# Registration and Regulation of Security-Based Swap Execution Facilities

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2011-2696

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** February 28, 2011
- **Citation:** 76 FR 10948

## Text

SECURITIES AND EXCHANGE COMMISSION
17 CFR Parts 240, 242, and 249
[Release No. 34-63825; File No. S7-06-11]
RIN 3235-AK93
Registration and Regulation of Security-Based Swap Execution Facilities

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule; proposed interpretation.

SUMMARY:

In accordance with Section 763 (“Section 763”) of Title VII (“Title VII”) of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”), the Securities and Exchange Commission (“SEC” or “Commission”) is proposing Regulation SB SEF under the Securities Exchange Act of 1934 (“Exchange Act”) that is designed to create a registration framework for security-based swap execution facilities (“SB SEFs”); establish rules with respect to the Dodd-Frank Act's requirement that a SB SEF must comply with the fourteen enumerated core principles (“Core Principles”) and enforce compliance with those principles; and implement a process for a SB SEF to submit to the Commission proposed changes to the SB SEF's rules. The Commission also is proposing an interpretation of the definition of “security-based swap execution facility” set forth in Section 3(a)(77) of the Exchange Act to provide guidance on the characteristics of those systems or platforms that would satisfy the statutory definition. In addition, the Commission is proposing to amend Rule 3a-1 under the Exchange Act to exempt a registered SB SEF from the Exchange Act's definition of “exchange” and to add Rule 15a-12 under the Exchange Act to exempt, subject to certain conditions, a registered SB SEF from regulation as a broker pursuant to Section 15(b) of the Exchange Act.

DATES:

Comments should be submitted on or before April 4, 2011.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's Internet comment form (
http://www.sec.gov/rules/proposed.shtml
); or

• Send an e-mail to
rule-comments@sec.gov.
Please include File Number S7-06-11 on the subject line; or

• Use the Federal eRulemaking Portal (
http://www.regulations.gov
). Follow the instructions for submitting comments.

Paper Comments

• Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F St., NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-06-11. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (
http://www.sec.gov/rules/proposed.shtml
). Comments are also available for Web site viewing and printing in the Commission's Public Reference Room, 100 F St., NE., Washington, DC 20549 on official business days between the hours of 10 a.m. and 3 p.m. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT:

Nancy J. Burke-Sanow, Assistant Director, at (202) 551-5621; David Liu, Senior Special Counsel, at (312) 353-6265; Constance Kiggins, Special Counsel, (202) 551-5701; Molly Kim, Special Counsel, at (202) 551-5644; Leah Mesfin, Special Counsel, at (202) 551-5655; Susie Cho, Special Counsel, at (202) 551-5639; Michou Nguyen, Special Counsel, (202) 551-5634; Heidi Pilpel, Special Counsel, (202) 551-5666; Steven Varholik, Special Counsel, at (202) 551-5615; Sarah Schandler, Special Counsel, at (202) 551-7145; and Iliana Lundblad, Attorney, at (202) 551-5871; Office of Market Supervision, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION:

The Commission is proposing new Regulation SB SEF under the Exchange Act governing the registration and regulation of SB SEFs, an interpretation with respect to the definition of a SB SEF and new Form SB SEF for applicants to register with the Commission as SB SEFs. The Commission also is proposing certain exemptions to facilitate the trading of security-based swaps (“SB swaps”) on SB SEFs.

I. Introduction

On July 21, 2010, the President signed the Dodd-Frank Act into law.
1

The Dodd-Frank Act was enacted, among other things, to promote the financial stability of the United States by improving accountability and transparency of the nation's financial system.
2

Title VII of the Dodd-Frank Act provides the Commission and the Commodity Futures Trading Commission (“CFTC”) with the authority to regulate over-the-counter (“OTC”) derivatives in light of the recent financial crisis, which demonstrated the need for enhanced regulation of the OTC derivatives market. The Dodd-Frank Act is intended to strengthen the existing regulatory structure concerning, and to provide the Commission and the CFTC with effective regulatory tools to oversee, the OTC swaps markets, which have grown exponentially in recent years and are capable of affecting significant sectors of the U.S. economy.

1
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Pub. L. 111-203, H.R. 4173).

2

See
Public Law 111-203 Preamble.

The Dodd-Frank Act provides that the CFTC will regulate “swaps,” the Commission will regulate “security-based swaps,” and the CFTC and the Commission will jointly regulate “mixed swaps.”
3

The Dodd-Frank Act amends

the Exchange Act to require, among other things, the following with respect to transactions in SB swaps regulated by the Commission: (1) Transactions in SB swaps must be cleared through a clearing agency if they are of a type that the Commission determines must be cleared, unless an exemption from mandatory clearing applies;
4

(2) if the SB swap is subject to the clearing requirement, the transaction must be executed on an exchange or on a SB SEF registered under Section 3D of the Exchange Act or a SB SEF exempt from registration under Section 3D(e) of the Exchange Act, unless no SB SEF or exchange makes such SB swap available for trading or the SB swap transaction is subject to the clearing exception in Section 3C(g) of the Exchange Act;
5

and (3) transactions in SB swaps (whether cleared or uncleared) must be reported to a registered security-based swap data repository (“SDR”) or the Commission.
6

3
Section 712(d) of the Dodd-Frank Act provides that the Commission and the CFTC, in consultation with the Board of Governors of the Federal Reserve System (“Federal Reserve”), shall further define the terms “swap,” “security-based swap,” “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” “eligible contract participant,” and “security-based swap agreement.” These terms are defined in Sections 721 and 761 of the Dodd-Frank Act and, with respect to the term “eligible contract participant,” in Section 1a(18) of the Commodity Exchange Act (“CEA”), 7 U.S.C. 1a(18), as re-designated and amended by Section 721 of the Dodd-Frank Act. Further, Section 721(c) of the Dodd-Frank Act requires the CFTC to adopt a rule to further define the terms “swap,” “swap dealer,” “major swap participant,” and “eligible contract participant” to include transactions and entities that have been structured to evade Title VII of the Dodd-Frank Act. Section 761(b) of the Dodd-Frank Act provides that the Commission may adopt a rule to further define the terms “security-based swap,” “security-based swap dealer,” “major security-based swap participant,” and “eligible contract participant,” with regard to security-based swaps, for the purpose of including transactions and entities that have been structured to evade Title VII of the Dodd-Frank Act. Finally, Section 712(a) of the Dodd-Frank Act provides that the Commission and CFTC, after consultation with the Federal Reserve, shall jointly prescribe regulations regarding “mixed swaps,” as may be necessary to carry out the purposes of Title VII. To assist the Commission and the CFTC in further defining the terms specified above, and to prescribe regulations regarding “mixed swaps” as may be necessary to carry out the purposes of Title VII, the Commission and the CFTC have sought comment from interested parties.
See
Securities Exchange Act Release Nos. 63452 (December 7, 2010), 75 FR 80174 (December

21, 2010) (File No. S7-39-10) (proposed rulemaking regarding definitions contained in Title VII of the Dodd-Frank Act relating to participants). The Commission also will propose rules regarding definitions contained in Title VII of the Dodd-Frank Act relating to products in a separate proposed rulemaking.
See also
Securities Exchange Act Release No. 62717 (August 13, 2010), 75 FR 51429 (August 20, 2010) (File No. S7-16-10) (advance joint notice of proposed rulemaking regarding definitions contained in Title VII of the Dodd-Frank Act).

4

See
Public Law 111-203, § 763(a) (adding Section 3C(a)(1) of the Exchange Act).

5

See
Public Law 111-203, § 763(a) (adding Section 3C(h) of the Exchange Act).
See also
Public Law 111-203, § 761(a) (adding Section 3(a)(77) of the Exchange Act), defining the term “security-based swap execution facility.” The Dodd-Frank Act amends the CEA to provide for a similar regulatory framework with respect to transactions in swaps regulated by the CFTC.

6

See
Public Law 111-203, § 761(a)(75) (adding Section 3(a)(75) of the Exchange Act) (defining the term “security-based swap data repository”). The registration of an SDR and the reporting of SB swaps are the subject of separate Commission rulemakings.
See
Securities Exchange Act Release Nos. 63347 (November 19, 2010), 75 FR 77306 (December 10, 2010) (File No. S7-35-10) (“SDR Release”) and 63346 (November 19, 2010), 75 FR 75208 (December 2, 2010) (File No. S7-34-10) (“Reporting and Dissemination Release”).

II. Regulatory Framework of Security-Based Swap Execution Facilities

Currently, SB swaps trade in the OTC market, rather than on regulated markets. Although some SB swaps have moved to centralized clearing, prior to the enactment of the Dodd-Frank Act, centralized clearing of SB swaps was not required. The current market for SB swaps is opaque, with little, if any, pre-trade transparency (the ability of market participants to see trading interest prior to a trade being executed) or post-trade transparency (the ability of market participants to see transaction information after a trade is executed). A key goal of the Dodd-Frank Act is to bring trading of SB swaps onto regulated markets,
7

as reflected in the statutory requirement that, subject to certain exceptions, any SB swap subject to mandatory clearing must be traded on a SB SEF or an exchange, unless no SB SEF or exchange makes such SB swap available for trading.

7

See
Public Law 111-203, preamble.

Section 763 of the Dodd-Frank Act amends the Exchange Act by adding various new statutory provisions to govern the regulation of SB SEFs.
8

Section 3C(h) of the Exchange Act specifies that transactions in SB swaps that are subject to the clearing requirement of Section 3C(a)(1) of the Exchange Act must be executed on an exchange or on a SB SEF registered with the Commission (or a SB SEF exempt from registration), unless no exchange or SB SEF makes the SB swap available to trade (referred to as the “mandatory trade execution requirement”) or the SB swap transaction is subject to the clearing exception in Section 3C(g) of the Exchange Act (“end-user exception”).
9

Further, Section 3D(a)(1) of the Exchange Act states that no person may operate a facility for the trading or processing of SB swaps, unless the facility is registered as a SB SEF or as a national securities exchange under that section.
10

Under Section 3D(b) of the Exchange Act, a SB SEF registered with the Commission may make SB swaps available for trading and facilitate trade processing of SB swaps.
11

Section 3D(c) of the Exchange Act requires a national securities exchange, to the extent it also operates a SB SEF and uses the same electronic trade execution system for listing and executing trades in SB swaps, to identify whether electronic trading of SB swaps is taking place on or through the exchange or the SB SEF.
12

8

See
Public Law 111-203, § 763 (adding Sections 3C and 3D of the Exchange Act).

9

See
Public Law 111-203, § 763 (adding Section 3C(h) of the Exchange Act).

10

See
Public Law 111-203, § 763(a) (adding Section 3D(a)(1) of the Exchange Act). The Commission views this requirement as applying only to facilities that meet the definition of “security-based swap execution facility” in Section 3(a)(77) under the Exchange Act. SB swaps that are not subject to the mandatory trade execution requirement would not have to be traded on a registered SB SEF and could be traded in the over-the-counter (“OTC”) market for SB swaps.

11

See
Public Law 111-203, § 763(c) (adding Section 3D(b) of the Exchange Act).

12

See
Public Law 111-203, § 763(c) (adding Section 3D(c) of the Exchange Act).

Section 3D(d) of the Exchange Act specifies that to be registered and maintain registration, a SB SEF must comply with fourteen Core Principles enumerated therein and any requirement that the Commission may impose by rule or regulation.
13

The Core Principles applicable to SB SEFs are captioned: (1) Compliance with Core Principles; (2) Compliance with Rules; (3) Security-Based Swaps Not Readily Susceptible to Manipulation; (4) Monitoring of Trading and Trade Processing; (5) Ability to Obtain Information; (6) Financial Integrity of Transactions; (7) Emergency Authority; (8) Timely Publication of Trading Information; (9) Recordkeeping and Reporting; (10) Antitrust Considerations; (11) Conflicts of Interest; (12) Financial Resources; (13) System Safeguards; and (14) Designation of Chief Compliance Officer.
14

As a result, a registered SB SEF would have certain regulatory obligations with respect to overseeing its market and the participants that trade on its facility. Further, Section 3D(f) of the Exchange Act states that the Commission shall prescribe rules governing the regulation of SB SEFs.
15

Finally, Section 3(a)(77) of the Exchange Act defines a SB SEF as a trading system or platform in which multiple participants have the ability to execute or trade SB swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that: (1) Facilitates the execution of SB swaps between persons; and (2) is not a national securities exchange.
16

13

See
Public Law 111-203, § 763(c) (adding Section 3D(d)(1)(A) of the Exchange Act).

14

See
Public Law 111-203, § 763(c) (adding Section 3D(d)(1)-(14) of the Exchange Act).

15

See
Public Law 111-203, § 763(c) (adding Section 3D(f) of the Exchange Act).

16

See
Public Law 111-203, § 761(a) (adding Section 3(a)(77) of the Exchange Act).

As regulated markets for the trading of SB swaps, SB SEFs, as well as exchanges that post or trade SB swaps (“SBS exchanges”), are intended to play an important role in enhancing the transparency and oversight of the market for SB swaps. SB SEFs should help further the statutory objective of greater transparency and a more competitive environment for the trading of SB swaps by providing a venue for multiple parties to execute trades in SB swaps and also by serving as a conduit for information regarding trading interest in SB swaps. As a result of the Dodd-Frank Act's provisions relating to SB SEFs, the Commission would have access to information on the trading of SB swaps that occurs on SB SEFs and information regarding trading by their participants. In addition, because SB SEFs would have certain regulatory obligations arising from their Core

Principles, such as monitoring trading, assuring the ability to obtain information, and establishing and enforcing rules and procedures to ensure the financial integrity of SB swaps entered on or though the SB SEF, these facilities can play an important role in helping to oversee the market for SB swaps on an ongoing basis and allowing regulators to quickly assess information regarding the potential for systemic risk across trading venues.

The Commission is mindful that any rules that the Commission may adopt regarding the regulation of SB SEFs could impact the incentives for existing or prospective platforms for the trading of SB swaps to enter or withdraw from this market. On the other hand, the rules to be adopted by the Commission for the trading of SB swaps should be sufficient to fulfill the objectives of the Dodd-Frank Act to promote financial stability and transparency. The Commission also is mindful that, both over time and as a result of Commission proposals to implement the Dodd-Frank Act, the further development of the SB swap market may alter some of the specific calculus for future regulation of SB SEFs.

The Commission notes that the CFTC is proposing rules relating to swap execution facilities (“SEFs”) as required under Section 733 of the Dodd-Frank Act.
17

Because there are differences between the markets and products that the Commission and the CFTC currently regulate, the approach that each agency may take regarding the regulation of SB SEFs and SEFs, respectively, also may differ in various respects. The Commission recognizes that commenters may respond to the Commission's proposals by referring to the CFTC's proposals and welcomes commenters' views and suggestions on the impact of any differences between the Commission and CFTC approaches to the regulation of SB SEFS and SEFs. The Commission is particularly interested in whether its proposed rulemaking would result in any duplicative or inconsistent efforts on the part of market participants subject to both regulatory regimes or would result in gaps between those regimes.

17

See
Public Law 111-203, § 733 (adding Section 5h of the CEA).
See also
76 FR 1214 (January 7, 2011) (“Notice of proposed SEF rulemaking by the CFTC”).

Further, the Commission is aware that regulators in other countries are considering reform of their swaps and derivatives markets and are interested in achieving a consistent approach to swaps regulation between the United States, Europe and other jurisdictions to mitigate the risk of regulatory arbitrage.
18

Although the Commission must be guided by the requirements of the Dodd-Frank Act in crafting proposed rules applicable to markets that trade SB swaps and the participants in those markets, the Commission recognizes that the particular rules that it may adopt under the Dodd-Frank Act may impact the incentives of market participants with respect to where they choose to engage in the trading of SB swaps.

18

See, e.g.,
Committee of European Securities Regulators (“CESR”), CESR Technical Advice to the European Commission in the context of the MiFID Review and Responses to the European Commission for Additional Information, dated October 13, 2010, available at
http://www.cesr-eu.org/index.php?page=contenu_groups&id=61&docmore=1
.

Commenters are urged to consider generally the role that regulation may play in fostering or limiting the development of the market for SB swaps (or, vice versa, the role that market developments may play in changing the nature and implications of regulation) and specifically to focus on this issue with respect to the proposals to establish a framework for the trading of SB swaps. In addition, commenters are urged to consider the effect of the Commission's proposals relating to SB SEFs on the global swaps and derivatives markets and to offer specific comments regarding how the proposals compare with the existing or proposed regulations of other jurisdictions.

III. The Definition of Security-Based Swap Execution Facilities

Since the enactment of the Dodd-Frank Act in July 2010, the Commission has engaged in a number of outreach programs relating to the legislation's rulemaking mandates, including trading of SB swaps on regulated markets.
19

On September 15, 2010, the staff of the Commission and of the CFTC conducted a joint roundtable to discuss issues related to the formation and regulation of SEFs and SB SEFs (“Roundtable”).
20

Topics discussed at the Roundtable included the scope of the definition of a SEF and SB SEF; registration of these facilities; products that would trade on a SEF and SB SEF; block trades; access to SEFs and SB SEFs; and cross-market issues.
21

The purpose of the Roundtable was to provide a forum for the discussion of these issues and to assist SEC and CFTC staff as they developed proposed rules to meet the Dodd-Frank Act's mandate to bring the trading of swaps and SB swaps subject to the mandatory clearing requirement onto organized markets. Panelists at the Roundtable provided comments on their experience with the current market structure for the trading of swaps and SB swaps and offered their views and suggestions on ways that that structure could change as a result of the legislation. Pursuant to the Commission's outreach, a range of individuals and entities, including swap dealers, brokers, end-users, academics and others, have expressed their views on a variety of topics, such as the scope of activities or the nature of platforms that should fall within the statutory definition of “security-based swap execution facility.”
22

19

See, e.g.,
Implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act, Transparency, Public Input on SEC Regulatory Initiatives under the Dodd-Frank Act Title VII—Wall Street Transparency and Accountability, Mandatory Exchange Trading and Swap Execution Facilities, available at
http://www.sec.gov/spotlight/dodd-frank.shtml.

20

See
Securities Exchange Release No. 62864 (September 8, 2010), 75 FR 55574 (September 13, 2010) (File No. 4-612). Webcast available at
http://www.sec.gov/news/openmeetings/2010/jac091510.shtml.

21

See
Press Release issued by the Commission on September 8, 2010, “SEC, CFTC To Host Joint September Roundtables On Swap and Security-Based Swap Matters” (File No. 2010-166), available at
http://www.sec.gov/news/press/2010/2010-166.htm.

22

See, e.g., http://www.sec.gov/spotlight/dodd-frank.shtml.

Many letters from market participants advocated for a flexible interpretation of the statutory definition of SB SEF.
23

In their letters, they argued that the definition of SB SEF should permit many different types of existing and new trading and execution platforms.
24

Certain market participants noted that the SB swap market is more customized and illiquid than the cash equities market and argued that a broad range of trading models would be necessary to address the SB swap market's unique characteristics and to allow this market to develop properly.
25

23

See, e.g.,
letter from Ben Macdonald, Global Head Fixed Income, Bloomberg LP, to Commission, dated September 22, 2010 (“Bloomberg Letter”), at 2; letter from Richard H. Baker, President and CEO, Managed Funds Association, to Elizabeth M. Murphy, Secretary, Commission, dated September 22, 2010 (“MFA Letter”), at 16; letter from Ernest C. Goodrich, Jr., Managing Director—Legal Department, and Marcelo Riffaud, Managing Director—Legal Department, Deutsche Bank AG, to David A. Stawick, Secretary, CFTC, and Elizabeth M. Murphy, Secretary, Commission, dated October 6, 2010 (“Deutsche Bank Letter”), at 5-6 and 8-9; and letter from Larry Tabb, CEO and Founder, Andy Nybo, Head of Derivatives, and Kevin C. McPartland, Senior Analyst, TABB Group, to Gary Gensler, Chairman, CFTC, and Mary Schapiro, Chairman, Commission, dated August 23, 2010 (“TABB Letter”), at 2.

24

See, e.g.,
Bloomberg Letter,
id.,
at 2; MFA Letter,
id.,
at 16; and Deutsche Bank Letter,
id.,
at 7.

25

See, e.g.,
Bloomberg Letter,
supra
note 23, at 2, and Deutsche Bank Letter,
supra
note 23, at 6-7.
See also

infra,
Section III.B for a discussion of the

Commission's interpretation of the definition of SB SEF.

Although many commenters who expressed a view regarding the definition of SB SEF favored allowing multiple platforms,
26

some commenters expressed concern about some types of platforms that potentially could meet the definition of SB SEF. One commenter believed that allowing multiple request for quote (“RFQ”) platforms,
27

without a price mechanism that aggregates prices across platforms, to meet the definition of SB SEF, could lead to a fragmented market, which could discourage competition.
28

Another commenter suggested that permitting an RFQ platform to be treated as a SB SEF could be viewed as preserving the
status quo
of a dealer-dominated market and believed that the Dodd-Frank Act envisioned that SB swaps would be traded on a facility akin to a limit order book platform.
29

26

See supra
note 23 and accompanying text.

27
In referring to a RFQ platform, the Commission means a trading platform where a customer who wishes to execute a SB swap disseminates a request for quote to one or more dealers and one or more of those dealers respond to the request with an executable quote.

28

See, e.g.,
Commentary by S. “Vish” Viswanathan, Professor, Fuqua School of Business, Duke University, at the Roundtable. Webcast available at
http://www.sec.gov/news/openmeetings/2010/jac091510.shtml.

29

See
Commentary by Heather Slavkin, Senior Legal Policy Advisor for the Office of Investment, AFL-CIO, at the Roundtable. Webcast available at
http://www.sec.gov/news/openmeetings/2010/jac091510.shtml.
See also infra,
Section III.B discussing the Commission's interpretation taking into account concerns raised by commenters.

The Commission also received other specific views about platforms that commenters believed should or should not be included in the definition of SB SEF. For example, one commenter believed that platforms that would not trade or execute SB swap transactions, such as pure trade processing facilities, would not meet the statutory definition of SB SEF.
30

A market participant, however, stated that in its view the statutory definition of SB SEF would encompass pure trade processing facilities.
31

30

See
letter from Mark D. Young, Skadden, Arps, Slate, Meagher & Flom LLP, to David A. Stawick, Secretary, CFTC, and Elizabeth M. Murphy, Secretary, Commission, dated September 22, 2010, at 3.

31

See
Meetings with SEC Officials: Memorandum from the Division of Trading and Markets regarding an August 25, 2010 Meeting with representatives of MarkitSERV, dated September 2, 2010, MarkitSERV PowerPoint Presentation, dated August 25, 2010 at p. 5-6, available at
http://www.sec.gov/comments/s7-16-10/s71610-96.pdf.

The information presented at the Roundtable and received from the public has helped to inform the proposals relating to SB SEFs that are part of this rulemaking. The Commission is mindful that there exists a wide range of views on the part of market participants and others about the nature of the activities or systems that would constitute, and the scope of activities permitted by, a SB SEF and therefore encourages interested persons to provide their views and suggestions, as well as any materials or data to support their positions, on this aspect of the proposed rulemaking. The Commission believes that the prudent course is to take where appropriate a deliberate and attentive approach to its regulation of SB SEFs that is informed by the state of development of SB swap trading on regulated markets. The Commission emphasizes, however, that any actions it may take now or in the future would be designed to further the overall objectives of the Dodd-Frank Act.

A. Current SB Swap Market

1. Trading Models

Unlike the markets for cash equity securities and listed options, the market for SB swaps currently is characterized by bilateral negotiation in the OTC swap market; is largely decentralized; many instruments are not standardized; and many SB swaps are not centrally cleared. The lack of uniform rules concerning the trading of SB swaps and the one-to-one nature of trade negotiation in SB swaps has resulted in the formation of distinct types of venues for the trading of these securities, ranging from bilateral negotiations carried out over the telephone, to single-dealer RFQ platforms, to multi-dealer RFQ platforms, to central limit order books outside the United States, and others, as more fully described below. The use of electronic media to execute transactions in SB swaps varies greatly across trading venues, with some venues being highly electronic whereas others rely almost exclusively on non-electronic means such as the telephone. The reasons for use of, or lack of use of, electronic media vary from such factors as user preference to limitations in the existing infrastructure of certain trading platforms. The description below of the ways in which SB swaps may be traded is based in part on discussions with market participants. The Commission solicits comments on the accuracy of this description.

The Commission uses the term “bilateral negotiation” to refer to the model whereby one party uses the telephone, e-mail or other communications to contact directly a potential counterparty to negotiate a SB swap. Once the terms are agreed, the SB swap transaction is executed and the terms are memorialized.
32

In a bilateral negotiation, there may be no pre-trade or post-trade transparency available to the marketplace because only the two parties to the transaction are aware of the terms of the negotiation and the final terms of the agreement. Further, no terms of the proposed transaction are firm until the transaction is executed. However, reputational costs generally serve as a deterrent to either party's failing to honor any quoted terms. Dealer to customer bilateral negotiation currently is used for all SB swap asset classes, and particularly for trading in less liquid SB swaps, in situations where the parties prefer a privately negotiated transaction, such as in executing block trades, or in other circumstances in which it is not cost effective for a party to the trade to use one of the execution methods described below.

32
For further discussion,
see, e.g.,
Securities Exchange Act Release No. 63727 (January 14, 2011), 76 FR 3859 (January 21, 2011) (proposing rules for the trade acknowledgement and verification of security-based swaps).

Another model for the trading of SB swaps is the single-dealer RFQ electronic trading platform. In a single-dealer RFQ platform, a dealer may post indicative quotes for SB swaps in various SB swap asset classes that the dealer is willing to trade. Only the dealer's approved customers would have access to the platform. When a customer wishes to transact in a SB swap, the customer requests an executable quote, the dealer provides one, and if customer accepts the dealer's quote, the transaction is executed electronically. If the dealer repeatedly responds to requests for executable quotes with quotes that are significantly less favorable than the dealer's indicative quotes posted on the single-dealer electronic trading platform, volume on the platform presumably would diminish and participants may no longer transact there. This type of platform generally provides pre-trade transparency in the form of indicative quotes on a pricing screen, but only from one dealer to its customer. Currently, there is no post-trade reporting of transactions on single-dealer platforms and thus there is no post-trade transparency.

A variant of the single-dealer model is an aggregator-type platform that combines two or more single-dealer RFQ platforms. In such a platform, a customer who has access to the platform, which is determined solely at the discretion of its operator and of the dealers involved, may see indicative quotes from multiple dealers at once instead of seeing quotes only from one

dealer as in the single-dealer RFQ platform. Although a participant can simultaneously view quotes from multiple dealers, the participant can request a firm quote from only one dealer at a time. One feature of the aggregated single-dealer platform as compared to the bilateral negotiation and single-dealer models described above is the ability of a participant in the aggregated single-dealer platform to see indicative quotes from multiple dealers. However, customers are not afforded an opportunity to send RFQs to multiple dealers at the same time to promote competitive pricing. Also, like the single-dealer electronic platform, there is no post-trade reporting of transactions and thus there is no post-trade transparency.

A third model is the multi-dealer RFQ electronic trading platform.
33

In a multi-dealer RFQ system, a requester can send an RFQ to solicit quotes on a certain SB swap from multiple dealers at the same time. Currently, dealers on a multi-dealer RFQ platform generally require the platform to set limits on the number of dealers to whom a customer may send an RFQ, and also may limit which dealers may participate on the platform. These platforms are sometimes owned by dealers themselves. After the RFQ is submitted, the recipients have a prescribed amount of time in which to respond to the RFQ with a quote. Responses to the RFQ are firm. The requestor then has the opportunity to review the responses and accept the best quote. A multi-dealer RFQ platform provides a certain degree of pre-trade transparency, depending on its characteristics. But to the extent that a requester is restricted by platform rules to soliciting quotes from a limited number of dealers, the customer's pre-trade transparency is restricted to that number of quotes it receives in response to its RFQ. In some instances requestors may prefer to limit the number of recipients of an RFQ as a way to protect proprietary trading strategies as dissemination of their interest to multiple dealers may increase hedging costs to dealers, and thus costs to the requestors as reflected in the prices from the dealers. Pre-trade transparency may also exist through the platform's dissemination of composite indicative quotes to all participants prior to trades. Post-trade transparency may exist if the platform chooses to disseminate information regarding executed transactions.

33
The single-dealer RFQ platform is an example of a system that permits customers to submit an RFQ to a single dealer, which is distinct from a multi-dealer RFQ platform that permits customers to solicit quotes from multiple dealers simultaneously instead of one dealer. The multi-dealer RFQ platform differs from a single-dealer aggregator platform because a participant in the aggregated single-dealer platform may only send a request to one dealer at a time and thus would not have the ability to interact with the bids or offers of multiple dealers simultaneously.

A fourth model for the trading of SB swaps is a limit order book system or similar system, which the Commission understands is not yet in operation for the trading of SB swaps in the United States but exists for the trading of SB swaps in Europe. Today, securities and futures exchanges in the United States display a limit order book in which firm bids and offers are posted for all participants to see, with the identity of the parties withheld until a transaction occurs. Bids and offers are then matched based on price-time priority or other established parameters and trades are executed accordingly. The quotes on a limit order book system are firm. A limit order book system may be a more suitable model for the trading of more liquid, rather than less liquid, SB swaps. In general, a limit order book system also provides greater pre-trade transparency than the three platforms described above because all participants can view bids and offers before placing their bids and offers. However, broadly communicating trading interest, particularly about a large trade, may increase hedging costs, and thus costs to investors as reflected in the prices from the dealers. The system can also provide post-trade transparency, to the extent that participants can see the terms of executed transactions.

A fifth type of trading, which the Commission herein refers to as “brokerage trading,” is used by brokers to execute SB swap trades on behalf of customers, often in larger sized transactions. In such a system, a broker receives a request from a customer (which may be a dealer) who seeks to execute a specific type of SB swap. The broker then interacts with other customers to fill the request and execute the transaction. The mode of interaction can vary depending on the size of the trade and the type of SB swap being traded. In some cases, the interaction is done purely by voice over the telephone, while in other cases, the interaction is electronic or a hybrid of voice and an electronic system. The level of automation and use of electronic means also vary depending on the technological state and functionality of the broker's platform.
34

This model often is used by dealers that seek to transact with other dealers through the use of an interdealer broker as an intermediary. In this model, there may be pre-trade transparency to the extent that participants are able to see bids and offers of other participants and post-trade transparency to the extent that participants can see the terms of executed transactions.

34
The Commission understands that a small portion of the brokerage trading in the United States is currently highly automated and has characteristics of a limit order book. However, while depth of the order book may be displayed, generally there may be only one bid or offer, and sometimes only one side of the market would be displayed (
i.e.,
a bid without an offer and vice versa). Because the volume in some SB swaps may be low, the electronic systems maintained by wholesale brokers would not necessarily include a matching engine that would provide for price-time priority or other execution parameters, unlike other types of electronic limit order books. Although the wholesale brokers' systems are electronic, the customer would need to perform some steps manually (
e.g.,
hit the bid or lift the offer) to execute a trade.

The five foregoing examples represent broadly the various types of models for the trading of OTC swaps in existence today. These examples may not represent every single method in existence today and the discussion above is intended to give an overview of the models without providing the nuances of each particular type.

2. The SB Swap Market and the Commission's Approach to SB SEF Definitions

In the Commission's view, the diverse nature of these examples demonstrates the extent to which, when compared with the equities markets, certain aspects of the SB swap market are still evolving.
35

In considering ways in which the Commission could approach the definition of SB SEF, the Commission has sought to facilitate competition and innovations in the SB swap market that could be used to promote more efficient trading in organized, transparent and regulated trading venues. The Commission does not believe it should simply overlay the same regulatory structure that is currently in place for equities, given important differences in the nature and maturity of the SB swap and equities markets. However, the Commission does believe that certain elements of equity

market structure may be directly relevant to the SB swap market.

35
For example, data from the Depository Trust and Clearing Corporation covering the period from March 22, 2010 to June 20, 2010 for single name credit default swaps revealed the following: Out of 998 types of swaps (
i.e.,
a swap based on one reference entity), only 55 had 10 or more trades per day (34 trades being the highest), and 827 of the swaps had 5 or fewer trades per day (531 of those only had 2 or fewer trades per day). In the data set, “trades per day” includes all tenors (
e.g.,
duration or expiry) in swaps of the same reference entity.
See http://www.dtcc.com/downloads/products/derivserv/CDS_Snapshot_Analysis_Sep17-2010.pdf;

see also

http://www.dtcc.com/products/derivserv/data_table_snap0002.php
and
http://www.dtcc.com/products/deriserv/data_table_snapshot.php.

Furthermore, rather than proposing a rule that would establish a prescribed configuration for SB SEFs that would meet the statutory definition of SB SEF, the Commission proposes to provide baseline principles interpreting the definition of SB SEF, consistent with the requirements of the Exchange Act, as amended by the Dodd-Frank Act, which any entity would need to be able to meet to register as a SB SEF. Such an approach is designed to allow flexibility to those trading venues that seek to register with the Commission as a SB SEF and to permit the continued development of organized markets for the trading of SB swaps. This more flexible approach also would allow the Commission to monitor the market for SB swaps and propose adjustments, as necessary, to any interpretation that it may adopt as this market sector continues to evolve.

However, the Commission recognizes that, consistent with the Dodd-Frank Act, the interpretation of the definition of SB SEF should: (1) Encourage the migration of trading SB swaps from the OTC market to SB SEFs (or exchanges), (2) provide a meaningful distinction between a SB SEF and an OTC trading venue, (3) promote further transparency of the SB swap market, and (4) to facilitate competition and innovation in the SB swap markets that could be used to promote more efficient trading in organized, transparent, and regulated trading venues. In addition, the interpretation of the definition of SB SEF should complement other aspects of proposed SB swap regulations, including those related to post trade transparency, mandatory clearing, and the general requirement that SB swaps that are subject to mandatory clearing only be traded on an exchange or SB SEF, unless no exchange or SB SEF makes the SB swap available to trade.

B. Scope of SB SEF Definition

As noted above, Section 3(a)(77) of the Exchange Act defines a SB SEF as a trading system or platform in which multiple participants have the ability to execute or trade SB swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that: (1) Facilitates the execution of SB swaps between persons; and (2) is not a national securities exchange.
36

36
As discussed
infra
Section XXI, an entity that meets the definition of SB SEF would be required to register as a SB SEF or a national securities exchange (unless exempted under Section 3D(e) of the Exchange Act if the Commission finds that the facility is subject to comparable, comprehensive supervision and regulation on a consolidated basis by the CFTC). A registered SB SEF would be required to satisfy all 14 Core Principles and any rules promulgated by the Commission, including proposed Rule 811(a)(3), which provides for certain requirements relating trading on a SB SEF.
See
Public Law 111-203, § 763(c) (adding Section 3D(a)(1) and (d)(1) of the Exchange Act).

A key issue noted at the Roundtable and raised by market participants generally regarding Dodd-Frank Act implementation is the scope of the definition of “security-based swap execution facility.”
37

SB swap industry participants have expressed an interest in, and offered their views on, the parameters of the definition of SB SEF.
38

Such participants asserted that the interpretation of the definition of SB SEF is a significant issue for the SB swap industry because, under the mandatory trade execution requirement in Section 3C(h) of the Exchange Act, a SB swap subject to mandatory clearing must be executed on a SB SEF or on an exchange, if made available for trading. The discussion below sets forth the Commission's preliminary view as to the meaning of the various elements of this definition.

37

See, e.g.,
Bloomberg Letter,
supra
note 23, at 2, and MFA Letter,
supra
note 23, at 16.

38

See supra
notes 23 to 25.

The “multiple participant to multiple participant” requirement in the definition of SB SEF prescribes that “multiple participants have the ability to execute or trade security-based swaps by accepting bids and offers made by multiple participants in the facility or system.”
39

Consistent with this requirement, the Commission proposes to interpret the definition of SB SEF to mean a system or platform that allows more than one participant to interact with the trading interest of more than one other participant on that system or platform. The Commission notes that this definition can be satisfied by various types of platforms, but some platforms that are currently used to trade SB swaps in the OTC market would not meet this definition, and would not be considered SB SEFs. As noted above, the Commission is aware that the movement of SB swaps trading onto regulated platforms is still in an emergent stage. Therefore, in considering ways in which the Commission could approach the definition of SB SEF, the Commission has sought to facilitate competition and innovations in the SB swaps market that could be used to promote more efficient trading in organized, transparent and regulated trading venues to support the Dodd-Frank Act's goal of moving the trading of SB swaps onto regulated markets.

39

See
Public Law 111-203, § 763(a) (adding Section 3(77) of the Exchange Act).

Under this proposed interpretation, if a system or platform were to allow an individual participant (of which there must be more than one on the system, but which do not need to be acting simultaneously) to send, at the same time, a single RFQ to all other liquidity providing participants on that system or platform and view responses from those participants, the Commission believes that such a model would satisfy the requirements of the statutory definition, even if the quote requesting participants are acting at different times. A key element to this model is that the SB SEF would not be able to limit the number of liquidity providing participants from whom a participant could request a quote on the SB SEF.
40

40

See infra
Section VIII.C.

The Commission further believes that the requirements of the statutory definition would be met if the system or platform not only provided the quote requesting participant with the ability to send a single RFQ to all liquidity providing participants, but also provided the quote requesting participant with the ability to choose to send an RFQ to fewer than all liquidity providing participants. In the Commission's view, a system or platform that affords a quote requesting participant the ability to send an RFQ to all participants, but also permits the quote requesting participant to choose to send an RFQ to fewer participants, would satisfy the statutory definition because multiple participants would have
the ability
to execute or trade SB swaps by accepting bids or offers made by multiple participants. The person exercising investment discretion for the transaction, whether it is the participant itself or the participant's customer, would be the person that would have the ability to choose to send the RFQ to less than all participants, as they would be in the best position to determine the impact on their interest of a broad or narrow dissemination of their RFQ.
41

41
Regardless of the number of participants to which a RFQ was sent, the response(s) to that RFQ would be required to be included in the composite indicative quote of the SB SEF.
See infra
note 152 and accompanying text.

Under the proposed interpretation of the definition of SB SEF, a SB SEF would be able to offer functionality to a participant (or a participant's customer) enabling that participant to choose to send a single RFQ to any number of specific liquidity providing participants on the SB SEF, including just a single liquidity provider. The

Commission requests comment on whether in addition to providing this flexibility to investors initiating RFQs, the interpretation should also set a floor for the minimum number of liquidity providers that must be included in an RFQ (and, if so, what that minimum number should be). Commenters should be mindful that in proposing its interpretation of the definition of SB SEF, the Commission is trying to balance the above-stated goal of encouraging SB swap trading to move onto regulated markets with the goal of promoting greater transparency in the trading of SB swaps.

On the one hand, providing investors as much choice as possible in determining how to route an RFQ on a SB SEF may incentivize investors to trade on a SB SEF when they otherwise might not have made that choice. Since those investors that have a fiduciary duty must seek best execution for a transaction, they may have a natural incentive to route to multiple dealers. However, this incentive may be impacted by the liquidity characteristics of the SB swap. Market participants, including dealers and buy-side customers, have raised concerns regarding pre-trade transparency of SB swap trades, particularly block trades. They believe that if other market participants know the terms of a trade prior to the time it is executed, those other market participants could attempt to profit from the information about the trade to the detriment of the initiator of the trade.
42

Therefore, particularly for illiquid SB swaps, an investor may determine that it is in its best interest not to broadly project its trading intention, and may choose to send a RFQ to one dealer.
43

Other investors could still benefit by the request because the response to that RFQ would become part of the composite indicative quote of that SB SEF.
44

Providing investors the choice to send a RFQ to only one dealer on a SB SEF—as long as they have the ability to send it to more than one if they chose to—may encourage investors to execute trades on a SB SEF even with respect to SB swaps that are not required to be traded on a SB SEF or an exchange, thus supporting the development of trading on regulated platforms and venues in the United States, rather than in other jurisdictions.

42

See
discussion in Section VIII.C and D
infra.

43

See
Reporting and Dissemination Release,
supra
note 6, at 89-93.

44

See
discussion of proposed Rule 811(d)(5) in Section VIII.C
infra.

On the other hand, requiring that all RFQs on a SB SEF be sent to more than one dealer could force competition among dealers more than if RFQs to a single dealer were permitted. This competition may lead to lower spreads as dealers compete with each other on price. Further, this competition may provide for a more robust composite indicative quote because a greater number of responses would be incorporated into the composite. In addition, requiring that RFQs be sent to more than one dealer provides for the possibility that a response from a dealer other than the one with whom the investor may have “pre-arranged” the transaction will result in a better price. However, market participants have expressed a concern that requiring a broad level of pre-trade transparency, particularly for illiquid products, may not lead to better prices and in certain circumstances may lead to worse prices provided by dealers if dealer hedging is made more difficult after the intent to trade has been projected to the entire market.

In addition, the Commission proposes to interpret the statutory requirement that “multiple participants have the ability to execute or trade SB swaps by accepting bids and offers made by multiple participants in the facility or system” to require a SB SEF to provide at least a basic functionality to allow any participant on the SB SEF the ability to make and display executable bids or offers accessible to all other participants on the SB SEF, if the participant chooses to do so. The Commission preliminarily believes that such a requirement would allow for increased price transparency beyond what would be found in the bilateral OTC market, if a market participant chooses to utilize the functionality to display a bid or offer.

Under the proposed interpretation of the definition of SB SEF (either with or without the additional requirement for a minimum number of liquidity providers to be included in every RFQ), the traditional bilateral negotiation model, as described above, would not fall within the definition of SB SEF because there would be only one party able to seek a quote and only one party that is able to provide a quote in response. The Commission believes that the inclusion of the phrase “through any means of interstate commerce” in the definition of SB SEF would not, by itself, support the proposition that bilateral negotiation would satisfy the definition's terms; the trading system or platform would still need to meet the other requirements of the definition, specifically, the requirement that multiple participants have the ability to execute or trade SB swaps by accepting bids and offers made by multiple participants in the facility or system (“multiple participant to multiple participant requirement”).

Likewise, a platform where there is a single dealer interacting with multiple customers on the other side of the transaction would not appear to meet the “multiple participant to multiple participant” requirement because the dealer is only one person. This would be true for aggregated single-dealer platforms as well, because a participant on such a platform may only submit one request at a time and receive only one response at a time, on a dealer-by-dealer basis.

The Commission proposes that the definition of SB SEF cannot be satisfied by the simple aggregation of trading interest across trading systems or platforms to meet the “multiple participant to multiple participant” requirement. That is, each trading method—when viewed in isolation—would need to individually meet the “multiple participant to multiple participant” requirement on its own. Thus, an entity that relies on a bilateral negotiation system with one participant on each end of the telephone or similar communication system, but with several such conversations occurring simultaneously, could not claim to meet the definition of SB SEF by asserting that when those conversations are viewed in the aggregate,
i.e.,
bilateral negotiation between persons A and B to facilitate one transaction, and bilateral negotiation between persons C and D, to facilitate a separate transaction, that the “multiple participant to multiple participant” requirement is met.
45

Two independent single-dealer platforms also may not be construed in the aggregate in order to meet the “multiple participant to multiple participant” requirement. In each of these situations, there is no opportunity for interaction among participants, except on a “one participant to one participant” basis.

45
However, as discussed further below in the discussion of the application of the definition of SB SEF to wholesale brokers, if person A negotiates with persons B, C and D as part of the same transaction, the “multiple participant to multiple participant” requirements may be able to be met.
See infra
note 46 and accompanying text.

However, a system or platform that provides for an auction for a class of SB swaps to be held at a prescribed time and that allows multiple participants to interact with each other, with trades executed pursuant to a pre-determined algorithm, could meet the proposed interpretation of the definition of SB SEF. In addition, the Commission believes that a limit order book system as described above for the trading of SB swaps could satisfy the proposed interpretation of the definition of SB

SEF. Such a model generally would allow interaction between multiple (
i.e.,
two or more) firm orders or bids and offers. Moreover, to satisfy the definition of SB SEF, a system or platform would not need to be limited to only one type of trading model. An entity that wishes to register as a SB SEF could operate different trading models for different SB swap products, as long as each trading system or platform on its own meets the interpretation of the definition of SB SEF that the Commission may adopt. For example, a SB SEF could operate both a multi-dealer RFQ mechanism for the trading of less liquid SB swaps and a limit order book for the trading of more liquid SB swaps.

The Commission has considered whether brokerage trading, as described above, would satisfy its proposed interpretation of the definition of SB SEF. On the one hand, brokerage trading relies to a certain degree on “voice” communication, such as telephonic communication between the broker and its customers. On the other hand, the wholesale broker
46

acts as an intermediary between various potential participants to a SB swap transaction, and may utilize electronic systems to display trading interest with which various participants could interact to transact in SB swaps. In some respects, the wholesale broker's role is similar to that of a floor broker on an exchange, in which the floor broker may use voice communication to find trading interest on the floor that can interact with an order from its customer. If after the wholesale broker receives a request from a customer (of which there must be more than one, but which do not need to be acting simultaneously) to execute a trade in a SB swap, and the broker then submits that request to all participants on the system or platform (or to less than all participants, if the customer has chosen to have the request sent to less than all participants), the Commission preliminarily believes that such a model could satisfy the Commission's proposed interpretation of the definition of SB SEF. Thus, the brokerage trading model may be able to satisfy the Commission's proposed interpretation of the definition of SB SEF to the extent that multiple participants would have access to the system or platform and their trading interest could interact with bids and offers of multiple other participants in that system or platform. Unless explicitly requested by the customer, for any given transaction if a wholesale broker typically acts only as the intermediary between a given customer and a single counterparty to facilitate the negotiation of a bilateral contract, the Commission does not believe this wholesale broker would meet the proposed interpretation of the definition of SB SEF. Because of the different variations of the wholesale broker system, however, each system would have to be evaluated on its own merits to determine whether it would meet the Commission's proposed interpretation of the definition of SB SEF.

46
For purposes of this proposing release, the term “wholesale brokers” generally refers to brokers that intermediate transactions in SB swaps between dealers or between dealers and end users.

The Commission's proposed interpretation of the definition of SB SEF would result in permitting to be registered as SB SEFs systems or platforms for the trading of SB swaps with a variety of features, and not just those systems or platforms with exchange-like features (for example, systems requiring all trading interest to be firm and displayed to all participants in the market). The concern with taking the latter approach is that the market for many SB swaps is fairly illiquid.
47

However, in the context of SB swaps that are subject to the mandatory clearing requirement, the Exchange Act requires that the trading of SB swaps must occur on a SB SEF or on an exchange, if the SB swap is made available for trading (unless certain exceptions apply). Thus, requiring every registered SB SEF to operate like a national securities exchange could result in (1) cleared SB swaps not being made available to trade on an exchange or SB SEF, with the result that SB swaps would continue to trade in the OTC SB swap market; or (2) if SB swaps subject to mandatory clearing are made available to trade on an exchange or SB SEF, the continued development of the SB swap market could be hindered, if participants are unwilling to display two-sided firm quotes to participants or if the requirement to do so results in bid-offer spreads that are so wide as to not be economical). If the definition of SB SEF is too narrowly construed, this could provide a disincentive for SB swap trading activity to move from the OTC swap market to regulated markets. A broader interpretation of the definition of SB SEF could have the beneficial result of increasing the proportion of trading occurring on regulated markets. Conversely, if the definition of SB SEF is too broadly construed, the Commission's regulatory scheme may not adequately advance the Dodd-Frank Act's goal of greater transparency. The Commission's proposed interpretation of the definition of SB SEF is intended to balance these concerns, promoting transparency as well as providing incentives for market participants to trade SB swaps on regulated markets pursuant to Commission rules and oversight, rather than in the OTC swap market.

47

See supra
note 35.

The Commission notes that no matter what other functionality a SB SEF puts in place (for example, a multi-dealer electronic RFQ mechanism), it also would be required to provide a basic functionality to allow any participant on the SB SEF the ability to make and display executable bids or offers accessible to all other participants on the SB SEF, if the market participant chooses to do so.

Considering the early stage of development of the regulatory framework for the SB swap market and the existing structure of the SB swap market, the Commission is mindful that its interpretation of the definition of SB SEF, and the rules it is proposing herein to implement the Dodd-Frank Act, could have unforeseen consequences, either beneficial or undesirable, with respect to the shape that this market will take. In the Commission's view, it is important that the regulatory structure will provide incentives for the trading of SB swaps on regulated markets that are designed to foster greater transparency and competition that are subject to Commission oversight, while at the same time allow for the continued efficient innovation and evolution of the SB swap market. The Commission therefore is seeking where appropriate to take a deliberate and attentive approach to the regulation of SB SEFs that is informed by the state of development of the trading of SB swaps on regulated markets.

C. Request for Comments

The Commission seeks commenters' views and suggestions on its proposed interpretation of the definition of SB SEF. Comment is requested on whether the Commission's proposed interpretation, which would require an RFQ to be sent to all participants but would allow the quote requesting participant to query less than all participants, is appropriate, or whether it is too narrow or too broad. Are there other interpretations of the statutory definition that would promote price transparency and competition, as well as incenting market participants to trade on SB SEFs rather than in the OTC market? If so, please explain. Does the proposed ability of the quote requesting participant to choose to send a RFQ to less than all participants, raise any concerns? Should the decision to

exercise the ability to choose to send a RFQ to less than all participants be required on a transaction-by-transaction basis? Why or why not? When should the opt-out feature be permitted other than on a transaction-by-transaction basis? What would be the potential benefits or costs of allowing an RFQ to be submitted to only one participant? What would be the potential benefits or costs of requiring that an RFQ be sent to more than one participant? If the Commission were to require that an RFQ be sent to more than one participant, how many should be the minimum? Should the Commission require that an RFQ be sent to two participants? Five participants (which is the number proposed by the CFTC)?
48

Or some other number of participants? Which approach—allowing a RFQ to be sent to one participant or requiring a minimum number greater than one—would better promote transparency? Which approach would encourage greater trading of SB swaps on SB SEFs? What impact, if any, would the various approaches have on market participants' incentives to trade within the United States or in other jurisdictions? How should the Commission weigh the possibility that trading may move to other jurisdictions in determining how best to regulate markets within the United States? What would be the costs and benefits to such an approach? What if only a small number of dealers were willing to provide quotes on the platform or in a particular SB swap?

48

See
Notice of proposed SEF rulemaking by the CFTC,
supra
note 17 (requiring that RFQs be disseminated to at least five participants).

Should the proposed interpretation that affords the ability to opt to have a RFQ sent to less than all participants be limited to block trades? Should a proposed interpretation that affords the ability to opt to have a RFQ sent to one participant be limited to block trades? What would be the benefits and costs of allowing the opt-out flexibility, to any number of participants, for block trades? For non-block trades? Are there factors that would cause a different result for block trades versus non-block trades? Would the flexibility for participants to choose to send a RFQ to less than all participants, including to just one participant, help to address concerns about the impact of pre-trade transparency on dealers' incentives or ability to provide competitive prices, as discussed more fully in Section VIII.C? If so, how so? If not, why not?

The Commission also is interested in learning commenters' views on whether the market for SB swaps would be enhanced or adversely affected by its proposed interpretation of the definition of SB SEF and, if so, in what ways.

Should there be a requirement that the execution of trades or the submission of bids and offers be done electronically?

Would the proposed requirement that an SB SEF provide functionality to allow any participant on an SB SEF to make and display executable bids or offers accessible to all market participants on the SB SEF, if the market participants choose to do so, be beneficial? What, if any, impact would requiring this functionality have on access to the SB SEF, or liquidity of the SB swaps traded on the SB SEF? Should the proposed requirement be modified? If so, how? What would be the advantages and disadvantages of such a proposal? Do commenters believe that market participants would utilize this functionality? Should the Commission require any particular method of displaying such bids or offers? For example, should the Commission require that the SB SEF post all of these executable bids and offers on a centralized screen visible by all participants? What would be the advantages and disadvantages of having such a centralized screen? What other method could be utilized to display such bids and offers?

In addition, the Commission requests comment on the consequences of its proposed interpretation of the definition of SB SEF on existing platforms that may seek to register as a SB SEF and on those platforms that would not be able to meet the proposed interpretation of the definition of SB SEF. What kinds of changes would existing platforms need to make to their current structure to fall within the proposed interpretation of the definition of SB SEF? Are there existing platforms that would not be able to restructure to meet the proposed interpretation,
e.g.,
single-dealer RFQ platforms? If so, what impact, if any, would that outcome have on the market for SB swaps? Are single-dealer platforms likely to become obsolete as trading of certain SB swaps moves to SB SEFs? Or, are such platforms likely to continue to exist to support the OTC market? What impact would the proposed interpretation have on competition among existing trading platforms and liquidity in SB swaps as trading of certain SB swaps moves to SB SEFs? Are new platforms likely to emerge to trade SB swaps?

The Commission is interested in learning commenters' views on the effect on the SB swap market if certain trading platforms would not meet the proposed interpretation of the definition of SB SEF and would not be able to register as a SB SEF, and therefore no longer would be able to trade SB swaps that are subject to mandatory clearing and are made available to trade on a SB SEF or an exchange. Are there any types of trading venues so critical to the proper functioning of the SB swap market that the Commission should consider expanding the proposed interpretation of the definition of SB SEF so that such entities could qualify as SB SEFs? If so, what trading platforms are they and what kinds of conditions should they be subject to? Should any such expansion of the proposed interpretation of the definition of SB SEF to cover such platforms be temporary and, if so, for how long? What would be the impact of such action on any platform that could meet an unexpanded definition of SB SEF? Market participants have expressed concern about the trading of illiquid SB swaps once platforms are configured to meet the statutory definition of SB SEF, particularly in light of the mandatory trade execution requirement. The Commission requests comment on the effect of its proposed interpretation of the definition of SB SEF on the trading of illiquid SB swaps. Would a multi-dealer RFQ system as discussed above sufficiently accommodate the trading of illiquid SB swaps? If not, what other models could meet the statutory definition of SB SEF and accommodate the trading of illiquid SB swaps? Would an interpretation of the definition of SB SEF that would allow an investor to choose to send an RFQ to one participant effectively accommodate the trading of illiquid SB swaps? Would an interpretation of the definition of SB SEF that would require that an RFQ be sent to more than one participant effectively accommodate the trading of illiquid SB swaps? In responding to these questions, the Commission requests that commenters take into account the Commission's discussion of SB swaps that are made available to trade in Section VIII.B below.

The discussion above contains several examples of trading models that the Commission believes would meet the statutory definition of SB SEF. Are there other trading models not discussed above that would meet the statutory definition of SB SEF? The discussion above also contains several examples of trading models that the Commission believes would not meet the statutory definition of SB SEF. Are there other models that should be excluded from the proposed interpretation?

The Commission seeks commenters' views on the role of wholesale brokers in the SB swap market and its view that trading of SB swaps by such brokers

potentially could satisfy the proposed interpretation of the definition of SB SEF. As noted above, the Commission has identified bilateral negotiation,
e.g.,
a trade occurring between two parties via the telephone, as a model that would not meet its proposed interpretation of the definition of a SB SEF. The Commission understands that wholesale brokers often act as intermediaries in executing SB swap transactions and may engage in bilateral negotiation when they attempt to complete an order. The Commission further understands that the orders that wholesale brokers attempt to fill may be large and that, as a result, they may interact with multiple participants in attempting to execute the transactions. The Commission also understands that these brokers may also maintain electronic systems for the display of trading interest that their customers can access. Do commenters agree that bilateral negotiation by wholesale brokers, by itself, should not meet the proposed interpretation of the definition of SB SEF? Is the Commission's view correct that there are ways in which wholesale brokers could restructure their operations to meet the proposed interpretation of the definition of SB SEF? How would such platforms or systems be structured to meet the proposed interpretation? What would be the impact on the SB swap market of any restructuring of a wholesale broker's business to meet the Commission's proposed interpretation of the definition of SB SEF, particularly in light of the fact that trades in SB swaps today frequently occur through bilateral negotiation? For those wholesale brokers that currently effect transactions in SB swaps, would the modifications that a wholesale brokerage firm would be required to make to satisfy the proposed interpretation of the definition of SB SEF, the proposed rules implementing the Core Principles, and the proposed registration requirements be too costly or otherwise impracticable to meet so that the firm would find it difficult to register as a SB SEF? The Commission recognizes that wholesale brokerage activities differ from dealer to customer activities in effecting SB swap transactions. Certain proposed requirements discussed below, such as impartial access, may affect wholesale brokers differently than SB SEFs that are not operated by such brokers. Comment is requested on any such different impact on wholesale brokers that intend to operate SB SEFs, including the costs and benefits of such impact. Should the Commission view wholesale brokers' SB SEF operations differently than the operations of other SB SEFs? If so, how so?

Another example of a trading platform that could meet the proposed interpretation of the definition of SB SEF would include a multi-dealer RFQ model. Do commenters agree that the definition of SB SEF should cover these types of trading platforms? If so, why? If not, why not?

Market participants also have expressed concern about any proposed interpretation of the definition of SB SEF that would result in others discerning their proprietary trading strategies. What would be the impact of the Commission's proposed interpretation of the definition of SB SEF on these concerns? Would one or more of the models discussed above that would meet the proposed interpretation of the definition of SB SEF provide an adequate level of comfort for these market participants? If not, is there a model that would meet the statutory definition of a SB SEF and yet account for these market participants' concerns?

As noted above, the Commission recognizes that the regulatory framework for the SB swap market is still in its early stages of development. What would be the impact on innovation in the SB swap market as a result of the proposed interpretation of the definition of SB SEF?

For example, under the proposed interpretation of the definition of a SB SEF, the SB SEF must provide a mechanism for the dissemination of firm quotes, if any, submitted by participants in the SB SEF. This functionality would allow a “limit order-book” model to emerge in parallel with other trading models on the SB SEF, including RFQ mechanisms, provided that each model meets all SB SEF requirements discussed above. The proposed interpretation is based on the premise that allowing more than one type of trading model to qualify as a SB SEF would, among other things, provide investors with more choices as well as encourage more types of SB swaps to trade on venues regulated by the Commission. Is there any scenario where this flexibility could impact competition or innovation because dealers may have their own preferences for one model over another? If so, under what scenario could this occur, and what consequences could result? For example, would the concentration of trading in the SB swap market raise concerns that, and provide incentives for, market participants that have a significant portion of the trading volume for certain types of SB swaps in one type of market structure to resist trading those SB swaps in a market structure that might otherwise be more efficient for that particular product?

The Commission also is interested in learning whether its proposed interpretation of the definition of SB SEF would influence market participants' decisions regarding the jurisdiction in which to execute their SB swap trades. Would the proposed interpretation affect a market participant's decision as to the jurisdiction in which to execute SB swaps transactions? If so, how? What other factors might also influence that decision, and how would those factors weigh against this factor? The Commission seeks commenters' views on whether, the ways in which, and to whom any migration to a different jurisdiction would be beneficial or adverse.

Commenters are urged, when considering all questions regarding the Commission's proposed interpretation of the definition of SB SEF, to take into account the rules being proposed by the Commission to implement the Core Principles, particularly the rules regarding the treatment and interaction of trading interest on a SB SEF, as discussed below.
49

The 14 Core Principles set forth in Section 3D(d) of the Exchange Act are integral to the regulation of a SB SEF. The Commission, in Sections VIII to XXII of this release, is proposing various rules to implement these Core Principles, as well as proposed registration requirements. The Commission also is interested in commenters' views on whether the Commission's proposed interpretation of the definition of SB SEF, along with its proposed rules implementing the Core Principles and proposed registration requirements, in the aggregate, are too permissive, are appropriate, or are too burdensome at this stage of development of the SB swap market. If commenters believe that the proposals in the aggregate are too permissive, the Commission is interested in being informed of ways in which they could be enhanced. If commenters believe that the proposals in the aggregate are too burdensome, the Commission is interested in being informed of ways in which they could be modified.

49

See infra
Section VIII (discussing Core Principle 2 and the requirements relating to a SB SEF's trading rules).

The Commission is interested in learning commenters' views on whether the combination of the proposed interpretation of the definition of SB SEF, its proposed rules implementing the Core Principles, and its proposed registration requirements would be too

onerous and thus would make it impractical or economically infeasible for entities that currently trade SB swaps to modify their procedures, personnel, systems or platform in order to operate as a SB SEF. If this is the case, the Commission seeks commenters views on ways that its proposed interpretation of the definition of SB SEF, its proposed rules implementing the Core Principles, or its proposed registration requirements could be modified so that entities that currently trade SB swaps could continue to do so and at the same time the statutory requirements of the Dodd-Frank Act relating to SB SEFs would be met. In particular, the Commission requests comment on the question of whether it should adopt a phased approach to the implementation and/or application of the proposed rules, whereby certain provisions would become operational only when certain designated timing, volume, liquidity, or other thresholds were met.
50

The Commission seeks commenters' views on the steps it could take to facilitate the transition to a more regulatory environment for those entities that currently trade SB swaps and expect to register as SB SEFs.
51

50

See infra
the discussion in Section XXV regarding a phased approach to implementation.

51

See infra
Section XXI.A.2 seeking commenters' views on a possible phased-in approach to any rules that the Commission may adopt with respect to SB SEFs.

IV. Exemption From the Definition of Exchange for Security-Based Swap Execution Facilities

An entity that meets the definition of SB SEF in Section 3(a)(77) of the Exchange Act may also meet the definition of “exchange” set forth in Section 3(a)(1) of the Exchange Act,
52

certain of the terms of which have been interpreted by the Commission in Rule 3b-16 of the Exchange Act.
53

The Commission believes that Congress did not intend that entities that meet the definition of SB SEF in Section 3(a)(77) of the Exchange Act and that comply with Section 3D of the Exchange Act and the rules and regulations promulgated by the Commission (including the requirement to register as a SB SEF) also would be subject to various requirements applicable to exchanges, including registration as a national securities exchange.
54

52
15 U.S.C. 78c(a)(1). The term “exchange” means any organization, association, or group of persons, whether incorporated or unincorporated, which constitutes, maintains, or provides a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange as that term is generally understood, and includes the market place and the market facilities maintained by such exchange.

53
17 CFR 240.3b-16 defines the phrase “market place or facilities for bringing together purchasers or sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange” to mean an organization, association or group of persons that (1) brings together the orders for securities of multiple buyers and sellers; and (2) uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of the trade.

54

See, e.g.,
Section 6 of the Exchange Act, 15 U.S.C. 78f, which, among other things, requires a national securities exchange to enforce compliance by its members and their associated persons with the Exchange Act and rules and regulations thereunder, as well as with the exchange's rules. National securities exchanges are self-regulatory organizations (“SROs”) for purposes of the Exchange Act and are subject to the requirements of Sections 17 and 19 of the Exchange Act, 15 U.S.C. 78q and78s. Section 17(a)(1) requires national securities exchanges to make and keep records for prescribed periods, and to furnish such records to the Commission as well as any related reports. Section 19(b) requires, among other things, SROs to file proposed rule changes with the Commission.

Section 3(a)(77) of the Exchange Act defines a SB SEF as a trading system or platform in which multiple participants have the ability to execute or trade SB swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that: (1) Facilitates the execution of SB swaps between persons; and (2)
is not a national securities exchange
(emphasis added).
55

Further, Section 3C(h) of the Exchange Act provides that transactions involving SB swaps subject to the clearing requirement be executed on either (1) an exchange or (2) a SB SEF registered under Section 3D of the Exchange Act or exempt from registration (unless no exchange or SB SEF makes the SB swap available to trade or the SB swap transaction is subject to a clearing exception).
56

Finally, Section 3D(a)(1) of the Exchange Act provides that no person may operate a facility for the trading or processing of SB swaps, unless the facility is registered as a SB SEF or as a national securities exchange.
57

The Commission interprets these provisions to mean that an entity that is registered as a SB SEF cannot also be a national securities exchange; that an exchange and a SB SEF registered under Section 3D of the Exchange Act (or exempt from such registration) are separate categories of regulated entities for the trading of SB swaps; and that an entity registered as a SB SEF would not also be required to register as a national securities exchange.

55

See
Public Law 111-203, § 761(a) (adding Section 3a(77) of the Exchange Act).

56

See
Public Law 111-203, § 763(a) (adding Section 3C(h) of the Exchange Act). The Commission notes that in this section Congress chose to use the term “exchange” as opposed to “national securities exchange.” An exchange only becomes a “national securities exchange” upon registration with the Commission pursuant to Section 6 of the Exchange Act.

57

See
Public Law 111-203, § 763(c) (adding Section 3D(a)(1) of the Exchange Act).

Section 36 of the Exchange Act
58

gives the Commission broad authority to exempt any person, security, or transaction from any provision of the Exchange Act and any rule or regulation thereunder. Such an exemption may be subject to conditions. Using this authority, the Commission is proposing to amend Rule 3a1-1 of the Exchange Act
59

by adding paragraph (a)(4) to exempt any SB SEF from the definition of “exchange,” if such SB SEF provides a marketplace solely for the trading of SB swaps (and no other security) and complies with the provisions of proposed Regulation SB SEF.
60

The effect of this exemption would be that an entity that registers as a SB SEF would not also have to register as a national securities exchange.

58
15 U.S.C. 78mm.

59
17 CFR 240.3a1-1.

60

See
proposed Rule 3a1-1(a)(4).

The Commission preliminarily believes that this proposed exemption is necessary and appropriate in the public interest and is consistent with the protection of investors because it would effectuate the intent of the Dodd-Frank Act, as expressed in Sections 3(a)(77), 3C(h) and 3D(a)(1) of the Exchange Act, and it would eliminate what the Commission believes would be a largely duplicative oversight of SB SEFs. The Commission believes that Congress specifically provided a comprehensive regulatory framework for SB SEFs in the Exchange Act, as amended by the Dodd-Frank Act, and therefore that such entities that are registered as SB SEFs should not also be required to register and be regulated as national securities exchanges. The Commission notes that a registered SB SEF that chose to provide a marketplace for the trading of any security other than a SB swap would not be in compliance with the exemption in proposed Rule 3a1-1(a)(4). Also, as the SB swaps markets continue to evolve, the Commission will continue to assess the appropriateness of, and/or take action with respect to, the proposed exemption from the definition of exchange.

The Commission requests comment on the proposed exemption in Rule 3a1-1(a)(4). Is the exemption necessary or appropriate? Are the conditions to the proposed exemption appropriate or should there be any additional

conditions? What are the benefits or drawbacks of the proposed exemption?

The definition of “security-based swap execution facility” and the definition of “exchange” (certain terms of which have been interpreted by Rule 3b-16 under the Exchange Act) are similar in that they both include the concept of multiple participants and multiple buyers and sellers, respectively. However, these definitions are not identical. It is possible that an entity that trades SB swaps would meet the criteria of Rule 3b-16 but not the definition of SB SEF contained in Section 3(a)(77) of the Exchange Act. If such an entity trades SB swaps that are subject to mandatory clearing and that are made available to trade on an exchange or SB SEF, it would be required to register as a national securities exchange, absent a limited volume exemption pursuant to Section 5 of the Exchange Act.
61

Should the Commission permit such a platform to register as a SB SEF pursuant to Section 3D(a)(1) of the Exchange Act?
62

Should the Commission instead provide an exemption from the definition of exchange for such an entity? If so, why, and what should be the conditions to any such exemption? What would be the benefits or drawbacks of any such exemption?

61
The trading of a SB swap on an ATS when that SB swap is subject to mandatory clearing and is made available to trade on a SB SEF or a national securities exchange would not satisfy the requirement of Section 3C(h) of the Exchange Act. Section 3C(h) of the Exchange Act states that, with respect to transactions involving SB swaps subject to the clearing requirement of subsection (a)(1) of Section 3C of the Exchange Act, the counterparties shall (A) execute the transaction on an exchange; or (B) execute the transaction on a SB SEF registered under Section 3D of the Exchange Act or a SB SEF that is exempt from registration under section 3D(e) of the Exchange Act. Although, as noted above, Section 3C(h) uses the term “exchange” as opposed to “national securities exchange,” an ATS would not satisfy this requirement because an ATS is exempt from the definition of exchange pursuant to Rule 3a1-1 under the Exchange Act.

62
Section 3D(a)(1) of the Exchange Act states that “no person may operate a facility for the trading or processing of security-based swaps, unless the facility is registered as a security-based swap execution facility or as a national securities exchange under this section.” Section 3(a)(77) of the Exchange Act defines “security-based swap execution facility” to mean a trading system or platform in which multiple participants have the ability to execute or trade SB swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that (A) facilitates the execution of SB swaps between persons; and (B) is not a national securities exchange. The Commission interprets these two provisions, taken together, to require registration as a SB SEF or a national securities exchange for any entity that meets the definition of SB SEF in Section 3(a)(77) of the Exchange Act.

V. Conditional Exemption From Regulation as Brokers for Security-Based Swap Execution Facilities

An entity that meets the definition of “security-based swap execution facility” in Section 3(a)(77) of the Exchange Act also would meet the definition of “broker” set forth in Section 3(a)(4) of the Exchange Act.
63

The term “broker” is generally defined to mean any person engaged in the business of effecting transactions in securities for the account of others.
64

A SB SEF is defined as a trading system or platform in which multiple participants have the ability to execute or trade SB swaps by accepting bids and offers made by multiple participants in the facility or system, through any means of interstate commerce, including any trading facility, that: (A) Facilitates the execution of SB swaps between persons; and (B) is not a national securities exchange.
65

A SB SEF, by facilitating the execution of SB swaps between persons, also would be engaged in the business of effecting transactions in securities for the account of others and therefore would meet the statutory definition of “broker.” Absent an exception or exemption, a SB SEF that effects transactions in SB swaps would be required to register as a broker pursuant to Sections 15(a)(1) and (b) of the Exchange Act
66

and to comply with the reporting and other requirements applicable to brokers under the Exchange Act and rules and regulations thereunder.

63
15 U.S.C. 78c(a)(4).

64

Id.
The term “security” in Section 3(a)(10) of the Exchange Act includes a “security-based swap.”
See
15 U.S.C. 78c(a)(10).

65

See
Public Law 111-203, § 761(a) (adding Section 3(a)(77) of the Exchange Act).

66
15 U.S.C. 78o(a)(1) and (b). Section 15(a)(1) generally provides that, absent an exception or exemption, a broker or dealer that uses the mails or any means of interstate commerce to effect transactions in, or to induce or attempt to induce the purchase or sale of, any security must register with the Commission. Section 15(b) generally provides the manner of registration of brokers and dealers and other requirements applicable to registered brokers and dealers.

As the Commission noted in its discussion regarding the exemption from the definition of “exchange” for SB SEFs, the Exchange Act, as amended by the Dodd-Frank Act, sets forth a comprehensive regulatory framework for SB SEFs. The Commission believes that this framework indicates that Congress did not intend for entities that meet the definition of SB SEF in Section 3(a)(77) of the Exchange Act and that comply with Section 3D of the Exchange Act and the rules and regulations thereunder (including the registration as a SB SEF) also to be subject to all of the requirements set forth in the Exchange Act and the rules and regulations thereunder applicable to brokers.
67

As discussed above, the Exchange Act, as amended, establishes the statutory structure for SB SEFs to register with the Commission and for the Commission to adopt rules and regulations that require these entities to comply with the Core Principles and enforce compliance with those Core Principles and any rules or regulations that the Commission may adopt.

67
Brokers and dealers must comply with the Exchange Act provisions and rules and regulations thereunder applicable to them.
See, e.g.,
Section 15 of the Exchange Act, 15 U.S.C. 78o, and rules and regulations thereunder. For example, brokers and dealers must comply with a number of regulations that govern their conduct, such as rules relating to customer confirmations and disclosure of credit terms in margin transactions.
See
17 CFR 240.10b-10 and 17 CFR 240.10b-16. They also must comply with a number of financial responsibility regulations, such as the net capital and customer protection rules.
See
17 CFR 240.15c3-1 and 17 CFR 240.15c3-3. Among other things, registered brokers and dealers also must make and keep current books and records relating to their business and detailing, among other things, securities transactions, money balances, and securities positions; keep records for required periods and furnish copies of those records to the Commission on request; and file certain financial reports with the Commission.
See
17 CFR 240.17a-3, 17 CFR 240.17a-4, and 17 CFR 240.17a-5.

Section 36 of the Exchange Act gives the Commission broad authority to exempt any person, security, or transaction from provisions of the Exchange Act and the rules thereunder.
68

Such an exemption may be subject to conditions.
69

Using this authority, as well as its authority to establish procedures regarding the registration of brokers, the Commission is proposing Rule 15a-12 under the Exchange Act to allow a SB SEF that is a broker solely due to its activity with respect to SB swaps executed on or through the SB SEF to satisfy the requirement to register as a broker by registering as a SB SEF. Such person, however, must not engage in any activity that would require registration as a broker other than facilitating the trading of SB swaps on or through the SB SEF in a manner consistent with Regulation SB SEF. For example, acting as an agent to a counterparty to a SB swap trade or acting in a discretionary manner with respect to the execution of a SB swap trade would indicate that such person may be acting as a broker and, if the person is acting as a broker, it would be required to register as such, unless an exemption or exception from registration was available. If an entity, such as an inter-dealer broker, for example, elects not to separate its inter-

dealer broker from its SB SEF or create a subsidiary for its SB SEF, and instead chooses to operate the SB SEF as the same entity as the broker, the inter-dealer broker would not qualify for the exemption.

68
15 U.S.C. 78mm.

69

See id.

In addition, the Commission is proposing to conditionally exempt any SB SEF from the Exchange Act and the rules and regulations thereunder applicable to brokers, except Exchange Act Sections 15(b)(4), 15(b)(6), and 17(b).
70

Under the proposed Rule, three key provisions of the Exchange Act that serve as the basis for Commission examination and enforcement of the Federal securities laws with respect to a registered broker would continue to apply to a SB SEF that relies on the exemption in proposed Rule 15a-12. Section 17(b) of the Exchange Act
71

authorizes the Commission to conduct reasonable periodic, special, or other examinations, of “[a]ll records” maintained by entities described in Section 17(a),
72

including registered brokers.
73

These examinations may be conducted “at any time, or from time to time,” as the Commission “deems necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of [the Exchange Act].”
74

Proposed Rule 15a-12 also would not exempt a broker that registers as a SB SEF from the statutory disqualification provisions in Sections 15(b)(4) and (6) of the Exchange Act, both with respect to itself and with respect to its associated persons.
75

Further, pursuant to proposed Rule 15a-12(d), a broker registered under Section 15a-12(a) of the Exchange Act that does not engage in any activity other than the facilitating and trading of SB swaps on or through the SB SEF in a manner consistent with Regulation SB SEF would be exempt from the Securities Investor Protection Act (“SIPA”), including membership in the Securities Investor Protection Corporation.
76

70

See
proposed Rule 15a-12(c).

71
15 U.S.C. 78q(b).
See also
15 U.S.C. 78m(h)(4).

72
15 U.S.C. 78q(a).

73
15 U.S.C. 78q(b).

74

Id.

75
15 U.S.C. 78o(b)(4) and (6).
See also
15 U.S.C. 78c(a)(18) (defining “person associated with a broker or dealer” or “associated person of a broker or dealer”).

76
Section 36 of the Exchange Act gives the Commission broad authority to exempt any person, security, or transaction from any of the provisions of the Exchange Act. This authority would include the ability of the Commission to grant an exemption under Section 36 from certain requirements of SIPA.
See
Securities Exchange Act Release No. 40594 (October 23, 1998), 63 FR 59362, 59366, n. 31 (November 3, 1998).

The Commission believes that the exemption in proposed Rule 15a-12 under the Exchange Act is necessary and appropriate in the public interest and consistent with the protection of investors because it would eliminate what the Commission believes would be unnecessary additional regulation of SB SEFs. Because SB SEFs would be required to register as such under Section 3D of the Exchange Act, it would be unnecessary for them also to be subject to statutory and regulatory provisions governing brokers, subject to certain exceptions set forth in the proposed rule. The Commission believes that Congress specifically provided a comprehensive regulatory framework for SB SEFs in the Exchange Act, as amended by the Dodd-Frank Act, and therefore that such entities generally should not also be regulated as brokers where such regulation would be duplicative and unnecessary. As such, the Commission preliminarily believes that the broker registration and oversight process can be accomplished largely through the entity's registration as a SB SEF. In this regard, the Commission also believes that it would be unnecessary and inconsistent with the comprehensive regulatory framework for SB SEFs to require a SB SEF, which would not be a custodian of customer funds or securities and would not otherwise operate as a broker, to comply with SIPA. SIPA is a comprehensive regulatory scheme for the orderly liquidation of failed broker-dealers and the return of customer property. If additional regulation is developed for brokers, any application of such regulation to SB SEFs would be proposed by rule. Any order, such as a suspension of the registration or trading of a security pursuant to Sections 12(j) or 12(k) of the Exchange Act,
77

if applicable to a SB SEF, would specify that it would be applicable to a SB SEF.

77
15 U.S.C. 78
l
(j) and (k).

The Commission notes that it is not exempting SB SEFs from registration as brokers; rather, it is proposing to eliminate an additive layer of regulation that the Commission believes is not necessary in light of its regulatory oversight of SB SEFs. The Commission does not believe, however, that it would be in the public interest to exempt SB SEFs from the examination requirements of Section 17(b) of the Exchange Act, the statutory disqualification provisions of Sections 15(b)(4) and (6) of the Exchange Act.

The Commission requests comment on all aspects of its proposed rule. Specifically, the Commission requests comment on the scope, form, and conditions of the proposed exemption. Is the exemption necessary? Should the Commission add additional conditions to its exemption, including requiring compliance with any other statutory provisions or any other rules or regulations applicable to brokers? If so, which ones, and why? Should the Commission exempt SB SEFs from the provisions of SIPA? If not, why not?

The Commission seeks comment on whether there is a need for SB SEFs to become members of a national securities association. Would it be beneficial to require SB SEFs to become members of a national securities association to provide an additional level of regulatory oversight in addition to oversight by the Commission? Why or why not? Should the proposed exemption include a condition requiring SB SEFs to comply with Section 15(b)(8) under the Exchange Act,
78

which requires a registered broker to be a member of a registered national securities association unless such broker effects transactions solely on a national securities exchange of which it is a member? What would be the advantages or disadvantages of such membership?

78
15 U.S.C. 78o(b)(8).

As noted above, the proposed Rule would not apply in those instances when the SB SEF is engaging in activity that is not solely related to the execution of SB swaps on or through the facility,
e.g.,
when the broker provides services such as acting as an agent to a counterparty to an SB swap trade or acts in a discretionary manner with respect to the execution of SB swap trades. In such instances, should the broker be required to comply with all Exchange Act and Commission requirements relating to brokers? If so, how would the broker be able to separate its brokerage function from its activities as a SB SEF? What potential conflict concerns would be raised, if any, if an entity that was engaged in brokerage activity in SB swaps on a SB SEF were affiliated with that SB SEF, or if an entity were engaging in brokerage activity in SB swaps on a SB SEF in the same legal entity that operates the SB SEF? If commenters believe that such activity would raise concerns, should the Commission require the entity's brokerage activities and its SB SEF activities to be conducted on separate legal entities? Or, should the Commission impose requirements on the ability of a broker to be affiliated with a SB SEF? If so, what conditions should the Commission impose, and how would they address any potential conflict concerns?

Are there any potential conflict concerns raised if a wholesale broker is affiliated with a SB SEF, or is operating

in the same legal entity as a SB SEF? If so, what are those concerns, and what are commenters views on whether and how such concerns should be addressed?

What would be the effect of having SB SEFs join a registered securities association without having a comparable SRO for security-based swap dealers (“SB swap dealers”) or major security-based swap participants (“major SB swap participants”)? Because SB SEFs would be subject to regulatory obligations, should the Commission provide guidance on the acceptable scope of any outsourcing of regulatory matters that the SB SEF could undertake?

VI. Access to Security-Based Swap Execution Facilities

The Dodd-Frank Act does not define the categories of market participants that may have access to trading on a registered SB SEF or the terms of such access. For the purposes of providing guidance on this issue and to ensure that SB SEFs grant access to their markets in a manner that is consistent with the Core Principles in Section 3D of the Exchange Act, the Commission is proposing Rule 809 and 811(b). Proposed Rule 809 would set forth the categories of persons that would be permitted to have direct access to trading on a registered SB SEF as a participant and also the terms and conditions that the SB SEF would need to adopt for granting such access.
79

Proposed Rule 811(b) would elaborate on the standards for providing impartial access.
80

The purpose of the proposed rules is to ensure that access to SB SEFs is granted in a manner that strikes an appropriate balance between the statutory requirements of impartial access (Core Principle 2) and financial integrity of transactions (Core Principle 6) for SB SEFs.

79

See
proposed Rule 809.

80

See
proposed Rule 811(b).

The Commission understands that, currently, trades in SB swaps occur among dealers on OTC inter-dealer markets, and between dealers and end-user customers on single- or multi-dealer OTC dealer-to-customer markets or through bilateral negotiations. In addition, trading of SB swaps in these OTC markets is dominated by a small number of large swap dealers.
81

When a small group of market participants dominates much of the trading in SB swaps, and exerts control over access to the SB swaps market, it raises concerns about open access and competition. If SB SEFs are controlled by a small group of dealers who also dominate trading in the market for SB swaps, the dealers may have economic incentives to exert undue influence to restrict the level of access to SB SEFs and thus impede competition by other market participants in order to increase their ability to maintain higher profit margins.
82

At the same time, in the absence of clearing or other financial safeguards, counterparties assess the degree of credit risk posed by each other, and enter into SB swap transactions only with other persons deemed to have an acceptable level of credit risk. Therefore, in the OTC market for SB swaps, open access and containing counterparty credit risk may be viewed as competing and potentially conflicting goals.

81

See
Office of the Comptroller of the Currency (“OCC”), Quarterly Report on Bank Trading and Derivatives Activities, First Quarter 2010 (“Derivatives activity in the U.S. banking system continues to be dominated by a small group of large financial institutions. Five large commercial banks represent 97% of the total banking industry notional amounts * * *.”). Several commenters on proposed Regulation MC, however, took issue with this statistic because the OCC data included information about U.S. dealers only.
See, e.g.,
Letter from Barry L. Zubrow, Executive Vice President & Chief Risk Officer, JP Morgan Chase & Co., to Elizabeth M. Murphy, Secretary, Commission, and David A. Stawick, Secretary, CFTC, dated November 17, 2010.

82
In addition, these market participants might be motivated to restrict the scope of SB swaps that are made available for trading at SB SEFs if there is a strong economic incentive to keep such SB swaps in the OTC market. Conflicts of interest concerns relating to SB SEFs are discussed in greater depth in the release proposing Regulation MC, which recently was published by the Commission as part of a rulemaking mandated by Section 765 of the Dodd-Frank Act.
See
Securities Exchange Act Release No. 63107 (October 14, 2010), 75 FR 65882 (October 26, 2010) (“Regulation MC Proposing Release”). Section 765 of the Dodd-Frank Act requires the Commission to adopt rules to mitigate specified conflicts of interest relating to SB SEFs, security-based swap clearing agencies, and SBS exchanges.

The Dodd-Frank Act addresses these competing concerns in several ways. Section 3C(a)(1) of the Exchange Act requires the mandatory clearing of SB swaps that the Commission determines must be cleared.
83

With respect to trading on SB SEFs, the Dodd-Frank Act requires SB SEFs to establish rules for both impartial access to their markets and the financial integrity of transactions on their markets, including with respect to clearance and settlement. Specifically, Core Principle 2 requires SB SEFs to provide market participants with impartial access to the market.
84

Under Core Principle 6, SB SEFs are required to establish and enforce rules and procedures for ensuring the financial integrity of SB swaps entered on or through the facilities of the SB SEF, including the clearance and settlement of SB swaps pursuant to Section 3C(a)(1) of the Exchange Act.
85

The Commission does not believe that the requirement for impartial access to a SB SEF under Core Principle 2 means that it must allow unfettered access to any and all persons. Rather, the requirements of Core Principle 6 that SB SEFs ensure the financial integrity of transactions on their markets, particularly with respect to the mandatory clearing requirement, permit SB SEF to have minimum standards for access to their markets, though such access must be provided on an impartial basis.

83

See
Public Law 111-203, § 763(a) (adding Section 3C(a)(1) of the Exchange Act). Section 3C(a)(1) makes it unlawful for a person to engage in a SB swap unless the SB swap is submitted for clearing to a registered clearing agency, if the SB swap is required to be cleared.

84

See
Public Law 111-203, § 763(c) (adding Section 3D(d)(2) of the Exchange Act).

85

See
Public Law 111-203, § 763(c) (adding Section 3D(d)(6) of the Exchange Act). Section 3C(a)(1) makes it unlawful for a person to engage in a SB swap unless the SB swap is submitted for clearing to a registered clearing agency, if the SB swap is required to be cleared.
See
Public Law 111-203, § 763(a) (adding Section 3C(a)(1) of the Exchange Act).

In recognition of the challenges in striking the balance between impartial access and financial integrity goals of the Dodd-Frank Act, and in view of the current dominance of trading in SB swaps in the OTC market by a small number of dealers, the Commission is proposing Rule 809 and Rule 811(b) to establish certain baseline principles for granting access to SB SEFs in compliance with the requirements of both Core Principles 2 and 6. Specifically, proposed Rule 809(a) through (c) and proposed Rule 811(b) would require that SB SEFs enact and apply objective standards for access to their markets, in compliance with the impartial access requirement of Core Principle 2. Proposed Rule 809(a) and (c)(1) through (4) would establish certain minimum, objective standards for SB SEF participants, in compliance with the financial integrity of transactions requirements of Core Principle 6.

A. Impartial Access

Proposed Rule 809(a) would provide that only registered SB swap dealers, major SB swap participants, or brokers (as defined in section 3(a)(4) of the Exchange Act), or eligible contract participants
86

would be eligible to

become participants in a SB SEF. Proposed Rule 809(b) would require a SB SEF to permit all eligible persons that meet the requirements for becoming a participant under Rule 809(a) and the SB SEF's rules to become participants in the SB SEF, consistent with the requirements for impartial access in Core Principle 2 and proposed Rule 811(b).
87

Proposed Rule 809(b) would, however, permit a SB SEF to choose to not permit any eligible contract participants that are not registered with the Commission as a SB swap dealer, major SB swap participant, or broker (as defined in section 3(a)(4) of the Act
88

) (“non-registered ECP”), to become participants in the SB SEF. Thus, under the proposed rule, while a SB SEF could choose to not allow any non-registered ECPs to become participants, if the SB SEF chose to permit such non-registered ECPs to become participants in the SB SEF, it could not selectively prohibit certain non-registered ECPs from becoming participants if they otherwise satisfied the SB SEF's requirements. In effect, proposed Rule 809(b) would limit the discretion involved in admitting participants to a SB SEF because it would impose an affirmative requirement on SB SEFs to grant qualified persons access to their markets as participants.
89

86
The term “eligible contract participant” is defined in Section 3(a)(65) of the Exchange Act as having the same meaning as in Section 1a of the CEA (7 U.S.C. 1a). As discussed above, this term

may be further defined by the Commission and the CFTC pursuant to various sections of the Dodd-Frank Act.
See supra
note 3.

87
Core Principle 2 requires a SB SEF to establish and enforce compliance with rules relating to any limitation on access to the facility and to provide market participants with impartial access to the market.
See
Public Law 111-203, § 763(c) (adding Section 3D(d)(2) of the Exchange Act).

88
15 U.S.C. 78c(a)(4).

89
This proposed requirement is analogous to the fair access requirement for national securities exchanges under Section 6(b)(2) of the Exchange Act, which also imposes an affirmative duty to admit qualified broker-dealers as members.
See
15 U.S.C. 78f(b)(2). “The rules of the exchange [must] provide that any registered broker or dealer or natural person associated with a registered broker or dealer may become a member of such exchange * * *.”

Proposed Rule 809(c) would require a SB SEF to establish rules setting forth requirements for eligible persons to become participants in the SB SEF consistent with the SB SEF's obligations under the Exchange Act and the rules thereunder, and includes certain enumerated minimum standards.
90

Proposed Rule 809(c), by requiring a SB SEF to codify its standards for becoming a participant in its market, would make the process of admitting participants transparent and rules-based, and thereby more objective. In addition, such rules would have to be consistent with proposed Rule 811(b), which would require every SB SEF to establish fair, objective, and not unreasonably discriminatory standards for granting impartial access to trading on the facility.
91

Proposed Rule 811(b) would require that a SB SEF may not unreasonably prohibit or limit any person with respect to access to the services offered by the SB SEF by applying those standards in an unfair or unreasonably discriminatory manner.
92

Proposed Rule 811(b)(3) also would require every SB SEF to make and keep records of all grants, denials, or limitations of access and to report that information on proposed Form SB SEF
93

and in the annual compliance report of the Chief Compliance Officer (“CCO”) pursuant to proposed Rule 823(c).

90

See
proposed Rule 809(c)(1)-(4) and
infra
notes 105-109 and accompanying text for a discussion of those proposed provisions.

91

See
proposed Rule 811(b)(1).

92

See
proposed Rule 811(b)(2).

93
The Commission is proposing that SB SEFs register on Form SB SEF.
See infra
Section XXII for a discussion of proposed Form SB SEF.

As was the case when the Commission adopted Regulation ATS,
94

these provisions are based on the principle that qualified market participants should have fair access to the nation's securities markets. Under the proposal, a SB SEF would have flexibility in establishing standards for impartial access so long as those standards are fair and objective and do not unreasonably discriminate, and the SB SEF does not apply the standards in an unfair or unreasonably discriminatory manner. For example, a SB SEF could establish objective minimum capital or credit requirements for participants, as long as they were not designed to, and did not have the effect of, unreasonably discriminating among persons seeking access to the SB SEF.
95

Similarly, a SB SEF could reasonably deny access to participants based on an unfavorable disciplinary history. Provided that these or other standards are objective and applied consistently to all potential participants, a SB SEF could be considered to be granting or denying access fairly. A denial of access might be unreasonable, however, if it were based solely, for example, on the business activities of a prospective participant that are unrelated to trading on the SB SEF.
96

94
17 CFR 242.300
et seq.

See
Securities Exchange Act Release No. 40760, (December 8, 1998), 63 FR 70844 (“ATS Adopting Release”) at notes 245 to 256.

95

See infra
Section XII for a discussion of the ability of a SB SEF to impose higher capital requirements.

96
The Commission also discussed fair access at length in the ATS Adopting Release.
See supra
note 94 at note 245.

The Commission believes that impartial access to SB SEFs would work in conjunction with rules proposed by the Commission to mitigate conflicts of interest that could arise when a small number of market participants, including their related persons, exercise control or undue influence over a SB SEF either through ownership of voting interests or participation in the governance of the SB SEF.
97

The Commission requests comment, however, on the extent to which both types of rules are necessary to ensure fair access to SB SEFs.

97

See
Regulation MC Proposing Release,
supra
note 82.

B. Financial Integrity

As noted above, proposed Rule 809(a) would permit only persons that are registered with the Commission as SB swap dealers, major SB swap participants, or brokers, or persons that are eligible contract participants (as defined in section 3(a)(65) of the Act) to become participants of a SB SEF.
98

Permitting registered SB swap dealers, major SB swap participants, and brokers to become participants would support the SB SEF's duty to ensure the financial integrity of transactions, including the clearance and settlement of SB swaps, under Core Principle 6.
99

Registered SB swap dealers, major SB swap participants, and brokers are all subject to, or would be subject to, minimum financial responsibility requirements (including margin and net capital requirements) and business conduct requirements as a result of their registered status under the Exchange Act, which the Commission believes would serve as a useful baseline for ensuring the financial integrity of their transactions entered on SB SEFs.
100

Moreover, the Commission notes that these registered persons are subject to Commission oversight for compliance with those requirements.
101

98

See
proposed Rule 809(a). The term “participant,” when used with respect to a SB SEF, would mean a person that is permitted to directly effect transactions on the SB SEF.
See
proposed Rule 800.

99
Core Principle 6 requires SB SEFs to establish and enforce rules and procedures for ensuring the financial integrity of SB swaps entered on or through the facilities of the SB SEF, including the clearance and settlement of SB swaps pursuant to Section 3C(a)(1) of the Exchange Act.
See
Public Law 111-203, § 763(c) (adding Section 3D(d)(6) of the Exchange Act).

100
The Exchange Act requires registered SB swap dealers and major SB swap participants to comply with certain minimum financial responsibility and business conduct requirements.
See
Public Law 111-203, § 764(a) (adding Sections 15F(e) and (h) of the Exchange Act). The financial responsibility and business conduct requirements applicable to registered SB swap dealers and major SB swap participants will be the subject of a separate rulemaking. Likewise, the Exchange Act requires registered brokers to comply with certain financial responsibility and business conduct obligations under Section 15(c) of the Exchange Act and the rules and regulations thereunder.
See
15 U.S.C.

78o(c), and Rules 15c1-2, 15c1-3, 15c2-1, 15c2-5, and 15c3-1 under the Exchange Act, 17 CFR 240.15c1-2, 15c1-3, 15c2-1, 15c2-5, and 15c3-1.

101
The Commission's regulatory and oversight authority includes and would include requirements to keep books and records open to the inspection and examination authority of the Commission.
See
Section 15F(f) of the Exchange Act, Public Law 111-203, § 764 (adding Section

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2011-2696. Public record. Not legal advice.