The SEC intends to implement its transaction reporting and public dissemination rules on 8 November to get further oversight into the security-based swaps market.
And while the regulator has tried in earnest to avoid unnecessary burden on market participants by aligning these new rules with the existing CFTC reporting rules – which have been embedded for nearly a decade at this point – there are several nuances in the SEC and CFTC rules we have identified which have the potential to cause increased operational responsibility and unexpected consequences.
The implementation date of the SEC’s new rules will be here before we know it, so to shine a light on what is to come, we have focussed on the two key differences between the SEC and CFTC reporting rules, what the differences mean in real terms, and clear questions to address to ensure preparedness over the next four months.
The SEC requirement to publicly disseminate mirror swaps: impact on prime brokers
The first area of SEC divergence from the CFTC rules concerns the prime brokerage (PB) mirror leg which reflects the swap between the PB – where the client account is held and managed – and their clients. It is an exact ‘mirror’ of the swap between the executing broker (EB), who writes the swap, and the PB. Currently, the CFTC only requires public dissemination of the swap between the EB and the PB – not the PB mirror swap.
The SEC is now requiring firms to publicly disseminate the mirror swap, stating that:
“[t]he Commission, […], continues to believe that disseminating each leg of a prime brokerage arrangement will enhance price discovery by helping market observers to distinguish between the price of a security-based swap and the cost of credit intermediation”.
Although this difference seems minor in the scope of the regulation, the dissemination of the mirror leg may contain sensitive ‘commission’ data embedded in the price, and so could bring additional complexity to the PB by potentially exposing part of their commercial model to their competitors.
PBs will potentially have to update their booking models to ensure the cost of intermediation is not captured in the price field and in turn, disseminated to the public. Further, public price dissemination of all legs of a PB security-based swap could provide a distorted view of the market.
In short, market participants will be required to further develop and adapt their reporting systems to this SEC requirement. They will be required to include mirror trades only for SEC reporting, update their control framework to capture these trades and ensure they are not exposing their own pricing model to their competitors.
The SEC’s final rule on arrange-negotiate-execute (ANE) transactions: impact on foreign dealers
The second key area of divergence from the CFTC is the SEC’s decision to include ANE transactions in the Regulation SBSR final rule. This rule is aimed at capturing security-based swaps arranged, negotiated, or executed by unregistered foreign dealers using personnel in the US with non-US counterparties.
The key driver behind this decision is that the SEC believes that most experts of US-based underliers are based in the US, and it therefore wants to have oversight of such transactions. Further to this, the regulator believes that if it does not include ANE transactions in the final rule, foreign dealers may have an unfair advantage in the US market.
Specifically, the SEC has stated:
“[t]his could create a competitive advantage for non-U.S. persons over similarly situated U.S. persons when they trade with foreign dealing entities. An unregistered foreign dealing entity might be able offer liquidity to a non-U.S. person at a lower price than to the U.S. person because the foreign dealing entity would not have to embed the potential costs of regulatory reporting and public dissemination into the price offered to the non-U.S. person.”
Most foreign dealers entering into security-based swaps are expected to meet the de minimis threshold and will therefore register as security-based swap dealers required to report to the SEC anyway. However, with this rule, the SEC is still clearly expecting some foreign dealers to remain below the de minimis threshold and engage in ANE transactions.
The likelihood of such entities not having reached swap dealer status to date is high, meaning these entities have no current reporting obligation to the CFTC and thus may not be aware of their new SEC obligation.
The ANE final rule and divergence from existing CFTC regulations necessitates additional controls and processes to be implemented for the impacted unregistered foreign dealers. For these unregistered foreign dealers, market participants should ask some crucially important questions:
- Will they be ready and able to comply with the upcoming rules?
- Do they have any reporting obligations today?
- Do they have infrastructure in place to report?
- How do they weigh the cost of building out a reporting infrastructure against the profitability of entering into these types of security-based swaps?
- How will ANE transactions be identified internally? i.e. Is the trader and/or salesperson location included in trade capture systems?
The SEC has hinted that substituted compliance might become available in the future, however, the SEC must make a comparability assessment and determination before a substituted compliance issue is ordered. Thus, on the reporting go-live date, all ANE transactions must be reported and substituted compliance will not yet be available.
The two scenarios in this article highlight key areas of divergence between the upcoming SEC rules and implemented CFTC rules. Prime brokers and unregistered foreign dealers will now have a bifurcated process for transactions that were previously withheld from CFTC reporting.
New processes and procedures must be implemented for both to comply with the upcoming regulation. In conclusion, an already complex process is being made more complex. Will these scenarios be granted no action relief? Watch this space!
By Stephanie Rubizhevsky and Benoit Julia, senior managers at Quorsus