SEC Swap Trading Analysis

A recent study that provides insight into Dodd-Frank Regulation

On March 15, 2012, the U.S. Securities and Exchange Commission (SEC) published an analysis of credit default swap (CDS) trading data that it accumulated during 2011. The intended use of this analysis is to help determine which firms will be subject to new trading rules established by the Dodd-Frank Act. Opponents of these new regulations are concerned with overregulation of the derivative trading markets. In the last year these opponents have legally challenged the new regulations based on a lack of supporting economic analysis and insufficient time allowed for public comments. Presumably, the SEC has released its analysis of this trading data in response to those past legal challenges. The 2010 Dodd-Frank Act established new regulatory requirements on companies such as large investment banks which are heavily involved in derivatives trading. Specifically, Title VII of the Act established a new framework for the regulation of swaps. The legislation was enacted primarily in response to the financial crisis and, among other things, intended to decrease risk, increase transparency, and bolster market integrity within the financial system by: (1) providing for the registration and comprehensive regulation of swap dealers, securitybased swap dealers, major swap participants and major security-based swap participants; (2) imposing clearing and trade execution requirements on swaps and security-based swaps, subject to certain exceptions; (3) creating rigorous recordkeeping and real-time reporting regimes; and (4) enhancing the rulemaking and enforcement authorities of the Commissions with respect to, among others, all registered entities and intermediaries subject to the Commissions oversight.1 The SEC and the U.S. Commodity Futures Trading Commission (CFTC) have struggled to date in determining which firms should qualify as swap dealers, security-based swap dealers, major swap participants and major security-based swap participants. Qualifying firms will be required to set aside more capital and will face higher margin requirements. Dealers in particular will be subject to increased scrutiny by the regulators. The report presents analyses of certain criteria that the SEC and CFTC are considering in order to define security-based swap dealer and major security-based swap participant as well as determine the de minimis statutory exception to the former definition. The analysis of security-based swap dealer activity in the swap market focuses on five criteria
1

Federal Register Vol. 75, No. 224, December 21, 2012

that may be used to determine if an entity qualifies as a dealer, as follows: 1) Whether an entity transacts with multiple counterparties 2) Whether an entity transacts with counterparties other than derivative dealers 3) Whether an entitys aggregate buy notional amount is within 45 55% of its aggregate gross notional transactions 4) Whether an entitys aggregate number of buy orders are within 45 55% of its aggregate number of transactions 5) Whether an entitys posting of margin occurs in less than 10% of their trades A review of the data disclosed in the report illustrates the relatively low number of entities that would be subject to regulation, potentially alleviating fears about overregulation. The number of entities qualifying as dealers per each criterion, irrespective of size, and the relative amount of the market covered by these entities is summarized below:
All Entities Criterion 1 Criterion 2 Analyzed (15+) (5+) Criterion 3 Criterion 4 Criterion 5

No. of Qualifying Entities Gross Notional

1,084

33

20

83

93

473 9,989

$ 12,628 $ 11,342 $ 10,982 $

9,656 $ 11,304 $

Further, to the extent an entity would have to pass multiple criteria to qualify for dealer status the number of entities passing at least two or at least three of the aforementioned criteria are as follows:

All Entities Analyzed Passing 2+ Passing 3+

No. of Qualifying Entities Gross Notional

1,084

92

41

$ 12,628 $ 11,402 $ 11,199

This analysis illustrates the relatively small number of firms that may be subject to the new regulations. Another trouble spot for regulators has been what the threshold should be to determine which entities will qualify as dealers. The agencies originally proposed $100 million in gross notional amount in 2010. However, this has been heatedly debated by industry groups concerned with overregulation of legitimate hedgers who do not pose a risk to the markets. Earlier this month, the SEC and CFTC discussed setting the threshold at $3 billion. The SECs analysis presented limited data related to aggregate gross notional, gross notional buy, and gross notional sell CDS positions of non-dealer market participants (i.e., major security-based swap participants) over the 12-month period ending December 31, 2011. The SEC stated that this data, may 2

reasonably be expected to predict the number of entities that need to determine whether they qualify as major security-based swap participants by virtue of having potential future exposure sufficient to approach the thresholds set forth by the rule defining substantial position for the purposes of the analysis.2 However, no further information was put forth as to what those thresholds might be. The SEC stated that the reason for the release of this analysis was, to allow the public to consider this supplemental information. As the SEC and CFTC have faced several legal challenges in the last year to rules they were required to issue under Dodd-Frank, getting a head start on garnering public approval most likely played a significant part in the release of this analysis. The SEC said in the release that it expects to adopt rules defining the discussed terms in the next several weeks.

Written by: Eric Holzman Director Veris Consulting, Inc. April 2012

U.S. Securities and Exchange Commission Division of Risk, Strategy, and Financial Innovation memorandum, dated March 15, 2012, pg. 22