# Application of “Security-Based Swap Dealer” and “Major Security-Based Swap Participant” Definitions to Cross-Border Security-Based Swap Activities; Republication > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3AR1-2014-15337 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** August 12, 2014 - **Citation:** 79 FR 47278 ## Text 17 CFR Parts 240, 241, and 250 Application of ``Security-Based Swap Dealer'' and ``Major Security- Based Swap Participant'' Definitions to Cross-Border Security-Based Swap Activities; Final Rule; Republication Federal Register / Vol. 79 , No. 155 / Tuesday, August 12, 2014 / Rules and Regulations [[Page 47278]] ----------------------------------------------------------------------- SECURITIES AND EXCHANGE COMMISSION 17 CFR Parts 240, 241, and 250 [Release No. 34-72472; File No. S7-02-13] RIN 3235-AL25 Application of ``Security-Based Swap Dealer'' and ``Major Security-Based Swap Participant'' Definitions to Cross-Border Security- Based Swap Activities; Republication Editorial Note: Proposed rule document 2014-15337 was originally published on pages 39067 through 39162 in the issue of Wednesday, July 9, 2014. In that publication the footnotes contained erroneous entries. The corrected document is republished in its entirety. AGENCY: Securities and Exchange Commission. ACTION: Final rules; interpretation. ----------------------------------------------------------------------- SUMMARY: The Securities and Exchange Commission (``SEC'' or ``Commission'') is adopting rules and providing guidance to address the application of certain provisions of the Securities Exchange Act of 1934 (``Exchange Act'') that were added by Subtitle B of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (``Dodd- Frank Act''), to cross-border security-based swap activities. These rules and guidance in large part focus on the application of the Title VII definitions of ``security-based swap dealer'' and ``major security- based swap participant'' in the cross-border context. The Commission also is adopting a procedural rule related to the submission of applications for substituted compliance. In addition, the Commission is adopting a rule addressing the scope of our authority, with respect to enforcement proceedings, under section 929P of the Dodd-Frank Act. DATES: Effective September 8, 2014. FOR FURTHER INFORMATION CONTACT: Richard Gabbert, Senior Special Counsel, Joshua Kans, Senior Special Counsel, or Margaret Rubin, Special Counsel, Office of Derivatives Policy, at 202-551-5870, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-7010. SUPPLEMENTARY INFORMATION: The Commission is adopting the following rules under the Exchange Act, accompanied by related guidance, regarding the application of Subtitle B of Title VII of the Dodd-Frank Act to cross-border activities: Rule 0-13 (filing procedures regarding substituted compliance requests); Rule 3a67-10 (regarding the cross- border implementation of the ``major security-based swap participant'' definition); Rule 3a71-3 (regarding the cross-border implementation of the de minimis exception to the ``security-based swap dealer'' definition); Rule 3a71-4 (regarding the cross-border implementation of the aggregation provisions of the dealer de minimis exception); and Rule 3a71-5 (regarding an exception, from the dealer de minimis analysis, for certain cleared anonymous transactions). The Commission is not addressing, as part of this release, certain other rules that we proposed regarding the application of Subtitle B of Title VII in the cross-border context. The Commission also is adopting Rule 250.1 to clarify the scope of its antifraud civil law-enforcement authority, with respect to enforcement proceedings, in the cross-border context. Table of Contents I. Background A. Scope of This Rulemaking B. The Dodd-Frank Act C. The Cross-Border Proposing Release and the CFTC Cross-Border Guidance D. Comments on the Proposal II. The Economic, Legal, and Policy Principles Guiding the Commission's Approach to the Application of Title VII to Cross- Border Activities A. Economic Considerations in the Cross-Border Regulation of Security-Based Swaps 1. Economic Features of the Security-Based Swap Market 2. Context for Regulatory Determinations B. Scope of Title VII's Application to Cross-Border Security- Based Swap Activity 1. Commenters' Views 2. Scope of Application of Title VII in the Cross-Border Context C. Principles Guiding Final Approach To Applying ``Security- Based Swap Dealer'' and ``Major Security-Based Swap Participant'' Definitions in the Cross-Border Context III. Baseline A. Current Security-Based Swap Market 1. Security-Based Swap Market Participants 2. Levels of Security-Based Swap Trading Activity B. Global Regulatory Efforts C. Cross-Market Participation IV. Cross-Border Application of Dealer De Minimis Exception A. Overview B. Application of De Minimis Exception To Dealing Activities of U.S. Persons 1. Proposed Approach and Commenters' Views 2. Final Rule C. Definition of ``U.S. Person'' 1. Proposed Approach 2. Commenters' Views 3. Final Rule 4. Representations Regarding U.S.-Person Status D. Application of De Minimis Exception To Dealing Activities of Conduit Affiliates 1. Proposed Approach and Commenters' Views 2. Final Rule E. Application of De Minimis Exception To Dealing Activities of Other Non-U.S. Persons 1. Dealing Transactions of Non-U.S. Persons That Are Subject to Recourse Guarantees by Their U.S. Affiliates 2. Dealing Transactions of Non-U.S. Persons Involving U.S. and Other Counterparties F. Application of the Exception's Aggregation Principles to Cross-Border Dealing Activity 1. Proposed Approach and Commenters' Views 2. Final Rule G. Exception for Cleared Anonymous Transactions 1. Proposed Approach and Commenters' Views 2. Final Rule H. Additional Issues 1. Particular Activities and Entities 2. Foreign Public Sector Financial Institutions and Government- Related Entities I. Economic Analysis of the Final Cross-Border Dealer De Minimis Rule 1. Programmatic Costs and Benefits 2. Assessment Costs 3. Alternative Approaches V. Cross-Border Application of Major Security-Based Swap Participant Thresholds A. Overview B. Application of the Major Security-Based Swap Participant Definition to U.S. Persons 1. Proposed Approach and Commenters' Views 2. Final Rule C. Application of the Major Security-Based Swap Participant Definition to Conduit Affiliates 1. Proposed Approach and Commenters' Views 2. Final Rule D. Application to Other Non-U.S. Persons 1. Positions With U.S. Persons Other Than Foreign Branches of U.S. Banks 2. Positions With Foreign Branches of U.S. Banks 3. Positions of Non-U.S. Persons That Are Subject to Recourse Guarantees by a U.S. Person E. Attribution 1. Positions Attributed to U.S. Person Guarantors 2. Positions Attributed to Non-U.S. Person Guarantors 3. Limited Circumstances Where Attribution of Guaranteed Security-Based Swap Positions Does Not Apply F. Other Issues Related to the Application of the Major Security-Based Swap Participant Definition 1. Threshold for Registration as a Major Security-Based Swap Participant 2. Entities That Maintain Legacy Portfolios [[Page 47279]] G. Foreign Public Sector Financial Institutions and Government- Related Entities H. Economic Analysis of Final Rules Regarding ``Major Security- Based Swap Participants'' 1. Programmatic Costs and Benefits 2. Assessment Costs 3. Alternative Approaches VI. Substituted Compliance Procedural Rule A. Proposed Approach and Commenters' Views B. Final Rule C. Economic Analysis VII. Antifraud Authority A. Final Rule B. Economic Analysis VIII. Impacts on Efficiency, Competition, and Capital Formation A. Competition B. Efficiency C. Capital Formation IX. Paperwork Reduction Act A. Introduction B. Reliance on Counterparty Representations Regarding Transactions Conducted Through a Foreign Branch 1. Summary of Collection of Information 2. Proposed Use of Information 3. Respondents 4. Total Initial and Annual Reporting and Recordkeeping Burdens C. Reliance on Counterparty Representations Regarding Non-U.S. Person Status 1. Summary of Collection of Information 2. Proposed Use of Information 3. Respondents 4. Total Initial and Annual Reporting and Recordkeeping Burdens X. Regulatory Flexibility Act Certification XI. Effective Date and Implementation Statutory Authority and Text of Final Rules I. Background A. Scope of This Rulemaking The Commission is adopting the first of a series of rules and providing guidance regarding the application of Title VII of the Dodd- Frank Act \1\ (``Title VII'') to cross-border security-based swap activities and persons engaged in those activities.\2\ This rulemaking primarily focuses on the application of the de minimis exception to the definition of ``security-based swap dealer'' in the cross-border context, and on the application of thresholds related to the definition of ``major security-based swap participant'' in the cross-border context. We also are adopting a procedural rule regarding the submission of ``substituted compliance'' requests to allow market participants to satisfy certain Title VII obligations by complying with comparable foreign regulatory requirements.\3\ --------------------------------------------------------------------------- \1\ Public Law 111-203, 124 Stat. 1376 (2010). Unless otherwise indicated, references to Title VII in this release are to Subtitle B of Title VII. \2\ Consistent with the scope of the final rules as discussed below, the references in this release to the application of Title VII to ``cross-border activities'' refer to security-based swap transactions involving: (i) A U.S. person and a non-U.S. person, or (ii) two non-U.S. persons conducting a security-based swap transaction that otherwise occurs in relevant part within the United States, including where performance of one or both counterparties under the security-based swap are guaranteed by a U.S. person. For purposes of this release only, ``cross-border activities'' do not indicate activities involving a transaction between two non-U.S. persons where one or both are conducting dealing activity within the United States, because, as discussed below, we anticipate considering this issue in a subsequent release. \3\ The procedural rule addresses only the process for submitting such substituted compliance requests to the Commission. It does not address issues regarding whether substituted compliance would be available in connection with particular regulatory requirements, and, if so, under what conditions. We expect to address those matters as part of later rulemakings. --------------------------------------------------------------------------- The rules and guidance we are adopting are based on our May 23, 2013 proposal, which addressed the application of Title VII in the cross-border context.\4\ Aside from addressing the definitions and procedural rule noted above, the Cross-Border Proposing Release also addressed a range of other cross-border issues, including issues regarding the requirements applicable to dealers and major participants, and requirements relating to mandatory clearing, trade execution, regulatory reporting, and public dissemination. The Cross- Border Proposing Release stated that it was possible that we would consider final rules and guidance related to some of those issues in the adopting releases related to the relevant substantive rulemakings, and that we would address others in a separate rulemaking.\5\ --------------------------------------------------------------------------- \4\ See Cross-Border Security-Based Swap Activities; Re-Proposal of Regulation SBSR and Certain Rules and Forms Relating to the Registration of Security-Based Swap Dealers and Major Security-Based Swap Participants, Exchange Act Release No. 69490 (May 1, 2013), 78 FR 30968 (May 23, 2013) (``Cross-Border Proposing Release''). \5\ See id. at 30974. --------------------------------------------------------------------------- This rulemaking's focus on the cross-border application of the dealer and major participant definitions reflects the critical and foundational role that those definitions occupy with regard to the implementation of Title VII.\6\ We expect to address other matters raised by the Cross-Border Proposing Release as part of subsequent rulemakings, to allow us to consider the cross-border application of the substantive requirements imposed by Title VII--including the economic consequences of that cross-border application--in conjunction with the final rules that will implement those substantive requirements.\7\ Market participants are not required to comply with certain of those Title VII requirements pending the publication of final rules or other Commission action, and temporarily are exempt from having to comply with certain other requirements added by or arising from Title VII.\8\ --------------------------------------------------------------------------- \6\ This rulemaking does not address the requirements under section 5 of the Securities Act applicable to security-based swap transactions. Security-based swaps, as securities, are subject to the provisions of the Securities Act of 1933 (15 U.S.C. 77a et seq.) (``Securities Act'') and the rules and regulations thereunder applicable to securities. The Securities Act requires that any offer and sale of a security must either be registered under the Securities Act (see section 5 of the Securities Act, 15 U.S.C. 77e) or made pursuant to an exemption from registration (see, e.g., sections 3 and 4 of the Securities Act, 15 U.S.C. 77c and 77d, respectively). In addition, the Securities Act requires that any offer to sell, offer to buy or purchase, or purchase or sale of, a security-based swap to any person who is not an eligible contract participant must be registered under the Securities Act (see section 5(e) of the Securities Act, 15 U.S.C. 77e(e)). Because of the statutory language of section 5(e) of the Securities Act, exemptions from this requirement in sections 3 and 4 of the Securities Act are not available. \7\ Those subsequent rulemakings may make use of definitions of ``U.S. person'' and certain other terms that we are adopting today. \8\ See Temporary Exemptions and Other Temporary Relief, Together With Information on Compliance Dates for New Provisions of the Securities Exchange Act of 1934 Applicable to Security-Based Swaps, Exchange Act Release No. 64678 (Jun. 15, 2011), 76 FR 36287 (Jun. 22, 2011) (clarifying the compliance date for certain requirements added by Title VII, and in some cases providing temporary exemptive relief in connection with those requirements); Order Extending Temporary Exemptions under the Securities Exchange Act of 1934 in Connection with the Revision of the Definition of ``Security'' to Encompass Security-Based Swaps, and Request for Comment, Exchange Act Release No. 71485 (Feb. 5, 2014), 79 FR 7731 (Feb. 10, 2014) (extending exemptive relief from certain Exchange Act provisions in connection with Title VII's revision of the Exchange Act definition of ``security'' to encompass security-based swaps). --------------------------------------------------------------------------- These final rules and guidance do not address one key issue related to the application of the ``security-based swap dealer'' definition in the cross-border context. In the Cross-Border Proposing Release, we proposed that non-U.S. persons must count, against the relevant thresholds of the de minimis exemption, their dealing activity involving ``transactions conducted within the United States.'' \9\ Commenters raised a number of significant issues related to this proposed requirement, including issues regarding the Commission's authority to impose this requirement and regarding the costs associated with this requirement. While we continue to preliminarily believe that the cross-border application of the security-based [[Page 47280]] swap dealer definition should account for activities in the United States related to dealing--even when neither party to the transaction is a U.S. person--we also believe that the final resolution of this issue can benefit from further consideration and public comment. Accordingly, we anticipate soliciting additional public comment regarding approaches by which the cross-border application of the dealer definition appropriately can reflect activity between two non- U.S. persons where one or both are conducting dealing activity within the United States. --------------------------------------------------------------------------- \9\ See proposed Exchange Act rule 3a71-3(b). The proposal further would have defined a ``transaction conducted within the United States'' to encompass transactions that are solicited, executed, or booked within the United States by or on behalf of either counterparty, regardless of either counterparty's location, domicile or residence status, subject to an exception for transactions conducted through the foreign branches of U.S. banks. See proposed Exchange Act rule 3a71-3(a)(5). --------------------------------------------------------------------------- B. The Dodd-Frank Act As discussed in the Cross-Border Proposing Release, the 2008 financial crisis highlighted significant issues in the over-the-counter (``OTC'') derivatives markets, which had experienced dramatic growth in the years leading up to the crisis and are capable of affecting significant sectors of the U.S. economy.\10\ The Dodd-Frank Act was enacted, among other reasons, to promote the financial stability of the United States by improving accountability and transparency in the financial system, including in connection with swaps and security-based swaps.\11\ --------------------------------------------------------------------------- \10\ See generally Cross-Border Proposing Release, 78 FR 30972- 73. \11\ See Pub. L. 111-203, Preamble (stating that the Dodd-Frank Act was enacted ``[t]o promote the financial stability of the United States by improving accountability and transparency in the financial system, to end `too big to fail', to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes''). --------------------------------------------------------------------------- Title VII provides for a comprehensive new regulatory framework for swaps and security-based swaps. Under this framework, the Commodity Futures Trading Commission (``CFTC'') regulates ``swaps'' while the Commission regulates ``security-based swaps,'' and the Commission and CFTC jointly regulate ``mixed swaps.'' The new framework encompasses the registration and comprehensive regulation of dealers and major participants, as well as requirements related to clearing, trade execution, regulatory reporting, and public dissemination.\12\ Security-based swap transactions are largely cross-border in practice,\13\ and the various market participants and infrastructures operate in a global market. To ensure that our regulatory framework appropriately reflects and addresses the nature and extent of the potential impact that the global market can have on U.S. persons and the U.S. financial system, it is critically important that we provide market participants with clear rules and guidance regarding how the regulatory framework mandated by Title VII will apply in the cross- border context. --------------------------------------------------------------------------- \12\ The Commission has proposed a series of rules regarding these matters. See Cross-Border Proposing Release, 78 FR 30972 nn.11-18. Most recently, the Commission proposed rules governing recordkeeping, reporting, and notification requirements for dealers and major participants. See Exchange Act Release No. 71958 (Apr. 17, 2014), 79 FR 25194 (May 2, 2014). The Dodd-Frank Act further provides that the SEC and CFTC jointly should further define certain terms, including ``security- based swap dealer'' and ``major security-based swap participant.'' See Dodd-Frank Act section 712(d). Pursuant to that requirement, the SEC and CFTC jointly adopted rules to further define those terms. See Further Definition of ``Swap Dealer,'' ``Security-Based Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-Based Swap Participant'' and ``Eligible Contract Participant,'' Exchange Act Release No. 66868 (Apr. 27, 2012), 77 FR 30596 (May 23, 2012) (``Intermediary Definitions Adopting Release''); see also Cross- Border Proposing Release, 78 FR 30972 n.9 (discussing joint rulemaking to further define various Title VII terms). \13\ See section II.A, infra, regarding the preponderance of cross-border activity in the security-based swap market. --------------------------------------------------------------------------- In developing these final rules and guidance, we have consulted and coordinated with the CFTC, the prudential regulators,\14\ and foreign regulatory authorities in accordance with the consultation provisions of the Dodd-Frank Act,\15\ and more generally as part of our domestic and international coordination efforts.\16\ Commission staff has participated in numerous bilateral and multilateral discussions with foreign regulatory authorities addressing the regulation of OTC derivatives.\17\ Through these discussions and the Commission staff's participation in various international task forces and working groups,\18\ we have gathered information about foreign regulatory reform efforts and the possibility of conflicts and gaps, as well as inconsistencies and overlaps, between U.S. and foreign regulatory regimes. We have taken this information into consideration in developing the final rules and guidance. --------------------------------------------------------------------------- \14\ The term ``prudential regulator'' is defined in section 1a(39) of the CEA, 7 U.S.C. 1a(39), and that definition is incorporated by reference in section 3(a)(74) of the Exchange Act, 15 U.S.C. 78c(a)(74). Pursuant to the definition, the Board of Governors of the Federal Reserve System (``Federal Reserve Board''), the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the Farm Credit Administration, or the Federal Housing Finance Agency (collectively, the ``prudential regulators'') is the ``prudential regulator'' of a security-based swap dealer or major security-based swap participant if the entity is directly supervised by that regulator. \15\ Section 712(a)(2) of the Dodd-Frank Act provides in part that the Commission shall ``consult and coordinate to the extent possible with the Commodity Futures Trading Commission and the prudential regulators for the purposes of assuring regulatory consistency and comparability, to the extent possible.'' In addition, section 752(a) of the Dodd-Frank Act provides in part that ``[i]n order to promote effective and consistent global regulation of swaps and security-based swaps, the Commodity Futures Trading Commission, the Securities and Exchange Commission, and the prudential regulators . . . as appropriate, shall consult and coordinate with foreign regulatory authorities on the establishment of consistent international standards with respect to the regulation (including fees) of swaps.'' \16\ In 2009, leaders of the Group of 20 (``G20'')--whose membership includes the United States, 18 other countries, and the European Union (``EU'')--called for global improvements in the functioning, transparency, and regulatory oversight of OTC derivatives markets. See G20 Leaders' Statement, Pittsburgh, United States, September 24-25, 2009, available at: http://www.treasury.gov/resource-center/international/g7-g20/Documents/pittsburgh_summit_leaders_statement_250909.pdf. (``G20 Leaders' Pittsburgh Statement''). In subsequent summits, the G20 leaders have reiterated their commitment to OTC derivatives regulatory reform. For example, in September 2013, the leaders of the G20 reaffirmed their commitments with respect to the regulation of the OTC derivatives markets, welcoming Financial Stability Board (``FSB'') members' confirmed actions and committed timetables to put the agreed OTC derivatives reforms into practice. See the G20 Leaders Declaration (September 2013), para. 71, available at: https://www.g20.org/sites/default/files/g20_resources/library/Saint_Petersburg_Declaration_ENGpdf (``G20 Leaders' St. Petersburg Declaration''). \17\ Senior representatives of authorities with responsibility for regulation of OTC derivatives have met on a number of occasions to discuss international coordination of OTC derivatives regulations. See, e.g., Report of the OTC Derivatives Regulators Group (``ODRG'') on Cross-Border Implementation Issues March 2014 (Mar. 31, 2014), available at: http://www.cftc.gov/ucm/groups/public/@internationalaffairs/documents/file/odrgreport033114.pdf. \18\ Commission representatives participate in the FSB's Working Group on OTC Derivatives Regulation (``ODWG''), both on its own behalf and as the representative of the International Organization of Securities Commissions (``IOSCO''), which is co-chair of the ODWG. A Commission representative also serves as one of the co- chairs of the IOSCO Task Force on OTC Derivatives Regulation. --------------------------------------------------------------------------- C. The Cross-Border Proposing Release and the CFTC Cross-Border Guidance In expressing our preliminary views regarding the application of Title VII to security-based swap activity carried out in the cross- border context (including to persons engaged in such activities), the Cross-Border Proposing Release recognized that the security-based swap market is global in nature and that it developed prior to the enactment of the Dodd-Frank Act.\19\ The proposal further recognized that the rules we adopt and guidance we provide regarding the cross-border application of Title VII could significantly affect the global security-based swap market.\20\ --------------------------------------------------------------------------- \19\ See Cross-Border Proposing Release, 78 FR 30975-76. \20\ See id. at 30975. --------------------------------------------------------------------------- Reflecting the range of regulatory requirements that Title VII imposes upon the security-based swap market, [[Page 47281]] the Cross-Border Proposing Release addressed the cross-border application of: (a) The de minimis exception to the ``security-based swap dealer'' definition; (b) the entity-level and transaction-level requirements applicable to security-based swap dealers (e.g., margin, capital, and business conduct requirements); (c) the ``substantial position'' and ``substantial counterparty exposure'' thresholds for the ``major security-based swap participant'' definition and the requirements applicable to major participants; (d) the registration of security-based swap clearing agencies and mandatory clearing requirements; (e) the registration of security-based swap execution facilities and mandatory trade execution requirements; and (f) the registration of security-based swap data repositories and regulatory reporting and public dissemination requirements. The proposal also addressed the potential for market participants to satisfy certain of those Title VII requirements by complying with comparable foreign rules as a substitute. This rulemaking establishes a process for submission of such requests. Following the Commission's proposal, the CFTC issued guidance regarding Title VII's application to cross-border swap activity.\21\ The CFTC Cross-Border Guidance differed from the Commission's proposed rules in certain ways, including, as discussed below, with regard to the meaning of ``U.S. person,'' the cross-border application of the de minimis exception to the dealer definition, the cross-border application of the major participant definition, and the process for submitting substituted compliance requests.\22\ --------------------------------------------------------------------------- \21\ See ``Interpretive Guidance and Policy Statement Regarding Compliance With Certain Swap Regulations'' (Jul. 17, 2013), 78 FR 45292 (Jul. 26, 2013) (``CFTC Cross-Border Guidance''). \22\ The CFTC Cross-Border Guidance currently is subject to legal challenge. See Complaint, Securities Indus. & Fin. Mkts. Ass'n. v. CFTC, No. 1:13-cv-1916 (D.D.C. filed Dec. 4, 2013). --------------------------------------------------------------------------- Certain foreign regulators also have addressed or are in the process of addressing issues related to the cross-border implementation of requirements applicable to OTC derivatives.\23\ --------------------------------------------------------------------------- \23\ See section III.B, infra. --------------------------------------------------------------------------- D. Comments on the Proposal The Commission received 36 comments in connection with the proposal.\24\ Several of the commenters addressed differences between the SEC's proposed rules and the CFTC Cross-Border Guidance, and urged the Commission to harmonize its rules with the approaches taken by the CFTC and by foreign regulators.\25\ --------------------------------------------------------------------------- \24\ The comment letters are located at: http://www.sec.gov/comments/s7-02-13/s70213.shtml. The majority of those commenters addressed, at least in part, the definitional issues that are the subject of this release. A number of commenters also addressed aspects of the proposal that are outside the scope of this release, and a few of those commenters only addressed issues that were outside the scope of this release (for example, addressing only proposed Regulation SBSR). We will consider those comments in connection with the relevant rulemakings. \25\ See, e.g., Managed Funds Assoc. and Alternative Investment Management Assoc. (``MFA/AIMA'') Letter at 3 (``We recognize that there are differences between the Commission's proposed approach and the CFTC Cross-Border Guidance, and we expect that other international regulators will similarly issue proposals related to the cross-border application of their regulations. Thus, in light of the global nature of the derivatives market, we urge continued harmonization with the CFTC and other regulatory authorities with respect to the extraterritorial scope of all these regimes. In particular, we encourage international coordination of substituted compliance regimes to ensure appropriate recognition of comparable regulations, create practical and administrable frameworks, and alleviate duplicative regulation.'' (footnotes omitted)). See also letter from six members of the United States Senate at 2 (stating that there should be no gaps or loopholes between the Commission's and the CFTC's rules); Futures and Options Association (``FOA'') Letter at 8 (urging the Commission and the CFTC ``to coordinate, to the extent possible, on their approaches in order to minimise distortions or other unintended consequences for market participants''); letter from Senator Jeffrey A. Merkley, et al., Congress of the United States (Aug. 6, 2013). Some commenters generally suggested that we harmonize with aspects of the CFTC Cross-Border Guidance, but also expressed preferences for particular elements of our proposed approach. See, e.g., Institute of International Bankers (``IIB'') Letter at 3-4 (generally emphasizing the need for consistency with the CFTC and European Securities and Markets Authority (``ESMA'') approaches, unless the SEC requirement is more flexible than those other requirements). One commenter took the view that the Commission's rules should be at least as strong as the CFTC Cross-Border Guidance, but should go further than the CFTC wherever necessary. See Better Markets (``BM'') Letter. See also Chris Barnard Letter at 2 (recommending that the Commission and the CFTC propose one set of rules applicable to cross-border activities to avoid duplicative and conflicting rules). --------------------------------------------------------------------------- Many of those commenters particularly focused on differences between the two regulators' meanings of the term ``U.S. person,'' with several suggesting that we change our proposed definition to align with the CFTC's approach.\26\ A number of commenters also addressed the definition of ``transaction conducted within the United States,'' with several opposing any use of the concept as part of the Commission's rules.\27\ --------------------------------------------------------------------------- \26\ See notes 192-224, infra, and accompanying text. \27\ As noted above, these final rules and guidance do not address the application of the ``transaction conducted within the United States'' concept to the dealer definition. We instead anticipate soliciting additional public comment regarding the issue. --------------------------------------------------------------------------- Commenters further raised a number of more general concerns in connection with the proposal, including concerns regarding cost-benefit issues,\28\ the clarity of the proposal as a whole,\29\ the link between the rules and the location of the associated risk,\30\ and perceived concessions to the financial industry.\31\ --------------------------------------------------------------------------- \28\ For example, a few commenters took the view that cost- benefit principles weighed in favor of consistency with the CFTC Cross-Border Guidance. See Securities Industry and Financial Markets Association/Futures Industry Association/Financial Services Roundtable (``SIFMA/FIA/FSR'') Letter at 3; PensionsEurope Letter (incorporating by reference SIFMA/FIA/FSR Letter; all references to SIFMA/FIA/FSR Letter incorporate reference to PensionsEurope Letter); IIB Letter at 2, 3. One commenter further took the view that cost-benefit principles merited rejection of the use of the ``transaction conducted within the United States'' concept. See SIFMA/FIA/FSR Letter at 3. See also Chris Barnard Letter at 2 (suggesting that there is insufficient administrative, legal, or economic rationale for having ``very different rules'' of cross- border application between the SEC and the CFTC); Coalition for Derivatives End-Users (``CDEU'') Letter at 2 (stating that conflicting regulatory regimes will result in increased compliance and regulatory costs and an inefficient financial system); Association of Financial Guaranty Insurers (``AFGI'') Letter, dated August 20, 2013 (``AFGI Letter I'') at 2 (stating that the security- based swap dealer and major security-based swap participant regime would be disruptive and have financial consequences for guaranty insurers and their counterparties who have legacy transactions with a projected run-off date in the near future); AFGI letter, dated July 22, 2013 (``AFGI Letter II'') at 4 (incorporated by reference in AFGI Letter I); AFGI letter, dated February 15, 2013 (``AFGI Letter III'') at 4 (incorporated by reference in AFGI Letter I). One commenter conversely argued that, in lieu of cost-benefit principles, the Commission instead should be guided by public interest and investor protection principles, as well as the Dodd- Frank Act's intent to increase financial system soundness and prevent another financial crisis. See BM Letter at 4, 37-45 (stating, inter alia, that ``Congress passed the Dodd-Frank Act knowing full well that it would impose significant costs on industry, yet it determined those costs were not only justified but necessary to stabilize our financial system and avoid another financial crisis''). One commenter challenged the adequacy--indeed, the existence--of the cost-benefit analysis in the proposing release. See CDEU Letter at 6 (``To better understand the negative effects of imposing conflicting rules on the market, the SEC should conduct a direct cost-benefit analysis of the conflicting rule regimes (e.g., with the European Market Infrastructure Regulation and the CFTC's cross- border guidance). Instead, the SEC asks the public to conduct such an analysis for the SEC: `what would be the economic impact, including the costs and benefits, of these differences on market participants . . . ?' ''). \29\ See BM Letter at 2-3, 7-8; CDEU Letter at 5. \30\ See Americans for Financial Reform (``AFR'') Letter, dated August 22, 2013 (``AFR Letter I'') at 3-4 (criticizing the proposal as having failed to apply the rules based on the geographic location of the entity ultimately responsible for the resulting liabilities, and stating that the rules should apply to transactions engaged in by ``guaranteed foreign subsidiaries of U.S. entities''). \31\ See BM Letter at 7-8 (stating that the proposal was the result of unwarranted and inappropriate concessions, such as with regard to the application of the de minimis threshold to U.S.- guaranteed entities). See also Karim Shariff letter at 1 (stating that the proposal will allow banks to take risks that will lead to an economic collapse). --------------------------------------------------------------------------- In addition, commenters addressed issues specific to the cross- border [[Page 47282]] application of the entity-level and transaction-level requirements for dealers,\32\ as well as requirements specific to clearing, trade execution, regulatory reporting and public disclosure.\33\ We expect to address those comments regarding the relevant substantive requirements in subsequent rulemakings and guidance regarding the relevant substantive requirements. --------------------------------------------------------------------------- \32\ See, e.g., BM Letter at 3, 20-21, 28 (stating that transactions conducted through foreign branches of U.S. dealers with non-U.S. persons should be subject to external business conduct requirements, and that margin should be treated as a transaction- level requirement); SIFMA/FIA/FSR Letter at A-22 to A-26 (addressing application of margin, segregation, external business conduct and certain other requirements). \33\ See, e.g., BM Letter at 3, 21-22 (criticizing exceptions from mandatory clearing and trade execution requirements); SIFMA/ FIA/FSR Letter at A-38 to A-52 (in part urging that application of regulatory reporting, public dissemination, trade execution and clearing requirements should follow the same rules as external business conduct requirements). --------------------------------------------------------------------------- Commenters also addressed the proposed availability of substituted compliance.\34\ Although today we are adopting a procedural rule regarding requests for substituted compliance, we generally expect to address the potential availability of substituted compliance for specific Title VII requirements in connection with subsequent rulemakings regarding each substantive requirement. --------------------------------------------------------------------------- \34\ See, e.g., AFR Letter I at 8, 12 (opposing rationale for substituted compliance, and noting need for the Commission to retain discretion to find a lack of comparability based on substantive enforcement issues); AFR letter to CFTC, dated August 27, 2012 (``AFR Letter II'') (stating that CFTC should narrow the scope of substituted compliance) (incorporated by reference in AFR Letter I); Michael Greenberger letter to CFTC, dated February 6, 2013 at 13 (``Greenberger Letter I'') (stating that substituted compliance should be a last resort and that the CFTC regime be enforced vigorously) (incorporated by reference in AFR Letter I); Michael Greenberger letter to CFTC, dated August 27, 2012 at 8, 19-23 (``Greenberger Letter II'') (explaining that international comity does not require that the CFTC exempt foreign subsidiaries from compliance with U.S. financial regulation) (incorporated by reference in AFR Letter I); BM Letter at 3, 26-27 (questioning authority for substituted compliance and suggesting potential for loopholes; also stating that substituted compliance should not be allowed for transactions with U.S. persons or for transactions in the United States and urging limited use of exemptive authority; further stating that the proposal gave only passing reference to foreign supervision and enforcement); SIFMA/FIA/FSR Letter at A-30 to A-38 (in part supporting the approach to focus on similar regulatory objectives rather than requiring foreign rules to be identical, stating that foreign branches should be able to make use of substituted compliance for certain purposes, stating that variations in foreign supervisory practices should not be assumed to be defects, and requesting further clarity regarding substituted compliance assessment factors); ESMA Letter at 1, 3-4 (suggesting particular expansions of the proposed scope of substituted compliance); European Commission (``EC'') Letter (supporting ``holistic'' approach toward substituted compliance based on comparison of regulatory outcomes). --------------------------------------------------------------------------- We have carefully considered the comments received in adopting the final rules and providing guidance. Our final rules and guidance further reflect consultation with the CFTC, prudential regulators, and foreign regulatory authorities with regard to the development of consistent and comparable standards. Accordingly, certain aspects of the final rules and guidance--such as, for example, the treatment of guaranteed affiliates of U.S. persons for purposes of the dealer de minimis exception--have been modified from the proposal.\35\ --------------------------------------------------------------------------- \35\ In this regard, the final rules in a number of areas take approaches that are similar to the approaches taken by the CFTC in its own cross-border guidance, although independent considerations have driven our approaches. Moreover, throughout the Cross-Border Proposing Release we recognized and solicited comment on the differences between our proposal and the CFTC's proposed guidance on the cross-border application of swap regulation. As noted above, many commenters urged harmonization with various aspects of the CFTC's guidance. We have taken these comments into account, and in developing final rules we have carefully considered the CFTC's guidance and the underlying policy rationales. Further, where we have determined such policy rationales and approaches are applicable in the context of the market for security-based swaps, we have adopted similar approaches to the CFTC (see, e.g., application of the de minimis exception to non-U.S. persons' dealing transactions with foreign branches of U.S. banks). --------------------------------------------------------------------------- II. The Economic, Legal, and Policy Principles Guiding the Commission's Approach to the Application of Title VII to Cross-Border Activities In this section, we describe the most significant economic considerations regarding the security-based swap market that we have taken into account in implementing the cross-border application of the security-based swap dealer and major security-based swap participant definitions of Title VII. We are sensitive to the economic consequences and effects, including costs and benefits, of our rules, including with respect to the scope of our application of the security-based swap dealer and major security-based swap participant definitions in the cross-border context. We have taken into consideration the costs and benefits associated with persons being brought within one of these definitions through our cross-border application, as well as the costs market participants may incur in determining whether they are within the scope of these definitions and thus subject to Title VII, while recognizing that the ultimate economic impact of these definitions will be determined in part by the final rules regarding the substantive requirements applicable to security-based swap dealers and major security-based swap participants. Some of these economic consequences and effects stem from statutory mandates, while others result from the discretion we exercise in implementing the mandates. A. Economic Considerations in the Cross-Border Regulation of Security- Based Swaps 1. Economic Features of the Security-Based Swap Market As noted above, the cross-border implementation of the rules defining security-based swap dealer and major security-based swap participant is the first in a series of final rules that consider the cross-border implications of security-based swaps and Title VII. In determining how Title VII security-based swap dealer and major security-based swap participant definitions should apply to persons and transactions in the cross-border context, the Commission has been informed by our analysis of current market activity, including the extent of cross-border trading activity in the security-based swap market. Several key features of the market inform our analysis. First, the security-based swap market is a global market. Security- based swap business currently takes place across national borders, with agreements negotiated and executed between counterparties often in different jurisdictions (and at times booked, managed, and hedged in still other jurisdictions). The global nature of the security-based swap market is evidenced by the data available to the Commission.\36\ Based on market data in the Depository Trust and Clearing Corporation's Trade Information Warehouse (``DTCC-TIW''),\37\ viewed from the perspective of the domiciles of the counterparties booking credit default swap (``CDS'') transactions, approximately 48 percent of price forming North American corporate single-name CDS transactions \38\ from [[Page 47283]] January 2008 to December 2012 were cross-border transactions between a U.S.-domiciled \39\ counterparty and a foreign-domiciled counterparty \40\ and an additional 39 percent of such CDS transactions were between two foreign-domiciled counterparties.\41\ Thus, approximately 13 percent of the North American corporate single-name CDS transactions in 2008-2012 were between two U.S.-domiciled counterparties.\42\ These statistics indicate that, rather than being an exception, cross-border North American corporate single-name CDS transactions are as common as intra-jurisdictional transactions in the security-based swap market.\43\ --------------------------------------------------------------------------- \36\ See section III.A.2, infra (discussing in detail the global nature of the security-based swap market). \37\ The information was made available to the Commission under an agreement with the DTCC-TIW and in accordance with guidance provided to DTCC-TIW by the OTC Derivatives Regulatory Forum (``ODRF''). \38\ This figure is based on all price-forming DTCC-TIW North American corporate single-name CDS transactions. Price-forming transactions include all new transactions, assignments, modifications to increase the notional amounts of previously executed transactions, and terminations of previously executed transactions. Transactions terminated, transactions entered into in connection with a compression exercise, and expiration of contracts at maturity are not considered price-forming and are therefore excluded, as are replacement trades and all bookkeeping-related trades. ``North American corporate single-name CDS transactions'' are classified as such because they use The International Swaps and Derivatives Association, Inc. (``ISDA'') North American documentation. These may include certain transactions involving non- U.S. reference entities. We do not have sufficiently reliable data on reference entity domicile (as opposed to counterparty domicile, which we have sought to identify in the manner described in note 39, infra) to limit our analysis to only U.S. single-name CDS. Although the inclusion of transactions involving such non-U.S. reference entities introduces some noise into the data, we do not believe that this noise is sufficiently significant to alter the conclusions we draw from the data. \39\ The domicile classifications in DTCC-TIW are based on the market participants' own reporting and have not been verified by Commission staff. Prior to enactment of the Dodd-Frank Act, funds and accounts did not formally report their domicile to DTCC-TIW because there was no systematic requirement to do so. After enactment of the Dodd-Frank Act, the DTCC-TIW has collected the registered office location of the account or fund. This information is self-reported on a voluntary basis. It is possible that some market participants may misclassify their domicile status because the databases in DTCC-TIW do not assign a unique legal entity identifier to each separate entity. It is also possible that the domicile classifications may not correspond precisely to treatment as a U.S. person under the rules adopted today. Notwithstanding these limitations, we believe that the cross-border and foreign activity presented in the analysis by the Commission's Division of Economic and Risk Analysis demonstrates the nature of the single- name CDS market. See section III.A.2, infra. \40\ DTCC-TIW classifies a foreign branch or foreign subsidiary of a U.S.-domiciled entity as foreign-domiciled. Therefore, CDS transactions classified as involving a foreign-domiciled counterparty in the DTCC-TIW data may include CDS transactions with a foreign branch or foreign subsidiary of a U.S.-domiciled entity as counterparty. \41\ Put another way, between 2008 and 2012, a vast majority (approximately 87 percent) of North American corporate single-name CDS transactions directly involved at least one foreign-domiciled counterparty. This observation is based on the data compiled by the Commission's Division of Economic and Risk Analysis on North American corporate single-name CDS transactions from DTCC-TIW between January 1, 2008, and December 31, 2012. See section III.A.2, infra. \42\ See id. \43\ We note, however, that, in addition to classifying transactions between a U.S. counterparty and a foreign branch of a U.S. bank as cross-border transactions, see note 40, supra, these statistics characterize as cross-border transactions some transactions in which all or substantially all of the activity takes place in the United States and all or much of the risk of the transactions ultimately is borne by U.S. persons. That is, a transaction is classified as cross-border if the legal domicile of at least one of the counterparties to the transaction is outside the United States, but if the transaction is classified as cross-border solely on the basis of legal domicile, the risk associated with these transactions may still ultimately be borne by U.S. persons. In this sense, our estimates of the cross-border allocation of security-based swap activity may not precisely reflect the proportion of transactions that are cross-border in nature. --------------------------------------------------------------------------- Second, dealers and other market participants are highly interconnected within this global market. While most market participants have only a few counterparties, dealers can have hundreds of counterparties, consisting of both non-dealing market participants (e.g., non-dealers, including commercial and financial market participants and investment funds) and other dealers.\44\ Furthermore, as described in more detail below, the great majority of trades are dealer-to-dealer, rather than dealer-to-non-dealer or non-dealer-to- non-dealer, and a large fraction of single-name CDS volume is between counterparties domiciled in different jurisdictions. This interconnectedness facilitates the use of security-based swaps as a tool for sharing financial and commercial risks. In an environment in which market participants can have diverse and offsetting risk exposures, security-based swap transactions can allow participants to transfer risks so that they are borne by those who can do so efficiently. The global scale of the security-based swap market allows counterparties to access liquidity across jurisdictional boundaries, providing U.S. market participants with opportunities to share these risks with counterparties around the world. As discussed further in section VIII, a broad set of counterparties across which risks can be shared may result in more efficient risk sharing. --------------------------------------------------------------------------- \44\ Based on an analysis of 2012 transaction data by staff in the Division of Economic and Risk Analysis, accounts associated with market participants recognized by ISDA as dealers had on average 403 counterparties. All other accounts (i.e., those more likely to belong to non-dealers) averaged four counterparties. --------------------------------------------------------------------------- However, these opportunities for international risk sharing also represent channels for risk transmission. In other words, the interconnectedness of security-based swap market participants provides paths for liquidity and risk to flow throughout the system, so that it can be difficult to isolate risks to a particular entity or geographic segment. Because dealers facilitate the great majority of security- based swap transactions, with bilateral relationships that extend to potentially hundreds of counterparties, liquidity problems or other forms of financial distress that begin in one entity or one corner of the globe can potentially spread throughout the network, with dealers as a central conduit. Third, as highlighted in the Intermediary Definitions Adopting Release, dealing activity within the market for security-based swaps is highly concentrated.\45\ This concentration in large part appears to reflect the fact that larger entities possess competitive advantages in engaging in OTC security-based swap dealing activities, particularly with regard to having sufficient financial resources to provide potential counterparties with adequate assurances of financial performance. --------------------------------------------------------------------------- \45\ See Intermediary Definitions Adopting Release, 77 FR 30639- 42. --------------------------------------------------------------------------- The security-based swap market developed as an OTC market, without centralized trading venues or dissemination of pre- or post-trade pricing and volume information. In markets without transparent pricing, access to information confers a competitive advantage. In the current security-based swap market, large dealers and other large market participants with a large share of order flow have an informational advantage over smaller dealers and non-dealers who, in the absence of pre-trade transparency, observe a smaller subset of the market. Greater private information about order flow enables better assessment of current market values by dealers, permitting them to extract economic rents from counterparties who are less informed.\46\ Non-dealers are aware of this information asymmetry, and certain non-dealers-- particularly larger entities who transact with many dealers--may be able to obtain access to competitive pricing or otherwise demand a price discount that reflects the information asymmetry. Typically, however, the value of private information (i.e., the economic rent or informational premium) will be earned by those who have the most information. In the case of security-based swap markets, it is predominantly dealers who observe the greatest order flow and benefit from market opacity. --------------------------------------------------------------------------- \46\ In this situation, economic rents are the profits that dealers earn by trading with counterparties who are less informed. In a market with competitive access to information, there is no informational premium; dealers only earn a liquidity premium. The difference between the competitive liquidity premium and the actual profits that dealers earn is the economic rent. --------------------------------------------------------------------------- [[Page 47284]] Taken together, the need for financial resources and the private information conveyed by order flow suggest that new entrants who intend to engage in security-based swap dealing activity in fact face high barriers to entry. One consequence of the current concentrated market structure is the potential for risk spillovers and contagion, which can occur when the financial sector as a whole (or certain key segments) becomes undercapitalized.\47\ Unlike most other securities transactions, a security-based swap gives rise to ongoing obligations between transaction counterparties during the life of the transaction. This means that each counterparty to the transaction undertakes the obligation to perform the security-based swap in accordance with its terms and bears counterparty credit risk and market risk until the transaction expires or is terminated.\48\ Within this interconnected market, participants may have ongoing bilateral obligations with multiple counterparties, allowing for efficient risk-sharing and access to liquidity throughout the global network. However, a primary risk of the integrated market is the potential for sequential counterparty failure and contagion when one or more large market participants become financially distressed, causing the market participant to default on its obligations to its counterparties.\49\ A default by one or more security-based swap dealers or major security-based swap participants, or even the perceived lack of creditworthiness of these large entities, could produce contagion, either through direct defaults and risk spillovers, reduced willingness to extend credit, reduced liquidity, or reduced valuations for financial instruments. As financial distress spreads, the aggregate financial system may become undercapitalized, hindering its ability to provide financial intermediation services, including security-based swap intermediation services. --------------------------------------------------------------------------- \47\ See Viral V. Acharya, Lasse H. Pedersen, Thomas Philippon, and Matthew Richardson, ``Measuring Systemic Risk'' (May 2010), available at: http://vlab.stern.nyu.edu/public/static/SR-v3.pdf. The authors use a theoretical model of the banking sector to show that, unless the external costs of their trades are considered, financial institutions will have an incentive to take risks that are borne by the aggregate financial sector. Under this theory, in the context of Title VII, the relevant external cost is the potential for risk spillovers and sequential counterparty failure, leading to an aggregate capital shortfall and breakdown of financial intermediation in the financial sector. \48\ See Intermediary Definitions Adopting Release, 77 FR 30616- 17 (noting that ``the completion of a purchase or sale transaction'' in the secondary equity or debt markets ``can be expected to terminate the mutual obligations of the parties,'' unlike security- based swap transactions, which often give rise to ``an ongoing obligation to exchange cash flows over the life of the agreement''). \49\ See Brunnermeier, Markus K., Andrew Crockett, Charles A. Goodhart, Avinash Persaud, and Hyun Song Shin. ``The Fundamental Principles of Financial Regulation.'' (2009) at 15, available at: www.princeton.edu/~markus/research/papers/Geneva11.pdf. --------------------------------------------------------------------------- In other words, the failure of a single large firm active in the security-based swap market can have consequences beyond the firm itself. One firm's default may reduce the willingness of dealers to trade with, or extend credit to, both non-dealers and other dealers. By reducing the availability of sufficient credit to provide intermediation services, and by reducing transaction volume that reveals information about underlying asset values, the effects of a dealer default may, through asset price and liquidity channels, spill over into other jurisdictions and even other markets in which security- based swap dealers participate. Given that firms may be expected to consider the implications of security-based swap activity only on their own operations, without considering aggregate financial sector risk,\50\ the financial system may end up bearing more risk than the aggregate capital of the intermediaries in the system can support and may cease to function normally during times of market distress. For example, during times of financial distress a dealer's leverage constraints may begin to bind, either because lenders require more collateral or because market declines erode a dealer's capital position, forcing the dealer to de- lever, either by selling assets or raising additional capital. Without adequate capital, the dealer may be unable to intermediate trades, potentially reducing liquidity in the markets it serves. Security-based swap positions replicate leveraged positions in the underlying asset, with a small amount of capital supporting large notional exposures.\51\ Given the leveraged nature of swap transactions, and the concentrated structure of the dealer market, in which a large amount of highly leveraged risk exposures may be concentrated in a relatively small number of entities that are responsible for the vast majority of global dealing activity,\52\ the potential consequences arising from financial instability in the security-based swap market may be acute. --------------------------------------------------------------------------- \50\ See Daron Acemoglu, Asuman Ozdaglar & Alireza Tahbaz- Salehi, Systemic Risk and Stability in Financial Networks (NBER Working Paper No. 18727, Jan. 2013), available at: http://www.nber.org/papers/w18727. \51\ See Giulio Girardi, Craig Lewis, and Mila Getmansky, ``Interconnectedness in the CDS Market,'' Division of Economic and Risk Analysis White Paper, April 2014, available at http://www.sec.gov/servlet/sec/dera/staff-papers/white-papers/credit-defaul-swaps-interconnectivity-04-2014.pdf (describing institutional features of credit default swaps). \52\ The Commission estimates that, of approximately 1,000 transacting agents that participated in single-name CDS transactions in 2012, nearly 80 percent of transactions, by notional volume, can be attributed to the 13 largest entities. See also section III.A.2, infra. --------------------------------------------------------------------------- In sum, the security-based swap market is characterized by a high level of interconnectedness, facilitating risk sharing by counterparties. Further, it is a global market, in which the potential for significant inter-jurisdictional activity and access to liquidity may enhance risk sharing among counterparties. At the same time, channels for risk sharing also represent channels for risk transmission. The global nature of this market, combined with the interconnectedness of market participants, means that liquidity shortfalls or risks that begin pooling in one corner of the market can potentially spread beyond that corner to the entire security-based swap market, with dealers as a key conduit. Because dealers and major participants are a large subset of all participants in the global security-based swap market and facilitate the majority of transactions (and thus reach many counterparties), concerns surrounding these types of spillovers are part of the framework in which we analyze the economic effects of our final rules implementing the security-based swap dealer and major participant definitions in the cross-border context.\53\ --------------------------------------------------------------------------- \53\ We have previously noted that, depending on the size of the security-based swap dealer, default by a security-based swap dealer ``could have adverse spillover or contagion effects that could create instability for the financial markets more generally.'' See Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers, Exchange Act Release No. 68071 (Oct. 18, 2012), 77 FR 70214, 70304 (Nov. 23, 2012) (``Capital and Margin Proposing Release''). --------------------------------------------------------------------------- 2. Context for Regulatory Determinations In determining how Title VII requirements should apply to persons and transactions in a market characterized by the types of risks we have described, we are aware of the potentially significant tradeoffs inherent in our policy decisions. Our primary economic considerations for promulgating rules and guidance regarding the application of the security-based swap dealer and major participant definitions to cross- border activities include the effect of our choices on efficiency, competition, and [[Page 47285]] capital formation,\54\ the potential risks of security-based swaps to U.S. market participants that could affect financial stability,\55\ the level of transparency and counterparty protection in the security-based swap market, and the costs to market participants.\56\ --------------------------------------------------------------------------- \54\ See Exchange Act section 3(f). \55\ Title VII imposes financial responsibility and risk mitigation requirements on registered security-based swap dealers and major security-based swap participants. As we noted in proposing rules regarding capital and margin requirements applicable to security-based swap dealers, ``the capital and margin requirements in particular are broadly intended to work in tandem to strengthen the financial system by reducing the potential for default to an acceptable level and limiting the amount of leverage that can be employed by [security-based swap dealers] and other market participants.'' See Capital and Margin Proposing Release, 77 FR 70304. We also noted that ``[r]equiring particular firms to hold more capital or exchange more margin may reduce the risk of default by one or more market participants and reduce the amount of leverage employed in the system generally, which in turn may have a number of important benefits.'' Id. \56\ As we noted in the Cross-Border Proposing Release, the Commission generally understands the ``U.S. financial system'' to include the U.S. banking system and the U.S. financial markets, including the U.S. security-based swap market, the traditional securities markets (e.g., the debt and equity markets), and the markets for other financial activities (e.g., lending). See Cross- Border Proposing Release, 78 FR 30980 n.97. --------------------------------------------------------------------------- As noted above, participants may use security-based swaps to manage financial and commercial risks and benefit from a liquid market with broad participation that facilitates risk sharing. We also recognize the possibility that the same channels that enable risk sharing also facilitate the transmission of risks and liquidity problems that begin pooling in one geographic segment of the market to the global security- based swap market. As described more fully in section III.A.1, U.S. entities may take on risk exposures in the security-based swap market by transacting with non-U.S. counterparties through non-U.S. affiliates. This suggests that an approach that applied these Title VII definitions to transactions only where all activity occurs inside the United States would have little effect in addressing the risks associated with security-based swaps, including risks and associated economic consequences flowing from contagion that may originate abroad and reach U.S. market participants through security-based swap activities and the multiple bilateral relationships that may form as a result of those activities. The global reach of security-based swap dealers, including U.S. dealers, participating in the vast majority of trades \57\ and extending to upwards of hundreds of counterparties,\58\ provides paths for these risks to flow back into the United States.\59\ --------------------------------------------------------------------------- \57\ See note 139, infra, and accompanying text. \58\ See note 44, supra. \59\ As discussed above, the global security-based swaps network, characterized by multiple bilateral relationships between counterparties, has the potential for risk spillovers and sequential counterparty failure. These exposures are not unique to the U.S. financial system. Indeed, the global scope of the security-based swap market suggests that, given our territorial approach to Title VII, there will be the fewest potential gaps in coverage if other jurisdictions also adopt similar comprehensive and comparable derivative regulations. See Section III.B for a discussion of global regulatory efforts in this space. --------------------------------------------------------------------------- At the same time, the Commission recognizes that the regulatory requirements we adopt for security-based swap dealers and major participants under Title VII may not reach all market participants that act as dealers or that have positions that pose considerable risk concerns in the global security-based swap markets. These limits to the application of Title VII raise several issues. First, market participants may shift their behavior. Final Title VII requirements may impose significant direct costs on participants falling within the security-based swap dealer and major security-based swap participant definitions that are not borne by other market participants, including costs related to capital and margin requirements, regulatory reporting requirements, and business conduct requirements. The costs of these requirements may provide economic incentive for some market participants falling within the dealer and major participant definitions to restructure their security-based swap business to seek to operate wholly outside of the Title VII regulatory framework by exiting the security-based swap market in the United States and not transacting with U.S. persons, potentially fragmenting liquidity across geographic boundaries.\60\ Conversely, such incentives potentially may be mitigated by the fact that capital and margin requirements, counterparty protections, and business conduct standards required by Title VII \61\ may promote financial stability and lead to non-dealer market participants exhibiting a preference for transacting with registered dealers and major participants. --------------------------------------------------------------------------- \60\ To the extent that registered dealers are ultimately subject to more extensive reporting and public dissemination requirements than other market participants under Title VII, these requirements may also alter the incentives of market participants to transact with registered dealers if, for example, public dissemination requirements reveal information that participants wish to treat as confidential about trading strategies or future hedging needs. Incentives for these participants to avoid registered dealers could potentially isolate liquidity to less transparent corners of the market. \61\ See, e.g., Exchange Act sections 15F(e), (f), (h) (providing that security-based swap dealers and major security-based swap participants be subject to requirements relating to capital and margin, reporting and recordkeeping, and business conduct). --------------------------------------------------------------------------- Second, to the extent that other jurisdictions may adopt requirements with different scopes or on different timelines, the requirements we adopt may also result in competitive distortions. That is, differences in regulatory requirements across jurisdictions, or the ability of certain non-U.S. market participants to avoid security-based swap dealer regulation under Title VII, may generate competitive burdens and provide incentives for non-U.S. persons to avoid transacting with U.S. persons. Third, key elements of the rules adopted today--the definition of ``U.S. person,'' as well as rules covering treatment of guaranteed transactions, transactions with foreign branches, transactions conducted through conduit affiliates, and cleared anonymous transactions, and rules covering aggregation standards--all have implications for how U.S. and non-U.S. entities perform their de minimis and major participant threshold calculations and may affect the number of participants who ultimately register as security-based swap dealers or major security-based swap participants. The number of persons required to register will affect the costs and benefits of the substantive Title VII requirements that will ultimately be adopted; depending on the final rules, more or fewer entities, and therefore more or fewer security-based swaps, will be subject to Title VII requirements applicable to security-based swap dealers and major security-based swap participants.\62\ Title VII requires the Commission to create a new regulatory regime that includes capital, margin, registration and reporting requirements aimed at increasing transparency and customer protections as well as mitigating the risk of financial contagion. Each of these requirements will impose new costs and regulatory burdens on persons that engage in security-based swap dealing activity at levels above the de minimis thresholds and on persons whose security-based swap positions are large enough to cause them to be major security-based swap participants. --------------------------------------------------------------------------- \62\ Any forward-looking analysis of the costs and benefits that flow from these Title VII requirements necessarily encompasses uncertain elements, since the final requirements have not been adopted. For example, whether foreign security-based swap dealers will be subject to the full range of Title VII requirements in all of their transactions will be determined in subsequent rulemaking. --------------------------------------------------------------------------- We expect that these requirements' application to security-based swap [[Page 47286]] dealers and major security-based swap participants subject to Title VII will be associated with a number of benefits to the security-based swap market and security-based swap market participants, including transparency, accountability, and increased counterparty protections.\63\ Nevertheless, as we discuss later in this release, the de minimis rules for non-U.S. persons could allow certain non-U.S. entities to avoid the costs of dealer registration, which could reduce the number of entities that register as security-based swap dealers, relative to the Commission's estimates in the Intermediary Definitions Adopting Release. Although the number of entities that are not required to register will depend on the availability of the de minimis exclusions, we believe that, to the extent that the final rules change the number of eventual registrants, the ultimate programmatic costs and benefits expected from Title VII may differ from those that were described in the Intermediary Definitions Adopting Release.\64\ --------------------------------------------------------------------------- \63\ Title VII imposes a number of business conduct requirements designed to protect counterparties to security-based swaps, including disclosures about material risks and conflicts of interest, disclosures concerning the daily mark, or value of the position, and segregation of customer assets and collateral from the dealer's assets. \64\ See section IV.I.1 for a discussion of how we expect the cross-border application of the de minimis exception to alter the number of entities required to register with the Commission, and how that may affect the programmatic costs and benefits of Title VII. --------------------------------------------------------------------------- Finally, the final rules determining how non-U.S. persons must perform their de minimis and major participant threshold calculations may face limits as to how precisely they address the risk mitigation goals of Title VII that are reflected in our rules implementing the de minimis exception and the ``major security-based swap participant'' definition. On the one hand, the scope of dealer and major participant regulation under Title VII may be subject to limitations on the ability to control risk because the global nature of counterparty interconnections means that it is difficult to prevent risk that pools in one geographic segment of the market from flowing throughout the entire security-based swap network. On the other hand, there is a possibility that the rules defining the scope of dealer and major participant regulation, including the territorial application of the definitions, may capture certain activity that does not represent risk to the U.S. financial system. Because these rules and guidance implementing Title VII regulatory definitions will not capture all transactions and all entities that engage in security-based swap activity, these rules and guidance therefore may create incentives for those entities at the boundaries of the definitions to restructure their business in a way that allows them to operate outside the scope of Title VII. However, as we described in the Intermediary Definitions Adopting Release, we have sought to implement the statutory dealer and major participant definitions in such a way as to impose the substantive rules of Title VII on those entities most likely to contribute to those risks that Title VII is intended to address without imposing unnecessary burdens on those who do not pose comparable risks to the U.S. financial system.\65\ --------------------------------------------------------------------------- \65\ In adopting the definition of ``security-based swap dealer,'' we intended to determine the set of entities in the security-based swap market for whom regulation ``is warranted due to the nature of their interactions with counterparties, or is warranted to promote market stability and transparency.'' See Intermediary Definitions Adopting Release, 77 FR 30726. Similarly, in adopting rules governing the ``major security-based swap participant'' definition, we sought to impose regulations applicable to major security-based swap participants in a way that reflects ``when it would be `prudent' that particular entities be subject to monitoring, management and oversight of entities that may be systemically important or may significantly impact the U.S. financial system.'' See id. at 30666. Future rulemakings that depend on these definitions are intended to address the transparency, risk, and customer protection goals of Title VII. For example, to further risk mitigation in the security-based swap market, we explained that ``section 15F(e) of the Exchange Act and related rules impose capital and margin requirements on dealers and major participants, which will reduce the financial risks of these institutions and contribute to the stability of the security-based swap market in particular and the U.S. financial system more generally.'' See id. at 30723. --------------------------------------------------------------------------- B. Scope of Title VII's Application to Cross-Border Security-Based Swap Activity Congress has given the Commission authority in Title VII to implement a security-based swap regulatory framework to address the potential effects of security-based swap activity on U.S. market participants, the financial stability of the United States, on the transparency of the U.S. financial system, and on the protection of counterparties.\66\ The global nature of the security-based swap market and the high proportion of cross-border transactions in that market \67\ mean that much of this activity occurs at least in part outside the United States and frequently involves persons that are incorporated, organized, or established in a location outside the United States.\68\ In light of these market realities, we noted in the proposal that applying Title VII only to persons incorporated, organized, or established within the United States or only to security- based swap activity occurring entirely within the United States would inappropriately exclude from regulation a majority of security-based swap activity that involves U.S. persons or otherwise involves conduct within the United States, even though such activity raises the types of concerns that we believe Congress intended to address through Title VII.\69\ --------------------------------------------------------------------------- \66\ See note 11, supra. See also Pub. L. 111-203 sections 701- 774 (providing for, among other things, a comprehensive new regulatory framework for security-based swaps, including by: (i) Providing for the registration and comprehensive regulation of security-based swap dealers and major security-based swap participants; (ii) imposing clearing and trade execution requirements on security-based swaps, subject to certain exceptions; and (iii) creating real-time reporting and public dissemination regimes for security-based swaps). \67\ See section II.A, supra (noting that cross-border activity accounts for the majority of security-based swaps involving U.S. firms). \68\ For example, a single financial firm engaged in dealing activity may utilize two or more entities domiciled in different countries to effectuate a single transaction with a counterparty that may similarly use multiple entities domiciled in different countries. \69\ See Cross-Border Proposing Release, 78 FR 30984. --------------------------------------------------------------------------- Because some commenters had, prior to the proposal, argued that section 30(c) of the Exchange Act limited our ability to reach certain types of activity occurring at least in part outside the United States,\70\ we discussed in some detail in the proposal our preliminary views on the appropriate approach to determining whether certain security-based swap activity that involves some conduct outside the United States also occurs within the United States for purposes of Title VII.\71\ In this subsection, we discuss comments received on this question following publication of our proposal and explain our final views--which remain largely unchanged from the proposal--on the proper approach to determining whether cross-border security-based swap activity occurs, in relevant part, within the United States.\72\ We then briefly describe how this framework [[Page 47287]] applies to specific types of transactions relevant to the rules we are adopting here.\73\ --------------------------------------------------------------------------- \70\ See id. at 30983. Exchange Act section 30(c) was added to the Act by Title VII and provides, among other things, that ``[n]o provision of [Title VII] . . . shall apply to any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the United States,'' unless that business is transacted in contravention of rules prescribed to prevent evasion of Title VII. See section 30(c) of the Exchange Act, 15 U.S.C. 78dd(c), added by section 772(b) of the Dodd-Frank Act. \71\ See Cross-Border Proposing Release, 78 FR 30984-87. \72\ We also interpret what it means for a person to ``transact a business in security-based swaps without the jurisdiction of the United States'' as set forth in Exchange Act section 30(c). 15 U.S.C. 78dd(c). \73\ The following discussion does not reflect a comprehensive analysis of the full range of transactions that may fall within our territorial approach to application of Title VII or of the full range of substantive requirements to which such transactions may be subject under Title VII. It is important to note that our approach to the application of Title VII security-based swap dealer and major security-based swap participant registration requirements does not limit, alter, or address the cross-border reach or extraterritorial application of any other provisions of the federal securities laws, including Commission rules, regulations, interpretations, or guidance. --------------------------------------------------------------------------- 1. Commenters' Views Prior to our proposal, several commenters raised concerns about the application of Title VII to security-based swap activity in the cross- border context and specifically about the possibility that we would impose Title VII requirements on ``extraterritorial'' conduct. We received only a few comments on this issue in response to our preliminary views set forth in the proposal, and these generally focused on the application of section 30(c) of the Exchange Act to specific types of activity that we proposed to subject to Title VII rather than the proposed territorial framework more broadly. One commenter expressed general agreement with our proposed guidance.\74\ Three commenters suggested that textual differences between section 30(c) of the Exchange Act and section 2(i) of the Commodity Exchange Act (``CEA'') do not require the Commission to take a different approach to application of Title VII to cross-border security-based swap activity from that taken by the CFTC.\75\ Two commenters expressed the view that section 30(c) of the Exchange Act, considered in light of what they described as the risk-based focus of Title VII, prohibited the Commission from imposing Title VII requirements on transactions carried out within the United States but booked in locations outside the United States.\76\ One commenter stated that section 30(c) of the Exchange Act prevents us from imposing Title VII requirements on transactions of guaranteed foreign affiliates of U.S. persons.\77\ One commenter argued that section 30(c) prevents application of Title VII to certain joint ventures.\78\ --------------------------------------------------------------------------- \74\ See BM Letter at 6. \75\ See IIB Letter at 4 (noting, inter alia, that section 712 of the Dodd-Frank Act requires consultation and coordination between the SEC, CFTC, and prudential regulators, and arguing that differences between Exchange Act section 30(c) and CEA section 2(i) do not require the Commission to take an approach to regulation of cross-border security-based swap activity that is ``fundamentally different'' from that taken by the CFTC); SIFMA/FIA/FSR Letter at A- 4 to A-5 (stating that Exchange Act section 30(c) must be read to harmonize with CFTC approach in light of congressional intent that rules be harmonized); FOA Letter at 7 (referring to this element of the SIFMA/FIA/FSR Letter). Section 2(i) of the CEA provides, inter alia, that Title VII requirements will not apply to activities outside the United States unless they ``have a direct and significant connection with activities in, or effect on, commerce of the United States.'' 7 U.S.C. 2(i). The CFTC Cross-Border Guidance was adopted as an interpretation of this provision. See CFTC Cross- Border Guidance, 78 FR 45295. \76\ See SIFMA/FIA/FSR Letter at 4, A-4 to A-6 (acknowledging that proposed application of Title VII to transactions conducted within the United States between two non-U.S. persons is consistent with Commission practice in traditional securities markets but arguing that similar language in sections 30(b) and 30(c) of the Exchange Act should be read differently, given the different nature of security-based swap transactions and focus of Title VII on risk); FOA Letter at 7 (referring to this element of the SIFMA/FIA/FSR Letter). These commenters argue that we should focus on risks to the U.S. financial system and the protection of U.S. counterparties, and that neither concern is raised by transactions between two non-U.S. persons that happen to occur within the United States. See SIFMA/ FIA/FSR Letter at A-5 to A-6. We continue to believe that this argument does not account for the full range of concerns addressed by Title VII, but, as discussed further below, we are not addressing issues surrounding the proposed ``transaction conducted within the United States'' definition in this release. Because, as discussed above, we are not adopting ``transaction conducted within the United States'' as part of the final rule, we anticipate considering these comments in connection with soliciting additional public comment. \77\ See id. at A-11 (stating that a guarantee may not necessarily import risk into the United States and thus creates ``no nexus for purposes of [s]ection 30(c) of the Exchange Act''). \78\ See Mitsubishi UFJ Financial Group (``MUFJ'') Letter at 4-5 (urging the Commission not to require both participants in a foreign joint venture to aggregate the dealing transactions of the joint venture for purposes of the dealer de minimis calculation). --------------------------------------------------------------------------- 2. Scope of Application of Title VII in the Cross-Border Context We continue to believe that a territorial approach to the application of Title VII is appropriate. This approach, properly understood, is grounded in the text of the relevant statutory provisions and is designed to help ensure that our application of the relevant provisions is consistent with the goals that the statute was intended to achieve. (a) Overview and General Approach As in our proposal, our analysis begins with an examination of the text of the statutory provision that imposes the relevant requirement. The statutory language generally identifies the types of conduct that trigger the relevant requirement and, by extension, the focus of the statute.\79\ Once we have identified the activity regulated by the statutory provision, we can determine whether a person is engaged in conduct that the statutory provision regulates and whether this conduct occurs within the United States. When the statutory text does not describe the relevant activity with specificity or provides for further Commission interpretation of statutory terms or requirements, this analysis may require us to identify through interpretation of the statutory text the specific activity that is relevant under the statute or to incorporate prior interpretations of the relevant statutory text.\80\ --------------------------------------------------------------------------- \79\ See Morrison v. National Australia Bank, Ltd., 130 S. Ct. 2869, 2884 (2010) (identifying focus of statutory language to determine what conduct was relevant in determining whether the statute was being applied to domestic conduct). Section 772(b) of the Dodd-Frank Act amends section 30 of the Exchange Act to provide that ``[n]o provision of [Title VII] * * * shall apply to any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the United States,'' unless that business is transacted in contravention of rules prescribed to prevent evasion of Title VII. See section 30(c) of the Exchange Act. As noted above, some commenters suggest that statutory language requiring us to coordinate and consult with the CFTC also requires us to interpret section 30(c) of the Exchange Act in a manner similar to the CFTC's interpretation of CEA section 2(i). See note 75, supra. However, in light of the differences between Exchange Act section 30(c) and CEA section 2(i), we do not find this argument persuasive. As noted above, however, in developing final rules we have carefully considered the CFTC's guidance and the underlying policy rationales, consistent with the statutory requirement that we consult and coordinate with the CFTC. \80\ The Dodd-Frank Act provides that the CFTC and SEC ``shall further define'' several terms, including ``security-based swap dealer'' and ``major security-based swap participant.'' Dodd-Frank Act section 712(d) (emphasis added). The Commissions fulfilled this mandate in the Intermediary Definitions Adopting Release. See Intermediary Definitions Adopting Release, 77 FR 30973. --------------------------------------------------------------------------- As noted above, the Dodd-Frank Act was enacted, in part, with the intent to address the risks to the financial stability of the United States posed by entities engaged in security-based swap activity, to promote transparency in the U.S. financial system, and to protect counterparties to such transactions.\81\ These purposes, considered together with the specific statutory requirement, lead us to conclude that it is appropriate to impose the statutory requirements, and rules or regulations thereunder, on security-based swap activity occurring within the United States even if certain conduct in connection with the security-based swap also occurs in part outside the United States. --------------------------------------------------------------------------- \81\ See e.g., note 11, supra. See also Exchange Act section 15F(h) (establishing business conduct standards for security-based swap dealers and major security-based swap participants). --------------------------------------------------------------------------- Contrary to the views expressed by some commenters,\82\ we do not agree that the location of risk alone should necessarily determine the scope of an appropriate territorial application of [[Page 47288]] every Title VII requirement, given that the definition and the relevant regulatory regime address not only risk but other concerns as well, as just described. For example, neither the statutory definition of ``security-based swap dealer,'' our subsequent further definition of the term pursuant to section 712(d) of the Dodd-Frank Act, nor the regulatory requirements applicable to security-based swap dealers focus solely on risk to the U.S. financial system.\83\ --------------------------------------------------------------------------- \82\ See notes 76-77, supra. \83\ See note 88, infra, and accompanying text (describing elements of statutory definition of ``security-based swap dealer''); note 90, infra, and accompanying text (describing elements of the further definition of ``security-based swap dealer'' adopted by the Commission and the CFTC pursuant to section 712(d) of the Dodd-Frank Act); Exchange Act section 15F(h) (establishing business conduct standards for security-based swap dealers). --------------------------------------------------------------------------- We believe that this approach to territorial application of Title VII provides a reasonable means of helping to ensure that our regulatory framework focuses on security-based swap activity that is most likely to raise the concerns that Congress intended to address in Title VII, including the potential effects of security-based swap activity on U.S. market participants, on the financial stability of the United States, on the transparency of the U.S. financial markets, and on the protection of counterparties.\84\ Persons that engage in relevant conduct, as identified through this analysis, within the United States are not, in our view, ``transact[ing] a business in security-based swaps without the jurisdiction of the United States,'' \85\ and thus are properly subject to regulation under Title VII. --------------------------------------------------------------------------- \84\ See note 11, supra. \85\ Exchange Act section 30(c). --------------------------------------------------------------------------- (b) Territorial Approach to Application of Title VII Security-Based Swap Dealer Registration Requirements In determining whether specific transactions should be included in a person's dealer de minimis calculation, we begin by looking to the statutory text to identify the type of dealing activity that the statute describes as relevant to a person's status as a security-based swap dealer.\86\ Section 3(a)(71) of the Exchange Act \87\ defines security-based swap dealer as a person that engages in any of the following types of activity: --------------------------------------------------------------------------- \86\ See Intermediary Definitions Adopting Release, 77 FR 30616- 30619 (further defining ``security-based swap dealer'' by identifying the types of activities that characterize dealing and that would therefore lead a transaction to be required to be included in a person's de minimis calculation under Exchange Act rule 3a71-2). \87\ 15 U.S.C. 78c(a)(71). --------------------------------------------------------------------------- (i) Holding oneself out as a dealer in security-based swaps, (ii) making a market in security-based swaps, (iii) regularly entering into security-based swaps with counterparties as an ordinary course of business for one's own account, or (iv) engaging in any activity causing oneself to be commonly known in the trade as a dealer in security-based swaps.\88\ --------------------------------------------------------------------------- \88\ Exchange Act section 3(a)(71)(A), 15 U.S.C. 78c(a)(71)(A). --------------------------------------------------------------------------- In accordance with the authority provided by section 712(d)(1) of the Dodd-Frank Act, which provides that the CFTC and the Commission shall by rule further define, among other things, ``security-based swap dealer,'' \89\ we further interpreted the statutory definition by identifying the types of activities that are relevant in determining whether a person is a security-based swap dealer.\90\ Pursuant to this further definition, indicia of security-based swap dealing activity include any of the following activities: --------------------------------------------------------------------------- \89\ See Dodd-Frank Act section 712(d)(1). \90\ See Intermediary Definitions Adopting Release, 77 FR 30617- 18. --------------------------------------------------------------------------- Providing liquidity to market professionals or other persons in connection with security-based swaps; seeking to profit by providing liquidity in connection with security-based swaps, providing advice in connection with security-based swaps or structuring security-based swaps; having a regular clientele and actively soliciting clients; using inter-dealer brokers; and acting as a market maker on an organized security-based swap exchange or trading system.\91\ --------------------------------------------------------------------------- \91\ Id. --------------------------------------------------------------------------- As the foregoing lists illustrate, both the statutory text and our interpretation further defining the statutory term include within the security-based swap dealer definition a range of activities. In the Intermediary Definitions Adopting Release, we stated that transactions arising from dealing activity, as identified by the indicia described above, would generally be subject to relevant Title VII requirements applicable to dealers, including that such transactions be included in a person's calculations for purposes of the dealer de minimis calculations. Our territorial approach applying Title VII to dealing activity similarly looks to whether any of the activities described above occur within the United States, and not simply to the location of the risk, as some commenters suggested is required under section 30(c) of the Exchange Act.\92\ To the extent that such activity does occur within the United States, the person engaged in such activity, in our view, is transacting a business in security-based swaps within the United States,\93\ and therefore applying Title VII to the activity by, among other things, requiring the person to include transactions arising from such activity in its de minimis calculation is consistent with a territorial approach, even if some of this activity (or other activity bearing the indicia of dealing activity) relating to the transaction also occurs outside the United States. --------------------------------------------------------------------------- \92\ See notes 76-77, supra. \93\ Cf. Exchange Act section 30(c) (limiting the application of, among other provisions, Title VII to ``any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the United States''). --------------------------------------------------------------------------- This approach is consistent with the purposes of the dealer definition and the de minimis exception as they relate to dealer regulation under Title VII. The de minimis exception excludes from the dealer registration requirement those entities that may engage in dealing activity but that do so in amounts that may not raise, to a degree that warrants application of security-based swap dealer requirements, the risk, counterparty protection, or other concerns that the dealer registration and regulatory framework were intended to address.\94\ On the other hand, dealing activity, as identified by the types of activities described above, carried out within the United States at levels exceeding the de minimis threshold is likely to raise these concerns, which would be addressed by requiring persons engaged in that volume of dealing activity to register as security-based swap dealers under Title VII and to comply with relevant requirements applicable to security-based swap dealers. Accordingly, to the extent that a person engages in dealing activity within the United States that results in transactions in a notional amount exceeding the applicable de minimis threshold, it is appropriate to require the person to register as a security-based swap dealer. --------------------------------------------------------------------------- \94\ See, e.g., Intermediary Definitions Adopting Release, 77 FR 30629-30 (noting that the de minimis threshold is intended to capture firms that engage in a level of dealing activity that is likely to raise the types of concerns that the dealer regulatory framework is intended to address). --------------------------------------------------------------------------- i. Dealing Activity of U.S. Persons Under the foregoing analysis and consistent with our proposal, when a U.S. person as defined under this final rule \95\ engages in dealing activity, it necessarily engages in such activity within the United States, even when it enters into such transactions through a [[Page 47289]] foreign branch or office. As discussed in further detail below, the definition of ``U.S. person'' in the final rule is intended, in part, to identify those persons for whom it is reasonable to infer that a significant portion of their financial and legal relationships are likely to exist within the United States and that it is therefore reasonable to conclude that risk arising from their security-based swap activities could manifest itself within the United States, regardless of the location of their counterparties, given the ongoing nature of the obligations that result from security-based swap transactions.\96\ --------------------------------------------------------------------------- \95\ See Exchange Act rule 3a71-3(a)(4). \96\ See section IV.C, infra. In our view, dealing activity involving such persons is particularly likely to raise the types of concerns Title VII was intended to address, including those related to risk to the U.S. financial system, transparency of the U.S. financial markets, and customer protection. --------------------------------------------------------------------------- Wherever a U.S. person enters into a transaction in a dealing capacity, it is the U.S. person as a whole that is holding itself out as a dealer in security-based swaps, given that the financial resources of the entire person stand behind any dealing activity of the U.S. person, both at the time it enters into the transaction and for the life of the contract, even when the U.S. person enters into the transaction through a foreign branch or office. Moreover, the U.S. person as a whole seeks to profit by providing liquidity and engaging in market-making in security-based swaps, and the financial resources of the entire person enable it to provide liquidity and engage in market-making in connection with security-based swaps. Its dealing counterparties will look to the entire U.S. person, even when the U.S. person enters into the transaction through a foreign branch or office, for performance on the transaction. The entire U.S. person assumes, and stands behind, the obligations arising from the resulting agreement and is directly exposed to liability arising from non-performance of the non-U.S. person.\97\ --------------------------------------------------------------------------- \97\ Cf. SIFMA/FIA/FSR Letter at 4, A-5 (stating that main purpose of Title VII is to address risk arising from security-based swap activity). --------------------------------------------------------------------------- For these reasons, in our view a person does not hold itself out as a security-based swap dealer as anything other than a single person even when it enters into transactions through its foreign branch or office.\98\ Because the foreign branch generally could not operate as a dealer absent the financial and other resources of the entire U.S. person, its dealing activity with all of its counterparties, including dealing activity conducted through its foreign branch or office, is best characterized as occurring, at least in part, within the United States and should therefore be included in the person's de minimis threshold calculation.\99\ --------------------------------------------------------------------------- \98\ This is consistent with the view expressed in our proposing release. See Cross-Border Proposing Release, 78 FR 30985. \99\ As discussed in further detail below, this interpretation is consistent with the goals of dealer regulation under Title VII. Security-based swap activity that results in a transaction involving a U.S.-person counterparty creates ongoing obligations that are borne by a U.S. person and, as such, is properly viewed as occurring within the United States. See note 186, infra. --------------------------------------------------------------------------- ii. Dealing Transactions of Non-U.S. Persons That Are Subject to Recourse Guarantees by Their U.S. Affiliates In the proposing release, we explained that we preliminarily believed that a territorial approach consistent with the text and purposes of the Dodd-Frank Act encompasses transactions involving a non-U.S. person counterparty whose dealing activity is guaranteed by a U.S. person.\100\ However, because we proposed to treat non-U.S. persons receiving a guarantee on their security-based swap transactions from a U.S. person like any other non-U.S. person for purposes of the de minimis exception (i.e., requiring them to include in their calculations only dealing activity involving U.S.-person counterparties or transactions conducted within the United States), we did not elaborate specifically on how the presence of a guarantee related to a territorial application of the dealer definition, including the de minimis exception. Because our final rule requires transactions of non- U.S. persons whose obligations under the security-based swap are subject to recourse guarantees enforceable against their U.S. affiliates to be included in the dealer de minimis calculation of the non-U.S. person, we address it here. --------------------------------------------------------------------------- \100\ In our proposal, we noted that in a security-based swap transaction between two non-U.S. persons where the performance of at least one side of the transaction is guaranteed by a U.S. person, the guarantee gives the guaranteed person's counterparty recourse to the U.S. person for performance of obligations owed by the guaranteed person under the security-based swap, and the U.S. guarantor exposes itself to the risk of the security-based swap as if it were a counterparty to the security-based swap through the security-based swap activity engaged in by the guaranteed person. See Cross-Border Proposing Release, 78 FR 30986-87. This interpretation of guarantee was consistent with our discussion of the application of the major participant tests to guaranteed positions in the Intermediary Definitions Adopting Release, where we, together with the CFTC, noted that a person's security-based swap positions are attributed to a parent, other affiliate, or guarantor for purposes of the major participant analysis to the extent that the counterparties to those positions have recourse to that parent, other affiliate, or guarantor in connection with the position; as we noted in that release, positions are not attributed in the absence of recourse. See Intermediary Definitions Adopting Release, 77 FR 30689. In this release, we continue to use the term ``guarantee'' to refer to an arrangement pursuant to which one party to a security-based swap transaction has recourse to its counterparty's parent, other affiliate, or guarantor with respect to the counterparty's obligations owed under the transaction. See section IV.E.1(b), infra. --------------------------------------------------------------------------- In our view, a non-U.S. person engaged in dealing activity, to the extent that one or more transactions arising from such activity are guaranteed by a U.S. person, is engaged in relevant activity for purposes of the security-based swap dealer definition within the United States, with respect to those transactions. By virtue of the guarantee, the non-U.S. person effectively acts together with the U.S. person to engage in the dealing activity that results in the transactions, and the non-U.S. person's dealing activity with respect to such transactions cannot reasonably be isolated from the U.S. person's activity in providing the guarantee. The U.S.-person guarantor together with the non-U.S. person whose dealing activity it guarantees, and not just the non-U.S. person, may seek to profit by providing liquidity and engaging in market-making in security-based swaps, and the non-U.S. person provides liquidity and engages in market-making in connection with security-based swaps by drawing on the U.S. person's financial resources.\101\ The non-U.S. person's counterparty, pursuant to the recourse guarantee, looks to both the non-U.S. person and its U.S. guarantor, which is responsible for performance on the transaction that is part of the non-U.S. person's dealing activity. In sum, the non-U.S. person is engaged in the United States in relevant dealing activity identified in the statutory definition and in our jointly adopted further definition of ``security-based swap dealer.'' --------------------------------------------------------------------------- \101\ Even if the U.S. guarantor generally does not hold itself out as a dealer or make a market in security-based swaps, the U.S. guarantor enables the non-U.S. person whose dealing activity it guarantees to engage in dealing activity by providing financial backing. We note that references to ``guarantee,'' ``recourse guarantee,'' or ``rights of recourse,'' as those terms are used in this release, may describe economic relationships that are different from ``guarantee'' under section 2(a)(1) of the Securities Act. We note, however, that, depending on the nature of the ``guarantee,'' ``recourse guarantee,'' or ``rights of recourse'' provided by the guarantor, the transaction at issue may involve not only a security- based swap between two non-U.S. persons but also the offer and sale of a security by a U.S. person, given that a ``guarantee'' of a security-based swap is itself a separate security issued by the U.S. guarantor. See, e.g., Securities Act section 2(a)(1), 15 U.S.C. 77b(a)(1) (including in the statutory definition of ``security'' a guarantee of a security). --------------------------------------------------------------------------- Moreover, the economic reality of the non-U.S. person's dealing activity, where the resulting transactions are guaranteed by a U.S. person, is identical, in relevant respects, to a transaction entered into directly by the [[Page 47290]] U.S. guarantor. By virtue of the guarantee, transactions arising from the non-U.S. person's dealing activity result in risk from the transaction being borne by a U.S. person (the guarantor, which is responsible for the transactions it guarantees in a manner similar to a direct counterparty to the transactions) and potentially the U.S. financial system in a manner similar to a dealing transaction entered into directly by a U.S. person. As with transactions entered into directly by a U.S. person, transactions for which a counterparty has a right of recourse against a U.S. person create risk to a U.S. person and potentially the U.S. financial system regardless of the location of the counterparty. Our interpretation of the statutory text of the definition, as well as our further definition of the term, as it applies to these entities is consistent with the purposes of Title VII, as discussed above. The exposure of the U.S. guarantor creates risk to U.S. persons and potentially to the U.S. financial system via the guarantor to a comparable degree as if the transaction were entered into directly by a U.S. person. We understand that in some circumstances a counterparty may choose not to enter into a security-based swap transaction (or may not do so on the same terms) with a non-U.S. subsidiary of a U.S. person when that non-U.S. subsidiary is acting in a dealing capacity to the extent that its dealing activity is not subject to a recourse guarantee by a U.S. affiliate, absent other circumstances (e.g., adequate capitalization of the hitherto-guaranteed affiliate). One commenter noted that U.S. guarantors may provide guarantees for a variety of reasons, including to satisfy regulatory requirements, to ``manage capital treatment across an entity,'' and to ``avoid negative credit rating consequences,'' and argued that a guarantee may therefore not create risk within the United States.\102\ Absent the creation of such risk, this commenter further argued that a guarantee creates ``no nexus for purposes of section 30(c) of the Exchange Act.'' \103\ However, regardless of the motivation for providing the guarantee, the non-U.S. person's dealing activity still occurs within the United States and creates risk within the United States in the manner described above. The commenter provided no evidence that the motivation for providing a guarantee affects this analysis: It neither alters the risk created within the United States by such a guarantee when it is provided by a U.S. person nor affects the economic reality of the transaction. Moreover, even if a person provides guarantees not in response to counterparty demands but to satisfy regulatory requirements or to avoid negative credit rating consequences, the very reasons for issuing the guarantee suggest that the non-U.S. person would not be able to engage in dealing activity, or to do so on the same terms, without the guarantee.\104\ --------------------------------------------------------------------------- \102\ SIFMA/FIA/FSR Letter at A-11. \103\ Id. \104\ In addition, this commenter suggested that any risk created by guarantees provided to prudentially regulated foreign entities is adequately addressed by the foreign prudential regulation. See id. Although we recognize that foreign prudential regulation may reduce the risk that a guaranteed foreign affiliate's counterparties will seek to enforce the terms of the guarantee against the U.S. guarantor (depending on the quality of prudential regulation in the foreign jurisdiction), it does not eliminate this risk, and the counterparty continues to retain a right of recourse under the guarantee against the guarantor. Given the role of a foreign person whose activity is guaranteed in creating risk within the United States through its dealing activity, we believe that it is important to ensure that such a foreign person be required to register as a security-based swap dealer to the extent that its guaranteed dealing transactions (together with any dealing transactions with U.S. persons) are included in its de minimis threshold calculations. As noted above, our proposal set forth a framework under which substituted compliance potentially would be available for certain Title VII requirements, including for dealer-specific requirements such as capital and margin, which should mitigate concerns about overlapping regulation of such entities. --------------------------------------------------------------------------- In sum, the guarantee provided by a U.S. person poses risk to U.S. persons and potentially to the U.S. financial system, and both the non- U.S. person whose dealing activity is guaranteed and its counterparty rely on the creditworthiness of the U.S. guarantor when entering into a security-based swap transaction and for the duration of the security- based swap. The economic reality of this transaction, even though entered into by a non-U.S. person, is substantially identical, in relevant respects, to a transaction entered into directly by a U.S. person. Accordingly, in our view, it is consistent with both the statutory text and with the purposes of the statute to identify such transactions as occurring within the United States for purposes of Title VII. iii. Dealing Activity of Other Non-U.S. Persons In our proposal, we stated that non-U.S. persons engaging in dealing activity would be required to count toward their de minimis thresholds only transactions arising from their dealing activity with U.S. persons or dealing activity otherwise conducted within the United States. Under the approach described above, and consistent with our proposal, we believe that a non-U.S. person engaged in dealing activity with U.S. persons engages in relevant activity for purposes of the security-based swap dealer definition within the United States.\105\ --------------------------------------------------------------------------- \105\ We continue to believe that security-based swap activity carried out within the United States may also be relevant activity under our territorial approach, even if the resulting transaction involves two non-U.S. counterparties. As discussed below, however, we anticipate soliciting additional public comment regarding the issue. --------------------------------------------------------------------------- Dealing activity of non-U.S. persons that involves counterparties who are U.S. persons, as that term is defined in the final rule, necessarily involves the performance by the non-U.S. person of relevant activity under the ``security-based swap dealer'' definition at least in part within the United States. For example, in our view, a non-U.S. person engaging in dealing activity with a U.S. person is holding itself out as a dealer in security-based swaps within the United States.\106\ Similarly, by entering into a transaction with a U.S. person in a dealing capacity, it is seeking to profit by providing liquidity within the United States and possibly engaging in market- making in security-based swaps within the United States, given that its decision to engage in dealing activity with U.S. persons, as defined by the rule, affects the liquidity of the security-based swap market within the United States. Particularly at volumes in excess of the de minimis threshold, entering into security-based swap transactions in a dealing capacity with U.S. persons likely is the type of activity that would cause a non-U.S. person ``to be commonly known in the trade as a dealer in security-based swaps'' \107\ within the United States, that constitutes ``regularly entering into security-based swaps with counterparties as an ordinary course of business for one's own account'' \108\ within the United States, and that permits a reasonable inference that it has a regular clientele and actively solicits clients within the United [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3AR1-2014-15337. Public record. Not legal advice.