# Capital Requirements of Swap Dealers and Major Swap Participants

> Briefs, arguments, decisions, and more.

URL: https://www.frixlaw.com/law-library/documents/fr%3A2016-29368

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** December 16, 2016
- **Citation:** 81 FR 91252

## Text

COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1, 23, and 140
RIN 3038—AD54
Capital Requirements of Swap Dealers and Major Swap Participants

AGENCY:

Commodity Futures Trading Commission.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

The Commodity Futures Trading Commission (“Commission” or “CFTC”) is proposing to adopt new regulations and to amend existing regulations to implement sections 4s(e) and (f) of the Commodity Exchange Act (“CEA”), as added by section 731 of the Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). Section 4s(e) requires the Commission to adopt capital requirements for swap dealers (“SDs”) and major swap participants (“MSPs”) that are not subject to capital rules of a prudential regulator. Section 4s(f) requires the Commission to adopt financial reporting and recordkeeping requirements for SDs and MSPs. The Commission also is proposing to amend existing capital rules for futures commission merchants (“FCMs”), providing specific capital deductions for market risk and credit risk for swaps and security-based swaps entered into by an FCM. The Commission is further proposing several technical amendments to the regulations.

DATES:

Comments must be received on or before March 16, 2017.

ADDRESSES:

You may submit comments, identified by RIN 3038-AD54 and “Capital Requirements for Swap Dealers and Major Swap Participants”, by any of the following methods:

•
CFTC Web site, via its Comments Online process: http://comments.cftc.gov
. Follow the instructions for submitting comments through the Web site.

•
Mail:
Send to Chris Kirkpatrick, Secretary, Commodity Futures Trading Commission, 1155 21st Street, NW., Washington, DC 20581.

•
Hand delivery/Courier:
Same as Mail above.

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

Please submit your comments using only one of these methods.

All comments must be submitted in English, or if not, accompanied by an English translation. Comments will be posted as received to
http://www.cftc.gov
. You should submit only information that you wish to make available publicly. If you wish the Commission to consider information that is exempt from disclosure under the Freedom of Information Act, a petition for confidential treatment of the exempt information may be submitted according to the procedures set forth in Regulation 145.9 of the Commission's regulations.
1

1
Commission regulations referred to herein are found at 17 CFR chapter 1. Commission regulations are accessible on the Commission's Web site,
http://www.cftc.gov
.

The Commission reserves the right, but shall have no obligation, to review, pre-screen, filter, redact, refuse or remove any or all of your submission from
http://
www.cftc.gov
that it may deem to be inappropriate for publication, such as obscene language. All submissions that have been redacted or removed that contain comments on the merits of the rulemaking will be retained in the public comment file and will be considered as required under the Administrative Procedure Act and other applicable laws, and may be accessible under the Freedom of Information Act.

FOR FURTHER INFORMATION CONTACT:

Eileen T. Flaherty, Director, Division of Swap Dealer and Intermediary Oversight, 202-418-5326,
eflaherty@cftc.gov;
Thomas Smith, Deputy Director, Division of Swap Dealer and Intermediary Oversight, 202-418-5495,
tsmith@cftc.gov;
Jennifer C.P. Bauer, Special Counsel, Division of Swap Dealer and Intermediary Oversight, 202-418-5472,
jbauer@cftc.gov;
Joshua Beale, Special Counsel, Division of Swap Dealer and Intermediary Oversight, 202-418-5446,
jbeale@cftc.gov;
Rafael Martinez, Senior Financial Risk Analyst, Division of Swap Dealer and Intermediary Oversight, 202-418-5462,
rmartinez@cftc.gov;
Paul Schlichting, Assistant General Counsel, Office of the General Counsel, 202-418-5884,
pschlichting@cftc.gov;
or Lihong McPhail, Research Economist, 202-418-5722,
lmcphail@cftc.gov,
Office of the Chief Economist; Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

A. Statutory Authority

B. Previous Proposed Rulemaking

C. Consultation With U.S. Securities and Exchange Commission and Prudential Regulators

II. Proposed Regulations and Amendments to Regulations

A. Capital

1. Introduction

2. Capital Requirements for Swap Dealers and Major Swap Participants

i. Capital Requirements for Swap Dealers Under a Bank-Based Capital Approach

a. Computation of Minimum Capital Requirement

b. Computation of Common Equity Tier 1 Capital To Meet Minimum Capital Requirement

ii. Capital Requirement for Swap Dealers Under a Net Liquid Assets Capital Approach

a. Computation of Minimum Capital Requirement

b. Computation of Net Capital To Meet Minimum Capital Requirement

(1) Swap Dealers Computation of Tentative Net Capital and Net Capital Without Approval To Use Internal Capital Models

(2) Swap Dealers Approved To Use Internal Capital Models

iii. Capital Requirement for Swap Dealers That Are “Predominantly Engaged in non-Financial Activities”

a. Computation of Minimum Capital Requirement

b. Computation of Tangible Net Worth To Meet Minimum Capital Requirement

iv. Capital Requirements for Major Swap Participants

3. Capital Requirements for FCMs

i. Introduction

ii. FCM Capital Charges for Swaps and Security-Based Swaps in Computing Adjusted Net Capital

a. Standardized Market Risk and Credit Risk Capital Charges

b. Model-Based Market Risk and Credit Risk Capital Charges

iii. Market Risk and Credit Risk Capital Models for Futures Commission Merchants That Are Not Alternative Net Capital Firms

iv. Liquidity Requirements

4. Model Approval Process

i. VaR Models

ii. Stressed VaR Models

iii. Specific Risk Models

iv. Incremental Risk Models

v. Comprehensive Risk Models

vi. Credit Risk Models

B. Swap Dealer and Major Swap Participant Liquidity Requirements and Equity Withdrawal Restrictions

1. Liquidity Requirements

i. Swap Dealers Subject to the Bank-Based Capital Approach

ii. Swap Dealers Subject to the Net Liquid Assets Capital Approach

2. Swap Dealer Equity Withdrawal Restrictions

C. Swap Dealer and Major Swap Participant Financial Recordkeeping, Reporting and Notification Requirements

1. Swap Dealer and Major Swap Participant Financial Recordkeeping and Financial Statement Reporting Requirements

2. Swap Dealer and Major Swap Participant Notice Requirements

3. Electronic Filing Requirements for Financial Reports and Regulatory Notices

4. Swap Dealer and Major Swap Participant Reporting of Position Information

5. Reporting Requirements for Swap Dealers Approved To Use Internal Capital Models

6. Financial Reporting Requirements for Swap Dealers and Major Swap Participants Subject to the Capital Rules of a Prudential Regulator

7. Weekly Position and Margin Reporting

D. Comparability Determinations for Eligible Swap Dealers and Major Swap Participants

E. Technical Amendments

1. Amendments to the Financial Reporting Requirements in Regulations 1.10 and 1.16

2. Amendments to the Notice Provisions in Regulation 1.12

3. Commission Receivables for Certain Swap Transactions in Regulation 1.17

4. Changes to Notice and Disclosure Requirements for Bulk Transfers in Regulation 1.65

5. Conforming Amendments to Delegated Authority Provisions in Regulation 140.91

III. Related Matters

A. Regulatory Flexibility Act

B. Paperwork Reduction Act

1. New Information Collection Requirements and Related Burden Estimates

i. Form SBS

ii. Notice of Failure to Maintain Minimum Financial Requirements

iii. Requests for Extensions of Time To File Financial Statements

iv. Capital Requirements Elections

v. Application for Use of Models

vi. Liquidity Requirements

vii. Financial Recordkeeping, Reporting and Notification Requirements for SDs and MSPs

viii. Capital Comparability Determinations

2. Information Collection Comments

IV. Cost Benefit Considerations

A. Background

B. Regulatory Capital

C. General Summary of Proposal

D. Baseline

E. Overview of Approaches

1. Bank Based Capital

2. Net Liquid Assets

3. Alternative Net Capital (“ANC”)

4. Tangible Net Worth

5. Substituted Compliance

F. Entities

1. Bank Subsidiaries

2. SD/BD (Without Models)

3. SD/BD/OTC Derivatives Dealers (Without Models)

4. SD/FCM (Without Models)

5. ANC Firms (SD/BD and/or FCMs That Use Models)

6. Stand-Alone SD (With and Without Models)

7. Non-Financial SD (With and Without Models)

8. MSP

9. Substituted Compliance

G. Liquidity and Funding Requirements

H. Reporting and Recordkeeping Requirements

I. Section 15(a) Factors

1. Protection of Market Participants and the Public

2. Efficiency, Competitiveness, and Financial Integrity of Swaps Markets

3. Price Discovery

4. Sound Risk Management Practices

5. Other Public Interest Considerations

I. Introduction

A. Statutory Authority

Section 731 of the Dodd-Frank Act
2

amended the CEA
3

by adding section 4s(e), which requires the Commission to adopt rules establishing capital requirements for SDs and MSPs to help ensure the safety and soundness of the SDs and MSPs.
4

Section 4s(e) applies a bifurcated approach requiring each SD and MSP subject to the capital requirements of a prudential regulator to meet the capital requirements adopted by the applicable prudential regulator, and requiring each SD and MSP that is not subject to the capital requirements of a prudential regulator to meet the capital requirements adopted by the Commission.
5

Therefore, SDs and MSPs that are not banking entities, including nonbank subsidiaries of bank holding companies regulated by the Federal Reserve Board, are subject to the Commission's capital requirements.
6

The Commission is also proposing in this release to require SDs to meet defined liquidity and funding requirements and is proposing certain limitations on the withdrawal of capital from SDs as part of the SD capital requirements.

2

See
Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the Dodd-Frank Act may be accessed at
http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm
.

3
7 U.S.C. 1
et seq.

4

See
7 U.S.C. 6s(e)(3)(A). Section 4s(e) also directs the Commission to adopt regulations for SDs and MSPs imposing initial and variation margin requirements on all swaps that are not cleared by a registered clearing organization. The Commission adopted final SD and MSP margin requirements for uncleared swap transactions on December 18, 2015.
See, Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants,
81 FR 636 (Jan. 6, 2016).

5
The term “prudential regulator” is defined in section 1a(39) of the CEA for purposes of the section 4s(e) capital requirements. Specifically, the term “prudential regulator” is defined to mean the Board of Governors of the Federal Reserve System (“Federal Reserve Board”); the Office of the Comptroller of the Currency (“OCC”); the Federal Deposit Insurance Corporation; the Farm Credit Administration; and the Federal Housing Finance Agency. All references to an “SD” or an “MSP” in this proposal will mean an SD or MSP that is subject to the Commission's capital rules, unless otherwise specified.

6
The prudential regulators, including the Federal Reserve Board and OCC which have capital responsibilities for SDs provisionally-registered with the Commission, have adopted capital rules that incorporate capital requirements for swap and security-based swap transactions. In this regard, the Federal Reserve Board and OCC have adopted revised capital rules to incorporate Basel III capital adequacy requirements.
See, Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action, Standardized Approach for Risk-weighted Assets, Market Discipline and Disclosure Requirements, Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital Rule,
78 FR 62018 (Oct. 11, 2013).

The Commission is also required to adopt regulations to implement provisions in section 4s related to financial reporting and recordkeeping by SDs and MSPs. Section 4s(f)(2) of the CEA directs the Commission to adopt rules governing financial condition reporting and recordkeeping for SDs and MSPs, and section 4s(f)(1)(A) requires each registered SD and MSP to make such reports as are required by Commission rule or regulation regarding the SD's or MSP's financial condition. The Commission is also proposing record retention and inspection requirements consistent with the provisions of section 4s(f)(1)(B).
7

Pursuant to the financial reporting provisions, the Commission is proposing that SDs and MSPs submit periodic financial information and swaps and security-based swaps position information to the Commission, and that SDs and MSPs file written notices with the Commission whenever defined reportable events are triggered.

7
The Commission previously finalized certain record retention requirements for SDs and MSPs regarding their swap activities.
See, Swap Dealer and Major Swap Participant Recordkeeping, Reporting, and Duties Rules; Futures Commission Merchant and Introducing Broker Conflicts of Interest Rules; and Chief Compliance Officer Rules for Swap Dealers, Major Swap Participants, and Futures Commission Merchants,
76 FR 20128 (Apr. 3, 2012).

In addition to proposing minimum capital and financial reporting requirements for SDs and MSPs, the Commission is also proposing to amend existing capital requirements for FCMs to include specific market risk capital charges and credit risk capital charges for swaps and security-based swaps transactions that are not cleared by clearing organizations.
8

Section 4s(a) of the CEA requires entities that engage in swap dealing activities and otherwise meet the definition of an SD to register with the Commission as SDs. The Commission expects that certain FCMs will engage in swap dealing activities that requires them to register as SDs. In addition, the Commission expects that other FCMs may engage in a level of swap dealing activity that is below the de minimis exception and, therefore, exempts the FCMs from registering as SDs.
9

Accordingly, the Commission is

proposing to amend Regulation 1.17 to establish specific capital requirements for FCMs that engage in swaps or security-based swaps that are not cleared by a clearing organization. These proposed capital requirements would apply to all FCMs that enter into uncleared swaps or security-based swaps. The Commission also is proposing technical amendments to several regulations as part of the proposed capital and financial recordkeeping and reporting requirements.

8
Section 4f(b) of the CEA authorizes the Commission to establish minimum financial requirements for FCMs. The Commission previously adopted minimum capital requirements for FCMs, which are set forth in Commission Regulation 1.17.

9
Regulation 1.3(ggg) defines the term “swap dealer” and contains a general exception from the definition for a person that engages in a de minimis

level of swap dealing activities. Regulation 1.3(ggg) generally defines the term “de minimis” to mean that the swap dealing activities of a person, or any other entity controlling, controlled by or under common control with the person, over the preceding 12 months have an aggregate gross notional amount of no more than $3 billion (subject to a phase in level of $8 billion) and an aggregate notional amount of no more than $25 million with regard to swaps in which the counterparty is a “special entity” as defined in section 4s(h)(2)(C) of the CEA and Commission Regulation 23.401(c).

B. Previous Proposed Rulemaking

The Commission previously proposed capital and financial reporting rules for SDs and MSPs in 2011.
10

The Commission received comments from a broad spectrum of market participants, industry representatives, and other interested parties. The commenters addressed numerous topics including the permissible use of models for computing capital and the need for harmonization of the Commission's rules with capital rules of the prudential regulators and the Securities and Exchange Commission (“SEC”).
11

10

See Capital Requirements of Swap Dealers and Major Swap Participants,
76 FR 27802 (May 12, 2011).

11
Comments received on the Commission's May 12, 2011 proposed capital and financial reporting rules are available on the Commission's Web site. Commenters included financial services associations, agricultural associations, energy associations, insurance associations, banks, brokerage firms, investment managers, insurance companies, pension funds, commercial end users, law firms, public interest organizations, and other members of the public.

The Commission elected to defer consideration of final capital rules until the Commission adopted final regulations governing margin requirements for SDs and MSPs engaging in uncleared swap transactions. The Commission adopted the final margin requirements for uncleared swaps in December 2015.
12

12

See
81 FR 636 (Jan. 6, 2016).

The Commission has considered the comments it received from its initial capital proposal in developing this proposal. In addition, and as discussed below, the Commission also has considered capital rules adopted by the prudential regulators and capital rules proposed by the SEC for security-based swap dealers (“SBSDs”) and major security-based swap participants (“MSBSPs”) in developing this proposal. The Commission further considered the impact of the final margin rules for uncleared swaps and the final rules addressing the cross-border application of the margin requirements for uncleared swaps in developing this proposal.
13

13
The Commission adopted final regulations addressing the cross-border application of the uncleared swaps margin rules.
See, Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants—Cross-Border Application of the Margin Requirements,
81 FR 34818 (May 31, 2016).

C. Consultation With U.S. Securities and Exchange Commission and Prudential Regulators

Section 4s(e)(3)(D) of the CEA provides that the CFTC, SEC, and prudential regulators (collectively, the “Agencies”) shall, to the maximum extent practicable, establish and maintain comparable minimum capital requirements for SDs and MSPs. Further, section 4s(e)(3)(D) directs staff of the Agencies to meet periodically, but no less frequently than annually, to consult on minimum capital requirements. Accordingly, staff from each of the Agencies had the opportunity to provide oral and/or written comments to the capital and financial reporting regulations for SDs and MSPs contained in this proposing release, and the proposal reflects certain elements of their comments.

II. Proposed Regulations and Amendments to Regulations

A. Capital

1. Introduction

Broadly speaking, in developing the proposed capital requirements for SDs and MSPs, the Commission strived to advance the statutory goal of helping to protect the safety and soundness of SDs and MSPs, while also taking into account the diverse nature of entities participating in the swaps market and the existing capital regimes that apply to these entities and/or their financial group. To that end, the Commission is proposing three alternative capital approaches for SDs and MSPs, which are intended to minimize competitive advantages that might otherwise arise if the Commission were to impose a singular capital approach in light of the different corporate and operating structures of the entities. The Commission further considered the degree to which its proposed capital requirements would be consistent with an existing regulatory framework (if any) to which these entities are already subject and the statutory objective of the capital requirements, to help ensure the safety and soundness of SD and MSP registrants.

The Commission has, to a great extent, drawn on existing CFTC, prudential regulator, and SEC capital rules in developing the proposed capital requirements for SDs and MSPs. Also, as discussed in this release, the Commission's proposed capital requirements for SDs and MSPs are consistent in many respects with the SEC's proposed capital requirements for SBSDs and MSBSPs, and the prudential regulators' capital requirements for banks and bank holding companies.
14

Specifically, the proposal, depending on the characteristics of the registered entity, would: (i) Permit SDs to elect a capital requirement that is based on existing bank holding company capital rules adopted by the Federal Reserve Board (the “bank-based capital approach”); (ii) permit SDs to elect a capital requirement that is based on the existing CFTC FCM capital rule, the existing SEC broker-dealer (“BD”) capital rule, and the SEC's proposed capital requirements for SBSDs, (the “net liquid assets capital approach”); or (iii) permit SDs that meet defined conditions designed to ensure that they are “predominantly engaged in non-financial activities” to compute their minimum regulatory capital based upon the firms' tangible net worth (the “tangible net worth capital approach”).

14
Section 15F(e) of the Exchange Act (15 U.S.C. 78o-10(e)(1)(B)) provides that the SEC shall prescribe capital and margin requirements for SBSDs and nonbank MSBSPs that do not have a prudential regulator. The SEC proposed capital requirements for SBSDs and MSBSPs in November 2012.
See Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants,
77 FR 70214 (Nov. 23, 2012). The prudential regulators adopted amendments to the capital rules for banks and bank holding companies to incorporate certain requirements set forth in the Dodd-Frank Act.
See,
78 FR 62018 (Oct. 11, 2013).

With respect to MSPs, the Commission is proposing a minimum regulatory capital requirement based upon the tangible net worth of the MSP. This tangible net worth approach is consistent with the SEC's proposed capital rule for MSBSPs as discussed in section II.A.2.iii of this release.

The Commission's proposed SD and MSP capital requirements are set forth in new Regulation 23.101, and are discussed in section II.A.2 of this release. Proposed Regulation 23.101 details the minimum capital requirements for each of the three capital approaches and the eligibility criteria (as applicable), and further

defines the capital computations for each approach, including various market risk and credit risk charges, whether using models or otherwise, to determine whether an SD satisfies the minimum capital requirements. The proposal also defines a minimum capital requirement for MSPs and defines the capital computation for MSPs.

The Commission is also proposing several amendments to Regulation 1.17, which governs the capital requirements for FCMs. The proposed amendments would establish specific market risk and credit risk capital charges for swap and security-based swap positions, and would provide a process for an FCM that is dually-registered as an SD to seek approval from the Commission or from the registered futures association (“RFA”) of which the FCM is a member to use internal capital models to compute market risk and credit risk capital charges.
15

The discussion of the proposed FCM capital amendments is contained in section II.A.3 of this release.

15
Section 3 of the CEA states that a purpose of the CEA is to establish a system of effective self-regulation under the oversight of the Commission. Consistent with the self-regulatory concept established under section 3, section 17 of the CEA provides a process whereby an association of persons may register with the Commission as a registered futures association (“RFA”). Currently, the National Futures Association (“NFA”) is the only RFA under section 17 of the CEA.

2. Capital Requirements for Swap Dealers and Major Swap Participants

The Commission is proposing capital requirements for SDs and MSPs in order to help ensure the safety and soundness of the SDs and MSPs by requiring such firms to maintain a minimum level of financial resources that is based upon the activities of the firms. Adequate levels of capital will allow SDs and MSPs to meet their obligations to swap and security-based swap counterparties and general creditors.

The Commission's proposed SD capital requirements in Regulation 23.101 are comprised of two components. First, an SD must compute the minimum amount of capital that the SD is required to maintain under proposed Regulation 23.101. Second, the SD must compute, based upon its balance sheet and certain adjustments including market risk and credit risk charges on its swaps, security-based swaps and other proprietary positions, the actual amount of capital that the SD maintains. The SD's actual capital must be equal to or greater than the SD's minimum capital requirement. This section discusses the proposed minimum amount of capital required to be maintained by an SD or MSP under the proposal and the proposed regulations governing the computation of the amount of capital that an SD or MSP actually maintains.

To provide SDs with flexibility given the diverse nature of their corporate structures and operations, the Commission is proposing a bank-based capital approach, a net liquid assets capital approach, and a tangible net worth capital approach for SDs. And as described below, SDs which are subject to existing capital requirements that would adequately address their swaps transactions may choose to remain under those existing requirements. The Commission believes that providing this flexibility is appropriate as both the bank-based capital approach and the net liquid assets capital approach are based on internationally-recognized and accepted approaches for establishing strong minimum capital requirements for financial institutions. Both of these approaches are designed to ensure that SD's meet their financial obligations and to help ensure that safety and soundness of the SD. Although there are differences between the bank-based and net liquid assets based capital approaches, they are structurally similar in that they evaluate the composition of the SD's balance sheet and are formulated to ensure the SD's ability to continue its operations in times of financial stress. The option to use the tangible net worth approach is appropriate because it would be available only for SDs that are predominantly engaged in non-financial activities. These SDs are primarily involved in commercial activities and engage in a relatively insignificant amount of financial transactions when compared to their entire operations, as described below. As the Commission has previously noted, financial firms generally present a higher level of systemic risk than commercial firms as the profitability and viability of financial firms is more tightly linked to the health of the financial system than commercial firms.
16

16

See
81 FR 636, 640 (Jan. 6, 2016).

In addition, as noted above, the Commission based the proposal on existing regulatory capital regimes. The Commission recognizes that certain of the current registered SDs are nonbank subsidiaries of bank holding companies that are already subject to the Federal Reserve Board's bank-based capital requirements for bank holding companies. The Commission anticipates that SDs that are nonbank subsidiaries of bank holding companies may elect the bank-based capital approach as the firms consolidate into bank holding companies that are subject to the Federal Reserve Board's bank-based capital requirements. The Commission's proposed bank-based capital approach would allow an SD that consolidates into a bank holding company to maintain books and records, and perform capital computations, in a manner that is consistent with its holding company parent entity.

Furthermore, several of the current provisionally-registered SDs are also dually-registered with the Commission as FCMs or dually-registered with the SEC as BDs or “OTC derivatives dealers,” and several of the current provisionally-registered SDs are anticipated to register with the SEC as SBSDs.
17

FCMs, BDs, and OTC derivatives dealers currently are subject to a net liquid assets capital requirement, and the SEC is proposing a net liquid assets capital requirement for SBSDs.
18

The Commission believes that permitting dually-registered SDs/SBSDs or SDs/OTC derivatives dealers to use a uniform CFTC-SEC net liquid assets capital approach would simplify the SDs recordkeeping obligations and allow them to use existing accounting and financial reporting systems. This approach is also consistent with the Commission's long-standing practice of maintaining a uniform capital rule for dually-registered FCM/BDs, while also imposing a strong capital requirement on the SDs to help ensure the safety and soundness of the firms.

17
An OTC derivatives dealer is a limited purpose BD established by SEC regulations. An OTC derivatives dealer's securities activities are limited to engaging in eligible OTC derivative instruments that are securities and other enumerated activities.
See
17 CFR 240.3b-12.

18
FCM capital requirements are set forth in CFTC Regulation 1.17. SEC Rule 15c3-1 (17 CFR 240.15c3-1) governs the capital requirements for BDs. SEC proposed Rule 18a-1 would govern the capital requirements for SBSDs that are not registered as BDs. (
See
77 FR 70214).

In addition to the bank-based capital approach and the net liquid assets capital approach, the Commission is also proposing to permit SDs that are “predominantly engaged in non-financial activities,” as defined below, to elect a capital approach that is based on the SD's tangible net worth.
19

The Commission is proposing the tangible net worth capital approach in recognition that not all SDs will be principally engaged in traditional dealing and other financial activities. The Commission anticipates that a small number of SDs will be substantially engaged in commercial operations that would make meeting a traditional bank-based capital approach or net liquid

assets capital approach extremely challenging, if at all possible, without substantial corporate restructuring. The Commission's proposal to use the tangible net worth approach would be limited to SDs that are predominantly engaged in non-financial (
i.e.,
commercial) activities.

19

See
proposed Regulation 23.101(a)(2).

The Commission's proposed approach of recognizing existing capital requirements on firms that register as SDs and the Commission's further recognition that not all SDs will be traditional financial firms offers potential benefits to swap market participants by encouraging more firms to act as SDs and to make markets in swaps. An approach that would impose a standardized capital requirement on firms that otherwise are subject to existing capital regimes that differ substantially from the standardized capital requirement or that would require substantial corporate reorganization to satisfy the standardized capital requirement would increase costs of swap transactions for swap dealers and their counterparties, including commercial end users and other non-financial market participants. A standardized capital requirement may also impose significant disincentives for certain SDs to remain in the market as dealers in swaps, which would concentrate dealing activities in a smaller number of firms. The Commission's proposal implements strong capital requirements to help ensure the safety and soundness of the SDs, while at the same time offers an appropriate degree of flexibility, recognizing that a single, standardized capital approach is not appropriate for all SDs which could result in significant burdens on all swap market participants.

Proposed Regulation 23.101 also is consistent with the statutory requirements under section 4s(e), which effectively provides that SDs subject to the capital rule of a prudential regulator are not subject to the Commission's capital rules.
20

Proposed Regulation 23.101(a)(3) would provide that an SD subject to the capital rules of a prudential regulator is not subject to the Commission's capital rules.

20

See
section 4s(e)(1) and (2).

Proposed Regulation 23.101(a)(4) also provides that certain SDs that are otherwise currently subject to the Commission's capital rules are not subject to Regulation 23.101. Specifically, proposed Regulation 23.101(a)(4) would provide that an SD that is also registered as an FCM with the Commission is subject to the Commission's FCM capital requirements contained in Regulation 1.17.
21

These SDs would be subject to the FCM capital requirements, which the Commission is proposing to amend in order to better reflect the specific risks of engaging in uncleared swaps and security-based swap transactions. The Commission is requiring an SD that is dually-registered as an FCM to meet the FCM capital requirements as such requirements reflect the Commission's long experience in regulating the financial requirements of FCMs. For example, the FCM capital requirement, which requires an FCM to hold at least one dollar of liquid assets to meet each dollar of liabilities (except certain subordinated debt), is designed to ensure that an FCM has adequate liquid resources to effectively operate as a market intermediary by having resources to pay customers' requests to withdraw funds and by satisfying its customers' obligations to clearing organizations. The Commission proposed amendments for FCMs are discussed in section II.A.3 of this release.

21
The Commission, as discussed in section II.A.3 of this release, also is proposing to amend Regulation 1.17 to specifically address capital requirements for FCMs that carry swaps and/or security-based swaps positions.

Lastly, proposed Regulation 23.101(a)(5) would contain a provision of “substituted compliance” for capital and financial reporting requirements for SDs that are: (1) Not organized under the laws of the U.S., and (2) not domiciled in the U.S. The proposal would permit these non-U.S. organized and domiciled SDs (or a regulatory authority in the SDs' home country jurisdictions) to petition the Commission to satisfy the Commission's capital and financial reporting requirements through substituted compliance with the capital and financial reporting requirements of the SDs' respective home country jurisdiction.
22

The proposed substituted compliance provisions and the Commission program of conducting comparability determinations of foreign jurisdictions capital requirements are discussed in section II.D of this release.

22
Proposed Regulations 23.101(a)(5) and 23.106.

i. Capital Requirement for Swap Dealers Under a Bank-Based Capital Approach

a. Computation of Minimum Capital Requirement

The Commission is proposing to provide SDs with an option to elect the bank-based capital approach based on the capital requirements adopted by the Federal Reserve Board for bank holding companies. The Federal Reserve Board's bank holding company capital requirements are consistent with the bank capital framework adopted by the Basel Committee on Banking Supervision (“BCBS”).
23

The BCBS framework is an internationally-recognized framework for setting capital requirements for banks and bank holding companies. The Commission believes that proposing capital requirements using the Federal Reserve Board's capital framework is appropriate as the framework specifically reflects swaps and security-based swaps in the capital requirements, and the framework was developed to provide prudential standards to help ensure the safety and soundness of bank and bank holding companies. In addition, as noted above, the proposal to allow SDs an option to elect this approach would provide efficiencies for several of the provisionally registered SDs that are part of a bank holding company structure, and have developed recordkeeping, accounting, and financial reporting systems that are designed to comply with existing prudential requirements.

23
BCBS is the primary global standard-setter for the prudential regulation of banks and provides a forum for cooperation on banking supervisory matters. Institutions represented on the BCBS include the Federal Reserve Board, the European Central Bank, Deutsche Bundesbank, Bank of France, Bank of England, Bank of Japan, and Bank of Canada.

The Commission's bank-based capital approach is set forth in proposed Regulation 23.101(a)(1)(i), and would require an SD to maintain a minimum level of regulatory capital that is equal to or in excess of the greater of the following four criteria:

(1) $20 million of common equity tier 1 capital, as defined under the bank holding company regulations in 12 CFR 217.20, as if the SD itself were a bank holding company subject to 12 CFR part 217;
24

24
Common equity tier 1 capital is defined in 12 CFR 217.20 of the Federal Reserve Board's rules. Common equity tier 1 capital generally represents the sum of a bank holding company's common stock instruments and any related surpluses, retained earnings, and accumulated other comprehensive income.

(2) common equity tier 1 capital, as defined under the bank holding company regulations in 12 CFR part 217.20, equal to or greater than eight percent of the SD's risk-weighted assets computed under the bank holding company regulations in 12 CFR part 217 as if the SD were a bank holding company subject to 12 CFR part 217;

(3) common equity tier 1 capital, as defined under 12 CFR 217.20, equal to or greater than 8 percent of the sum of:

(a) The amount of “uncleared swaps margin” (as that term is defined in

proposed Regulation 23.100) for each uncleared swap position open on the books of the SD, computed on a counterparty by counterparty basis pursuant to Regulation 23.154;
25

25
The term “uncleared swap margin” is defined in Regulation 23.100 to mean the amount of initial margin that a swap dealer would be required to collect from each swap counterparty pursuant to the margin rules for uncleared swap transactions (Regulation 23.154). The term “uncleared swap margin” includes all uncleared swaps that an SD is required to collect margin for under the margin regulations, and also includes all uncleared swaps that are exempt or excluded from the margin requirements including swaps with commercial end users, swaps entered into prior to the respective compliance dates of the Commission's margin requirements set forth in Regulation 23.161 (
i.e.,
legacy swaps), and excluded swaps with an affiliated entity.

(b) the amount of initial margin that would be required for each uncleared security-based swap position open on the books of the SD, computed on a counterparty-by-counterparty basis pursuant to proposed SEC Rule 18a-3(c)(1)(i)(B), without regard to any initial margin exemptions or exclusions that the rules of the SEC may provide to such security-based swap positions; and

(c) the amount of initial margin required by a clearing organization for cleared proprietary futures, foreign futures, swaps, and security-based swap positions open on the books of the SD; or

(4) the capital required by an RFA of which each SD is a member.

Each of the proposed minimum capital criteria is discussed below.

The first criterion under the Commission's proposal is that all SDs that elect the bank-based capital approach must maintain a minimum of $20 million of common equity tier 1 capital. The Commission believes that given the role that SDs play in the financial markets by engaging in swap dealing activities that it is appropriate to require that all SDs maintain a minimum level of capital, stated as an absolute dollar amount that does not fluctuate with the level of the firms' dealing activities to help ensure the safety and soundness of SDs.

The proposed $20 million of minimum capital is consistent with the minimum regulatory capital requirements proposed by the Commission in this release for SDs that elect the net liquid assets capital approach or the tangible net worth capital approach discussed in sections II.A.2.ii and II.A.2.iii, respectively, of this release. The $20 million minimum capital requirement is also consistent with the net capital requirement proposed by the SEC for SBSDs, and is consistent with the current minimum net capital requirements for OTC derivatives dealers registered with the SEC.
26

26
The SEC proposed capital requirements for SBSDs would impose a minimum net capital requirement of $20 million for SBSDs that are not approved to use internal capital models and a $100 million dollar tentative net capital and $20 million net capital requirement for SBSDs that are approved to use internal capital models.
See
77 FR 70214 (Nov. 23, 2012). SEC Rule 15c3-1(a)(5) (17 CFR 240.15c3-1(a)(5)) currently requires an OTC derivatives dealer that has obtained approval to use capital models to maintain a minimum of $100 million of tentative net capital and $20 million of net capital.

The second criterion of the minimum capital requirement for SDs that elect the bank-based capital approach is that the SD must maintain common equity tier 1 capital equal to or greater than eight percent of the SD's risk-weighted assets computed under the bank holding company regulations in 12 CFR part 217 as if the SD were a bank holding company. In effect, this provision of Regulation 23.101(a)(1)(i) imposes a capital approach on a SD that is generally consistent with the approach that the Federal Reserve Board imposes on bank holding companies.
27

The Commission believes it is important to include this criterion so that an SD would maintain a level of common equity tier 1 capital that is comparable to the level it would have to maintain if it were subject to the capital rules of the Federal Reserve Board.

27
As discussed further below, the Commission's proposal differs from the rules of the Federal Reserve Board in that the Commission's proposal would require an SD to add to its risk weighted assets the market risk capital charges computed in accordance with Regulation 1.17 if the SD has not obtained approval from the Commission or from an RFA to use internal market risk and credit risk models.

The Commission is also proposing to measure the required minimum amount of regulatory capital in terms of a minimum ratio of total qualifying capital to risk-weighted assets of eight percent, in a manner that is comparable to the Federal Reserve Board's capital rules for bank holding companies.
28

For purposes of the Commission's proposal, as is also the case for the Federal Reserve Board's minimum ratio requirement, the assets and off-balance sheet transactions or exposures of the bank holding company are weighted relative to their risk.
29

Thus, under the Commission's proposal, the greater the perceived risk of the assets and the off-balance sheet items, the greater the weighting for the risk and the greater the amount of capital necessary to cover eight percent of the risk-weighted assets.
30

28

See
12 CFR 217.10.

29

See
12 CFR 217 subparts D, E, and F.

30
Large, complex banks also must make further adjustments to these risk-weighted assets for the additional capital they must hold to reflect the market risk of their trading assets
See
12 CFR 217 subpart F. The market risk requirements generally apply to Federal Reserve Board-regulated institutions with aggregate trading assets and trading liabilities equal to 10 percent or more of total assets or one billion dollars or more.

Proposed Regulation 23.101(a)(1)(i) would require an SD that elects a bank-based capital approach to compute its risk-weighted assets in accordance with the Federal Reserve Board's capital requirements contained in 12 CFR part 217. The proposal includes the two general approaches to computing risk-weighted assets under 12 CFR part 217. The first approach is for SDs that have not obtained Commission or RFA approval to calculate their risk-weighted assets using internal credit risk and market risk models. Proposed Regulation 23.103 would require these SDs to use a standardized, or rules-based, approach to computing their risk-weighted assets. Under this approach, these SDs would use the credit risk charges from the Federal Reserve Board's standardized approach under subpart D of 12 CFR 217 and the market risk charges that are set forth in Regulation 1.17.
31

Regulation 1.17 contains the standard market risk capital charges that have been imposed on FCMs for many years. Generally, market risk charges are determined by multiplying the notional value or market value of an asset by a fixed percentage set forth in the regulations.
32

The market risk charges are then multiplied by a factor of 12.5 and added to the total risk-weighted assets of the SD.
33

31
The Federal Reserve Board's standardized approach under subpart D of 12 CFR 217 applies only to credit risk charges; the Federal Reserve Board has not adopted standardized market risk charges. Bank and bank holding companies that are subject to market risk charges are required to use internal models and, accordingly, subpart D of 12 CFR 217 does not include a standardized approach for computing market risk charges. To address this issue, the Commission is proposing that an SD that has not obtained Commission or RFA approval to use internal market risk models must apply the rules-based market risk capital charges contained in Regulation 1.17 in computing its total risk-weighted assets.

32
For example, U.S. Treasuries are subject to capital charges of between zero and six percent depending on the time to maturity of each treasury instrument, and readily marketable equity securities are subject to a 15 percent capital charge.
See
Regulation 1.17(c)(5)(v), which references SEC Rule 15c3-1(c)(2)(vi) (17 CFR 240.15c3-1(c)(2)(vi)). SEC Rule 15c3-1(c)(2)(vi)(A)(1) provides that a BD shall take a capital charge on U.S. Treasuries of between zero and six percent of the fair market value of the instrument depending upon the time to maturity. Rule 15c3-1(c)(2)(vi)(j) provides a capital charge for equities equal to 15 percent of the fair market value of the securities.

33
The 12.5 multiplication factor is necessary to ensure that the SD maintains common equity tier 1 capital at level to cover the full amount of the

market risk charge. Since the SD is required to maintain common equity tier 1 capital equal to or in excess of eight percent of the risk-weighted assets, the market risk charge is multiplied by 12.5, which effectively requires the SD to hold common equity tier 1 capital in an amount equal to the full amount of the market risk charge. This approach is consistent with the Federal Reserve Board's approach to bank holding companies.

The second approach to computing risk-weighted assets allows SDs that have obtained Commission or RFA approval of internal credit risk and market risk models to use those models to calculate their risk-weighted assets. For SDs that have been approved to use internal models to compute market risk and credit risk, the models would have to meet the qualitative and quantitative requirements set forth in proposed Regulation 23.102 and Appendix A to Regulation 23.102, which are based upon the Federal Reserve Board's qualitative and quantitative requirements in 12 CFR 217.
34

The proposed qualitative and quantitative requirements for the models, and the proposed model submission process, are discussed in section II.4 of this release.

34
Federal Reserve Board model-based capital charges for credit risk and market risk are set forth in 12 CFR part 217 subparts E and F, respectively.

The third criterion that comprises the SD minimum capital requirement under the proposed bank-based capital approach would require an SD to maintain common equity tier 1 capital equal to or in excess of eight percent of the sum of: (1) The SD's uncleared swaps margin requirements for uncleared swaps transactions, (2) the initial margin that would be required for each uncleared security-based swap transactions pursuant to SEC's proposed Rule 18a-3(c)(1)(i)(B), without regard for any amounts or security-based swaps that may be exempted or excluded under the SEC's proposal, (3) the risk margin required on the SD's cleared futures, foreign futures, and swaps positions, and (4) the amount of initial margin required by a clearing organization that clears the SD's proprietary security-based swaps. Each of these elements is discussed below.

This criterion is intended to ensure that an SD maintains a minimum level of capital that is correlated to the risk associated with the SD's trading activities. The Commission believes that this approach would be appropriate for SDs as the minimum capital requirement would be correlated with the “risk” of the SD's futures, foreign futures, swaps, and security-based swaps positions as measured by the margin required on the positions. Specifically, the SD's minimum capital requirement would increase or decrease as the amount of margin necessary to support the SD's futures, foreign futures, swaps and security-based swaps positions increased or decreased. This approach is consistent with the Commission's current approach to establishing a minimum capital requirement for FCMs.
35

35
FCMs are required to maintain a minimum level of adjusted net capital that is equal to or greater than eight percent of the margin required on futures, foreign futures, and cleared swaps positions carried by the FCM in customer and noncustomer accounts.
See
Regulation 1.17(a)(1)(i)(B).

As noted above, the term “uncleared swaps margin” is defined in proposed Regulation 23.100 and would mean the amount of initial margin that the SD would be required to collect from a swap counterparty pursuant to the Commission's margin rules for uncleared swap transactions in Commission Regulations 23.150 through 23.161, subject to certain adjustments to incorporate an amount for the initial margin for swaps that are otherwise exempt or excluded from the Commission's margin requirements. The SD would compute the uncleared margin amount on a portfolio basis for each of its counterparties. Similarly, the Commission would also require the SD to compute, again on a portfolio basis, the amount of initial margin that would be required for each uncleared security-based swap pursuant to SEC's proposed Rule 18a-3(c)(1)(i)(B) without regard for any exemptions or exclusions that may be provided by the SEC's proposal. The term “risk margin” is defined in Regulation 1.17(b)(8), and generally refers to the amount of margin required by clearing organizations that clear futures, foreign futures, and swaps transactions. Similarly, the proposed rules would also include the amount of initial margin required by clearing organizations for an SD's cleared security-based swaps.

The proposal would require an SD to include all swaps and security-based swaps in the computation, including swaps that are excluded from the Commission's margin rules for uncleared swaps and any security-based swaps that the SEC may exclude from its margin rules when adopted as final. Specifically, the proposal would provide that an SD must include in its computation of the uncleared swaps margin each outstanding swap, including swaps exempt from the scope of the Commission's swaps margin rules by Regulation 23.150 (“TRIPRA Exemption”),
36

foreign exchange swap as the term is defined in Regulation 23.151, or netting set of swaps or foreign exchange swaps, for each counterparty, as if that counterparty were an unaffiliated SD.

36
Title III of the Terrorism Risk Insurance Program Reauthorization Act of 2015 amended sections 731 and 764 of the Dodd-Frank Act to provide that the Commission's margin requirements shall not apply to a swap in which a counterparty: (1) Qualifies for an exception under section 2(h)(7)(A) of the CEA; (2) qualifies for an exemption issued under section 4(c)(1) of the CEA for cooperative entities as defined in such exemption; or (3) satisfies the criteria in section 2(h)(7)(D) of the CEA.
See
Public Law 114-1, 129 Stat. 3.

The Commission's proposal also would require an SD to include the initial margin for all swaps that would otherwise fall below the $50 million initial margin threshold amount or the $500,000 minimum transfer amount, as defined in Regulation 23.151, for purposes of computing the uncleared swap margin amount. As such, the uncleared swap margin amount would be the amount that an SD would have to collect from a counterparty, assuming that the exclusions and exemptions for collecting initial margin for uncleared swaps set forth in Regulations 23.150-161 would not apply, and also assuming that the thresholds under which initial margin and/or variation margin would not need to be exchanged would not apply. Accordingly, uncleared swaps that are not subject to the margin requirement such as those executed prior to the compliance date for margin requirements (“legacy swaps”), inter-affiliate swaps, and TRIPRA Exemption swaps would have to be taken into account in determining the capital requirement.

The Commission is proposing to include these swaps and comparable security-based swaps in the computation as it believes that it would be appropriate to require an SD to maintain capital for unmargined swap and security-based swap exposures to counterparties, so that capital would be available to cover the “residual” risk of a counterparty's uncleared swaps and security-based swap positions. The Commission believes that its approach is consistent with its statutory mandate—helping to ensure the safety and soundness of the SDs subject to its jurisdiction—to require an SD to reserve capital for all of its uncollateralized exposures, including the exposures that have been excluded or exempted from the Commission's margin requirements. This includes swaps where the counterparty is a commercial end user or an affiliate of the SD, as the uncollateralized exposures from these counterparties present risk to the financial condition of the SD.

The Commission's proposal to require an SD to reserve capital for uncollateralized exposures to swap and security-based swap counterparties is not inconsistent with the Commission's

regulations exempting or excluding uncleared swaps with certain counterparties from margin requirements.
37

Initial margin is a transaction-based financial resource. Initial margin protects counterparties to a swap transaction as well as the overall financial system. Initial margin serves both as a check on risk-taking that might exceed a counterparty's financial capacity and as a resource that can limit losses when there is a failure by a counterparty to meet its obligations. If a swap counterparty defaults, the other party may use initial margin to cover some or all of the loss.

37

See
Regulation 23.150.

In developing its proposed margin requirements for uncleared swap transactions, the Commission recognized that different categories of counterparties present different levels of risk.
38

The Commission stated its belief that financial firms generally present a higher level of risk than non-financial firms due to the profitability and viability of financial firms being more tightly linked to the health of the financial system than non-financial firms.
39

Non-financial end users, however, generally use swaps to hedge commercial risk and were deemed to pose less risk to SDs.
40

Due to the differences in perceived risk and potential systemic effects, and consistent with Congressional intent, the Commission excluded non-financial end users from the margin requirements.

38

See Margin Requirements for Uncleared Swaps for Swap Dealers and Major Swap Participants; Proposed Rule
79 FR 59898 (Oct. 3, 2014).

39

Id.

40

Id.

Capital, however, serves as an overall financial resource for the SD and is intended to cover potential risks that are not adequately covered by other risk management programs (
i.e.,
“residual risk”) including margin on uncleared swaps. Capital is intended to help ensure the safety and soundness of the SD by providing financial resources to allow an SD to absorb unanticipated losses and declines in asset values from all aspects of its business operations, including swap dealing activities, while also continuing to meet its financial obligations. The Commission is proposing to require that an SD reserve capital against all uncollateralized swaps exposures, as such exposures pose residual risk not covered by other assets of the SD. Accordingly, capital is necessary to provide a financial cushion to protect an SD from financial exposures, including uncollateralized exposures to swap counterparties.

The Commission's proposal would not require an SD to reserve capital equal to the full amount of its uncollateralized swap exposures. The Commission's proposal would require an SD to reserve capital equal to a percentage of its uncollateralized exposures. In this respect, the Commission's capital requirement would not have the same impact on the SD with respect to such uncollaterized swaps (
e.g.,
an SD's funding or pricing of swaps) as would the application of the Commission's margin requirements to such swaps. The Commission's proposal should also not have the same impact on the cost to commercial end users who are counterparties to such uncollaterized swaps as would imposition of margin requirements on such swaps, because of the different impact on an SD's funding or pricing of swaps and because margin requirements impose specific transactional costs on counterparties (
e.g.,
establishment of custodial arrangements, documentation requirements) that are not generated by SD capital requirements. The Commission's proposed approach regarding the inclusion of uncollateralized swap exposures in the SD's capital requirements is also consistent with the approach adopted by the prudential regulators in setting capital requirements for SDs subject to their jurisdiction and is consistent with the approach proposed by the SEC for SBSDs.

The proposed capital requirement would require an SD to include in the eight percent calculation the amount of margin required by a clearing organization for the SD's proprietary cleared swaps, security-based swaps, futures, and foreign futures positions. The Commission notes that while the proposed minimum capital requirement based on eight percent of margin on cleared and uncleared swaps is consistent with the SEC's proposal for SBSDs, the SEC approach would require an SBSD to maintain a minimum level of net capital equal to or greater than eight percent of the risk margin required on cleared and uncleared security-based swaps only. The Commission's proposal would expand the products included in the SD's minimum capital requirement to include swaps, security-based swaps, futures and foreign futures positions. The Commission is expanding the products beyond the SEC proposal as it believes that it is appropriate for SDs to maintain a minimum level of capital that reflects the extent of the risks posed by the full, broad range of the SDs' proprietary positions.

The fourth criterion of the proposed minimum capital requirements would require an SD to maintain the minimum level of capital required by an RFA of which the SD is a member. The proposed minimum capital requirement based on membership requirements of an RFA is consistent with current FCM capital requirements under Regulation 1.17, and reflects Commission regulations that require each SD to be a member of an RFA.
41

The proposal also is consistent with section 17(p)(2) of the CEA, which provides, in relevant part, that an RFA must adopt rules establishing minimum capital and other financial requirements applicable to the RFA's members for which such requirements are imposed by the Commission.
42

As noted above, the NFA currently is the only RFA. The proposal recognizes that the NFA would be required by section 17 of the CEA to adopt SD capital rules once the Commission imposes capital requirements on SDs, and would incorporate the NFA minimum capital requirements into the Commission's regulation.

41

See
Regulations 1.17(a)(1)(i)(C) and 170.16.

42

See
section 17(p)(2) of the CEA, which requires RFAs to adopt rules establishing minimum capital and other financial requirements applicable to its members for which such requirements are imposed by the Commission, provided that such requirements may not be less stringent than the requirements imposed by the CEA or by Commission regulations.

b. Computation of Common Equity Tier 1 Capital To Meet Minimum Capital Requirement

Each SD subject to the bank-based capital approach is required to maintain a level of common equity tier 1 capital that is equal to or in excess of the highest of the three criteria listed in section II.A.2.i above. The Commission is proposing to limit the SD's capital that qualifies to satisfy the SD's minimum capital requirement to common equity tier 1 capital. This limitation would be different from the Federal Reserve Board's requirements, which allow a bank holding company to meet its minimum capital requirements with a combination of common equity tier 1 capital, additional tier 1 capital, and tier 2 capital.
43

43
Under the Federal Reserve Board's rules, a bank holding company's total capital must equal or exceed at least eight percent of its risk-weighted assets. In addition, at least six percent of the bank holding company's capital must be in the form of tier 1 capital, and at least 4.5 percent of the tier 1 capital must qualify as common equity tier 1 capital. The remaining two percent of capital may be comprised of tier 2 capital.

The Commission is proposing the stricter standard as common equity tier 1 capital is a more conservative form of capital than additional tier 1 or tier 2 capital, particularly as it relates to the

permanence of the capital and its availability to absorb unexpected losses. As noted above, common equity tier 1 capital is defined in 12 CFR 217.20 to generally comprise the sum of a bank holding company's common stock instruments and any related surpluses, retained earnings, and accumulated other comprehensive income. Tier 1 capital includes common equity tier 1 capital and further includes such instruments as preferred stock. Tier 2 capital includes certain types of instruments that include both debt and equity characteristics (
e.g.,
certain perpetual preferred stock instruments and subordinated term debt instruments).
44

The Commission also is proposing the stricter common equity tier 1 requirement as it is not proposing to include in the SD's minimum capital requirement certain of the prudential regulators' capital add-ons, including the capital conservation buffer and the countercyclical capital buffer.
45

In order for the SD to meet its minimum requirements, it must demonstrate that its common equity tier 1 capital equals or exceeds the highest of the minimum requirements set forth in proposed Regulation 23.101(a)(1)(i) and discussed in section II.A.2.i.a above.

44

See
12 CFR 217.10.

45

See
12 CFR 217.11. The capital conservation buffer and the countercyclical capital buffer represent capital “add-ons” to the standard bank capital requirements and are intended to require entities subject to the rules to have certain levels of capital in order to make capital distributions and discretionary bonuses.

Request for Comment

The Commission requests comment on all aspects of the proposed bank-based capital approach. In addition, the Commission requests comment, including empirical data in support of comments, in response to the following questions:

1. Is the proposed $20 million fixed amount of minimum tier 1 capital appropriate? If not, explain why not. If the minimum fixed-dollar amount should be set at a level greater or lesser than $20 million, explain what that greater or less amount should be and explain why that is a more appropriate amount.

2. Is the proposed minimum capital requirement based upon an SD's common equity tier 1 capital appropriate? If not, explain why, and suggest what modifications the Commission should make to the regulation. For example, should the proposal include tier 1 capital other than common equity tier 1 capital? Are there specific elements of tier 1 capital that the Commission should include in addition to common equity tier 1 capital? Are there specific elements of tier 2 capital that the Commission should include in the regulation?

3. Is the proposed minimum capital requirement based upon eight percent of the SD's risk weighted assets appropriate? If not, explain why not. Is the proposed requirement that the SD add to its risk-weighted assets market risk capital charges computed in accordance with Regulation 1.17 if the SD has not obtained the approval of the Commission or of an RFA to use internal models appropriate? Are there other options to compute market risk charges when models are not approved? Should the 8 percent be set at a higher or lower level? If so, what percent should the Commission consider?

4. Is the proposed minimum capital requirement based upon eight percent of the margin required on the SD's cleared and uncleared swaps and security-based swaps, and the margin required on the SD's futures and foreign futures appropriate? If not, explain why not. Should the percentage be set at a higher or lower level? Please explain your response. Is including in the computation margin for swaps and security-based swaps that are exempt or excluded from the uncleared margin requirements (
e.g.,
legacy swaps and security-based swaps, and swaps with commercial end users) appropriate? If not, explain why these uncollateralized exposures do not result in risk to the SD without capital to address that risk.

5. Commodity Exchange Act section 4s(e)(3)(A) only cites the risk of uncleared swaps in setting standards for capital. Additionally, in the Commission's final swap dealer definition rule, it said it will “in connection with promulgation of final rules relating to capital requirements for swap dealers and major swap participants, consider institution of reduced capital requirements for entities or individuals that fall within the swap dealer definition and that execute swaps only on exchanges, using only proprietary funds.”
46

Given these pronouncements, should the Commission exclude cleared swaps from the capital calculation requirements?

46
77 FR 30596, 30610 fn. 199 (May 23, 2012).

6. In addition to swaps, the proposal includes security-based swaps, futures, and foreign futures in the capital calculation requirements. The SEC's capital proposal only included security-based swaps. Given the statements above in question 5 and the narrower scope of the SEC's proposal, should the Commission limit its capital calculation requirements to uncleared swaps only?

7. If the swap dealer
de minimis
level falls to $3 billion, what impact would the proposed capital rule have on any new potential registrants? Please provide any quantitative estimates.

ii. Capital Requirement for Swap Dealers Under a Net Liquid Assets Capital Approach

a. Computation of Minimum Capital Requirement

Proposed Regulation 23.101(a)(ii) would permit an SD to elect to be subject to a net liquid assets capital approach. The net liquid assets capital approach is consistent with the Commission's current capital approach for FCMs, and is consistent with the SEC's proposed capital rule for SBSDs and the SEC's current capital requirements for BDs and OTC derivatives dealers.
47

Harmonization of the CFTC and SEC capital requirements benefit firms that are dually-registered (including dually-registered SDs and SBSDs) as such firms should be able to meet the regulatory requirements of both the CFTC and SEC with a uniform set of books and records, and one capital computation. This concept of a harmonized capital approach is consistent with the Commission's and SEC's long standing uniform capital rule for FCMs and BDs. An SD that elects the proposed net liquid assets capital rule contained in Regulation 23.101(a)(1)(ii) would be required to comply with proposed SEC Rule 18a-1 as if the SD were a SBSD registered with the SEC, subject to several modifications discussed below.
48

47
The SEC has proposed a net liquid assets capital requirement for SBSDs that is set forth in proposed SEC Rule 18a-1.
See
77 FR 70214 (Nov. 23, 2012).

48

See
SEC proposed Rule 18a-1(a)(1) (77 FR 70214).

SDs that elect to comply with the proposed net liquid assets capital approach would be required to maintain a minimum level of net capital
49

equal to or greater than the highest of the following criteria:

49
Net capital is generally defined to mean the SD's liquid assets (less deductions for potential decreases in value of the assets) less all of the SD's liabilities (excluding qualifying subordinated debt).

(1) $20 million;

(2) net capital equal to or greater than eight percent of the sum of:

(a) The amount of “uncleared swaps margin” (as that term is defined in proposed Regulation 23.100) for each uncleared swap position open on the books of the SD, computed on a counterparty by counterparty basis pursuant to Regulation 23.154;

(b) the amount of initial margin that would be required for each uncleared security-based swap position open on the books of the SD, computed on a counterparty-by-counterparty basis pursuant to proposed SEC Rule 18a-3(c)(1)(i)(B), without regard for any amounts that may be excluded or exempted under the SEC's rules;

(c) the amount of “risk margin requirement” (as that term is defined in Regulation 1.17(b)(8)) for the SD's cleared futures, foreign futures, and swaps positions open on the books of the SD; and

(d) the amount of initial margin required by a clearing organization for proprietary cleared security-based swaps positions open on the books of the SD; or

(3) the capital required by the RFA of which the SD is a member.

In addition, the proposal provides that an SD that has received approval from the Commission, or from an RFA of which the SD is a member, to use internal models to compute market risk and credit risk capital charges for its swaps and/or security-based swaps and other proprietary positions when computing its capital, as described in section II.A.4 of this release, must maintain a minimum level of tentative net capital equal to $100 million and net capital of $20 million.
50

The proposal is consistent with the SEC's proposed requirement that SBSDs that have obtained approval to use internal capital models must maintain tentative net capital of $100 million and net capital of $20 million.
51

50
SEC Rules generally define “tentative net capital” as the registrant's assets less liabilities (excluding certain qualifying subordinated debt), and “net capital” as tentative net capital less certain capital deductions such as market risk and credit risk deductions.
See
17 CFR 240.15c3-1.

51

See
SEC proposed Rule 18a-1(a)(2), (77 FR 70214, 70333).

The first criterion of proposed Regulation 23.101(a)(1)(ii) would require the SD to maintain a minimum of $20 million of net capital. This requirement is consistent with the minimum requirements proposed for SDs under the bank-based capital approach discussed in section II.A.2.i.a of this release. As discussed in section II.A.2.i.a above, the Commission believes that given the role that SDs play in the financial markets by engaging in swap dealing activities that it is appropriate to require that all SDs maintain a minimum level of capital, stated as an absolute dollar amount that does not fluctuate with the level of the firms' dealing activities to help ensure the safety and soundness of the SDs. Furthermore, the proposed $20 million minimum capital requirement is consistent with the SEC's current minimum capital requirement for OTC derivatives dealers and the SEC proposed minimum capital requirement for SBSDs.

The second criterion under the net liquid assets capital approach would require an SD to maintain a minimum level of net capital equal to or greater than eight percent of the sum of: (1) The amount of “uncleared swap margin” (as that term is proposed to be defined in Regulation 23.100) for each uncleared swap position open on the books of the SD, computed on a counterparty by counterparty basis pursuant to Regulation 23.154; (2) the amount of initial margin that would be required for each uncleared security-based swap position open on the books of the SD, computed on a counterparty by counterparty basis pursuant to SEC proposed Rule 18a-3(c)(1)(i)(B) without regard to any initial margin exemptions or exclusions that the rules of the SEC may provide to such security-based swap positons; (3) the amount of “risk margin” (as defined in Regulation 1.17(b)(8)) required by a clearing organization for the SD's futures, swaps, and foreign futures positions that are open on the books of the SD; and (4) the amount of initial margin required by a clearing organization for security-based swaps that are open on the books of the SD.

Consistent with the requirements for SDs that elect the bank-based capital approach discussed in section II.A.2.a above, an SD that elects the net liquid assets approach would have to include all swaps and security-based swaps in its computation of the margin for uncleared swaps subject to the eight percent calculation, including any swaps positions that are not included in the Commission's margin requirements in Regulations 23.150 through 23.161 and any security-based swaps positions that may be exempt or excluded from the SEC's proposed margin requirements in Rule 18a-3(c)(1)(i)(B).

Consistent with the bank-based capital approach discussed in section II.A.2.a above, this minimum capital requirement is generally comparable to the SEC's proposed minimum capital requirement for SBSDs, with the exception that the SEC proposal only requires a SBSD to compute its minimum capital requirement based upon eight percent of the initial margin required on cleared and uncleared security-based swaps. The Commission is proposing to require that an SD expand the positions subject to the eight percent initial margin minimum capital requirement to include the SD's proprietary swaps, futures, and foreign futures positions. The Commission believes that the minimum capital requirement should reflect these additional positions to more fully reflect the potential exposure from all of the SD's swaps, security-based swaps, futures and foreign futures positions. Accordingly, the Commission's proposal has adjusted the calculation to include these additional positions of the SD.

The proposed third criterion would require an SD to maintain net capital that is equal to or greater than the amount of net capital required by the RFA of which is a member. As discussed more fully in section II.A.2.i.a above, this provision recognizes that an RFA is required to adopt minimum capital requirements for SDs pursuant to Commission Regulation 170.16 and section 17(p)(2) of the CEA.

b. Computation of Net Capital To Meet Minimum Capital Requirement

Each SD that elects the proposed net liquid assets capital approach would be required to maintain net capital in excess of the highest of the three criteria listed above. The second component of the proposed capital requirement would require an SD to compute its net capital, including applicable charges for market and credit risk on its swaps and security-based swaps positions and other proprietary positions (including debt instruments such as U.S. treasury instruments and municipal bonds, and equity instruments), and determine if such net capital equals or exceeds the highest level required under the three criteria discussed in section II.A.2.ii.a above.

Proposed Regulation 23.101(a)(1)(ii) would require each SD electing the net liquid assets capital approach to compute its tentative net capital and net capital in accordance with the SEC's proposed computation of tentative net capital and net capital for SBSDs under proposed Rule 18a-1 as if the SD were a SBSD, subject to several adjustments. Under proposed SEC Rule 18a-1, a SBSD that has not received permission to use models to compute its market risk and credit risk capital charges, as described below, must maintain net capital of not less than the greater of $20 million or eight percent of the risk margin amount on cleared and uncleared security-based swaps positions. For a SBSD that has received permission from the SEC to use internal models to compute its market risk and credit risk capital charges, the SBSD must at all times maintain tentative net capital of not less than $100 million and adjusted net capital of not less than the greater of $20 million or eight percent

of the risk margin amount on cleared and uncleared security-based swaps positions. The Commission is proposing the SEC's general approach with the adjustments to include an SD's swaps, security-bases swaps, futures and foreign futures positions in its calculation of the eight percent minimum capital requirement as discussed above.

(1) Swap Dealers Computation of Tentative Net Capital and Net Capital Without Approval To Use Internal Capital Models

The Commission is proposing that an SD electing the net liquid assets capital approach which has not obtained Commission or RFA approval to use internal models to compute its market risk and credit risk charges for positions in swaps, security-based swaps, and other proprietary positions must use the standardized capital charges set forth in proposed SEC Rule 18a-1 and the appendices thereto. The use of standardized capital charges would be consistent with the SEC's proposal for SBSDs that have not obtained SEC approval to use internal capital models to compute market risk and credit risk capital charges. The Commission anticipates that this consistency would promote parity between SDs and SBSDs, as well as efficiency for an entity that is dually-registered as both an SBSD and SD.

Under the Commission's proposal, an SD would be required to compute a market risk capital charge for swaps and security-based swaps by multiplying the notional amount or fair market value of the swap or the security-based swap by a specified percentage set forth in proposed Rule 18a-1. The resulting market risk charge would be deducted from the SD's tentative net capital to arrive at the firm's net capital.

SDs would also be required to compute standardized credit risk charges pursuant to proposed Rule 18a-1. Rule 18a-1 generally provides that a SBSD's unsecured receivables are subject to a 100 percent credit risk capital charge (
i.e.,
the SBSD would have to deduct 100 percent of any unsecured receivable balance from tentative net capital in computing its net capital). The Commission, however, is modifying the SEC approach in proposed Regulation 23.101(a)(1)(ii) by providing that an SD may recognize as a secured receivable, and not take a capital charge for, the amount of initial margin that the SD has deposited with a third party custodian for uncleared swap transactions pursuant to the Commission's margin rules at Regulations 23.150 through 23.161 or margin deposited with a third party custodian for uncleared security-based swap transactions pursuant to the SEC's proposed margin rules.
52

Regulation 23.157 provides that each SD that posts margin with a third party custodian must enter into an agreement with the custodian that, in relevant part: (1) Prohibits the custodian from rehypothecating, repledging, reusing, or otherwise transferring the collateral held by the custodian; and (2) is a legally binding and enforceable agreement under the laws of all relevant jurisdictions including in the event of bankruptcy, insolvency, or similar proceeding.

52
Under the SEC's proposed Rule 18a-1, a SBSD would not be permitted to include margin funds deposited with a third party custodian as a current asset in computing the SBSD's net capital.

(2) Swap Dealers Approved To Use Internal Capital Models

The Commission is proposing to permit an SD that elects a net liquid assets capital approach to seek Commission or RFA approval to use internal models to compute market risk and credit risk capital charges on its swaps, security-based swaps and other proprietary positions in lieu of the standardized deductions contained in the SEC's proposed Rule 18a-1. In order to be considered for approval, the SD's models would have to meet the qualitative and quantitative requirements set forth in proposed Regulation 23.102 and Appendix A to Regulation 23.102.

The Federal Reserve Board has adopted quantitative and qualitative requirements for internal models used by bank holding companies to compute market risk and credit risk capital charges.
53

In developing the proposed market risk and credit risk requirements for SDs, including the proposed quantitative and qualitative requirements, the Commission has incorporated the market risk and credit risk model requirements adopted by the Federal Reserve Board. The Commission's proposed model requirements are also comparable to the SEC's model requirements. The model requirements and the process for obtaining Commission or RFA review is set forth in section II.4 of this release.

53

See,
12 CFR 217, subparts E and F.

Request for Comment

The Commission requests comment on all aspects of the proposed net liquid assets capital approach. In addition, the Commission requests comment, including empirical data in support of comments, in response to the following questions:

1. Is the proposed minimum $20 million fixed-dollar amount of net capital appropriate for SDs that elect a net liquid assets capital approach? If not, explain why not. If the minimum fixed-dollar amount should be set at a level greater or lesser than $20 million, explain what that amount should be and why that is a more appropriate amount.

2. Is the proposed minimum $100 million fixed dollar amount of tentative net capital appropriate for SDs that use market risk and credit risk models approved by the Commission or by an RFA? If not, explain why not. If the minimum fixed-dollar amount should be set at a level greater or lesser than $100 million, explain what that amount should be and explain why that is more appropriate.

3. Is the proposed minimum capital requirement based upon eight percent of the margin required on the SD's cleared and uncleared swaps and security-based swaps, and the margin required on the SD's futures and foreign futures appropriate? If not, explain why not. Should the percentage be set at a higher or lower level? Is so, what percent should the Commission consider? Please explain your response. Is including in the computation margin for swaps and security-based swaps that are exempt or excluded from the uncleared margin requirements (
e.g.,
legacy swaps and security-based swaps, and swaps with commercial end users) appropriate? If not, explain why these uncollateralized exposures would not result in an SD that is not adequately capitalized.

4. Is the proposed requirement for an SD to compute its capital in accordance with the SEC proposed capital rules for stand-alone SBSDs (
i.e.,
SEC proposed Rule 18a-1) appropriate? If not, explain why not. What other alternatives approaches should the Commission consider?

5. Is the proposal to allow SDs to recognize as current assets margin funds deposited with third-party custodians as margin for uncleared swaps or security-based swaps in accordance with the Commission's margin rules or the SEC's proposed margin rules appropriate? If not, explain why not.

6. Are there other adjustments to the SEC's proposed capital rules for SBSDs that the Commission should consider in adopting such requirements for SDs that elect the net liquid asset capital approach? Is so, explain such adjustments and why the Commission should consider such adjustments.

7. If the swap dealer de minimis level falls to $3 billion, what impact would the capital rule have on any new

potential registrants? Please provide any quantitative estimates.

iii. Capital Requirement for Swap Dealers That Are “Predominantly Engaged in non-Financial Activities”

a. Computation of the Minimum Capital Requirement

The Commission is proposing that SDs that are “predominantly engaged in non-financial activities”, as defined below, would be permitted to elect a capital requirement based upon the SD's tangible net worth.
54

An SD eligible to elect the tangible net worth approach would have to maintain tangible net worth in an amount equal to or in excess of the greatest of:

54

See
proposed Regulation 23.101(a)(2)(ii).

(1) $20 million plus the amount of the SD's market risk exposure requirement and credit risk exposure requirement associated with the SD's swap and related hedge positions that are part of the SD's swap dealing activities;

(2) Eight percent of the sum of:

(a) The amount of uncleared swap margin (as that term is defined in Regulation 23.100) for each uncleared swap position open on the books of the SD, computed on a counterparty by counterparty basis pursuant to Regulation 23.154 without regard to any initial margin exemptions or thresholds that the Commission's margin rules may provide;

(b) the amount of initial margin that would be required for each uncleared security-based swap position open on the books of the SD, computed on a counterparty by counterparty basis pursuant to 17 CFR 240.18a-3(c)(1)(i)(B) without regard to any initial margin exemptions or exclusions that the rules of the SEC may provide to such security-based swap positions; and

(c) the amount of initial margin required by clearing organizations for cleared proprietary futures, foreign futures, swaps and security-based swaps positions open on the books of the SD; or

(3) the amount of net capital required by the registered futures association of which the SD is a member.

The Commission is proposing that in order to be eligible to elect the tangible net worth capital approach, an SD's overall financial activities would have to be insignificant in relation to its other overall non-financial activities. Accordingly, proposed Regulation 23.101(a)(2) would define the term “predominantly engaged in non-financial activities” by referencing the definition of the term “financial activities” under the Federal Reserve Board's regulations establishing criteria for determining if a nonbank financial company is predominantly engaged in financial activities.
55

For purposes of the proposal, an entity would be considered “primarily engaged in non-financial activities” if: (1) The consolidated annual gross financial revenues of the entity in either of its two most recently completed fiscal years represents less than 15 percent of the entity's consolidated gross revenue in that fiscal year (“15% revenue test”), and (2) the consolidated total financial assets of an entity at the end of its two most recently completed fiscal years represents less than 15 percent of the entity's consolidated total assets as of the end of the fiscal year (“15% asset test”). For purposes of the 15% revenue test, consolidated annual gross financial revenues means that portion of the consolidated total revenue of the entity that are related to activities that are financial in nature. For purposes of the 15% asset test, consolidated total financial assets means that portion of the consolidated total assets of the entity that are related to activities that are financial in nature.

55

See,
12 CFR 242.3. The Financial Stability Oversight Council will use the criteria when it considers the potential designation of a nonbank financial company for consolidated supervision by the Federal Reserve Board.

The Commission is proposing to define the financial activities covered by the 15% revenue test and 15% asset test by reference to the listed financial activities set forth in Appendix A of 12 CFR part 242, which covers an extensive range of financial activities and services. The financial activities include, among other things: (1) Lending, exchanging, transferring, investing for others, or safeguarding money or securities; (2) insuring, guaranteeing, or indemnifying against loss or harm, damage or death in any state; (3) providing financial, investment, or economic advisory services; (4) issuing or selling interests in a pool; (5) underwriting, dealing in, or making a market in securities; and (6) engaging as principal in the investment and trading of certain financial instruments. The Commission, however, is proposing to explicitly provide that accounts receivable from non-financial activities, which may meet the definition of financial activities under 12 CFR part 242, may be excluded by the SD from the computation of its financial activities. The purpose of providing this exclusion is to prevent the SD's non-financial activities from becoming part of the computation of the firm's financial activities merely on the basis that the non-financial activities result in the SD recognizing receivables.

The Commission is proposing an option to use a tangible net worth capital approach as it recognizes that certain entities that engage primarily in non-financial activities may currently or in the future meet the statutory and regulatory definition of the term “swap dealer” and, therefore, will be required to register as such with the Commission.
56

However, while these entities may engage in dealing activities, they are primarily commercial entities and differ from financial entities in various ways, including the composition of their balance sheet (
e.g.,
the types of assets they hold), the types of transactions they enter into, and the types of market participants and swap counterparties that they deal with. Because of these differences, the Commission believes that application of the bank-based or net liquid assets capital approaches to these SDs could result in inappropriate capital requirements that would not be proportionate to the risk associated with them, and, therefore, these SDs should have the option to apply a tangible net worth approach.
57

56
The term “swap dealer” is defined by section 1a(49) of the CEA and § 1.3(ggg) of the Commission's regulations. Section 1.3(ggg)(3) provides that an entity may apply to limit its designation as an SD to specified categories of swaps or specified activities in connection with swaps.

57
Furthermore, as a SD, the firm is subject to the Commission's final swaps margin requirements.

b. Computation of Tangible Net Worth To Meet Minimum Capital Requirement

Proposed Regulation 23.101(a)(2) would require an SD to maintain tangible net worth in an amount equal to or in excess of the greater of the tangible net worth of the SD plus the market risk capital charges and credit risk capital charges associated with the SD's dealing swaps and related hedging, or eight percent of the initial margin required on the SD's proprietary swaps, security-based swaps, futures, and foreign futures. The term “tangible net worth” is proposed to be defined as the net worth of an SD as determined in accordance with generally accepted accounting principles in the United States, excluding goodwill and other intangible assets.
58

The proposal would further require an SD in computing its tangible net worth to include all liabilities or obligations of a subsidiary or affiliate that the SD guarantees, endorses, or assumes either directly or indirectly to ensure that the tangible net worth of the SD reflects the full extent

of the SD's potential financial obligations.
59

The proposed definition would further provide that in determining net worth, all long and short positions in swaps, security-based swaps and related positions must be marked to their market value to ensure that the tangible net worth reflects the current market value of the SD's swaps and security-based swaps, including any accrued losses on such positions.
60

58

See
proposed Regulation 23.100.

59

See
proposed definition of “tangible net worth” in Regulation 23.100.

60

Id.

In proposing this approach and as discussed above, the Commission recognizes that SDs that predominantly engage in non-financial activities may differ from financial entities. However, the Commission also recognizes that capital should account for all the activities entered into by the entity and not just its swap dealing activities in order to help ensure the safety and soundness of the SD.
61

By requiring the SD electing this approach to maintain tangible net worth equal to its liabilities and swaps market risk and credit risk exposures, the Commission believes that its approach would impose a sufficient level of capital (
i.e.,
unencumbered tangible assets) to help ensure the safety and soundness of an SD and that the SD can meet its swap-related obligations to its swap counterparties.

61
Section 4s(e)(2)(C) of the CEA states that for SDs that are designated as SDs for one single class or category of swap or activities, the Commission shall take into account the risks associated with other types of swaps or classes of swaps or categories of swaps engaged in and the other activities conducted by that person that are not otherwise subject to regulation applicable to that person by virtue of the status of the person as an SD.

Pursuant to the proposal, the SD would have to compute its market risk charges and credit risk charges associated with its dealing swaps and related hedges. Proposed Regulation 23.101(a)(2)(i)(A) provides that the SD may use internal capital models to compute its market risk and credit risk capital charges if the SD has obtained the approval of the Commission or an RFA. If the SD has not obtained approval to use internal capital models, the SD must use the standardized deductions under Regulation 1.17.

Request for Comment

The Commission requests comment on all aspects of the proposed tangible net worth capital approach for SDs that are predominantly engaged in non-financial activities. In addition, the Commission requests comment, including empirical data in support of comments, in response to the following questions:

1. Is the proposed minimum net capital requirement of $20 million plus the amount of the SD's market risk and credit risk charges for its dealing swaps appropriate for SDs that are eligible and elect the tangible net worth net capital approach? If not, explain why not. If the minimum dollar amount should be set at a level greater or lesser than $20 million, explain what that amount should be and explain why that is more appropriate.

2. Should the market risk and credit risk associated with the SD's security-based swap positions be added to the market risk and credit risk associated with the SD's swap positions in setting the minimum capital requirement under proposed Regulation 23.101(a)(2)(A)? Explain why or why not such security-based swap positions should or should not be included in the minimum capital requirement. Provide any empirical data to support your analysis.

3. Is the proposed minimum capital requirement based upon eight percent of the margin required on the SD's cleared and uncleared swaps and security-based swaps, and the margin required on the SD's futures and foreign futures appropriate? If not, explain why not. Should the percentage be set at a higher or lower level? Please explain your response. Is including in the computation margin for swaps and security-based swaps that are exempt or excluded from the uncleared margin requirements (
e.g.,
legacy swaps and security-based swaps, and swaps with commercial end users) appropriate? If not, explain why these uncollateralized exposures would not result in an SD that is not adequately capitalized.

4. Is the Commission's proposed 15% revenue test and 15% asset test appropriate for determining whether an SD is predominantly engaged in non-financial activities? If not, explain why not. What other alternatives should the Commission consider? If the approach is appropriate, should the Commission consider raising or lowering the percentages in the 15% revenue test and the 15% asset test?

5. Is the Commission's proposed reference to the definition of the term “financial activities” in Rule 242.3 of the Federal Reserve Board (12 CFR 242.3) to define whether an SD's activities are “financial activities” for purposes of computing the 15% revenue test and 15% asset test appropriate? If not, explain why not. Provide other alternatives that the Commission should consider.

6. Is the Commission's adjustment in the application of Rule 242.3 to permit SDs to exclude receivables resulting from non-financial activities from the term “financial activities” in computing the 15% revenue and 15% asset tests appropriate? If not, explain why not. Are there other adjustments that the Commission should consider in the application of the 15% revenue and 15% asset tests? If yes, explain what those adjustments are and why it is appropriate for the Commission to make such adjustments.

iv. Capital Requirements for Major Swap Participants

Proposed new Regulation 23.101(b) would establish capital requirements for MSPs that are not subject to the capital rules of a prudential regulator.
62

An MSP is by definition a person that is not a swap dealer and that: (1) Maintains a substantial position in swaps, excluding positions held to hedge or mitigate commercial risk; (2) has outstanding swaps that create substantial counterparty exposures that could have serious adverse effects on the financial stability of the U.S. banking system or financial markets; or (3) is a financial entity that is highly leveraged, is not subject to capital requirements of a prudential regulator, and has a substantial position in swaps, including positions used to hedge and mitigate commercial risk.
63

62
There are currently no MSPs provisionally registered with the Commission.

63

See
Regulation 1.3(hhh).

Under proposed Regulation 23.101(b), an MSP would be required to maintain positive tangible net worth or the amount of capital required by the RFA of which the MSP is a member. A tangible net worth standard is being proposed for MSPs, rather than the net liquid assets capital approach or the bank-based capital approach, as the Commission anticipates that entities that register as MSPs may engage in a diverse range of business activities different from, and broader than, the activities engaged in by SDs. For example, MSPs may engage in commercial activities that require them to have substantial fixed assets to support manufacturing and/or result in them having significant assets comprised of non-current assets as defined in the Regulations. In addition, MSPs typically use swaps for different purposes (
e.g.,
hedging or investing) than SDs, which engage in swaps as a dealing activity. The Commission believes requiring MSPs to comply with the proposed net liquid assets capital approach or bank-based capital approach could result in MSPs having to obtain significant additional capital or engage in costly restructuring.

The term “tangible net worth” is proposed to be defined as the net worth of an MSP as determined in accordance with generally accepted accounting principles in the United States, excluding goodwill and other intangible assets.
64

The proposal would further require an MSP in computing its tangible net worth to include all liabilities or obligations of a subsidiary or affiliate that the MSP guarantees, endorses, or assumes either directly or indirectly to ensure that the tangible net worth of the MSP reflects the full extent of the MSP's potential financial obligations.
65

The proposed definition would further provide that in determining net worth, all long and short positions in swaps, security-based swaps and related positions must be marked to their market value to ensure that the tangible net worth reflects the current market value of the MSP's swaps and security-based swaps, including any accrued losses on such positions.
66

64

See
proposed Regulation 23.100.

65

See
proposed Regulation 23.100.

66

Id.

In developing the proposed positive tangible net worth requirement for MSPs, the Commission also considered the impact of its recent margin rules for uncleared swap transactions. Under the margin rules, MSPs are required to post and collect initial margin and variation margin with SDs, other MSPs, and financial end users (subject to certain thresholds and minimum transfer amounts). The exchanging of variation margin and the posting of initial margin by MSPs will substantially reduce their uncollateralized exposures, which will mitigate the possibility that MSPs could destabilize the financial markets or present systemic risk. Lastly, the Commission's proposed MSP capital standard and definitions are comparable with the SEC's proposal for MSBSPs, and are intended to require an MSP to maintain a sufficient level of assets to meet its obligations to counterparties and creditors and to help ensure the safety and soundness of the MSP.

Request for Comment

The Commission requests comment on the proposed capital requirements for MSPs. In addition, the Commission requests comment, including empirical data in support of comments, in response to the following questions:

1. Is a tangible net worth test an appropriate standard for MSPs? If not, explain why not. Would the net liquid assets approach or bank-based capital approach be a more appropriate method for establishing capital requirements for MSPs? If so, please state which approach is more appropriate and describe the rationale for such approach. What other capital approaches should the Commission consider for MSPs?

2. Should the proposed minimum capital requirement for MSPs include a minimum fixed-dollar amount of tangible net worth, for example, equal to $20 million or some greater or lesser amount? Is so, explain the merits of imposing a fixed-dollar amount and identify the recommended fixed-dollar amount.

3. Should proposed Regulation 23.101(b) require an MSP to maintain positive tangible net worth in an amount in excess of the market risk and credit risk charges on the MSP's swaps and security-based swap positions? If so, please explain why. Should any other adjustments be made to the MSP's minimum capital requirement? If so, please explain why.

3. Capital Requirements for FCMs

i. Introduction

Section 4s(e)(3)(B)(i) of the CEA provides that the requirements applicable to SDs and MSPs under section 4s do not limit the Commission's authority with respect to FCM regulatory requirements.
67

The Commission's current capital requirements for FCMs are contained in Regulation 1.17, and are designed to require a minimum level of “liquid assets” in excess of the FCM's liabilities to provide resources for the FCM to meet its financial obligations as a market intermediary in the regulated futures and cleared swaps markets. Specifically, an FCM is required to hold at all times more than one dollar of highly liquid assets for each dollar of unsubordinated liabilities (
e.g.,
money owed to customers, counterparties and creditors). The capital requirements also are intended to ensure that an FCM maintains a sufficient level of liquid assets to wind-down its operations by transferring customer accounts to other FCMs in the event that the FCM decides, or is forced, to cease operations.

67
Section 4s(e)(3)(B)(i) states that nothing in section 4s(e) imposing capital and margin requirement on SDs and MSPs limits, or shall be construed to limit, the authority of the Commission to set financial responsibility rules for FCMs pursuant to section 4f(a).

Regulation 1.17(a) specifies the minimum amount of adjusted net capital that an FCM is required to maintain as the greatest of: (1) $1 million; (2) for an FCM that engages in off-exchange foreign currency transactions with retail forex customers,
68

$20 million, plus five percent of the FCM's liabilities to the retail forex customers that exceed $10 million; (3) eight percent of the sum of the risk margin of futures, options on futures, foreign futures, and swap positions cleared by a clearing organization and carried by the FCM in customer and non-customer accounts;
69

(4) the amount of adjusted net capital required by the RFA of which the FCM is a member; and (5) for an FCM that also is registered with the SEC as a BD, the amount of net capital required by the rules of the SEC.

68
Regulation 5.1(k) defines the term “retail forex customer” as a person, other than an eligible contract participant as defined in section 1a(18) of the CEA, acting on its own behalf in any account agreement, contract or transaction described in section 2(c)(2)(B) or 2(c)(2)(C) of the CEA.

69
The term “risk margin” is defined in Regulation 1.17(b)(8).

Regulation 1.17(c)(5) defines the term “adjusted net capital” as an FCM's “current assets” (
i.e.,
current, liquid assets excluding, however, most unsecured receivables), less all of the FCM's liabilities (except certain qualifying subordinated debt). An FCM is further required to impose certain prescribed capital deductions (“capital charges” or “haircuts”) from the current market value of the FCM's proprietary positions (
e.g.,
futures positions, securities, debt instruments, money market instruments, and commodities) in computing its adjusted net capital to reflect potential market risk and credit risk of the firm's current assets.

An FCM, in computing its adjusted net capital, is required to compute a capital charge to reflect the potential market risk associated with uncleared swap and security-based swap positions. Regulation 1.17(c)(5) establishes specific capital charges for market risk for an FCM's proprietary positions in physical inventory, forward contracts, fixed price commitments, and securities. Regulation 1.17(c)(5) does not explicitly address uncleared swap or security-based swap positions. The Commission, however, requires an FCM to use the capital charges specified in Regulation 1.17(c)(5)(ii), or the capital charges established by SEC Rule 15c3-1 for dually registered FCM-BDs, to compute its capital charges for uncleared swap and security-based swap positions.

The Commission is proposing to amend the minimum adjusted net capital requirements for FCMs that are also registered as SDs. In this regard, the Commission is proposing amendments to Regulation 1.17(a) that would require an FCM that is also an SD to maintain

adjusted net capital that is equal to or greater than the highest of:

(1) $20 million;

(2) Eight percent of the sum of the following:

(a) The total risk margin (as defined in Regulation 1.17(b)(8)) for positions carried by the FCM in customer and non-customer accounts;

(b) the total initial margin that the FCM is required to post with a clearing agency or broker for security-based swaps positions carried in customer and non-customer accounts;

(c) the total uncleared swaps margin as defined in Regulation 23.100;

(d) the total initial margin that the FCM is required to post with a broker or clearing organization for all proprietary cleared swap positions carried by the FCM;

(e) the total initial margin computed pursuant to SEC Rule 18a-3(c)(1)(i)(B) (17 CFR 240.181-3(c)(1)(i)(B)) for all proprietary uncleared security-based swap positions carried by an FCM, without regard to any exemptions or exclusions that may be available to the FCM under the SEC's proposal; and

(f) the total initial margin that the FCM is required to post with a broker or clearing agency for proprietary cleared security-based swaps;

(3) the amount of net capital required by the SEC if the FCM was a BD; or

(4) the amount of capital required by the RFA of which the FCM was a member.

The Commission's proposed increase in the FCM's minimum capital requirement from $1 million to $20 million is consistent with the Commission's proposal to adopt a minimum $20 million capital requirement for SDs and MSPs, and is necessary and appropriate given the change and increase in risk when the FCM is registered as an SD and engaging in uncleared swap activities. The Commission also notes that the proposed minimum dollar amount of $20 million is consistent with the current minimum dollar amount of adjusted net capital imposed by Regulation 1.17(a) on FCMs that engage in OTC forex transactions with counterparties that do not qualify as ECPs, and is consistent with the minimum dollar amount of net capital proposed by the SEC for SBSDs.
70

70
The SEC proposed capital requirements for SBSDs and MSBSPs was proposed in 2012.
See
Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers, 77 FR 70214 (Nov. 23, 2012).

The Commission is also proposing amendments to Regulation 1.17(a) to require an FCM to include eight percent of the uncleared swaps margin in its adjusted net capital. Currently FCMs must maintain adjusted net capital in excess of eight percent of the risk margin on futures, foreign futures and cleared swaps positions carried in customer and noncustomer accounts. The proposed amendments would also include in the FCM's minimum capital requirements eight percent of the “uncleared swaps margin” for uncleared swaps and the initial margin for uncleared security-based swaps position for which the FCM is a counterparty. The term “uncleared swaps margin” is defined in proposed new Regulation 23.100 as the amount of initial margin that an SD would be required to collect pursuant to the Commission's uncleared swaps margin rules for each outstanding swap.
71

The “uncleared swaps margin” would include both swaps that an SD is required to collect margin for under the margin rules as well as swaps that are exempt from the margin rules. For example, the FCM would be required to compute the amount of initial margin that an SD would be required to collect from commercial end users and affiliated counterparties as if the swaps were not exempt from the scope of the Commission's margin requirements. In addition, the FCM would have to compute the initial margin requirements for exempt foreign exchange swaps and foreign exchange forwards as if the transactions were not exempt from the Commission's margin requirements. Finally, the “uncleared swaps margin” amount would not exclude initial margin that was below the initial margin threshold amount or the minimum margin transfer amounts defined in Regulation 23.151. Not excluding these amounts in determining the capital requirement is consistent with the approach as described above for those SDs that elect to apply a net capital standard as these uncollateralized exposures may present risk to the SD for which it should maintain capital. Similarly, the Commission would require an FCM to include in its initial margin amounts for security-based swap positions both the amounts that an SD would be required to collect and the amounts that the SD would not be required to collect if the SD were treated as an SBSD under SEC's proposed rule 18a-3(c)(1)(i)(B) due to the SEC provided an exemption or exclusion on the requirement to post or collect initial margin.

71

See
Regulations 23.150, 23.152, and 23.154.

As discussed above, the capital rule is intended to help ensure the safety and soundness of the SD. Accordingly, the FCM's capital should reflect uncollateralized exposures to swap counterparties.

ii. FCM Capital Charges for Swaps and Security-Based Swaps in Computing Adjusted Net Capital

As noted in section II.A.3.i above, in computing its adjusted net capital, an FCM is required to take certain market risk and credit risk capital charges on its proprietary positions. Regulation 1.17(c) provides two approaches for an FCM to take capital charges in computing its adjusted net capital. The first approach is a rules-based approach of standardized haircuts that are set forth in Regulation 1.17(c)(5). The second approach is an approved model approach that is currently available only to FCMs that are dual-registered FCM/BDs that have been approved by the SEC to use internal models to compute market risk and credit risk capital charges in lieu of standardized capital charges. These dually-registered FCM/BDs are referred to as Alternative Net Capital Firms (“ANC Firms”).

a. Standardized Market Risk and Credit Risk Capital Charges

Currently, Regulation 1.17(c)(5) does not explicitly define market risk capital charges for swaps, and the Commission has imposed the general standardized haircuts that are applicable to inventory, fixed price commitments, and forward contracts to swaps. For example, an energy swap that is not offset by a futures contract is considered a fixed price commitment under Regulation 1.17(c)(5) and the FCM is required to take a market risk capital charge equal to 20 percent of the notional value of the energy swap. The purpose of the capital charge is to require an FCM to reserve a minimum level of capital to cover potential future losses in the value of the swap, which may have to be paid to the swap counterparty in the form of variation margin or otherwise.

The Commission recognizes that the current market risk capital charges, which were not explicitly designed for swaps or security-based swaps, should be amended to provide specific capital charges. Accordingly, the Commission is proposing to amend Regulation 1.17(c)(5)(iii) to provide a schedule of standardized market risk capital deductions for positions in credit default swaps, interest rate swaps, foreign exchange swaps, commodity swaps, and all other uncleared swaps. This schedule of standardized capital deductions is the same as the standardized market risk capital deduction proposed by the SEC for such positions in SEC Rule 15c3-1 (17 CFR

240.15c3-1).
72

The Commission is also proposing to amend Regulation 1.17(c)(5)(iv) to provide that the FCM must impose the standardized market risk capital deduction set forth in SEC Rule 15c3-1 (17 CFR 240.15c3-1) for any security-based swap positions.

72

See
77 FR 70214 (Nov. 23, 2012).

Except for credit default swaps as described below, the proposed standardized market risk capital deductions would be the deduction currently prescribed in 17 CFR 240.15c3-1 or proposed amended Regulation 1.17 applicable to the instrument referenced by the swap multiplied by the contract's notional amount.

The proposed standardized market risk deductions for swaps that are credit default swaps are designed to account for the unique attributes of these positions. Credit default swaps are generally defined by the reference asset or entity, the notional amount, the duration of the contract, and credit events. Therefore, the Commission believes that proposing a schedule of deductions for credit default swaps based on a “maturity grid” approach would be appropriate, as the Commission currently applies a maturity grid approach in setting standardized capital deductions for debt instruments.
73

Under the proposal, the market risk capital deductions for credit default swaps would be based on two variables: The length of time to maturity and the amount of the current offered basis point spread on the credit default swap. The Commission's proposed standardized deductions are consistent with the SEC's proposed amendments to its capital rule.

73
The capital deductions for debt instruments are incorporated into Regulation 1.17 by cross reference to the SEC's standardized capital charges for debt instruments.
See
Regulation 1.17(c)(5)(v).

The Commission would allow an FCM to net long and short positions where the credit default swaps reference the same entity or obligation, reference the same credit events that would trigger payment by the seller of the protection, reference the same basket of obligations that would determine the amount of payment by the seller of protection upon the occurrence of a credit event, and are in the same or adjacent maturity and spread categories (as long as the long and short positions each have maturities within three months of the other maturity category). In this case, the FCM would need to take the specified percentage deduction only on the notional amount of the excess long or short position.

The Commission would also allow limited netting in, for example, long and short credit default swap positions in the same maturity and spread categories and that reference corporate entities in the same industry sector; where the FCM is long (short) the bond or asset and long (short) protection through a credit default swap referencing the same underlying bond or asset.

As noted above, the Commission is proposing the same market risk haircut schedule for swaps as proposed by the SEC in its proposed capital and margin rule for SBSDs. The Commission understands that the proposed capital charges for credit default swaps are derived from the SEC's experience with maturity grids for other securities. Given the Commission's experience with FCMs and the financial transactions that they may enter into, and also in recognition of the SEC's experience with BDs and their financial products, the Commission believes that these charges should account for the risks of engaging in these swaps and security-based swaps. Further, the Commission believes that its approach is appropriate, given its long history of referencing 17 CFR 240.15c3-1 in setting forth capital deductions for certain financial instruments held by FCMs and the SEC's reciprocal practice of referencing Regulation 1.17 when setting forth capital deductions for certain CFTC-regulated products held by BDs. The Commission further believes that this harmonized approach would benefit registrants that are dually registered with the Commission and the SEC.

FCMs also are currently required to take a capital charge to reflect credit risk associated with uncleared swap and security-based swap transactions. Regulation 1.17(c)(2)(ii) requires an FCM to exclude unsecured receivables, which includes any unsecured receivables from swap and security-based swap counterparties and would include any margin collateral for swap or security-based swap transactions that the FCM deposits with a third-party custodian pursuant to the Commission's or SEC's uncleared margin rules.

The Commission is proposing to amend Regulation 1.17(c)(2)(ii) to permit FCM's to include margin deposited with third-party custodians for swap and security-based swap transactions, provided that such margin is held by the custodians in accordance with the requirements established by the Commission and SEC rules, as applicable.

b. Model-Based Market Risk and Credit Risk Capital Charges

As noted in section II.A.3 above, the SEC has approved certain BDs to use internal models for computing market risk capital charges in lieu of the standardized haircuts in SEC Rule 15c3-1(c)(2)(vi) and (vii) (17 CFR 240.15c3-1(c)(2)(vi) and (vii)) for their proprietary positions in securities, debt instruments, futures, security-based swaps and swaps and for computing credit risk charges associated with exposures from swap and security-based swap counterparties in lieu of the unsecured receivable capital charges in Rule 15c3-1(c)(2)(iv) (17 CFR 240.15c3-1(c)(2)(iv)). The BDs that have been approved to use these internal models are referred to as ANC Firms. As described in section II.A.3 above, ANC Firms may obtain SEC approval to use internal models to compute their capital. Once approved by the SEC to use internal models, the ANC Firms that are also registered as FCMs may use the same models to compute market risk and credit risk charges under CFTC Regulation 1.17.

The ANC Firms' market risk and credit risk models must satisfy certain qualitative and quantitative req

[Text truncated at 120,000 characters. The full text is on the page linked above.]

---

Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2016-29368. Public record. Not legal advice.