SEC Proposes OTC Derivatives Reforms. Defers Cross-border Worries.

On October 17, 2012, the SEC published its long awaited proposals for new rules governing "security-based swaps."  Recognizing the considerable concern over the cross-border effect of this proposed new regime for OTC derivatives, the Commission chose to set those worries aside to be addressed more fully in a forthcoming separate release. They explain that this approach will allow market participants, foreign regulators, and others an opportunity to weigh in on the issues raised by the proposed OTC Derivatives framework as a whole.

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. (emphasis added)  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.

Under the mandate imposed by Dodd-Frank, the SEC is charged with creating a new regulatory regime for OTC derivatives within the agency's jurisdiction, namely security-based swaps. The SEC's new security-based swaps regulations, if adopted, would:

1. establish how much capital dealers in security-based swaps need to hold, hen and how these dealers need to collect collateral, or margin, to protect against losses from counterparties; 
2. regulate how these dealers segregate and protect funds and securities held for customers;  
3. prescribe new capital and margin requirements for major security-based swap participants — entities that do not act as dealers but hold large positions in security-based swaps; and 
4. mandate new risk management requirements for security-based swap dealers. 

In addition, the Commission's proposals include rules to increase capital requirements for the largest broker-dealers that use internal models in calculating how much capital they need to hold, and also subject these firms to new specific liquidity standards.

The aim of these proposals is to help ensure the safety and soundness of security-based swap dealers and major security-based swap participants. The margin rules are required to be appropriate for the risk associated with security-based swaps that are not “cleared” by a security-based swap clearing agency. The proposed segregation rules are intended to facilitate the prompt return of customer property to customers before or during a liquidation proceeding if a security-based swap dealer fails.

Responding to criticisms that the SEC, CFTC, and prudential regulators have not coordinated their OTC Derivatives regulatory activities properly, the SEC's release describes its efforts with other regulators.  Differences are inevitable, however, and the SEC explains that these areas of policy difference between the regulators are precisely the topics the Commission would like input and analysis.  

The Commission’s proposals differ in some respects from proposals of the prudential regulators and the CFTC, and such differences are described below in connection with the relevant proposals.  While some differencesare based on differences in the activities of securities firms, banks, and commodities firms, or differences in the products at issue, other differences may reflect an alternative approach to balancing the relevant policy choices and considerations.  Where these differences exist, comment is sought on the advantages and disadvantages of each proposal and whether a given proposal is appropriate based on differences in the business models of the types of entities that would be subject to the respective proposal, the risks of these entities, and any other factors commenters believe relevant.

Given what is at stake, comment on this proposal and the forthcoming release on cross-border OTC derivatives issues will likely be voluminous.  Comments on the proposal are due 30 days after it is published in the Federal Register.