On October 18, 2012, the SEC issued proposed rules setting out capital, margin and margin collateral segregation requirements for certain security-based swap dealers (SBSDs) and major security-based swap participants (MSBSPs), as required under Title VII of the Dodd-Frank Act. The SEC's proposal would:

These requirements would create an additional layer of compliance obligations for parties that are also swap dealers (SDs) or major swap participants (MSPs) subject to CFTC SD and MSP rules (see US Derivatives Regulation: Requirements for Swap Dealers and MSPs Checklist).

For information on levels of SBS activity that will cause an entity to be designated as a SBSDs or MSBSPs under Title VII, see Practice Note, Is Your Client a Swap Dealer or Major Swap Participant? Breakdown of Final Dodd-Frank Definitional Rulemaking.

Under the proposed rules, capital requirements for nonbank SBSDs would be based on the Exchange Act's rule governing capital for broker-dealers (Rule 15c3-1). The capital requirements rules would cover both nonbank SBSDs that are registered as broker-dealers (broker-dealer SBSDs) and those not registered as broker-dealers (stand-alone SBSDs). The minimum capital requirements would distinguish between broker-dealer SBSDs and stand-alone SBSDs and would also vary depending on whether the SEC had approved the firm to use internal models to calculate its regulatory capital.

The capital requirements for both broker-dealer SBSDs and stand-alone SBSDs would consist of:

However, broker-dealer SBSDs would also be subject to the ratio requirements for broker-dealers in Exchange Act Rule 15c3-1. The proposed rules would also increase the minimum capital requirements from $500 million to $1 billion for broker-dealers that use internal models to compute capital charges and are subject to an "alternative net capital regime" under Exchange Act Rule 15c3-1 (ANC broker-dealers), regardless of whether they also register as SBSDs. The proposed rules would require nonbank SBSDs that are not approved to use internal risk capital models to apply standardized percentage deductions or haircuts when computing net capital.

Nonbank SBSDs would be required to take a capital charge for the full amount of unsecured receivables, including uncollateralized exposures to derivatives counterparties. However, ANC broker-dealers and stand-alone SBSDs using models could take a lower credit charge for uncollateralized exposures to commercial end users (see Summary Table). Note that, under the proposed rules, commercial end users would not be required to post margin to cover their exposure under SBS.

Nonbank SBSDs would be required to comply with the risk management standards in Exchange Act Rule 15c3-4. ANC broker-dealers and stand-alone SBSDs using internal models would also have a new liquidity requirement. Nonbank MSBSPs would need to maintain a positive tangible net worth and comply with Exchange Act Rule 15c3-4. As proposed, there has been some concern that nonbank SBSDs using their own internal model to calculate risk could be able to manipulate the model to achieve the results that they want.

The proposed rules would base uncleared SBS margin requirements for nonbank SBSDs on the requirements for broker-dealers set by the self-regulatory organizations. Similar to these rules, unless an exception applies, a nonbank SBSD would be required to collect margin collateral from its uncleared SBS counterparties to cover current and potential future exposure under those SBS. Nonbank SBSDs would be required to conduct daily calculations to determine these exposures and to collect the required eligible margin collateral from counterparties on the next business day.

The value of any securities and money market instruments posted as margin collateral for these SBS transactions would be discounted by applying the appropriate haircut for purposes of these calculations (for more on haircuts and eligible collateral generally, see Standard Clauses, Sample ISDA CSA Collateral Eligibility Table).

The proposed rules would require nonbank SBSDs to monitor the risk of each account of a counterparty to an uncleared SBS. Nonbank SBSDs would also need to establish, maintain and document procedures and guidelines for monitoring the risks of these accounts.

Nonbank MSBSPs would be required to conduct daily calculations of the amount of equity in the account of each counterparty to an uncleared SBS to determine whether the nonbank MSBSP has current exposure to the counterparty or the counterparty has current exposure to the nonbank MSBSP. "Equity" is defined as the total current fair market value of securities positions in the counterparty account (excluding the time value of an over-the-counter option), plus any credit balance and less any debit balance in the account, after applying a qualifying netting agreement with respect to gross derivatives payables and receivables. Nonbank MSBSPs would not be required to calculate or collect margin collateral for potential future exposure.

Note that commercial end users would be exempt from posting margin in connection with their SBS transactions (see Summary Table).

Proposed Rule 18a-4 would establish additional segregation requirements for SBSDs dealing in cleared and uncleared SBS that would be based on Exchange Act Rule 15c3-3, the broker-dealer segregation rule. Like that rule, the proposed SEC rules would allow the collateral posted by counterparties in connection with their SBS to be commingled and segregated by the SBSD on an omnibus basis as under CFTC LSOC rules (see Practice Note, US Derivatives Regulation: Margin Collateral Rules: Rules on Segregation and Rehypothecation of Derivatives Margin Collateral).

Collateral posted by counterparties with respect to uncleared SBS would be required to be treated in the same manner as collateral posted with respect to cleared SBS in cases where the counterparty does not elect individual segregation and does not affirmatively waive segregation altogether. That is, "omnibus segregation" of these funds would be permitted. SBSDs would be permitted to use securities posted by SBS customer counterparties in connection with SBS to be used only to cover the SBSD's current exposure to the customer under the customer's SBS or to finance the customer's transactions.

SBSDs would be prohibited from using any securities posted to collateralize such SBS transactions that are in excess of these amounts to finance their own business. SBSDs would be required to maintain possession and control of all such excess securities collateral provided by the SBS customer counterparty.

Nonbank SBSDs would be required to maintain a reserve of funds or qualified securities for the benefit of their uncleared SBS customer counterparties in a specially designated bank account. The account would need to be equal in value to the net cash owed by the SBSD to its SBS counterparties under their uncleared SBS. Net cash owed under these SBS would be calculated using a formula similar to the formula used by broker-dealers for segregating assets for customers.

The proposed rules would require SBSDs and MSBSPs to provide notice that the counterparty has the right to require segregation of its collateral posted with the SBSD or MSBSP to collateralize its uncleared SBS, as required by Section 3E(f)(1)(A) of the Exchange Act, before the execution of the first uncleared SBS with a counterparty. The rules would also require SBSDs to obtain subordination agreements from their SBS counterparties that opt out of the proposed new omnibus segregation requirements because they elect individual segregation under Section 3E(f) of the Exchange Act or agree that the SBSD need not segregate their posted margin collateral at all.

The SEC is accepting comments on the proposed rules for 60 days after they are published in the Federal Register.

For more information on the proposed rules, see the SEC's press release.

For a list of helpful resources that organize and explain the regulation of swaps under the Dodd-Frank Act, see the US Derivatives Regulation: Swaps Compliance Toolkit.

To learn more about swap margin collateral requirements under Dodd-Frank, see Practice Note, US Derivatives Regulation: Margin Collateral Rules.