OTC Derivatives Dealers
Federal RegisterNov 3, 1998
Ask Donna
What actually matters in this document.
Text
SUMMARY: The Securities and Exchange Commission is adopting rules and
rule amendments under the Securities Exchange Act of 1934 that tailor
capital, margin, and other broker-dealer regulatory requirements to a
class of registered dealers, called OTC derivatives dealers, that are
active in over-the-counter derivatives markets. Registration as an OTC
derivatives dealer under these rules is optional and is an alternative
to registration as a broker-dealer under the traditional broker-dealer
regulatory structure. It is available only to entities that engage in
dealer activities in eligible over-the-counter derivative instruments
and that meet certain financial responsibility and other requirements.
EFFECTIVE DATE: The rules and rule amendments shall become effective on
January 4, 1999.
FOR FURTHER INFORMATION CONTACT:
General
Catherine McGuire, Chief Counsel, Patrice M. Gliniecki, Special
Counsel, or Laura S. Pruitt, Special Counsel, at (202) 942-0073,
Division of Market Regulation, Securities and Exchange Commission, 450
Fifth Street, NW, Mail Stop 10-1, Washington, DC 20549.
Financial Responsibility and Books and Records
Michael Macchiaroli, Associate Director, at (202) 942-0132, Thomas
K. McGowan, Assistant Director, at (202) 942-0177, Christopher Salter,
Attorney, at (202) 942-0148, Victoria Pawelski, Attorney, at (202) 942-
4169, Matt Hughey, Accountant, at (202) 942-0143, or Gary Gregson,
Statistician, at (202) 942-4156, Division of Market Regulation,
Securities and Exchange Commission, 450 Fifth Street, NW, Mail Stop 10-
1, Washington, DC 20549.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Executive Summary
A. Introduction
B. The Proposing Release
C. Final Rules and Rule Amendments
1. General
2. Scope of Permissible Securities Activities
a. Eligible OTC Derivative Instruments
b. Cash Management Securities Activities
c. Ancillary Portfolio Management Securities Activities
3. Intermediation of Securities Transactions
4. Exemptions for OTC Derivatives Dealers
a. Exemption from SRO Membership
b. Exemption from Certain Margin Requirements
c. Exemption from SIPA
5. Section 11(a) of the Exchange Act
6. Net Capital Requirements
7. Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3
8. Recordkeeping and Reporting
II. Discussion: New Rules and Amended Rules
A. Definitions
1. Rule 3b-12; Definition of OTC Derivatives Dealer
2. Rule 3b-13; Definition of Eligible OTC Derivative Instrument
3. Proposed Rule 3b-14; Definition of Permissible Derivatives
Counterparty
4. Proposed Rule 3b-16; Definition of Hybrid Security
5. Rules 3b-14 and 3b-15; Definitions of Cash Management
Securities Activities and Ancillary Portfolio Management
Securities Activities
a. Rule 3b-14; Cash Management Securities Activities
i. Counterparty Collateral
ii. Cash Management
iii. Financing
b. Rule 3b-15; Ancillary Portfolio Management Securities
Activities
i. Hedging
ii. Arbitrage
iii. Trading
iv. Documentation of Activities
B. Amendment to Rule 15b1-1; Registration with the Commission
C. Rule 15a-1; Securities Activities of OTC Derivatives Dealers
1. Scope of Permissible Securities Activities
2. Commission Orders Regarding OTC Derivatives Dealers'
Activities
3. Intermediation of Securities Transactions
4. Communications Regarding Securities Transactions
5. Confirmation of Securities Transactions
6. Position Limits
D. Exemptions for OTC Derivatives Dealers
1. Rule 15b9-2; Exemption from SRO Membership
2. Rule 36a1-1; Exemption from Certain Margin Requirements
3. Rule 36a1-2; Exemption from SIPA
E. Rule 11a1-6; Transactions for Certain Accounts of OTC
Derivatives Dealers
F. Net Capital Requirements for OTC Derivatives Dealers
1. Overview of Amendments to Rule 15c3-1
2. Reasons for Allowing OTC Derivatives Dealers to Use Value-at-
Risk Models
3. Discussion of Net Capital Requirements
a. Rule 15c3-1(a)(5)
b. Appendix F
i. Application Requirement
ii. Market Risk
iii. Credit Risk
iv. Qualitative Requirements for Value-at-Risk Models
v. Quantitative Requirements for Value-at-Risk Models
G. Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3
H. Recordkeeping and Reporting
1. Amendments to Rules 17a-3 and 17a-4; Books and Records to be
Maintained by OTC Derivatives Dealers
2. Amendments to Rule 17a-11; Notification Requirements
3. Rule 15c3-4; Internal Risk Management Control Systems for OTC
Derivatives Dealers
4. Rule 17a-12; Reports to be Made by OTC Derivatives Dealers
5. Amendments to Form X-17A-5
III. Costs and Benefits of the Rules and Rule Amendments
A. Comments and Survey
B. Benefits
1. Regulatory Capital Effects
2. Operational Cost Savings
3. Decreased Margin Requirements
C. Costs
1. Costs of Combining Activities into One Operation
2. Registration as an OTC Derivatives Dealer
3. Risk Management Adjustments
4. Books and Records Requirements
5. Regulatory Reporting
6. Regulation U Margin Requirements
D. Conclusion
IV. Efficiency, Competition, and Capital Formation
V. Summary of Final Regulatory Flexibility Analysis
A. Need for the Rules and Rule Amendments
B. Small Entities Subject to the Rules
C. Projected Reporting, Recordkeeping, and Other Compliance
Requirements
D. Alternatives to Minimize Effect on Small Entities
VI. Paperwork Reduction Act
VII. Statutory Authority
Text of Rules and Rule Amendments
I. Executive Summary
A. Introduction
Over-the-counter (``OTC'') derivative instruments are important
financial management tools employed by many corporations, financial
institutions, governmental entities, and other end-users. Participants
in the OTC derivatives markets engage in transactions involving a wide
range of instruments in order to effectively manage risks associated
with their business activities or their financial assets.
Whether OTC derivatives transactions are structured as interest
rate swaps, cross currency swaps, equity swaps, basis swaps, total
return swaps, asset swaps, credit swaps, or options, they share certain
characteristics.\1\ For
[[Page 59363]]
example, each has a value or return related to the value or return of
an underlying asset. Asset classes can consist of securities or
virtually any other financial instrument, financial measure, or
physical commodity, such as interest rates, securities indices, foreign
currencies, metals or energy products, or spreads between the values of
different assets. More importantly, each of these instruments can
provide users with a carefully tailored method for managing a variety
of risks.\2\
---------------------------------------------------------------------------
\1\ Swaps are contracts that typically allow the parties to the
contract to exchange cash flows related to the value or performance
of certain assets, rates, or indices for a specified period of time.
See generally Peter A. Abken, Beyond Plain Vanilla: A Taxonomy of
Swaps, Financial Derivatives Reader (Robert W. Kolb, ed.) (1992).
Most swaps are based on currencies or interest rates. Swaps that
provide for an exchange of values based on the value or performance
of equity securities make up a small, but growing, share of the
swaps market. Options are instruments that generally provide the
holder, in exchange for the payment of a premium, with benefits of
favorable movements in the underlying asset or index with limited or
no exposure to losses from unfavorable price movements. Typically,
OTC options provide for cash settlement, rather than the delivery of
the underlying asset. Credit derivatives function like contingent
options to the extent payments under the contract are triggered by
the occurrence of a credit event, such as a decline in an issuer's
credit rating or default in performance under a debt obligation.
\2\ See, e.g., Clifford W. Smith, Jr., Charles W. Smithson, and
D. Sykes Wilford, Managing Financial Risk, Financial Derivatives
Reader (Robert W. Kolb, ed.) (1992); Group of Thirty, Derivatives:
Practices and Principles (July 1993), Financial Derivatives: Actions
Needed to Protect the Financial System, United States General
Accounting Office Report (May 1994).
---------------------------------------------------------------------------
OTC derivative instruments, for example, can be used by
corporations and local governments to lower funding costs, or by
multinational corporations to manage risk associated with fluctuating
exchange rates. They can also be used by portfolio managers to manage
volatility in investment portfolios or to obtain exposure to different
assets without taking a position in the cash markets. Because of the
benefits these instruments offer, the derivatives markets have grown
significantly over the past two decades.\3\
---------------------------------------------------------------------------
\3\ The International Swaps and Derivatives Association
(``ISDA'') estimates that, as of December 31, 1996, the combined
notional amount of globally outstanding interest rate swaps,
currency swaps, and interest rate options has grown to over $29
trillion. See ``ISDA Market Survey,'' ISDA Internet web site (http:/
/www.isda.org).
---------------------------------------------------------------------------
The traditional broker-dealer regulatory structure under the
Securities Exchange Act of 1934 (``Exchange Act),\4\ however, has not
permitted a firm to operate a competitive OTC derivatives business in
the United States that involves the broad range of OTC derivative
instruments currently available to participants in these markets. While
some of these OTC derivative instruments are securities, others are
not. OTC options on equity securities or on U.S. government securities,
for example, are securities within the meaning of section 3(a)(10) of
the Exchange Act.\5\ Firms that effect transactions in these or other
OTC derivative instruments that are securities in the United States are
required to register as broker-dealers under section 15(b) of the
Exchange Act \6\ and fulfill all requirements applicable to other
securities broker-dealers, including Exchange Act rules governing
margin and capital.
---------------------------------------------------------------------------
\4\ 15 U.S.C. 78a et seq.
\5\ 15 U.S.C. 78c(a)(10)
\6\ 15 U.S.C. 78o(b).
---------------------------------------------------------------------------
Traditional U.S. broker-dealer regulation seems particularly
restrictive when contrasted with OTC derivatives activities that are
conducted outside of the broker-dealer regulatory regime. Firms located
off-shore can often structure their securities activities in a manner
that will avoid or lessen the regulatory burdens imposed on broker-
dealers under U.S. law. For example, off-shore firms can often avoid
registering as broker-dealers in the United States if they engage in
securities transactions only with non-U.S. persons, or if they comply
with the requirements of Rule 15a-6 under the Exchange Act.\7\
---------------------------------------------------------------------------
\7\ 17 CFR 240.15a-6.
---------------------------------------------------------------------------
Similarly, because U.S. banks are excluded from the Exchange Act
definitions of ``broker'' and ``dealer,'' \8\ they are not subject to
U.S. broker-dealer regulation. They, therefore, may engage in a broad
range of OTC derivatives activities in accordance with guidance issued
by their appropriate banking regulators.\9\ In addition, firms that
effect transactions only in OTC derivative instruments that are not
securities are not subject to U.S. broker-dealer regulation.
---------------------------------------------------------------------------
\8\ See Section 3(a)(4) of the Exchange Act (15 U.S.C.
78c(a)(4)) (defining broker) and Section 3(a)(5) of the Exchange Act
(15 U.S.C. 78c(a)(5)) (defining dealer). The exclusion for banks
from the definitions of ``broker'' and ``dealer'' under the Exchange
Act is available only to those banking institutions that satisfy the
definition of ``bank'' set forth in Section 3(a)(6) of the Exchange
Act (15 U.S.C. 78c(a)(6)).
\9\ Banking regulators have issued guidance to banks engaging in
derivatives activities. See e.g., Federal Financial Institutions
Examination Council, Supervisory Policy Statement on Investment
Securities and End-User Derivatives Activities, 63 FR 20191 (Apr.
23, 1998); Federal Reserve Board, Trading and Capital-Markets
Activities Manual (1998) (including discussions of various
derivative instruments, such as credit derivatives); Federal Reserve
SR Letter 97-21, Risk Management and Capital Adequacy of Exposures
Arising from Secondary Market Credit Activities (July 11, 1997);
Federal Reserve SR Letter 97-18, Application of Market Risk Capital
Requirements to Credit Derivatives (June 13, 1997); FDIC FIL 62-96,
Supervisory Guidance for Credit Derivatives (Aug. 19, 1996); Federal
Reserve SR Letter 96-17, Supervisory Guidance for Credit Derivatives
(Aug. 12, 1996); OCC Bulletin 96-43, Credit Derivatives (Aug. 12
1996); OCC Bulletin 96-25, Fiduciary Risk Management of Derivatives
and Mortgage-Backed Securities (Apr. 30, 1996); OCC Bulletin 94-31,
Questions and Answers for BC-277 (May 10, 1994); and Risk Management
of Financial Derivatives, OCC Banking Circular No. 277 (Oct. 1993).
---------------------------------------------------------------------------
The potential costs of broker-dealer regulation, as applied to
dealers in OTC derivative instruments, have affected the way U.S.
securities firms conduct business in the OTC derivatives markets. In
many instances, U.S. securities firms have decided to separate their
securities activities from their non-securities activities. These firms
often place their non-securities OTC derivatives activities in
separate, unregistered affiliates located in the United States, and
conduct some or all of their securities OTC derivatives activities from
abroad. However, fragmenting a firm's OTC derivatives business in this
manner may hinder its ability to manage risk and compete for business.
For example, U.S. securities firms have voiced concerns regarding
their ability to manage counterparty credit risk effectively under the
traditional broker-dealer regulatory regime. Typically, in order to
reduce credit exposure to a single counterparty, dealers in OTC
derivative instruments enter into master agreements with their
counterparties that provide for netting of the outstanding financial
obligations existing between the dealers and their counterparties. As
these firms have pointed out, it would be more efficient and effective
to conduct both securities and non-securities OTC derivatives
transactions with a counterparty through a single legal entity, subject
to appropriately tailored regulatory requirements, rather than through
multiple legal entities. The firms have also indicated that certain
counterparties prefer to deal with a firm through a single entity that
is capable of transacting business across a broad range of OTC
derivative instruments.
B. The Proposing Release
In response to the concerns raised by firms seeking to conduct an
OTC derivatives business in the United States, the Commission proposed
to establish a form of limited broker-dealer regulation that would give
the firms an opportunity to conduct business in a vehicle subject to
modified regulation appropriate to the OTC derivatives markets.\10\
This form of limited broker-dealer regulation was intended to allow
securities firms to establish dealer
[[Page 59364]]
affiliates, referred to as ``OTC derivatives dealers,'' that would be
able to compete more effectively with banks and foreign dealers in
global OTC derivatives markets, while also maintaining standards
necessary to ensure investor protection.
---------------------------------------------------------------------------
\10\ Exchange Act Release No. 39454 (Dec. 17, 1997), 62 FR 67940
(Dec. 30, 1997) (``Proposing Release'').
---------------------------------------------------------------------------
In the Proposing Release, the Commission specifically solicited
comment on the extent to which persons eligible to become registered as
OTC derivatives dealers believed that the proposal would address
competitive inequalities that discouraged securities firms from
conducting an OTC derivatives business in the United States. Commenters
were also asked to express their views on the application of the
Commission's broker-dealer rules to OTC derivatives dealers and whether
additional amendments or exemptions were needed for this class of
dealers.
The Commission received twenty-one comment letters in response to
the proposed rules and rule amendments, including comments from, among
others, industry representatives, self-regulatory organizations, and
other regulators.\11\ The majority of the commenters endorsed the
Commission's initiative to develop an alternative regulatory framework
for OTC derivatives dealers. These commenters supported the
Commission's intent to provide a regulatory framework for OTC
derivatives dealers that would enable these dealers to compete more
effectively with both banks and foreign dealers in OTC derivatives
markets. They often noted in particular their support of the
Commission's efforts to address the regulatory costs imposed by
existing capital requirements on securities firms seeking to operate an
OTC derivatives business in the United States.\12\
---------------------------------------------------------------------------
\11\ The staff of the Division of Market Regulation has prepared
a summary of the comment letters received on the proposed rules and
rule amendments entitled ``Comment Summary for Proposing Release on
OTC Derivatives Dealers'' (hereinafter referred to as ``Comment
Summary''). Copies of the comment letters and the Comment Summary
have been placed in Public Reference File No. S7-30-97 and are
available for inspection in the Commission's Public Reference Room.
\12\ See Letters cited in Section II., n.1 of the Comment
Summary.
---------------------------------------------------------------------------
The commenters, however, also suggested that the Commission modify
the proposed rules and rule amendments in various ways to more
accurately reflect the manner in which firms conduct an OTC derivatives
business. Many commenters stressed the need for the alternative
regulatory regime to establish a practical commercial framework for the
conduct of this business and to provide U.S. securities firms with
flexibility in structuring their derivatives activities.
C. Final Rules and Rule Amendments
1. General
After considering the comment letters, the Commission is adopting
rules and rule amendments that will allow U.S. securities firms to
establish separately capitalized entities that may engage in dealer
activities in eligible OTC derivative instruments, which include both
securities and non-securities OTC derivative instruments. OTC
derivatives dealers are also permitted to engage in certain additional
securities activities related to conducting an OTC derivatives
business. A firm engaging in the permitted activities has the option of
registering with the Commission under Section 15(b) of the Exchange
Act\13\ as an OTC derivatives dealer, subject to specially tailored
capital, margin, and various other requirements.
---------------------------------------------------------------------------
\13\ 15 U.S.C. 78o(b).
---------------------------------------------------------------------------
These tailored requirements are intended, in part, to improve the
efficiency and competitiveness of U.S. securities firms active in
global OTC derivatives markets. By permitting U.S. securities firms to
conduct both securities and non-securities OTC derivatives activities
through a single legal entity, the new structure will enable the firms
to enter into more comprehensive netting arrangements with
counterparties and thus more effectively manage credit risk. End-users
should also benefit as a result of a reduction in the legal risks that
arise when securities firms structure their derivatives activities in a
manner that avoids U.S. broker-dealer registration.\14\ As noted by one
commenter, all participants in the OTC derivatives markets have a vital
interest in ensuring that OTC derivatives transactions are available in
a framework where the legal rights and obligations of the parties to an
agreement are certain and enforceable.\15\ The new regulatory regime
for OTC derivatives dealers is intended to help provide that legal
certainty to these markets.
---------------------------------------------------------------------------
\14\ See, e.g., Comment Letter from the End-Users of Derivatives
Association, Inc. (``EUDA Letter''). p. 1.
\15\ See Comment Letter from the International Swaps and
Derivatives Association, Inc. (``ISDA Letter''), pp. 1-2.
---------------------------------------------------------------------------
As a ``dealer'' under the Exchange Act,\16\ an OTC derivatives
dealer remains subject to all other rules applicable to ``fully
regulated broker-dealers,'' \17\ unless otherwise provided by the new
rules and rule amendments. In addition, the Commission wishes to
emphasize that purchasers and sellers of OTC derivative instruments
that are securities will continue to be protected by the general anti-
manipulation and anti-fraud provisions, including Section 17(a) of the
Securities Act of 1933,\18\ and Section 9(a) \19\ and 10(b) \20\ of the
Exchange Act, and Rule 10b-5 thereunder.\21\
---------------------------------------------------------------------------
\16\ See Section 3(a)(5) of the Exchange Act (15 U.S.C.
78c(a)(5)).
\17\ For purposes of this release, the term ``fully regulated
broker-dealer'' means a broker or dealer that is registered with the
Commission under section 15(b) of the Exchange Act (15 U.S.C.
78o(b)), but that is not an OTC derivatives dealer, and therefore is
subject to all statutes, rules, and regulations imposed on broker-
dealers under the transitional broker-dealer regulatory regime,
including membership in a securities self-regulatory organization.
\18\ 15 U.S.C. 78q(a).
\19\ 15 U.S.C. 78i(a).
\20\ 15 U.S.C. 78j(a).
\21\ 17 CFR 240.10b-5. See, e.g., In the Matter of BT Securities
Corporation, Exchange Act Release No. 35136 (Dec. 22, 1994).
---------------------------------------------------------------------------
An OTC derivatives dealer also remains subject to all applicable
statutes, rules, and regulations of other U.S. financial regulators. In
particular, to the extent that the Commodity Exchange Act (``CEA'')
\22\ and the rules and regulations adopted under the CEA apply to the
activities of an OTC derivatives dealer, the new regulatory structure
in no way alters the application of these laws to the activities of an
OTC derivatives dealer.
---------------------------------------------------------------------------
\22\ 7 U.S.C. 1 et seq.
---------------------------------------------------------------------------
2. Scope of Permissible Securities Activities
In order to take advantage of the new regulatory regime for
conducting an OTC derivatives dealer business in the United States, an
OTC derivatives dealer must, among other things, limit its securities
activities to those specified in Rules 3b-12 and 15a-1. In general,
these rules provide that an OTC derivatives dealer's securities
activities must be limited to (1) engaging in dealer activities in
eligible OTC derivative instruments (as defined in Rule 3b-13) that are
securities; (2) issuing and reacquiring securities that are issued by
the dealer, including warrants on securities, hybrid securities, and
structured notes; (3) engaging in cash management securities activities
(as defined in Rule 3b-14); (4) engaging in ancillary portfolio
management securities activities (as defined in Rule 3b-15); and (5)
engaging in such other securities activities that the Commission
designates by order.\23\ An OTC
[[Page 59365]]
derivatives dealer must also be affiliated with a fully regulated
broker-dealer.\24\
---------------------------------------------------------------------------
\23\ The alternative regulatory framework generally does not
limit the non-securities activities of an OTC derivatives dealer,
provided that the dealer complies with financial responsibility and
internal risk management controls requirements. An OTC derivatives
dealer's non-securities activities are also restricted under this
framework by the practical limitations imposed by the definitions of
``cash management securities activities'' and ``ancillary portfolio
management securities activities.''
\24\ As proposed, the alternative regulatory framework defined
the term ``permissible derivatives counterparty,'' and required that
an OTC derivatives dealer's counterparties be limited to such
persons. In response to commenters' concerns, and in light of the
protections afforded through other provisions of the alternative
regulatory framework, the final rules do not restrict the persons
that may act as counterparties in OTC derivatives transactions. The
final rules, however, do not exempt OTC derivatives dealers or their
fully regulated broker-dealer affiliates from counterparty
limitations imposed under any other applicable regulatory or self-
regulatory requirements.
---------------------------------------------------------------------------
The Commission has defined the terms ``cash management securities
activities'' and ``ancillary portfolio management securities
activities.'' \25\ These two terms replace the term ``permissible risk
management, arbitrage, and trading transactions,'' which was included
in the Proposing Release. The new terms serve substantially the same
purpose as the proposed term in that they describe the additional
securities activities in which an OTC derivatives dealer may engage in
connection with its OTC derivatives dealer business. As a practical
matter, a firm seeking to register as an OTC derivatives dealer will
need to be able to conduct these additional securities activities, such
as engaging in certain financing and hedging transactions, in order to
compete effectively with other market participants.
---------------------------------------------------------------------------
\25\ See Rules 3b-14 (17 CFR 240.3b-14) and 3b-15 (17 CFR
240.3b-15).
---------------------------------------------------------------------------
The final rules and rule amendments also contain restrictions to
prevent U.S. securities firms from moving their general securities
dealing activities into the new OTC derivatives dealer entity, or from
using these entities for substantial proprietary trading activities.
For example, the definitions of both ``cash management securities
activities'' and ``ancillary portfolio management securities
activities'' include limitations to prevent an OTC derivatives dealer
from engaging in dealing activities in cash market instruments or from
establishing a proprietary trading desk.
In addition, an OTC derivatives dealer's securities activities must
consist primarily of dealer activities in eligible OTC derivative
instruments that are securities, issuing and reacquiring its issued
securities, and cash management securities activities. Thus, if the
securities activities of an OTC derivatives dealer were to consist only
or primarily of ancillary portfolio management securities activities,
the dealer would be in violation of the rules.
a. Eligible OTC Derivative Instruments. As noted above, an OTC
derivatives dealer is permitted to engage in dealer activities in
``eligible OTC derivative instruments,'' as that term is defined in
Rule 3b-13. The term is defined broadly to encompass the wide range of
securities and non-securities OTC derivative instruments currently
existing in the derivatives markets, as well as to allow for the
inclusion of reasonably similar instruments that market participants
may develop in the future. The types of instruments that generally
satisfy the criteria set forth in Rule 3b-13 include interest rate
swaps, currency swaps, securities swaps, commodity swaps, OTC options
on similar asset classes, long-dated forwards on securities, and
forwards relating to assets other than securities. Other types of
instruments also satisfy the criteria in the rule.
Short-dated securities forwards, however, are excluded from the
definition of eligible OTC derivative instrument, as are securities
derivative instruments that are listed or traded on a national
securities exchange or on Nasdaq. Except as otherwise determined by the
Commission by order, a securities derivative instrument that is one of
a class of fungible instruments that are standardized as to their
material economic terms is also excluded from the definition.
The new regulatory framework also allows an OTC derivatives dealer
to issue and reacquire its issued securities, including hybrid
securities. For purposes of Rules 3b-12 and 15a-1, which describe the
permissible securities activities of an OTC derivatives dealer, the
term ``hybrid security'' is defined as a security that incorporates
payment features economically similar to the OTC derivative instruments
that are enumerated in the definition.\26\ The term ``hybrid security''
is used only in the context of an OTC derivatives dealer's permissible
securities activities under the rules, and is not intended to have a
broader application.
---------------------------------------------------------------------------
\26\ See Rules 3b-12(d) (17 CFR 240.3b-12(d)) and 15a-1(e) (17
CFR 240.15a-1(e).
---------------------------------------------------------------------------
b. Cash Management Securities Activities. An OTC derivatives dealer
may engage in ``cash management securities activities,'' as defined in
Rule 3b-14. Under the rule, an OTC derivatives dealer may engage in
cash management securities activities in connection with its
permissible securities activities or its non-securities activities
(that involve eligible OTC derivative instruments or other financial
instruments). Cash management securities activities include (1) any
acquisition or disposition of collateral provided by a counterparty, or
any acquisition or disposition of collateral to be provided to a
counterparty; (2) cash management; and (3) financing of certain
positions of the dealer. Any securities trading activities associated
with cash management by an OTC derivatives dealer must be at a level
commensurate with the dealer's bona fide operational needs, taking into
consideration the Commission's capital requirements for the dealer and
the amount of capital needed by the dealer to satisfy counterparties'
credit requirements.
c. Ancillary Portfolio Management Securities Activities. An OTC
derivatives dealer may also engage in ``ancillary portfolio management
securities activities,'' as defined in Rule 3b-15. These securities
activities must be limited to transactions in connection with the OTC
derivatives dealer's dealer activities in eligible OTC derivative
instruments, the issuance of securities by the dealer, or such other
securities activities that the Commission designates by order. They
must also (1) be conducted for the purpose of reducing the dealer's
market or credit risk or consist of incidental trading activities for
portfolio management purposes; and (2) be limited to risk exposures
within the market, credit, leverage, or liquidity risk parameters set
forth in the trading authorizations granted to the associated person
(or to the associated person's supervisor) who executes the transaction
for the dealer, and in the written guidelines approved by the dealer's
governing body and included in the dealer's internal risk management
control system (as required under new Rule 15c3-4). Rule 3b-15 also
requires that ancillary portfolio management securities activities be
conducted only by associated persons of the dealer who perform
substantial duties for the dealer in connection with its dealer
activities in eligible OTC derivative instruments.
Again, the limitations on an OTC derivatives dealer's ancillary
portfolio management securities activities under Rule 3b-15 are aimed
at preventing a fully regulated broker-dealer from moving its
securities book into its OTC derivatives dealer affiliate or otherwise
permitting the OTC derivatives dealer to engage in substantial
proprietary securities trading activities. An OTC derivatives dealer's
ability to engage in incidental securities trading activities for
portfolio management purposes under Rule 3b-15, however, recognizes
[[Page 59366]]
that the dealer may to a limited extent engage in securities trading
activity that may not be for the specific purpose of reducing its
market or credit risk.
The new regulatory structure for OTC derivatives dealers
incorporates the concept of managing risk on a portfolio-wide basis and
does not expressly limit the range of permissible ancillary portfolio
management securities activities. Instead, these activities are limited
by the requirement that they not give rise to risk exposures that, on
an aggregate portfolio basis, exceed the risk limits adopted for the
dealer's business under the rules. They are also limited by other
requirements that serve to ensure that the OTC derivatives dealer does
not engage in dealer activities in securities that are not eligible OTC
derivative instruments. The final rules are intended to be flexible and
to accommodate current business practices of OTC derivatives dealers.
Because the rules define a broad scope of permissible securities
activities, however, the restrictions on proprietary trading and
dealing in cash market instruments may prove inadequate. Rule 15a-1
therefore preserves the Commission's ability to clarify, by order,
whether certain securities activities are within the scope of ancillary
portfolio management securities activities.\27\
---------------------------------------------------------------------------
\27\ See Rule 15a-1(b)(4) (17 CFR 240.15a-1(b)(4)).
---------------------------------------------------------------------------
3. Intermediation of Securities Transactions
Rule 15a-1 generally requires that all securities transactions of
an OTC derivatives dealer, including securities OTC derivatives
transactions, be effected through its fully regulated broker-dealer
affiliate.\28\ The intermediation requirement is designed, in part, to
ensure that all securities transactions remain subject to existing
sales practice standards and to reduce the risk that counterparties
will mistakenly view an OTC derivatives dealer as a fully regulated
broker-dealer. Certain professional counterparties, however, are less
likely to need or expect the protections offered by the fully regulated
broker-dealer under this framework. Therefore, the rules provide two
limited exceptions to the broker-dealer intermediation requirement for
securities transactions.
---------------------------------------------------------------------------
\28\ See Rule 15a-1(c) (17 CFR 240.15a-1(c)). An OTC derivatives
dealer may issue and reacquire its issued securities through an
unaffiliated fully regulated broker-dealer. Id.
---------------------------------------------------------------------------
First, an OTC derivatives dealer is not required to use its fully
regulated broker-dealer affiliate to effect securities transactions
with a registered broker or dealer, a bank acting in a dealer capacity,
a foreign broker or dealer, or an affiliate of the OTC derivatives
dealer, provided that the counterparty is acting as principal. Second,
if an OTC derivatives dealer engages in an ancillary portfolio
management securities activity involving a foreign security, it is not
required to effect that securities transaction through its fully
regulated broker-dealer affiliate if a registered broker or dealer, a
bank, or a foreign broker or dealer is acting as agent for the OTC
derivatives dealer.
In addition, any person that solicits a potential counterparty to
engage in a securities transaction with an OTC derivatives dealer, or
otherwise has any contact with the counterparty regarding the
transaction, generally must be a registered representative of the fully
regulated broker-dealer affiliate.\29\ These persons may be dual
employees of both the OTC derivatives dealer and the fully regulated
broker-dealer. However, if the counterparty is a registered broker or
dealer, a bank acting in a dealer capacity, a foreign broker or dealer,
or an affiliate of the OTC derivatives dealer, employees of the OTC
derivatives dealer may solicit or have other forms of contact with the
counterparty, even if they are not also registered representatives of
the fully regulated broker-dealer. This is consistent with the
exception for these same counterparties from the general requirement
that an OTC derivatives dealer's securities transactions be effected
through its fully regulated broker-dealer affiliate.
---------------------------------------------------------------------------
\29\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)). The rule provides
an exception for clerical and ministerial activities that are
conducted by associated persons of the OTC derivatives dealer.
---------------------------------------------------------------------------
In addition, the rule does not require registered representatives
of the fully regulated broker-dealer affiliate to be involved in
contacts with foreign counterparties, in certain situations. Contacts
with a foreign counterparty may generally be conducted by an associated
person of a foreign broker or dealer who is not resident in the United
States, if the foreign broker or dealer is affiliated with the OTC
derivatives dealer and is registered under applicable local law. This
approach recognizes the global nature of the OTC derivatives markets,
and the practical limitations imposed by requiring registered
representatives of the fully regulated broker-dealer affiliate to
participate in all such contacts. Any resulting securities transaction,
however, must generally be effected through the OTC derivatives
dealer's fully regulated broker-dealer affiliate.
4. Exemptions for OTC Derivatives Dealers
The final rules and rule amendments provide exemptions from certain
provisions of the Exchange Act to OTC derivatives dealers due to, among
other things, the unique nature of this business. Specifically, OTC
derivatives dealers are exempted from (a) membership in a securities
self-regulatory organization (``SRO''); (b) certain margin requirements
under the Exchange Act; and (c) the provisions of the Securities
Investor Protection Act of 1970\30\ (``SIPA''), including membership in
the Securities Investor Protection Corporation (``SIPC'').\31\
---------------------------------------------------------------------------
\30\ 15 U.S.C. 78aaa et seq.
\31\ In 1996, Congress added section 36 to the Exchange Act (15
U.S.C. 78mm), which gives the Commission broad authority to exempt
any person from any of the provisions of the Exchange Act. The
exemptions from certain margin requirements under the Exchange Act
and from SIPA were adopted using this new exemptive authority.
---------------------------------------------------------------------------
a. Exemption from SRO Membership. Under Rule 15b9-2, OTC
derivatives dealers are exempt from membership in an SRO. SRO
membership for OTC derivatives dealers, and the additional regulation
it entails, is not warranted at this time. As a practical matter,
certain SRO rules are not consistent with the OTC derivatives dealer
regulatory structure, and accordingly, should not apply directly to the
OTC derivatives dealer. In addition, with limited exceptions, all
securities transactions of an OTC derivatives dealer must be effected
through its fully regulated broker-dealer affiliate, which will be an
SRO member. As a result, SRO rules, including sales practice
requirements, will generally apply to these securities transactions.
While the Commission had proposed that the designated examining
authority (``DEA'') of the OTC derivatives dealer's fully regulated
broker-dealer affiliate would review the OTC derivatives dealer's
activities for violations of Commission rules, the New York Stock
Exchange (``NYSE'') and the National Association of Securities Dealers,
Inc. (``NASD'') expressed serious concerns with overseeing OTC
derivatives dealers on a contractual basis (without the dealers being
SRO members). The Commission staff, therefore, will examine OTC
derivatives dealers to ensure compliance with Commission rules.
b. Exemption from Certain Margin Requirements. Federal regulations
that govern the collateral, or margin, that must be collected by
dealers in connection with securities transactions have created certain
competitive inequalities between registered broker-
[[Page 59367]]
dealers and other entities, including banks, that conduct an OTC
derivatives business. Registered broker-dealers that extend credit for
the purpose of purchasing or carrying securities are required to comply
with the provisions of Regulation T.\32\ The margin requirements for
banks are contained in Regulation U.\33\
---------------------------------------------------------------------------
\32\ 12 CFR 220.1.
\33\ 12 CFR 221.1.
---------------------------------------------------------------------------
After the Commission issued the Proposing Release, several
amendments to Regulation T were adopted that reduced the regulatory
distinctions between broker-dealers and other lenders.\34\ In general,
Regulation T and Regulation U permit lenders to extend good faith
credit against all non-equity securities and set specific limits on the
amount of credit lenders can extend on equity securities.\35\ However,
several differences between Regulation T and Regulation U still remain,
such as margin requirements for short OTC options. U.S. securities
firms have indicated that because of these differences, applying
Regulation T to their OTC derivatives business would continue to
unnecessarily inhibit their ability to compete in the derivatives
markets with banks and other lenders subject to Regulation U.
---------------------------------------------------------------------------
\34\ See Securities Credit Transactions, Borrowing by Brokers
and Dealers, Docket Nos. R-0905, R-0923, and R-0944, 63 FR 2806 (Jan
16, 1998).
\35\ See, e.g., 12 CFR 221.2(f).
---------------------------------------------------------------------------
Given the nature of the bilateral financial instruments and the
relative sophistication of the counterparties in the OTC derivatives
markets, and the safeguards against excessive leverage contained in
Regulation U, the requirements of Regulation U are more appropriate for
the lending that occurs in these markets. Accordingly, under Rule 36a1-
1, transactions involving extensions of credit by an OTC derivatives
dealer are exempt from the provisions of Section 7(c) of the Exchange
Act \36\ and Regulation T, provided that the OTC derivatives dealer
complies with Section 7(d) of the Exchange Act \37\ and Regulation
U.\38\
---------------------------------------------------------------------------
\36\ 15 U.S.C. 78g(c).
\37\ 15 U.S.C. 78g(d).
\38\ Because Regulation U is promulgated pursuant to Section
7(d) of the Exchange Act, an OTC derivatives dealer remains subject
to that provision. In addition, Rule 36a1-1 (17 CFR 240.36a1-1)
applies only to extensions of credit by an OTC derivatives dealer.
Section 7 of the Exchange Act continues to apply to persons
extending credit to an OTC derivatives dealer. Credit extended to an
OTC derivatives dealer, like credit extended to a fully regulated
broker-dealer, however, is excepted from section 7 of the Exchange
Act is it satisfies the conditions for such exceptions contained in
section 7.
---------------------------------------------------------------------------
c. Exemption from SIPA. Under Rule 36a1-2, OTC derivatives dealers
are exempt from the provisions of SIPA, including membership in SIPC.
The application of SIPA's liquidation provisions to an OTC derivatives
dealer in bankruptcy could undermine certain provisions of the
bankruptcy code applicable to the dealer's business. As a result, the
application of SIPA to OTC derivatives dealers would create legal
uncertainty about the rights of counterparties in transactions with OTC
derivatives dealers in the event of dealer insolvency. This uncertainty
could impair the ability of securities firms electing to register OTC
derivatives dealers to compete effectively with banks and foreign
dealers, which are not subject to similar legal uncertainty.
5. Section 11(a) of the Exchange Act
Rule 11a1-6 provides an exception under section 11(a) of the
Exchange Act \39\ for certain transactions effected by a fully
regulated broker-dealer for the account of its OTC derivatives dealer
affiliate. Section 11(a) makes it unlawful for a member of a national
securities exchange to effect transactions on that exchange for certain
accounts, including its own account or the account of an associated
person.
---------------------------------------------------------------------------
\39\ 15 U.S.C. 78k(a).
---------------------------------------------------------------------------
This general prohibition, however, is subject to numerous
exceptions. Among these is a general exception under section
11(a)(1)(G) for a member's proprietary transactions, where the member
is primarily engaged in a public securities business, as indicated by
certain calculations involving the member's gross revenues from the
preceding fiscal year (the ``business mix'' test), and the transactions
``yield,'' in accordance with Commission rules, priority, parity, and
precedence to transactions for accounts of persons who are not members,
or associated with members, of the exchange.\40\
---------------------------------------------------------------------------
\40\ See 15 U.S.C. 78k(a)(1)(G).
---------------------------------------------------------------------------
Rule 11a1-2 under the Exchange Act generally permits a member to
effect a transaction for the account of an associated person if the
member could have effected the transaction for its own account. The
rule, however, requires that the associated person independently meet
the ``business mix'' test in order for the member to rely on the
exception provided under Section 11(a)(1)(G) for transactions effected
for the account of that associated person.
Because an OTC derivatives dealer will be a newly created entity,
it will not be able to demonstrate that it meets this test.
Accordingly, new Rule 11a1-6, like existing Rule 11a1-2, allows a fully
regulated broker-dealer member to effect a transaction on the exchange
for the account of an affiliated OTC derivatives dealer if the member
would have been permitted to effect the transaction for its own
account. Rule 11a1-6 allows the fully regulated broker-dealer to rely
on the exception under section 11(a)(1)(G) for transactions it effects
for its OTC derivatives dealer affiliate even if that affiliate does
not meet the ``business mix'' test. The fully regulated broker-dealer
and the OTC derivatives dealer must comply with all other requirements
of section 11(a).
6. Net Capital Requirements
The net capital rule has been amended to include an alternative net
capital regime for OTC derivatives dealers. Under the amendments, an
OTC derivatives dealer will be subject to higher minimum capital
requirements than a fully regulated broker-dealer. The OTC derivatives
dealer, however, may also be authorized by the Commission to use value-
at-risk (``VAR'') models to calculate capital charges for market risk
and to take alternative charges for credit risk than those currently
prescribed. The minimum capital requirements for an OTC derivatives
dealer are tentative net capital of at least $100 million and net
capital of at least $20 million. Under the circumstances, these minimum
amounts will provide a sufficient liquid capital cushion for entities
that elect to register as an OTC derivatives dealer.
In order to use VAR models to calculate capital charges for market
risk and to take alternative charges for credit risk, under new
Appendix F to Rule 15c3-1, an OTC derivatives dealer must file an
application with, and obtain authorization from, the Commission. The
application, among other things, must describe the OTC derivatives
dealer's VAR model or models, including the manner in which the model
or models meet the requirements specified in Appendix F, and the
dealer's internal risk management controls system (as required under
Rule 15c3-4). The OTC derivatives dealer must also describe in the
application any non-marketable securities that it wants to include in
its VAR calculation.
An OTC derivatives dealer's VAR model must meet certain qualitative
and quantitative requirements under Appendix F that parallel rules
currently followed by U.S. banking agencies. To meet the qualitative
requirements, among other things, an OTC derivatives dealer must
integrate its VAR model into the firm's daily risk management process,
and subject its VAR model to stress tests, internal and external
audits, and backtesting. The quantitative requirements contain
statistical
[[Page 59368]]
parameters for VAR measures using a time horizon that is appropriate in
the regulatory capital context, as well as risk factors that must be
addressed in any model used. These parameters include the use of a ten-
day holding period and a 99% confidence level.
An OTC derivatives dealer applying Appendix F must also compute a
two-part credit risk capital charge, calculated on a counterparty-by-
counterparty basis. The first part of the charge is calculated based on
the net replacement value of all outstanding transactions with each
counterparty after taking into account netting arrangements and
possession of liquid collateral multiplied by a counterparty factor
derived from the creditworthiness of that counterparty. The second part
of the credit risk charge is a concentration charge that is also based
on the creditworthiness of a particular counterparty, but that only
applies when the net replacement value in the account of that
counterparty exceeds 25% of the OTC derivatives dealer's tentative net
capital.
Under Rule 15c3-4, an OTC derivatives dealer using Appendix F is
also required to establish a comprehensive system of internal controls
for monitoring and managing risks associated with its business
activities. The establishment of a system of controls is an important
element of the Commission's regulatory regime for OTC derivatives
dealers. The risks that an OTC derivatives dealer's system of internal
controls must specifically address include market, credit, leverage,
liquidity, legal, and operational risks associated with conducting an
OTC derivatives business.
The Commission will authorize an OTC derivatives dealer to use
Appendix F if it determines that the dealer has met the requirements
set forth in the rules relating to its VAR model and internal risk
management control systems. In addition, an OTC derivatives dealer must
file an application with the Commission before making any material
changes to its VAR model or internal risk management control systems
and receive authorization before implementing any such changes.
7. Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3
Under the new regulatory structure, a counterparty to an OTC
derivatives transaction generally will not be considered a ``customer''
for purposes of Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3, the
Commission's hypothecation and customer protection rules, and will not
be protected by SIPA. In particular, except as otherwise agreed to in
writing, if an OTC derivatives dealer notifies its counterparty that it
will not segregate the collateral and may use the counterparty's
collateral to further its own business operations, including
commingling and pledging the counterparty's assets, the counterparty
will not be considered a ``customer'' of the dealer for purposes of
Rules 8c-1, 15c2-1, 15c3-2, and 15c3-3.
8. Recordkeeping and Reporting
The rules governing recordkeeping and reporting for an OTC
derivatives dealer have also been modified. The rules will remain
substantially the same as for fully regulated broker-dealers, but they
have been tailored to the business of OTC derivatives dealers.
Reporting will be required only on a quarterly basis. The reports will
include, among other things, information from the dealer regarding its
VAR computations, as well as various credit concentration information.
II. Discussion: New Rules and Amended Rules
After consideration of the issues raised in comment letters
concerning the alternative regulatory structure for OTC derivatives
dealers, the Commission is adopting new Rules 3b-12, 3b-13, 3b-14, 3b-
15, 11a1-6, 15a-1, 15b9-2, 15c3-4, 17a-12, 36a1-1, and 36a1-2 \41\
under the Exchange Act.\42\ The Commission is also amending Rule 30-3
of the Commission's rules of practice \43\ and Exchange Act Rules 8c-1,
15b1-1, 15c2-1, 15c2-5, 15c3-1, 15c3-2, 15c3-3, 17a-3, 17a-4, 17a-5,
and 17a-11.\44\ In addition, the Commission is revising Form X-17A-5
(FOCUS report).\45\
---------------------------------------------------------------------------
\41\ 17 CFR 240.3b-12, 240.3b-13, 240.3b-14, 240.3b-15,
240.11a1-6, 240.15a-1, 240.15b9-2, 240.15c3-4, 240.17a-12, 240.36a1-
1, and 240.36a1-2.
\42\ 15 U.S.C. 78a et seq.
\43\17 CFR 200.30-3.
\44\ 17 CFR 240.8c-1, 240.15b1-1, 240.15c2-1, 240.15c2-5,
240.15c3-1, 240.15c3-2, 240.15c3-3, 240.17a-3, 240.17a-4, 240.17a-5,
and 240.17a-11.
\45\ 17 CFR 249.617.
---------------------------------------------------------------------------
A. Definitions
The final rules set forth definitions of four new terms: (1) OTC
derivatives dealer; (2) eligible OTC derivative instrument; (3) cash
management securities activities; and (4) ancillary portfolio
management securities activities. Although the Commission had also
proposed to define the term ``permissible derivatives counterparty,''
the Commission has determined that it is unnecessary to use the term in
the final rules and rule amendments. In addition, the Commission is not
adopting a separate rule defining ``hybrid security,'' as proposed, but
rather is including a definition of ``hybrid security'' only for
purposes of the final rules that use the term. The definitions of the
new terms, and the reasons for adopting them in their revised forms,
are described below.
1. Rule 3b-12; Definition of OTC Derivatives Dealer
As proposed, Rule 3b-12 would have defined OTC derivatives dealer
to mean any dealer that limited its securities activities to (1)
engaging as a counterparty in transactions in eligible OTC derivative
instruments with permissible derivatives counterparties; (2) issuing
and reacquiring issued securities through a fully regulated broker or
dealer; or (3) engaging in other securities transactions that the
Commission designated by order. The OTC derivatives dealer would also
have been permitted to engage in ``permissible risk management,
arbitrage, and trading transactions,'' in connection with any of these
securities activities.
The proposed definition of OTC derivatives dealer was intended to
identify a category of dealers that would primarily be engaged as
counterparties in OTC derivatives transactions. The proposed definition
also recognized that these dealers would need to engage in certain
limited securities trading activities in connection with their OTC
derivatives dealing activities in order to operate a competitive
business. The Proposing Release, however, emphasized that an OTC
derivatives dealer should not be able to take advantage of the modified
regulatory requirements to engage in activities better suited to full
broker-dealer regulation.\46\
---------------------------------------------------------------------------
\46\ Proposing Release, Section II.A.1., n.17, 62 FR at 67942,
n.17.
---------------------------------------------------------------------------
Several commenters requested that the Commission clarify that the
non-securities activities in which an OTC derivatives dealer would be
permitted to engage would not be limited in either scope or volume
(subject only to capital considerations).\47\ The commenters were
concerned that the language in the summary of the Proposing Release
stating that registration as an OTC derivatives dealer was available
only to entities acting primarily as counterparties in privately
negotiated OTC derivatives transactions was
[[Page 59369]]
potentially inconsistent with the ability of these entities to engage
in any non-securities activities.\48\ In response to these comments,
the Commission has revised the definition of OTC derivatives dealer to
emphasize that the definition limits only the securities activities
\49\ of a dealer seeking to operate an OTC derivatives business under
the new framework.\50\
---------------------------------------------------------------------------
\47\ See Comment Summary, Section IV.A.1.; Comment Letter from
the Securities Industry Association's (``SIA'') OTC Derivative
Products Committee, dated April 6, 1998 (``SIA Letter I''), p. 5;
Comment Letter from Merrill Lynch & Co., Inc. (``Merrill Lynch
Letter''), p. 4.
\48\ See, e.g., SIA Letter I, p. 5.
\49\ As a practical matter, the non-securities activities of an
OTC derivatives dealer are limited by the capital requirements and
by the limits imposed on cash management and ancillary portfolio
management securities activities under this regulatory structure.
This parallels the system for fully regulated broker-dealers, which
does not prohibit non-securities activities by definition, but
rather imposes practical limitations on those activities under the
financial responsibility rules.
\50\ In its comment letter, the Commodity Futures Trading
Commission (``CFTC'') stated that the proposal for the alternative
regulatory framework for OTC derivatives dealers extended beyond the
Commission's authority to regulate securities. See Comment Letter
from the CFTC (``CFTC Letter''), p. 1. While the proposal was
appropriately restricted in scope to fall within the Commission's
statutory jurisdiction, the revisions made to Rule 3b-12 (17 CFR
240.3b-12), as well as to the other rules and rule amendments, that
strengthen the focus of the new regulatory framework on the
securities activities of an OTC derivatives dealer serve to clarify
the scope of the Commission's jurisdiction.
---------------------------------------------------------------------------
Several commenters also questioned the proposed definition's limits
on the scope of securities activities in which an OTC derivatives
dealer could engage.\51\ Merrill Lynch & Co., Inc. (``Merrill Lynch'')
suggested that an OTC derivatives dealer should be permitted to engage
in a full range of activities in securities derivative instruments
(including acting as a dealer in such instruments).\52\ Merrill Lynch
also noted that there were numerous types of securities principal
transactions in which an OTC derivatives dealer would need to engage to
support its derivatives business. It expressed concern that any
limitation on the nature or scope of such transactions could
unnecessarily restrict, and in certain cases could increase the risk
of, the dealer's derivatives business.\53\ Other commenters believed
that monitoring the limitations in the proposed rule could create
unnecessary burdens for both the dealers and the Commission, and that
the limitations were not always consistent with the manner in which an
OTC derivatives business is currently conducted.\54\
---------------------------------------------------------------------------
\51\ See letters cited in Section IV.A.2. of the Comment
Summary.
\52\ Merrill Lynch Letter, p. 4.
\53\ Merrill Lynch Letter, p. 5. Similarly, the SIA commented
that, so long as an OTC derivatives dealer limited its securities
dealing activities to transactions in eligible OTC derivative
instruments with permissible derivatives counterparties, it was
neither necessary nor desirable to limit the non-dealing securities
activities of an OTC derivatives dealer. SIA Letter I, p. 6.
\54\ E.g., SIA Letter I, p. 6.
---------------------------------------------------------------------------
Commenters also addressed the issue that the alternative regulatory
structure for OTC derivatives dealers is not intended to permit U.S.
securities firms to move their general securities dealing activities
into an OTC derivatives dealer affiliate or to establish proprietary
securities trading desks in the new entity.\55\ In this regard, the
Government Finance Officers Association (``GFOA'') questioned whether
the proposal provided sufficient safeguards to ensure that a firm did
not move its dealer activity in cash market instruments, such as stocks
and bonds, to an OTC derivatives dealer.\56\ Other commenters, however,
believed that the proposal contained enough restrictions on securities
dealing activities to avoid such behavior by an OTC derivatives dealer
acting in good faith.\57\
---------------------------------------------------------------------------
\55\ See, e.g, Proposing Release, Section II.A.1., n.17, 62 FR
67942, n.17.
\56\ Comment Letter from the Government Finance Officers
Association (``GFOA Letter''), p. 3.
\57\ E.g., Comment Letter from Morgan Stanley Dean Witter
(``MSDW Letter''), p. 10. In addition, one commenter suggested a
simple prohibition on that business instead of a series of detailed
and complex prophylactic limitations on the permissible activities
of an OTC derivatives dealer. Comment Letter from Salomon Smith
Barney (``Salomon Smith Barney Letter''), p. 2.
---------------------------------------------------------------------------
Taking these comments into account, the final rule provides that an
OTC derivatives dealer is a dealer that is affiliated with a registered
broker or dealer (other than an OTC derivatives dealer) and whose
securities activities are limited to (1) engaging in dealer \58\
activities in eligible OTC derivative instruments that are securities;
(2) issuing and reacquiring securities that are issued by the dealer,
including warrants on securities, hybrid securities,\59\ and structured
notes;\60\ (3) engaging in cash management securities activities (as
defined in Rule 3b-14); (4) engaging in ancillary portfolio management
securities activities (as defined in Rule 3b-15); and (5) engaging in
such other securities activities that the Commission designates by
order.
---------------------------------------------------------------------------
\58\ When used in the context of eligible OTC derivative
instruments (as defined in Rule 3b-13 (17 CFR 240.3b-13) or in the
context of OTC derivative instruments in general, the term
``dealer'' activities includes buying, selling, and entering into
OTC derivative instruments. See Section 3(a)(5) of the Exchange Act
(15 U.S.C. 78c(a)(5)) (defining dealer).
\59\ See Section II.A.4. below, discussing the definition of the
term ``hybrid security.''
\60\ In the Proposing Release, the requirement that an OTC
derivatives dealer issue or reacquire its issued securities through
a fully regulated broker or dealer (other than an OTC derivatives
dealer) was set forth in proposed Rule 3b-12(a)(2), as well as in
proposed Rule 15a-1(a)(1)(ii), regarding the permissible securities
activities of an OTC derivatives dealer. This requirement, however,
has been omitted from final Rule 3b-12, and included only in final
Rule 15a-1(c). In this regard, while the securities transactions of
an OTC derivatives dealer generally must be effected through an
affiliated fully regulated broker-dealer, an OTC derivatives dealer
may issue and reacquire its issued securities through an
unaffiliated fully regulated broker-dealer. See Rule 15a-1(c) (17
CFR 240.15a-1(c)) (discussed in Section II.C.3. below).
---------------------------------------------------------------------------
As detailed in Section II.A.5. below, the Commission has defined
the terms ``cash management securities activities'' and ``ancillary
portfolio management securities activities.'' These two terms replace
the term ``permissible risk management, arbitrage, and trading
transactions,'' which was included in the Proposing Release. The new
terms serve substantially the same purpose as the proposed term in that
they describe the additional securities activities in which an OTC
derivatives dealer may engage in connection with its OTC derivatives
business. As a practical matter, a firm seeking to register as an OTC
derivatives dealer will need to be able to conduct these additional
securities activities, such as engaging in certain financing and
hedging transactions, in order to compete effectively with other market
participants.
The focus of the alternative regulatory structure for OTC
derivatives dealers, however, is on providing a regulatory vehicle that
will allow a U.S. securities firm to establish a separately capitalized
entity through which to book an OTC derivatives business. As a result,
the final rules, including the definitions of ``cash management
securities activities'' and ``ancillary portfolio management securities
activities'' contain appropriate limitations to prevent an OTC
derivatives dealer from engaging in dealing activities in cash market
instruments or in substantial proprietary trading activities.
Rule 3b-12, as adopted, also requires that the securities
activities of an OTC derivatives dealer consist primarily of engaging
in dealer activities in eligible OTC derivative instruments that are
securities, issuing and reacquiring its issued securities, and engaging
in cash management securities activities. Thus, if the securities
activities of an OTC derivatives dealer were to consist only or
primarily of ancillary portfolio management securities activities, the
OTC derivatives dealer would be in violation of the rule. For instance,
an OTC derivatives dealer that trades in exchange-traded futures
contracts may not engage in securities activities that consist only or
primarily of managing the risks of those futures transactions.
[[Page 59370]]
In addition, Rule 3b-12 expressly states that an OTC derivatives
dealer's securities activities may not consist of any securities
activities other than those included in the rule, including engaging in
any transaction in any security that is not an eligible OTC derivative
instrument, except for cash management securities activities, ancillary
portfolio management securities activities, and such other securities
activities that the Commission may designate by order. This position is
consistent with the general principle that a broker-dealer is not
permitted to move dealer activities in cash market instruments into the
OTC derivatives dealer.\61\
---------------------------------------------------------------------------
\61\ As stated in the Proposing Release, except to the extent
expressly permitted under the rules and rule amendments, an OTC
derivatives dealer may not engage directly or indirectly in any
activity that may otherwise cause it to be a ``dealer'' as defined
in Section 3(a)(5) of the Exchange Act (15 U.S.C. 78c(a)(5)). This
includes, but is not limited to, without regard to the security, (1)
purchasing or selling securities as principal from or to customers;
(2) carrying a dealer inventory in securities (or any portion of an
affiliated broker-dealer's inventory); (3) quoting a market in or
publishing quotes for securities (other than quotes on one side of
the market on a quotations system generally available to non-broker-
dealers, such as a retail screen broker for government securities)
in connection with the purchase or sale of securities permitted
under Rule 15a-1; (4) holding itself out as a dealer or market-maker
or as being otherwise willing to buy or sell one or more securities
on a continuous basis; (5) engaging in trading in securities for the
benefit of others (including any affiliate), rather than solely for
the purpose of the OTC derivatives dealer's investment, liquidity,
or other permissible trading objective; (6) providing incidental
investment advice with respect to securities; (7) participating in a
selling group or underwriting with respect to securities; or (8)
engaging in purchases or sales of securities from or to an
affiliated broker-dealer except at prevailing market prices. See
Proposing Release, Section II.A.4., n.24, 62 FR at 67944, n.24.
---------------------------------------------------------------------------
As some commenters noted, the ability of the Commission to issue
orders under Rule 15a-1(b)(1) identifying other permissible securities
activities in which an OTC derivatives dealer may engage should help to
mitigate concerns that the definition sets forth specific limitations
on the securities activities of these entities.\62\ As provided in the
Proposing Release, the Commission is amending Rule 30-3 of the Rules of
Practice to delegate its authority to issue these orders to the
Director of the Division of Market Regulation.\63\
---------------------------------------------------------------------------
\62\ See, e.g., SIA Letter I, pp. 6-7. See also Rule 15a-1(b)(1)
(17 CFR 240.15a-1(b)(1)) and Section II.C.2. below, discussing the
ability of the Commission to issue orders under Rule 15a-1(b) (17
CFR 240.15a-1(b)) regarding the securities activities of OTC
derivatives dealers.
\63\ Proposing Release, Section II.C., n.27, 62 FR at 67944,
n.27. See Rule 30-3(a)(64) (17 CFR 200.30-3(a)(64)).
---------------------------------------------------------------------------
2. Rule 3b-13; Definition of Eligible OTC Derivative Instrument
An OTC derivatives dealer is permitted to engage in dealer
activities in eligible OTC derivative instruments, as that term is
defined in Rule 3b-13. As proposed, Rule 3b-13 would have defined
``eligible OTC derivative instrument'' to mean any agreement, contract,
or transaction (1) that is not part of a fungible class of agreements,
contracts, or transactions that are standardized as to their material
economic terms; (2) that is based, in whole or in part, on the value
of, any interest in, any quantitative measure of, or the occurrence of
any event relating to, one or more securities, commodities, currencies,
interest or other rates, indices, or other assets, or involve certain
long-dated forward contracts, specifically contracts to purchase or
sell a security on a firm basis at least one year following the
transaction date; \64\ and (3) that is not entered into and traded on
or through an exchange, an electronic marketplace, or similar facility
supervised or regulated by the Commission, or any other multilateral
transaction execution facility.\65\
---------------------------------------------------------------------------
\64\ The concern with forwards is that an OTC derivatives dealer
should not be able to engage in dealer activities in short-dated
securities forwards that may in effect replicate cash market
instruments or in certain government securities forwards, such as
Government National Mortgage Association (GNMA) forwards.
\65\ Proposing Release, Section II.A.2., 62 FR at 67942.
---------------------------------------------------------------------------
Several commenters criticized this proposed definition.\66\ For
example, the SIA argued that the proposed definition failed to include
certain important categories of transactions, such as transactions that
are based on the occurrence or nonoccurrence of specified events, but
that do not technically relate to one or more securities, commodities,
and the like, although they are associated with financial consequences,
such as credit derivatives.\67\ Morgan Stanley Dean Witter argued that
the requirement that eligible OTC derivative instruments be based on at
least one of an enumerated list of underlying assets could
unnecessarily limit these dealers' activities in rapidly evolving
products while Commission approval was being sought on a product-by-
product basis.\68\
---------------------------------------------------------------------------
\66\ See letters cited in Section IV.B. of the Comment Summary.
\67\ SIA Letter I, pp. 9-10; see also Merrill Lynch Letter, p.
7.
\68\ MSDW Letter, p. 6.
---------------------------------------------------------------------------
The SIA also suggested alternative definitions of ``eligible OTC
derivative instrument'' and recommended that the Commission clarify
that it was not intending to construe or expand the definition of
``security'' under the Exchange Act.\69\ Several commenters asked that
the Commission clarify what instruments would be considered
``securities'' OTC derivative instruments and ``non-securities'' OTC
derivative instruments for purposes of the rules.\70\ Merrill Lynch
agreed in principle with the approach of proposed Rule 3b-13, but also
suggested that an OTC derivatives dealer be able to seek expedited
interpretative guidance for new derivative instruments.\71\
---------------------------------------------------------------------------
\69\ SIA Letter I, p. 10. See also Comment Letter from SIA,
dated October 16, 1998 (``SIA Letter II''), pp. 2-3.
\70\ EUDA Letter, p. 2; GFOA Letter, p. 1; Comment Letter from
the New York Stock Exchange (``NYSE Letter''), p. 3.
\71\ Merrill Lynch Letter, p. 7.
---------------------------------------------------------------------------
Several commenters were also concerned that the proposed definition
required that forwards have a duration period of one year or more in
order to qualify as an eligible OTC derivative instrument, and
suggested shorter periods, such as one month or two weeks.\72\ The SIA
suggested that, in including a duration period for forwards, the
definition should distinguish between government securities forwards
and forwards involving non-government securities.\73\ In addition, the
SIA maintained that those securities forwards having material features
of a type described in the definition of eligible OTC derivative
instrument should qualify as eligible OTC derivative instruments.\74\
---------------------------------------------------------------------------
\72\ SIA Letter I, pp. 9-10; Merrill Lynch Letter, p. 7; Comment
Letter from D.E. Shaw & Co. L.P. (``DESCO Letter''), p. 7.
\73\ SIA Letter II, p. 2.
\74\ Id.
---------------------------------------------------------------------------
Several commenters raised concerns with the use of concepts from
the CEA in defining the term eligible OTC derivative instrument. In its
comment letter, the Commodity Futures Trading Commission (``CFTC'')
noted that the proposed definition relied on criteria that were similar
to, but not the same as, the criteria for qualifying transactions under
the CFTC's part 35 swaps exemption.\75\ The CFTC stated that a
registered OTC derivatives dealer could effect transactions that would
be permissible under the proposed rules, but that would not be exempted
under part 35 from the provisions of the CEA, and thus market
participants might face legal uncertainty concerns in entering into
certain derivatives transactions.
---------------------------------------------------------------------------
\75\ CFTC Letter, pp. 11-12. The CFTC's Part 35 regulations
exempt certain swap transactions from most provisions of the CEA,
provided that the transaction is conducted solely between ``eligible
swap participants,'' as defined in part 35 (17 CFR part 35).
---------------------------------------------------------------------------
On a similar note, two commenters were concerned that the proposed
[[Page 59371]]
definition adopted concepts from the CEA in excluding transactions that
were standardized or traded on ``an exchange, an electronic
marketplace, or similar facility supervised or regulated by the
Commission, or any other multilateral transaction execution facility.''
\76\ The SIA argued that the text potentially could exclude from the
definition a broad range of transactions involving exempt securities,
as well as transactions that did not involve securities at all, which
it believed should not be excluded from the proposed definition. The
SIA also opined that the proposed language would spawn significant
uncertainty over its scope.\77\ Morgan Stanley Dean Witter similarly
claimed that the use of terms contained in the CEA that were not
commonly understood in the securities law context caused the definition
of ``eligible OTC derivative instrument'' to be ambiguous.\78\
---------------------------------------------------------------------------
\76\ SIA Letter I, pp. 9-10; MSDW Letter, pp. 7-8.
\77\ SIA Letter I, p.9.
\78\ MSDW Letter, pp. 7-8.
---------------------------------------------------------------------------
In response to these comments, the Commission has revised the
definition of eligible OTC derivative instrument in several ways. As
adopted, Rule 3b-13 defines eligible OTC derivative instrument to mean,
subject to certain exceptions, any contract, agreement, or transaction
that provides, in whole or in part, on a firm or contingent basis, for
the purchase or sale of, or is based on the value of, or any interest
in, one or more commodities, securities, currencies, interest or other
rates, indices, quantitative measures, or other financial or economic
interests or property of any kind, or that involves any payment or
delivery that is dependent on the occurrence or nonoccurrence of any
event associated with a potential financial, economic, or commercial
consequence, or any combination or permutation of the foregoing.\79\
The term eligible OTC derivative instrument, however, does not include
certain forwards on securities, securities listed or traded on a
national securities exchange or on Nasdaq, or fungible securities
derivative instruments that are standardized as to their material
economic terms.\80\
---------------------------------------------------------------------------
\79\ Rule 3b-13(a) (17 CFR 240.3b-13(a).
\80\ See Rule 3b-13(b) (17 CFR 240.3b-13).
---------------------------------------------------------------------------
Rule 3b-13 defines eligible OTC derivative instrument broadly to
encompass the wide range of securities and non-securities OTC
derivative instruments currently existing in the derivatives markets,
as well as to allow for the inclusion of reasonably similar instruments
that market participants may develop in the future. The types of
instruments that generally satisfy the criteria set forth in Rule 3b-13
include interest rate swaps, currency swaps, equity swaps, swaps
involving physical commodities (such as metals or petroleum), OTC
options on equities (including equity indices), OTC options on U.S.
government securities, OTC debt options (including options on debt
indices), options on physical commodities, long-dated forwards on
securities, and forwards relating to other types of assets. Other types
of instruments also satisfy the criteria in the rule.
The definition of eligible OTC derivative instrument has also been
revised to omit terms commonly understood in the context of the CEA. As
a technical matter, exchange-traded futures will now fall within the
definition of eligible OTC derivative instrument. As discussed in
Section II.A.1. above, however, the rules limit only the securities
activities of an OTC derivatives dealer, and, subject to appropriate
capital treatment and compliance with internal risk management controls
requirements, an OTC derivatives dealer generally may engage in any
non-securities activities. Thus, the new regulatory structure does not
limit an OTC derivatives dealer's ability to engage in futures
activities, which is consistent with the current approach toward the
regulation of general securities broker-dealers. The activities of an
OTC derivatives dealer, however, must comply with any and all
applicable laws, including the CEA to the extent it applies to any
particular transaction.
In response to comments raised by the SIA,\81\ the final rule also
distinguishes between government securities forwards and other
securities forwards with respect to duration periods. Rule 3b-13
generally excludes from the definition of eligible OTC derivative
instrument forwards on a government security that settle within twelve
months, and certain other securities forwards that satisfy the
definition of ``eligible forward contract'' \82\ that settle within
four months.\83\ Although the duration period for an ``eligible forward
contract'' is shorter than the original proposal of one year for all
securities forwards, the periods better reflect the manner in which an
OTC derivatives business is conducted and will continue to constrain an
OTC derivatives dealer from improperly engaging in the types of forward
transactions that should occur in its fully regulated broker-dealer
affiliate.\84\ The final rule has also been revised to include as
eligible OTC derivative instruments those securities forwards that have
material economic features primarily of a type described in the
definition of eligible OTC derivative instrument (other than the
provision for the purchase and sale of a security on a firm basis).
---------------------------------------------------------------------------
\81\ See supra note 73.
\82\ For purpose of Rule 3b-13, the term ``eligible forward
contract'' means ``a forward contract that provides for the purchase
or sale of a security other than a government security, provided
that, if such contract provides for the purchase or sale of margin
stock (as defined in Regulation U of the Regulations of the Board of
Governors of the Federal Reserve System, 12 CFR part 221), such
contract either (1) provides for the purchase or sale of such stock
by the issuer thereof (or an affiliate that is not a bank or a
broker or dealer); or (2) provides for the transfer of transaction
collateral in an amount that would satisfy the requirements, if any,
that would be applicable assuming the OTC derivatives dealer party
to such transaction were not eligible for the exemption from
Regulation T of the Regulations of the Board of Governors of the
Federal Reserve System, 12 CFR part 220, set forth in (Rule 36a1-1).
\83\ In its comment letter, the SIA requested guidance regarding
the application of the duration requirement for securities forwards
in the context of certain transaction structures that require a
forward to be market-to-market and repriced. See SIA Letter II, p.
2, n.1. For example, a contract may provide that it is to be
periodically marked-to-market and repriced with a settlement payment
to be made on each repricing date in an amount equal to the change
in the value of the underlying security. Id. In response to the
SIA's request, under Rule 3b-13, where a securities forward
transaction provides for reset or repricing dates, such dates will
be viewed as settlement dates, and will cause the forward to be
separated into shorter duration periods, only if the parties can
close out the transaction on such dates. For example, if a one-year
securities forward resets monthly to mitigate the credit risk
associated with the transaction, and the parties can close out the
forward on the reset date, for purposes of Rule 3b-13, the
transaction will be regarded as separate one-month forward
transaction. If, however, the parties are not able to close out the
forward, or otherwise discharge their obligations under the contract
by accelerating all or part of the originally scheduled physical
settlement, on the reset dates, then the reset dates will not be
viewed as separate settlement dates.
\84\ A fully regulated broker-dealer is not permitted to move
its securities book to the OTC derivatives dealer by forwarding out
its positions and then reversing those transactions. See Rule 15a-
1(a) (17 CFR 240.15a-1(a).
---------------------------------------------------------------------------
The definition of eligible OTC derivative instrument excludes
securities derivative instruments that are listed or traded on an
exchange or on Nasdaq. Similarly, the definition excludes those
securities derivative instruments that are one of a class of fungible
instruments that are standardized as to their material economic terms.
With respect to the exclusion for certain fungible instruments, the
Commission has retained the authority under Rule 15a-1(b)(2) to
determine by order that a securities derivative instrument that is one
of a class of fungible instruments that are standardized as to their
material economic terms is within the scope of eligible OTC derivative
instrument. This
[[Page 59372]]
authority will permit the Commission, in limited circumstances, to
expand the types of securities derivative instruments in which an OTC
derivatives dealer may engage in dealer activities. The Commission is
amending Rule 30-3 of the Rules of Practice to delegate this authority
to the Director of the Division of Market Regulation.\85\
---------------------------------------------------------------------------
\85\ See Rule 30-3(a)(65) (17 CFR 200.30-3(a)(65). See also
Section II.C.2. below, discussing the ability of the Commission to
issue orders under rule 15a-1(b) (17 CFR 240.15a-1(b) regarding the
securities activities of OTC derivatives dealers.
---------------------------------------------------------------------------
As noted above, the Commission responded to commenters' concerns by
adopting an expansive definition of eligible OTC derivative instrument,
with few exclusions. The final rule thereby permits an OTC derivatives
dealer to deal in a broad array of financial instruments in order to
accommodate current business practices.\86\ Because of this
accommodation, however, the Commission has also reserved the authority
under Rule 15a-1(b) to issue orders clarifying whether certain
contracts, agreements, or transactions are within the scope of eligible
OTC derivative instrument.\87\
---------------------------------------------------------------------------
\86\ The Commission will consider the economic realities of a
securities transaction, and not the label assigned to the
transaction, for purposes of determining whether a particular
transaction is permitted under the alternative regulatory framework.
See, e.g., In the Matter of BT Securities Corporation, Exchange Act
Release No. 35136 (Dec. 22, 1994). For example, an OTC derivatives
dealer may not engage in a forward transaction that would otherwise
not be permitted under the framework in the guise of options or
other permitted transactions.
\87\ See Rule 15a-1(b)(3) (17 CFR 240.15a-1(b)(3). Unlike other
provisions contained in these rules that permit the expansion of OTC
derivatives dealers' activities, this authority has not been
delegated to the staff.
---------------------------------------------------------------------------
The final rules, however, do not define the term ``securities OTC
derivative instrument,'' which is intended to encompass OTC derivative
instruments that are securities. The term ``security'' is defined in
section 3(a)(10) of the Exchange Act,\88\ and the final rules do not
interpret or amend the definition of ``security'' under the Exchange
Act. Staff guidance will continue to remain available regarding the
applicability of the federal securities laws to any particular OTC
derivative instrument.\89\
---------------------------------------------------------------------------
\88\ 15 U.S.C. 78c(a)(10).
\89\ Questions on this subject should be addressed to the Office
of Chief Counsel, Division of Market Regulation, Securities and
Exchange Commission, 450 Fifth Street, NW, Mail Stop 10-1,
Washington, DC 20549, (202) 942-0073
---------------------------------------------------------------------------
3. Proposed Rule 3b-14; Definition of Permissible Derivatives
Counterparty
Proposed Rule 3b-14 defined those entities and natural persons that
would have been eligible to engage in an OTC derivatives transaction
with an OTC derivatives dealer. As the Proposing Release noted, these
persons included the same persons who currently are eligible to effect
transactions with swaps dealers under the CFTC's Part 35
regulations.\90\ The Proposing Release also sought specific comment on
whether the definition of permissible derivatives counterparty should
be expanded to include natural persons having at least $5 million in
total assets who entered into OTC derivatives transactions to hedge
existing or anticipated assets or liabilities.\91\
---------------------------------------------------------------------------
\90\ Proposing Release, Section II.A.3., 62 FR at 67942.
\91\ Id.
---------------------------------------------------------------------------
Most commenters suggested that a broad range of persons should be
able to act as permissible derivatives counterparties, and believed
that the definition should be expanded, at a minimum, to include
natural persons having at least $5 million in total assets as
proposed.\92\ The SIA opined that these natural persons were
appropriate counterparties and would benefit from having access to risk
mitigation products that could be tailored to their individual
circumstances and objectives.\93\
---------------------------------------------------------------------------
\92\ See letters cited in Section IV.C. of the Comment Summary.
\93\ SIA Letter I, p. 10.
---------------------------------------------------------------------------
A few commenters, however, raised concerns that the proposed group
of permissible derivatives counterparties could include unsophisticated
persons who would need the protections provided by the securities sales
practice requirements.\94\ D.E. Shaw & Co. noted that an OTC
derivatives dealer would have to rely upon information provided by the
counterparty as to its total assets or net worth, and suggested that an
OTC derivatives dealer should only be required to have a ``reasonable
belief'' that the counterparty was a ``permissible derivatives
counterparty.'' \95\
---------------------------------------------------------------------------
\94\ See, e.g., NYSE Letter, p. 3; EUDA Letter, p. 2.
\95\ DESCO Letter, pp. 7-8.
---------------------------------------------------------------------------
The CFTC, in turn, raised concerns that conflicts might arise
between the Commission's rules and the CFTC's rules in connection with
the proposed definition of permissible derivatives counterparty,
particularly if the definition were expanded to include parties who
would not be eligible swap participants under the CFTC's Part 35
regulations. The CFTC suggested that if an OTC derivatives dealer were
to enter into a transaction with a permissible derivatives counterparty
that was not an eligible swap participant, the transaction would be
outside the exemption of the Part 35 regulations, and could therefore
constitute an illegal futures or commodity option contract.\96\
---------------------------------------------------------------------------
\96\ CFTC Letter, p. 12.
---------------------------------------------------------------------------
In response to commenters' concerns, and in light of the
protections afforded through other provisions of the alternative
regulatory framework, the final rules do not restrict the persons that
may act as counterparties in OTC derivatives transactions with an OTC
derivatives dealer. Instead, the final rules contain certain safeguards
designed to protect an OTC derivatives dealer's counterparties, as well
as to prevent trading in standardized and fungible OTC derivative
instruments that are securities.
In particular, Rule 15a-1 requires, subject to limited exceptions,
an OTC derivatives dealer to effect any securities transaction through
its fully regulated broker-dealer affiliate, subject to all applicable
sales practice requirements.\97\ In addition, Rule 3b-13 excepts from
the definition of eligible OTC derivative instrument those securities
contracts that are one of a class of fungible instruments that are
standardized as to their material economic terms.\98\ The elimination
of counterparty restrictions also addresses concerns that confusion
about the applicability of the CEA could arise as a result of any
differences between the terms ``permissible derivatives counterparty''
and ``eligible swap participant.'' As noted above, this rulemaking does
not affect the applicability of the CEA to any particular transaction.
---------------------------------------------------------------------------
\97\ Rule 15a-1(c) (17 CFR 240.15a-1(c)).
\98\ Rule 3b-13(b)(2)(ii) (17 CFR 240.3b-13(b)(2)(ii)).
---------------------------------------------------------------------------
4. Proposed Rule 3b-16; Definition of Hybrid Security
As proposed, Rule 3b-16 would have defined hybrid security to mean
a security that incorporates payment features economically similar to
options, forwards, futures, swap agreements, or collars involving
currencies, interest rates, commodities, securities, or indices (or any
combination, permutation, or derivative of such contract or underlying
interest). The definition of hybrid security did not raise many
comments.
The CFTC, however, expressed concerns that, in proposing a
definition of hybrid security, no consideration was given to the scope
of the exemption for hybrid instruments contained in the CFTC's Part 34
regulations.\99\ The CFTC
[[Page 59373]]
noted that some of the instruments that would qualify as ``acceptable''
hybrid securities were actually futures or commodity option contracts
that were not exempted under the CFTC's Part 34 regulations and could
thus be illegal under the CEA.\100\
---------------------------------------------------------------------------
\99\ CFTC Letter, p. 13. Hybrid instruments are depository
instruments or securities instruments, such as debt or equity
securities, that have one or more commodity-dependent components
with payment features similar to commodity futures or commodity
option contracts. Under the CFTC's part 34 regulations, such
instruments may be exempt from regulation under the CEA if the sum
of the commodity-dependent values of the commodity-dependent
components of the instrument is less than the commodity-dependent
value of the commodity-independent component. 17 CFR part 34.
\100\ CFTC Letter, p. 13.
---------------------------------------------------------------------------
The term hybrid security, however, is limited to securities that
incorporate the enumerated payment features. In addition, the
alternative regulatory framework employs the term only in the context
of an OTC derivatives dealer's ability to issue and reacquire its
issued securities (including hybrid securities) under Rules 3b-12 and
15a-1. Moreover, as stated previously, an OTC derivatives dealer
remains subject to all other applicable statutes, rules, and
regulations. To the extent that the offer and sale of hybrid securities
by an OTC derivatives dealer are covered by the CEA, the transactions
would need to be structured to qualify for available exemptions.
Nevertheless, because of the limited use of the term under the
alternative regulatory framework, the Commission is not adopting a
separate rule defining ``hybrid security,'' but rather is including a
definition of the term only for purposes of Rules 3b-12 and 15a-1.
Certain revisions have been made to the definition of ``hybrid
security'' to achieve conformity with the revisions to the final
definition of eligible OTC derivative instrument as set forth in Rule
3b-13.\101\ Accordingly, for purposes of Rules 3b-12 and 15a-1, a
``hybrid security'' is defined to mean a security that incorporates
payment features economically similar to options, forwards, futures,
swap agreements, or collars involving currencies, interest or other
rates, commodities, securities, indices, quantitative measures, or
other financial or economic interests or property of any kind, or any
payment or delivery that is dependent on the occurrence or
nonoccurrence of any event associated with a potential financial,
economic, or commercial consequence (or any combination, permutation,
or derivative of such contract or underlying interest).\102\
---------------------------------------------------------------------------
\101\ See discussion at Section II.A.2. above See also SIA
Letter II, p. 3, n.2.
\102\ See Rules 3b-12(d) (17 CFR 240.3b-12(d)) and 15a-1(e) (17
CFR 240.15a-1(e)).
---------------------------------------------------------------------------
5. Rules 3b-14 and 3b-15; Definitions of Cash Management Securities
Activities and Ancillary Portfolio Management Securities Activities
Proposed Rule 3b-15 would have permitted an OTC derivatives dealer
to engage in a limited range of securities activities, described under
the rule as ``permissible risk management, arbitrage, and trading
transactions,'' in connection with the dealer's business as a
counterparty in eligible OTC derivative instruments and as an issuer of
securities. As discussed above, the focus of the alternate regulatory
system for OTC derivatives dealers is to permit U.S. securities firms
to establish a separately capitalized booking vehicle for an OTC
derivatives business. However, in order to operate a competitive
business, an OTC derivatives dealer must also be able to engage in
limited securities trading activities in connection with its OTC
derivatives dealing business. This includes the ability to take
possession of and sell counterparty collateral, to invest short-term
cash balances, to engage in certain financing transactions, and to
manage risks associated with its OTC derivatives positions or its
issuance of securities.
These related securities activities, however, must be subject to
appropriate limitations to prevent an OTC derivatives dealer from
engaging in dealing activity in cash market instruments. An OTC
derivatives dealer should not be provided with an unfair regulatory
advantage over a fully regulated broker-dealer due to the availability
of modified capital and margin requirements. In addition, an entity
that engages in comprehensive securities dealing activity should be
subject to full broker-dealer regulation, including existing capital
and margin requirements, and be subject to supervision by an SRO.
Moreover, appropriate limitations on the related securities
activities of an OTC derivatives dealer must be in place to prevent the
dealer from engaging in substantial proprietary securities trading
activities. The alternative regulatory framework is not intended to
allow an OTC derivatives dealer to operate in a manner similar to an
active securities trader, such as a hedge fund. Accordingly, under the
final rules, an OTC derivatives dealer may not engage in any
transaction in any security that is not an eligible OTC derivative
instrument, with the exception of activities permitted under final
Rules 3b-14 and 3b-15, as discussed below.\103\
---------------------------------------------------------------------------
\103\ See Rules 3b-12(c) (17 CFR 240.3b-12(c)) and 15a-1(a)(3)
(17 CFR 240.15a-1(a)(3)).
---------------------------------------------------------------------------
Under the regulatory framework, as proposed, the definition of
``permissible risk management, arbitrage, and trading transactions''
attempted to carefully define activities associated with managing the
risk of an OTC derivatives dealer's business, while excluding other
securities dealing and proprietary trading activities. Based on the
comments received on the scope of ``permissible risk management,
arbitrage, and trading transactions,'' however, the final rules have
been restructured to more accurately reflect the types of cash
management and portfolio management activities engaged in by dealers in
OTC derivative instruments. Therefore, as noted above, the Commission
is not adopting a definition of ``permissible risk management,
arbitrage, and trading transactions,'' but rather is defining two new
terms: ``cash management securities activities'' and ``ancillary
portfolio management securities activities.'' \104\
---------------------------------------------------------------------------
\104\ With certain exceptions (see Section II.C.3. below), all
cash management securities activities and ancillary portfolio
management securities activities must be effected through an OTC
derivatives dealer's fully regulated broker-dealer affiliate. See
Rule 15a-1(c) (17 CFR 240.15a-1(c)).
---------------------------------------------------------------------------
a. Rule 3b-14; Cash Management Securities Activities. An OTC
derivatives dealer may engage in ``cash management securities
activities,'' as defined in Rule 3b-14. Under the rule, an OTC
derivatives dealer may engage in cash management securities activities
in connection with its securities activities as permitted under Rule
15a-1 (discussed in Section II.C.1. below) or its non-securities
activities that involve eligible OTC derivative instruments or other
financial instruments. Cash management securities activities are
limited to (1) any taking possession of, and any subsequent sale or
disposition of, collateral provided by a counterparty, or any
acquisition of, and any subsequent sale or disposition of, collateral
to be provided to a counterparty; (2) cash management; and (3)
financing of certain positions of the dealer. Each of these three
categories of cash management securities activities is discussed in
more detail below.
i. Counterparty Collateral. Proposed Rule 3b-15(a) would have
allowed an OTC derivatives dealer to take possession of and sell
counterparty collateral, in connection with the dealer's business as a
counterparty in eligible OTC derivative instruments and as an issuer of
securities. The SIA
[[Page 59374]]
argued that this provision unduly restricted the scope of activities,
and requested that the rule be modified to allow an OTC derivatives
dealer to engage in (1) any disposition of collateral provided by a
counterparty; and (2) the acquisition of, and any subsequent sale or
disposition of, collateral to be provided to a counterparty.\105\
---------------------------------------------------------------------------
\105\ SIA Letter I, p. 8.
---------------------------------------------------------------------------
To allow an OTC derivatives dealer to take appropriate action with
respect to counterparty collateral, an OTC derivatives dealer's
activities should not be limited to taking possession of and selling
collateral, but should also extend to other dispositions of the
collateral. Therefore, Rule 3b-14(a), as adopted, has been revised to
expand the permissible activities of an OTC derivatives dealer with
respect to counterparty collateral.
Rule 3b-14(a), like proposed Rule 3b-15(a), does not limit any use
of the counterparty collateral consistent with the agreements entered
into between dealers and their counterparties. As the End-Users of
Derivatives Association, Inc. (``EUDA'') noted, many end-users deny
counterparties free use of posted collateral because it may expose the
pledging party to significant additional credit risk.\106\ In this
regard, Rule 3b-14 is not intended to have any effect on individually
negotiated collateral support agreements or any rehypothecation rights
contained in these agreements.
---------------------------------------------------------------------------
\106\ EUDA Letter, p. 3.
---------------------------------------------------------------------------
ii. Cash Management. Rule 3b-14(b), as adopted, permits an OTC
derivatives dealer to engage in cash management activities in
connection with the dealer's securities activities (as permitted under
Rule 15a-1) or its non-securities activities that involve eligible OTC
derivative instruments or other financial instruments.\107\ Rule 3b-
14(b) applies only to managing cash of the OTC derivatives dealer, and
not of its affiliates. Thus, any securities trading activities
associated with cash management by an OTC derivatives dealer must be at
a level commensurate with the OTC derivatives dealer's bona fide
operational needs, taking into consideration the Commission's capital
requirements for the OTC derivatives dealer and the amount of capital
needed to satisfy the credit requirements of counterparties.
---------------------------------------------------------------------------
\107\ As proposed, Rule 3b-15(b) would have permitted an OTC
derivatives dealer to engage in transactions involving cash
management, in connection with the dealer's business as a
counterparty in eligible OTC instruments and as an issuer of
securities. Proposing Release, Section II.A4., 62 FR at 67943. No
commenters specifically addressed permitted cash management
practices.
---------------------------------------------------------------------------
Cash management securities activities must also be limited to
trading in instruments that are sufficiently liquid and otherwise
recognized as appropriate cash management instruments. In addition,
these activities may not involve moving government securities
repurchase agreement or other trading books from a fully regulated
broker-dealer into its OTC derivatives dealer affiliate.
iii. Financing. Under proposed Rule 3b-15(d), an OTC derivatives
dealer generally would have been permitted to engage in financing
transactions in connection with its business as a counterparty in
eligible OTC derivative instruments and as an issuer of securities. The
proposed rule would also have required that these financing activities
be limited to transactions involving securities positions established
through the taking possession of or sale of counterparty collateral,
cash management, or hedging activity. The SIA regarded these
limitations as unduly restrictive, and believed that an OTC derivatives
dealer should be permitted to finance any aspect of its permitted
activities, subject to compliance with Section 7(c) or (d) of the
Exchange Act, as applicable.\108\
---------------------------------------------------------------------------
\108\ SIA Letter I, p. 8.
---------------------------------------------------------------------------
In response to these concerns, Rule 3b-14(c) provides that an OTC
derivatives dealer may finance through securities transactions any
position of the dealer acquired in connection with its permissible
securities activities or its non-securities activities that involve
eligible OTC derivative instruments or other financial instruments.
Proposed Rule 3b-15 would have permitted financing of certain
securities positions by means of repurchase and reverse repurchase
agreements, buy/sell transactions,\109\ and lending and borrowing
transactions. The final rule eliminates the list of restrictions on the
types of transactions in which an OTC derivatives dealer may engage to
finance its positions. However, a broker-dealer may not run such things
as a repurchase agreement, stock lending, or buy/sell book out of an
affiliated OTC derivatives dealer in order, for example, to have access
to financing for the OTC derivatives dealer's business.
---------------------------------------------------------------------------
\109\ A buy/sell transaction is in many respects the economic
equivalent of a repurchase transaction. The principal respect in
which it differs is that title to the instrument that is the subject
of the transaction passes to another party. See Proposing Release,
Section II.A.4., n.22, 62 FR at 67943, n.22.
---------------------------------------------------------------------------
b. Rule 3b-15; Ancillary Portfolio Management Securities
Activities. In addition to cash management securities activities, an
OTC derivatives dealer may engage in ``ancillary portfolio management
securities activities,'' as defined in Rule 3b-15. Under the rule,
these securities activities must be limited to transactions in
connection with the OTC derivatives dealer's dealer activities in
eligible OTC derivative instruments, the issuance of securities by the
dealer, or such other securities activities that the Commission may
designate by order. They must also (1) be conducted for the purpose of
reducing the market or credit risk of the dealer or consist of
incidental trading activities for portfolio management purposes; and
(2) be limited to risk exposures within the market, credit, leverage,
and liquidity risk parameters set forth in both the trading
authorizations granted to the associated person (or to the associated
person's supervisor) who executes the transaction for, or on behalf of,
the dealer, and the written guidelines approved by the dealer's
governing body and included in the dealer's internal risk management
control system.\110\ Rule 3b-15 also requires that ancillary portfolio
management securities activities be conducted only by associated
persons of the dealer who perform substantial duties for or on behalf
of the dealer in connection with its dealer activities in eligible OTC
derivative instruments.
---------------------------------------------------------------------------
\110\ As discussed in Section II.H.3. below, Rule 15c3-4 (17 CFR
240.15c3-4) requires an OTC derivatives dealer to establish,
document, and maintain a system of internal controls for monitoring
and managing risk associated with its business activities.
---------------------------------------------------------------------------
The limitations on an OTC derivatives dealer's portfolio management
activities under Rule 3b-15 are aimed at preventing the fully regulated
broker-dealer from moving its securities book into its OTC derivatives
dealer affiliate, establishing a proprietary trading desk in the OTC
derivatives dealer, or authorizing personnel or trading units
specifically to engage in proprietary trading activities.\111\ These
activities are not within the scope of an OTC derivatives dealer's
primary role as a booking vehicle for OTC derivatives transactions, and
a firm engaging in
[[Page 59375]]
these activities would be in violation of the rules.\112\
---------------------------------------------------------------------------
\111\ See also Section II.A.1. above, discussing the limitations
on securities activities imposed under Rule 3b-12. In short, the
scope of permissible portfolio management securities activities is
further limited by the requirement under Rule 3b-12 that the
securities activities of an OTC derivatives dealer consist primarily
of engaging in dealer activities in eligible OTC derivative
instruments that are securities, issuing and requiring securities
that are issued by the dealer, and cash management securities
activities. See Rule 3b-12(b) (17 CFR 240.3b-12(b)).
\112\ See Rule 15a-1 (17 CFR 240.15a-1), and discussion in
Section II.C. below.
---------------------------------------------------------------------------
Rule 3b-15, however, does permit an OTC derivatives dealer to
engage in incidental securities trading activities for portfolio
management purposes. In permitting this, the rule recognizes that an
OTC derivatives dealer may to a limited extent engage in a securities
trading activity for portfolio management purposes that may not
necessarily be for the specific purpose of reducing the dealer's market
or credit risk.\113\ This provision of the rule, however, is not
intended to permit an OTC derivatives dealer to engage in substantial
securities trading that is not for the purpose of reducing the dealer's
market or credit risk arising out of its dealer activities in eligible
OTC derivative instruments (or its issuance of securities).
---------------------------------------------------------------------------
\113\ For example, a firm that has a long position in equity
volatility as a result of OTC derivatives transactions with
counterparties is not required to engage in ancillary portfolio
management securities activities that reduce that volatility
exposure. Instead, for example, a firm that believes that equity
volatility exposure. Instead, for example, a firm that believes that
equity volatility is underpriced in the market could enter into
exchange-listed derivatives transactions to create or increase
existing long volatility exposure. Similarly, a firm whose OTC
derivatives portfolio included risk exposure to a particular asset
category or credit could enter into non-OTC derivatives transactions
in securities that would effectively convert that exposure to a
different asset category or credit.
---------------------------------------------------------------------------
As discussed more fully below, the Commission has responded to
commenters by easing the restrictions on the non-dealing securities
activities of OTC derivatives dealers and by broadly defining ancillary
portfolio management securities activities. The final rules are
intended to be flexible and to accommodate current business practices
of OTC derivatives dealers. Because, as drafted, the rule defines a
broad scope of permissible activities, the restrictions on proprietary
trading and dealing in cash markets may prove inadequate. Thus, Rule
15a-1(b)(4) preserves the Commission's ability to clarify, by order,
whether certain securities activities of an OTC derivatives dealer are
within the scope of ancillary portfolio management securities
activities.\114\
---------------------------------------------------------------------------
\114\ See Rule 15a-1(b)(4) (17 CFR 240.15a-1(b)(4)). The
Commission is not delegating this authority to its staff.
---------------------------------------------------------------------------
Because the commenters generally focused on the categories of
activities identified in the definition of ``permissible risk
management, arbitrage, and trading transactions'' under proposed Rule
3b-15, each of these categories is discussed separately below.
i. Hedging. Under proposed Rule 3b-15(c), an OTC derivatives dealer
would have been permitted to ``hedge an element of market or credit
risk associated with one or more existing or anticipated transactions
in eligible OTC derivative instruments or the issuance of securities,
including warrants on securities, hybrid securities, or structured
notes.'' This is the only section of the proposed rules that
specifically addressed the risk management practices of an OTC
derivatives dealer. For that reason, some commenters believed that the
Commission should more clearly define what activities would be
considered ``hedging activity.'' \115\ They essentially did not want an
OTC derivatives dealer to be limited to hedging only those risks
arising in connection with the dealer's business as a counterparty in
eligible OTC derivative instruments and as an issuer of securities, but
rather wanted the firm to be able to manage risks on a portfolio-wide
basis through hedging or other risk management techniques.
---------------------------------------------------------------------------
\115\ See, e.g., Comment Letter from the Association of the Bar
of the City of New York, Committee on Futures Regulation (``ABCNY
Committee Letter''), p. 3; see also letters cited in Section
IV.F.1.b. of the Comment Summary.
---------------------------------------------------------------------------
For instance, the SIA regarded the limitation on the ``hedging''
activities listed in the proposed rule as unduly restrictive, and
believed that an OTC derivatives dealer should be permitted to ``engage
in any risk management transaction that is designed to implement
management's decision as to the market risk profile the firm wishes to
obtain.'' \116\ In this regard, the SIA commented that dealers do more
than just hedge their positions, and that many dealers take on levels
of risk consistent with certain risk parameters. The SIA also claimed
that an OTC derivatives dealer should be permitted to manage the risks
associated with cash management, financing, and other permissible
securities positions, in addition to the risks arising from permissible
derivative and hybrid positions.\117\ D.E. Shaw & Co., in turn, stated
that an OTC derivatives dealer should also be able to engage in risk
management activities that involve the hedging of ``liquidity, legal,
or operational risks, or any other risks for which derivative hedging
products are developed.'' \118\
---------------------------------------------------------------------------
\116\ SIA Letter I, p. 8.
\117\ Id. See also Merrill Lynch Letter, p. 5. In a later
comment letter, the SIA also stated that, so long as an OTC
derivatives dealer's securities activities consisted primarily of
conducting an OTC derivatives dealing business, an OTC derivatives
dealer should be permitted to engage in cash market securities
trading activities for portfolio management purposes, provided that
these activities did not give rise to portfolio risk exposures that,
on an aggregate basis, exceeded the risk management parameters for
the dealer's business pursuant to proposed Rule 15c3-4. SIA Letter
II, p. 1. It maintained that this approach would permit the dealers
to engage in portfolio management activities consistent with the
manner in which such firms currently manage their OTC derivatives
businesses, but would still preclude firms from establishing OTC
derivatives dealers to conduct a proprietary trading business in
cash market securities. Id. While Rule 3b-15, as adopted, has been
revised in response to the SIA's comments, the rule includes
additional limitations as a means of permitting reasonable portfolio
management securities activities, while also prohibiting overly
broad securities trading activities.
\118\ DESCO Letter, p. 7.
---------------------------------------------------------------------------
As discussed earlier, in response to comments received regarding
the manner in which dealers in OTC derivative instruments conduct their
business activities, the Commission has restructured the final rules to
better reflect current firm practices. As a result, Rule 3b-15, as
adopted, incorporates the concept of managing risk on a portfolio-wide
basis, and omits any reference to the term ``hedging.'' Thus, the rule
does not expressly limit the range of permissible portfolio management
securities activities. Instead, these activities are limited by the
requirement that they not give rise to risk exposures that, on an
aggregate portfolio basis, exceed the risk limits adopted for the
dealer's business under Rule 15c3-4,\119\ as well as other requirements
that serve to ensure that the OTC derivatives dealer does not engage in
dealer activities in cash market securities or substantial proprietary
trading activities.
---------------------------------------------------------------------------
\119\ In addition to the risk parameters set forth in the
written guidelines included in the dealer's internal risk management
control system under Rule 15c3-4 (17 CFR 240.15c3-4), the
appropriate levels of risk assumed by an OTC derivatives dealer are
also to be determined by the dealer through trading authorizations
or limits placed on the associated person executing a transaction on
the dealer's behalf. See Rule 3b-15(a)(3)(i) (17 CFR 240.3b-
15(a)(3)(i)).
---------------------------------------------------------------------------
ii. Arbitrage. Under proposed Rule 3b-15(e), an OTC derivatives
dealer would have been permitted to engage in a transaction involving
arbitrage, provided that any arbitrage involving securities was limited
to arbitrage of a securities position that was acquired in connection
with the taking possession of or selling of counterparty collateral,
cash management, or hedging activity.\120\ The SIA requested that
[[Page 59376]]
permissible arbitrage activities be expanded to include (1) arbitrage
of eligible OTC derivatives instruments; (2) arbitrage of short
securities positions; and (3) arbitrage of prospective securities
purchases or sales under permitted forward arrangements.\121\
---------------------------------------------------------------------------
\120\ The Proposing Release further stated that permissible
arbitrage transactions would be limited to transactions involving
closely related cash market and derivative instruments that were
effected close to one another in time for purposes of taking
advantage of price disparities in different markets. An example
would include transactions involving the purchase or sale of an
equity security and the acquisition of an option on the same equity
security that were effected close together in time, taking into
consideration market liquidity and hours of market operations.
Proposing Release, Section II.A.4., n.23, 62 FR at 67943, n.23.
\121\ SIA Letter I, p. 8. See also Section IV.F.1.d. of the
Comment Summary.
---------------------------------------------------------------------------
The final rules do not use the term ``arbitrage'' in describing the
scope of risk management activities in which an OTC derivatives dealer
may engage. Instead, the rules are intended to permit any portfolio
management transaction, including arbitrage transactions, that meet the
conditions in the rules. As a practical matter, however, a firm
engaging in an OTC derivatives business typically does not engage in
``arbitrage'' transactions that would not otherwise qualify as an
ancillary portfolio management securities activity. Rule 3b-15 allows a
firm to manage its positions and make a profit, provided that the
activities occur in connection with its derivatives dealing business
(or the issuance of securities) and meet the other conditions set forth
in the rule.
iii. Trading. To avoid inadvertent violations of the proposed rules
through an inability to properly document the purpose of a transaction,
proposed Rule 3b-15(f) would have allowed the OTC derivatives dealer to
engage in a limited number of certain additional trading transactions.
In particular, an OTC derivatives dealer generally would have been
permitted to engage in no more than 150 additional securities
transactions per year relating to a securities position acquired in
connection with the taking possession of or selling of counterparty
collateral, cash management, or hedging activity. Proposed Rule 3b-
15(f) would have further required an OTC derivatives dealer engaging in
any such trading transaction to maintain and enforce written policies
and procedures reasonably designed to achieve compliance with the other
provisions of proposed Rule 3b-15.
Commenters generally criticized proposed Rule 3b-15(f).\122\ This
provision was essentially crafted to create a limited ``safe harbor''
to protect dealers from committing inadvertent violations of the
proposed rules because of their inability to properly document the
purpose of a transaction. The majority of commenters, however, had
difficulty understanding or applying the provision. For example, the
SIA expressed concern that the limitation on trading activities might
inadvertently exclude the purchase or disposition of securities
delivered or received, or to be delivered or received, by the OTC
derivatives dealer pursuant to the terms of an eligible OTC derivative
instrument.\123\ It also recommended that the proposed 150 transaction
basket be clarified to indicate that the basket was not intended to
place a limit on the number of securities transactions that could be
entered into by an OTC derivatives dealer if such transactions could be
demonstrated to relate to permitted activities.
---------------------------------------------------------------------------
\122\ See Section IV.F.1.e. of the Comment Summary.
\123\ SIA Letter I, pp. 8-9.
---------------------------------------------------------------------------
Several commenters thought the 150 transaction limit was too low.
For example, the SIA believed that the proposed basket was potentially
too small and would not adequately reflect the character and scope of a
particular firm's activities.\124\ As an alternative, several
commenters recommended that the size of any such basket be related to
the scope of the OTC derivatives dealer's activities rather than a
specified number of transactions.\125\ The Committee on Futures
Regulation of the Association of the Bar of the City of New York
suggested that, instead of an arbitrary number of ``allowable''
transactions per year, the Commission, through its examination process,
make determinations of whether a securities transaction was entered
into with a good faith belief that it satisfied one of the purposes set
forth in the rule.\126\
---------------------------------------------------------------------------
\124\ Id.
\125\ E.g., SIA Letter I, p. 9; Merrill Lynch Letter, p. 6.
\126\ ABCNY Committee Letter, p. 3.
---------------------------------------------------------------------------
In response to these comments, the Commission has not included a
safe harbor provision in either Rule 3b-14 or Rule 3b-15 allowing for
inadvertent violations of the rules. Rather, under the final rules, an
OTC derivatives dealer may engage in cash management securities
activities and ancillary portfolio management securities activities, as
those terms are defined in Rules 3b-14 and 3b-15.
iv. Documentation of Activities. Proposed Rule 3b-15(f), which
contained the 150 transaction ``safe harbor,'' also generated concern
regarding whether an OTC derivatives dealer would be required to
document the purpose of each individual transaction. Commenters argued
that, to the extent the rules required individual transaction
documentation, they were inconsistent with portfolio management
practices. Instead, commenters suggested that dealers be allowed to
demonstrate on a portfolio-wide basis that their cash market
transactions were consistent with the restrictions set forth in the
rules.\127\
---------------------------------------------------------------------------
\127\ See Section IV.F.2. of the Comment Summary.
---------------------------------------------------------------------------
As discussed in the Proposing Release, the nature of risk
management activities makes it difficult to determine whether a
particular transaction satisfies the requirements set forth in the
rules.\128\ The requirement that an OTC derivatives dealer develop
reasonable procedures for ensuring compliance with the restrictions in
the rules was intended, in fact, to accommodate current portfolio risk
management practices. The rules do not require that documentation of
the intended purposes of individual securities trades be maintained by
the OTC derivatives dealer. Rather, an OTC derivatives dealer must
develop reasonable procedures for ensuring compliance with the
restrictions set forth in the rules and for demonstrating the
relationship between its risk management activities and the positions
it maintains on a portfolio-wide basis.\129\
---------------------------------------------------------------------------
\128\ Proposing Release, Section II.A.4., 62 FR at 67943.
\129\ See Section II.H.3. below, discussing Rule 15c3-4 (17 CFR
240.15c3-4), which addresses internal risk management control
systems for OTC derivatives dealers.
---------------------------------------------------------------------------
B. Amendment to Rule 15b1-1; Registration With the Commission
Under the proposed amendments to Rule 15b1-1,\130\ a firm seeking
to register as an OTC derivatives dealer would have been required to
register with the Commission by filing Form BD, the Uniform Application
for Broker-Dealer Registration.\131\ No comments were received
regarding these proposed amendments. Accordingly, the amendments to
Rule 15b1-1 are being adopted as proposed.
---------------------------------------------------------------------------
\130\ 17 CFR 240.15b1-1.
\131\ 17 CFR 249.501.
---------------------------------------------------------------------------
A firm that elects to register as an OTC derivatives dealer must
file an application for registration on Form BD, in accordance with the
instructions on the form. The form must be filed with the Central
Registration Depository, a computer system operated by the NASD. In
completing Item 10 of the form, which asks an applicant to disclose its
planned business activities, an OTC derivatives dealer must respond by
checking ``other'' and writing in that it proposes to engage in the
business of an OTC derivatives dealer.\132\ Some OTC
[[Page 59377]]
derivatives dealers may also be required to comply with Exchange Act
provisions applicable to government securities activities.\133\ For
instance, if an OTC derivatives dealer were to write an option on a
government security, it would be considered to be a government
securities dealer. Pursuant to Section 15C(a)(1)(B)(i),\134\ a broker
or dealer effecting, inducing, or attempting to induce the purchase or
sale of a government security must file with the appropriate regulatory
agency written notice that it is a government securities broker or
dealer.\135\ As a result, an OTC derivatives dealer that engages in
government securities transactions must also file notice of such
activities with the Commission, by checking ``yes'' in response to Item
13A on Form BD.
---------------------------------------------------------------------------
\132\ See also Section II.F.3.b.i. below, discussing the
requirement that an OTC derivatives dealer send an application to
the Commission with respect to the dealer's use of VAR models to
calculate net capital.
\133\ In this regard, the SIA noted in its comment letter that
an OTC derivatives dealer registered with the Commission that
engages in transactions in eligible OTC derivative instruments that
government securities would exempt from registration as a government
securities dealer under Exchange Act Section 15C (15 U.S.C. 78o-5),
subject to the notice requirement under Exchange Act section
15c(a)(1)(B) (15 U.S.C. 78o-5(a)(1)(B). SIA Letter I, p. 13.
\134\ 15 U.S.C. 78o-5(a)(1)(B)(i).
\135\ It must similarly file a written notice when it ceases to
act as a government securities broker or dealer. 15 U.S.C. 78o-
5(a)(1)(B)(i). See also Section 3(a)(44) of the Exchange Act (15
U.S.C. 78c(a)(44)) (defining government securities dealer).
---------------------------------------------------------------------------
C. Rule 15a-1; Securities Activities of OTC Derivatives Dealers
1. Scope of Permissible Securities Activities
Proposed Rule 15a-1 would have permitted an OTC derivatives dealer
to (1) engage as a counterparty in transactions in eligible OTC
derivative instruments with permissible derivatives counterparties; (2)
issue and reacquire issued securities, including warrants on
securities, hybrid securities, and structured notes; and (3) engage in
other securities transactions that the Commission designated by order.
In connection with these activities, an OTC derivatives dealer would
also have been permitted to engage in permissible risk management,
arbitrage, and trading transactions, as defined in proposed Rule 3b-15.
Because Rule 15a-1 describes the securities activities in which an
OTC derivatives dealer may engage, it parallels the requirements
contained in Rule 3b-12, which defines the term ``OTC derivatives
dealer.'' Thus, the comments addressing proposed Rule 15a-1 were
generally consistent with those concerning proposed Rule 3b-12.\136\
The SIA urged that the rule be simplified by (1) making the proposed
regulatory category available to ``dealers who are not engaged in the
business of buying and selling securities other than securities that
are eligible OTC derivative instruments''; and (2) deleting the
proposed restrictions on non-dealing activities in securities contained
in proposed Rule 15a-1.\137\
---------------------------------------------------------------------------
\136\ See Section II.A.1. above. For example, several commenters
believed that the scope of permissible securities transactions under
proposed Rule 15a-1 should be expanded, and that the proposed rule
would unduly restrict the activities of an OTC derivatives dealer.
See, generally, letters cited in Sections IV.A. and IV.E. of the
Comment Summary.
\137\ SIA Letter I, pp. 6-7.
---------------------------------------------------------------------------
As discussed earlier, however, the new regime is not intended to
permit an OTC derivatives dealer to engage in substantial proprietary
securities trading activities. Rather, the purpose of the alternative
regulatory framework is to allow U.S. securities firms to elect to
establish a separately capitalized vehicle in which to book a client-
oriented OTC derivatives business. As a result, the restrictions on
these activities in Rule 15a-1 are necessary.
For the reasons discussed above and in Section II.A.1. with respect
to the definition of OTC derivatives dealer, the Commission has revised
Rule 15a-1 to provide that the securities activities of OTC derivatives
dealer must be limited to (1) engaging in dealer activities in eligible
OTC derivative instruments that are securities; (2) issuing and
reacquiring securities that are issued by the dealer, including
warrants on securities, hybrid securities, and structured notes; \138\
(3) engaging in cash management securities activities; (4) engaging in
ancillary portfolio management securities activities; and (5) engaging
in such other securities activities that the Commission designates by
order. In addition, an OTC derivatives dealer's securities activities
must consist primarily of engaging in dealer activities in eligible OTC
derivative instruments that are securities, issuing and reacquiring its
issued securities, and engaging in cash management securities
activities.\139\
---------------------------------------------------------------------------
\138\ D.E. Shaw & Co. requested clarification regarding the
ability of an OTC derivatives dealer to issue and reacquire its
issued securities through a fully regulated broker-dealer. It asked
whether the phrase meant that the fully regulated broker-dealer must
be the issuer of the security or whether the fully regulated broker-
dealer must act as principal or agent in the purchase of securities
from, or the sale of securities to, the customer. D.E. Shaw & Co.
also asked whether the OTC derivatives dealer could be the issuer of
the security, as long as the OTC derivatives dealer complied with
the registration, confirmation, and similar requirements set forth
in the proposed rule. DESCO Letter, p. 9. In short, under Rule 15a-
1, an OTC derivatives dealer may only issue its own securities, or
reacquire its own securities, through a fully regulated broker-
dealer; it may not act in a sales capacity or directly reacquire its
securities from holders of such securities, except in limited
circumstances with respect to certain counterparties. See Rule 15a-
1(c) (17 CFR 240.15a-1(c)).
\139\ As noted in Section II.A.1. above, although the rules
limit the securities activities of OTC derivatives dealers, the
Commission has retained the authority under Rule 15a-1 to identify
other permissible securities activities for these entities. See Rule
15a-1(b)(1) (17 CFR 240.15a-1(b)(1)). This authority has been
delegated to the Director of the Division of Market Regulation. See
Rule 30-3(a)(64) (17 CFR 200.30-3(a)(64).
---------------------------------------------------------------------------
The alternative regulatory framework for OTC derivatives dealers,
as adopted, also includes a provision requiring that the dealer develop
procedures to help ensure that it does not engage in securities
activities beyond those permitted under Rule 15a-1. As discussed
further in Section II.H.3. below, new Rule 15c3-4 requires an OTC
derivatives dealer to establish, document, and maintain a system of
internal risk management controls to assist it in managing the risks
associated with its business activities. As part of its obligations
under Rule 15c3-4, an OTC derivatives dealer's written guidelines must
include and discuss the dealer's procedures to prevent it from engaging
in securities transactions that are not permitted under Rule 15a-1. In
addition, Rule 15c3-4 requires the OTC derivatives dealer's management
to periodically review the dealer's business activities for consistency
with risk management guidelines, including whether procedures are in
place to prevent the dealer from engaging in any impermissible
securities transaction.
2. Commission Orders Regarding OTC Derivatives Dealers' Activities
Under Rule 15a-1(b), the Commission by order, entered upon its own
initiative or after considering an application for exemptive relief,
may clarify or expand the scope of permissible securities activities in
which an OTC derivatives dealer may engage or the scope of eligible OTC
derivative instruments. As discussed in earlier sections of this
release, such orders may (1) identify other permissible securities
activities in which an OTC derivatives dealer may engage; (2) determine
that a class of fungible instruments that are standardized as to their
material economic terms is within the scope of eligible OTC derivative
instrument; (3) clarify whether certain contracts, agreements, or
transactions are within the scope of eligible OTC derivative
instrument; or (4) clarify whether certain securities activities are
within the scope of ancillary portfolio management securities
activities.
Applications for exemptive orders under Section 15a-1(b) should be
filed
[[Page 59378]]
in accordance with Commission procedures set forth in Rule 0-12 under
the Exchange Act.\140\ The Commission may issue such orders to the
extent they are necessary or appropriate in the public interest, and
consistent with the protection of investors. In considering such
orders, the Commission will consider whether the securities activities
are of the type and nature of activities in which an OTC derivatives
dealer may engage under Rule 15a-1, including whether such activities
are integrated into, or integral to, the OTC derivatives dealing
business of OTC derivatives dealers.
---------------------------------------------------------------------------
\140\ 17 CFR 240.0-12.
---------------------------------------------------------------------------
3. Intermediation of Securities Transactions
Proposed Rule 15a-1 would have required an OTC derivatives dealer
to effect all securities transactions through a fully regulated broker-
dealer. Accordingly, under proposed Rule 15a-1, all applicable SRO
sales practice requirements would have applied to the securities
transactions of an OTC derivatives dealer.
Several commenters argued that a fully regulated broker-dealer
should not be required to intermediate every securities
transaction.\141\ The SIA maintained that the interpositioning of a
broker-dealer was not necessary, particularly given the sophisticated
character of the permissible derivatives counterparties, the active
participation by such counterparties in structuring instruments to
fulfill their particular needs, and the consensual negotiation of the
terms of individual transactions.\142\ The SIA further stated that, at
a minimum, an OTC derivatives dealer should not be required to effect
securities transactions through a fully regulated broker-dealer (1)
where the counterparty to the transaction was a bank, broker-dealer,
government securities broker, government securities dealer, or
supranational organization; or (2) in connection with risk management,
financing, arbitrage, or other trading transactions in which the OTC
derivatives dealer was not acting in its capacity as a dealer, but
rather as an investor or end-user.\143\ The SIA also objected to the
intermediation requirement in the context of offshore transactions
involving foreign securities.\144\
---------------------------------------------------------------------------
\141\ See letters cited in Section IV.E.1. of the Comment
Summary.
\142\ SIA Letter I, p. 11.
\143\ SIA Letter I, p. 11. Similarly, D.E. Shaw & Co. argued
that, in order to level the playing field with non-U.S. broker-
dealers, an OTC derivatives dealer should be permitted to transact
business directly (without a U.S. broker-dealer intermediary) with
all parties with whom a non-U.S. broker-dealer could effect business
under Rule 15a-6(a)(4) under the Exchange Act (17 CFR 240.15a-
6(a)(4)), including a registered broker or dealer or a bank acting
in a broker or dealer capacity. Likewise, it believed that where the
OTC derivatives dealer itself is the counterparty to a securities
derivatives transaction, the OTC derivatives dealer should not be
required to effect the securities transaction through a fully
regulated broker-dealer in connection with risk management,
financing, arbitrage, or other trading transactions. DESCO Letter,
p. 4.
\144\ SIA Letter II, pp. 3-4. The SIA argued that the proposed
broker-dealer intermediation requirement in the context of offshore
transactions involving foreign securities could create significant
burdens on registrants, without meaningful corresponding benefits.
According to the SIA, if offshore transactions involving foreign
securities are required to be intermediated by the fully regulated
broker-dealer affiliate, firms might be required to register their
non-U.S. offices as branch offices of their fully regulated U.S.
broker-dealer (with potentially adverse tax, licensing, or other
regulatory consequences) or to confront prohibitive logistical
obstacles to compliance with the proposed requirement. The SIA was
also concerned about the application of this provision to OTC
derivatives transactions arranged and effected by employees resident
in a foreign office of an OTC derivatives dealer with a counterparty
that is also resident in a foreign jurisdiction. In this regard, it
noted that local law may require that the transaction be effected
through a locally registered entity, so that a transaction would
have to be intermediated by two separate entities. For that reason,
it suggested an exception to Rule 15a-1 for permissible securities
transaction with foreign counterparties that are arranged and
effected by non-U.S. resident employees of an OTC derivatives
dealer.
---------------------------------------------------------------------------
D.E. Shaw & Co. also questioned whether an OTC derivatives dealer
needed to effect a securities transaction through an affiliated broker-
dealer. It claimed that an OTC derivatives dealer should also be able
to effect these transactions through a bank or broker-dealer with which
it had a working relationship.\145\ Other commenters questioned the
proposed rule's distinction between securities transactions and non-
securities transactions, and claimed that if sales practice protection
was warranted for securities transactions, then counterparties should
receive similar protection for non-securities transactions undertaken
with an OTC derivatives dealer.\146\ The Chicago Board Options Exchange
(``CBOE''), in turn, sought clarification as to which specific SRO
sales practice rules would apply to a fully regulated broker-dealer
effecting securities transactions for an OTC derivatives dealer's
counterparties.\147\
---------------------------------------------------------------------------
\145\ DESCO Letter, p. 3. D.E. Shaw & Co. stated that the
restriction to use affiliates limited flexibility and placed an
unnecessary burden on U.S. firms conducting a domestic derivatives
business.
\146\ See, e.g., GFOA Letter, pp. 2-3; EUDA Letter, p. 2.
\147\ Comment Letter from the Chicago Board Options Exchange
(''CBOE Letter''), p. 5. The CBOE asserted that there is currently a
disparity between NASD and NYSE options sales practice rules as
applied to listed options, and argued that this disparity, as well
as any other disparity between sales practice rules' application to
qualified counterparties' OTC derivatives transactions and their
listed options transactions, should be remedied.
---------------------------------------------------------------------------
Based on the comments received, Rule 15a-1, as adopted, provides
certain limited exceptions to the requirement that securities
transactions of an OTC derivatives dealer be effected through its fully
regulated broker-dealer affiliate.\148\ However, the rule has not been
revised, as requested by some commenters, to eliminate the
intermediation requirement in connection with cash management or
ancillary portfolio management securities transactions in which the OTC
derivatives dealer is not acting as a dealer, but rather as an investor
or end-user.\149\ Accordingly, all cash management securities
activities and ancillary portfolio management securities activities of
an OTC derivatives dealer must be effected by a fully regulated broker-
dealer, unless the transaction is subject to one of the limited
exceptions discussed below.\150\
---------------------------------------------------------------------------
\148\ As noted earlier, an OTC derivative dealer may issue and
reacquire its issued securities through an unaffiliated fully
regulated broker-dealer. See Rule 15a-1(c) (17 CFR 240.15a-1(c)).
\149\ See supra note 143 and accompanying text.
\150\ In addition, the Commission has not revised Rule 15a-1 to
extend sales practice requirements to non-securities transactions.
As a general matter, sales practice requirements arising under the
federal securities laws and SRO rules apply only to the securities
transactions of broker-dealers.
---------------------------------------------------------------------------
The requirement that securities transactions be effected through a
fully regulated broker-dealer is designed, in part, to ensure that all
securities transactions remain subject to existing sales practice
standards.\151\ The requirement is also intended to prevent any
regulatory disparity from arising between an OTC derivatives dealer,
which is subject to modified capital and margin requirements, and a
fully regulated broker-dealer in connection with conducting securities
transactions. In addition, it is designed to reduce the risk that
counterparties will mistakenly view an OTC derivatives dealer as a
fully regulated broker-dealer, rather than as a booking vehicle for
derivatives transactions.\152\
---------------------------------------------------------------------------
\151\ Unless otherwise expressly provided in the rules and rule
amendments, the fully regulated broker-dealer must comply with all
applicable sales practice requirements when effecting any securities
transaction for, or on behalf of, an OTC derivatives dealer.
\152\ For these same reasons, an OTC derivatives dealer may not
effect a securities transaction through an unaffiliated broker-
dealer, except in limited circumstances, or through a bank.
---------------------------------------------------------------------------
However, if the counterparty to a securities transaction is acting
as principal and is itself either a registered broker or dealer
(including another OTC
[[Page 59379]]
derivatives dealer), a bank acting in a dealer capacity, a foreign
broker or dealer,\153\ or an affiliate of the OTC derivatives
dealer,\154\ the counterparty is less likely to require the protections
afforded by sales practice requirements. In addition, these
counterparties are not likely to mistakenly believe that an OTC
derivatives dealer is a fully regulated broker-dealer engaging in
general securities transactions. Therefore, an OTC derivatives dealer
is not required to use its fully regulated broker-dealer affiliate to
effect securities transactions with these listed entities. This
exception, however, applies only when the counterparty is acting as a
principal (that is, for its own account), and not as agent for one of
its customers.\155\
---------------------------------------------------------------------------
\153\ The term ``foreign broker or dealer'' as used in Rule 15a-
1 means ``any person not resident in the United States (including
any U.S. person engaged in business as a broker or dealer entirely
outside the United States, except as otherwise permitted by
Sec. 240.15a-6 (17 CFR 240.15a-6)) that is not an office or branch
of, or a natural person associated with, a registered broker or
dealer, whose securities activities, if conducted in the United
States, would be described by the definition of `broker' in section
3(a)(4) of the Act (15 U.S.C. 78c(a)(4)) or `dealer' in section
3(a)(5) of the Act (15 U.S.C. 78c(a)(5)).'' See See 15a-1(g) (17 CFR
240.15a-1(g)). In general, a foreign bank may be able to satisfy the
terms of this definition.
\154\ For purposes of Rule 15a-1, the term ``affiliate'' means
``any organization (whether incorporated or unincorporated) that
directly or indirectly controls, is controlled by, or is under
common control with, the OTC derivatives dealer.'' See Rule 15a-1(f)
(17 CFR 240.15a-1(f)).
\155\ With respect to offshore transactions involving foreign
securities, Rule 15a-1 has not been revised to the extent suggested
by some commenters (see supra note 144), in part because of concerns
regarding the application of sales practice protections to foreign
counterparties and the proper maintenance of books and records
regarding those transactions. However, the general requirement that
communications regarding securities transactions be conducted by
associated persons of the affiliated fully regulated broker-dealer
has been revised to reflect the fact that firms operate OTC
derivatives businesses on a global basis, See Rule 15a-1(d) (17 CFR
240.15a-1(d)) (further discussed in Section II.C.4. below).
---------------------------------------------------------------------------
There is a second limited exception to Rule 15a-1(c), as adopted.
If an OTC derivatives dealer engages in a transaction that is an
ancillary portfolio management securities activity involving a foreign
security,\156\ it is not required to effect that transaction through
its fully regulated broker-dealer affiliate if a registered broker or
dealer, a bank, or a foreign broker or dealer is acting as agent for
the OTC derivatives dealer.\157\ This exception will permit an OTC
derivatives dealer to select one of these professional intermediaries
to represent it in foreign markets when purchasing or selling foreign
securities for hedging or portfolio management purposes.
---------------------------------------------------------------------------
\156\ For purposes of Rule 15a-1, the term foreign security
means ``any security (including a depositary share issued by a
United States bank, provided that the depositary share is initially
offered and sold outside the United States in accordance with
Regulation S (17 CFR 230.901 through 230.904)) issued by a person
not organized or incorporated under the laws of the United States,
provided the transaction that involves such security is not effected
on a national securities exchange or on a market operated by a
registered national securities association; or a debt security
(including a convertible debt security) issued by an issuer
organized or incorporated under the laws of the United States that
is initially offered and sold outside the United States in
accordance with Regulation S (17 CFR 230.901 through 230.904).'' See
Rule 15a-1(h) [17 CFR 240.15a-1(h)].
\157\ See Rule 15a-1(c)(2) (17 CFR 240.15a-1(c)(2)). Rule 15c3-4
(17 CFR 240.15c3-4) requires that an OTC derivatives dealer's
written guidelines include the dealer's procedures to prevent it
from improperly relying on the exceptions to Rule 15a-1(c) and (d)
(discussed in Section II.C.4. below).
---------------------------------------------------------------------------
4. Communications Regarding Securities Transactions
The requirement that securities transactions be effected through a
fully regulated broker-dealer means that the OTC derivatives dealer's
counterparties in these transactions will be considered customers of
the fully regulated broker-dealer. Therefore, any person that solicits
a potential counterparty to engage in a securities transaction with an
OTC derivatives dealer, or otherwise has any contact with the
counterparty regarding the transaction, generally must be a registered
representative of the fully regulated broker-dealer affiliate.\158\ As
noted in the Proposing Release, these persons may be dual employees of
the fully regulated broker-dealer and the OTC derivatives dealer,
subject to appropriate supervision by both firms.\159\
---------------------------------------------------------------------------
\158\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)).
\159\ Fully regulated broker-dealers are responsible for
supervising only the securities activities of these dual employees.
They are not responsible for supervising a dual employee's non-
securities OTC derivatives activities conducted on behalf of the OTC
derivatives dealer.
---------------------------------------------------------------------------
The SIA, however, argued that all employees of the OTC derivatives
dealer having contact with counterparties to OTC derivatives
transactions effected through a fully regulated broker-dealer should
not have to be employees of the fully regulated broker-dealer and be
licensed as registered representatives of that firm.\160\ D.E. Shaw &
Co. claimed that the requirement for any person discussing the terms of
a securities transaction with a counterparty to be a registered
representative of the fully regulated broker-dealer was broader than
current NASD requirements. It therefore requested clarification that
the proposed rule would not expand the types of activities that would
require registration of associated persons.\161\
---------------------------------------------------------------------------
\160\ SIA Letter I, p. 12.
\161\ DESCO Letter, p. 4.
---------------------------------------------------------------------------
Under the final rule, whether a registered representative of an OTC
derivatives dealer's fully regulated broker-dealer affiliate must be
involved in all contacts with a counterparty relating to a securities
transaction depends on the nature of the counterparty. Under Rule 15a-
1(d), if the counterparty is a registered broker or dealer, a bank
acting in a dealer capacity, a foreign broker or dealer, or an
affiliate of the OTC derivatives dealer, a registered representative of
the fully regulated broker-dealer affiliate does not have to be
involved in the contact. Thus, employees of the OTC derivatives dealer
may solicit or otherwise contact these enumerated counterparties, even
if the employees are not also registered representatives of the fully
regulated broker-dealer.\162\
---------------------------------------------------------------------------
\162\ This is consistent with the exception set forth in Rule
15a-1(c)(1) (17 CFR 240.15a-1(c)(1)).
---------------------------------------------------------------------------
In addition, in some circumstances, registered representatives of
the fully regulated broker-dealer affiliate are not required to be
involved in contacts with foreign counterparties. Under Rule 15a-1(d),
contacts with a foreign counterparty may generally be conducted by an
associated person of a foreign broker or dealer who is not resident in
the United States, if the foreign broker or dealer is affiliated with
the OTC derivatives dealer and is registered by a foreign financial
regulatory authority in the jurisdiction in which the counterparty is
resident or the associated person is located.\163\ Any resulting
securities transaction, however, must generally be effected through the
OTC derivatives dealer's fully regulated broker-dealer affiliate.
---------------------------------------------------------------------------
\163\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)) and Rule 15a-1(i)
(17 CFR 240.15a-1(i)). See also supra note 155 and accompanying
text. This approach responds to commenters' concerns that it would
be inefficient and impractical to require a registered
representative of the OTC derivatives dealer's fully regulated
broker-dealer affiliate to conduct all contacts with all foreign
counterparties concerning permissible securities activities with the
OTC derivatives dealer.
---------------------------------------------------------------------------
The new regulatory structure for OTC derivatives dealers does not
expand on the types of activities that require registration of
associated persons under existing SRO rules. For example, to the extent
contact with an OTC derivatives dealer's counterparty regarding a
securities transaction involves only clerical or ministerial activities
that currently may be conducted by an unregistered associated person of
a fully regulated broker-dealer, then the employee of the OTC
derivatives dealer performing such activities need not be a registered
representative.\164\ Persons performing clerical and ministerial
[[Page 59380]]
functions may also be dual employees of the OTC derivatives dealer and
the fully regulated broker-dealer affiliate.
---------------------------------------------------------------------------
\164\ See Rule 15a-1(d) (17 CFR 240.15a-1(d)).
---------------------------------------------------------------------------
5. Confirmation of Securities Transactions
Rule 10b-10 under the Exchange Act \165\ requires broker-dealers to
send a written confirmation of each securities transaction with a
customer at or before completion of the transaction, containing certain
material information about the transaction. The Proposing Release
stated that in a securities transaction between an OTC derivatives
dealer and a counterparty (or customer) effected through a fully
regulated broker-dealer, the OTC derivatives dealer and the fully
regulated broker-dealer would each be responsible for sending a
confirmation to the counterparty under the rule.\166\ It further stated
that certain customers could choose not to receive two confirmations
for each securities transaction, but rather could instruct the OTC
derivatives dealer and the fully regulated broker-dealer to send one
joint confirmation on behalf of both parties.\167\
---------------------------------------------------------------------------
\1
This text is long and has been trimmed here. Open the source document for the complete record.
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.