WASHINGTON (CN) – The Securities and Exchange Commission has adopted new rules defining terms used in regulation of the over-the-counter swaps market.
The rule, jointly written with the Commodities Futures Trading Commission, was mandated by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which did not fully define terms like “security-based swap dealer” and “majority security-based swap participant.”
Security-based swaps are based on the underlying performance of a single security, loan, narrow index of securities or events relating to the performance of a single issuer or issuers of securities in such an index. These swaps are regulated by the SEC, while all other swaps are regulated by the CFTC.
Lack of clear definition did not stop the SEC and the CFTC from proposing record-keeping requirements, registration mandates, reporting triggers and exemptions from the Securities Act that used the terms.
In an opening statement before the definitions were announced, commission chair Mary Schapiro said the SEC staff had worked hard to tailor the rules to met the commissioners’ goal of “preserving key counterparty and market protections while promoting regulatory efficiency.”
The definitions focus on monetary thresholds to distinguish dealers and market participants who make some security and non-security based swaps as part of their general market strategies and those who focus on such activities.
For instance, only dealers that trade more than $3 billion in credit default swaps over a 12 month period would be considered a “security-based swap dealer.” Credit default swaps are financial agreements where the seller agrees to pay the buyer if a default by the underlying company, government or borrower occurs.
The threshold is set much lower for other security-based swaps – $150 million in trades over a 12 month period – reflecting the much smaller volume of the market these swaps represent.
Both thresholds are larger than the $100 million across-the-board notional threshold the SEC had proposed. In addition, the rule omitted a proposal to limit the number of security-based swaps a dealer could enter into over a year and limits on the number of counterparties a person could transact security-based swaps with.
The SEC will phase in the thresholds and for now only entities and individuals who transact $8 billion or more in credit-default swaps, or $400 million on other security-based swaps over a 12 month period will fall within the new definition. The SEC has not determined when the phase-in period will end.
The new rules include the standard criteria from Dodd-Frank that a security-based swap dealer is someone who holds himself out as such, makes a market in the swaps, regularly enters into such swaps with counterparties as an ordinary course of business for his own account, or otherwise engages in activity causing him to be “commonly known in the trade as a dealer or market maker in security-based swaps.”
Dodd-Frank broadly defined three categories of “major securities-based swap participants’ including those who hold “substantial positions” in a major swap category; those whose outstanding swaps create “substantial counterparty exposure” that could have adverse effects on the markets, and entities that are “highly leveraged” relative to their liquid assets and that maintain a substantial position in a any of the major security-based swap categories.
Under the new rules, a person or entity has a “substantial position” in a security-based swap if they have current daily uncollateralized exposure of $1 billion or more in a major category of such swaps and that exposure rises $2 billion or more in the future after applying a risk multiplier and discounts for cleared positions and netting agreements.
The definition excludes positions held for hedging and mitigating commercial risk and for positions held by some employee retirement plans.
A similar test is used to define “substantial counterparty exposure” except that the current and future uncollateralized exposure threshold rises to $4 billion across all of the party’s trading positions and does not exclude hedging or risk mitigation.
The SEC defines “highly leveraged” as a ratio of liabilities to equity in excess of 12-to-1, a middle ground between proposed ratios of 8-to-1 and 15-to-1.
While the new rule becomes effective 60 days after it is published in the Federal Register, dealers and swap participants will not have to register with the SEC until it adopts final registration rules.