PwC discusses Ten Key Points from the SEC’s Business Conduct Standards for Swap Entities

One down, three to go: SEC rulemaking is heating up.

Last month, the Securities and Exchange Commission (SEC) finalized business conduct standards for security-based swap dealers (SBSDs).[1] The completion of this rule by the SEC is significant because few security-based swap (SBS) rules have been finalized as compared to the numerous rules completed by the Commodity Futures Trading Commission (CFTC) that govern other types of swaps.[2] These business conduct standards represent the first of four rulemakings that must be finalized before SBSDs will have to register with the SEC.[3]

The SEC’s rule will impact how SBSDs communicate with their counterparties and how they supervise their businesses by generally requiring them to (a) establish supervisor and chief compliance officer (CCO) duties, (b) collect or verify information about the counterparty, and (c) provide certain disclosures regarding the SBS (i.e., material information, clearing rights, and daily mark).

  1. SBSDs already subject to the CFTC’s requirements can leverage existing compliance frameworks. The SEC’s rule is broadly consistent with the CFTC’s business conduct standards which already apply to the largest swap market participants (and to the vast majority of swaps in the market). Many of these already CFTC-registered swap dealers also deal in SBS and will ultimately have to register with the SEC (subjecting them to both agencies’ business conduct standards). Fortunately, the SEC took a less prescriptive approach to some standards than did the CFTC in order to create efficiencies for dealers that have already established infrastructure to become CFTC-compliant. For example, while the SEC’s standards only require Dodd-Frank mandated risk management procedures, the CFTC went further by specifically requiring the establishment of a risk management program that includes risk identification and periodic risk exposure reports. Therefore, although swap dealers will have a fair amount of work to do to establish new processes related to SBS, they can leverage many existing processes and lessons learned from their CFTC compliance efforts.
  2. The CCO requirement looks familiar. Similar to the CFTC’s CCO requirement, the SEC’s business conduct standards mandate that SBSDs designate a CCO who reports directly to the board and is responsible for the firm’s legal and regulatory compliance. Additionally, the CCO must certify and submit an annual compliance report to the SEC that assesses the firm’s compliance system. This should not be a heavy lift for dealers that are already CFTC compliant in this respect.
  3. SBSDs and other swap dealers will not be considered fiduciaries of employee benefit plans. Conducting business with employee benefit plans may have subjected a swap dealer to fiduciary duties under the Department of Labor’s fiduciary duty rule. However, the SEC, the CFTC, and the DOL collaborated to ensure SBSDs and CFTC-registered swap dealers would not be considered fiduciaries under the DOL’s rule due to their compliance with the business conduct standards (e.g., disclosing information concerning trade and relationship characteristics). Therefore, dealers will not be subject to heightened fiduciary obligations when dealing with employee benefit plans.[4]
  4. The SEC requires SBSDs to explicitly determine that smaller counterparties are suitable trading partners. Both the SEC and CFTC allow dealers to forgo making their own determination of whether or not a counterparty is capable of evaluating the risks of a recommended swap. Instead, they may rely on a representation from the counterparty (or its agent) that it is aware of the risks of the transaction. However, the final SEC rule diverges from the CFTC’s standards by limiting the use of this representation to counterparties with over $50 million in total assets. As a result, SBSDs face the challenging prospect of having to do their own due diligence, or obtaining written representations, from their many smaller counterparties.
  5. Rule divergence from the CFTC does not necessarily imply considerable extra work for SBSDs. The SEC has imposed certain additional requirements on SBSDs which diverge from the CFTC, e.g., establishing supervisor duties. The SEC and CFTC requirements for supervision both require a supervisory system, designation of supervisors, and determinations of supervisors’ qualifications, but the SEC goes further by prescribing specific expectations of supervisors. However, the additional requirements should not present significant implementation challenges as they reflect existing FINRA standards, and most market participants should already have such a supervisory system in place.
  6. Additional disclosures for uncleared SBS. Both the CFTC and SEC require dealers to disclose valuations (i.e., daily marks) to their counterparties that include the methodology and assumptions as well as any changes resulting in a significant impact to the valuation. However, the SEC goes further by requiring SBSDs to identify where market data were obtained to value the SBS. As a result, SBSDs that are also CFTC-registered swap dealers should consider adding market data disclosures for all of their swap transactions as an efficient way to address this divergence between the rules.
  7. The SEC continues its rule-by-rule approach to cross-border for non-US SBSDs. Unlike the CFTC’s approach of applying its cross-border guidance to non-US swap dealers after it finished its rulemakings (i.e., applying the guidance to many prior rulemakings at once),[5] the SEC is applying its cross-border provisions to non-US SBSDs in real time. The SEC applied its finalized reporting standards to non-US SBSDs last year as part of its reporting rulemaking and is now applying its business conduct standards to non-US SBDSs as part of this rulemaking. As a result, non-US SBSDs have more certainty as to which particular requirements of each SEC rulemaking they will have to comply with, thereby avoiding the costly guesswork CFTC-registered swap dealers endured.
  8. Foreign branches of US SBSDs will have to be cautious with respect to their transactions with non-US counterparties. The CFTC and the SEC both apply their standards to a transaction between a non-US SBSD and another non-US counterparty when the transaction is “arranged, negotiated, or executed” by US-located personnel of the non-US SBSD (i.e., the transaction has a US nexus).[6] However, unlike the CFTC, the SEC requires that their standards will also apply to transactions between a US SBSDs’ foreign branches and its non-US counterparties if either the foreign branch or the non-US counterparty has a US nexus. Therefore, foreign branches of US SBSDs will need to review the way trades are booked with non-US counterparties and will need to seek representations that the counterparty does not have a US nexus in order to ensure the trades do not fall under the SEC’s jurisdiction.
  9. The SEC is not making substituted compliance determinations pertaining to business conduct standards. When the SEC finalized its cross-border rule in June 2014, it indicated that it would address the availability of substituted compliance (i.e., allowing another nation’s rule to substitute for an SEC rule) as part of later rulemakings such as the business conduct standards.[7] However, the business conduct rule’s preamble explicitly denies the availability of substituted compliance for any foreign jurisdiction. Therefore, until the SEC reconsiders, non-US SBSDs are left in an uncertain situation, especially because the CFTC granted substituted compliance in December 2013 for some business conduct standards (e.g., several of the CCO duties described above).[8]
  10. The SBSD registration date is likely closer than originally anticipated. The SEC has, perhaps accidentally, provided a clue as to the timing of when it will require SBSD registration. One provision of the business conduct rule tells non-US SBSDs that they must identify all of their transactions to which SEC regulations will apply by the later of (a) approximately 12 months from now[9] or (b) when SBS entities must register under the final registration rule.[10] By including the clause regarding 12 months, the rule is signaling that registration could be required before 12 months has passed. Therefore, the SEC appears to be indicating that, over the next year, it intends to finalize the three rulemakings needed to implicate registration (discussed above), which would be a significant fast forwarding of the pace of SEC swaps rulemakings. SBSDs, both US and non-US, should organize their resources accordingly.


[1] The standards were proposed by the SEC on June 29, 2011, and the proposal regarding their cross-border application was issued on May 1, 2013. The standards also apply to major security-based swap participants.

[2] For a recent analysis of the outstanding challenges swap dealers face as a result of these CFTC rulemakings, see PwC’s Regulatory brief, Derivatives: Year-ahead US roadmap (February 2016).

[3] The remaining three rulemakings pertain to (1) capital, margin, and segregation, (2) reporting and recordkeeping, and (3) statutory disqualification. See PwC’s First take, Ten key points from the SEC’s swap dealer registration and waiver rulemakings (August 2015) for our analysis of the proposed statutory disqualification rule and for our view that SEC registration may not immediately require compliance with business conduct or other rules. See also PwC’s First take, Ten key points from the SEC’s swaps reporting and disclosure rules (February 2015) for an analysis of the portion of the reporting rulemaking that has been finalized and of the portion that remains outstanding.

[4] See PwC’s First take, Ten Key Points from the DOL’s fiduciary duty rule (April 2016) for details regarding these heightened obligations.

[5] See PwC’s Regulatory brief, Derivatives: CFTC finalizes cross-border guidance and extends timeframe for conformance (July 2013).

[6] See note 2.

[7] See PwC’s First take, Ten key points from the SEC’s final cross-border rule (June 2014).

[8] See PwC’s Regulatory brief, Derivatives: A first take on cross-border comparability (December 2013) for details regarding the CFTC’s substituted compliance determinations.

[9] Technically, the rule says approximately 12 months after publication of the rule in the Federal Register. This publication should occur fairly shortly.

[10] See note 3.

The preceding post comes to us from PwC.  The post is based on PwC’s first take, which is available here and was published on May 5, 2016.