Risk Mitigation Techniques for Uncleared Security-Based Swaps

Federal RegisterFeb 15, 2019

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 240

[Release No. 34-84861; File No. S7-28-18]

RIN 3235-AL83

Risk Mitigation Techniques for Uncleared Security-Based Swaps

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“SEC” or “Commission”) is proposing rules that would require the application of specific risk mitigation techniques to portfolios of security-based swaps not submitted for clearing. In particular, the proposal would establish requirements for each registered security-based swap dealer (“SBS dealer”) and each registered major security-based swap participant (“major SBS participant”) (each SBS dealer and each major SBS participant hereafter referred to as an “SBS Entity” and together referred to as “SBS Entities”) with respect to, among other things, reconciling outstanding security-based swaps with applicable counterparties on a periodic basis, engaging in certain forms of portfolio compression exercises, as appropriate, and executing written security-based swap trading relationship documentation with each of its counterparties prior to, or contemporaneously with, executing a security-based swap transaction. In addition, the Commission is proposing an interpretation to address the application of the portfolio reconciliation, portfolio compression, and trading relationship documentation requirements to cross-border security-based swap activities and is proposing to amend Rule 3a71-6 to address the potential availability of substituted compliance in connection with those requirements. Moreover, the proposed rules would make corresponding changes to the recordkeeping, reporting, and notification requirements applicable to SBS Entities. Finally, the Commission is requesting comment on how certain aspects of the proposed rules address how a security-based swap data repository (“SDR”) could potentially satisfy its obligation to verify the terms of each security-based swap with both counterparties to the transaction.

DATES:

Comments should be received on or before April 16, 2019.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form (

http://www.sec.gov/rules/proposed.shtml

); or

• Send an email to

rule-comments@sec.gov.

Please include File Number S7-28-18 on the subject line; or

Paper Comments

• Send paper comments to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-28-18. This file number should be included on the subject line if email is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's internet website (

http://www.sec.gov/rules/proposed.shtml

). Comments are also available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549 on official business days between the hours of 10:00 a.m. and 3:00 p.m. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make available publicly.

Studies, memoranda, or other substantive items may be added by the Commission or staff to the comment file during this rulemaking. A notification of the inclusion in the comment file of any such materials will be made available on the SEC's website. To ensure direct electronic receipt of such notifications, sign up through the “Stay Connected” option at

www.sec.gov

to receive notifications by email.

FOR FURTHER INFORMATION CONTACT:

Carol McGee, Assistant Director, or Andrew Bernstein, Senior Special Counsel, at (202) 551-5870, Office of Derivatives Policy, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-8010.

SUPPLEMENTARY INFORMATION:

The Commission is proposing for public comment the following new rules:

Commission

reference

CFR citation

(17 CFR)

Securities Exchange Act of 1934 (“Exchange Act”):

Rule 15Fi-3

§ 240.15Fi-3.

Rule 15Fi-4

§ 240.15Fi-4.

Rule 15Fi-5

§ 240.15Fi-5.

The Commission also is proposing for comment amendments to:

15 U.S.C. 78a

et seq.

Commission

reference

CFR citation

(17 CFR)

Exchange Act:

Rule 3a71-6

§ 240.3a71-6.

Rule 15Fi-1

§ 240.15Fi-1.

Rule 17a-3

§ 240.17a-3.

Rule 17a-4

§ 240.17a-4.

Rule 18a-5 (proposed)

§ 240.18a-5 (proposed).

Rule 18a-6 (proposed)

§ 240.18a-6 (proposed).

Finally, the Commission is requesting comment under:

In April 2014, the Commission proposed new Rules 18a-5 and 18a-6, and amendments to existing Rules 17a-3 and 17a-4.

See

Recordkeeping and Reporting Requirements for Security-Based Swap Dealers, Major Security-Based Swap Participants, and Broker-Dealers; Capital Rule for Certain Security-Based Swap Dealers, Exchange Act Release No. 71958 (Apr. 17, 2014), 79 FR 25194 (May 2, 2014) (“SBS Books and Records Proposing Release”). Although those proposed rules and rule amendments have not yet been adopted by the Commission, all of the relevant proposals included in this release are based on the proposed regulatory text contained in the SBS Books and Records Proposing Release.

Commission

reference

CFR or U.S.C.

citation

Exchange Act:

Section 13(n)(5)(B)

15 U.S.C. 78m(n)(5).

Rule 13n-4(b)(3)

17 CFR 240.13n-4(b)(3).

Table of Contents

I. Proposed Rules and Rule Amendments

A. Background

B. Rule 15Fi-3 (Portfolio Reconciliation)

1. Overview of Portfolio Reconciliation

2. Scope of the Portfolio Reconciliation Requirements

3. Proposed Rule 15Fi-3(a): Portfolio Reconciliation With Other SBS Entities

4. Proposed Rule 15Fi-3(a): Resolution of Discrepancies With Other SBS Entities

5. Proposed Rule 15Fi-3(b): Portfolio Reconciliation With Other Counterparties

6. Reporting of Valuation Disputes

7. Application of Proposed Rule 15Fi-3 to Cleared Security-Based Swaps

8. Comments Requested

C. Rule 15Fi-4 (Portfolio Compression)

1. Overview of Portfolio Compression

2. Scope of Proposed Rule 15Fi-4—Portfolio Compression Exercises

3. Scope of Proposed Rule 15Fi-4—Bilateral Offset

4. Application of Proposed Rule 15Fi-4 to Cleared Security-Based Swaps

5. Comments Requested

D. Rule 15Fi-5 (Trading Relationship Documentation)

1. Overview of Trading Relationship Documentation

2. Scope of Proposed Rule 15Fi-5

3. Proposed Rule 15Fi-5(b)(4): Documenting Valuation Methodologies

4. Proposed Rule 15Fi-5(b)(5) and (6): Other Disclosure Requirements

5. Proposed Rule 15Fi-5(c): Audit of Security-Based Swap Trading Relationship Documentation

6. Exceptions to the Trading Relationship Documentation Requirements

7. Comments Requested

E. Verification of Transaction Data by SDRs

1. Reconciliation of Terms Submitted to an SDR

2. Documentation of Regulatory Reporting Obligations

3. Comments Requested

F. Recordkeeping Requirements

1. Proposed Amendments to Recordkeeping Rules

2. Comments Requested

II. Cross-Border Application of Rules 15Fi-3 Through 15Fi-5

A. Background on the Cross-Border Application of Title VII Requirements

B. Proposed Cross-Border Interpretation

C. Comments Requested

III. Availability of Substituted Compliance for Rules 15Fi-3 Through 15Fi-5

A. Existing Substituted Compliance Rule

B. Proposed Amendment to Rule 3a71-6

1. Basis for Substituted Compliance in Connection With the Portfolio Reconciliation, Portfolio Compression, and Trading Relationship Documentation Requirements

2. Comparability Criteria, and Consideration of Related Requirements

3. Comments Requested

IV. General Request or Comment

V. Paperwork Reduction Act

A. Summary of Collections of Information

1. Proposed Rule 15Fi-3: Portfolio Reconciliation

2. Proposed Rule 15Fi-4: Portfolio Compression

3. Proposed Rule 15Fi-5: Written Trading Relationship Documentation

4. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: Books and Records Requirements

5. Proposed Amendment to Rule 3a71-6: Substituted Compliance

B. Proposed Use of Information

1. Proposed Rule 15Fi-3: Portfolio Reconciliation

2. Proposed Rule 15Fi-4: Portfolio Compression

3. Proposed Rule 15Fi-5: Written Trading Relationship Documentation

4. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: Books and Records Requirements

5. Proposed Amendment to Rule 3a71-6: Substituted Compliance

C. Respondents

D. Total Annual Recordkeeping Burden

1. Portfolio Reconciliation Activities Generally

2. Establishing, Maintaining, and Enforcing Written Policies and Procedures

3. Reporting of Certain Valuation Disputes

4. Proposed Rule 15Fi-4: Portfolio Compression

5. Proposed Rule 15Fi-5: Written Trading Relationship Documentation

6. Proposed Amendments to Rules 17a-3, 17a-4, 18a-5, and 18a-6: Books and Records Requirements

7. Proposed Amendment to Rule 3a71-6: Substituted Compliance

E. Collection of Information Is Mandatory

F. Confidentiality

G. Request for Comment

VI. Economic Analysis

A. Broad Economic Considerations

B. Economic Baseline

1. Security-Based Swap Market Activity and Participants

a. Available Data From the Security-Based Swap Market

b. Affected SBS Entities

c. Other Market Participants

d. Outstanding Positions

2. Current Portfolio Reconciliation Practices

3. Current Portfolio Compression Practices

4. Current Trading Relationship Documentation Practices

C. Economic Costs and Benefits, Including Impact on Efficiency, Competition, and Capital Formation

1. Effects on Efficiency, Competition, and Capital Formation

a. Broad Market Effects

b. Substituted Compliance

2. Portfolio Reconciliation

a. Requirements

b. Benefits

c. Costs

d. Alternatives

3. Portfolio Compression

a. Requirements

b. Benefits

c. Costs

d. Alternatives

4. Trading Relationship Documentation

a. Requirements

b. Benefits

c. Costs

d. Alternatives

5. Recordkeeping Requirements

a. Requirements

b. Benefits

c. Costs

d. Alternatives

6. Cross-Border Application of Rules 15Fi-3 Through 15Fi-5.

a. Requirements

b. Benefits

c. Costs

D. Request for Comment

VII. Consideration of Impact on the Economy

VIII. Regulatory Flexibility Act Certification

IX. Statutory Basis and Text of Proposed Rules

I. Proposed Rules and Rule Amendments

A. Background

Section 15F(i)(1) of the Exchange Act, as added by Section 764(a) of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”),

requires each SBS Entity to conform with such standards as may be prescribed by the Commission, by rule or regulation, that relate to timely and accurate confirmation, processing, netting, documentation, and valuation of all security-based swaps.

Section 15F(i)(2) of the Exchange Act provides that the Commission shall adopt rules governing documentation standards for SBS Entities.

Public Law 111-203, 124 Stat. 1376 (2010). Unless otherwise indicated, references to “Title VII” in this release are to Subtitle B of Title VII of the Dodd-Frank Act.

15 U.S.C. 78o-10(i)(1).

15 U.S.C. 78o-10(i)(2).

The Commission previously adopted rules requiring SBS Entities to provide trade acknowledgments and to verify those trade acknowledgments with their counterparties to security-based swap transactions,

but has not proposed rules concerning portfolio reconciliation, portfolio compression, or trading relationship documentation. By contrast, the Commodity Futures Trading Commission (“CFTC”) has implemented rules setting forth standards for the timely and accurate confirmation of swaps, addressing the reconciliation and compression of swap portfolios, and setting forth requirements for documenting the swap trading relationship between swap dealers or major swap participants (each swap dealer and each major swap participant hereafter referred to as a “Swap Entity” and together referred to as “Swap Entities”) and their counterparties.

See

Trade Acknowledgment and Verification of Security-Based Swap Transactions, Exchange Act Release No. 78011 (June 8, 2016), 81 FR 39807 (June 17, 2016) (“Trade Acknowledgment and Verification Adopting Release”).

See

Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship Documentation Requirements for Swap Dealers and Major Swap Participants, 77 FR 55904 (Sept. 11, 2012) (“CFTC Risk Mitigation Adopting Release”). The European Commission (“EC”) has implemented similar measures.

See

Commission Delegated Regulation (EU) No. 149/2013 (Dec. 18, 2012) supplementing Regulation (EU) No. 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for over-the-counter (“OTC”) derivatives contracts not cleared by a central counterparty (Feb. 23, 2013),

available at: http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:052:0011:0024:en:PDF.

Regulatory authorities in other jurisdictions (

e.g.,

the Hong Kong Monetary Authority and the Monetary Authority of Singapore) have also proposed requirements similar to those adopted by the CFTC and the EC. In addition, the Canadian Securities Administrators (“CSA”) published a consultation paper in 2016 proposing a requirement that financial institutions enter into a written agreement documenting the material terms and conditions of any non-centrally cleared derivative, including standards related to the maintenance, review, and contents of that documentation.

See

CSA Consultation Paper 95-401—Margin and Collateral Requirements for Non-Centrally Cleared Derivatives (Jul. 7, 2016),

available at: http://www.osc.gov.on.ca/documents/en/Securities-Category9/csa_20160707_95-401_collateral-requirements-cleared-derivatives.pdf.

Accordingly, the Commission is today proposing requirements applicable to SBS Entities addressing, among other things, reconciling and compressing portfolios of uncleared security-based swaps and executing written trading relationship documentation with each counterparty prior to or contemporaneously with executing an uncleared security-based swap. In developing this proposal, we have consulted and coordinated with the CFTC, the prudential regulators,

and foreign regulatory authorities in accordance with the consultation mandate of the Dodd-Frank Act.

We also have consulted and coordinated with foreign regulatory authorities through Commission staff participation in numerous bilateral and multilateral discussions with foreign regulatory authorities addressing the regulation of OTC derivatives.

Through these multilateral and bilateral discussions and the Commission staff's participation in various international task forces and working groups, we have gathered information about foreign regulatory reform efforts and their effect on, and relationship with, the U.S. regulatory regime. The Commission has taken, and will continue to take, these discussions into consideration in developing rules, forms, and interpretations for implementing Title VII of the Dodd-Frank Act.

For purposes of this statement, the term “prudential regulator” is defined in Section 1a(39) of the CEA, 7 U.S.C. 1a(39), and that definition is incorporated by reference into Section 3(a)(74) of the Exchange Act, 15 U.S.C. 78c(a)(74). Pursuant to that definition, the Board of Governors of the Federal Reserve System (“Federal Reserve Board”), the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation (“FDIC”), the Farm Credit Administration, or the Federal Housing Finance Agency (collectively, the “prudential regulators”) is the “prudential regulator” of an SBS Entity if the entity is directly supervised by that regulator. Separately, we are proposing a definition of “prudential regulator,” to be used for purposes of the proposed portfolio reconciliation and trading relationship documentation requirements.

See infra

note 48. That proposed definition also references Section 3(a)(74) of the Exchange Act and includes the same list of agencies as noted above.

Section 712(a)(2) of the Dodd-Frank Act provides in part that the Commission shall “consult and coordinate to the extent possible with the Commodity Futures Trading Commission and the prudential regulators for the purposes of assuring regulatory consistency and comparability, to the extent possible.”

In addition, Section 752(a) of the Dodd-Frank Act provides, in part, that “[i]n order to promote effective and consistent global regulation of swaps and security-based swaps, the Commodity Futures Trading Commission, the Securities and Exchange Commission, and the prudential regulators . . . as appropriate, shall consult and coordinate with foreign regulatory authorities on the establishment of consistent international standards with respect to the regulation (including fees) of swaps.”

Staff participates in a number of international standard-setting bodies and workstreams working on OTC derivatives reforms. For example, Commission staff participated in the International Organization of Securities Commissions' (“IOSCO”) preparation of a report regarding risk mitigation standards for non-centrally cleared OTC derivatives.

See

Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives (Jan. 28, 2015),

available at: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD469.pdf.

IOSCO developed those standards in consultation with the Basel Committee on Banking Supervision and the Committee on Payments and Market Infrastructures.

Finally, the Commission recognizes that the CFTC rules pertaining to portfolio reconciliation, portfolio compression, and written trading relationship documentation have been in effect since 2012, and that any SBS Entity that also is registered with the CFTC as a Swap Entity will already have incurred systems and compliance costs in connection with the corresponding CFTC requirements. In order to minimize compliance burdens on such potential dual registrants in connection with the rules we are proposing today, we have attempted to harmonize this proposal with the existing CFTC rules wherever possible. There are, however, a limited number of provisions where we preliminarily believe it is appropriate to diverge from a particular aspect of the CFTC rules. Each of those differences is described below, along with the preliminary reasons for the different approaches. To the extent that no such substantive difference is described, it is because we have preliminarily determined that none exists. However, below we welcome and solicit comment on any potential substantive differences between the proposed rules and the corresponding CFTC rules, as well as on the decision to harmonize with the CFTC, both as an overall approach and with respect to any specific provisions of the proposed rules.

B. Rule 15Fi-3 (Portfolio Reconciliation)

1. Overview of Portfolio Reconciliation

In the Trade Acknowledgement and Verification Adopting Release, the Commission noted the importance of confirming trades in a timely manner, explaining that the process of confirming the terms of a transaction is essential for SBS Entities “to effectively measure and manage market and credit risk.”

The Commission further explained that “a backlog of unconfirmed trades could hinder the settlement process, particularly if errors go undetected or a counterparty disputes the terms of a transaction.”

Such disruptions in the settlement process could, in turn, lead to broader market instability in the case of a credit event involving a reference entity on which many different counterparties have, in the aggregate, a large notional outstanding exposure.

Trade Acknowledgement and Verification Adopting release, 81 FR at 39833.

Id.

In this regard, portfolio reconciliation addresses many of these same issues, but unlike the confirmation process, which occurs at the outset of a transaction, reconciliation operates throughout the life of the transaction. If a security-based swap transaction is accurately confirmed by both parties during the trade acknowledgement and verification process, reconciliation helps to identify any discrepancies in terms that do not remain constant throughout the life of a trade. Furthermore, if a discrepancy is

not

identified during the trade acknowledgement and verification process, it could be identified during a subsequent reconciliation exercise.

The Commission preliminarily believes that portfolio reconciliation serves as an important mechanism for promoting risk mitigation by requiring security-based swap counterparties to have established processes for identifying and resolving discrepancies involving key terms of their transactions. To illustrate this point, if a term necessary for calculating the market value of a security-based swap is not properly confirmed during the trade acknowledgment and verification process, such as due to some form of systems or human error, that discrepancy could lead to complications at various points throughout the life of the transaction, which could become particularly problematic if it remains undetected until such time as the parties are required to perform on their obligations.

Thus, portfolio reconciliation could help to mitigate the possibility of a discrepancy unexpectedly affecting performance under the security-based swap transaction by increasing the likelihood

that the parties are and remain in agreement with respect to all material terms.

See

Summary of OTC Commitments, Attachment to the July 31, 2008 letter from the Operations Management Group to Timothy Geithner, President, Federal Reserve Bank of New York (“FRBNY”),

available at: https://www.newyorkfed.org/medialibrary/media/newsevents/news/markets/2008/CommitmentSummaryTable.pdf

(“Positive affirmation of trade economics is a key risk mitigation technique for OTC derivatives because it assures that each counterparty's risk management system accurately reflect the economic details of trades that have not yet been matched.”). Although this particular commitment was made in the context of the trade affirmation process, we believe that the same basic principle supports the need to reconcile terms throughout the life of a trade, even if a term is accurately reflected in a firm's system as a result of the affirmation process. This is particularly true for terms that do not remain constant during the life of a trade.

This practice is particularly relevant with respect to terms used to perform a valuation of the financial instrument. Specifically, unresolved discrepancies regarding the value of a security-based swap can lead to, among other things, difficulties in the application of any processes that depend on the valuation being accurate, such as determining the amount of margin that must be posted or collected during the life of a security-based swap transaction. In the aggregate, such errors and other complications could result in significant uncollateralized exposure in the uncleared security-based swap markets (or alternatively, potentially inefficient overcollateralization).

In addition, valuation discrepancies identified during reconciliation could help to identify problems with one or both of the counterparties' internal valuation systems and models, or possibly even with a firm's internal controls. For example, in a report analyzing federal assistance to American International Group, Inc. (“AIG”) following the events of September 2008, the General Accountability Office (“GAO”) noted that in structuring this relief one of the many open issues the FRBNY had to address was the number of collateral disputes AIG had with its counterparties.

GAO further explained that “[t]o the extent that lower valuations (more CDO value lost) produced greater collateral postings, counterparties had an interest in seeking lower valuations. Similarly, to the extent that higher valuations (less CDO value lost) meant smaller collateral postings, AIG had an interest in seeking higher valuations.”

See

GAO, Financial Crisis: Review of Federal Reserve System Financial Assistance to American International Group, Inc., GAO-11-616 (Sept. 2011),

available at http://www.gao.gov/assets/590/585560.pdf

(“According to information we reviewed, on a [collateralized debt obligation (“CDO”)] portfolio of $71 billion . . . , AIG and its counterparties had valuation differences totaling $4.3 billion. Among a group of 15 counterparties, 9 had valued their assets differently than AIG.”).

Id.

at 82.

In light of this information, the Commission preliminarily believes that the use of portfolio reconciliation to help maintain an agreed-upon valuation of a security-based swap throughout the lifecycle of a transaction should be a hallmark of prudent risk mitigation practices within the operations of an SBS Entity. Accordingly, the Commission is proposing new Rule 15Fi-3 under the Exchange Act,

which generally would require those entities, in connection with security-based swaps not submitted for clearing, to (1) engage in portfolio reconciliation with counterparties who are SBS Entities and (2) establish, maintain, and follow written policies and procedures reasonably designed to ensure that they engage in portfolio reconciliation with counterparties who are not SBS Entities. In both cases, the frequency of the portfolio reconciliation would be based on the number of outstanding transactions with the applicable counterparty.

Unless otherwise noted, all references to rules (both proposed and existing) without an accompanying statutory reference are to rules adopted (or proposed to be adopted) under the Exchange Act.

2. Scope of the Portfolio Reconciliation Requirements

For purposes of proposed Rule 15Fi-3,

the Commission is proposing to amend existing Rule 15Fi-1 to add a definition of “portfolio reconciliation.”

As proposed, this term would be defined to mean any process by which the counterparties to one or more uncleared security-based swaps:

The corresponding CFTC rule is 17 CFR 23.502. The structure of the CFTC rule, including the subsections, mirrors the structure of proposed Rule 15Fi-3.

See

proposed Rule 15Fi-1(l). The corresponding CFTC definition is in 17 CFR 23.500(i).

(i) Exchange the material terms of all security-based swaps in the security-based swap portfolio between the counterparties;

(ii) Exchange each counterparty's valuation of each security-based swap in the security-based swap portfolio between the counterparties as of the close of business on the immediately preceding business day; and

(iii) Resolve any discrepancy in valuations or material terms.

For purposes of this proposed definition, the Commission also is proposing to amend Rule 15Fi-1 to add the terms “security-based swap portfolio,” which would be defined to mean all security-based swaps currently in effect between a particular SBS Entity and a particular counterparty,

and “valuation,” which would be defined to mean the current market value or net present value of a security-based swap.

Both of these definitions help to establish the scope of the portfolio reconciliation requirements in proposed Rule 15Fi-3, with the former defining which security-based swaps are subject to the rule and the latter defining one of the two categories of information that must be exchanged during a reconciliation (the other being “material terms”). Moreover, for consistency with the corresponding CFTC rules applicable to Swap Entities, these definitions are substantively identical to the CFTC's corresponding definitions, which we preliminarily believe are appropriately scoped and clear for purposes of proposed Rule 15Fi-3.

See

proposed Rule 15Fi-1(o). The corresponding CFTC definition is in 17 CFR 23.500(k)

See

proposed Rule 15Fi-1(q). The corresponding CFTC definition is in 17 CFR 23.500(m).

With respect to the phrase “material terms,” the proposed definition would follow a similar approach to the one taken by the CFTC in that it would base the definition on the terms required to be reported to an SDR pursuant to Regulation SBSR.

Unlike the approach taken by the CFTC, however, which has adopted a single definition of “material terms,” the definition in proposed Rule 15Fi-1(i) would be bifurcated depending on whether a security-based swap transaction had already been included in a security-based swap portfolio and reconciled pursuant to proposed Rule 15Fi-3.

With respect to any security-based swap that has

not

yet been reconciled as part of a security-based swap portfolio, “material terms” would be defined to mean each term that is required to be reported to a registered SDR pursuant to Rule 901 under the Exchange Act.

With respect to all other security-based swaps within a security-based swap portfolio, the definition of “material terms” would continue to be based on the reporting requirements in Rule 901, but would exclude any term that is not relevant to the ongoing rights and obligations of the

parties and the valuation of the security-based swap.

17 CFR 242.900 to 242.909.

CFTC Rule 23.500(g) defines “material terms” to include the minimum primary economic terms (as defined in Appendix 1 of part 45 of the CFTC's regulations) of a swap, other than the 24 specific data fields identified in that rule.

See

17 CFR 23.500(g). Among the excluded fields are: (1) The status of either counterparty as a swap dealer, major swap participant, financial entity, or U.S. person; (2) an indication that the swap will be allocated and certain information regarding the agent and the original swap; (3) an indication that the swap is a multi-asset swap and a further indication of its primary and secondary asset class; (4) an indication that the swap is a mixed swap and the identification of any non-CFTC registered swap data repository to which it is also reported (if applicable); (5) the block trade indicator, execution timestamp, and timestamp for submission to a swap data repository; (6) the clearing indicator and clearing venue; and (7) certain information regarding the application of the end user exception from mandatory clearing.

See

proposed Rule 15Fi-1(i)(1) (referencing 17 CFR 242.901).

See

proposed Rule 15Fi-1(i)(2).

The Commission preliminarily believes that the data set submitted to an SDR under Rule 901 is an appropriate measure for determining which terms should be reconciled pursuant to proposed Rule 15Fi-3. As noted above, the Commission believes that one of the fundamental goals of the portfolio reconciliation process is to help ensure that both counterparties to a security-based swap are in agreement on all of the terms necessary for developing a comprehensive understanding of each of their rights and obligations under the security-based swap, and that they remain in such agreement throughout the life of the transaction. To effect that objective, we are proposing that the term “portfolio reconciliation” be defined in part as the exchange of the “material terms” of all security-based swaps in the security-based swap portfolio between the counterparties. Similarly, in adopting Regulation SBSR the Commission explained that the Title VII regulatory reporting requirement “is designed to allow the Commission and other relevant authorities to have access to comprehensive information about security-based swap activity in registered SDRs.”

The Commission therefore preliminarily believes that the terms that must be reported to an SDR under Regulation SBSR are a good proxy for identifying the “material terms” that should be subject to the portfolio reconciliation requirements.

See

Regulation SBSR—Reporting and Dissemination of Security-Based Swap Information; Final Rule, Exchange Act Release No. 74244 (Feb. 11, 2015), 80 FR 14563, 14646 (Mar. 19, 2015) (“Regulation SBSR Adopting Release”).

The Commission also preliminarily believes that basing the definition of “material terms” on what is required to be reported to an SDR provides certainty for SBS Entities regarding what information must be reconciled, which should in turn reduce the burdens on those entities without lessening the benefits of the proposed rule (which are described earlier in this section and in the Economic Analysis section below). Furthermore, the proposed approach is designed to allow affected counterparties to leverage the same systems used for SDR reporting for purposes of the portfolio reconciliation requirements, should such synergies exist. Moreover, this proposed approach would promote the same policy goals that underpin a particular requirement imposed on SDRs to verify the terms of each security-based swap with both counterparties to the transaction, as discussed in detail in Section I.E below.

The Commission preliminarily believes that the proposed rule is reasonably tailored to avoid unnecessary burdens while still promoting important risk mitigation goals inherent to the portfolio reconciliation process. That said, certain terms of a security-based swap transaction may be material the first time that a transaction is reconciled, but might not be material during a subsequent reconciliation. This could be true, for example, with respect to any term of a transaction that does not affect any ongoing rights or obligations of the parties and that has no effect on the valuation of the security-based swap. Accordingly, the definition of “material terms” in proposed Rule 15Fi-1(i)(2) provides that with respect to any subsequent reconciliations, SBS Entities may exclude any term that is not relevant to the ongoing rights and obligations of the parties and the valuation of the security-based swap, regardless of the fact that the term was required to be reported to an SDR under Regulation SBSR.

For example, the Commission preliminarily believes that the 24 terms excluded from the CFTC definition could be excluded from the proposed definition of “material terms” in the context of security-based swaps that have previously been reconciled.

The Commission does not, however, believe that a term would be appropriately excluded from the definition of “material terms” if it was resubmitted to an SDR because of an error in how it was initially reported or due to a lifecycle event. In those circumstances, the Commission preliminarily believes that such term would continue to be material for the same reasons that every term subject to a reporting requirement under Rule 901 would be material the first time that a transaction is reconciled. Once the updated term is reconciled, however, an SBS Entity would be able to exclude that term from subsequent reconciliations to the extent that it determines that it is not relevant to the ongoing rights and obligations of the parties and the valuation of the security-based swap.

See supra

note 23 (discussing CFTC Rule 23.500(g)). We further recognize that when the CFTC adopted amendments to Rule 23.500(g) to exclude these terms, it noted that “removal of these terms from reconciliations would alleviate the burden of resolving discrepancies in terms of a swap that are not relevant to the ongoing rights and obligations of the parties and the valuation of the swap without impairing the [CFTC's] regulatory mission.”

See

Definitions of “Portfolio Reconciliation” and “Material Terms” for Purposes of Swap Portfolio Reconciliation, 81 FR 27309, 27311 (May 6, 2016).

Finally, the Commission recognizes that our proposed definition of “material terms” would differ from the corresponding CFTC definition in that Swap Entities would never need to reconcile the 24 terms excluded from the definition of “material terms” in CFTC Rule 23.500(g). Nevertheless, we are proposing to require all reported terms to be reconciled at least initially because, among other things, such requirement could potentially help to address an issue related to how registered SDRs can verify the information that they receive, as discussed in detail in Section I.E below. However, below we solicit comment on our approach, and particularly welcome comments on any trade-offs that may exist as between our efforts to address the SDR-related issue and any additional burdens resulting from a definition of “material terms” that departs from the corresponding CFTC rule, particularly in the context of CFTC-regulated Swap Entities that also may register with the Commission as SBS Entities.

3. Proposed Rule 15Fi-3(a): Portfolio Reconciliation With Other SBS Entities

The Commission is proposing to bifurcate proposed Rule 15Fi-3 based on the particular type of counterparty with which the SBS Entity transacts. For transactions between two SBS Entities, proposed Rule 15Fi-3(a) would require the two sides to engage in portfolio reconciliation at frequencies that are based on the size of the security-based swap portfolio between the two parties, expressed in ranges (or tiers).

See

proposed Rule 15Fi-3(a).

Under this tiered approach, if the two SBS Entity counterparties maintain a security-based swap portfolio that includes 500 or more security-based swaps, portfolio reconciliation would need to occur once each business day for as long as the portfolio exceeds this threshold. If a security-based swap portfolio between two SBS Entities includes more than 50 but fewer than 500 security-based swaps on any business day during a week, portfolio reconciliation would be required to occur on a weekly basis. For a security-based swap portfolio between two SBS Entities that includes no more than 50 security-based swaps at any time during the calendar quarter, portfolio reconciliation would be required on a quarterly basis.

See

proposed Rule 15Fi-3(a)(3). For the avoidance of doubt, if a security-based swap portfolio between two SBS Entity counterparties crosses from one threshold to another, both sides would be required to comply with the proposed rule as of the date that the requirement applies. For example, if two SBS Entities that have long maintained a portfolio of 50 or fewer security-based swaps (and accordingly reconcile on a quarterly basis) exceed the 50 transaction threshold, the two sides would become subject to the weekly reconciliation requirement as of the first day that the portfolio exceeds 50 security-based swaps (or the daily reconciliation requirement if the portfolio increases to 500 or more security-based swaps). By

contrast, if two SBS Entities that maintain a security-based swap portfolio of more than 500 transactions fall below that threshold, they could begin reconciling on a weekly basis as of the first business day after the date on which they were able to verify that their security-based swap portfolio has fallen below 500 transactions.

The Commission preliminarily believes that the proposed tiering of obligations, whereby the frequency of the portfolio reconciliation would be based on the number of outstanding transactions with the applicable counterparty, represents a reasonable attempt to calibrate the costs to the benefits expected from reconciling a person's security-based swap portfolio at regular intervals. All other things being equal, a larger and more complex portfolio represents a greater potential for loss than a smaller, less complex portfolio. Therefore, the proposed rule would require more frequent reconciliation of the larger, more complex portfolio. We also note that the CFTC has adopted rules that utilize identical levels as our proposal, and that divergence from those thresholds could lead to additional costs and other inefficiencies for SBS Entities that are also registered with the CFTC as Swap Entities.

When it adopted the same numerical thresholds in 2012, the CFTC noted that the requirement to reconcile portfolios with 500 or more swaps on a daily basis was consistent with the commitments made by the OTC Derivatives Steering Group's 14 major dealers (“G-14 dealers”) in December 2008 as well as international regulatory efforts underway at the time of the CFTC's release.

See CFTC Risk Mitigation Adopting Release,

77 FR at 55928 nn. 35 and 36.

See also

Summary of OTC Commitments, Attachment to the June 2, 2009 letter from G-14 dealers and certain buy-side participants to William C. Dudley, President, FRBNY,

available at: https://www.newyorkfed.org/medialibrary/media/newsevents/news/markets/2009/060209table.pdf

(committing, “[b]y June 30, 2009, [to] execute daily collateralized portfolio reconciliations for collateralized portfolios in excess of 500 trades between [Operations Management Group] dealers as detailed in the December 31, 2008 Collateral Update letter”).

See also

Attachment to the Mar. 31, 2011 letter from the G-14 dealers and certain buy-side participants to William C. Dudley, President, FRBNY,

available at: https://www.newyorkfed.org/medialibrary/media/newsevents/news/markets/2011/SCL0331.pdf

(“We commit to reduce the threshold for routine portfolio reconciliation of collateralized portfolios from those exceeding 1,000 transactions to those exceeding 500 transactions starting June 30, 2011. These portfolios will be reconciled at least monthly.”) (internal citation omitted).

In addition to the requirements regarding the frequency of the reconciliation, proposed Rule 15Fi-3(a)(1) would require SBS Entities to agree in writing with each of their counterparties on the terms of the portfolio reconciliation including, if applicable, agreement on the selection of any third party service provider who may be performing the reconciliation.

In practice, the Commission notes that an SBS Entity could satisfy such requirement by including the terms governing the portfolio reconciliation process in the written security-based swap trading relationship documentation that the SBS Entity executes with its counterparty which, pursuant to proposed Rule 15Fi-5 would be required to be executed prior to, or contemporaneously with, the two parties executing any new security-based swap transaction.

This practice should help to ensure that portfolio reconciliation begins without delay after execution of the transaction and is designed to minimize the number of disagreements regarding the portfolio reconciliation process itself.

Proposed Rule 15Fi-3(a)(2) provides that portfolio reconciliation may be performed either on a bilateral basis by the counterparties or by a third party selected by the counterparties in accordance with paragraph (a)(1) of the proposed rule. The Commission notes that CFTC Rule 23.502(a)(2), which is comparable to proposed Rule 15Fi-3(a)(2), uses the term “qualified third party.” When it adopted the above provision in 2012, the CFTC explained that it “expects that parties will determine if the third-party is qualified based on their own policies.”

See

CFTC Risk Mitigation Release, 77 FR at 55929. In addition, the CFTC's portfolio reconciliation requirements for transactions between Swap Entities and counterparties that are

not

Swap Entities do not require the relevant third party to be “qualified” and, instead, provide that “[t]he portfolio reconciliation may be performed on a bilateral basis by the counterparties or by one or more third parties

selected by the counterparties.” See

17 CFR 23.502(b)(2) (emphasis added). Accordingly, the Commission has decided not to refer to a “qualified third party” and, instead, uses the term “third party selected by the counterparties” for purposes of proposed Rule 15Fi-3(a)(2). We preliminarily believe that it is sufficient for our purposes to refer solely to the fact that a third party has been selected.

Once the two parties have agreed in writing on the terms of the portfolio reconciliation for the first time, the requirement could then be satisfied in connection with any new security-based swap transaction executed by the two sides merely by agreeing in writing to abide by the existing agreement regarding the reconciliation process.

Finally, the Commission has preliminarily determined not to propose the CFTC's definition of “business day” and to rely on the definition in existing Rule 15Fi-1, which was adopted in 2016 in connection with the trade acknowledgement and verification requirements in Rule 15Fi-2. That definition includes “any day other than a Saturday, Sunday, or legal holiday.”

Specifically, we believe that the existing definition of “business day” is broadly consistent with other uses of the term within the Commission's rules.

We also do not believe it necessary to have two different definitions of the same term promulgated under the same legal authority (

i.e.,

Section 15F(i) of the Exchange Act), one for purposes of the portfolio reconciliation rules and the other for purposes of the trade acknowledgement and verification rules.

Moreover, we believe that this definition provides market participants with the flexibility to determine which holidays are “legal holidays” for purposes of the portfolio reconciliation requirements in proposed Rule 15Fi-3, which should be particularly useful given the cross-border nature of the OTC derivatives market.

However, below we solicit comment on our approach.

Under this proposal, the definition of “business day” currently in Rule 15Fi-1(a) would be renumbered as proposed Rule 15Fi-1(b).

See, e.g.,

17 CFR 270.2a-7(a)(4) (“Business day means any day other than Saturday, Sunday, or any customary business holiday.”) and 17 CFR 230.261(b) (“Business day [means] [a]ny day, except Saturdays, Sundays or United States federal holidays.”).

By contrast, the applicable definition of “business day” for purposes of the CFTC's portfolio reconciliation rules is contained in CFTC Rule 1.3(b), and includes “any day other than a Sunday or holiday.” That definition also provides instructions for computing time periods for CFTC rules that include notice requirements.

As a reminder, the proposal would require SBS entities to agree in writing with each of their counterparties on the terms of the portfolio reconciliation pursuant to proposed Rule 15Fi-3(a)(1) (in the case of security-based swap portfolios with other SBS Entities) and Rule 15Fi-3(b)(1) (in the case of security-based swap portfolios with all other counterparties). Accordingly, such agreement between an SBS Entity and its counterparty could include a determination as to which holidays would be considered “legal holidays” for purposes of any applicable portfolio reconciliation exercises involving those two parties.

4. Proposed Rule 15Fi-3(a): Resolution of Discrepancies With Other SBS Entities

Proposed Rule 15Fi-3(a) also would require each SBS Entity to take additional actions in the event of a discrepancy with a counterparty that is an SBS Entity. First, proposed Rule 15Fi-3(a)(4) would require the two SBS Entities to resolve

immediately

any discrepancy in a material term, whether identified directly as part of the portfolio reconciliation or otherwise. We preliminarily believe that this timeframe is appropriate given the ongoing nature of security-based swap transactions, as well as the potential for disagreements between the counterparties regarding the terms of a transaction to compound over the course of the security-based swap transaction. We have not, however, proposed a fixed definition of “immediately” as we believe that the amount of time that will be needed to resolve a discrepancy will depend on the particular facts and circumstances involved, including the complexity of the material term in question and the

magnitude of the discrepancy. We have, however, solicited comment on this approach.

At the same time, we also recognize that discrepancies related to the

valuation

of a security-based swap could be particularly difficult to resolve in a short period of time. Accordingly, proposed Rule 15Fi-3(a)(5) would require SBS Entities to have policies and procedures reasonably designed to resolve valuation discrepancies no later than five business days from the date they were discovered, which we preliminarily believe to be both a reasonable and appropriate amount of time to resolve such discrepancies. As a condition to this requirement, however, proposed Rule 15Fi-3(a)(5) would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to identify how it will comply with any variation margin requirements under Section 15F(e) of the Exchange Act

and any related regulations pending resolution of the valuation discrepancy. Although we preliminarily believe that counterparties should be given sufficient time to resolve valuation discrepancies, we also believe it to be important for those counterparties to take reasonable steps during the pendency of the resolution to ensure that they are continuing to manage their credit risk to each other by way of exchanging variation margin.

15 U.S.C. 78o-10(e).

Moreover, proposed Rule 15Fi-3(a)(5) provides that for purposes of the requirement to resolve valuation discrepancies within five business days of being identified, a difference between the lower valuation and the higher valuation of less than 10% of the higher valuation need not be deemed a discrepancy. This 10% threshold would apply on a transaction-by-transaction basis and not on a portfolio level. As discussed in the immediately preceding paragraph, the Commission recognizes that valuation discrepancies could be challenging and costly to resolve. Accordingly, we preliminarily believe that providing SBS Entities with a clear understanding of exactly which valuation discrepancies would need to be resolved within five business days will help focus the internal resources of both counterparties on the largest discrepancies. At the same time, however, the Commission believes that, in most cases, prudent risk mitigation of a firm's security-based swap portfolio and proper governance over an entity's operations would involve ensuring that, at least to a certain degree, most valuation discrepancies are ultimately resolved.

For the avoidance of doubt, an SBS Entity that identifies a valuation discrepancy in excess of 10% would be in compliance with the proposed rule if it resolves such discrepancy to a level below 10%, even if the entire discrepancy is not completely eliminated. Thus, an SBS Entity would not be required to reduce an 11% valuation discrepancy down to zero, in contrast to an SBS Entity with a 9% valuation discrepancy, who would have no further obligations under proposed Rule 15Fi-3(a)(5).

5. Proposed Rule 15Fi-3(b): Portfolio Reconciliation With Other Counterparties

Proposed Rule 15Fi-3(b) would establish reconciliation requirements for security-based swap portfolios between an SBS Entity and a counterparty that is

not

an SBS Entity. Although there is some broad similarity between proposed Rule 15Fi-3(b) and the rules applicable to security-based swap portfolios between two SBS Entities, we have preliminarily determined to take a more streamlined approach with respect to security-based swaps between an SBS Entity and its non-SBS Entity counterparties, similar to the CFTC's approach. This approach reflects our preliminary view that a dealer-to-dealer portfolio may be associated with a degree of market interconnectedness and volume that could potentially carry considerable market-wide risks, at least as compared to a security-based swap portfolio that involves only one SBS Entity. Moreover, the Commission preliminarily believes it to be appropriate to impose more prescriptive requirements in cases where both entities are subject to the SEC's requirements for registered entities. Accordingly, there are differences in both the application of the portfolio reconciliation requirements with non-SBS Entity counterparties as well as in the thresholds governing the frequency of the required reconciliation exercises.

Specifically, the proposal would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to ensure that it engages in portfolio reconciliation with non-SBS Entity counterparties as set forth in the rule.

This is in contrast to proposed Rule 15Fi-3(a), which expressly requires portfolio reconciliation with respect to transactions where both counterparties are SBS Entities. In addition, the policies and procedures would require that the portfolio reconciliation be performed no less frequently than: (1) Once each calendar quarter for each security-based swap portfolio that includes more than 100 security-based swaps at any time during the calendar quarter and (2) once annually for each security-based swap portfolio that includes no more than 100 security-based swaps at any time during the calendar year.

See

proposed Rule 15Fi-3(b). Additionally, proposed Rule 15Fi-3(b) contains a slight deviation from corresponding CFTC Rule 23.502(b) to eliminate language that we believe to be redundant. We do not intend for such clarification to signify any substantive differences between proposed rule Rule15Fi-3(b) and CFTC Rule 23.502(b).

See

proposed Rule 15Fi-3(b)(3).

As we previously explained, the Commission preliminarily believes that basing the required frequency of the portfolio reconciliation on the number of outstanding transactions with the applicable counterparty represents a reasonable attempt to calibrate the costs to the benefits expected from reconciling a person's security-based swap portfolio at regular intervals. As we also noted above, all other things being equal a larger and more complex portfolio represents a greater potential for loss than a smaller, less complex portfolio. As before, in selecting the specific levels we recognize that the CFTC has adopted rules with identical thresholds and frequencies and that divergence from those thresholds could lead to additional costs and other inefficiencies for SBS Entities that are also registered with the CFTC as Swap Entities.

See supra

note 31 (discussing how the CFTC arrived at setting the numerical thresholds for the requirement to engage in portfolio reconciliation as between two Swap Entities.).

In addition, paragraph (b)(1) of proposed Rule 15Fi-3 would require that the applicable policies and procedures be reasonably designed to ensure that each SBS Entity agrees in writing with each of its non-SBS Entity counterparties on the terms of the portfolio reconciliation including, if applicable, agreement on the selection of any third party service provider who may be performing the reconciliation, and paragraph (b)(2) provides that under such required policies and procedures, the portfolio reconciliation may be performed on a bilateral basis by the counterparties or by one or more third parties selected by the counterparties.

To the extent that the counterparties elect to use a third party to provide these services, the policies and procedures should be reasonably designed to ensure that the SBS Entity and its counterparty agree on the selection of that third party in writing in accordance with the requirements set forth in proposed Rule 15Fi-3(b)(1).

See

proposed Rules 15Fi-3(b)(1) and (2).

See

proposed Rule 15Fi-3(b)(2). As noted in the discussion of the corresponding provision in Rule 15Fi-3(a)(1), an SBS Entity could in practice

satisfy such requirement by including the terms governing the portfolio reconciliation process in the written security-based swap trading relationship documentation that it executes with its counterparty which, pursuant to proposed Rule 15Fi-5 would be required to be executed prior to, or contemporaneously with, the two parties executing any new security-based swap transaction. In addition, once the two parties have agreed in writing on the terms of the portfolio reconciliation for the first time, the requirement could then be satisfied in connection with any new security-based swap transaction executed by the two sides merely by agreeing in writing to abide by the existing agreement regarding the reconciliation process.

See supra

notes 32 and 33 and accompanying text.

Finally, proposed Rule 15Fi-3(b)(4) would require each SBS Entity to establish, maintain, and follow written procedures reasonably designed to resolve any discrepancies in the valuation or a material term of each security-based swap identified as part of a portfolio reconciliation or otherwise with a non-SBS Entity counterparty in a timely fashion.

We are reluctant to provide a fixed definition of “timely fashion” in the context of resolving discrepancies with counterparties who are not SBS Entities due to the fact that such counterparties may vary considerably in terms of their size, sophistication, and background. Although it may be possible to resolve most valuation discrepancies with large hedge funds and pension funds within the five-business-day period applicable to transactions between two SBS Entities, that timeframe may be much more challenging with respect to transactions with smaller buy-side firms. Accordingly, below we request comment on the amount of time SBS Entities should be provided to resolve discrepancies in the valuation or a material term with respect to transactions with a non-SBS Entity counterparty. Commenters are particularly encouraged to explain how any recommended time period appropriately balances the importance of quickly resolving valuation discrepancies to the greatest extent possible, with an understanding that more complex discrepancies could involve the need for additional discussion and time for resolution.

Similar to the requirement in paragraph (a) of the proposed rule for portfolio reconciliation with counterparties that are also SBS Entities, proposed Rule 15Fi-3(b)(4) provides that a difference between the lower valuation and the higher valuation of less than 10% of the higher valuation need not be deemed a discrepancy for purposes of that paragraph.

See supra

note 39 and accompanying text (discussing the 10% threshold in the context of Rule 15Fi-3(a)(5)).

6. Reporting of Valuation Disputes

Valuation is one of the most fundamental elements for determining the economic rights and obligations of each of the counterparties to a security-based swap transaction. For example, market participants manage their credit risks to their counterparties by exchanging margin with each other in an amount determined using the value of the underlying security-based swap. If those valuations are not accurate for any reason, such as human or system errors, problems with the valuation methodology, or an issue affecting the timeliness of the calculation, that error could result in one of the counterparties having an uncollaterialized credit exposure and a potential for loss in the event of a default.

Given those risks, proposed Rule 15Fi-3(c) would require each SBS Entity to promptly notify the Commission of any security-based swap valuation dispute in excess of $20,000,000 (or its equivalent in any other currency), at either the transaction or portfolio level,

if not resolved within: (1) Three business days, if the dispute is with a counterparty that is an SBS Entity; or (2) five business days, if the dispute is with a counterparty that is not an SBS Entity. Such notification would be required to be in a form and manner acceptable to the Commission,

and would also be required to be sent to any applicable prudential regulator (

i.e.,

in the case of any SBS Entity that is also a bank).

The language “at either the transaction or portfolio level” is not included in CFTC Rule 23.502(c), which is the corresponding requirement applicable to Swap Entities. The specific requirements as to the operation of CFTC Rule 23.502(c) are contained in the rules of the National Futures Association (“NFA”), which the CFTC has authorized to, among other things, receive and review notices of reportable swap valuation disputes.

See

Performance of Certain Functions by the National Futures Association Related to Notices of Swap Valuation Disputes Filed by Swap Dealers and Major Swap Participants, 81 FR 3390 (Jan. 21, 2016). A detailed discussion of the NFA requirements, including with respect to whether notices of swap valuation disputes should be filed at either the transaction or portfolio level, is set forth at the end of this Section I.B.6.

With respect to the language addressing the form and manner of submitting such notices, our intention is to provide SBS Entities with flexibility to determine the most efficient and cost-effective means of making such submissions, so long as it is deemed to be acceptable by the Commission. At the same time, we also understand that SBS Entities may prefer to have more specific direction as to how to report these disputes to the Commission (and any applicable prudential regulator). Accordingly, below we solicit comment on the form of notice that would be required to be submitted pursuant to the proposal.

Additionally, the Commission is proposing to amend Rule 15Fi-1 to add the term “prudential regulator,” which would be defined to have the same meaning given to the term in Section 3(a)(74) of the Exchange Act, 15 U.S.C. 78c(a)(74), and would include the Federal Reserve Board, the Office of the Comptroller of the Currency, the FDIC, the Farm Credit Association, and the Federal Housing Finance Agency, as applicable to the specific type of SBS Entity.

See

proposed Rule 15Fi-1(m).

We note that the CFTC has adopted a nearly identical requirement with the same $20,000,000 threshold and timeframes, and that divergence from those requirements could lead to additional costs and other inefficiencies for SBS Entities that are also registered with the CFTC as Swap Entities.

In addition, when the CFTC adopted this requirement, it explained that “the $20,000,000 materiality threshold for reporting is sufficiently high to eliminate unnecessary `noise' from over-reporting, but not so high as to eliminate reporting that the [CFTC] may find of regulatory value, such as a large number of relatively small disputes that in aggregate could provide the [CFTC] with information regarding a widespread market disruption.”

We preliminarily concur with that justification, and also note that such notifications could assist the Commission in identifying potential issues with respect to an SBS Entity's internal valuation methodology. That said, we also invite public comment as to whether the dollar threshold or reporting periods should be modified in any way.

See

CFTC Risk Mitigation Adopting Release 77 FR at 55914.

Id.

The CFTC has a nearly identical requirement in its Rule 23.502(c), except that it also requires Swap Entities to send such notices to the Commission when the dispute involves a swap that is also a security-based swap agreement, of which a material term is based on the price, yield, value, or volatility of any security or any group or index of securities, or any interest therein.

See

17 CFR 23.502(c) (citing the inclusion of security-based swap agreements in the definition of “swap” in 7 U.S.C. 1a(47)(v)). Because there is no corresponding inclusion of swap agreements in the definition of “security-based swap agreement” in Section 3(a)(68) of the Exchange Act (15 U.S.C. 78c(a)), proposed Rule 15Fi-3(c) does not contain a requirement to provide notices of any security-based swap valuation disputes to the CFTC.

We have preliminarily determined not to provide a fixed definition of the term “promptly” in the context of when the SBS Entity would need to provide the Commission of an applicable security-based swap valuation dispute. Although we would expect that SBS Entities would be able to provide these notices to the Commission as soon as the disputes exceed the applicable timeframes (

e.g.,

the beginning of fourth business day in the case of a dispute between two SBS Entities), we also understand that some notices may take longer to prepare, such as in cases when the counterparties are unable to agree even on the size of the dispute.

Finally, the Commission notes that on January 2, 2018, the NFA's Interpretive Notice entitled, “NFA Compliance Rule 2-49: Swap Valuation Dispute Filing Requirements” went into effect.

Among other things, that interpretive notice describes the types of disputes that would trigger a notice requirement. Specifically, if the swap dealer and its counterparty exchange collateral, NFA

Interpretive Notice to Rule 2-49 provides that the swap dealer would be required to file notice of any dispute regarding (1) the amount of initial margin to be posted or collected pursuant to a collateralized eligible master netting agreement

if the dispute exceeds the $20 million reporting threshold and (2) the amount of variation margin to be posted or collected pursuant to such master netting agreement if the dispute exceeds the $20 million reporting threshold. Because master netting agreements by definition operate at the portfolio level, such notices also would apply to the relevant swap portfolio.

See

NFA Interpretive Notice to Rule 2-49,

available at: https://www.nfa.futures.org/rulebook/rules.aspx?Section=9&RuleID=9072.

NFA Interpretive Notice to Rule 2-49 defines “collateralized eligible master netting agreement” to include an eligible master agreement, including any applicable schedule and credit support annex.

To the extent that a swap dealer and its counterparty do not exchange collateral, NFA Interpretive Notice to Rule 2-49 requires the swap dealer to submit a notice to the NFA upon being notified by its counterparty that such counterparty is disputing any valuation provided by the swap dealer if the dispute exceeds the $20 million reporting threshold. Such notices would either be at the portfolio or transaction level, depending on the particular valuation in question. That is, if the counterparty disputes a valuation provided by the swap dealer related to a particular transaction, the notice provided by the swap dealer to the NFA also would need to be at the transaction level. By contrast, if the counterparty disputes a portfolio valuation provided by the swap dealer, the notice provided by the swap dealer to the NFA also would need to be at the portfolio level.

See id.

See also

Transcript of the NFA Swap Valuation Dispute Notices and Swap Dealer Risk Data Reports Webinar (Oct. 12, 2017),

available at: https://www.nfa.futures.org/members/member-resources/files/transcripts/svdwebinar-transcriptoct2017.pdf.

NFA Interpretive Notice to Rule 2-49 also provides that swap dealers should not file a daily notice of a previously reported dispute even if the valuation dispute amount changes. Instead, swap dealers are required to notify the NFA of certain changes to the dispute amount on the 15th (or the following business day if the 15th is a weekend or holiday) and last business day of each month by amending any previously filed notice where the dispute amount has increased in $20 million incremental bands.

NFA Notice to Interpretive Rule 2-49 also requires swap dealers to file termination notices of disputes that are no longer reportable under CFTC Rule 23.502(c).

In addition, on July 20, 2017, NFA issued a Notice to Members (I-17-13) outlining the types of disputes that must be reported under the Interpretive Notice to Rule 2-49 and specifying the information that will be required in NFA's dispute form.

Below we solicit comment on whether the Commission should incorporate some or all of the NFA's approach, including with respect to any of the specific requirements described above, directly into proposed Rule 15Fi-3(c).

See

NFA Interpretive Notice to Rule 2-49, supra note 52. NFA Interpretive Notice to Rule 2-49 provided an example of a swap dealer that filed a notice of a $30 million dispute, noting that an amended notice updating the dispute amount would be required if that dispute increases to $40 million or more and each subsequent $20 million increment (

i.e.,

the dispute amount increases to $60 million or more, $80 million or more, etc.), or if the amount decreases at these $20 million increments.

See id.

Under NFA Interpretive Notice to Rule 2-49, the termination notice would be due on the 15th (or the following business day if the 15th is a weekend or holiday) and the last business day of the month based on the dispute amount on the reporting date.

See

NFA Notice to Members I-17-30,

available at https://www.nfa.futures.org/news/newsNotice.asp?ArticleID=4827.

That notice provided that all swap valuation disputes must include: (1) The swap dealer's NFA ID and legal entity identifier (“LEI”), (2) the dispute reportable date, (3) the dispute type, (4) the dispute termination date, (5) the receiver/payer, (6) the disputed amount, in U.S. Dollars (“USD”), (7) the counterparty name, and (8) counterparty LEI or Privacy Law Identifier. For initial and variation margin disputes, the swap dealer would also be required to provide (1) the unique swap identifier, (2) the base currency notional amount, (3) the base currency code, (4) the notional value USD equivalent, (5) the asset type, and (6) the product type. For disputes where no collateral is exchange, the notice also would need to include the credit support annex/netting agreement ID.

7. Application of Proposed Rule 15Fi-3 to Cleared Security-Based Swaps

Pursuant to proposed Rule 15Fi-3(d), the new requirements regarding portfolio reconciliation would not apply to a “clearing transaction” which, pursuant to existing Rule 15Fi-1(c) under the Exchange Act, is defined as a security-based swap that has a clearing agency as a direct counterparty.

Notwithstanding this provision, the Commission understands that some parties may offer portfolio reconciliation services with respect to OTC derivative transactions novated to a clearing agency. Although the Commission recognizes the importance of reconciling the terms of security-based swap transactions between a clearing member (either acting on its own behalf or for the benefit of a customer) and the clearing agency, we preliminarily believe that the issue of reconciling the terms of cleared trades is more appropriately addressed by the rules governing a clearing agency's risk management practices, as well as by the documentation governing the relationship between a clearing agency and its members.

See

proposed Rule 15Fi-3(d). Under existing Rule 15Fi-1(b) under the Exchange Act (which would be renumbered as Rule 15Fi-1(c) under the proposed rules), the term “clearing agency” means a clearing agency registered with the Commission pursuant to Section 17A of the Exchange Act and provides central counterparty services for security-based swap transactions.

See also

Trade Acknowledgement and Verification Adopting release, 81 FR at 39820-21 (explaining the agency and principal models of clearing in the context of providing a comparable exception from the trade acknowledgement and verification requirements).

8. Comments Requested

The Commission generally requests comments on all aspects of proposed Rule 15Fi-3, as well as any definitions in Rule 15Fi-1 that are used in proposed Rule 15Fi-3. In addition, the Commission requests comments on the following specific issues:

• Do commenters agree with the three activities comprising the scope of the Commission's proposed definition of “portfolio reconciliation”? Why or why not?

• Do you agree that the scope of the proposed definition of “material terms” for purposes of the portfolio reconciliation requirements in proposed Rule 15Fi-3 should be coterminous with the terms of a security-based swap that must be reported to an SDR under Regulation SBSR? Why or why not? Do you believe that there are any terms that must be reported to an SDR that should

not

be subject to the proposed portfolio reconciliation requirements? If so, which term(s) and why?

• As opposed to using a fixed definition of “material terms,” should the Commission adopt a more flexible definition? For example, are there other uses of materiality, such as with regard to the disclosure of information in registration statements (including accounting statements) or proxy solicitations that would be useful to include? Why or why not?

• Do you agree with the Commission's preliminary approach of allowing SBS Entities to exclude certain information from the definition of “material terms” after a transaction is reconciled the first time so long as the excluded terms are not relevant to the ongoing rights and obligations of the parties and the valuation of the security-based swap? Alternatively, should the definition be revised to conform to the corresponding CFTC definition, which excludes certain terms for purposes of all portfolio reconciliations? Why or why not? With respect to either approach, which terms should be excluded and why? For example, should the final definition include as rule text some or all of the specific data elements

excluded from the CFTC's definition? Which ones and why? By contrast, are there any terms that would be excluded for purposes of subsequent reconciliations under the proposed approach that should also be excluded from the initial reconciliation? Which ones and why?

• Do commenters agree with the decision to use the existing definition of “business day” (as currently in effect for the security-based swap trade acknowledgement and verification requirements) for purposes of the portfolio reconciliation requirements in proposed Rule 15Fi-3? If not, why not and how should that definition be modified for purposes of the proposed portfolio reconciliation requirements? For example, should the definition specify which jurisdiction's legal holidays are the default for specifying which holidays are not included in the definition of “business days”? Would the differences between the proposed definition of “business day” and the corresponding CFTC definition (which includes “any day other than a Sunday or holiday”) create any practical difficulties for dual SEC-CFTC registrants? If so, what are they? Should the Commission instead adopt a definition of “business day” that mirrors the CFTC definition? Why or why not?

• Do commenters agree with the proposed approach of basing the required frequency of portfolio reconciliation in proposed Rule 15Fi-3 on the type of counterparty involved (

i.e.,

its status as an SBS Entity) and on the size of the security-based swap portfolio? If not, why not? If commenters believe that the proposed approach should be retained, should any of the particular frequencies proposed (

e.g.,

daily, weekly, quarterly, or annually) be modified to be either more or less frequent?

• Proposed Rule 15Fi-3 permits the portfolio reconciliation exercises required thereunder to be performed by a third party, with the only qualification being that the selection of that third party has been agreed to by both of the parties in writing. As an alternative approach, should the Commission instead establish specific requirements for qualifying third parties that offer portfolio reconciliation services used for compliance with the rule? If so, how should a third party be deemed to be qualified to provide portfolio reconciliation services and who should make such a determination?

• Should the Commission's rules require two SBS Entities to resolve a discrepancy in a material term “immediately”? Why or why not? Should the Commission define or provide an interpretation of the term “immediately,” such as “without undue delay,” or, as an alternative, specify a fixed period of time in the rule text within which SBS Entities would be required to comply with proposed Rule 15Fi-3(a)(4)? Why or why not and, if so, how much time should be provided?

• Are there any current industry practices that relate to how counterparties to swaps and security-based swaps resolve discrepancies in a material term in the case of a dealer-to-dealer transaction? If any such practices exist, please describe them, including with regard to the length of time that it typically takes to resolve these types of discrepancies. Are there particular material terms for which a discrepancy typically takes a longer (or shorter) amount of time to resolve? If so, which ones?

• Should the Commission require SBS Entities to have policies and procedures reasonably designed to resolve any discrepancy in a valuation (with another SBS Entity) identified as part of a portfolio reconciliation or otherwise as soon as possible, but in any event within five business days after the date on which the discrepancy is first identified? Why or why not? Should SBS Entities be provided with more days to resolve these discrepancies? Should they have fewer days?

• Are there any current industry practices that relate to how counterparties to swaps and security-based swaps resolve valuation discrepancies in the case of a dealer-to-dealer transaction? If any such practices exist, please describe them, including with regard to the length of time that it typically takes to resolve these types of discrepancies. Are there particular circumstances that typically make valuation disputes more (or less) difficult and time-consuming to resolve? If so, which ones?

• Should the Commission require SBS Entities to have policies and procedures reasonably designed to resolve any discrepancy in a valuation or material term with a counterparty that is not an SBS Entity (identified either as part of a portfolio reconciliation or otherwise) in a timely fashion? Why or why not? Should the Commission define or provide an interpretation of the term “timely fashion,” or, as an alternative, specify a fixed period of time in the rule text within which SBS Entities would be required to comply with proposed Rule 15Fi-3(b)(4)? Why or why not and, if so, how much time should be provided? In suggesting potential timeframes, we note that the period for resolving discrepancies in a valuation or material term with

non-SBS Entities

should likely not be shorter than the five business days provided in the parallel requirement applicable to valuation discrepancies between two

SBS Entities.

Should the Commission look at any other similar provisions under the federal securities laws addressing dispute resolution procedures as a guide for determining the amount of time that an SBS Entity should be provided to resolve discrepancies pursuant to proposed Rule 15Fi-3(b)(4)? If so, which ones?

• Are there any current industry practices that relate to how counterparties to swaps and security-based swaps resolve discrepancies in a valuation or material term in the case of a transaction between a dealer and a non-dealer? If any such practices exist, please describe them, including with regard to the length of time that it typically takes to resolve these types of discrepancies. Are there particular terms for which a discrepancy typically takes a longer (or shorter) amount of time to resolve? If so, which ones? In this context, should valuation discrepancies be treated differently than discrepancies in some (or all) material terms? If so, which ones and why?

• Do you agree with the Commission's proposed approach of deeming valuation differences of less than 10% not to be discrepancies for purposes of requiring resolution under either proposed Rule 15Fi-3(a)(5) or (b)(4)? If not, why not and how should the rules address the resolution of valuation differences? Should the threshold be based on the actual dollar amount of the valuation difference (or the related currency equivalent) instead of being expressed as a percentage of the difference of the two amounts?

• How has the 10% threshold functioned in the context of CFTC rules applicable to Swap Entities? Has that threshold been under-inclusive, in the sense that it may not identity a sufficient number of swap valuation discrepancies that could affect performance under the swap transaction? Why or why not? By contrast, has the CFTC's 10% threshold been over-inclusive, in the sense that it has captured swap valuation discrepancies that typically would not affect performance under the swap transaction? Why or why not?

• Proposed Rule 15Fi-3(c) would require SBS Entities to promptly notify the Commission, in a form and manner acceptable to the Commission, and any applicable prudential regulator of any security-based swap valuation dispute in excess of $20,000,000 (or its

equivalent in any other currency) if not resolved within either three business days, if the dispute is with a counterparty that is an SBS Entity, or five business days, if the dispute is with a counterparty that is not an SBS Entity. Do commenters agree with this requirement? Why or why not? As an alternative, should the Commission instead require SBS Entities to make and keep records of these unresolved disputes? Why or why not? Is $20,000,000 the appropriate threshold for notifying the Commission of unresolved disputes? If not, should the threshold be higher or lower? Should the threshold instead be expressed as a percentage? Do commenters agree with the proposed timeframes for submitting such a report? If not, should they be increased or decreased?

• Should the Commission establish a specific process for how SBS Entities would need to provide notices of valuation disputes to the Commission pursuant to proposed Rule 15Fi-3(c)? If so, how should such notices be provided? For example, should the Commission require that such notices be submitted in electronic format through the EDGAR system (or any successor system thereto, as designated by the Commission)? Why or why not? Alternatively, should the Commission create a dedicated email box to accept such notices in letter format? Why or why not? Should these notices be submitted on a confidential basis? If so, how would that affect the potential delivery options?

• As discussed above, the NFA has issued an interpretive notice to NFA Compliance Rule 2-49 and a separate notice to its members that, together, specify the timing, frequency, and contents for submitting notices of swap valuation disputes pursuant to CFTC Rule 23.502(c).

Should the Commission consider incorporating some or all of those requirements into proposed Rule 15Fi-3(c) at adoption? If so, which ones and why, and should any of the requirements promulgated by the NFA be modified as part of the process of incorporating them into the Commission's rules to account for differences between the swap and security-based swap markets?

See supra

notes 52-57 and accompanying text.

• Do commenters agree with the proposed exception from the reconciliation requirement for clearing transactions? Why or why not? Because the definition of “clearing transactions” only includes transactions cleared at a clearing agency registered with the Commission pursuant to Section 17A of the Exchange Act, security-based swaps cleared at a foreign clearing agency that is not registered with the Commission would

not

be deemed to be “cleared” for these purposes, and would therefore be subject to proposed Rule 15Fi-3. Should the Commission modify the scope of the exception for cleared security-based swaps, such as by including transactions that are cleared at a clearing agency that is not registered with the Commission pursuant to Section 17A of the Exchange Act, whether because of an applicable exemption from registration or because the Exchange Act does not cover the activities of the clearing agency? Why or why not?

• With respect to any Swap Entity that could potentially register with the Commission as an SBS Entity, would the portfolio reconciliation protocols (or any other applicable documentation) already in existence with respect to CFTC Rule 23.502 satisfy the requirements in proposed Rule 15Fi-3? Why or why not? Should proposed Rule 15Fi-3 be modified to account for the way that market participants have designed their existing protocols (or any other applicable documentation) to be compliant with the CFTC's rules? Why or why not? For the purposes of compliance with the proposed portfolio reconciliation rules, should the Commission allow compliance with the CFTC's parallel requirements for some period of time to allow dual SEC-CFTC registrants to conform their existing portfolio reconciliation protocols (or any other applicable documentation) following the adoption of proposed Rule 15Fi-3? If so, on what factors should that reliance be conditioned and how long of a compliance period should be provided? In the alternative, should the Commission delay compliance with, or establish phased compliance deadlines for, some or all of these requirements? Please explain the nature of any compliance challenges (including any additional documentation requirements), and the basis for any suggested compliance period.

• As previously noted, proposed Rule 15Fi-3 has been designed to be as consistent as possible with CFTC Rule 23.502, which imposes portfolio reconciliation requirements on Swap Entities, in order to avoid requiring dual SEC-CFTC registrants to incur additional systems or compliance costs due to differences between the two agencies' approaches. To the extent that any such differences remain, should the Commission consider, for any firm dually-registered as both an SBS Entity and Swap Entity (regardless of whether such firm is also registered with the Commission as a broker-dealer or with the CFTC as a futures commission merchant), permitting such firm to comply with proposed Rule 15Fi-3 on an ongoing basis by complying with CFTC Rule 23.502, as if such rule applied to security-based swaps? If so, what conditions, if any, should be placed on such reliance?

• Should SBS dealers and major SBS participants be treated the same for purposes of the portfolio reconciliation requirements in proposed Rule 15Fi-3? Why or why not?

C. Rule 15Fi-4 (Portfolio Compression)

1. Overview of Portfolio Compression

Portfolio compression generally refers to a post-trade processing exercise that allows two or more market participants to eliminate redundant derivatives transactions within their portfolios in a manner that does not change their net exposure. Compression exercises typically take place in “cycles,” whereby each participating counterparty designates particular contracts within its portfolio as being eligible for compression and specifies its risk tolerances with respect to the composition of its derivatives portfolio following completion of the cycle.

Following an analysis of the submitted contracts, counterparties may be provided with the option of terminating or modifying those contracts and replacing them with a smaller number of substantially similar contracts. In most cases, the gross notional value of the replacement and remaining contracts is reduced, although the counterparty's net exposure typically remains the same.

See, e.g.,

ISDA Study,

Interest Rate Swaps Compression: A Progress Report,

(Feb. 2012),

available at: http://www2.isda.org/attachment/NDAzMw==/IRS%20compression%20progress%20report%20-%20Feb%202012.pdf.

In 2011, the Commission issued an order granting temporary exemptions from the requirement to register as a clearing agency under Section 17A of the Exchange Act for entities providing certain clearing services for security-based swaps including, among other things, tear-up and compression services. That order contains general descriptions of the portfolio compression process, based on discussions between Commission staff and market participants prior to the issuance of the exemptive order.

See

Order Pursuant to Section 36 of the Securities Exchange Act of 1934 Granting Temporary Exemptions from Clearing Agency Registration Requirements under Section 17A(b) of the Exchange Act for Entities Providing Certain Clearing Services for Security-Based Swaps, Exchange Act Release No. 64796 (Jul. 1, 2011), 76 FR 39963 (Jul. 7, 2011) (“Clearing Services Exemptive Order”).

By reducing the total number of open contracts, portfolio compression is intended to help market participants manage their post-trade risks in a number of important ways. For example, two or more counterparties

that are active in the OTC derivatives markets might have built up positions in the same (or comparable) products that, when analyzed at the portfolio level across all applicable counterparties, offset each other. Eliminating these offsetting and redundant uncleared derivatives transactions through compression—as measured both by the number of contracts and total notional value—reduces a market participant's gross exposure to its direct counterparties, including by eliminating all exposure to certain counterparties.

Reducing the total number of outstanding contracts within a derivatives portfolio also provides important operational benefits and efficiencies for market participants in that there are fewer open contracts to manage, maintain, and settle, resulting in fewer opportunities for processing errors, failures, or other problems that could develop throughout the lifecycle of a transaction.

Accordingly, the Commission preliminarily believes that the use of portfolio compression by SBS Entities, where appropriate given the circumstances (and to the extent that such activity is not already occurring), should provide important processing improvements consistent with the overall framework of Section 15F(i) of the Exchange Act.

See

Darrell Duffie, Ada Li, and Theo Lubke, Policy Perspectives of OTC Derivatives Market Infrastructure, FRBNY Staff Report No. 424, dated Jan. 2010, as revised Mar. 2010,

available at: http://www.newyorkfed.org/research/staff_reports/sr424.pdf

(“FRBNY OTC Derivatives Report”) (“In some types of derivatives that are not cleared, major market participants tend to build offsetting positions with different counterparties, long with one set of counterparties, and short with the others. In many cases, these offsetting positions are redundant. They serve no useful business purpose and create counterparty risk. Market participants should continue to engage in regular market-wide portfolio compression exercises in order to eliminate these redundant positions.”).

See also,

John Kiff,

et al.,

Credit Derivatives: Systemic Risks and Policy Options, IMF Working Paper No. 254 (Nov. 2009),

available at: http://www.imf.org/external/pubs/ft/wp/2009/wp09254.pdf

(“Multilateral netting, typically operationalized via `tear-up' or `compression' operations that eliminate redundant contracts, reduces both individual and system counterparty credit risk.”).

See

Portfolio compression platform launched to reduce CDS operational risk, Hedgeweek (Sept. 8, 2008) (explaining that a portfolio compression platform “reduces operational risk while leaving market risk profiles unchanged,” which is achieved “by terminating existing trades and replacing them with a smaller number of new replacement trades that carry the same risk profile and cash flows as the initial portfolio but have less capital exposure”).

See

15 U.S.C. 78

-8 (requiring SBS Entities to “conform with such standards as may be prescribed by the Commission, by rule or regulation, that relate to timely and accurate confirmation, processing, netting, documentation, and valuation of all security-based swaps”).

2. Scope of Proposed Rule 15Fi-4—Portfolio Compression Exercises

For purposes of proposed Rule 15Fi-4 under the Exchange Act, the phrase “portfolio compression exercise” would generally refer to an exercise by which security-based swap counterparties wholly terminate or change the notional value of some or all of the security-based swaps submitted by the counterparties for inclusion in the portfolio compression exercise and, depending on the methodology employed, replace the terminated security-based swaps with other security-based swaps whose combined notional value (or some other measure of risk) is less than the combined notional value (or some other measure of risk) of the terminated security-based swaps in the exercise.

In order to incorporate that concept into the proposal, the Commission is proposing to amend Rule 15Fi-1 to create definitions for both “bilateral portfolio compression exercise”

and “multilateral portfolio compression exercise.”

These two definitions are nearly identical, with the sole difference being that the former would apply to a portfolio compression exercise that includes only two security-based swap counterparties, while the latter would refer to a portfolio compression exercise that includes more than two security-based swap counterparties.

The corresponding CFTC rule is 17 CFR 23.503. The structure of the CFTC rule, including the subsections, mirrors the structure of proposed Rule 15Fi-4.

See

proposed Rule 15Fi-1(a). The corresponding CFTC definition is in 17 CFR 23.500(b).

See

proposed Rule 15Fi-1(j). The corresponding CFTC definition is in 17 CFR 23.500(h).

As noted below in Section I.C.4, proposed Rule 15Fi-4 is applicable only to uncleared security-based swaps.

Under proposed Rule 15Fi-4(a), SBS Entities would be required to establish, maintain, and follow written policies and procedures for periodically engaging in both bilateral portfolio compression exercises and multilateral portfolio compression exercises, in each case when appropriate, with any counterparties that are SBS Entities.

To the extent that an SBS Entity transacts with counterparties that are

not

SBS Entities, proposed Rule 15Fi-4(b) provides that the policies and procedures required under the proposed rule would require that portfolio compression exercises occur when appropriate

and only to the extent requested by any such counterparty.

See

proposed Rules 15Fi-4(a)(2) and (3).

CFTC Rule 23.503(b), which is the corresponding CFTC compression rule applicable to transactions with counterparties that are not SBS Entities does not contain the caveat that the compression or offset covered by the applicable policies and procedures would only need to occur “when appropriate.” Rather, we preliminarily believe it to be prudent to allow an SBS Entity to engage in bilateral offset or compression exercises (to the extent requested by its non-SBS Entity counterparty) only in circumstances when doing so was appropriate for the SBS Entity in light of the particular facts and circumstances involved, recognizing of course that such discretion should not be used by the SBS Entity arbitrarily not to honor the request by its counterparty. Below we solicit comment on this difference.

See

proposed Rule 15Fi-4(b). As we noted in discussing the proposed portfolio reconciliation requirements, the Commission preliminarily believes it to be appropriate to impose more prescriptive requirements in cases where both entities are subject to the SEC's requirements for registered entities.

The one exception to this statement is the requirement in both proposed Rules 15Fi-4(a)(2) and (a)(3) that such policies and procedures address the evaluation of portfolio compression exercises that are initiated, offered, or sponsored by any third party. The Commission preliminarily believes that the decision of which party to use (or not use) to conduct a compression exercise is of critical importance to the overall determination of whether to participate in compression. Although the Commission takes no position with respect to the type or identity of the party used to conduct a compression exercise, we recognize that a number of parties are currently offering such services, including third-party vendors and some self-regulatory organizations (

e.g.,

clearing agencies). The Commission also understands that there may be some instances where compression could be performed without the use of a third-party service provider.

The proposed definitions of “bilateral portfolio compression exercise” and “multilateral portfolio compression exercise” are designed to be sufficiently broad as to provide market participants with maximum flexibility when complying with proposed Rule 15Fi-4, while also retaining the key elements necessary to achieve the important risk reducing benefits previously discussed—namely the reduction of counterparty and operational risk achieved by terminating offsetting security-based swap transactions. Accordingly, we are not proposing specific requirements as to the contents of the policies and procedures created to comply with these rules.

In addition, for consistency with the rules applicable to Swap Entities, these definitions are substantively identical to the CFTC's corresponding definitions, which we preliminarily believe are appropriately scoped and clear for purposes of proposed Rule 15Fi-4.

Rather, the Commission recognizes that a decision to engage in a process that could ultimately result in the termination or modification of existing contracts, and the potential entry into new ones, should be made in accordance with policies and procedures that are tailored to the specific risks and operations of the relevant SBS Entity. Such policies and procedures should, in the Commission's view, be permitted to take into account the specific risk tolerances of the regulated entity, including with respect to such areas as operational, funding, liquidity, and credit risk, and also reflect the possibility that firms may have legitimate business reasons for maintaining certain offsetting security-based swap positions, even if in theory they could be compressed.

For example, the Commission understands that an SBS Entity might be unable to participate in a particular portfolio compression exercise that could result in it transacting with certain counterparties (

e.g.,

because a counterparty poses an unacceptable level of credit risk), or in certain types of transactions. To the extent that such limitations exist and are reflected in the policies and procedures required pursuant to proposed Rules 15Fi-4(a) and (b), an SBS Entity would be in compliance with the proposed rules so long as it follows those policies and procedures, even if it determines not to engage in a particular compression exercise.

Finally, in comparing the requirements we are proposing today with respect to bilateral and multilateral compression exercises with those previously adopted by the CFTC, we note two differences that we believe to be minor and technical in nature. First, CFTC Rule 23.503(a)(3)(i) requires that any policies and procedures related to multilateral portfolio compression address, among other things, participation in all multilateral portfolio compression exercises required by CFTC regulation or order. We have preliminarily determined not to include a comparable requirement in proposed Rule 15Fi-4(a)(3). Although the Commission would expect that any comprehensive policy or procedure would, as a matter of course, reflect any applicable laws and regulations expressly mandating participation in certain types of portfolio compression exercises, there are currently no Commission regulations or orders mandating participation in any particular type of portfolio compression exercise, and we are reluctant to include a requirement that could lead to confusion by suggesting that such regulations or orders exist.

Second, CFTC Rule 23.503(a)(3)(ii) requires that any policies and procedures related to

multilateral

portfolio compression exercises evaluate, among other things, any services that are initiated, offered, or sponsored by any third party.

The CFTC did not, however, include such a requirement in the corresponding requirement related to policies and procedures addressing

bilateral

portfolio compression exercises.

Although the inclusion of a specific requirement in the rule should not be interpreted as creating an exhaustive list of what we would expect to see included in the policies and procedures, we understand that bilateral portfolio compression services are currently being offered by third-party vendors. Evaluating those services would seem to be a natural part of the process of broadly analyzing the applicability of bilateral compression in general. Therefore, we are proposing to expressly include a similar requirement in

both

proposed Rules 15Fi-4(a)(2) (policies and procedures regarding bilateral compression) and 15Fi-4(a)(3) (policies and procedures regarding multilateral compression).

See

17 CFR 23.503(a)(3)(ii).

See

17 CFR 23.503(a)(2).

3. Scope of Proposed Rule 15Fi-4—Bilateral Offset

As we previously noted, the Commission has preliminarily made the determination not to suggest a preference as to the use of any particular type of compression, or as to the type or identity of the party conducting the exercise and has, instead, proposed broad definitions of the terms “bilateral portfolio compression exercise” and “multilateral portfolio compression exercise.” In addition, the Commission recognizes that there may be other ways for market participants to reduce the size of their derivatives portfolios that may not be considered to be “portfolio compression exercises” for purposes of those two proposed definitions.

In light of those considerations, proposed Rule 15Fi-4(a)(1) would require each SBS Entity to establish, maintain, and follow written policies and procedures for terminating each “fully offsetting security-based swap” that it maintains with another SBS Entity in a timely fashion, when appropriate.

To the extent that an SBS Entity transacts with a counterparty that is

not

an SBS Entity, the requirements of proposed Rule 15Fi-4(b) would be identical to those in proposed Rule 15Fi-4(a)(1), except that the required policies and procedures would only need to address engaging in bilateral offset when appropriate and to the extent requested by the counterparty. The Commission preliminarily believes that by not proposing prescriptive requirements as to the form of bilateral offset that would need to be reflected in an SBS Entity's policies and procedures, the proposed rule would allow the counterparties flexibility in the manner in which they reduce the size of their security-based swap portfolios in light of each counterparty's unique risks and operations.

The Commission also is proposing to amend Rule 15Fi-1 to add the term “fully offsetting security-based swaps,” which would be defined as “security-based swaps of equivalent terms where no net cash flow would be owed to either counterparty after the offset of payment obligations thereunder.”

See

proposed Rule 15Fi-1(h). For consistency with the rules applicable to Swap Entities, this definition is substantively identical to the CFTC's corresponding definition in 17 CFR 23.500(f), which we preliminarily believe is appropriately scoped and clear for purposes of proposed Rule 15Fi-4.

In addition, the proposed rules regarding bilateral offset have been designed to reflect the Commission's understanding that firms may have legitimate business reasons for maintaining fully offsetting security-based swap transactions. As such, proposed Rules 15Fi-4(a)(1) and (b) would require a firm's policies and procedures to address the termination of fully offsetting security-based swaps only “when appropriate.”

Finally, for purposes of proposed Rules 15Fi-4(a)(1) and (b), the Commission would generally consider an SBS Entity to have terminated each fully offsetting security-based swap in a “timely fashion” so long as (1) termination of the offsetting security-based swaps occurs within a period that is reasonable in light of the circumstances of each particular transaction and (2) the relevant SBS Entity is otherwise in compliance with its policies and procedures regarding bilateral offset.

4. Application of Proposed Rule 15Fi-4 to Cleared Security-Based Swaps

Pursuant to proposed Rule 15Fi-4(c), the new requirements regarding portfolio compression would not apply to a “clearing transaction” which, pursuant to existing Rule 15Fi-1(c) under the Exchange Act, is defined as a security-based swap that has a clearing agency as a direct counterparty.

Notwithstanding this provision, the Commission recognizes that portfolio compression is not limited to uncleared

swaps and that compression services may be offered either by a clearing agency itself or by a third-party vendor that works collaboratively with the clearing agency.

Although the risk-reducing benefits that could be realized through the compression of cleared security-based swaps, we preliminarily believe that the issue of whether and when compression should occur within a clearing agency is best addressed by the rules governing the clearing agency's risk management practices, as well as by the documentation governing the relationship between the clearing agency and its members.

See supra

note 58 and accompanying text.

Notwithstanding the applicability of the requirements of proposed Rule 15Fi-4, the Commission reminds any third parties performing compression or offset services to keep in mind any potential requirements under other provisions of the securities laws. For example, the Commission has stated that the provision of tear-up and compression services for security-based swaps would qualify these participants as clearing agencies and therefore trigger the statutory requirement to register as clearing agencies pursuant to Section 17A of the Exchange Act, absent exemptive relief (which the Commission provided on a conditional temporary basis in July 2011).

See

Clearing Services Exemptive Order, 76 FR at 39964.

The corresponding CFTC rule is 17 CFR 23.503(c).

5. Comments Requested

The Commission generally requests comments on all aspects of Proposed Rule 15Fi-4 (and any related definitions). In addition, the Commission requests comments on the following specific issues:

• Do commenters agree with the scope of the Commission's approach of proposing broad definitions of “bilateral portfolio compression exercise” and “multilateral portfolio compression exercise”? Why or why not?

• Should SBS Entities be required to have policies and procedures in place for terminating fully offsetting security-based swaps in a timely fashion? Why or why not? Do you agree with the proposed interpretation of the term “timely fashion” to mean that the relevant security-based swaps should be terminated within a period that is reasonable in light of the circumstances of each particular transaction (so long as the relevant SBS Entity is otherwise in compliance with its policies and procedures regarding bilateral offset)? Why or why not? Should the Commission instead specify a fixed period of time for the required termination of these security-based swaps? Why or why not?

• With respect to any Swap Entity that could potentially register with the Commission as an SBS Entity, would the portfolio compression protocols (or any other applicable documentation) already in existence with respect to CFTC Rule 23.503 satisfy the requirements in proposed Rule 15Fi-4? Why or why not? Should proposed Rule 15Fi-4 be modified to account for the way that market participants have designed their existing protocols (or any other applicable documentation) to be compliant with the CFTC's rules? Why or why not? For the purposes of compliance with the proposed portfolio compression rules, should the Commission allow compliance with the CFTC's parallel requirements for some period of time to allow dual SEC-CFTC registrants to conform their existing portfolio compression protocols (or any other applicable documentation) following the adoption of proposed Rule 15Fi-4? If so, on what factors should that reliance be conditioned and how long of a compliance period should be provided? In the alternative, should the Commission delay compliance with, or establish phased compliance deadlines for, some or all of these requirements? Please explain the nature of any compliance challenges (including any additional documentation requirements), and the basis for any suggested compliance period.

• As previously noted, proposed Rule 15Fi-4 has been designed to be as consistent as possible with CFTC Rule 23.503, which imposes portfolio compression requirements on Swap Entities, in order to avoid requiring dual SEC-CFTC registrants to incur additional systems or compliance costs due to differences between the two agencies' approaches. To the extent that any such differences remain, should the Commission consider, for any firm dually-registered as both an SBS Entity and Swap Entity (regardless of whether such firm is also registered with the Commission as a broker-dealer or with the CFTC as a futures commission merchant), permitting such firm to comply with proposed Rule 15Fi-4 on an ongoing basis by complying with CFTC Rule 23.503, as if such rule applied to security-based swaps? If so, what conditions, if any, should be placed on such reliance?

• Do commenters agree with the proposed exception from the compression requirements in proposed Rule 15Fi-4 for clearing transactions? Why or why not? Because the definition of “clearing transactions” only includes transactions cleared at a clearing agency registered with the Commission pursuant to Section 17A of the Exchange Act, security-based swaps cleared at a foreign clearing agency that is not registered with the Commission would

not

be deemed to be “cleared” for these purposes, and would therefore be subject to proposed Rule 15Fi-4. Should the Commission modify the scope of the exception for cleared security-based swaps, such as by including transactions that are cleared at a clearing agency that is not registered with the Commission pursuant to Section 17A of the Exchange Act, whether because of an applicable exemption from registration or because the Exchange Act does not cover the activities of the clearing? Why or why not?

• Proposed Rule 15Fi-4(b) requires each SBS Entity to establish, maintain, and follow written policies and procedures for periodically terminating fully offsetting security-based swaps and for engaging in bilateral or multilateral portfolio compression exercises with respect to security-based swaps in which its counterparty is an entity other than an SBS Entity, “when appropriate” and to the extent requested by any such counterparty. CFTC Rule 23.503(b) does not contain the “when appropriate” qualifier and provides only that a Swap Entity's policies and procedures address engaging in bilateral offset or compression exercises “to the extent requested” by a counterparty that is not a Swap Entity. Would the Commission's proposed approach create any practical difficulties for dual SEC-CFTC registrants? If so, what are they? Should the Commission instead strike the “when appropriate” qualifier in order to mirror the corresponding CFTC requirement? Why or why not? To the extent that the Commission were to follow the approach of CFTC Rule 23.503(b), should there be a reasonableness standard to address situations when a request by a non-SBS Entity counterparty to engage in bilateral offset or compression exercises would be not be reasonable, such as a situation when doing so could be detrimental to the SBS Entity? If so, under what conditions should an SBS Entity be able to refuse a request from a non-SBS Entity counterparty to engage in such activity pursuant to proposed Rule 15Fi-4(b)?

• What practices, if any, are currently being used (or are currently under consideration) by market participants with respect to the use of portfolio compression across asset classes? For example, could a compression exercise occur with respect to two or more counterparties maintaining portfolios of both single-name credit default swaps (“CDS”) and index CDS? If so, should the Commission modify proposed Rule 15Fi-4, or provide related interpretive guidance to accommodate portfolio compression across asset classes?

• Should SBS dealers and major SBS participants be treated the same for purposes of the portfolio compression requirements in proposed Rule 15Fi-4? Why or why not?

D. Rule 15Fi-5 (Trading Relationship Documentation)

1. Overview of Trading Relationship Documentation

Section 15F(i)(2) of the Exchange Act provides that the Commission shall adopt rules governing documentation standards for SBS Entities. Just as portfolio reconciliation is designed to allow counterparties to manage their internal risks by better ensuring agreement with respect to the terms of the transaction (and thereby avoiding complications at various points throughout the life of the transaction),

requiring each SBS Entity to document the terms of the trading relationship with each of its counterparties before executing a new security-based swap transaction should promote sound collateral and risk management practices by enhancing transparency and legal certainty regarding each party's rights and obligations under the transaction. This, in turn, should help to reduce counterparty credit risk and promote certainty regarding the agreed-upon valuation and other material terms of a security-based swap.

Having adequate written documentation prior to, or contemporaneously with, executing a security-based swap should also facilitate the ability of the counterparties to engage in portfolio reconciliation, as would be required under these proposed rules, in an efficient and cost-effective manner.

See supra

Section I.B.1.

See, e.g.,

Sylvie A. Durham, Terminating Derivatives Transactions: Risk Mitigation and Close-Out Netting § 8:1 (Nov. 2010) (“[L]egal contractual provisions are the foundation on which the rights and obligations of the parties are based, and sound collateral and risk management practices may be ineffective if the legal rights of the parties are not clearly set forth.”).

2. Scope of Proposed Rule 15Fi-5

In light of the important risk mitigating factors described above, the Commission is proposing Rule 15Fi-5, which establishes certain requirements for SBS Entities related to the use of written trading relationship documentation in connection with their security-based swap transactions.

Specifically, proposed Rule 15Fi-5(a)(2) would require each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to ensure that it executes written security-based swap trading relationship documentation with each of its counterparties prior to, or contemporaneously with, executing a security-based swap with any counterparty.

The proposed rule would further require that the policies and procedures required thereunder be approved in writing by a senior officer of the SBS Entity, and that a record of the approval be retained.

The corresponding CFTC rule is 17 CFR 23.504. The structure of the CFTC rule, including the subsections, mirrors the structure of proposed Rule 15Fi-5.

Among other exceptions discussed below in Section I.D.6, proposed Rule 15Fi-5 is applicable only to uncleared security-based swaps.

See

proposed Rule 15Fi-5(b)(2). For purposes of this requirement, the Commission preliminarily views the term “senior officer” as covering only the most senior executives in the organization, such as a firm's chief executive officer, chief financial officer, chief legal officer, chief compliance officer, president, or other person at a similar level. This approach is similar to how the Commission has previously interpreted the term in the context of other requirements applicable to SBS Entities.

See

Registration Process for Security-Based Swap Dealers and Major Security-Based Swap Participants, Exchange Act Release No. 75611 (Aug. 5, 2015), 80 FR 48964, 48968 n. 29 (Aug.14, 2015) (“SBS Entity Registration Adopting Release”). By contrast, CFTC Rule 23.504 uses the term “senior management,” which is not further defined in either CFTC Rules 23.500 or 23.504. We preliminarily view this difference as a clarification and do not believe that it represents a substantive difference between the two sets of rules, but below we solicit comment on this issue.

Pursuant to proposed Rule 15Fi-5(b)(1), the required policies and procedures would require that the security-based swap trading relationship documentation be in writing. The policies and procedures would also require that the documentation include all terms governing the trading relationship between the SBS Entity and its counterparty, including, without limitation, terms addressing payment obligations, netting of payments, events of default or other termination events, calculation and netting of obligations upon termination, transfer of rights and obligations, allocation of any applicable regulatory reporting obligations (including pursuant to Regulation SBSR), governing law, valuation, and dispute resolution.

We note that CFTC Rule 23.504 does not contain a comparable provision to the requirement in proposed Rule 15Fi-5(b)(1) that the trading relationship documentation address “applicable regulatory reporting obligations (including pursuant to Regulation SBSR).” The Commission is proposing this requirement not only because of our view that reporting arrangements should be clarified in advance, due to the importance of ensuring that the transaction is reported accurately and in a timely manner, but also because the inclusion of such provision could potentially help to address an issue related to how SDRs can verify the information that they receive, as discussed in detail in Section I.E below.

For purposes of Rule 15Fi-5(b)(2), all trade acknowledgements and verifications of security-based swap transactions required under Rule 15Fi-2 would be deemed to be security-based swap trading relationship documentation, as they often may contain one or more terms contemplated by the policies and procedures required by proposed Rule 15Fi-5. Further, the Commission understands that in some transactions, the parties may choose to document their trading relationship by using a stand-alone “long-form confirmation” that includes all of the terms governing the relationship. The proposed rule is not intended to interfere with this practice. Accordingly, we preliminarily believe that the use of a “long-form confirmation” would comply with proposed Rule 15Fi-5 so long as such document is: (1) In written form and includes all of the elements of the trading relationship required under the rule (whether by incorporating them by reference from a standard master agreement or by expressly restating them in the confirmation) and (2) executed prior to, or contemporaneously with, the execution of each relevant security-based swap.

The policies and procedures required by the proposed rule also would require that the security-based swap trading relationship documentation include credit support arrangements.

Such credit support would be required to contain, among other things and in accordance with applicable requirements under regulations adopted by the Commission or any prudential regulators,

and without limitation, the following:

See

proposed Rule 15Fi-5(b)(3).

See supra

note 48.

• Initial and variation margin requirements, if any;

• types of assets that may be used as margin and asset valuation haircuts, if any;

• investment and re-hypothecation terms for assets used as margin for uncleared security-based swaps, if any; and

• custodial arrangements for margin assets, including whether margin assets are to be segregated with an independent third party, in accordance with Section 3E(f) of the Exchange Act, if any.

15 U.S.C. 78c-5(f).

As the Commission has previously explained, ensuring that uncleared OTC derivatives transactions are appropriately collateralized was one of the key elements of the Title VII reforms.

Accordingly, we preliminarily believe that policies and procedures requiring counterparties to

clearly document the applicable processes and requirements for calculating and exchanging margin in connection with a security-based swap transaction is an important step in achieving this broader regulatory objective.

See supra

Section I.B.1.

3. Proposed Rule 15Fi-5(b)(4): Documenting Valuation Methodologies

As mentioned throughout this release, ensuring that security-based swaps are accurately valued throughout the duration of a contract should play an important role in protecting the integrity of the OTC derivatives market, both at the level of an individual participant and systemically across the broader financial market.

Accordingly, proposed Rule 15Fi-5(b)(4) would require that the applicable policies and procedures provide that the relevant swap trading relationship documentation between certain types of counterparties include written documentation in which the parties agree on the process, which may include any agreed upon methods, procedures, rules, and inputs, for determining the value of each security-based swap at any time from execution to the termination, maturity, or expiration of such security-based swap for the purposes of complying with the margin requirements under Section 15F(e) of the Exchange Act (and applicable regulations),

and the risk management requirements under Section 15F(j) of the Exchange Act (and applicable regulations).

To the maximum extent practicable, such valuations would need to be based on recently-executed transactions, valuations provided by independent third parties, or other objective criteria.

See id.

See

15 U.S.C. 78o-10(e). For the avoidance of doubt, the requirements in proposed Rule 15Fi-5(b)(4) are intended to facilitate agreement between an SBS Entity and its counterparty as to how they will determine the value of a security-based swap in order to, among other things, comply with the margin requirements promulgated by either the Commission or, with respect to an SBS Entity that is a bank, the applicable prudential regulator. These requirements are not intended in any way to supersede those underlying margin requirements.

See

15 U.S.C. 78o-10(j).

See

proposed Rule 15Fi-5(b)(4)(i).

The requirements in proposed Rule 15Fi-5(b)(4) regarding valuation methodology would apply to security-based swap trading relationship documentation entered into between: (1) Two SBS Entities; (2) an SBS Entity and a “financial counterparty;” and (3) an SBS Entity and any other counterparty, if requested by such counterparty. Accordingly, we are also proposing to amend Rule 15Fi-1 to add a definition of “financial counterparty,” which would include any counterparty that is not an SBS Entity

and

that is one of the following:

• A swap dealer;

• a major swap participant;

• a commodity pool as defined in Section 1a(10) of the Commodity Exchange Act (7 U.S.C. 1a(10));

• a private fund as defined in Section 202(a)(29) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a));

• an employee benefit plan as defined in paragraphs (3) and (32) of Section 3 of the Employee Retirement Income Security Act of 1974 (29 U.S.C. 1002); and

• a person predominantly engaged in activities that are in the business of banking or, in activities that are financial in nature, as defined in Section 4(k) of the Bank Holding Company Act of 1956 (12 U.S.C. 1843k).

See

proposed Rule 15Fi-1(g). The corresponding definition in CFTC Rule 23.500(e) is referred to as a “financial entity.”. We replaced the word “entity” with “counterparty” to avoid any confusion due to the fact that there are other definitions of “financial entity” within the Exchange Act and its implementing regulations. For example, term “financial entity” is used in Section 3C(g) of the Exchange Act for purposes of the statutory exception to the mandatory clearing requirement in Title VII.

See

15 U.S.C. 78c-3(g)(3). Similarly, there is a definition of “financial entity” in Rule 3a67-6 under the Exchange Act, which is used for one of the tests for determining a person's status under the definition of “major security-based swap participant” in Section 3(a)(67) of the Exchange Act.

See

15 U.S.C. 78. Other than the different titles, we do not believe that there are any substantive differences between the CFTC's definition of “financial entity” and the proposed definition of “financial counterparty.”

Further, proposed Rule 15Fi-5(b)(4)(ii) has been designed to help ensure that the required valuation documentation between SBS Entities and their counterparties contains sufficient guidance and information in the event of a problem with determining the value of a security-based swap. Specifically, the documentation required by the applicable policies and procedures must include

either:

(1) Alternative methods for determining the value of the security-based swap for the purposes of complying with proposed Rule 15Fi-5(b)(4) in the event of the unavailability or other failure of any input required to value the security-based swap for such purposes; or (2) a valuation dispute resolution process by which the value of the security-based swap shall be determined for the purposes of complying with the rule.

See

proposed Rule 15Fi-5(b)(4)(ii).

To the extent that the prescribed valuation documentation needs to be updated, revised, or otherwise modified, proposed Rule 15Fi-5(b)(4)(iv) provides that the parties may agree on changes or procedures for modifying or amending such documentation at any time.

Finally, in recognition of the fact that valuation data and methodologies often include, or may be based on, private information, proposed Rule 15Fi-5(b)(4)(iii) makes clear that an SBS Entity is not required to disclose to the counterparty confidential, proprietary information about any model it may use to value a security-based swap.

The text of CFTC Rule 23.504(b)(4)(iv), which is the corresponding subsection under CFTC rules, provides that “[t]he parties may agree on changes or procedures for modifying or amending the documentation required by this paragraph at any time.” Proposed Rule 15Fi-5(b)(4)(iv) does not contain the phrase “required by this paragraph.” We view this to be solely a technical change and do not intend for it to represent a substantive deviation from the corresponding CFTC rule. Rather, the difference is intended to avoid any suggestion that the parties could amend the underlying requirements contained in proposed Rule 15Fi-5(b)(4).

4. Proposed Rule 15Fi-5(b)(5) and (6): Other Disclosure Requirements

Proposed Rule 15Fi-5 also would require that the policies and procedures governing the applicable trading relationship documentation require an SBS Entity and its counterparty to disclose to each other certain information regarding their legal and bankruptcy status, and to include a statement regarding the status of a security-based swap if accepted for clearing by a CCP. The first requirement relates to whether the SBS Entity or its counterparty is subject to a particular legal regime in the event of its failure, such as FDIC receivership for banks or orderly liquidation for certain financial companies that meet the requirements set forth in Title II of the Dodd-Frank Act.

As background, Title II of the Dodd-Frank Act provides for an alternative insolvency regime for the “orderly liquidation” of large financial companies,

including broker-dealers,

that meet specified criteria (each a “covered financial company”) as set forth in Title II of the Dodd-Frank Act.

If the covered financial company is (1) a broker or dealer and (2) a member of the Securities Investor Protection Corporation (“SIPC”), such “covered broker or dealer” would be placed into an orderly liquidation proceeding with the FDIC appointed as receiver.

Because this orderly liquidation process, which was modeled on the receivership process used for failed banks, is different from the liquidation regimes established under the Securities Investor Protection Act of 1970

100

or by the U.S. Bankruptcy Code,

101

the Commission preliminarily believes it to be appropriate to require counterparties to a security-based swap transaction to disclose to each other whether this alternative regime may potentially apply in the event of an insolvency.

See

12 U.S.C. 5382; 12 U.S.C. 5383.

The term “financial company” is defined in 12 U.S.C. 5381(a)(11) to include any company (as defined in 12 U.S.C. 5381(a)(5)) that—

(A) is incorporated or organized under any provision of Federal law or the laws of any State;

(B) is—

(i) a bank holding company (as defined in 12 U.S.C. 1841(a));

(ii) a nonbank financial company supervised by the Federal Reserve Board;

(iii) any company that is predominantly engaged in activities that the Federal Reserve Board has determined are financial in nature or incidental thereto for purposes of 12 U.S.C. 1843(k) (other than a company described in clause (i) or (ii)); or

(iv) any subsidiary of any company described in any of clauses (i) through (iii) that is predominantly engaged in activities that the Federal Reserve Board has determined are financial in nature or incidental

thereto for purposes of 12 U.S.C. 1843(k) (other than a subsidiary that is an insured depository institution or an insurance company); and

(C) is not a Farm Credit System institution chartered under and subject to the provisions of the Farm Credit Act of 1971, as amended (12 U.S.C. 2001

et seq.

), a governmental entity, or a regulated entity, as defined under 12 U.S.C. 4502(20).

Section 203 of the Dodd-Frank Act sets forth the process for designating a financial company as a “covered financial company.” In the case of a broker-dealer, or when a financial company's largest U.S. subsidiary is a broker-dealer, Section 203(a)(1)(B) provides that the Federal Reserve Board and the Commission (in each case subject to the approval of a two-thirds majority of each agency's members), in consultation with the FDIC, may, either on their own initiative or at the request of the Secretary of the U.S. Treasury (“Secretary”), issue a written orderly liquidation recommendation to the Secretary.

See

12 U.S.C. 5383(a). Section 203(b) requires the Secretary (after consultation with the President) to take action on the recommendation upon an affirmative determination that, among other things, the failure of a financial company would have serious adverse effects on financial stability in the United States and that taking action under the orderly liquidation authority with respect to that company would avoid or mitigate such adverse effects.

See

12 U.S.C. 5383(b).

See

12 U.S.C. 5384. Section 205(a) of the Dodd-Frank Act requires the FDIC, as the appointed receiver for any covered broker or dealer, to appoint SIPC as trustee for the liquidation.

See

12 U.S.C. 5385(a).

100

15 U.S.C. 78aaa

et seq.

101

11 U.S.C. 101

et seq.

Accordingly, proposed Rule 15Fi-5(b)(5) would require that each SBS Entity's policies and procedures require that the security-based swap trading relationship documentation contain a statement as to whether it or its counterparty is an insured depository institution or financial company. Further, the documentation also would need to contain a statement that the orderly liquidation provisions of the Dodd-Frank Act and the Federal Deposit Insurance Act

102

may limit the rights of the parties under their trading relationship documentation should either party be deemed a “covered financial company” or is otherwise subject to having the FDIC appointed as a receiver. The documentation would further be required to state that such limitations relate to the right of the non-covered party to terminate, liquidate, or net any security-based swap by reason of the appointment of the FDIC as receiver, notwithstanding the agreement of the parties in the security-based swap trading relationship documentation, and of certain rights of the FDIC to transfer security-based swaps of the covered party. Finally, the policies and procedures would require that the trading relationship documentation contain an agreement between the SBS Entity and its counterparty to provide notice if either it or its counterparty becomes or ceases to be an insured depository institution or a financial company.

103

102

12 U.S.C. 1811

et seq.

103

Specifically, proposed Rule 15Fi-5(b)(5) would require that an SBS Entity's policies and procedures require that the applicable security-based swap trading relationship documentation contain:

(A) A statement of whether the SBS Entity is an insured depository institution (as defined in 12 U.S.C. 1813) or a financial company (as defined in Section 201(a)(11) of the Dodd-Frank Act, 12 U.S.C. 5381(a)(11));

(B) A statement of whether the counterparty is an insured depository institution or financial company;

(C) A statement that in the event either the SBS Entity or its counterparty becomes a covered financial company (as defined in 12 U.S.C. 5381(a)(8)) or is an insured depository institution for which the FDIC has been appointed as a receiver (the “covered party”), certain limitations under Title II of the Dodd-Frank Act or the Federal Deposit Insurance Act may apply to the right of the non-covered party to terminate, liquidate, or net any security-based swap by reason of the appointment of the FDIC as receiver, notwithstanding the agreement of the parties in the security-based swap trading relationship documentation, and that the FDIC may have certain rights to transfer security-based swaps of the covered party under Section 210(c)(9)(A) of the Dodd-Frank Act, 12 U.S.C. 5390(c)(9)(A), or 12 U.S.C. 1821(e)(9)(A); and

(D) An agreement between the SBS Entity and its counterparty to provide notice if either it or its counterparty becomes or ceases to be an insured depository institution or a financial company.

Second, the policies and procures required pursuant to proposed Rule 15Fi-5(b)(6) would require the security-based swap trading relationship documentation of each SBS Entity disclose certain information regarding the status of a security-based swap accepted for clearing by a clearing agency. Specifically, such documentation would need to contain a notice that, upon acceptance of a security-based swap by a clearing agency:

• The original security-based swap is extinguished;

• The original security-based swap is replaced by equal and opposite security-based swaps with the clearing agency; and

• All terms of the security-based swap shall conform to the product specifications of the cleared security-based swap established under the clearing agency's rules.

The Commission preliminarily believes that this disclosure should provide important information to counterparties regarding the effects of clearing a trade at a clearing agency and clarify the status of the contract following its acceptance and novation at the clearing agency.

5. Proposed Rule 15Fi-5(c): Audit of Security-Based Swap Trading Relationship Documentation

Proposed Rule 15Fi-5(c) would require each SBS Entity to have an independent auditor conduct periodic audits sufficient to identify any material weakness in its documentation policies and procedures required by the rule. The proposal also would require that a record of the results of each audit be retained for a period of three years after the conclusion of the audit.

104

The Commission preliminarily believes that requiring periodic audits of a firm's security-based swap trading relationship documentation is consistent with sound risk mitigation practices and is designed to reduce the prevalence of discrepancies during the course of these transactions. This proposed requirement differs slightly from CFTC Rule 23.504(c), which references an independent “internal or external” auditor.

105

104

The three year holding period for these records is contained in the applicable recordkeeping, reporting, and notification requirements for SBS Entities, as opposed to in proposed Rule 15Fi-5(c) itself.

105

See

17 CFR 23.504(c). In the Commission's experience overseeing accounting and auditing standards in the context of certain disclosure requirements under the federal securities laws, an internal auditor typically reports to the management of the applicable entity, which would be inconsistent with the Commission's auditor independence rules.

See

Rule 2-01(c)(2) of Regulation S-X (Employment Relationships). 17 CFR 210.2-01(c). At the same time, we are not foreclosing the possibility that there could be alternative structures to the typical “internal” auditor employment relationship that could, if structured properly, not be inconsistent with the Commission's auditor independence rules and request comment below identifying and describing such potential structures.

6. Exceptions to the Trading Relationship Documentation Requirements

Proposed Rule 15Fi-5(a)(1) would establish three different exceptions from the basic requirement that each SBS Entity establish, maintain, and follow written policies and procedures reasonably designed to ensure that it executes written security-based swap trading relationship documentation with each of its counterparties prior to, or contemporaneously with, executing a security-based swap with any counterparty. First, proposed Rule 15Fi-5(a)(1)(i) would provide an exception for security-based swaps executed prior to the date on which an SBS Entity is required to be in compliance with the documentation rule. Although the Commission recognizes the significant risk mitigation benefits associated with ensuring that all transactions are supported by comprehensive and accurate documentation, we also understand that it may be impractical to require SBS Entities to have policies and procedures to bring existing transactions into compliance with these proposed rules, particularly when weighing any potential benefits of doing so against the potential costs. Accordingly, we preliminarily believe that those transactions should be excepted from the proposed documentation requirements.

106

As discussed in detail in Section I.F.1 of this release, the Commission also is proposing amendments to Rule 17a-4 and to proposed Rule 18a-6 that would, among other things, require SBS Entities to retain all security-based swap trading relationship documentation with counterparties required to be created under proposed Rule 15Fi-5. Because security-based swaps executed prior to the date on which an SBS Entity is required to be in compliance with proposed Rule 15Fi-5 would be exempt from the underlying documentation requirement, any trading relationship documentation voluntarily entered into in respect of those transactions would not be deemed to have been created pursuant to proposed Rule 15Fi-5.

To the extent that an SBS Entity maintains an existing security-based swap portfolio with a counterparty that pre-dates the compliance date, proposed Rule 15F-5(a)(1)(i) would provide an exception from the documentation requirements only with respect to those

existing

transactions. This means that the SBS Entity would not be in violation of Rule 15Fi-5 solely as a result of having policies and procedures that do not require such SBS Entity to have executed written security-based swap trading relationship documentation with any counterparty with respect to those existing transactions, or if the existing documentation that it maintains with the counterparty does not otherwise comply with the requirements of the rule. However, if the SBS Entity enters into

new

security-based swap transactions with the counterparty, the exception would not apply to those new trades, even if trading relationship documentation already existed. Under those circumstances, the SBS Entity's policies and procedures would be need to be reasonably designed to ensure that the existing documentation complies with the proposed rule before using it as the basis to enter into any new security-based swaps with that counterparty.

Second, proposed Rule 15Fi-5(a)(1)(ii) would provide an exception for any “clearing transaction” which, pursuant to existing Rule 15Fi-1(c), is defined as a security-based swap that has a clearing agency as a direct counterparty.

107

This exception is intended to recognize the fact that once a security-based swap is cleared, the transaction is governed primarily by the terms of the agreements in effect between the clearing member and the clearing agency (as well as between the clearing member and its customer, if applicable).

107

See supra

note 58 and accompanying text.

Finally, proposed Rule 15Fi-5(a)(1)(iii) would provide an exception for security-based swaps executed anonymously on a national securities exchange or a security-based swap execution facility (“SBSEF”), provided that:

• Such security-based swaps are intended to be cleared and are actually submitted for clearing to a clearing agency;

• All terms of such security-based swaps conform to the rules of the clearing agency; and

• Upon acceptance of such security-based swap by the clearing agency: (1) The original security-based swap is extinguished; (2) the original security-based swap is replaced by equal and opposite security-based swaps with the clearing agency; and (3) all terms of the security-based swap shall conform to the product specifications of the cleared security-based swap established under the clearing agency's rules.

The exception in proposed Rule 15Fi-5(a)(1)(iii) is intended to recognize the fact that the documentation requirements may be largely impossible to comply with in the context of cleared anonymous transactions by virtue of the fact that, by definition, the parties to these transactions would not know the identity their counterparties. Therefore, trading relationship documentation with any such counterparty would be unnecessary and impractical.

The exception provided for in proposed Rule 15Fi-5(a)(1)(iii) is limited—and therefore distinguishable from the exception for cleared security-based swap transactions—in one important respect to account for instances where a transaction is not accepted for clearing following its submission. For example, an SBS Entity may enter into a security-based swap transaction on an anonymous basis on a national securities exchange or an SBSEF, fully intending for the transaction to be submitted to, and cleared by, a clearing agency. In some cases, the transaction may be rejected by the clearing agency for reasons which the SBS Entity did not know (or had no reasonable basis to know) prior to its submission, such as possible operational or clerical errors or if one of the clearing members unintentionally exceeded its clearing limits. If a bilateral transaction continues to exist between the two counterparties (who would no longer be unknown to each other), written trading relationship documentation governing that transaction might not exist between them.

Under those circumstances, the Commission preliminarily believes that the objectives of Rule 15Fi-5 would not be satisfied if the SBS Entity and its counterparty did not ultimately have written agreement on the terms of the remaining security-based swap transaction. At the same time, however, because the transaction was initially entered into on an anonymous basis, the two sides might need additional time to agree to the terms of the trading relationship documentation, particularly if they previously had not engaged in any other transactions. Accordingly, the Commission is proposing that if an SBS Entity that is relying on the exception in proposed Rule 15Fi-5(a)(1)(iii) subsequently receives notice that the relevant security-based swap transaction has not been accepted for clearing by a clearing agency, the applicable policies and procedures would need to require that the SBS Entity be in compliance with the requirements of proposed Rule 15Fi-5 in all respects promptly after receipt of such notice.

108

The provisions in proposed Rule 15Fi-5(a)(iii) to account for cleared anonymous transactions that are submitted for clearing, but ultimately not accepted, are not included in CFTC Rule 23.504. We have included this provision to account for situations when an SBS Entity could be otherwise deemed to be not in compliance with proposed Rule 15Fi-5 due to a transaction being rejected for clearing for reasons which the SBS Entity did not know (or have a reasonable basis to know) prior to when the transaction was submitted to the clearing agency.

The Commission notes that whether a contract that has not been accepted for

clearing by a clearing agency continues to exist may depend on the rules of the particular SBSEF, national securities exchange, or clearing agency, or the agreement of the counterparties. If the end result is that a security-based swap continues to exist despite being rejected by the clearing agency, then the policies and procedures would need to require that the SBS Entity be in compliance with the requirements of Rule 15Fi-5 with respect to that transaction. If the rejection from clearing results in a termination or voiding of the original security-based swap, then there is no security-based swap for which it is necessary to comply with Rule 15Fi-5.

7. Comments Requested

The Commission generally requests comments on all aspects of Proposed Rule 15Fi-5 (and any related definitions). In addition, the Commission requests comments on the following specific issues:

• Do commenters agree with the scope of the proposed exception from the trading relationship documentation requirements in proposed Rule 15Fi-5 for clearing transactions? Why or why not? Because the definition of “clearing transactions” only includes transactions cleared at a clearing agency registered with the Commission pursuant to Section 17A of the Exchange Act, security-based swaps cleared at a foreign clearing agency that is not registered with the Commission would

not

be deemed to be “cleared” for these purposes, and would therefore be subject to proposed Rule 15Fi-5. Should the Commission modify the scope of the exception for cleared security-based swaps, such as by including transactions that are cleared at a clearing agency that is not registered with the Commission pursuant to Section 17A of the Exchange Act, whether because of an applicable exemption from registration or because Exchange Act does not cover the activities of the clearing agency? Why or why not?

• Do commenters agree with the proposed exception from the trading relationship documentation requirements for security-based swaps executed anonymously on a national securities exchange or an SBSEF? Is it sufficiently comprehensive? Why or why not? The proposed exception also provides that if a security-based swap executed anonymously on a platform is subsequently rejected for clearing, the SBS Entity would then be required to come into compliance with the documentation requirements “promptly” after receipt of the notice of rejection. Do you agree with this approach? Why or why not? Should the Commission define or provide an interpretation of the word “promptly” for these purposes or, as an alternative, specify a fixed period of time in the rule text in which SBS Entities would be required to comply with proposed Rule 15Fi-5? Why or why not and, if so, how much time should be provided?

• Are there any current industry practices that relate to how counterparties to swaps and security-based swaps treat transactions executed anonymously on a trading platform, but subsequently rejected for clearing? If any such practices exist, please describe them, including with regard to the length of time that it typically takes to document these transactions, if they remain in effect.

• With respect to any Swap Entity that could potentially register with the Commission as an SBS Entity, would the documentation protocols (or any other applicable documentation) already in existence with respect to CFTC Rule 23.504 satisfy the requirements in proposed Rule 15Fi-5? Why or why not? Should proposed Rule 15Fi-5 be modified to account for the way that market participants have designed their existing protocols (or any other applicable documentation) to be compliant with the CFTC's rules? Why or why not? For the purposes of compliance with the proposed documentation rules, should the Commission allow compliance with the CFTC's parallel documentation rules for some period of time to allow dual SEC-CFTC registrants to conform their existing documentation protocols (or any other applicable documentation) following the adoption of proposed Rule 15Fi-5? If so, on what factors should that reliance be conditioned and how long of a compliance period should be provided? In the alternative, should the Commission delay compliance with, or establish phased compliance deadlines for, some or all of these requirements? Please explain the nature of any compliance challenges (including any additional documentation requirements), and the basis for any suggested compliance period.

• As previously noted, proposed Rule 15Fi-5 has been designed to be as consistent as possible with CFTC Rule 23.504, which imposes trading relationship documentation requirements on Swap Entities, in order to avoid requiring dual SEC-CFTC registrants to incur additional systems or compliance costs due to differences between the two agencies' approaches. To the extent that any such differences remain, should the Commission consider, for any firm dually-registered as both an SBS Entity and Swap Entity (regardless of whether such firm is also registered with the Commission as a broker-dealer or with the CFTC as a futures commission merchant), permitting such firm to comply with proposed Rule 15Fi-5 on an ongoing basis by complying with CFTC Rule 23.504, as if such rule applied to security-based swaps? If so, what conditions, if any, should be placed on such reliance?

• In addition to the exceptions set forth in the proposed rule, are there other types of security-based swaps that should not be subject to the underlying trading relationship documentation requirements?

• Should the Commission require that the policies and procedures governing the required written security-based swap trading relationship documentation be approved by a senior officer of the SBS Entity, as is currently contemplated pursuant to proposed Rule 15Fi-5? Why or why not? As an alternative to requiring action by a senior officer, should such approval come instead from the governing body of the SBS Entity? Why or why not? As an additional alternative, should the Commission consider requiring approval of those policies and procedures by someone below the senior officer level? If so, who within an SBS Entity should approve them?

• For purposes of the requirement that a senior officer approve the policies and procedures required by proposed Rule 15Fi-5, the Commission has preliminarily interpreted the term “senior officer” as covering only the most senior executives in the organization, such as a firm's chief executive officer, chief financial officer, chief legal officer, chief compliance officer, president, or other person at a similar level. Do commenters agree with such interpretation? Why or why not? Does the proposed interpretation create any differences with respect to the manner in which Swap Entities are required to comply with CFTC Rule 23.504(a)(2), which uses the term “senior management”? Should the explanation included in the Commission's proposed interpretation instead be included in the rule text?

• Proposed Rule 15Fi-5 does not contain a comprehensive list of all of the terms that should be addressed in the required security-based swap trading relationship documentation. Rather, it provides that the documentation must include “all terms governing the trading relationship” between the SBS Entity and its counterparty and also contains a non-exclusive list of terms that must be

included. Do commenters agree with that approach? Why or why not? Should the Commission consider modifying the list of terms specifically identified in proposed Rule 15Fi-5(b)(1)?

• Should the Commission provide any additional specificity and/or guidance as it relates to one or more of the terms identified in proposed Rule 15Fi-5(b)(1) as required to be included in the trading relationship documentation? For example, should the rule specify the types of payment obligation terms that should be addressed in the documentation? Are there any particular details regarding potential events of default or termination events that should be specified in the documentation? Should the information requirements regarding the terms of the credit support arrangements between the two parties be modified in any way? In each case, why or why not and what additional details or guidance should be provided?

• Proposed Rule 15Fi-5(b)(1) requires that the security-based swap trading relationship documentation that SBS Entities execute with the counterparties include terms addressing dispute resolution. Should the Commission provide any additional specificity with respect to this proposed requirement, including by identifying what particular aspects of the dispute resolution process should be addressed in the documentation? For example, should the documentation include specific requirements regarding the methods for identifying, recording, and monitoring disputes? Should the terms governing dispute resolution identify specific time periods applicable to the process? Are there particular aspects regarding communications between the counterparties that should be specified in connection with the terms related to dispute resolution, such as the method for providing notice of a potential or actual dispute? In each case, why or why not, and what additional details or guidance should be provided?

• Proposed Rule 15Fi-5(b)(4) would require SBS Entities to include in their security-based swap trading relationship documentation with certain counterparties written agreement on the terms for valuing security-based swaps for the purposes of complying with the margin and risk management requirements. Do you agree with the scope of that requirement? Why or why not? Should these requirements apply to an SBS Entity's transactions with all counterparties, including non-financial counterparties, without regard to whether they are requested? Why or why not? Is there any additional information that should be included in this requirement, or should any of the proposed requirements be modified or deleted? Do the provisions related to valuation discrepancies provide a sufficient basis for helping to ensure that disputes related to the value of a security-based swap are resolved in as efficient a manner as possible, or should any changes be made to these requirements? Should the requirements regarding valuation be modified in any way to account for the use of internal and/or proprietary inputs and models? In each case, why or why not, and how and why should the proposed rule be modified?

• Are the protections in the proposed rule regarding the treatment of confidential, proprietary information in connection with the required valuation agreement sufficient to meet the needs of both the party providing the information and the party receiving it? If not, how should the proposal be revised to address any such concerns?

• In addition to the terms governing the valuation agreement in proposed Rule 15Fi-5(b)(4), are there any other requirements that should be limited to, or modified for, certain types of counterparties (

e.g.,

financial counterparties)? If so, which ones, and what particular requirements should apply?

• Do the disclosure requirements in paragraphs (5) and (6) of proposed Rule 15Fi-5(b), as they relate to the “insured depository institution” or “financial company” status of the SBS Entity or its counterparty and to the status of a security-based swap accepted for clearing, respectively, provide useful and relevant information to counterparties to security-based swaps? Why or why not? Should any other disclosure requirements be modified or deleted? If so, which ones and how? Should any additional disclosure requirements be added to the proposed rule? If so, what should be added and why?

• Do commenters agree with the scope of the proposed definition of “financial counterparty” in proposed Rule 15Fi-1(g), which is used for determining when the required security-based swap trading relationship documentation would need to include the valuation methodology set forth in proposed Rule 15Fi-5(b)(4)? Should that definition be expanded to include other types of financial entities, such as SEC-registered broker-dealers, investment companies, or investment advisers? If so, which types of entities should be added to the definition and why?

• Do commenters agree with the proposed requirements related to the performance of periodic audits of the SBS Entity's security-based swap relationship documentation, as set forth in proposed Rule 15Fi-5(c)? Why or why not? If not, how should they be clarified? Should the Commission provide any additional specificity regarding what constitutes “independence” for these purposes? If so, how should that standard be measured and evaluated? For example, the Commission has extensive experience with respect to determining what constitutes “independence” in the context o

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