SEC Proposes Expanded Regulation of Security-based Swap Clearing Agencies

Practical Law Legal Update 5-561-1427 (Approx. 4 pages)

SEC Proposes Expanded Regulation of Security-based Swap Clearing Agencies

by��Practical Law Finance

Published on 19 Mar 2014 • USA (National/Federal)

The SEC issued a proposed rule that would expand regulation of clearing agencies registered with the SEC that clear security-based swaps (SBS) and are therefore viewed as systemically important.

On March 12, 2014, the SEC issued a proposed rule, which would expand regulatory requirements for SEC-registered securities clearing agencies (SCAs) that are deemed systemically important (covered SCAs) because they clear security-based swaps (SBS). In 2012, the SEC issued Rule 17Ad-22 under the Securities Exchange Act of 1934 (17 C.F.R. § 240.17Ad–22), which established standards for risk management and operation of registered SCAs. This new proposal would augment the regulatory framework under Rule 17Ad-22 for covered SCAs only, subjecting them to two tiers of regulation:

The existing regulation for registered SCAs.
The new heightened regulatory standards for covered SCAs under this proposed rule.

Covered SCAs include clearinghouses:

That the Financial Stability Oversight Counsel (FSOC) deems systemically important, for which the SEC is the supervisory agency under Title VIII of the Dodd-Frank Act.
That provide clearing for SBS or that are otherwise involved with more complex risk profiles, unless the FSOC has deemed the clearinghouse systemically significant and the entity falls within the CFTC's supervisory power under Title VIII of the Dodd-Frank Act.
That are determined to be covered SCAs by the SEC under proposed rule 17Ab2-2, which, among other things, requires that the SEC publish notice of its intention to consider a clearinghouse for covered treatment as well as a 30-day public comment period.

Among other things, the proposal dictates policies and procedures that a covered SCA would be required to adopt on the treatment of posted margin collateral and settlement (see Collateral, Margin and Settlements), which is of particular importance to derivatives market participants. Covered SCAs would also be required to create and enforce policies and procedures that mitigate risk in areas that include, among others:

General organization, including standard qualifications for directors and internal audit procedures.
Financial risk management, including liquidity and credit risk.
Settlement and settlement systems.
Central securities depositories.
Default management.
Business and operational risk management, including required equity and liquidity levels and procedures for recapitalization in times of financial distress.
Access.
Efficiency.
Transparency.

Public comment on this proposal is being accepted on or before May 27, 2014. Comments may be submitted on the SEC website.

Collateral, Margin and Settlement

The proposed rule contains provisions that address daily margin collateral posting, allocation of losses and other important topics for market participants, including, among others, proposed rules:

17Ad-22(e)(5), which addresses the types of collateral that a covered SCA is allowed to hold. Covered clearinghouses would be required to create and enforce policies that are reasonably designed to ensure that posted collateral has low credit, liquidity and market risks, similar to requirements for SEC-registered clearinghouses under Rule 17Ad-22(d)(3). Additionally, covered SCAs would be required to set policies that would determine haircuts and concentration limits for collateral if the SCA requires collateral to be posted to manage its own or its clearing members' credit exposure in order to avoid under-collateralization in the event of a system-wide price deterioration of a particular type of asset. These policies would need to be reviewed at least annually.
17Ad-22(e)(6), which would require covered SCAs to create and enforce policies reasonably designed to cover its credit exposure to its clearing members (referred to in the rule as "participants") through a risk-based margin system, similar to requirements for non-covered SCAs under existing rule 17Ad-22(b)(4) (240 C.F.R. 17Ad-22(b)(4)). However, proposed rule 17Ad-22(e)(6) also requires the covered SCA to, among other things:
- actively manage its margin system to specifically account for the complexity of the product, its risk characteristics and the volume of trading;
- mark to market margin, at least daily;
- provide a mechanism to make intra-day variation margin calls;
- retain margin sufficient to cover its potential future exposure in the event of a participant default, with a 99% confidence level; and
- on at least a monthly basis, preform a conforming sensitivity analysis of margin resources and realign parameters and assumptions for back testing, which is a comparison of the forecasted losses with the actual losses incurred by participants, to determine the accuracy of the models.
17Ad-22(e)(8), which addresses settlement finality. The proposal would require that the covered SCAs establish policies and procedures for the final settlement of transactions no later than the end of the day on which the payment is due, and, when necessary, in real time.
17Ad-22(e)(16), which addresses custody and investment risk for clearinghouse and market participant assets (posted collateral). Similar to existing Rule 17Ad-22(d)(3), which is applicable to registered SCAs, the proposal would require that covered SCAs create and enforce procedures reasonably designed to, among other things:
- safeguard its own and its participants' assets and minimize risk of loss;
- minimize delays in accessing its own or its participants' assets; and
- restrict investments of its own assets, its participant/clearing members' assets and customer assets to instruments with minimal credit, market and liquidity risk.

SEC Proposes Expanded Regulation of Security-based Swap Clearing Agencies | Practical Law