Recent Developments for Security-Based Swap Entities

Recent Developments for Security-Based Swap Entities

Title VII of the Dodd-Frank Act gave the Securities and Exchange Commission regulatory authority over all security-based swap dealers and major security-based swap participants. The SEC is currently finalizing new regulations intended to make the market more transparent, efficient, and accessible. Though many provisions have yet to be finalized, banking entities should begin to develop compliance processes as soon as possible.

 Swap Definition

Swaps are financial contracts in which two counterparties agree to exchange or “swap” the cash flows from one party’s financial instrument with the cash flows from an instrument owned by the other party.  Security-based swaps (“SBS”) include swaps whose underlying asset is a single-name security, loan, or narrow-based index of securities. Entities that are conducting significant transactions in SBS are required to register as either a Security-Based Swap Dealer (“SBSD”) or a Major Security-Based Swap Participant (“MSBSP”).

Registration

The Final Registration Rule was published in the Federal Register on August 14, 2015. To ensure that existing entities will not be required to cease operations pending the Commission’s consideration on their application, the Final Rule allows for a “conditional registration” that gives SBSDs and MSBSPs the opportunity to come into compliance with the new rules gradually. Following the conditional registration, the SEC will either grant the applicant permanent registration or require the applicant to correct deficiencies and resubmit.

Though the rule went into effect on October 13, 2015, the Registration Compliance Date (also referred to as the “SBS Counting Date”) is still unknown.  Entities who engage in Security-Based Swaps (SBS) are not required to begin calculating whether their activities exceed the thresholds to become SBSDs or MSBSPs until two months prior to the Registration Compliance Date, which will be determined by pending filings by the SEC.  Only security-based swap positions held on or after this date will be included in determining if an SBS Entity must register. The Registration Compliance Date will be crucial for SBS entities, as many other Final Rule compliance dates will rely on Registration.

Cross-Border Security- Based Swap Activity

On February 10, 2016, the SEC finalized the Cross-Border Security-Based Swap Activity Rule. The Final Rule requires that a non-U.S. person that uses U.S. personnel to arrange, negotiate or execute an SBS transaction in connection with the non-U.S. person’s SBS dealing activity must include such transactions in determining whether the non-U.S. person would be required to register as an SBSD with the SEC. Put more simply, if a person outside of the U.S. uses someone in the U.S. to complete a swap transaction, this swap must be included in the de minimis calculation.

The de minimis exception is important to potential swap entities because the SEC has ruled that a person will not have to register if its activity and the activity of its affiliates remain below certain thresholds, as illustrated below:

For these reasons, security-based swap entities may reconsider where they will arrange, negotiate, or execute their swap activity.

Business Conduct Standards

On April 14, 2016, the SEC issued the final rules implementing a set of business conduct standards and Chief Compliance Officer requirements for SBSDs and MSBSPs. According to the SEC, “The Rules are designed to enhance transparency, facilitate informed customer decision-making, and heighten standards of professional conduct to better protect investors.”

The SEC stated that it worked closely with the Commodities Futures Trading Commission (CFTC), the regulatory body for swap dealers (SD) and major swap participants (MSP), throughout all stages of the Business Conduct Standards rulemaking process. The CFTC issued external business conduct standards in 2012 for SDs and MSPs, and most entities have worked diligently to be compliant. It is worth noting that the SEC rules have subtle differences in wording from the CFTC rules, but each regulator attempted to portray similar principles (ex: SEC will not grant substituted compliance for business conduct standards and CFTC will).

The SEC has designated specific requirements as applicable to all security-based entities (SBSD & MSBSP) and others as applicable only to SBSDs.

Both security-based swap dealers and major swap participants are required to:

• Verify whether a counterparty is an eligible contract participant and whether it is a special entity
• Disclose to the counterparty material information about the security-based swap, including material risks, characteristics, incentives and conflicts of interest
• Provide the counterparty with information concerning the daily mark of the security-based swap, as well as concerning the ability to require clearing of the security-based swap
• Communicate with counterparties in a fair and balanced manner based on principles of fair dealing and good faith
• Establish a supervisory and compliance infrastructure
• Designate a chief compliance officer who is required to fulfill the described duties and prepare an annual compliance report

Only security-based swap dealers are required to:

Determine that any recommendations they make regarding security-based swaps are suitable for their counterparties

Establish, maintain and enforce policies and procedures reasonably designed to obtain and retain a record of the essential facts concerning each known counterpart that are necessary to conduct business with such counterparty

The effective date of these rules will be 60 days following their publication in the Federal Register. However, much like the SBS Entity Registration Compliance Date, the exact compliance date for the Business Conduct Standards is unknown at this point.

Trade Acknowledgement and Verification Rules

The Trade Acknowledgment and Verification Rules for security-based swap transactions were recently finalized by the SEC. As SEC Chair Mary Jo White expressed, "These rules will result in more accurate and timely documentation for security-based swap transactions, which is a cornerstone of effective risk management."

Announced on June 8, 2016, the final rule will require SBS entities to provide a trade acknowledgment that contains all of the terms of the transaction. Basically, the entity will have to acknowledge the terms of the trade and verify or dispute those terms. Furthermore, the rule will require entities to have a robust policy and procedure framework around trade acknowledgments and to provide an electronic trade acknowledgment to its transaction counterparty no later than the end of the first business day following the day of execution.

Similar to the business conduct standards, the compliance date for the final trade acknowledgment and verification rule is unknown and will be based on the Registration Rules for SBS entities.

Additional Security-Based Swap Transaction Reporting Rules

Last, but certainly not least, on July 13, 2016 the SEC announced that it would adopt new Final Rules governing security-based swap data reporting (SBSR) and public dissemination. Final Regulation SBSR addresses many issues left open by the Commission's initial proposal in 2015, such as the application of the regulation to SBS activity of non-US persons within the United States. Listed below are key points of the regulation:

• National securities exchanges or SEFs must report SBS executed on the platform that will be submitted to clearing
• A registered clearing agency must report any SBS to which it is a direct counterparty and whether or not it accepts a transaction for clearing
• Registered SDRs may not impose fees or restrictions on the SBS transaction data required for public dissemination
• Any SBS transaction connected with a non-US person's SBS dealing activity that is arranged by its personnel or an agent in a US branch or office must be reported and publicly disseminated
• A new compliance schedule for portions of Regulation SBSR that have not yet been assigned compliance dates
• Compliance for these portions of Regulation SBSR will be phased in over a period of months, beginning on the first Monday that is the later of: six months after the date on which the first SDR that can accept transaction reports in an asset class registers with the Commission; or one month after security-based swap dealers and major security-based swap participants are required to register with the Commission.

Sia Partners’ Approach to Assess Compliance

Following the SEC’s finalization of the above rules, banking entities will continue the process of implementing the many requirements to comply with the newly approved regulations. Sia Partners can not only independently assess an entity’s compliance with the applicable SEC rules, but also factor in newly issued requirements. Our objectives will include identifying any potential gaps in the compliance framework and presenting remediation recommendations for enhanced SBS entity governance. Sia Partners’ extensive knowledge in swap dealer assessments has assisted in the development of a security-based swap dealer matrix that helps to drive compliance assessments both efficiently and effectively.

The process will begin with a thorough review of all SEC security-based rules applicable to the banking entity followed by the development of a detailed questionnaire that highlights the high-risk components of the rules. Next, a data gathering phase will include the collection of required documentation and interviews with key stakeholders. These stakeholders would then validate the processes and controls identified by the Sia Partners team. The final step of the approach will be to identify compliance gaps within the banking entity’s framework and to complete a comprehensive report recommending how to achieve full remediation.

Source:En,Finance