New Proposal
The SEC made its first proposal last week toward regulating the swaps market. See SEC Proposes Rules to Mitigate Conflicts of Interest Involving Security-Based Swaps. The initial foray is an attempt to minimize conflicts of interest situations in security-based derivatives clearing and trading markets.
Background - Dodd-Frank
Under the Dodd-Frank Act security based swaps (generally speaking swaps on stocks, stock indexes, bonds, and stock options – but not generally on commodities, interest rate swaps, currencies or futures which will be the province of the Commodities Futures Trading Commission) will be regulated by the SEC.
Among other things under Dodd-Frank: (1) absent an exemption, a security- based swap must be cleared through a clearing agency if it is of a type the SEC determines must be so cleared (2) transactions in security- based swaps must be reported and (3) security based swaps subject to clearing requirements must generally be traded on a registered trading platform.
Dodd Frank also required the SEC to adopt rules to mitigate conflicts of interest by limiting institutional control (covered institutions are called “Specified Entities”) over securities swaps agencies or exchanges. These facilities are technically called “security-based swap execution facilities”.
Dodd-Frank defines "security-based swap execution facility" ("security-based SEF") to mean "a trading system or platform in which multiple participants have the ability to execute or trade security-based swaps 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 (A) facilitates the execution of security-based swaps between persons; and (B) is not a national securities exchange."
SEC Concerns About Concentration and Conflicts of Interest
The OTC derivatives market is highly concentrated. The SEC reports that: “For example, five large commercial banks currently represent 97 percent of the total U.S. banking industry notional amounts of derivatives outstanding (Office of the Comptroller of the Currency, Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2010).” The SEC feels that if there is similar concentration in the clearing agencies (and even if such concentration continues on OTC transactions) there will be adverse effects on the markets.
Three key areas of adverse effect of such control over clearing agencies have been identified by the SEC (1) limiting access to participation in the security based swap clearing agencies to persons who are not already part of the club of participants in the clearing agency (2) limiting the scope of products eligible for clearing to “push” those products to OTC markets where participant profits are greater and (3) lowering risk management control to reduce the amount of financial resources participants would have to expend as collateral margin or guaranty funds to the security based swap agency.
Accordingly the SEC is proposing Regulation MC.
Proposed Regulation MC - Securities Swap Clearing Agencies
Regulation MC contains two alternate structures to limit financial institutional control over securities swap clearing agencies.
The first alternative focuses on limiting the voting interests held by directly or indirectly by participants of a security-based swap clearing facility to no greater than a 20% individual position or a 40% aggregate position for all participants. Participants in excess of these positions would be required to divest their excess holdings. 35% of the Board would need to be independent directors. The nominating committees would have to be composed of a majority of independent directors.
The second alternative focuses on governance restrictions as the primary means to mitigate conflicts of interest although it does contain a 5% direct or indirect individual voting limitation but no 40% aggregate voting interest limitation. The majority of the Board would have to be independent directors. The nominating committee would have to be composed solely of independent directors.
Proposed Regulation MC - Exchanges and other Swap-trading Venues
Regulation MC would also cover exchanges and other swap-trading venues, the rule would prevent participants or members from controlling 20% of the voting shares. Those markets would also need to have a majority of independent directors on their boards as well as nominating committees consisting solely of independent directors. Additionally, a regulatory oversight committee consisting of solely independent directors would be required. Finally, disciplinary panels of such organizations would have to be balanced in terms of composition and include at least one independent director.
Comment Sought
The SEC is seeking public comment on the proposal.
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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com. Nothing in this blog is legal advice and readers should not rely on anything in this blog as being legal advice.
