Daily Rules, Proposed Rules, and Notices of the Federal Government
The Commission is hereby adopting § 23.500 through § 23.505
The final rules adopted herein were proposed in three separate notices of proposed rulemaking.
The Chairman and Commissioners, as well as Commission staff, participated in numerous meetings with representatives of potential SDs and MSPs, trade associations, public interest groups, traders, and other interested parties. In addition, the Commission has consulted with other U.S. financial regulators including: (i) The Securities and Exchange Commission (SEC); (ii) the Board of Governors of the Federal Reserve System; (iii) the Office of the Comptroller of the Currency; and (iv) the Federal Deposit Insurance Corporation. Staff from each of these agencies has had the opportunity to provide oral and/or written comments to this adopting release, and the final regulations incorporate elements of the comments provided.
The Commission is mindful of the benefits of harmonizing its regulatory framework with that of its counterparts in foreign countries. The Commission has therefore monitored global advisory, legislative, and regulatory proposals, and has consulted with foreign regulators in developing the final regulations. Specifically, Commission staff has consulted with the European Securities and Markets Authority (ESMA), which has recently released a consultation paper for the regulation of OTC derivatives containing draft technical standards that are substantially similar to some of the rules adopted by the Commission in this release, as further noted below.
Several commenters raised general concerns with the legal authority for or structure of the proposed rules, or their possible effect on existing transactions.
The Working Group of Commercial Energy Firms (The Working Group)
The Commission notes that section 731 of the Dodd-Frank Act added a new section 4s(i) to the CEA that states that each registered SD and MSP shall conform with such standards as may be prescribed by the Commission by rule or regulation that relate to timely and accurate confirmation, processing, netting, documentation, and valuation of all swaps. Section 4s(i) also states that the Commission shall adopt rules governing documentation standards for SDs and MSPs.
Swaps and swap trading relationship documentation are contractual arrangements that necessarily involve more than a single party. The Commission believes that the statutory requirement that the Commission adopt rules governing documentation standards relating to confirmation, processing, netting, documentation, and valuation of
In response to a request for comment in the Documentation NPRM asking how long SDs and MSPs should have to bring existing swap documentation into compliance with the proposed rules and whether a safe harbor should be provided for dormant trade documentation, the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA), in a joint comment letter (ISDA & SIFMA), strongly urged the Commission to specify that only new transactions entered into after the effective date of the rules are subject to the rules' requirements, and that it is not mandatory to amend terms or agreements that apply to transactions entered into prior to such date. ISDA & SIFMA further argued that Commission rules relating to business conduct, the confirmation process, confidentiality and privacy, collateral segregation requirements, and margin and capital may all directly or indirectly require registrants to make amendments to existing relationship documentation, and that it would be extremely inefficient, time consuming and costly for registrants to engage in separate rounds of amendments with their trading counterparties for each set of Dodd-Frank Act rulemakings. ISDA & SIFMA recommended that registrants be permitted to develop plans to update their agreements in an integrated manner for the full range of Dodd-Frank Act requirements, and implementation timelines should reflect the requirements of such an approach, keeping in mind that those requirements will not be known until the scope and terms of all of the relevant Commission regulations (and those of the SEC) are more clearly delineated.
The Working Group and the Financial Services Roundtable (FSR) also urged the Commission to apply the rules to new swaps only, arguing that renegotiation of existing documentation would take significantly longer than six months; may be impossible in some cases; and is not a good use of limited resources of market participants that will already be taxed with the necessary changes mandated by the Dodd-Frank Act and the Commission's other rules. Likewise, the Coalition for Derivatives End-Users urged the Commission to exempt trades entered into before the enactment of the Dodd-Frank Act from the requirements of the rules and the Managed Funds Association (MFA) strongly objected to the Commission applying any of these requirements to existing contracts. MFA argued that section 739(5) of the Dodd-Frank Act specifically provides that the Dodd-Frank Act shall not constitute a “regulatory change, or similar event * * * that would permit a party to terminate, renegotiate, modify, amend, or supplement one or more transactions under the swap.” MFA believes that imposing these requirements on existing agreements would clearly require that existing agreements be “renegotiated.”
The Federal Home Loan Banks (FHLBs) noted on the other hand that netting of pre-existing transactions with new transactions is critical to efficient hedging, and thus documentation for pre-existing swaps will need to be modified to maintain the benefits of netting.
Having considered these comments, the Commission agrees with commenters that the rules should not apply retrospectively and will require compliance with the rules only with respect to swaps entered after the date on which compliance with the rules is required, as discussed below. With respect to the comment of the FHLBs, the Commission notes that the rules would not prohibit parties from arranging their documentation to maintain the benefits of netting between pre-existing swaps and swaps entered after the date compliance with the rules is required if they so choose. In addition, with regard to ISDA & SIFMA's argument that swap trading documentation would need to be amended when rules relating to segregation and margin are finalized, the Commission observes that those rules are likely to provide for additional time for documentation to be brought into compliance.
With respect to the validity of transactions where the parties fail to comply with the rules, The Working Group argued that for the sake of legal certainty, a failure to comply with the proposed rules should not result in invalidation of swaps entered into under deficient swap trading relationship documentation. The Coalition of Physical Energy Companies (COPE) recommended that the Commission make clear that section 739 of the Dodd-Frank Act, regarding legal certainty, applies to the proposed regulations so that SD or MSP noncompliance with the rules will not otherwise affect the enforceability of a swap. MFA and the International Energy Credit Association (IECA) also believe that it is imperative that the Commission affirmatively clarify that defects in required regulatory documentation do not render a contract void or voidable by one of the parties or constitute a breach of the swap documentation. IECA added that a party should not have a private right of action with respect to documentation that does not comply with the rules. IECA further requested that the Commission add specific language to proposed § 23.504. The FHLBs made the same argument as IECA, adding that the Commission can enforce the provisions through penalties for SDs and MSPs.
Upon consideration of these comments, the Commission is clarifying that it is not the intent of the rules to provide swap counterparties with a
Several commenters requested that the Commission clarify the standing under the rules of the ISDA Master Agreement and Credit Support Annex (the ISDA Agreements), which are prevalent in the swaps market. Specifically, ISDA & SIFMA commented that the proposed rules could create uncertainty as to the level of documentation required because the proposed rules require that “all terms” governing the swap trading relationship be documented. ISDA & SIFMA thus requested that the Commission acknowledge the general adequacy of the ISDA Agreements for purposes of the rule to enhance legal certainty and market stability. Similarly, COPE argued that many end users have already negotiated existing documentation under the ISDA architecture and thus requested that the Commission make clear that: (1) ISDA Agreements or any substantially similar master agreements satisfy the documentation requirements of the final rules; (2) in accordance with the ISDA Agreements and applicable state law, swaps are binding when made orally; and (3) long-form confirmations that contain all requisite legal terms to establish a binding agreement also satisfy the requirements of the rules. IECA also recommended that the Commission expressly state that the ISDA Agreements satisfy the documentation requirements of the final rules or state how the ISDA Agreements are deficient to eliminate any confusion. Finally, the Coalition for Derivatives End-Users argued that, given that the ISDA Agreements are used by nearly all end users and that such documentation substantially complies with the proposed rules, the Commission should expressly state that the ISDA Agreements satisfy the documentation requirements of the rules.
On the other hand, the Committee on the Investment of Employee Benefit Assets (CIEBA) anticipates that ISDA may initiate a uniform protocol to conform existing ISDA Agreements to the requirements of the rules. In this regard, CIEBA stated that ISDA protocols, which in the past have typically been developed by dealer-dominated ISDA committees, are not form documents that can be revised by the parties. Rather, CIEBA argues, end users may only adopt these protocols on a “take it or leave it” basis, which may not be in their best interests. Accordingly, CIEBA recommended that the Commission not, either explicitly or implicitly, require market participants to consent to ISDA protocols in order to comply with the Dodd-Frank Act or the Commission's regulations.
The Commission notes that many comments received with respect to this and other rulemakings stated that swaps are privately negotiated bilateral contracts. Although the Commission recognizes that the ISDA Agreements in their pre-printed form as published by ISDA are capable of compliance with the rules, such agreements are subject to customization by counterparties. In addition, the Commission notes that while the pre-printed form of the ISDA Master Agreement is capable of addressing the requirements of proposed § 23.504(b)(1), it is not possible to determine if the pre-printed form of the ISDA Credit Support Annex will comply with proposed § 23.504(b)(3), because that section requires that the documentation include credit support arrangements that comply with the Commission's rules regarding initial and variation margin and custodial arrangements, which have been proposed but not yet finalized. Further, the Commission does not believe that the standard ISDA Agreements address the swap valuation requirements of § 23.504(b)(4), the orderly liquidation termination provisions of § 23.504(b)(5), or the clearing records required by § 23.504(b)(6). Given the foregoing, the Commission declines to endorse the ISDA Agreements as meeting the requirements of the rules in all instances.
The proposed regulations did not differentiate between SDs and MSPs, but, rather, applied identical rules to both types of entities. In this regard, BlackRock commented that MSPs are buy-side entities, yet many of the proposed documentation standards are designed to regulate dealing activity. BlackRock believes these requirements should not apply to MSPs because they are unnecessary and will cause both MSPs and the Commission to use resources inefficiently.
The Commission is not modifying the regulations to differentiate between SDs and MSPs. The Commission observes that section 4s(i) of the CEA, as added by the Dodd-Frank Act, does not differentiate between SDs and MSPs. The Commission thus has determined that the intent of section 4s(i) is to apply the same requirements to MSPs and SDs, and the Commission is taking the same approach in the final regulations.
Section 4s(i)(1) requires swap dealers and major swap participants to “conform with such standards as may be prescribed by the Commission by rule or regulation that relate to timely and accurate confirmation, processing, netting, documentation, and valuation of all swaps.” Under section 4s(i)(2), the Commission is required to adopt rules “governing documentation standards for swap dealers and major swap participants.”
OTC derivatives market participants typically have relied on the use of industry standard legal documentation, including master netting agreements, definitions, schedules, and confirmations, to document their swap trading relationships. This industry standard documentation, such as the widely used ISDA Master Agreement and related definitions, schedules, and confirmations specific to particular asset classes, offers a framework for documenting the transactions between counterparties for OTC derivatives products.
To promote the “timely and accurate * * * documentation * * * of all swaps” under section 4s(i)(1) of the CEA, in the Documentation NPRM, the Commission proposed § 23.504(a), which required that swap dealers and major swap participants establish,
In response to a request for comment in the Documentation NPRM regarding whether proposed § 23.504 should include a safe harbor for swaps entered into on, or subject to the rules of, a board of trade designated as a contract market, ISDA & SIFMA, as well as the American Benefits Counsel and the Committee on Investment of Employee Benefit Assets (jointly, ABC & CIEBA), recommended that the Commission provide such a safe harbor for swaps executed on a swap execution facility (SEF) or designated contract market (DCM). ISDA & SIFMA commented that the safe harbor is especially needed for those transactions where the SD or MSP will not know the identity of its counterparty until just before or after execution. ISDA & SIFMA also urged the Commission to clarify that the term “swap trading relationship documentation” is used to describe only bilateral documentation between parties to uncleared swaps. MFA also recommended that the Commission clarify that exchange traded or cleared swaps, which will be subject to standard contract terms, are not subject to the documentation rules. The Working Group commented that the swap trading relationship requirement in § 23.504(a) includes a carve-out for swaps cleared with a DCO, but § 23.504(b)(6) includes express requirements for the swap trading relationship documentation with respect to cleared swaps. Given the apparent contradiction, The Working Group requested that the Commission clarify whether the other requirements of § 23.504 apply to swaps that are intended to be cleared contemporaneously with execution or that are executed on a SEF or DCM.
In response to The Working Group's comment expressing confusion about whether § 23.504 applies to swaps that are cleared by a DCO and to ISDA & SIFMA's comment regarding applicability to cleared swaps, as well as the applicability to pre-existing swaps per the discussion above, the Commission is modifying § 23.504 to clarify the overall applicability of the rule by adding a new paragraph (a)(1) as set forth in the regulatory text of this rule.
This revision clarifies the circumstances under which the rule applies. The proviso in § 23.504(a)(1)(ii) would achieve the rule's goal of avoiding differences between the terms of a swap as carried at the DCO level and at the clearing member level, which could compromise the benefits of clearing. Any such differences raise both customer protection and systemic risk concerns. From a customer protection standpoint, if the terms of the swap at the customer level differ from those at the clearing level, then the customer will not receive the full transparency and liquidity benefits of clearing, and legal and basis risk will be introduced into the customer position. Similarly, from a systemic perspective, any differences could diminish overall price discovery and liquidity and increase uncertainties and unnecessary costs into the insolvency resolution process. The cross reference to § 39.12(b)(6) imports the specific requirements that had been included in proposed § 23.504(b)(6)(v). See below for a more complete discussion of § 23.504(b)(6).
In response to the comment from ISDA & SIFMA, the Commission clarifies that swaps executed anonymously on a SEF or traded on a DCM prior to clearing by a DCO are not subject to the requirements of § 23.504. For those swaps that are not executed anonymously, the swap trading relationship documentation requirements of § 23.504 would apply.
Proposed § 23.504(b) required that all terms governing the trading relationship between an SD or MSP and its counterparty be documented in writing. Proposed § 23.504(a) required that SDs and MSPs establish policies and procedures reasonably designed to ensure that the required swap trading relationship documentation be executed prior to or contemporaneously with entering into a swap transaction with any counterparty. The Commission notes the industry practice whereby counterparties enter into a “long-form confirmation” after execution of transaction, where the long-form confirmation contains both the terms of the transaction and many, if not all, terms usually documented in a master agreement until such time as a complete master agreement is negotiated and executed.
The Office of the Comptroller of the Currency (OCC) commented that the proposed rule may require master agreements between all counterparties even if a “long-form” confirmation would sufficiently address legal risks, creating a significant expense and burden for end users. Similarly, IECA commented that long form confirmations that incorporate the terms of a standard master agreement are useful for certain new transaction relationships. In this respect, IECA recommends that § 23.504(b)(1) be modified to make clear that terms can be incorporated by reference.
In response to these comments, the Commission has determined that so long as a “long-form” confirmation includes all terms of the trading relationship documented in writing prior to or contemporaneously with the assumption of risk arising from swap transactions, the “long-form” confirmation would comply with the rules. However, the Commission is not modifying the rule to permit execution of a long-form confirmation subsequent to the execution of a swap transaction, which the Commission believes results in some period, however short, in which the terms of the trading relationship between the parties are not in written form. In response to the comment of IECA, the rule does not prohibit incorporation of terms by reference. Thus, so long as the terms incorporated by reference are in written form, the documentation would be in compliance with the rule.
Proposed § 23.504(b)(2) states that swap trading relationship documentation includes transaction confirmations. Proposed § 23.504(a) requires swap trading relationship documentation to be executed prior to or contemporaneously with entering into any swap with a counterparty. However, proposed § 23.501 provides for specific post-execution time periods for confirming swaps. This apparent contradiction was identified by a number of commenters.
In order to reconcile the apparent contradiction, ISDA & SIFMA recommended that confirmations be excluded from swap trading relationship documentation and be treated solely in § 23.501. MFA also recommended that confirmations be treated solely in § 23.501, noting that if forced to choose between quick execution and the negotiation of all
IECA noted that many short term transactions are executed orally and often documented by recording, ending before a written confirmation can be completed. IECA also stated that if all confirmations must be in writing, the additional employee time cost for each market participant would be substantial and is not included in the annual cost analysis. The Working Group also commented that in some instances, it may take longer to negotiate a written confirmation for a swap or complete the necessary mid- and back-office processes than the planned duration of the swap at issue. IECA recommended that proposed § 23.504(b)(2) be modified by adding at the end, “which confirmations need not be in writing.”
MetLife commented that the requirement to document “all” terms of a trading relationship is overly burdensome. MetLife believes the documentation subject to regulation should be clarified to mean two sets of documents: A master agreement, credit support arrangement and master confirmation agreement and second, transaction specific confirmations. The confirmations can include any trade specific terms including specific valuation methodologies or inputs not already contained in the master documentation. Differentiation would assist with clarity for policies and procedures and with the audit requirements.
The Coalition for Derivatives End-Users and The Working Group commented that the rule may require pre-trade negotiation and disadvantage the party that is most sensitive to the timing of the swap in such negotiations. The Working Group believes such party may have to accept less than favorable terms in order to execute within its desired time frame, and that the rule would make it very difficult for parties to enter into short-term swaps. The Coalition for Derivatives End-Users point out that end-users often trade by auction and given the low probability of winning, SDs will not want to incur the expense of negotiating documents in advance. The Coalition for Derivatives End-Users also point out that even where established relationships exist, newly formed affiliates may trade based on existing expectations, but without the documents fully executed.
On the other hand, CIEBA commended the Commission for including all terms in swap trading relationship documentation. CIEBA believes this approach will minimize the potential for disputes over swap terms during the confirmation process caused by the introduction of new “standard” terms after the swap is executed, which CIEBA stated is a frequent occurrence. CIEBA recommended that the Commission confirm in its final rules that the requirement that documentation “shall include all terms governing the trading relationship between the swap dealer or major swap participant and its counterparty” would require all terms to be in writing prior to or at the time of entering into the swap transaction, except for terms such as price, quantity and tenor, that are customarily agreed to contemporaneously with entering into a swap transaction. CIEBA recommended that the rule require these remaining terms to be documented in writing contemporaneously with entering into the swap transaction.
Having considered these comments, the Commission has determined that proposed § 23.504(a) should be clarified with respect to the inclusion of swap confirmations in swap trading relationship documentation. The Commission is therefore modifying the proposed rule to make clear that the timing of confirmations of swap transactions is subject to § 23.501, and that swap trading relationship documentation other than confirmations of swap transactions is required to be executed prior to or contemporaneously with entering into any swap transaction.
The Commission does not, however, agree with commenters suggesting that terms governing a swap or a trading relationship need not be in writing. The Commission recognizes that binding swap contracts may be created orally under applicable law and the rule does not affect parties' ability to enforce such contracts. However, an orderly swap market and the goal of reducing operational risk require that such oral contracts be appropriately documented as soon as possible. In response to the comments of CIEBA, the Commission believes the modifications to the confirmation time periods in § 23.501 discussed below adequately address CIEBA's concerns. Given the foregoing, the Commission is modifying proposed § 23.504(a) to read as set forth in the regulatory text of this rule
The proposed regulations did not include an exemption or different rules for documenting swap trading relationships between affiliates. Shell Energy North America (Shell) commented that an end user trading with an affiliated SD/MSP does not have valuation, trade, and documentation risks that nonaffiliated entities may have, that such transactions only allocate risk within the legal entity, and, accordingly, affiliate transactions should be exempted from the documentation rules.
The Commission is not persuaded that the risk of undocumented (and therefore objectively indiscernible) terms governing swaps is obviated because the trading relationship is with an affiliate. The Commission has regulatory interests in knowing or being able to discover the full extent of a registered SD's or MSP's risk exposure, whether to external or affiliated counterparties, and is not modifying the rule in response to this comment. The Commission observes that to the extent certain risks are not present in affiliate trading relationships, the documentation of the terms related to such risks should be non-controversial and easily accomplished. For example, because affiliates are generally under common control, the documentation of an agreement on valuation methodologies should not require extensive negotiation as it may between non-affiliated counterparties.
Proposed § 23.504(a) required that each SD and MSP establish, maintain, and enforce policies and procedures designed to ensure that prior to or contemporaneously with entering into a swap transaction, it executes swap trading relationship documentation that complies with the rules.
CEIBA questions what is intended by the requirement for SDs and MSPs to “enforce policies and procedures” in § 23.504(a). CEIBA believes the use of the term “enforce” with respect to SDs' and MSPs' procedures is contrary to the Dodd-Frank Act, because it implies that such procedures have the force of law and can be imposed on counterparties absent mutual agreement. CIEBA recommended that the word “enforce” should be deleted.
Having considered this comment, the Commission is modifying the proposed rule by replacing the term “enforce” with the term “follow.” The intent of the term “enforce” in the proposed rule was to require SDs and MSPs to in fact follow the policies and procedures established to meet the requirements of the proposed rule, rather than to enforce
In the Documentation NPRM, the Commission asked whether the proposed rules should specifically delineate the types of payment obligation terms that must be included in the trading relationship documentation.
CIEBA commented that the Commission need not dictate every term that must appear in swap trading relationship documentation, and that it is important to defined benefit plans to be able to negotiate payment obligation terms in their documentation.
The Commission agrees with CIEBA on this issue and has not modified the rule to further define the types of payment obligation terms required to be specified in swap trading relationship documentation.
In the Documentation NPRM, the Commission asked whether the requirement for agreement on events of default or termination events should be further defined, such as adding provisions related to cross default.
The Coalition for Derivatives End-Users commented that the ISDA documentation sufficiently addresses these issues and that parties should be allowed to negotiate these terms bilaterally so the Commission need not further define such terms. CIEBA agreed that parties should be allowed to negotiate these terms bilaterally so the Commission need not further define such terms.
The Commission agrees with the commenters on this point and has not modified the rule to further define the types of events of defaults and termination events required to be specified in swap trading relationship documentation.
Proposed § 23.504(a) required SDs' and MSPs' documentation policies and procedures to be approved in writing by senior management of the SD or MSP.
The Working Group raised a concern that this requirement will be used to the negotiating advantage by SDs and MSPs who will claim that the form of documentation had been approved for regulatory purposes and cannot be changed without a prohibitively lengthy internal approval process. In addition, The Working Group argued that rigid documentation standards that must be approved by senior management could severely limit the flexibility of SDs, ending the ability of end users to obtain customized swaps in a timely manner. The Working Group recommended that the Commission allow current practice to continue where trading managers can authorize deviations from standard trade documentation so long as such amendment does not violate the overarching policies and procedures set by internal management authorized by the governing body.
MFA similarly commented that the senior management approval requirement, together with the cumulative effect of the proscriptive documentation rules, may lead to the institutionalization of the terms favored by SDs and MSPs. As a result, MFA is concerned that SDs and MSPs will compel their customers to accept unfavorable terms or forego time-sensitive market opportunities. Accordingly, MFA recommended that each party should be free to assess requisite approval levels for various kinds of swap activity based on its unique organizational structure.
IECA commented that review by senior management is an unnecessary use of management time. Most SDs and MSPs have risk management policies that provide a framework for elevating issues through levels of management as applicable. By requiring senior management to review too many modifications, many that can be reviewed by lower levels with appropriate expertise, it is likely that senior management may actually miss the major issues that should get attention. Also, IECA argued that the chilling effect of the rule could stifle risk management efforts, innovation, and increase counterparty risk as review processes become too rigid in order to comply with regulatory requirements.
The Commission is not modifying the rule based on these comments. The commenters' concerns are overly broad because the rule requires senior management of SDs and MSPs to approve the “policies and procedures” governing swap trading documentation practices, not to approve each agreement, transaction, or modifications thereto. The rule does not prohibit SDs and MSPs from establishing policies and procedures instituting a framework for elevating issues through a hierarchy of management as each sees fit, so long as such framework has been approved in writing by senior management.
Proposed § 23.504(b)(1) required SDs' and MSP's swap trading relationship documentation to include dispute resolution procedures. In the Documentation NPRM preamble, the Commission asked whether the proposed rules should include specific requirements for dispute resolution (such as time limits), and if so, what requirements are appropriate for all swaps.
ISDA & SIFMA objected that the requirement that the parties agree to dispute resolution procedures is not authorized by the Dodd-Frank Act and that denying parties to a swap access to the judicial system is not a measure that should be taken lightly or without Congressional consideration. Similarly, IECA believes the proposed regulations for dispute resolution are too specific and could violate separation of powers under the Constitution.
On the other hand, CIEBA responded that the rules should not include specific requirements, with the exception of requiring the availability of independent valuation agents that are agreed upon by the parties. CIEBA recommended that the Commission propose only a set of fair and even-handed principles for resolving disputes.
In response to these comments, the Commission is modifying the proposed rule to delete the term “procedures” from the requirement that swap trading relationship documentation include “terms addressing * * * dispute resolution procedures.” The Commission notes that the rule as proposed was not intended to require SDs and MSPs to agree with their counterparties on specific procedures to be followed in the event of a dispute, but rather to require that dispute resolution be addressed in a manner agreeable to both parties, whether it be in the form of specific procedures or a general statement that disputes will be resolved in accordance with applicable law. The Commission believes that some form of agreement on the handling of disputes between SDs, MSPs, and their counterparties will be essential to ensuring the orderly operation of the swaps market.
Proposed § 23.504(b)(3) required that the swap trading relationship documentation include certain specified details of the credit support arrangements of the parties.
Better Markets recommended that the Commission revise the proposed rule to
Michael Greenberger commented that leaving terms and rules regarding credit extension and transactional fees to subjective desires of market participants will be counterproductive. Mr. Greenberger supports the comment letter by Better Markets, Inc., which urges the Commission to propose definitive rules requiring documentation of credit extension and transactional fees.
COPE asked the Commission to clarify that the rule requires trading documentation to include any applicable margin provisions and related haircuts, but does not require margining and haircuts unless agreed by the parties. IECA echoed the COPE comment, stating that the proposed rule is unclear whether parties can enter into a swap that requires no margin, as is contemplated in the Dodd Frank Act.
CIEBA commented that proposed § 23.504(b)(3) should be clarified by adding the words “if any” to the end of each of subsections (i) through (iv) to make clear that end users are not required to post initial margin or allow rehypothecation.
Having considered these comments, the Commission is of the view that the proposed rule was not intended to require margin or related terms where such are not required pursuant to other Commission regulations or the applicable regulations adopted by prudential regulators. The proposed rule was intended to require written documentation of any credit support arrangement, whether that be a guarantee, security agreement, a margining agreement, or other collateral arrangement, but only to require written documentation of margin terms if margin requirements are imposed by Commission regulations, the regulations of prudential regulators, or are otherwise agreed between SDs, MSPs, and their counterparties. Thus, in response to commenters' requests for clarification, the Commission is modifying the proposed rule as recommended by CIEBA by adding “if any” at the end of each of subsections (i) through (iv) of § 23.504(b)(3). The Commission expects that other forms of credit support arrangements will be documented in accordance with the rule as well.
However, the Commission is not revising the rule to enumerate the terms of any extension of credit that are required to be included in the documentation, as recommended by Better Markets. The Commission believes that the rule, as proposed and as adopted by this release, already requires documentation of initial and variation margin requirements, which necessarily will entail documentation of any extension of credit, i.e., the documentation will reflect whether margining is subject to any credit extension threshold. Thus, to the extent applicable, credit support arrangements must include, at a minimum, the maximum amount of credit to be extended, the method for determining how much credit has been extended, and any term of the facility and early call rights. During negotiations regarding credit support arrangements, counterparties would be well served to address issues related to the embedded cost of credit. The Commission also observes that transactional fees are required to be disclosed under § 23.431 of the Business Conduct Standards for SDs and MSPs Dealing with Counterparties.
The proposed regulations did not require SDs and MSPs to document the legal enforceability of netting and collateral arrangements in the swap trading relationship documentation.
In this regard, Volvo Financial Services Europe (Volvo) recommended that the Commission adopt a rule that states clearly that credit support arrangements should include legal opinions (updated annually) verifying the perfection of security interests in collateral supporting net exposures. Volvo argued that lack of legal certainty contributed to losses in the 2008 financial crisis where counterparties discovered that un-perfected security interests resulted in the unenforceability of pledged collateral. Specifically, Volvo recommended that the Commission revise the proposed rules to require: (i) Mandatory collateralization, (ii) robust legal opinions (updated annually) on enforceability of collateral arrangements, (iii) zero risk weighting if robust legal opinions are obtained, and (iv) regular collateral audits by the Commission to ensure that market participants perform the perfection formalities of security interests.
Although the Commission agrees with the commenter that SDs and MSPs should support their collateral arrangements with all necessary legal analysis, the Commission has not made any changes to the proposed rule based on this comment because the Commission believes (1) Volvo's concerns regarding margining of uncleared swaps are addressed in the Commission's proposed margin rules, or the prudential regulators' proposed margin rules, as applicable, and (2) Volvo's concerns regarding the legal enforceability of collateral arrangements is addressed in risk management rules adopted by the Commission in February, 2012.
Proposed § 23.504(b)(4) required that the swap trading relationship documentation of each SD and MSP with their counterparties include an agreement in writing on the methods, procedures, rules, and inputs for determining the value of each swap at any time from execution to the termination, maturity, or expiration of such swap.
Twenty of the comment letters received by the Commission addressed the proposed valuation requirement in § 23.504(b)(4). Many of those comments raised similar concerns about the proposal, as summarized thematically, below:
The Working Group, ISDA & SIFMA, FSR, White & Case, Morgan Stanley, COPE, MFA, IECA, FHLBs, Hess Energy Trading Company, LLC (Hess), Riverside Risk Advisors LLC, and Edison Electric Institute (EEI) commented that valuation disputes provide valuable information to both market participants and regulators about pricing dislocations and associated credit risks and a static, rigid valuation methodology necessarily produces values that become increasingly outdated over time and could impede
The Working Group, ISDA & SIFMA, FSR, Markit, Freddie Mac, COPE, MFA, FHLBs, CIEBA, EEI, and the Coalition of Derivatives End Users commented that requiring agreement on valuation methodologies and set alternative methods will materially increase the pre-execution negotiating burden without an offsetting benefit and agreement on models for complex swaps would require negotiations that could take sophisticated professionals months to complete, if such could be completed at all.
The Working Group, FSR, OCC, and Markit commented that it is impossible to state valuation methodologies with the required specificity without disclosing proprietary information about the parties' internal models.
OCC and Hess commented that requiring agreement on valuation methodologies may discourage development of more refined, dynamic swap valuation models, which would lead to use of less sophisticated or vanilla models that are less accurate than their proprietary counterparts.
ISDA & SIFMA and IECA commented that agreeing on a methodology that could survive the loss of any input to the valuation is wholly unworkable, will diminish standardization as parties negotiate bespoke approaches to valuation, and will undermine legal certainty if the valuation methodology is determined not to be adaptable to all circumstances.
COPE, FHLBs, MFA, EEI, and Markit commented that there is no business need for swap-by-swap valuation formulas because valuation of exposures with counterparties is usually conducted on a portfolio basis and documented in a master agreement, and that agreement on swap-by-swap valuation formulas also is likely to disrupt trading.
Several commenters also recommended alternative approaches to the valuation requirement. The Working Group, Morgan Stanley, MFA, IECA, FHLBs, CIEBA, and MetLife suggested that the focus of the rule should be on the valuation dispute resolution process rather than valuation methodologies that include fallback alternatives and other static terms. MetLife specifically recommended that the Commission establish “mandatory dispute resolution guidelines” that include a requirement for a third party arbiter after a set period of time.
With respect to valuation methodologies, CIEBA and Chris Barnard recommended that the rule require SDs to value swaps on the basis of transparent models that can be replicated by their counterparty. The Working Group requested that the Commission clarify that parties are permitted to use different valuation methodologies under different circumstances (i.e., mid-market valuation for collateral purposes and replacement cost valuation for terminations). Markit and MFA requested that the Commission clarify that parties may rely on a more general set of inputs, models, and fallbacks for valuation purposes, rather than the exhaustive fallbacks required by the rule. White & Case and IECA recommended that the Commission permit parties to change the valuation method and inputs as the market changes over time. Freddie Mac suggested that the rule should provide that the valuation methodology requirement can be satisfied by executing industry standard documentation that provides for a commercially reasonable valuation methodology. The Coalition of Derivatives End Users, IECA, and Chris Barnard recommended that proprietary inputs be allowed under the rule.
More generally, FSR recommended that the Commission withdraw the proposed valuation requirement until the Commission has the time to conduct a thorough study, including a comprehensive cost-benefit analysis, whereas Markit recommended that the rule be modified to explicitly allow parties to comply with the rule by agreeing that an independent third party may provide any or all of the elements required to agree upon the valuation of swaps. The Coalition of Derivatives End Users recommended that the Commission change the rule to require SDs and MSPs to provide commercially reasonable information to substantiate its valuations upon an end user's request, instead of requiring extensive pre-trade documentation of valuation methodology.
The Working Group recommended that the Commission modify the rule to provide that the valuation requirements for cleared swaps or swaps executed on a trading facility should be satisfied by referencing the price provided by the relevant DCO or facility, while Markit recommended that the Commission clarify that neither prices of recently executed transactions or any other single pricing input should be regarded as preferable inputs for the valuation of swaps and explicitly permit parties to use pricing sources other than DCOs, even for cleared swaps.
A number of commenters supported the rule. Chris Barnard strongly supported the requirement that the agreed methods, procedures, rules and inputs constitute a “complete and independently verifiable methodology for valuing each swap entered into between the parties,” and that the methodology must include alternatives “in the event that one or more inputs to the methodology become unavailable or fail.” Mr. Barnard also supported the requirement for SDs and MSPs to “resolve a dispute over the valuation of a swap within one business day.” Michael Greenberger generally supported the valuation methodology rule to promote transparency and financial integrity. MetLife agreed with the proposal that parties should determine upfront what the valuation methodologies will be to help mitigate disputes, but believes that disputes will not be eliminated by the rule.
CIEBA commended the Commission for requiring objective and specific valuation mechanisms in swaps documentation and believes that this requirement will limit the potential for valuation disputes. However, CIEBA believes requiring objective and specific valuation mechanisms is not enough. In addition to requiring SDs to value swaps using transparent models that can be replicated by their counterparties, CIEBA recommended that the Commission require the mechanisms or procedures by which disputes are resolved to be fair and even-handed and should not override existing contractual protections negotiated by the parties.
Having considered these comments, the Commission is modifying and clarifying the proposal in a number of ways. First, in response to concerns from non-financial entities regarding the cost and the challenges of pre-execution negotiation, the Commission is modifying the rule to require valuation documentation only at the request of non-financial entities. In other words, non-financial entities will have the ability, but not the obligation, to enter into negotiations on valuation with their SD or MSP counterparties. As discussed below, the rule will continue to apply to SDs, MSPs, and financial entities.
While the Commission agrees with commenters regarding the importance of using transparent models that can be replicated, the Commission recognizes concerns about protecting proprietary information used in internal valuation models. Thus, the Commission has modified the rule to clarify the requirement that the agreement on valuation use objective criteria, such as recently-executed transactions and valuations provided by independent third parties. In this regard, the
Additionally, the Commission confirms commenters' understanding that proprietary models may be used for purposes of valuation, provided that both parties agree to the use of one party's confidential, proprietary model. An agreement by the parties to use one party's confidential, proprietary model is sufficient to satisfy the requirements of § 23.504(b)(4)(i), including the requirement that the parties agree on the methods, procedures, rules and inputs for determining the value of each swap. On the other end of the spectrum from simply agreeing to use one party's model, counterparties may, if they choose, elect to negotiate precisely which model and inputs will govern the valuation of their swaps. Counterparties would be free to elect either of these options or many other possibilities under the terms of § 23.504(b)(4) so long as the resulting valuations are sufficient to comply with the margin requirements under section 4s(e) of the CEA and the risk management requirements under section 4s(j) of the CEA, and there is a dispute resolution process in place or a viable alternative method for determining the value of the swap. Moreover, the Commission is modifying proposed § 23.504(b)(4)(iii) to clarify that confidential, proprietary model information is protected under the rule.
To address concerns that the use of the phrase “methods, procedures, rules, and inputs” could be interpreted as requiring agreement on the precise model and all inputs for valuing a swap, the Commission is modifying the rule text to require that parties agree on “the process, including methods, procedures, rules, and inputs for determining the value of each swap.”
Importantly, the Commission is responding to commenters' concerns about the requirement that the valuation documentation be stated with sufficient specificity to allow the SD, MSP, the Commission, and any prudential regulator to value the swap “independently in a substantially comparable manner.” Commenters viewed this standard as problematic because they read it to require disclosure of proprietary information or to prevent the updating or revising of models, among other things. Accordingly, the Commission has determined to remove this provision from the final rule. So long as the valuation documentation is stated with sufficient specificity to determine the value of the swap for purposes of complying with the requirements of the rule—namely, the margin and risk management requirements under section 4s of the CEA and Part 23 of Commission regulations—the requirements of § 23.504(b)(4)(i) would be met.
Under this approach, parties may rely on a general set of methods, inputs, models, and fallbacks for valuation purposes so long as the process is sufficient to determine the value of a swap. In response to concerns that the proposal would require a methodology that would be static or rigid over time, the Commission is further modifying the rule to make explicitly clear that the parties may agree on a process, including methods or procedures for modifying or amending the valuation process as circumstances require and as the market changes over time.
The Commission does not disagree with commenters that differences in valuations can provide valuable information to both market participants and regulators about pricing dislocations and associated credit risks. Moreover, the objective is not to produce values that become increasingly outdated over time. Rather, the Commission believes that by requiring agreement between counterparties on the methods and inputs for valuation of each swap, § 23.504(b)(4) will assist SDs and MSPs and their counterparties to arrive at valuations necessary for margining and internal risk management, and to resolve valuation disputes in a timely manner, thereby reducing risk.
Agreement between SDs, MSPs, and their financial entity counterparties on the proper daily valuation of the swaps in their swap portfolio is an essential component of the Commission's margin proposal. Under proposed § 23.151, non-bank SDs and MS