Navigating the “New Normal” for Security-Based Swaps: Buy-Side Considerations for the SEC’s Security-Based Swap Rules

With the U.S. Securities and Exchange Commission’s rules governing security-based swaps under Title VII of the Dodd-Frank Act poised to take effect this year, Ropes & Gray derivatives & commodities attorneys Molly Moore and Egan Cammack discuss issues that asset managers and other buy-side market participants will need to consider and steps they will need to take to prepare for this new regulatory regime.

Transcript:

Molly Moore: Welcome, everyone, and thank you for joining us today on this Ropes & Gray podcast. I’m Molly Moore, counsel in our asset management group, and I’m joined by my colleague, Egan Cammack, who is also counsel in our asset managementgroup.In today’s podcast, we’re going to discuss at a high-level, issues that buy-side market participants will need to look out for as the U.S. Securities Exchange Commission’s (the SEC’s) long-awaited regulatory regime for “security-based swaps” is rolled out. With this regulatory regime scheduled to take effect beginning in the fourth quarter of this year, we’re expecting security-based swap rules to be a focus of market participants in these markets in the coming months

Egan, would you like to get us started?

Egan Cammack: Sure, and thanks, Molly. Well, I think it’s fair to assume most of our listeners have been focused on other things over the last year or so, not to mention the industry-wide LIBOR transition efforts, so it’s easy to see how developments regarding security-based swaps may have gotten lost in the shuffle. That being said, the new rules—we’ll call them the “SBS Rules”—are something our clients should have on their radar lest they be taken by surprise by new requirements and information requests.

The best place to get started is to remind listeners that jurisdiction over over-the-counter (OTC) swaps regulation in the U.S. is generally split into two buckets:

1. The SEC has jurisdiction over “security-based swaps,” which, very generally, include OTC derivatives based on single securities or loans, baskets of securities, swaps on “narrow-based security indexes” and single name credit default swaps.
2. The Commodity Futures Trading Commission (the CFTC) has jurisdiction over pretty much all other “swaps,” including interest rate swaps, foreign exchange products (with some caveats), commodity swaps and swaps over broad-based equity or credit indices.

While the CFTC was relatively quick to finalize the rules governing swaps subject to its jurisdiction post Dodd-Frank—perhaps because they comprise such a large percentage of the swaps market—the SEC only recently finalized its rules. The good news is that the SBS Rules, in large part, track those that apply to CFTC-regulated swaps. There are some notable differences in the rules, however, and compliance with them will require a few extra steps.

Molly Moore: Let’s talk about some of those “extra steps.” The first, and arguably most important step, is for dealers to determine whether the SBS Rules apply to security-based swaps entered into with their counterparties. To help dealers with this task, the International Swaps and Derivatives Association (ISDA) recently published a “U.S. Self-Disclosure Letter,” which is comprised of a request for information, coming from the dealer, or the “Information Recipient,” and a response letter coming from the counterparty in which the counterparty makes various elections as to its registration status, its connection to the United States and whether it is exempt under the SEC’s margin rules. ISDA has drafted the letter to be comprehensive and elicit information required by dealers to determine not just the applicability of the SBS Rules, but also the CFTC and U.S. banking regulators’ swaps rules in as few questions as possible. If they haven’t already, market participants will likely see some form of this letter in their inboxes in the near future. Some dealer counterparties may still require clients to fill out the new self-disclosure letter even if they have previously provided responses to prior versions of other ISDA self-disclosure letters or questionnaires. 

Listeners may be happy to hear that an electronic version of the letter can be completed on IHS Markit’s ISDA Amend platform. That said, we appreciate that clients may have questions on how they should complete the letter and what the implications of their responses are, especially given its broad scope. A listener might be curious to learn, for instance, that an entity may be considered a “U.S. Person” and therefore “in scope” for certain CFTC rules, but not “in scope” under the SBS Rules because the definition of “U.S. Person” is generally narrower under the SBS Rules.  

Egan Cammack: Thanks, Molly. It’s helpful that ISDA has provided market participants with a way to complete “step one” of determining whether the SBS Rules apply, but what about “step two,” actual compliance with the provisions of the SBS Rules? Those trading CFTC-regulated swaps will likely recall the ISDA Dodd-Frank Protocols published in August 2012 and March 2013. At a high-level, these protocols allowed parties to amend their swaps documentation to include representations and covenants addressing various requirements under Dodd-Frank—for instance, a counterparty might represent that it “has exercised independent judgment in executing a swap” to help a dealer satisfy external business conduct requirements. Do similar protocols exist for the SEC’s security-based swap regime and will clients be asked to complete them?

Molly Moore: Yes, indeed they do exist. For those who have already adhered to ISDA’s August 2012 and March 2013 Dodd-Frank Protocols in connection with their swaps trading, ISDA has published an “SBS Top-Up Protocol,” which, very generally, “converts” the various representations and covenants made by parties under the previous Dodd-Frank protocols to apply to the parallel set of external business conduct, reporting, relationship documentation and other equivalent rules under the SEC security-based swap regime. The adherence process is pretty straight-forward: A party wishing to adhere must simply complete and submit the adherence letter on the ISDA website—no additional questionnaire elections need to be made. Adhering parties will, however, need to provide the adherence letter identification number (ALID) that was generated by their adherences to the previous Dodd-Frank protocols. Helpfully, ISDA has published FAQs for the SBS Top-Up Protocol on its website that include instructions for how to track down those ALIDs.

For counterparties trading security-based swaps that have not adhered to the previous Dodd-Frank protocols (and do not plan on adhering to them), ISDA has published a full “2021 SBS Protocol.” The process for adhering to and making elections under this protocol is very similar to the previous Dodd-Frank Protocols. As with the SBS Top-Up Protocol, a party wishing to adhere will need to submit an adherence letter on the ISDA website. However, an adherent to the full SBS Protocol will need to take the additional step of completing either paper questionnaires or making questionnaire elections electronically on Markit’s ISDA Amend platform. The questions will look very similar to what one might have seen in the previous Dodd-Frank protocols, with some rule-specific adjustments.

Egan Cammack: Thanks, Molly—that’s helpful. So, taking stock of what we’ve covered so far, it sounds like our listeners can expect another round of disclosure letters, protocol adherences and questionnaires to complete—all geared towards helping dealers determine whether the SBS Rules apply and then satisfying their requirements under Dodd-Frank as needed. Getting into more of the substance of all of this though, what does it really mean for our clients if it turns out their security-based swaps are “in-scope” for the SBS Rules? What, in your view, are some of the key considerations our clients should be aware of?

Molly Moore: Well, the SEC announced in early May that it has approved the registration of the first security-based swap data repository—DTCC Data Repository—capable of accepting trade data for security-based swap transactions, including in the equity and credit derivative asset classes. This started the clock for the effectiveness of the security-based swap reporting regime, which will now go live on November 8, 2021.

The upshot is that, as of this fall, security-based swaps will generally need to be reported to DTCC within 24 hours of trade execution and upon the occurrence of certain “life-cycle events,” which would include, for example, the amendment, termination or assignment of a security-based swap. Like the CFTC reporting rules for swaps, some of the data, including what is considered “primary” trade information, such as the reference asset, price and notional amount of a trade, is required to be publicly disseminated. As with the CFTC’s reporting rules, the identities of trade counterparties are not, however, required to be publicly disseminated.

As to who needs to do the reporting, when a non-dealer counterparty, such as an asset manager, is facing a registered security-based swap dealer, it will be the dealer’s obligation to report. So, reporting itself will not likely be a heavy lift for most asset managers. That said, the public dissemination requirement for security-based swaps will be a new consideration when trading security-based swaps.

Egan Cammack: That’s a good point, and I expect clients that have been more hesitant to share information about their investment strategies and positions in the security-based swaps market may want to mull over the public dissemination requirement as it relates to future trading.

Another thing that clients should be aware of is that, like the CFTC swap rules, the SBS Rules also require historical trade data to be reported—both for security-based swaps entered into before the SBS Rules for reporting take effect and after the passage of the Dodd-Frank Act in July 2010, as well as security-based swaps that were entered into prior to enactment of the Dodd-Frank Act and outstanding at the time of enactment. Again, this may not be operationally burdensome when it comes to security-based swaps entered into with security-based swap dealers, where the dealer will generally have the obligation to report, but it might be an operational pain point for clients who entered into security-based swaps with non-dealer counterparties. Moreover, going forward, clients will generally need to agree who will have the operational burden of reporting security-based swaps entered into with a non-security-based swap dealer. Notably, there is no exception under the SBS reporting rules for inter-affiliate swaps.

Molly Moore: Thanks for that additional color, Egan. Another thing we’d be remiss if we didn’t mention are the new margin rules that will come into effect for non-bank “security-based swap dealers.”

To back up a step, the Dodd-Frank Act gives the SEC power to define and regulate a new set of registrants—security-based swap dealers. Some of these security-based swap dealers, namely those regulated as banks, will be, or already are, required to comply with the U.S. banking regulators’ uncleared margin rules, which, as many of you know, were promulgated years ago and are already in effect as it relates to variation margin and are in the process of being “phased-in” for initial margin.

The SEC’s uncleared margin rules are a distinct set of rules that will apply to all non-bank security-based swap dealers, except for those that fit within a narrow alternative compliance mechanism available for a subset of CFTC-registered swap dealers. We don’t yet know the full list of dealers who will be required to register as security-based swap dealers, nor will it necessarily be apparent if or how the SEC margin rules will apply to such registrants. Answers to these questions will depend on the type of security-based swap dealer clients are facing, such as a security-based swap dealer that is also registered as a broker dealer or a security-based swap dealer that is classified as an “OTC derivatives dealer” under the CFTC swap rules. Dealers are going to have to provide information and guidance on these questions, and we encourage clients to reach out to their security-based swap counterparties to inquire about whether they expect to be registered as security-based swap dealers and what the impact of that registration is expected to be.

Egan Cammack: With that said, the good news for many of our listeners is that the SEC margin rules overlap and “harmonize” in many key aspects with the uncleared swap margin rules promulgated by other regulators, including the CFTC, U.S. banking regulators and European regulators. As with the existing margin rules under those regimes, the exchange of daily variation margin will be required under the SEC margin rules. Additionally, security-based swap dealers subject to the SBS margin rules will be required to collect initial margin to the extent the dealer’s (and its affiliates’) exposure under swaps and security-based swaps traded with a counterparty (and its affiliates) surpasses a $50,000,000 threshold. There is also, as one might expect, an exception to the margin requirements for “commercial end-users” that is generally consistent with other regulatory regimes. The transfer of initial and variation margin is also subject to a $500,000 minimum transfer amount.

Despite these similarities with other regulatory margin regimes—and we won’t go into all of them—there are also some key differences. For example, security-based swap dealers subject to the SEC margin rules are only required to collect, and not post, initial margin. Another critical difference is that the SEC margin rules do not include an exception from initial margin requirements for trades involving counterparties whose use of non-cleared derivatives is below a certain notional amount. As many listeners know, the CFTC and U.S. banking regulators’ rules only apply to swaps between a swap dealer and a counterparty that is a financial end-user with at least $8 billion in aggregate notional amount of non-cleared derivatives. This could mean that clients might have to post initial margin to a dealer under the SEC margin rules before they would have to do so under those other regulatory regimes.

Molly Moore: Thanks, Egan. One other point to note is that the SEC has extended the deadline for compliance with initial margin requirements for “Phase 6+ Entities,” which generally means entities that have aggregate notional amount of OTC derivatives of $50 billion or less. This provides much-needed relief to many asset managers and their clients, and aligns implementation of the SEC’s initial margin rules with Phase 6 of other regulators’ initial margin rules. 

While we are on the topic of differences, another key departure from other regulatory margin regimes is how margin (and other customer property) is required to be held. Under the CFTC and U.S. banking regulators’ rules, any regulatory initial margin collected by a dealer is required to be held with a third party custodian. Under the SEC margin rules, the dealer can hold the collateral, but must (with some limited exceptions) do so in a segregated account that can include the money, securities or property of other customers (what is called “omnibus segregation”). That said, clients have the right to elect that the collateral be held in a segregated account with a third party custodian subject to certain conditions. Security-based swap dealers are required to give notice to their counterparties of this right.

Egan Cammack: I’m glad you brought this up, Molly, because the point about different approaches to margining and collateral segregation under the SEC margin rules underscores another key point for our clients—documenting all of this is not necessarily going to be straightforward. Clients with ISDA Credit Support Annexes will need to work with dealers to amend these documents to capture not only regulatory margin requirements under different rulesets, but also take into account the concept of any additional non-regulatory or “house” initial margin requirements imposed by their dealer counterparties. Additionally, if a client elects to have initial margin individually segregated at a third party custodian that will necessitate the negotiation of a control agreement. Thankfully, ISDA has developed template “bolt-on” supplements to its Credit Support Annexes, which will facilitate elections and necessary technical updates to accommodate the SEC’s margin requirements for security-based swaps, but there will invariably be some level of customization that will be required to work with existing documentation.

Molly Moore: Thanks, Egan. I think that covers it for today. To our listeners, we encourage you to keep an eye out for further developments relating to the SBS Rules and their implementation. Please do not hesitate to reach out to us if you have any questions regarding the new rules or need assistance reviewing any documentation, questionnaires or disclosure letters in connection with the rules. For more information on the topics that we discussed or other topics of interest to the asset management industry, please visit our website at www.ropesgray.com. And of course, we can help you navigate any of the topics we discussed, so please don't hesitate to get in touch. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple and Spotify. Thanks again for listening.