market participants, or by the 
registered market participant itself.\321\ The decision to request 
substituted compliance is voluntary, and therefore, to the extent that 
requests are made by individual market participants, such participants 
would request substituted compliance

[[Page 4669]]

only if compliance with foreign regulatory requirements was less 
costly, in their own assessment, than compliance with both the foreign 
regulatory regime and the relevant Title VII requirements, including 
portfolio reconciliation, portfolio compression, and trading 
relationship documentation requirements. Even after a substituted 
compliance determination is made, market participants would only choose 
substituted compliance for portfolio reconciliation, compression, and 
documentation requirements if the benefits that they expect to receive 
from transacting in the U.S. markets exceed the costs that they expect 
to bear for doing so.
---------------------------------------------------------------------------

    \321\ See Cross-Border Adopting Release, 79 FR at 47277.
---------------------------------------------------------------------------

D. Request for Comment

    The Commission requests comment on all aspects of this initial 
economic analysis, including whether the analysis has: (i) Identified 
all benefits and costs, including all effects on efficiency, 
competition, and capital formation; (ii) given due consideration to 
each benefit and cost, including each effect on efficiency, 
competition, and capital formation; and (iii) identified and considered 
reasonable alternatives to the proposed regulations. We request and 
encourage any interested person to submit comments regarding the 
proposed regulations and our analysis of the potential effects of the 
proposed regulations. We request that commenters identify sources of 
data and information as well as provide data and information to assist 
us in analyzing the economic consequences of the proposed rule and 
proposed amendments. We also are interested in comments on the 
qualitative benefits and costs we have identified and any benefits and 
costs we may have overlooked. In addition to our general request for 
comment on the economic analysis associated with the proposed rule and 
proposed amendments, we request specific comment on certain aspects of 
the proposal:
     We request comment on our characterization of current 
portfolio reconciliation practices. Do commenters agree that the 
proposed portfolio reconciliation rules are similar to current best 
practices? If not, how are they different? Are there third party 
service providers that offer portfolio reconciliation services? If so, 
what are the costs associated with using such services?
     We request comment on our characterization of current 
portfolio compression practices. Do commenters agree that the proposed 
portfolio compression rules are similar to current best practices? If 
not, how are they different? The Commission understands that there are 
third party service providers that offer portfolio compression 
services. What are the direct and indirect costs of using such service 
providers?
     We request comment on our characterization of current 
trading relationship documentation practices. Do commenters agree with 
our characterization? If not, how are they different?
     We request comment on our characterization of the benefits 
of the proposed regulations concerning portfolio reconciliation. The 
Commission preliminarily believes that the main benefit of portfolio 
reconciliation is improved management of market and credit risks 
associated with particular transactions. Do commenters agree with this 
characterization of the benefits? Are there other benefits of the 
proposed rule that have not been identified in our discussion and that 
warrant consideration? Are the assumptions that form the basis of our 
analysis of the benefits appropriate? Can commenters provide data that 
supports or opposes these assumptions? Can commenters provide data that 
would help the Commission quantify the magnitude of the benefits 
identified in our discussion or other benefits that we did not identify 
in our discussion and that warrant consideration?
     We request comment on our characterization of the costs of 
the proposed regulations concerning portfolio reconciliation. The 
Commission preliminarily believes that making its rules as similar as 
practicable to those of the CFTC will mitigate compliance costs for SBS 
entities. The Commission also preliminarily believes that ongoing 
portfolio reconciliation costs would likely be a function of portfolio 
size and the availability of third party service providers. Do 
commenters agree with our characterization of the costs? Are there 
other costs of the proposed rule that have not been identified in our 
discussion and that warrant consideration? Are the assumptions that 
form the basis of our analysis of the costs appropriate? Can commenters 
provide data that supports or opposes these assumptions? Can commenters 
provide data that would help the Commission quantify the magnitude of 
the costs identified in our discussion or other costs that we did not 
identify in our discussion and that warrant consideration?
     We request comment on our characterization of the benefits 
of the proposed rules concerning portfolio compression. The Commission 
preliminarily believes that the main benefit of the proposed portfolio 
compression rule is the potential for reducing the overall risk, cost, 
and inefficiencies associated with maintaining offsetting transactions. 
Do commenters agree with this characterization of the benefits? Are 
there other benefits of the proposed rule that have not been identified 
in our discussion and that warrant consideration? Are the assumptions 
that form the basis of our analysis of the benefits appropriate? Can 
commenters provide data that supports or opposes these assumptions? Can 
commenters provide data that would help the Commission quantify the 
magnitude of the benefits identified in our discussion or other 
benefits that we did not identify in our discussion and that warrant 
consideration?
     We request comment on our characterization of the costs of 
the proposed regulations concerning portfolio compression. The 
Commission preliminarily believes the making its rules as similar as 
practicable to those of the CFTC will mitigate compliance costs for SBS 
entities. Do commenters agree with our characterization of the costs? 
Are there other costs of the proposed rule that have not been 
identified in our discussion and that warrant consideration? Are the 
assumptions that form the basis of our analysis of the costs 
appropriate? The Commission preliminarily believes third-party service 
providers often facilitate multilateral portfolio compression but lacks 
data on the costs to participants of using these services. Can 
commenters provide data that supports or opposes these assumptions? Can 
commenters provide data that would help the Commission quantify the 
magnitude of the costs identified in our discussion or other costs that 
we did not identify in our discussion and that warrant consideration?
     We request comment on our characterization of the benefits 
of the proposed rules concerning trading relationship documentation. 
The Commission preliminarily believes that the main benefit of the 
proposed trading relationship documentation rule is the potential for 
reducing the likelihood of collateral and legal disputes between 
counterparties that might expose each side to significant counterparty 
credit risk. Do commenters agree with this characterization of the 
benefits? Are there other benefits of the proposed rule that have not 
been identified in our discussion and that warrant consideration? Are 
the assumptions that form the basis of our analysis of the

[[Page 4670]]

benefits appropriate? Can commenters provide data that supports or 
opposes these assumptions? Can commenters provide data that would help 
the Commission quantify the magnitude of the benefits identified in our 
discussion or other benefits that we did not identify in our discussion 
and that warrant consideration?
     We request comment on our characterization of the costs of 
the proposed regulations concerning trading relationship documentation. 
The Commission preliminarily believes the widespread use of standard 
documentation mitigates the costs of the proposed rule. Do commenters 
agree with our characterization of the costs? Are there other costs of 
the proposed rule that have not been identified in our discussion and 
that warrant consideration? Are the assumptions that form the basis of 
our analysis of the costs appropriate? Can commenters provide data that 
would help the Commission quantify the magnitude of the costs 
identified in our discussion or other costs that we did not identify in 
our discussion and that warrant consideration?
     Are there any effects on efficiency, competition, and 
capital formation that are not identified or are misidentified in our 
economic analysis? Please be specific and provide data and analysis to 
support your views.
     Do commenters believe that the alternatives the Commission 
considered are appropriate? Are there other reasonable alternatives 
that the Commission should consider? If so, please provide additional 
alternatives and how their costs and benefits would compare to the 
proposal.
     We request and encourage any interested person to submit 
comments regarding any aspect of the economic analysis of the proposed 
rule, specific issues discussed in the economic analysis, and other 
matters that may have an effect on the costs or benefits of the 
proposed rule. With regard to any comments, we note that such comments 
are of particular assistance to our rulemaking initiative if 
accompanied by supporting data and analysis of the issues addressed in 
those comments.

VII. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996 (``SBREFA'') \322\ the Commission requests comment on the 
potential impact of the proposed rules and amendments on the economy on 
an annual basis. The Commission also requests comment on any potential 
increases in costs or prices for consumers or individual industries, 
and any potential effect on competition, investment, or innovation. 
Commenters are requested to provide empirical data and other factual 
support for their views to the extent possible.
---------------------------------------------------------------------------

    \322\ Public Law 104-121, Title II, 110 Stat. 857 (1996) 
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note 
to 5 U.S.C. 601).
---------------------------------------------------------------------------

VIII. Regulatory Flexibility Act Certification

    The Regulatory Flexibility Act of 1980 (``RFA'') \323\ requires the 
Commission, in promulgating rules, to consider the impact of those 
rules on small entities. Section 603(a) \324\ of the Administrative 
Procedure Act,\325\ as amended by the RFA, generally requires the 
Commission to undertake a regulatory flexibility analysis of all 
proposed rules to determine the impact of such rulemaking on ``small 
entities.'' Section 605(b) of the RFA \326\ provides that this 
requirement shall not apply to any proposed rule or proposed rule 
amendment which, if adopted, would not have a significant economic 
impact on a substantial number of small entities.
---------------------------------------------------------------------------

    \323\ 5 U.S.C. 601 et seq.
    \324\ 5 U.S.C. 603(a).
    \325\ 5 U.S.C. 551 et seq.
    \326\ 5 U.S.C. 605(b).
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    For purposes of Commission rulemaking in connection with the 
RFA,\327\ a small entity includes: (1) When used with reference to an 
``issuer'' or a ``person,'' other than an investment company, an 
``issuer'' or ``person'' that, on the last day of its most recent 
fiscal year, had total assets of $5 million or less; \328\ or (2) a 
broker-dealer with total capital (net worth plus subordinated 
liabilities) of less than $500,000 on the date in the prior fiscal year 
as of which its audited financial statements were prepared pursuant to 
Rule 17a-5(d) under the Exchange Act,\329\ or, if not required to file 
such statements, a broker-dealer with total capital (net worth plus 
subordinated liabilities) of less than $500,000 on the last day of the 
preceding fiscal year (or in the time that it has been in business, if 
shorter); and is not affiliated with any person (other than a natural 
person) that is not a small business or small organization.\330\ Under 
the standards adopted by the Small Business Administration, small 
entities in the finance and insurance industry include the following: 
(i) For entities engaged in credit intermediation and related 
activities, entities with $175 million or less in assets; \331\ (ii) 
for entities engaged in non-depository credit intermediation and 
certain other activities, entities with $7 million or less in annual 
receipts; \332\ (iii) for entities engaged in financial investments and 
related activities, entities with $7 million or less in annual 
receipts; \333\ (iv) for insurance carriers and entities engaged in 
related activities, entities with $7 million or less in annual 
receipts; \334\ and (v) for funds, trusts, and other financial 
vehicles, entities with $7 million or less in annual receipts.\335\
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    \327\ Although Section 601(b) of the RFA defines the term 
``small entity,'' the statute permits agencies to formulate their 
own definitions. The Commission has adopted definitions for the term 
``small entity'' for the purposes of Commission rulemaking in 
accordance with the RFA. Those definitions, as relevant to this 
proposed rulemaking, are set forth in Rule 0-10 under the Exchange 
Act, 17 CFR 240.0-10. See Exchange Act Release No. 18451 (Jan., 28, 
1982), 47 FR 5215 (Feb., 4, 1982) (File No. AS-305).
    \328\ See 17 CFR 240.0-10(a).
    \329\ 17 CFR 240.17a-5(d).
    \330\ See 17 CFR 240.0-10(c).
    \331\ See 13 CFR 121.201 (Subsector 522).
    \332\ See id. at Subsector 522.
    \333\ See id. at Subsector 523.
    \334\ See id. at Subsector 524.
    \335\ See id. at Subsector 525.
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    With respect to SBS Entities, based on feedback from market 
participants and our information about the security-based swap markets, 
and consistent with our position in prior Dodd-Frank Act rulemakings, 
the Commission continues to believe that (1) the types of entities that 
would engage in more than a de minimis amount of dealing activity 
involving security-based swaps--which generally would be large 
financial institutions--would not be ``small entities'' for purposes of 
the RFA and (2) the types of entities that may have security-based swap 
positions above the level required to be ``major security-based swap 
participants'' would not be ``small entities'' for purposes of the 
RFA.\336\
---------------------------------------------------------------------------

    \336\ See SBS Entity Registration Adopting Release, 80 FR at 
49013; SBS Books and Records Proposing Release, 79 FR at 25296-97 
and n.1441; Intermediary Definitions Adopting Release, 77 FR at 
30743. See also Sections V (Paperwork Reduction Act) and VI 
(Economic Analysis) (discussing, among other things, the economic 
impact, including the estimated compliance costs and burdens, of the 
amendments).
---------------------------------------------------------------------------

    For the foregoing reasons, the Commission certifies that neither 
proposed Rules 15Fi-3 through 15Fi, nor the proposed amendments to 
Rules 3a71-6, 15Fi-1, 17a-3, 17a-4, 18a-5 (proposed) and 18a-6 
(proposed) would, if adopted, have a significant economic impact on a 
substantial number of small entities. The Commission encourages written 
comments regarding this certification. The Commission solicits comment 
as to whether the proposed rules could have an effect on small

[[Page 4671]]

entities that has not been considered. The Commission requests that 
commenters describe the nature of any impact on small entities and 
provide empirical data to support the extent of such impact.

IX. Statutory Basis and Text of Proposed Rules

    The Commission is proposing to revise Rules 3a71-6, 15Fi-1, 17a-3, 
and 17a-4 under the Exchange Act (17 CFR 240.3a71-6, 17 CFR 240.15Fi-1, 
17 CFR 240.17a-3 [as proposed to be amended at 79 FR 25193, May 2, 
2014], and 17 CFR 240.17a-4 [as proposed to be amended at 79 FR 25193, 
May 2, 2014]), to revise proposed Rules 18a-5 and 18a-6 under the 
Exchange Act (17 CFR 240.18a-5 [as proposed to be adopted at 79 FR 
25193, May 2, 2014] and 17 CFR 240.18a-6 [as proposed to be adopted at 
79 FR 25193, May 2, 2014]) and to add new Rules 15Fi-3, 15Fi-4, and 
15Fi-5 under the Exchange Act (17 CFR 240.15Fi-3, 17 CFR 240.15Fi-4, 
and 17 CFR 240.15Fi-5) pursuant to the authority conferred by the 
Exchange Act, as amended, and particularly sections 3(b), 15F, 17, and 
23(a).\337\
---------------------------------------------------------------------------

    \337\ 15 U.S.C. 78c(b), 78o-10, 78q, 78w(a), and 78mm.
---------------------------------------------------------------------------

List of Subjects in 17 CFR Part 240

    Reporting and recordkeeping requirements, Securities, Security-
based swaps, Security-based swap dealers, Major security-based swap 
participants.

Text of the Amendments

    In accordance with the foregoing, the Securities and Exchange 
Commission proposes to amend Title 17, chapter II of the Code of 
Federal Regulations as follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

0
1. The general authority citation for Part 240 continues to read as 
follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss,77ttt, 78c, 78c-3, 78c-5, 78d, 78e, 78f, 
78g, 78i, 78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78n-1, 78o, 78o-4, 
78o-10, 78p, 78q, 78q-1, 78s, 78u-5, 78w, 78x, 78ll, 78mm, 80a-20, 
80a-23, 80a-29, 80a-37, 80b-3, 80b-4, 80b-11, 7201 et seq., and 
8302; 7 U.S.C. 2(c)(2)(E); 12 U.S.C. 5221(e)(3); 18 U.S.C. 1350; and 
Pub. L. 111-203, 939A, 124 Stat. 1376 (2010), unless otherwise 
noted.

0
2. Section 240.3a71-6 is amended by adding paragraph (d)(4) to read as 
follows:


Sec.  240.3a71-6  Substituted compliance for security-based swap 
dealers and major security-based swap participants.

* * * * *
    (d) * * *
    (4) Portfolio reconciliation, portfolio compression, and trading 
relationship documentation requirements. The portfolio reconciliation, 
portfolio compression, and trading relationship documentation 
requirements of section 15F(i) of the Act (15 U.S.C. 78o-10(i)) and 
Sec. Sec.  240.15Fi-3 through 15Fi-5; provided, however, that prior to 
making such a substituted compliance determination the Commission 
intends to consider whether the requirements of the foreign financial 
regulatory system for engaging in portfolio reconciliation and 
portfolio compression and for executing trading relationship 
documentation with counterparties, the duties imposed by the foreign 
financial regulatory system, and the information that is required to be 
provided to counterparties pursuant to the requirements of the foreign 
financial regulatory system, are comparable to those required pursuant 
to the applicable provisions arising under the Act and its rules and 
regulations.
0
3. Revise Sec.  240.15Fi-1 to read as follows:


Sec.  240.15Fi-1   Definitions.

    For the purposes of Sec.  240.15Fi-1 through Sec.  240.15Fi-5:
    (a) The term bilateral portfolio compression exercise means an 
exercise by which two security-based swap counterparties wholly 
terminate or change the notional value of some or all of the security-
based swaps submitted by the counterparties for inclusion in the 
portfolio compression exercise and, depending on the methodology 
employed, replace the terminated security-based swaps with other 
security-based swaps whose combined notional value (or some other 
measure of risk) is less than the combined notional value (or some 
other measure of risk) of the terminated security-based swaps in the 
exercise.
    (b) The term business day means any day other than a Saturday, 
Sunday, or legal holiday.
    (c) The term clearing agency means a clearing agency as defined in 
section 3(a)(23) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(23)) that is registered pursuant to section 17A of the 
Securities Exchange Act of 1934 (15 U.S.C. 78q-1) and provides central 
counterparty services for security-based swap transactions.
    (d) The term clearing transaction means a security-based swap that 
has a clearing agency as a direct counterparty.
    (e) The term day of execution means the calendar day of the 
counterparty to the security-based swap transaction that ends the 
latest, provided that if a security-based swap transaction is
    (1) Entered into after 4:00 p.m. in the place of a counterparty; or
    (2) Entered into on a day that is not a business day in the place 
of a counterparty, then such security-based swap transaction shall be 
deemed to have been entered into by that counterparty on the 
immediately succeeding business day of that counterparty, and the day 
of execution shall be determined with reference to such business day.
    (f) The term execution means the point at which the counterparties 
become irrevocably bound to a transaction under applicable law.
    (g) The term financial counterparty means a counterparty that is 
not a security-based swap dealer or a major security-based swap 
participant and that is one of the following:
    (1) A swap dealer;
    (2) A major swap participant;
    (3) A commodity pool as defined in section 1a(10) of the Commodity 
Exchange Act (7 U.S.C. 1a(10));
    (4) A private fund as defined in section 202(a)(29) of the 
Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a));
    (5) An employee benefit plan as defined in paragraphs (3) and (32) 
of section 3 of the Employee Retirement Income Security Act of 1974 (29 
U.S.C. 1002); and
    (6) A person predominantly engaged in activities that are in the 
business of banking, or in activities that are financial in nature, as 
defined in section 4(k) of the Bank Holding Company Act of 1956 (12 
U.S.C. 1843k).
    (h) The term fully offsetting security-based swaps means security-
based swaps of equivalent terms where no net cash flow would be owed to 
either counterparty after the offset of payment obligations thereunder.
    (i) The term material terms means:
    (1) With respect to any security-based swap that has not yet been 
included in a security-based swap portfolio and reconciled pursuant to 
Sec.  240.15Fi-3, each term that is required to be reported to a 
registered swap data repository or the Commission pursuant to Sec.  
242.901 of this chapter; and
    (2) With respect to all other security-based swaps within a 
security-based swap portfolio, each term that is required to be 
reported to a registered swap data repository or the Commission 
pursuant to Sec.  242.901 of this chapter; provided, however, that such 
definition does not include any term that is not

[[Page 4672]]

relevant to the ongoing rights and obligations of the parties and the 
valuation of the security-based swap.
    (j) The term multilateral portfolio compression exercise means an 
exercise by which multiple security-based swap counterparties wholly 
terminate or change the notional value of some or all of the security-
based swaps submitted by the counterparties for inclusion in the 
portfolio compression exercise and, depending on the methodology 
employed, replace the terminated security-based swaps with other 
security-based swaps whose combined notional value (or some other 
measure of risk) is less than the combined notional value (or some 
other measure of risk) of the terminated security-based swaps in the 
exercise.
    (k) The term national securities exchange means an exchange as 
defined in section 3(a)(1) of the Securities Exchange Act of 1934 (15 
U.S.C. 78c(a)(1)) that is registered pursuant to section 6 of the 
Securities Exchange Act of 1934 (15 U.S.C. 78f).
    (l) The term portfolio reconciliation means any process by which 
the counterparties to one or more security-based swaps:
    (1) Exchange the material terms of all security-based swaps in the 
security-based swap portfolio between the counterparties;
    (2) Exchange each counterparty's valuation of each security-based 
swap in the security-based swap portfolio between the counterparties as 
of the close of business on the immediately preceding business day; and
    (3) Resolve any discrepancy in valuations or material terms.
    (m) The term prudential regulator has the meaning given to the term 
in section 3(a)(74) of the Act (15 U.S.C. 78c(a)(74)) and includes the 
Board of Governors of the Federal Reserve System, the Office of the 
Comptroller of the Currency, the Federal Deposit Insurance Corporation, 
the Farm Credit Association, and the Federal Housing Finance Agency, as 
applicable to the security-based swap dealer or major security-based 
swap participant.
    (n) The term security-based swap execution facility means a 
security-based swap execution facility as defined in section 3(a)(77) 
of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(77)) that is 
registered pursuant to section 3D of the Securities Exchange Act of 
1934 (15 U.S.C. 78c-4).
    (o) The term security-based swap portfolio means all security-based 
swaps currently in effect between a particular security-based swap 
dealer or major security-based swap participant and a particular 
counterparty.
    (p) The term trade acknowledgment means a written or electronic 
record of a security-based swap transaction sent by one counterparty of 
the security-based swap transaction to the other.
    (q) The term valuation means the current market value or net 
present value of a security-based swap.
    (r) The term verification means the process by which a trade 
acknowledgment has been manually, electronically, or by some other 
legally equivalent means, signed by the receiving counterparty.
0
4. Section 240.15Fi-3 is added to read as follows:


Sec.  240.15Fi-3  Security-based swap portfolio reconciliation.

    (a) Security-based swaps with security-based swap dealers or major 
security-based swap participants. Each security-based swap dealer and 
major security-based swap participant shall engage in portfolio 
reconciliation as follows for all security-based swaps in which its 
counterparty is also a security-based swap dealer or major security-
based swap participant.
    (1) Each security-based swap dealer or major security-based swap 
participant shall agree in writing with each of its counterparties on 
the terms of the portfolio reconciliation including, if applicable, 
agreement on the selection of any third party service provider who may 
be performing the portfolio reconciliation.
    (2) The portfolio reconciliation may be performed on a bilateral 
basis by the counterparties or by a third party selected by the 
counterparties in accordance with paragraph (a)(1) of this section.
    (3) The portfolio reconciliation shall be performed no less 
frequently than:
    (i) Once each business day for each security-based swap portfolio 
that includes 500 or more security-based swaps;
    (ii) Once each week for each security-based swap portfolio that 
includes more than 50 but fewer than 500 security-based swaps on any 
business day during the week; and
    (iii) Once each calendar quarter for each security-based swap 
portfolio that includes no more than 50 security-based swaps at any 
time during the calendar quarter.
    (4) Each security-based swap dealer and major security-based swap 
participant shall resolve immediately any discrepancy in a material 
term of a security-based swap identified as part of a portfolio 
reconciliation or otherwise.
    (5) Each security-based swap dealer and major security-based swap 
participant shall establish, maintain, and follow written policies and 
procedures reasonably designed to resolve any discrepancy in a 
valuation identified as part of a portfolio reconciliation or otherwise 
as soon as possible, but in any event within five business days after 
the date on which the discrepancy is first identified, provided that 
the security-based swap dealer and major security-based swap 
participant establishes, maintains, and follows written policies and 
procedures reasonably designed to identify how the security-based swap 
dealer or major security-based swap participant will comply with any 
variation margin requirements under section 15F(e) of the Act (15 
U.S.C. 78o-10(e)) and regulations thereunder pending resolution of the 
discrepancy in valuation. For purposes of this paragraph, a difference 
between the lower valuation and the higher valuation of less than 10 
percent of the higher valuation need not be deemed a discrepancy.
    (b) Security-based swaps with entities other than security-based 
swap dealers or major security-based swap participants. Each security-
based swap dealer and major security-based swap participant shall 
establish, maintain, and follow written policies and procedures 
reasonably designed to ensure that it engages in portfolio 
reconciliation for all security-based swaps in which its counterparty 
is neither a security-based swap dealer nor a major security-based swap 
participant as follows.
    (1) Each security-based swap dealer or major security-based swap 
participant shall agree in writing with each of its counterparties on 
the terms of the portfolio reconciliation including, if applicable, 
agreement on the selection of any third party service provider who may 
be performing the reconciliation.
    (2) The portfolio reconciliation may be performed on a bilateral 
basis by the counterparties or by one or more third parties selected by 
the counterparties in accordance with paragraph (b)(1) of this section.
    (3) The portfolio reconciliation will be required to be performed 
no less frequently than:
    (i) Once each calendar quarter for each security-based swap 
portfolio that includes more than 100 security-based swaps at any time 
during the calendar quarter; and
    (ii) Once annually for each security-based swap portfolio that 
includes no more than 100 security-based swaps at any time during the 
calendar year.
    (4) Each security-based swap dealer or major security-based swap 
participant shall establish, maintain, and follow

[[Page 4673]]

written procedures reasonably designed to resolve any discrepancies in 
the valuation or material terms of each security-based swap identified 
as part of a portfolio reconciliation or otherwise with a counterparty 
that is neither a security-based swap dealer nor major security-based 
swap participant in a timely fashion. For purposes of this paragraph, a 
difference between the lower valuation and the higher valuation of less 
than 10 percent of the higher valuation need not be deemed a 
discrepancy.
    (c) Reporting of Security-Based Swap Valuation Disputes. Each 
security-based swap dealer and major security-based swap participant 
shall promptly notify the Commission, in a form and manner acceptable 
to the Commission, and any applicable prudential regulator of any 
security-based swap valuation dispute in excess of $20,000,000 (or its 
equivalent in any other currency), at either the transaction or 
portfolio level, if not resolved within:
    (1) Three business days, if the dispute is with a counterparty that 
is a security-based swap dealer or major security-based swap 
participant; or
    (2) Five business days, if the dispute is with a counterparty that 
is not a security-based swap dealer or major security-based swap 
participant.
    (d) Reconciliation of cleared security-based swaps. Nothing in this 
section shall apply to any clearing transaction.
0
5. Section 240.15Fi-4 is added to read as follows:


Sec.  240.15Fi-4  Security-based swap portfolio compression.

    (a) Portfolio compression with security-based swap dealers and 
major security-based swap participants--(1) Bilateral offset. Each 
security-based swap dealer and major security-based swap participant 
shall establish, maintain, and follow written policies and procedures 
for terminating each fully offsetting security-based swap between a 
security-based swap dealer or major security-based swap participant and 
another security-based swap dealer or major security-based swap 
participant in a timely fashion, when appropriate.
    (2) Bilateral compression. Each security-based swap dealer and 
major security-based swap participant shall establish, maintain, and 
follow written policies and procedures for periodically engaging in 
bilateral portfolio compression exercises, when appropriate, with each 
counterparty that is also a security-based swap dealer or major 
security-based swap participant. Such policies and procedures shall 
address, among other things, the evaluation of bilateral portfolio 
compression exercises that are initiated, offered, or sponsored by any 
third party.
    (3) Multilateral compression. Each security-based swap dealer and 
major security-based swap participant shall establish, maintain, and 
follow written policies and procedures for periodically engaging in 
multilateral portfolio compression exercises, when appropriate, with 
each counterparty that is also a security-based swap dealer or major 
security-based swap participant. Such policies and procedures shall 
address, among other things, the evaluation of multilateral portfolio 
compression exercises that are initiated, offered, or sponsored by any 
third party.
    (b) Portfolio compression with counterparties other than security-
based swap dealers and major security-based swap participants. Each 
security-based swap dealer and major security-based swap participant 
shall 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 respect to security-based swaps in which its 
counterparty is an entity other than a security-based swap dealer or 
major security-based swap participant, when appropriate and to the 
extent requested by any such counterparty.
    (c) Portfolio compression of cleared security-based swaps. Nothing 
in this section shall apply to any clearing transaction.
0
6. Section 240.15Fi-5 is added to read as follows:


Sec.  240.15Fi-5  Security-based swap trading relationship 
documentation.

    (a)(1) Applicability. The requirements of this section shall not 
apply to:
    (i) Security-based swaps executed prior to the date on which a 
security-based swap dealer or major security-based swap participant is 
required to be in compliance with this section;
    (ii) Any clearing transaction; and
    (iii) Security-based swaps executed anonymously on a national 
securities exchange or a security-based swap execution facility, 
Provided that:
    (A) Such security-based swaps are intended to be cleared and are 
actually submitted for clearing to a clearing agency;
    (B) All terms of such security-based swaps conform to the rules of 
the clearing agency; and
    (C) Upon acceptance of such security-based swap by the clearing 
agency:
    (1) The original security-based swap is extinguished;
    (2) The original security-based swap is replaced by equal and 
opposite security-based swaps with the clearing agency; and
    (3) All terms of the security-based swap shall conform to the 
product specifications of the cleared security-based swap established 
under the clearing agency's rules; and Provided further, That if a 
security-based swap dealer or major security-based swap participant 
receives notice that a security-based swap transaction has not been 
accepted for clearing by a clearing agency, the security-based swap 
dealer or major security-based swap participant shall be required to 
comply with the requirements of this section in all respects promptly 
after receipt of such notice.
    (2) Policies and procedures. Each security-based swap dealer and 
major security-based swap participant shall establish, maintain, and 
follow written policies and procedures reasonably designed to ensure 
that the security-based swap dealer or major security-based swap 
participant executes written security-based swap trading relationship 
documentation with its counterparty that complies with the requirements 
of this section. The policies and procedures shall be approved in 
writing by a senior officer of the security-based swap dealer or major 
security-based swap participant, and a record of the approval shall be 
retained. Other than trade acknowledgements and verifications of 
security-based swap transactions under Sec.  240.15Fi-2, the security-
based swap trading relationship documentation shall be executed prior 
to, or contemporaneously with, executing a security-based swap with any 
counterparty.
    (b) Security-based swap trading relationship documentation. (1) The 
security-based swap trading relationship documentation shall be in 
writing and shall include all terms governing the trading relationship 
between the security-based swap dealer or major security-based swap 
participant 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 
Sec. Sec.  242.900 to 242.909) of this chapter, governing law, 
valuation, and dispute resolution.
    (2) The security-based swap trading relationship documentation 
shall include all trade acknowledgements and verifications of security-
based swap transactions under Sec.  240.15Fi-2.
    (3) The security-based swap trading relationship documentation 
shall

[[Page 4674]]

include credit support arrangements, which shall contain, in accordance 
with applicable requirements under Commission regulations or 
regulations adopted by prudential regulators and without limitation, 
the following:
    (i) Initial and variation margin requirements, if any;
    (ii) Types of assets that may be used as margin and asset valuation 
haircuts, if any;
    (iii) Investment and re-hypothecation terms for assets used as 
margin for uncleared security-based swaps, if any; and
    (iv) Custodial arrangements for margin assets, including whether 
margin assets are to be segregated with an independent third party, in 
accordance with section 3E(f) of the Act (15 U.S.C. 78c-5(f)), if any.
    (4)(i) The security-based swap trading relationship documentation 
between security-based swap dealers, between major security-based swap 
participants, between a security-based swap dealer and major security-
based swap participant, between a security-based swap dealer or major 
security-based swap participant and a financial counterparty, and, if 
requested by any other counterparty, between a security-based swap 
dealer or major security-based swap participant and such counterparty, 
shall 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 for the purposes of complying with the margin 
requirements under section 15F(e) of the Act (15 U.S.C. 78o-10(e)) and 
regulations thereunder, and the risk management requirements under 
section 15F(j) of the Act (15 U.S.C. 78o-10(j)) of the Act and 
regulations thereunder. To the maximum extent practicable, the 
valuation of each security-based swap shall be based on recently-
executed transactions, valuations provided by independent third 
parties, or other objective criteria.
    (ii) Such documentation shall include either:
    (A) Alternative methods for determining the value of the security-
based swap for the purposes of complying with this paragraph in the 
event of the unavailability or other failure of any input required to 
value the security-based swap for such purposes; or
    (B) A valuation dispute resolution process by which the value of 
the security-based swap shall be determined for the purposes of 
complying with this paragraph (b)(4).
    (iii) A security-based swap dealer or major security-based swap 
participant is not required to disclose to the counterparty 
confidential, proprietary information about any model it may use to 
value a security-based swap.
    (iv) The parties may agree on changes or procedures for modifying 
or amending the documentation at any time.
    (5) The security-based swap trading relationship documentation of a 
security-based swap dealer or major security-based swap participant 
shall include the following:
    (i) A statement of whether the security-based swap dealer or major 
security-based swap participant is an insured depository institution 
(as defined in 12 U.S.C. 1813) or a financial company (as defined in 
section 201(a)(11) of the Dodd-Frank Act, 12 U.S.C. 5381(a)(11));
    (ii) A statement of whether the counterparty is an insured 
depository institution or financial company;
    (iii) A statement that in the event either the security-based swap 
dealer or major security-based swap participant or its counterparty 
becomes a covered financial company (as defined in section 201(a)(8) of 
the Dodd-Frank Wall Street Reform and Consumer Protection Act, 12 
U.S.C. 5381(a)(8)) or is an insured depository institution for which 
the Federal Deposit Insurance Corporation (FDIC) has been appointed as 
a receiver (the ``covered party''), certain limitations under Title II 
of the Dodd-Frank Act or the Federal Deposit Insurance Act may apply to 
the right of the non-covered party to terminate, liquidate, or net any 
security-based swap by reason of the appointment of the FDIC as 
receiver, notwithstanding the agreement of the parties in the security-
based swap trading relationship documentation, and that the FDIC may 
have certain rights to transfer security-based swaps of the covered 
party under section 210(c)(9)(A) of the Dodd-Frank Wall Street Reform 
and Consumer Protection Act, 12 U.S.C. 5390(c)(9)(A), or 12 U.S.C. 
1821(e)(9)(A); and
    (iv) An agreement between the security-based swap dealer or major 
security-based swap participant and its counterparty to provide notice 
if either it or its counterparty becomes or ceases to be an insured 
depository institution or a financial company.
    (6) The security-based swap trading relationship documentation of 
each security-based swap dealer and major security-based swap 
participant shall contain a notice that, upon acceptance of a security-
based swap by a clearing agency:
    (i) The original security-based swap is extinguished;
    (ii) The original security-based swap is replaced by equal and 
opposite security-based swaps with the clearing agency; and
    (iii) All terms of the security-based swap shall conform to the 
product specifications of the cleared security-based swap established 
under the clearing agency's rules.
    (c) Audit of security-based swap trading relationship 
documentation. Each security-based swap dealer and major security-based 
swap participant shall have an independent auditor conduct periodic 
audits sufficient to identify any material weakness in its 
documentation policies and procedures required by this section. A 
record of the results of each audit shall be retained.
0
7. Section 240.17a-3, as proposed to be amended at 79 FR 25193, May 2, 
2014 is further amended by adding paragraph (a)(31) to read as follows:


Sec.  240.17a-3   Records to be made by certain brokers and dealers.

* * * * *
    (a) * * *
    (31)(i) A record of each security-based swap portfolio 
reconciliation, whether conducted pursuant to Sec.  240.15Fi-3 or 
otherwise, including the dates of the security-based swap portfolio 
reconciliation, the number of portfolio reconciliation discrepancies, 
the number of security-based swap valuation disputes (including the 
time-to-resolution of each valuation dispute and the age of outstanding 
valuation disputes, categorized by transaction and counterparty), and 
the name of the third-party entity performing the security-based swap 
portfolio reconciliation, if any.
    (ii) A copy of each notification required to be provided to the 
Commission pursuant to Sec.  240.15Fi-3(c).
    (iii) A record of each bilateral offset and each bilateral 
portfolio compression exercise or multilateral portfolio compression 
exercise in which it participates, whether conducted pursuant to Sec.  
240.15Fi-4 or otherwise, including the dates of the offset or 
compression, the security-based swaps included in the offset or 
compression, the identity of the counterparties participating in the 
offset or compression, the results of the compression, and the name of 
the third-party entity performing the offset or compression, if any.
* * * * *

[[Page 4675]]

0
8. Section 240.17a-4, as proposed to be amended at 79 FR 25193, May 2, 
2014 is amended by revising paragraph (b)(1) and adding paragraphs 
(e)(10) and (11) to read as follows:


Sec.  240.17a-4   Records to be preserved by certain exchange members, 
brokers and dealers.

* * * * *
    (b) * * *
    (1) All records required to be made pursuant to Sec.  240.17a-
3(a)(4), (a)(6), (a)(7), (a)(8), (a)(9), (a)(10), (a)(11), (a)(16), 
(a)(18), (a)(19), (a)(20), (a)(24), (a)(25), (a)(26), (a)(27), (a)(28), 
(a)(29), (a)(30), and (a)(31), and analogous records created pursuant 
to Sec.  240.17a-3(e).
* * * * *
    (e) * * *
    (10) The written policies and procedures required pursuant to 
Sec. Sec.  240.15Fi-3, 240.15Fi-4, and 240.15Fi-5 until three years 
after termination of the use of the policies and procedures.
    (11) (i) Each written agreement with counterparties on the terms of 
portfolio reconciliation with those counterparties as required to be 
created under Sec.  240.15Fi-3(a)(1) and (b)(1) until three years after 
the termination of the agreement and all transactions governed thereby.
    (ii) Security-based swap trading relationship documentation with 
counterparties required to be created under Sec.  240.15Fi-5 until 
three years after the termination of such documentation and all 
transactions governed thereby.
    (iii) A record of the results of each audit required to be 
performed pursuant to Sec.  240.15Fi-5(c) until three years after the 
conclusion of the audit.
* * * * *
0
9. Section 240.18a-5, as proposed to be added at 79 FR 25193, May 2, 
2014, is further amended by adding paragraphs (a)(18) and (b)(14) to 
read as follows:


Sec.  240.18a-5   Records to be made by certain security-based swap 
dealers and major security-based swap participants.

* * * * *
    (a) * * *
    (18)(i) A record of each security-based swap portfolio 
reconciliation, whether conducted pursuant to Sec.  240.15Fi-3 or 
otherwise, including the dates of the security-based swap portfolio 
reconciliation, the number of portfolio reconciliation discrepancies, 
the number of security-based swap valuation disputes (including the 
time-to-resolution of each valuation dispute and the age of outstanding 
valuation disputes, categorized by transaction and counterparty), and 
the name of the third-party entity performing the security-based swap 
portfolio reconciliation, if any.
    (ii) A copy of each notification required to be provided to the 
Commission pursuant to Sec.  240.15Fi-3(c).
    (iii) A record of each bilateral offset and each bilateral 
portfolio compression exercise or multilateral portfolio compression 
exercise in which it participates, whether conducted pursuant to Sec.  
240.15Fi-4 or otherwise, including the dates of the offset or 
compression, the security-based swaps included in the offset or 
compression, the identity of the counterparties participating in the 
offset or compression, the results of the compression, and the name of 
the third-party entity performing the offset or compression, if any.
* * * * *
    (b) * * *
    (14)(i) A record of each security-based swap portfolio 
reconciliation, whether conducted pursuant to Sec.  240.15Fi-3 or 
otherwise, including the dates of the security-based swap portfolio 
reconciliation, the number of portfolio reconciliation discrepancies, 
the number of security-based swap valuation disputes (including the 
time-to-resolution of each valuation dispute and the age of outstanding 
valuation disputes, categorized by transaction and counterparty), and 
the name of the third-party entity performing the security-based swap 
portfolio reconciliation, if any.
    (ii) A copy of each notification required to be provided to the 
Commission pursuant to Sec.  240.15Fi-3(c).
    (iii) A record of each bilateral offset and each bilateral 
portfolio compression exercise or multilateral portfolio compression 
exercise in which it participates, whether conducted pursuant to Sec.  
240.15Fi-4 or otherwise, including the dates of the offset or 
compression, the security-based swaps included in the offset or 
compression, the identity of the counterparties participating in the 
offset or compression, the results of the compression, and the name of 
the third-party entity performing the offset or compression, if any.
* * * * *
0
10. Section 240.18a-6, as proposed to be added at 79 FR 25193, May 2, 
2014, is further amended by revising paragraphs (b)(1)(i) and (b)(2)(i) 
and adding paragraphs (d)(4) and (d)(5) to read as follows:


Sec.  240.18a-6   Records to be preserved by certain security-based 
swap dealers and major security-based swap participants.

* * * * *
    (b) * * *
    (1) * * *
    (i) All records required to be made pursuant to Sec. Sec.  240.18a-
5(a)(5), (a)(6), (a)(7), (a)(8), (a)(9), (a)(11), (a)(12), (a)(13), 
(a)(14), (a)(15), (a)(16), (a)(17), and (a)(18).
* * * * *
    (2) * * *
    (i) All records required to be made pursuant to Sec.  240.18a-
5(b)(4), (b)(5), (b)(6), (b)(7), (b)(9), (b)(10), (b)(11), (b)(12), 
(b)(13), and (b)(14).
* * * * *
    (d) * * *
    (4) The written policies and procedures required pursuant to 
Sec. Sec.  240.15Fi-3, 240.15Fi-4, and 240.15Fi-5 until three years 
after termination of the use of the policies and procedures.
    (5)(i) Each written agreement with counterparties on the terms of 
portfolio reconciliation with those counterparties as required to be 
created under Sec.  240.15Fi-3(a)(1) and (b)(1) until three years after 
the termination of the agreement and all transactions governed thereby.
    (ii) Security-based swap trading relationship documentation with 
counterparties required to be created under Sec.  240.15Fi-5 until 
three years after the termination of such documentation and all 
transactions governed thereby.
    (iii) A record of the results of each audit required to be 
performed pursuant to Sec.  240.15Fi-5(c) until three years after the 
conclusion of the audit.
* * * * *

    By the Commission.

    Dated: December 19, 2018.
Brent J. Fields,
 Secretary.
[FR Doc. 2018-27979 Filed 2-14-19; 8:45 am]
 BILLING CODE 8011-01-P

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