The SEC proposed new rules for "security-based swaps' ("SBS's") designed to mitigate conflicts of interest, or "COI's."  We covered yesterday's announcement;  today, we provide FACTS.  For complete a read, click onto:  [ SEC PR 2010-190, 10/13 ].

    Proposed Regulation MC:  An Overview.   The Dodd-Frank Act authorizes the SEC to regulate security-based swaps and to take steps to encourage centralized clearing, fair competition and transparency in the trading of security-based swaps.  Section 765 of the Act lays out requirements for mitigating conflicts of interests at 3 participants in this market:  (i) clearing agencies;  (ii) security-based swap execution facilities (SEFs);  (iii) national securities exchanges.  The CFTC recently proposed similar rules with respect to derivatives clearing organizations, swap execution facilities, and boards of trade designated as contract markets. 

    What's an SEF?   Dodd-Frank defines "security-based swap execution facility" as "a trading system or platform in which multiple participants have the ability to execute or trade SBS's by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility that:  (i) facilitates the execution of SBS's between persons; and (ii) is not a national securities exchange."

    What Are The Conflict of Interest (COI) Concerns?   The OTC derivatives market has a relatively high concentration of market activity among a limited number of dealers that earn significant revenues from the currently opaque OTC market - e.g., 5 large commercial banks currently represent 97% of the total U.S. banking industry notional amounts of derivatives outstanding.  This concentrated market structure creates the potential for conflicts of interests if a similarly small number of firms are able to control the trading and clearing venues for the SBS's market.  Commission staff has identified 3 primary areas where it believes a COI could adversely affect the central clearing of security-based swaps.

1. Participants could seek to limit access to the SBS clearing agency by other participants in order to maintain a competitive advantage.
2. Participants could seek to limit the scope of products eligible for clearing at the SBS clearing agency, particularly if there's an economic incentive to keep the product traded in the OTC market.
3. Participants or members of security-based SEFs and SBS exchanges, may be motivated to restrict the scope of SBS's that are eligible for trading if there's a strong economic incentive to keep such swaps in the OTC

Similarly, such participants or members may seek to restrict the number of direct participants in the trading venue in order to limit competition and increase their ability to maintain higher profit margins.  They also may have an incentive to promote their commercial interests over the regulatory oversight responsibilities of the facilities or exchanges.

    Key Elements of Proposed Regulation MC.   Each of the 3 entity types would be required to adopt ownership and voting limitations, as well as certain governance requirements.  With respect to clearing agencies, the rules would require one of the following two alternatives:

    Alternative 1. 

• Restrict an individual clearing agency participant from beneficially owning or voting more than 20% of any voting interest in the SBS clearing agency.
• Restrict clearing agency participants from beneficially owning or voting more than 40% of any voting interest in the SBS clearing agency in the aggregate with any other clearing agency participants.
• The board of directors and any committee that has authority to act on behalf of the board be composed of 35% of independent directors.
• The nominating committee be composed of a majority of independent directors.

    Alternative 2.

• Restrict an individual clearing agency participant from beneficially owning or voting more than 5% of any voting interest in the SBS clearing agency.
• The board of directors and any committee that has authority to act on behalf of the board be composed of a majority of independent directors.
• The nominating committee be composed solely of independent directors.

    Other Key Elements.  

• Security-based SEFs and SBS exchanges restrict participants or members, as applicable, from owning or holding more than 20% of any voting interest of such entity.
• The board of directors of a security-based SEF or SBS exchange, any executive committee of the board of a security-based SEF or SBS exchange, and any board committee exercising powers of the board of a security-based SEF or SBS exchange be composed of a majority of independent directors.
• The nominating committee of a security-based SEF or SBS exchange consists solely of independent directors.
• The board of directors of a security-based SEF or SBS exchange establish a regulatory oversight committee consisting solely of independent directors to oversee the security-based SEF's or SBS exchange's regulatory program, and any recommendation of a regulatory oversight committee that is not adopted by the board of a security-based SEF or SBS exchange be reported promptly to the SEC.
• The disciplinary panels of a SBS clearing agency, security-based SEF or SBS exchange be compositionally balanced and include one person who would qualify as an independent director.