The dividing line between a "swap" subject to oversight by the Commodity Futures Trading Commission (CFTC) and an SBS subject to SEC regulation is not obvious and derives from the historical allocation of jurisdiction between the two regulators. The definition of SBS includes, for example, (i) certain credit derivatives based on either a single security or loan or on a narrow-based security index (i.e., nine or fewer) or issuer of securities in a narrow-based security index, and (ii) equity derivatives, total return swaps, or contracts for differences on a single security, loan, or narrow-based security index. The determination of whether an instrument is a swap or an SBS is generally made as of the time the parties enter into the transaction and static throughout the life of the transaction.
When Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") was enacted in 2010, a new era of derivatives regulation began. There are several regulators charged with implementing the regulations under the Dodd-Frank Act. The CFTC, which has jurisdiction over "swaps," and the U.S. Banking Regulators (the "Prudential Regulators"), which supervise the derivatives activities of banking entities, have already implemented their major rulemakings. The SEC, which regulates SBS, has not. However, as of November 1, 2021, certain financial intermediaries will be required to register with the SEC as SBSDs and will have to comply with the SEC’s SBS regulations. The SEC SBS Margin Rules, discussed in detail below, are applicable to SBSDs and, following recent relief from the SEC,1 will have a compliance date of September 1, 2022, which is consistent with the compliance dates for each of the CFTC and Prudential Regulators margin rules.
The SEC’s SBS regulations largely parallel existing CFTC regulations. They differ in that the SEC rules apply to different products (SBS rather than swaps) and create a new class of registrants (SBSDs rather than swap dealers). In the same manner that CFTC rules directly regulate SDs and their counterparties indirectly, the SEC’s rules directly regulate the conduct of SBSDs and only indirectly the conduct of end user counterparties. Similar to the CFTC’s regulations, the SEC’s SBS regulations address (a) SBSD external business conduct rules (including suitability and requirements for special entities);2 (b) required SBS trading relationship documentation; (c) portfolio reconciliation; and (d) margin for non-cleared SBS. The swap and SBS regulatory regimes are not identical, however, and as such SBSDs will be subject to additional documentation requirements, which is why you may be asked to adhere to an additional protocol event if you have already adhered to previous Dodd-Frank protocols. You likely adhered to the ISDA August 2012 DF Protocol and the ISDA March 2013 DF Protocol (together, the "DF Protocol").3 Building on the information exchanged under the DF Protocol, ISDA has launched the "SBS Top-Up Protocol" to address SBS regulations not covered by the DF Protocol.
If they have not already, SBSDs may begin to contact you to obtain information that will facilitate their determination of whether your trading relationship is subject to the SEC’s SBS rules and whether any additional agreements are necessary.
Information exchange with SBSDs
Although you have likely provided many status disclosures to swap dealers in the past decade with respect to swaps, SBSDs may ask for additional information and representations that reflect differences in the respective CFTC and SEC regulatory regimes. SBSDs may request such information on a bilateral basis or you may communicate such information uniformly to all registered SBSDs – which may be done via ISDA Amend – through the U.S. Self-Disclosure Letter, which ISDA published on January 15, 2021.4
Separate from providing information to an SBSD, some SBSDs may be required to deliver certain information to you regarding segregation of initial margin (IM)5 under the SBS Margin Rules. The SBSDs will likely provide you such information on one of two forms published by ISDA. The two forms of "SEC IM Segregation Right Notice" are designed to enable non-bank SBSDs6 to notify in-scope counterparties of their right to require segregation of IM for uncleared SBS transactions. Which form you receive, if any, from your non-bank SBSD will depend on whether the SEC broker-dealer regulations apply to such SBSD.7 Where segregation is permitted but not required, you should consider whether you would prefer not to require segregation (which results in a functional treatment of margin similar to variation margin (VM)) or whether to require segregation at an independent custodian (as IM is treated under both of the CFTC margin rules and PR Margin Rules).
Updating the Dodd-Frank protocols – ISDA’s new SBS protocols
The SBS Top-Up Protocol is responsive to myriad SEC rules, including reporting and dissemination of SBS information, business conduct standards for SBSDs and major SBS participants, and the treatment of cross-border SBS. As between DF Protocol adherents, the SBS Top-Up Protocol may be used to amend the terms previously included in their agreements to meet the SEC as well as CFTC requirements, making use of the information previously exchanged in the DF Protocol.
Adhering to the SBS Top-Up Protocol is straightforward. Unlike the DF Protocol, the SBS Top-Up Protocol does not require the exchange of a questionnaire. You will, however, be required to provide the Adherence Letter ID assigned to you when adhering to the ISDA August 2012 DF Protocol and/or the ISDA March 2013 DF Protocol.8 There is an adherence fee of US$500 for each adhering entity, and detailed adherence instructions are available on ISDA’s website.9
If you have not adhered to the DF Protocol, then there is no previously exchanged information to leverage. In such case, you may deliver the requested information to SBSDs and uniformly amend your trading documentation by adhering the ISDA 2021 SBS Protocol. The ISDA 2021 SBS Protocol is a comprehensive protocol that does require the delivery of a completed questionnaire, in addition to the adherence letter. There is an adherence fee of US$500 for each adhering entity.10
SEC SBS Margin Rules
As discussed above, the SEC SBS Margin Rules are applicable to Phase 6+ Counterparties as of September 1, 2022.
Are you in scope?
The SEC SBS Margin Rules may apply if you trade uncleared SBS with an entity required to register as an SBSD. If you have been trading SBS with SDs subject to the Prudential Regulators margin rules (i.e., banks), then SBS has been subject to VM requirements since 2017 and IM requirements on a staggered compliance timeline dependent on the amount of your derivatives trading activity. If your dealer is a registered broker-dealer, however, then the SEC SBS Margin Rules will mark the beginning of mandatory margin exchange for uncleared SBS. Unless an exception applies, an SBSD must:
- Collect (but not post) IM above a US$50 million dollar threshold from a counterparty to an uncleared SBS transaction; and
- Exchange VM.
One exception to these requirements applies to any uncleared SBS between and SBSD and any end user that qualifies from the clearing requirement in section 3C(g)(1) of the Securities Exchange Act of 1934.11 An end user is an entity that is (i) not a financial entity and (ii) using the uncleared SBS to hedge or mitigate commercial risk. A financial entity includes (a) commodity pools; (b) private funds; (c) employee benefit plans; and (d) persons predominantly engaged in activities that are in the business of banking or financial in nature.
Treasury affiliates satisfying the exception from the clearing requirement in section 3C(g)(4)12 of the Exchange Act are also out of scope for the SEC SBS Margin Rules. The treasury affiliate exception under the SEC SBS Margin Rules is the same as under the margin rules promulgated by each of the CFTC and the Prudential Regulators.
"Commercial end user" status may be communicated to an SBSD in Part III of the U.S. Self-Disclosure Letter.
Are the SEC SBS Margin Rules different from the CFTC and Prudential Regulators margin rules?
Yes. While the CFTC margin rules apply only to swaps and the Prudential Regulators rules apply to both swaps and SBS, the SEC SBS Margin Rules apply only to uncleared SBS traded with a non-bank SBSD, including entities that are registered with the SEC as both a Broker-Dealer. If your dealer is a bank SBSD, the Prudential Regulators’ margin rules will apply. If your dealer is a non-bank SBSD that is not a registered Broker-Dealer but is registered with the CFTC as a swap dealer, then if such SBSD meets certain conditions it may be able to comply with the CFTC margin rules in lieu of the SBS Margin Rules.
Although the SEC SBS Margin Rules derive from the same global framework as the margin rules implemented by the CFTC and Prudential Regulators (and other G20 regulators), the SEC SBS Margin Rules have several unique aspects. Of most relevance to commercial end users, funds, and other financial end users, are the following novel features of the SEC SBS Margin Rules:
- An SBSD is not required to (but may) post IM to any counterparty;
- IM does not need to be held at an independent custodian;
- There is no "Material Swaps Exposure" concept, and thus no exception to an SBSD’s requirement to collect IM from a commercial end user counterparty that has an AANA of less than US$8 billion; and
- There is a two-month compliance period where parties can agree to rule-compliant documentation following the breach of the US$50 million IM threshold.
In addition, the cross-border application of the SEC SBS Margin Rules differs from the PR Margin Rules and CFTC margin rules.
What additional documentation may be required under the SEC SBS Margin Rules?
Depending on whether IM will be segregated, parties may address the SEC SBS Margin Regulation using one of two "bolt on" agreements that ISDA published to supplement ISDA existing margin documentation.13 The first supplement, the SEC IM Supplement (Third Party Segregation), is an add-on to existing IM documentation and is applicable where the parties agree to segregate their SEC IM with an unaffiliated custodian. The other supplement, the SEC IM Supplement ([Omnibus][No] Segregation), is an add-on to the existing VM documentation. It is designed to be used by parties that will not segregate their IM with an unaffiliated custodian. These "bolt on" supplements are in addition to and do not replace any of the existing documentation suite. If you intend to portfolio margin cash products and derivatives, then there are additional documentation and structural issues to consider.
What should I do now?
Although the regulatory obligations imposed by the SEC SBS Margin Rules apply directly to the SBSD (and not to you), you may wish to take the following steps now:
- Review your derivatives portfolio and business plans for SBS activity.
- Be prepared to exchange information with SBSDs regarding your categorization for certain SBS rules (i.e., commercial end user, U.S. Person).
- Consider whether to require an SBSD to segregate IM, if applicable.
- Review your DF Protocol adherence letters in connection with the SBS Top-Up Protocol.
Authored by Evan Koster and Adam Lapidus.