[ by Howard Haykin ]

Capital, Margin, Segregation Requirements for Dealers, Major Participants and Broker-Dealers.

The SEC, as mandated by sections 763 and 764 of the Dodd-Frank Reform Act, proposes significant requirements for governing security-based swap transactions and key players and participants.  This proposal, in excess of 400 pages, would encompass: 

• Each dealer (“SBSD").
• Each major security-based swap participant (“MSBSP”).
• Segregation Requirements for SBSDs
• Notification Requirements with respect to segregation for SBSDs and MSBSPs.
• Increased minimum net capital requirements for broker-dealers permitted to use the alternative internal model-based method for computing net capital (“ANC broker-dealers”).

Background Information.   The Dodd-Frank Act ushers in a new regulatory framework for OTC derivatives.  In this regard, Title VII was enacted, among other reasons, to reduce risk, increase transparency, and promote market integrity within the financial system by, among other things:

• providing for the registration and regulation of SBSDs and MSBSPs;
• imposing clearing and trade execution requirements on standardized derivative products;
• creating recordkeeping and real-time reporting regimes; and,
• enhancing the SEC's rulemaking and enforcement authorities with respect to all registered entities and intermediaries subject to the Commission’s oversight.

In those cases where nonbank SBSDs and nonbank MSBSPs do not have a prudential regulator, Section 764 of Dodd-Frank provides the Commission with authority to prescribe capital and margin requirements - and these are captured in Section 15F(e)(1)(B) of the Exchange Act.  Section 763 of Dodd-Frank provides the Commission with authority to establish segregation requirements for SBSDs and MSBSPs.

Similar authority is bestowed upon the CFTC, as follows:  Section 4s(e)(1)(B) of the CEA provides that the CFTC shall prescribe capital and margin requirements for swap dealers and major swap participants for which there is not a prudential regulator (“nonbank swap dealers” and “nonbank swap participants”).8 Section 15F(e)(1)(A) of the Exchange Act provides that the prudential regulators shall prescribe capital and margin requirements for bank SBSDs and bank MSBSPs, and section 4s(e)(1)(A) of the CEA provides that the prudential regulators shall prescribe capital and margin requirements for swap dealers and major swap participants for which there is a prudential regulator (“bank swap dealers” and “bank swap participants”).9 The prudential regulators have proposed capital and margin requirements for bank swap dealers, bank SBSDs, bank swap participants, and bank MSBSPs. 

And, the CFTC has proposed capital and margin requirements for nonbank swap dealers and nonbank major swap participants.The CFTC also has adopted segregation requirements for cleared swaps and proposed segregation requirements for non-cleared swaps.

Under sections 763 and 764 of Dodd-Frank, the SEC is proposing amendments to Rule 15c3-1 and Rule 15c3-3 and will propose new Rules 18a-1 (including appendices to Rule 18a-1), 18a-2, 18a-3, and 18a-4 (including an exhibit to Rule 18a-4) that would establish capital and margin requirements for nonbank SBSDs, including broker-dealers that are registered as SBSDs (“broker-dealer SBSDs”), and nonbank MSBSPs. They also would establish segregation requirements for SBSDs and notification requirements with respect to segregation for SBSDs and MSBSPs.

Further, the proposals also would ...  increase the minimum net capital requirements and establish liquidity requirements for ANC broker-dealers.  An ANC broker-dealer is a broker-dealer that has been approved by the Commission to use internal value-at-risk (“VaR”) models to determine market risk charges for proprietary securities and derivatives positions and to take a credit risk charge in lieu of a 100% charge for unsecured receivables related to OTC derivatives transactions (hereinafter, collectively “internal models”).  The proposed amendments applicable to ANC broker-dealers are designed to account for their large size, the scale of their custodial activities, and the potential substantial leverage they may take on if they become more active in the security-based swap markets under the Dodd-Frank Act reforms, which, among other things, require dealers in security-based swaps to register with the Commission.

Finally, some of the proposed amendments to Rule 15c3-1 would apply to broker-dealers that are not registered as SBSDs. These proposed amendments are designed to maintain a consistent capital treatment for security-based swaps and swaps under Rule 15c3-1 and proposed new Rule 18a-1.

Existing Capital, Margin, Segregation Requirements.   As discussed in the text of the Proposed Rule, the proposals for capital, margin, and segregation requirements for SBSDs and MSBSPs are based in large part on existing capital, margin, and segregation requirements for broker-dealers (“broker-dealer financial responsibility requirements”).The broker-dealer financial responsibility requirements served as the model for the proposals because the financial markets in which SBSDs and MSBSPs are expected to operate are similar to the financial markets in which broker-dealers operate. In addition, as discussed below, the objectives of the broker-dealer financial responsibility requirements are similar to the objectives underlying the proposals. Moreover, the broker-dealer financial responsibility requirements have existed for many years and have facilitated the prudent operation of broker-dealers.  Consequently, they provide a reasonable template for building a financial responsibility program for SBSDs and MSBSPs. Furthermore, it is expected that some nonbank SBSDs also will register as broker-dealers in order to be able to offer customers a broader range of services than a nonbank SBSD not registered as a broker-dealer (“stand-alone SBSD”) would be permitted to engage in. Therefore, establishing consistent financial responsibility requirements would avoid potential competitive disparities between stand-alone SBSDs and broker-dealer SBSDs.

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Impact Upon International Commerce.   The capital, margin, and segregation requirements ultimately adopted, like other requirements established under the Dodd-Frank Act, could have a substantial impact on international commerce and the relative competitive position of intermediaries operating in various, or multiple, jurisdictions. In particular, intermediaries operating in the U.S. and in other jurisdictions could be advantaged or disadvantaged if corresponding requirements are not established in other jurisdictions or if the Commission’s rules are substantially more or less stringent than corresponding requirements in other jurisdictions. This could, among other potential impacts, affect the ability of intermediaries and other market participants based in the U.S. to participate in non-U.S. markets, the ability of non-U.S.-based intermediaries and other market participants to participate in U.S. markets, and whether and how international firms make use of global “booking entities” to centralize risks related to security-based swaps. These issues have been the focus of numerous comments to the Commission and other regulators, Congressional inquiries, and other public dialogue.

The potential international implications of the proposed capital, margin, and segregation requirements warrant further consideration. However, consistent with the Commission’s general approach with respect to its other proposals under Title VII, these implications are recognized here but not fully addressed. Instead, the Commission intends to publish a comprehensive release seeking public comment on the full spectrum of issues relating to the application of Title VII to cross-border security-based swap transactions and non-U.S. persons that act in capacities regulated under the Dodd-Frank Act. This approach will provide market participants, foreign regulators, and other interested parties with an opportunity to consider, as an integrated whole, the proposed approach to the cross-border application of Title VII, including capital, margin, and segregation requirements.        
 

For further details, go:   [SEC Proposed Rule Release 34-68071,  10/19/12].