SEC's New Proposed Rules On Security-Based Swaps

by Glen Shapiro, LawAndTax-News.com, New York

18 October 2010

The United States’ Securities and Exchange Commission (SEC) has considered three sets of rules related to the Dodd-Frank Wall Street Reform and Consumer Protection Act and concerning security-based swaps and the asset-backed securities (ABS) market.

Prior to passage of the Dodd-Frank Act, the SEC said that the over-the-counter derivatives market was largely unregulated. The new rules are aimed at filling in a number of significant regulatory gaps and giving the SEC important new tools to better protect investors.

Firstly, the SEC has adopted an interim rule that requires certain swaps dealers and other parties to report security-based swap information to the SEC or to a registered security-based swap data repository. Parties also are required to preserve data pertaining to the terms of security-based swaps in support of the reporting requirements.

"This interim final rule provides a means for the Commission to gain a better understanding of the security-based swap markets, including their size and scope," said SEC Chairman Mary L. Schapiro. "Until such time as final rules are adopted, this interim rule clarifies who needs to do security-based swaps reporting, what needs to be reported, and when such reporting needs to occur."

Secondly, the SEC is consulting on proposed rules which are intended to mitigate conflicts of interest for security-based swap clearing agencies, security-based swap execution facilities (SEFs) and national securities exchanges that post security-based swaps or make them available for trading.

The SEC's proposed rules - known as Proposed Regulation MC - require security-based swap clearing agencies, security-based SEFs and security-based swap exchanges to adopt ownership and voting limitations, as well as certain governance requirements. Recently, it noted that the Commodity Futures Trading Commission had proposed similar rules with respect to derivatives clearing organizations.

The SEC pointed out that five large banks currently represent 97% of the total US banking industry’s notional amounts of derivatives outstanding, and this concentrated market structure creates the potential for conflicts of interests if a similarly small number of firms are able to control the trading and clearing venues for the security-based swaps market.

It proposes, therefore, that security-based SEFs and security-based swap exchanges should restrict participants or members, as applicable, from owning or holding more than 20% of any voting interest of such an entity.

"The concern about conflicts of interest stems from the fact that the over-the-counter derivatives markets have a relatively high concentration of market activity through a limited number of dealers who earn significant revenues from their transactions," said Schapiro. "By creating a structure that would promote more independent voices within clearing organizations and trading venues, this proposed rule is intended to make these entities less susceptible to promoting the interests of a few participants."

And, finally, the SEC is consulting on a proposal to enhance disclosure to investors in the ABS market. The SEC’s proposed rules require issuers of ABS to perform a review of the assets underlying the securities and publicly disclose information relating to the review.

The proposal requires an issuer or underwriter of ABS to make publicly available the findings and conclusions of any third-party due diligence report. The SEC has also requested for comment on whether it should set a minimum review standard, including possible standards that could be included in a final rule.

“This marks the third Commission proposal to address the ABS issues that came to light during the financial crisis,” said Schapiro. “This proposal will require issuers to provide investors with better information about the loans backing the asset-backed securities.”

In addition to the current proposal, the SEC recently proposed regulations to require issuers of ABS - and credit rating agencies that rate ABS - to provide investors with new disclosures about representations, warranties, and enforcement mechanisms. And, last April, it proposed rules that would revise the disclosure, reporting and offering process for ABS.

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