On December 18th, the SEC approved new rules requiring the application of risk mitigation techniques to portfolios of uncleared security-based swaps. These new rules (15Fi-3, 15Fi-4, and 15Fi-5) establish requirements for registered security-based swap dealers and major security-based swap participants (SBS Entities) to: periodically reconcile outstanding security-based swaps with counterparties, engage in certain forms of portfolio compression exercises, as appropriate, and execute written trading relationship documentation with each of their counterparties prior to, or simultaneously with, executing a security-based swap transaction.
Thursday, January 02. 2020
The rules were adopted pursuant to Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. As part of a large rule-making effort, the SEC also adopted amendments to its existing cross-border rule to provide a means to request the substituted compliance with respect to the portfolio reconciliation, compression, and trading relationship documentation requirements. In addition, the SEC made changes to its recently-adopted recordkeeping, reporting, and notification rules to incorporate records relating to the new risk mitigation requirements.
The new rules fall under the Securities Exchange Act of 1934 and are outlined below.
Rule 15Fi-3: Portfolio Reconciliation
Under the new requirements, “portfolio reconciliation” will be defined to mean the process by which two parties to one or more security-based swaps:
- Exchange the terms of all security-based swaps in the security-based swap portfolio between the counterparties
- Exchange each counterparty’s valuation of all outstanding security-based swaps entered into between the counterparties as of the close of business of the immediately preceding business day
- Resolve any discrepancy in valuations or material terms. For this purpose, “material terms” includes each term of a security-based swap that is required to be reported to a registered swap data repository or to the SEC pursuant to Regulation SBSR, other than a term that is not relevant to the ongoing rights and obligations of the parties and the valuation of the security-based swap.
Rule 15Fi-3(a) will apply to security-based swap portfolios between two SBS Entities as follows:
- SBS Entity counterparties will be required to engage in portfolio reconciliation no less frequently than (i) each business day for each portfolio that includes 500 or more security-based swaps; (ii) weekly for each portfolio that includes more than 50 but fewer than 500 security-based swaps on the business day during any week; and (iii) quarterly for each portfolio that includes no more than 50 security-based swaps at any time during the calendar quarter
- Any discrepancy in a material term (other than with respect to valuation) must immediately be resolved
- Discrepancies in valuation that are ten percent or greater of the higher valuation must be resolved as soon as possible but no later than five business days after identifying the discrepancy
Rule 15Fi-3(b) will apply to security-based swap portfolios between an SBS Entity and a counterparty who is not an SBS Entity as follows:
- The SBS Entity is required to establish, maintain, and follow written policies and procedures reasonably designed to ensure that it engages in portfolio reconciliation no less frequently than: (i) quarterly for each portfolio that includes more than 100 security-based swaps at any time during the calendar quarter and (ii) annually for each portfolio that includes no more than 100 security-based swaps at any time during the calendar year
- The policies must also provide that any discrepancy in the validation or in a material term must be resolved in a “timely fashion”
Rule 15Fi-3(c) establishes a reporting obligation in the event of certain unresolved security-based swap valuation disputes as follows:
- An SBS Entity is required to notify the SEC promptly of any security-based swap valuation dispute in excess of $20,000,00 at either the transaction or portfolio level if this dispute is not resolved in: (i) three business days,if the dispute is with a counterparty that is an SBS Entity; or (ii) five business days if the dispute is with a counterparty that is not an SBS Entity.
Rule 15Fi04(a): Portfolio Compression
Rule 15Fi-4(a) will apply to security-based swap portfolios between two SBS Entities and requires each SBS Entity to establish, maintain, and follow written policies and procedures regarding:
- Evaluating both bilateral and multilateral portfolio compression exercises that are initiated, offered, or sponsored by any third party
- Periodically engaging in both bilateral and multilateral portfolio compression exercises in each case where appropriate with its SBS Entity counterparties
- When appropriate, terminating each fully offsetting security-based swap with its SBS Entity counterparties in a timely fashion
Rule 15Fi-4(b) will apply to security-based swap portfolios between an SBS Entity and a counterparty who is not an SBS Entity. It requires the SBS Entity to establish, maintain, and follow written policies and procedures for
periodically terminating fully offsetting security-based swaps. It also mandates engaging in bilateral or multilateral portfolio compression exercises with the applicable counterparty when appropriate and requested by any such counterparty.
Rule 15Fi-5: Trading Relationship Documentation
Rule 15Fi-5(a)(2) requires each SBS Entity to establish, maintain, and follow written policies and procedures reasonably designed to ensure that the entity executes written security-based swap trading relationship documentation with each of its counterparties (regardless of whether the counterparty is an SBS Entity) prior to, or simultaneously with, executing a security-based swap with such counterparty.
Keeping with Rules 15Fi-5(b)(1) and (3), the procedures and policies must:
- Require that the security-based swap trading relationship documentation be in writing and that it include all terms governing the trading relationship between the SBS Entity and its counterparty. This includes, without limitation, terms addressing payment obligations, netting of payments, events of default or other termination events, calculation and netting of obligations upon termination, transfer of rights and obligations, governing law, valuation, and dispute resolution.
- Require that the security-based swap trading relationship documentation include credit support arrangements addressing certain margin-related matters identified in the SEC rule.
Rule 15Fi-5(b)(4) will require that the policies and procedures provide that the applicable swap trading relationship documentation between certain specified types of financial counterparties include written sections in which the parties agree on the process. This may include any agreed upon methods, procedures, rules, and inputs, for determining the value of each security-based swap at any time from execution to the termination, maturity, or expiration of such security-based
- The above-mentioned valuation methodology will be used for the purposes of complying with the margin requirements under Section 15F(e) of the Exchange Act (and applicable regulations) and the risk management requirements under Section 15F(j) of the Exchange Act (and applicable regulations).
- The rule specifies that an SBS Entity will not be required to disclose confidential, proprietary information to the counterparty about any model it may use to value a security-based swap.
Rules 15Fi-5(b)(5) and (6) will require that the policies and procedures governing the applicable trading relationship documentation mandate that SBS Entities disclose certain information to their counterparties regarding both their legal status and the status of the security-based swap.
Finally, Rule 15Fi-5(c) will require each SBS Entity to have an independent auditor conduct periodic examinations sufficient to identify any material weakness in its documentation policies and procedures required by the rule.
The release also includes a final cross-border interpretation to treat new Rules 15Fi-3 through 15Fi-5 as entity-level requirements which apply to an SBS Entity’s entire security-based swap business without exception. This includes business in connection with any security-based swap business it conducts with foreign counterparties. The new ruleset also amends Rule 3a71-6 to address the potential availability of substituted compliance in connection with Rules 15Fi-3 through 15Fi-5. Finally, there are amendments to the recordkeeping, reporting, and notification requirements applicable to SBS Entities that now require SBS Entities to make and keep records regarding portfolio reconciliation, bilateral offsets, bilateral or multilateral portfolio compression, valuation disputes, and written trading relationship documentation.
These new rules will become effective 60 days after publication in the Federal Register. The compliance date is 18 months after the effective date of the final rules and guidance addressing the cross-border application of certain security-based swap requirements, which the SEC also adopted on December 18th in a separate release.