[Federal Register Volume 75, Number 206 (Tuesday, October 26, 2010)]
[Proposed Rules]
[Pages 65882-65932]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2010-26315]
[[Page 65881]]
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Part IV
Securities and Exchange Commission
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17 CFR Part 242
Ownership Limitations and Governance Requirements for Security-Based
Swap Clearing Agencies, Security-Based Swap Execution Facilities, and
NationalSecurities Exchanges With Respect to Security-Based Swaps Under
Regulation MC; Proposed Rule
Federal Register / Vol. 75 , No. 206 / Tuesday, October 26, 2010 /
Proposed Rules
[[Page 65882]]
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SECURITIES AND EXCHANGE COMMISSION
17 CFR Part 242
[Release No. 34-63107; File No. S7-27-10]
RIN 3235-AK74
Ownership Limitations and Governance Requirements for Security-
Based Swap Clearing Agencies, Security-Based Swap Execution Facilities,
and National Securities Exchanges With Respect to Security-Based Swaps
Under Regulation MC
AGENCY: Securities and Exchange Commission.
ACTION: Proposed rule.
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SUMMARY: In accordance with Section 765 (``Section 765'') of Title VII
(``Title VII'') of the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (``Dodd-Frank Act''), the Securities and
Exchange Commission (``SEC'' or ``Commission'') is proposing Regulation
MC under the Securities Exchange Act of 1934 (``Exchange Act'') for
clearing agencies that clear security-based swaps (``security-based
swap clearing agencies'') and for security-based swap execution
facilities (``SB SEFs'') and national securities exchanges that post or
make available for trading security-based swaps (``SBS exchanges'').
Regulation MC is designed to mitigate potential conflicts of interest
that could exist at these entities. Specifically, the Commission seeks
to mitigate the potential conflicts of interest through conditions and
structures relating to ownership, voting, and governance of security-
based swap clearing agencies, SB SEFs, and SBS exchanges.
DATES: Comments should be submitted on or before November 26, 2010.
ADDRESSES: Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
Send an e-mail to [email protected]. Please include
File Number S7-27-10 on the subject line; or
Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F St., NE.,
Washington, DC 20549-1090.
All submissions should refer to File Number S7-27-10. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for Web site viewing and printing in the
Commission's Public Reference Room, 100 F St., NE., Washington, DC
20549 on official business days between the hours of 10 a.m. and 3 p.m.
All comments received will be posted without change; the Commission
does not edit personal identifying information from submissions. You
should submit only information that you wish to make available
publicly.
FOR FURTHER INFORMATION CONTACT: Proposals relating to security-based
swap clearing agencies: Catherine Moore, Senior Special Counsel, at
(202) 551-5710; and Joseph P. Kamnik, Special Counsel, at (202) 551-
5710; Office of Clearance and Settlement, Division of Trading and
Markets, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-7010; proposals relating to security-based swap
execution facilities and national securities exchanges that post or
make available for trading security-based swaps: Nancy Burke-Sanow,
Assistant Director, at (202) 551-5621; Molly Kim, Special Counsel, at
(202) 551-5644; Steven Varholik, Special Counsel, at (202) 551-5615;
Sarah Schandler, Attorney, at (202) 551-7145; and Iliana Lundblad,
Attorney, at (202) 551-5871; Office of Market Supervision, Division of
Trading and Markets, Securities and Exchange Commission, 100 F Street,
NE., Washington, DC 20549-7010.
SUPPLEMENTARY INFORMATION: The Commission is proposing new Regulation
MC under the Exchange Act relating to conflicts of interest with
respect to security-based swap clearing agencies, SB SEFs, and SBS
exchanges.
I. Introduction
On July 21, 2010, the President signed the Dodd-Frank Act into
law.\1\ The Dodd-Frank Act was enacted to, among other purposes,
promote the financial stability of the United States by improving
accountability and transparency in the financial system.\2\ Title VII
of the Dodd-Frank Act provides the Commission and the Commodity Futures
Trading Commission (``CFTC'') with the authority to regulate over-the-
counter (``OTC'') derivatives in light of the recent financial crisis,
which demonstrated the need for enhanced regulation in the OTC
derivatives market. The Dodd-Frank Act is intended to close loopholes
in the existing regulatory structure and to provide the Commission and
the CFTC with effective regulatory tools to oversee the OTC swaps
market, which has grown exponentially in recent years and is capable of
affecting significant sectors of the U.S. economy.
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\1\ The Dodd-Frank Wall Street Reform and Consumer Protection
Act (Pub. L. 111-203, H.R. 4173).
\2\ See Public Law 111-203, Preamble.
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The Dodd-Frank Act provides that the CFTC will regulate ``swaps,''
the Commission will regulate ``security-based swaps,'' and the CFTC and
the Commission will jointly regulate ``mixed swaps.'' \3\ The Dodd-
Frank Act amends the Exchange Act to require, among other things, the
following: (1) Transactions in security-based swaps must be cleared
through a clearing agency if they are of a type that the Commission
determines must be cleared, unless an exemption from mandatory clearing
applies; (2) transactions in security-based swaps must be reported to a
registered security-based swap data repository or
[[Page 65883]]
the Commission; and (3) if a security-based swap is subject to a
clearing requirement, it must be traded on a registered trading
platform, i.e., a SB SEF or SBS exchange, unless no facility makes such
security-based swap available for trading.\4\
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\3\ Section 712(d) of the Dodd-Frank Act provides that the
Commission and the CFTC, in consultation with the Board of Governors
of the Federal Reserve System (``Federal Reserve''), shall jointly
further define the terms ``swap,'' ``security-based swap,'' ``swap
dealer,'' ``security-based swap dealer,'' ``major swap
participant,'' ``major security-based swap participant,'' ``eligible
contract participant,'' and ``security-based swap agreement.'' These
terms are defined in Sections 721 and 761 of the Dodd-Frank Act and,
with respect to the term ``eligible contract participant,'' in
Section 1a(18) of the Commodity Exchange Act (``CEA''), 7 U.S.C.
1a(18), as re-designated and amended by Section 721 of the Dodd-
Frank Act. Further, Section 721(c) of the Dodd-Frank Act requires
the CFTC to adopt a rule to further define the terms ``swap,''
``swap dealer,'' ``major swap participant,'' and ``eligible contract
participant,'' and Section 761(b) of the Dodd-Frank Act permits the
Commission to adopt a rule to further define the terms ``security-
based swap,'' ``security-based swap dealer,'' ``major security-based
swap participant,'' and ``eligible contract participant,'' with
regard to security-based swaps, for the purpose of including
transactions and entities that have been structured to evade Title
VII of the Dodd-Frank Act. Finally, Section 712(a) of the Dodd-Frank
Act provides that the Commission and CFTC, after consultation with
the Federal Reserve, shall jointly prescribe regulations regarding
``mixed swaps'' as may be necessary to carry out the purposes of
Title VII. To assist the Commission and CFTC in further defining the
terms specified above, and to prescribe regulations regarding
``mixed swaps'' as may be necessary to carry out the purposes of
Title VII, the Commission and the CFTC have requested comment from
interested parties. See Securities Exchange Act Release No. 62717
(August 13, 2010), 75 FR 51429 (August 20, 2010) (File No. S7-16-10)
(advance joint notice of proposed rulemaking regarding definitions
contained in Title VII of the Dodd-Frank Act) (``Definitions
Release'').
\4\ See Section 761 of the Dodd-Frank Act, added as Section
3(a)(77) of the Exchange Act, 15 U.S.C. 78(c)(a), which defines the
term ``security-based swap execution facility'' to mean ``a trading
system or platform in which multiple participants have the ability
to execute or trade security-based swaps by accepting bids and
offers made by multiple participants in the facility or system,
through any means of interstate commerce, including any trading
facility that (A) facilitates the execution of security-based swaps
between persons; and (B) is not a national securities exchange.''
See Public Law 111-203, Section 761. The Dodd-Frank Act amends the
CEA to provide for a similar regulatory framework with respect to
transactions in swaps regulated by the CFTC.
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II. Mandated Rulemaking on Mitigating Conflicts of Interest
Section 765 of the Dodd-Frank Act requires the Commission to adopt
rules to mitigate specified conflicts of interest.\5\ Section 765(a)
requires the Commission to adopt rules, which rules may include
numerical limits on the control of, or the voting rights with respect
to, any security-based swap clearing agency, or on the control of any
SB SEF or SBS exchange, by specified entities, such as a bank holding
company with total consolidated assets of $50 billion or more,\6\ a
nonbank financial company,\7\ an affiliate of such bank holding company
or nonbank financial company, a security-based swap dealer,\8\ or a
major security-based swap participant (collectively, ``Specified
Entities'').\9\
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\5\ See Public Law 111-203, Section 765.
\6\ The term ``bank holding company'' has the meaning set forth
in Section 2 of the Bank Holding Company Act of 1956 (12 U.S.C.
1841) (``Bank Holding Company Act''), and generally means any
company that has control over any bank or over any company that is
or becomes a bank holding company by virtue of the Bank Holding
Company Act.
\7\ Under Section 765(a) of the Dodd-Frank Act, the term
``nonbank financial company'' has the meaning set forth in Section
102 of the Dodd-Frank Act, and generally means a company, other than
a bank holding company, national securities exchange, clearing
agency, SB SEF, registered security-based swap data repository,
board of trade designated as a contract market (``DCM''),
derivatives clearing organization, swap execution facility (``SEF'')
or registered swap data repository, that is predominantly engaged in
financial activities (including through a branch in the U.S., if
such company is incorporated or organized in a country other than
the U.S.). See Public Law 111-203, Section 102 for the complete
definition.
\8\ Pursuant to Section 761 of the Dodd-Frank Act, the term
``security-based swap dealer'' is added as Section 3(a)(71) of the
Exchange Act, 15 U.S.C 78c(a), and generally means any person who
(A) holds themselves out as a dealer in security-based swaps; (B)
makes a market in security-based swaps; (C) regularly enters into
security-based swaps with counterparties as an ordinary course of
business for its own account; or (D) engages in any activity causing
it to be commonly known in the trade as a dealer or market maker in
security-based swaps. See Public Law 111-203, Section 761 for the
complete definition. See also Definitions Release, 75 FR 51429,
supra note 3.
\9\ Pursuant to Section 761 of the Dodd-Frank Act, the term
``major security-based swap participant'' is added as Section
3(a)(67) of the Exchange Act, 15 U.S.C 78c(a), and generally means
any person (A) who is not a security-based swap dealer; and (B)(I)
who maintains a substantial position in security-based swaps for any
of the major security-based swap categories, as such categories are
determined by the Commission, excluding positions held for hedging
or mitigating commercial risk; (II) whose outstanding security-based
swaps create substantial counterparty exposure that could have
serious adverse effects on the financial stability of the U.S.
banking system or financial markets; or (III) that is a financial
entity that (a) is highly leveraged relative to the amount of
capital such entity holds and that is not subject to capital
requirements established by an appropriate Federal banking
regulator; and (b) maintains a substantial position in outstanding
security-based swaps in any major security-based swap category, as
such categories are determined by the Commission. See Public Law
111-203, Section 761 for the complete definition. See also
Definitions Release, 75 FR 51429, supra note 3.
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Section 765(b)--captioned ``Purposes''--provides that the
Commission shall adopt such rules if it determines they are necessary
or appropriate to improve the governance of, or to mitigate systemic
risk, promote competition or mitigate conflicts of interest in
connection with a security-based swap dealer's or major security-based
swap participant's conduct of business with, a security-based swap
clearing agency, SB SEF, or SBS exchange and in which such security-
based swap dealer or major security-based swap participant has a
material debt or equity investment.\10\ Section 765(b) sets forth a
number of underlying policy objectives for the Commission's
rulemaking--improving governance, mitigating systemic risk, promoting
competition, and mitigating conflicts of interest with respect to
security-based swap clearing agencies, SB SEFs, and SBS exchanges. In
considering proposed rules to mitigate conflicts of interest, the
Commission is mindful that, in some instances, certain of these diverse
policy objectives may be in tension with others. For example, as
described in Section III.A.2.a below, with respect to security-based
swap clearing agencies, the statutory objective of promoting
competition, which may be furthered through enhanced access to cleared
products and clearing venues, may to some extent be in tension with the
objective of minimizing systemic risk through effective risk management
of the clearing agency.
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\10\ See Public Law 111-203, Section 765(b).
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Section 765(c) of the Dodd-Frank Act also provides that in adopting
rules under Section 765, the Commission shall consider any conflicts of
interest arising from the amount of equity ownership and voting by a
single investor; the ability of owners to vote, cause the vote of, or
withhold votes entitled to be cast on any matters by the holders of the
ownership interest; and the governance arrangements of any derivatives
clearing organization that clears swaps, or swap execution facility or
board of trade designated as a contract market that posts swaps or
makes swaps available for trading.\11\
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\11\ See Public Law 111-203, Section 765(c). Although this
provision refers to swaps and to entities regulated by the CFTC, the
Commission believes that the Congress intended it to refer to
security-based swaps and to security-based swap clearing agencies,
SB SEFs, and SBS exchanges, because Section 765 pertains to
transactions in security-based swaps and persons and entities
related thereto.
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The Commission is cognizant that the proposed rules discussed
herein, as well as other proposals that the Commission may consider in
the coming months to implement the Dodd-Frank Act, if adopted, could
significantly affect--and be significantly affected by--the nature and
scope of the security-based swaps market in a number of ways. For
example, the Commission recognizes that if the measures proposed in
this release are adopted and are too onerous for new entrants, they
could hinder the further development of a market for security-based
swaps by unduly discouraging competition and the formation of new
security-based swap clearing agencies and of new SB SEFs or SBS
exchanges. On the other hand, if the Commission adopts rules that are
too permissive, conflicts of interest may be inadequately mitigated and
such conflicts may incentivize restricting access to centralized
clearing and lack of transparency in the trading of security-based
swaps as described in detail in Section III below. The Commission is
also mindful that the further development of the security-based swaps
market may alter the calculus for future regulation of conflicts of
interest. As commenters review the instant proposals, they are urged to
consider generally the role that regulation may play in fostering or
limiting the development of the market for security-based swaps (or,
vice versa, the role that market developments may play in changing the
nature and implications of regulation) and specifically to focus on
this issue with respect to the proposals to mitigate conflicts of
interest for security-based swap clearing agencies, SB SEFs, and SBS
exchanges.
[[Page 65884]]
The Commission must adopt the rules required by Section 765 of the
Dodd-Frank Act by January 17, 2011, which is 180 days after enactment
of the Dodd-Frank Act.\12\ The Commission therefore is proposing
Regulation MC under the Exchange Act to mitigate conflicts of interest
with respect to security-based swap clearing agencies, SB SEFs, and SBS
exchanges.
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\12\ Section 726 of the Dodd-Frank Act similarly requires the
CFTC to adopt rules designed to mitigate conflicts of interest with
respect to entities under its jurisdiction that clear or trade
swaps. See Public Law 111-203, Section 726. The Commission
preliminarily believes that an entity that registers with the
Commission as either a security-based swap clearing agency or a SB
SEF is likely to register also with the CFTC as a derivatives
clearing organization or swap execution facility, respectively. As a
result, the Commission staff and the CFTC staff have consulted and
coordinated with one another regarding their respective agencies'
proposed rules to mitigate conflicts of interest.
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This proposed rulemaking is among the first that the Commission has
considered in connection with its mandates under the Dodd-Frank Act,
and the Commission is mindful of the considerations raised by this
timing. In particular, under the prescribed timeframes of the Dodd-
Frank Act, the Commission must propose rules required by Section 765
before it has the opportunity to consider proposed rules that also are
likely to affect the development of security-based swap clearing
agencies, SB SEFs, and SBS exchanges, as well as the security-based
swaps market overall. The Commission also notes that the market for
security-based swaps is in a nascent stage of development compared to
the markets for equity securities and listed options and that the
market for security-based swaps could develop further as the Dodd-Frank
Act is fully implemented and these transactions continue to move to
central clearing and trading on organized markets.
III. Discussion of Potential Conflicts of Interest
A. Security-Based Swap Clearing Agencies
1. Current Regulatory Structure
Credit market events from the last few years have demonstrated that
a security-based swaps market operating without meaningful regulation
\13\ and central counterparties \14\ can pose systemic risks. In
November 2008, under the auspices of the President's Working Group on
Financial Markets, the Secretary of the Department of the Treasury, the
Chairs of the Board of Governors of the Federal Reserve, the Office of
the Comptroller of the Currency, the CFTC, and the Commission
established as a policy objective for the OTC derivatives market that
regulators and prudential supervisors require participants in a central
counterparty (``CCP'') arrangement to clear all eligible contracts
through that CCP.\15\ In furtherance of this policy objective, the
Commission, the Federal Reserve, and the CFTC signed a Memorandum of
Understanding that established a framework for consultation and
information sharing on issues related to central counterparties for the
OTC derivatives market.\16\
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\13\ See, generally, Policy Objectives for the OTC Derivatives
Market, The President's Working Group on Financial Markets (November
14, 2008) (available at http://www.ustreas.gov/press/releases/reports/policyobjectives.pdf).
\14\ See The Role of Credit Derivatives in the U.S. Economy
before the H. Agric. Comm., 110th Cong. (2008) (Statement of Erik
Sirri, Director of the Division of Trading and Markets, Commission)
(available at http://agriculture.house.gov/testimony/110/110-49.pdf).
\15\ See supra note 13. See also Policy Statement on Financial
Market Developments, The President's Working Group on Financial
Markets (March 13, 2008) (available at http://www.treas.gov/press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf) and
Progress Update on March Policy Statement on Financial Market
Developments, The President's Working Group on Financial Markets
(October 2008) (available at http://www.treas.gov/press/releases/reports/q4progress%20update.pdf).
\16\ See Memorandum of Understanding Between the Board of
Governors of the Federal Reserve System, the U.S. Commodity Futures
Trading Commission, and the U.S. Securities and Exchange Commission
Regarding Central Counterparties for Credit Default Swaps (November
14, 2008) (available at http://www.treas.gov/press/releases/reports/finalmou.pdf).
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The Commission has taken steps to help foster the prompt
development of CCPs. In particular, the Commission acted to authorize
the clearing of OTC security-based swaps by permitting certain clearing
agencies to clear credit default swaps (``CDS'') on a temporary
conditional basis.\17\ Today, a significant volume of CDS transactions
is cleared centrally and the Commission monitors the activities of
these clearing agencies.\18\
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\17\ The Commission authorized five entities to clear credit
default swaps. See Securities Exchange Act Release Nos. 60372 (July
23, 2009), 74 FR 37748 (July 29, 2009) and 61973 (April 23, 2010),
75 FR 22656 (April 29, 2010) (CDS clearing by ICE Clear Europe
Limited); 60373 (July 23, 2009), 74 FR 37740 (July 29, 2009) and
61975 (April 23, 2010), 75 FR 22641 (April 29, 2010) (CDS clearing
by Eurex Clearing AG); 59578 (March 13, 2009), 74 FR 11781 (March
19, 2009), 61164 (December 14, 2009), 74 FR 67258 (December 18,
2009) and 61803 (March 30, 2010), 75 FR 17181 (April 5, 2010) (CDS
clearing by Chicago Mercantile Exchange Inc.); 59527 (March 6,
2009), 74 FR 10791 (March 12, 2009), 61119 (December 4, 2009), 74 FR
65554 (December 10, 2009) and 61662 (March 5, 2010), 75 FR 11589
(March 11, 2010) (CDS clearing by ICE Trust US LLC); 59164 (December
24, 2008), 74 FR 139 (January 2, 2009) (temporary CDS clearing by
LIFFE A&M and LCH.Clearnet Ltd.) (collectively, ``CDS Clearing
Exemption Orders''). LIFFE A&M and LCH.Clearnet Ltd. allowed their
order to lapse without seeking renewal.
\18\ To date most cleared CDS transactions have cleared at ICE
Trust US LLC (``ICE Trust'') or ICE Clear Europe Limited (``ICE
Clear Europe''). As of October 8, 2010, ICE Trust had cleared
approximately $7.1 trillion notional amount of CDS contracts based
on indices of securities and approximately $490 billion notional
amount of CDS contracts based on individual reference entities or
securities. As of October 8, 2010, ICE Clear Europe had cleared
approximately [euro]3.09 trillion notional amount of CDS contracts
based on indices of securities and approximately [euro]560 billion
notional amount of CDS contracts based on individual reference
entities or securities. See https://www.theice.com/marketdata/reports/ReportCenter.shtml.
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The Exchange Act does not impose specific requirements regarding
the ownership structure of a clearing agency. As a result, clearing
agencies may operate under a variety of appropriate organizational
structures provided that they have the capacity to meet the standards
in Section 17A of the Exchange Act.\19\ Certain clearing agencies
registered with the Commission are owned either by participants or by
securities exchanges.\20\ Other clearing agencies, such as the
security-based swap clearing agencies that, once registered, would be
required to comply with proposed Regulation MC, are subsidiaries of or
partly-owned by publicly traded companies.\21\ These entities are not
wholly-owned by participants or exchanges and may have different
governance related issues than the securities clearing agencies
currently registered with the Commission.
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\19\ See 78q-1(b)(3)(A).
\20\ The Depository Trust and Clearing Corporation (``DTCC'') is
participant-owned and has three separate subsidiaries that are
registered clearing agencies which function as quasi-utilities. The
Options Clearing Corporation is owned by five unaffiliated options
exchanges.
\21\ These clearing agencies include ICE Trust US LLC, ICE Clear
Europe Limited, Eurex Clearing AG, and Chicago Mercantile Exchange
Inc.
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Upon the effective date of Title VII of the Dodd-Frank Act,
clearing agencies that clear and settle security-based swap
transactions will be subject to a number of regulatory obligations that
are intended to promote the policy objectives of the Dodd-Frank Act,
including increased clearing of security-based swaps and effective risk
management. Accordingly, security-based swap clearing agencies will be
required to be registered with, and regulated by, the Commission under
Section 17A.\22\ In addition, all registered
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clearing agencies must comply with the standards in Section 17A, which
include, but are not limited to, maintaining rules for promoting the
prompt and accurate clearance and settlement of securities
transactions, assuring the safeguarding of securities and funds which
are in the custody or control of the clearing agency or for which it is
responsible, fostering cooperation and coordination with persons
engaged in the clearance and settlement of securities transactions,
removing impediments to and perfecting the mechanism of a national
system for the prompt and accurate clearance and settlement of
securities transactions, and, in general, protecting investors and the
public interest.\23\ A registered clearing agency is also required to
provide fair access to clearing and to have the capacity to facilitate
the prompt and accurate clearance and settlement of securities
transactions and derivative agreements, contracts, and transactions for
which it is responsible, as well as to safeguard securities and funds
in its custody or control or for which it is responsible.\24\
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\22\ Section 763(b) of the Dodd-Frank Act adds new Section
17A(k) to the Exchange Act, which authorizes the Commission to
exempt, conditionally or unconditionally, a security-based swap
clearing agency from registration if the Commission determines it is
subject to comparable, comprehensive supervision and regulation by
the CFTC or appropriate government authorities in the home country
of the security-based swap clearing agency. See Public Law 111-203,
Section 763(b).
\23\ See 15 U.S.C. 78q-1(b)(3)(F). Section 17A of the Exchange
Act also includes standards that help to mitigate conflicts of
interest. See infra Section IV.C. for a discussion of these
standards.
\24\ 15 U.S.C. 78q-1(b)(3)(A), (B), and (F).
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Pursuant to Section 765 of the Dodd-Frank Act, the Commission must
identify the nature and sources of any conflicts of interest relating
to the voting interests in and governance of a security-based swap
clearing agency that may interfere with achieving the policy objectives
described above or with the clearing agency complying with the
regulatory mandates of Section 17A of the Exchange Act described above,
including the obligation to adopt rules consistent with the protection
of investors and the public interest.
2. Sources of Conflicts of Interest
The Commission's experience in monitoring the activities of the
clearing agencies engaged in clearing CDS has provided it with insight
into the potential sources of conflicts of interest that may exist at
security-based swap clearing agencies. Since shortly after the
enactment of the Dodd-Frank Act, the Commission staff and staff from
the CFTC have met with interested persons to learn more about potential
conflicts. Moreover, on August 20, 2010, the staff of the Commission
and CFTC held a joint public roundtable in part to gain further insight
into the sources of conflicts of interest at security-based swap
clearing agencies, SB SEFs, and SBS exchanges, as well as methods for
mitigating conflicts of interest (``Conflicts Roundtable'').\25\
Panelists from this roundtable included industry and non-industry
participants.\26\
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\25\ See Securities Exchange Act Release No. 62725, 75 FR 51305
(August 19, 2010). The Commission solicited comments on the
Conflicts Roundtable (comments received by the Commission are
available at http://sec.gov/cgi-bin/ruling-comments?ruling=4-609&rule_path=/comments/4-609&file_num=4-609&action=Show_Form&title=SEC%2DCFTC Roundtable on Swaps and Security%2DBased
Swaps%3A Notice of roundtable discussion and request for comment).
\26\ The transcript of the Conflicts Roundtable is available on
the CFTC's Web site at http://cftc.gov/ucm/groups/public/@newsroom/documents/file/derivative9sub082010.pdf.
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Drawing on these experiences, the Commission has reviewed the
potential for conflicts of interest at security-based swap clearing
agencies in accordance with Section 765 of the Dodd-Frank Act and has
identified those conflicts that could affect access to clearing agency
services, products eligible for clearing, and risk management practices
of the clearing agencies. Preliminarily, the Commission believes that
the most significant conflicts of interest that may have an adverse
effect on statutory goals in Section 765 of the Dodd-Frank Act are
those that arise when a small number of participants,\27\ including
participants that are Specified Entities and including related persons
of the participants,\28\ exercise undue control or influence over a
security-based swap clearing agency.
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\27\ The term ``participant'' when used with respect to a
clearing agency has the meaning set forth in Section 3(a)(24) of the
Exchange Act, 15 U.S.C 78c(a), and shall include Specified Entities.
See proposed Rule 700(o) under Regulation MC.
\28\ See infra Section IV.A.3. for a discussion of ``related
person'' in the context of a security-based swap clearing agency.
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The Commission has identified three key areas where it believes a
conflict of interest of participants who exercise undue control or
influence over a security-based swap clearing agency could adversely
affect the central clearing of security-based swaps. First,
participants could limit access to the security-based swap clearing
agency, either by restricting direct participation in the security-
based swap clearing agency or restricting indirect access by
controlling the ability of non-participants to enter into correspondent
clearing arrangements.\29\ Second, participants could limit the scope
of products eligible for clearing at the security-based swap clearing
agency, particularly if there is a strong economic incentive to keep a
product traded in the OTC market for security-based swaps. Third,
participants could use their influence to lower the risk management
controls of a security-based swap clearing agency in order to reduce
the amount of collateral they would be required to contribute and
liquidity resources they would have to expend as margin or guaranty
fund to the security-based swap clearing agency.
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\29\ See, generally, Matthew Leising and Shannon D. Harrington,
``Wall Street Dominance of Swaps Must End, Brokers Say (Update 1),''
Bloomberg (March 16, 2010).
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Each of these potential conflicts of interest could limit the
benefits of a security-based swap clearing agency in the security-based
swaps market, and even potentially cause substantial harm to that
market and the broader financial markets, as described below. Conflicts
of interest in these areas could also potentially undermine the
mandatory clearing requirement in Section 763 of the Dodd-Frank Act,
thereby affecting transparency, investor protection, risk management,
efficiency, and competition in the security-based swaps market.\30\
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\30\ See Public Law 111-203, Section 763(a). Section 763(a) of
the Dodd-Frank Act adds new Section 3C to the Exchange Act, which
requires clearing for certain security-based swaps. Specifically,
Section 3C(a)(1) provides that ``It shall be unlawful for any person
to engage in a security-based swap unless that person submits such
security-based swap for clearing to a clearing agency that is
registered under the Exchange Act or a clearing agency that is
exempt from registration under the Exchange Act if the security-
based swap is required to be cleared.''
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a. Limitations on Open Access to Security-Based Swap Clearing Agencies
The Commission believes that the increased use of central clearing
for security-based swaps should help to promote robust risk management,
foster greater efficiencies, improve investor protection, and promote
transparency in the market for security-based swaps. For these reasons,
the Commission has encouraged the use of central clearing for security-
based swaps.\31\ A consequence of increased use of central clearing
services, however, is that participants that control or influence a
security-based swap clearing agency may gain a competitive advantage in
the security-based swaps market by restricting access to the clearing
agency. If that occurred, financial institutions and marketplaces that
do not have access to central clearing would have limited ability to
trade in or list security-based swaps. This problem would continue to
exist after the mandatory clearing requirement under Section 763 of the
Dodd-Frank Act becomes effective, because financial institutions may be
required either to submit security-based swaps for central
[[Page 65886]]
clearing or face heightened capital or margin requirements associated
with bilateral agreements.
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\31\ See CDS Clearing Exemption Orders, supra note 17.
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Market participants generally obtain access to a clearing agency in
one of two ways: (1) Directly, by becoming a participant in a clearing
agency or (2) indirectly, by entering into a correspondent clearing
arrangement with a participant in a clearing agency.\32\ There are
several ways that both direct and indirect access to a security-based
swap clearing agency could be restricted if persons who make decisions
for or act on behalf of the clearing agency have a conflict of interest
because of their incentives to further their own business interests
outside of the security-based swap clearing agency. Participants may
seek to limit the number of other direct participants in a security-
based swap clearing agency in order to limit competition and increase
their ability to maintain higher profit margins. A security-based swap
clearing agency that is controlled by a limited number of participants
might also adopt policies and procedures that are designed to unduly
restrict access, or have the effect of unduly restricting access, to
the clearing agency by other participants in ways that are unrelated to
sound risk management practices.\33\ At the same time, affording
greater access to the clearing agency at some point may come at the
expense of sound risk management practices.
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\32\ Correspondent clearing is an arrangement between a current
participant of a clearing agency and a non-participant that desires
to use the clearing agency for clearance and settlement services.
\33\ An example of such restrictive policies and procedures
would be a clearing agency establishing prohibitively high
participation standards so that only the largest financial
institutions qualify as participants.
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The Commission recognizes that security-based swap clearing
agencies must establish reasonable participation standards in order to
ensure the participants in the clearing agency do not expose it to
unacceptable risk or otherwise adversely affect the performance of the
clearing agency, particularly during periods of market stress. However,
participant standards may have the effect of restricting access to the
clearing agency. On the one hand, panelists at the Conflicts Roundtable
and others have raised the concern that participation requirements
could be unnecessarily restrictive and primarily designed to limit the
number of entities that are permitted to become direct participants in
the clearing agency.\34\ While appropriate participation standards are
necessary for the sound operation of the security-based swap clearing
agency, unduly high standards may needlessly exclude persons who are
otherwise qualified to clear security-based swaps. On the other hand,
some panelists at the Conflicts Roundtable also suggested that
increasing access can come at the expense of sound risk management
practices.\35\
---------------------------------------------------------------------------
\34\ See, generally, Swaps and Derivatives Market Association,
``Lessening Systemic Risk: Removing Final Hurdles to Clearing OTC
Derivatives'' (available at http://media.ft.com/cms/fe51a538-78d7-11df-a312-00144feabdc0.pdf) (``SDMA Letter''). See also Public
Roundtable on Governance and Conflicts of Interest in the Clearing
and Listing of Swaps, comments of Darrell Duffie (``[W]e want to be
very careful that the members of a central clearing counterparty
that determine what gets cleared * * * are the members that have * *
* the right social incentives to create competition.'') (available
at http://cftc.gov/ucm/groups/public/@newsroom/documents/file/derivative9sub082010.pdf at 62).
\35\ See supra note 25.
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Access could also be restricted by the way that clearing members
determine executable end-of-day settlement prices. Since there is
currently no exchange or other venue that publishes security-based swap
prices, the Commission has required security-based swap clearing
agencies to publish end-of-day settlement prices and any other prices
with respect to cleared security-based swaps that the security-based
swap clearing agency may use to calculate mark-to-market
requirements.\36\ To ensure that end-of-day settlement prices are
reliable and consistent, a security-based swap clearing agency may
require that the price submission be executable.\37\ The security-based
swap clearing agency, however, might not permit an entity to rely on a
third party to provide an executable end-of-day settlement price. This
could potentially prevent all but the largest dealer firms from having
direct access to the clearing agency as they may be the only firms that
have the processes to determine executable end-of-day settlement
prices.\38\
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\36\ See, e.g., CDS Clearing Exemption Orders, supra note 17.
\37\ As part of their internal processes, security-based swap
clearing agencies generally calculate end-of-day settlement prices
for each product in which they hold a cleared interest each business
day. See, e.g., Letter from Kevin McClear, ICE Trust, to Elizabeth
Murphy, Secretary, Commission, December 4, 2009, and letter from Ann
K. Shuman, Managing Director and Deputy General Counsel, CME, to
Elizabeth Murphy, Secretary, Commission, December 14, 2009. One
method for calculating an end-of-day settlement price for open
positions is based on prices submitted by participants. As part of
this mark-to-market process, the security-based swap clearing agency
may periodically require participants to execute certain security-
based swap trades at the applicable end-of-day settlement price.
This is designed to ensure that participants' submitted prices
reflect their best assessment of the value of their open positions
on a daily basis. Id.
\38\ See SDMA Letter, supra note 34.
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In situations where direct access is limited by reasonable
participation standards, non-participant firms may be able to access
the security-based swap clearing agency through correspondent clearing
arrangements with direct participants. Correspondent clearing is common
in securities markets as well as in futures markets. However, the non-
participant firms ultimately would be required to enter into a
correspondent clearing arrangement with a participant in order to have
the transactions submitted to the security-based swap clearing agency.
Thus, the success of correspondent clearing arrangements depends on the
willingness of security-based swap participants to enter into such
arrangements with non-participant firms that may act as direct
competitors to the participants. Given that current participants may
have an incentive to restrict access to potential competitors,
correspondent clearing arrangements may not be readily established
while only the large dealer firms are direct participants in the
security-based swap clearing agency.
In addition, procedural barriers may prohibit a firm from having
indirect access to a security-based swap clearing agency. For example,
although there are no overt restrictions on indirect access at the
currently exempted security-based swap clearing agencies, many of the
processing platforms by which participants submit transactions to the
security-based swap clearing agency do not have the functionality to
allow a non-participant firm to submit a trade with a customer to the
security-based swap clearing agency through a correspondent arrangement
with a direct member.
Prohibitively burdensome or restrictive direct participation
standards and lack of availability of correspondent clearing
arrangements effectively deny non-participant firms access to the
security-based swap clearing agency's services and, accordingly, create
a substantial competitive advantage for those firms that are direct
participants in the security-based swap clearing agency. As previously
noted, this competitive advantage would become even more significant
after the mandatory clearing requirement for security-based swaps in
the Dodd-Frank Act becomes effective.
b. Limitations on the Scope of Products Eligible for Clearing
As discussed above, Congress found and the Commission believes that
increased use of central clearing would provide significant benefits to
the security-based swaps market and mitigate systemic risk,
particularly
[[Page 65887]]
during times of financial crisis. Central clearing of security-based
swaps likely would result in lower spreads and lower transaction costs
for end-users. A participant in a security-based swap clearing agency
might, however, derive greater revenues from its activities in the OTC
market for security-based swaps than it would from sharing in the
profits of a security-based swap clearing agency in which it holds a
financial interest. As a result, the increased use of central clearing
may be contrary to the economic interests of some participants to a
security-based swap clearing agency. Such participants or their related
persons could therefore seek to have the security-based swap clearing
agency limit the types of security-based swaps that are eligible for
clearing at a security-based swap clearing agency over which they
exercise influence or control.\39\
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\39\ Representative Barney Frank, who chaired the conference
committee that reconciled the House Bill and the Senate Bill,
referred to this specific concern when discussing the amendment
adding Section 765 to the Dodd-Frank Act. Chairman Frank stated,
``The purpose of this in part is to get many more derivatives
cleared. But the clearing houses have the right to refuse them if
they say the transactions aren't suitable for clearing. We believe
that some banks have an interest in not having them cleared. So we
don't want entities that have an interest and [sic] there being no
clearing, owning the clearing houses. That's why this is an
important amendment to us, and it was passed after considerable
debate on the House floor.'' House-Senate Conf. Comm. Holds Markup
on HR 4173, Financial Regulatory Overhaul Bill, June 24, 2010,
reprinted in CQ Congressional Transcripts, 111th Cong. 182 (2010)
(statement of Barney Frank, Chairman, House Comm. on Fin. Serv.).
---------------------------------------------------------------------------
A further incentive for a clearing agency controlled by
participants to restrict the products that are eligible for clearing at
the security-based swap clearing agency may be to control a security-
based swap's price transparency. Trading in the OTC derivatives market
is currently dominated by a small number of firms.\40\ Prior to the use
of clearing agencies to clear security-based swaps, end-users had to
transact directly with a small number of firms to trade in security-
based swaps without the benefit of publicly available pricing data.
Security-based swap clearing agencies provide greater price
transparency by making certain price data available to the public and
thereby helping to reduce the information asymmetry that benefits firms
in the OTC market.\41\ Publicly available pricing data may result in
reducing the spreads and reduce the profit per trade for firms that
have dominated the OTC market.
---------------------------------------------------------------------------
\40\ See Office of the Comptroller of the Currency, Quarterly
Report on Bank Trading and Derivatives Activities, First Quarter
2010. (``Derivatives activity in the U.S. banking system continues
to be dominated by a small group of large financial institutions.
Five large commercial banks represent 97% of the total banking
industry notional amounts * * *.'')
\41\ See Darrell Duffie, Ada Li, and Theo Lubke, ``Policy
Perspectives on OTC Derivatives Market Infrastructure,'' Federal
Reserve Bank of New York Staff Report No. 424, dated January 2010,
as revised March 2010 (``Even after an OTC derivatives product has
achieved relatively active trading * * * dealers have an incentive
to maintain the wide bid-ask spreads that they can obtain in the OTC
market * * *. Thus, from the viewpoint of profits, dealers may
prefer to reduce the migration of derivatives trading from the OTC
market to central exchanges.'').
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While certain security-based swaps may be suitable for central
clearing, the Commission recognizes the possibility that some security-
based swaps may not be suitable for clearing if their risks cannot be
adequately managed by the security-based swap clearing agency. Clearing
products whose risks cannot be adequately managed may increase the
potential of a default of a participant or even the failure of the
security-based swap clearing agency.\42\ This in turn could adversely
affect systemic risk, as participants and their customers would likely
have significant funds and securities tied to the clearing agency and
would be dependent on the continued operations of a security-based swap
clearing agency in order to enter into new transactions in security-
based swaps. This again highlights the potential tensions between sound
risk management and the increased use of central clearing services.
Expanding the number and scope of products cleared would in some cases
be in the best interests of the security-based swap clearing agency and
the security-based swaps market generally, because it provides
processing efficiencies and replaces bilateral counterparty risk.
However, allowing a greater number and scope of products to be
centrally cleared would in some cases be harmful to the security-based
swap clearing agency and the security-based swaps market, if sound risk
management standards are compromised in order to clear those products.
---------------------------------------------------------------------------
\42\ Section 763(a) adds new Section 3C(d)(3)(A) to the Exchange
Act, which prohibits the Commission from requiring any clearing
agency to accept a security-based swap for central clearing. See
Public Law 111-203, Section 763(a).
---------------------------------------------------------------------------
The Commission is mindful of the need to balance goals associated
with promoting the central clearing of security-based swaps and
assuring that proposed rules are designed to increase the number of
products eligible for central clearing with the goals associated with
effective risk management. The Commission is also aware that any rules
that it may ultimately adopt relating to conflicts of interest may
affect this balance. The Commission believes, however, that decisions
regarding the products that are eligible for clearing by a security-
based swap clearing agency should not be subject to undue influence by
parties that have a financial interest in keeping such products from
being centrally cleared, while also noting that non-participants may
have an interest in increasing access, which potentially could serve to
compromise effective risk management.
c. Reduced Risk Management Controls
Security-based swap clearing agencies will perform a critical
function in mitigating financial risk for market participants. The
Commission believes that through uniform margining and other risk
controls, including controls over market-wide concentrations that
cannot be implemented effectively when counterparty risk management is
decentralized, security-based swap clearing agencies would help to
prevent a single market participant's failure from destabilizing other
market participants and, ultimately, the broader financial system.
Although participants may seek to raise risk management controls in
order to restrict access to the clearing agency or protect their
financial stake in the clearing agency, they might also seek to lower
certain risk management controls such as margin requirements in order
to release collateral that they may wish to use for other purposes.
Furthermore, as security-based swap clearing agencies become more
established and the mandatory clearing requirement under Section 763 is
implemented, more security-based swaps will likely be centrally cleared
and clearing participants will be required to provide a substantially
larger amount of liquid collateral to security-based swap clearing
agencies in the form of margin. As a result, participants may be
willing to accept greater risk than is prudent for the security-based
swap clearing agency in order to reduce the amount of their margin
contributions. A reduction in risk management controls ultimately could
function to increase systemic risk by increasing the potential for a
financial loss that must be borne by the participants of the security-
based swap clearing agency.\43\
---------------------------------------------------------------------------
\43\ Such a scenario would arise, for example, where a
defaulting participant has contributed insufficient margin to meet
its obligations to the security-based swap clearing agency.
---------------------------------------------------------------------------
The Commission recognizes that participants generally have a
financial incentive to ensure that the security-based swap clearing
agency collects sufficient margin from each participant.
[[Page 65888]]
A clearing agency's rules and procedures typically provide that in the
event of a participant default, losses exceeding a participant's
individual margin contribution may be satisfied from a guaranty fund
composed of contributions from all participants. As a result,
participants have a unique financial incentive to ensure that the
security-based swap clearing agency has sufficient collateral from each
participant to withstand a participant default in almost all market
conditions. However, participant defaults occur infrequently and the
incentive for participants to protect their guaranty fund contributions
may have less weight than the incentive to reduce margin requirements
in order to release margin collateral for immediate use.
A non-participant does not contribute to a guaranty fund and may
not have the same incentives as a participant with respect to
establishing and maintaining sufficiently robust participant margin
requirements. Non-participants' incentives may be to focus less on risk
management and focus more on allowing more participants to be admitted
to the clearing agency and more products to be made eligible for
central clearing.
d. Implications for Ownership and Governance
As described above, conflicts of interest may arise if participants
exercise undue control or influence over a security-based swap clearing
agency. This influence, typically acquired through an ownership stake
in the clearing agency, generally may be exercised by participants
through either (i) voting interests in the security-based swap clearing
agency or (ii) participation in the governance of the security-based
swap clearing agency, such as by selecting (or influencing the
selection of) the directors of the security-based swap clearing
agency.\44\ In either case, undue control or influence may be
particularly acute if (i) the participants are part of the process for
nominating the directors, even if such participants are not themselves
directors, or (ii) the election of directors is subject to concentrated
voting power in a small number of participants, especially if such
participants also dominate much of the trading in security-based swaps
and could use their controlling position to maintain or extend their
dominant market position.
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\44\ Section 765 of the Dodd-Frank Act authorizes the Commission
to adopt rules regarding conflicts of interest of Specified Entities
at security-based swap clearing agencies in general. However, the
Commission preliminarily believes that those entities that are
participants in a security-based swap clearing agency will have a
conflict of interest that could be acted upon to adversely affect
the development of the market for security-based swaps consistent
with the policy objectives of Section 765 of the Dodd-Frank Act.
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In addition, it is important to consider the likely incentives of
individual directors, once they are on the Board, when they are
governing the security-based swap clearing agency.\45\ Directors of a
security-based swap clearing agency owe a fiduciary duty to the
security-based swap clearing agency and all of its shareholders. In
addition, among other obligations, the Board as a whole is ultimately
responsible for overseeing the clearing agency's compliance with the
regulatory obligations of security-based swap clearing agencies under
the Dodd-Frank Act and the Exchange Act, including the open and fair
access requirements. At the same time, however, directors may be
subject to different perspectives when fulfilling these duties and
roles. Although the Commission recognizes that incentives and
motivations may vary among directors and over time for a range of
reasons--and therefore it is not possible to predict precisely how any
individual director will address a particular matter--directors who are
appointed by or related to participants (``participant-related
directors'') may on balance be more likely to reflect the views of
participants than would directors who are not appointed by or related
to participants (``non-participant-related directors'').\46\
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\45\ The Commission's discussion in this Release of the
motivations or incentives of directors of a clearing agency, SB SEF,
or SBS exchange comes in the context of requiring modes of
governance that permit consideration of a variety of perspectives.
As noted throughout this Release, a company's directors have a duty
to all the company's shareholders, and the Commission does not
regard any directors as simply surrogates for a particular group of
shareholders. The Commission's discussion is intended to forestall
possible conflicts and does not reflect findings that particular
conflicts are present.
\46\ This distinction between participant-related and non-
participant-related directors may be most significant where the
clearing agency is (i) a publicly owned corporation, or part of a
publicly owned corporation, or (ii) otherwise owned by persons other
than participants. The Commission recognizes that ownership
structures for clearing agencies may take other forms, including
ownership solely by participants, in which case the incentives and
perspectives of the directors may be somewhat different.
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In light of these dynamics, as between the two categories of
directors, participant-related directors, like participants themselves,
may on balance be more likely to favor reducing or minimizing the risk
exposure of the clearing agency, potentially at the expense of more
open access. In addition, participant-related directors may also be
more likely to favor restricting access to the clearing agency, which
as discussed above would serve to preserve profits that participants
earn through trading security-based swaps in the OTC markets.
In contrast, non-participant-related directors may, on balance, be
more likely to seek to maximize the value of the enterprise, which, in
addition to sound risk management, may involve increasing the revenues
of the security-based swap clearing agency, such as by expanding the
number and scope of products being cleared. Moreover, at a minimum it
would seem less likely that non-participant-related directors would
favor unduly restricting access to the clearing agency and its
services. Thus, non-participant-related directors may be inclined to
favor expanded access to products and services, which may increase the
amount of risk that the clearing agency must successfully manage. The
interest in expanded access to products and services may be especially
relevant in the early stages of a clearing agency's development, when
establishing a new entity as a viable clearing agency is especially
important.
The Commission recognizes that other factors may also affect
director incentives and behavior. For example, it may be argued that
participant-related directors may in general have greater risk
management expertise and experience than non-participant-related
directors, and that non-participant-related directors may tend to defer
to the views or judgment of participants or participant-related
directors on risk matters, with the effect that open access may be
unduly compromised in favor of risk management. On the other hand, it
may be argued that qualified non-participant-related directors with
sufficient risk management expertise can be readily found, and in any
event these directors' independence of participants would justify their
heightened involvement on the Board.
In addition, directors may face other conflicts of interest. For
example, there may be conflicts between the competing interests of
different shareholders--whether or not participants--which could have
implications for director behavior, as discussed more fully below.
There also may be a tension between the directors' incentives to
maximize profits and their duties to oversee the security-based swap
clearing agency's compliance with applicable legal restrictions which,
although not necessarily unique to clearing agencies, may nevertheless
affect how they decide any particular matter.
As described more fully below, the proposed rules are intended to
strike a balance among these various
[[Page 65889]]
considerations by allowing participants to maintain a significant voice
within a security-based swap clearing agency while also imposing
ownership limitations and independent director requirements to mitigate
the potential influences of participant owners and participant-related
directors.
e. Request for Comments Regarding Identified Conflicts of Interest
The Commission requests comment on the conflicts of interest it has
identified with respect to security-based swap clearing agencies,
including the conflicts related to participant standards, product
eligibility, and risk management. Do commenters agree with the
potential conflict concerns that the Commission has identified? Some
parties have questioned the benefits of central clearing generally in
terms of reducing systemic risk,\47\ potentially suggesting a different
analysis with respect to the identified conflicts of interest. What are
commenters views on the potential benefits and costs of central
clearing and the resulting effect on the conflicts of interest
analysis?
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\47\ See, e.g., Craig Pirrong, ``The Inefficiency of Clearing
Mandates,'' Cato Institute Policy Analysis No. 665, July 21, 2010.
---------------------------------------------------------------------------
What effect would the identified conflicts of interest likely have?
Should the Commission focus on any of these conflicts more than others?
Are there other existing conflicts concerns that commenters believe
warrant scrutiny? If so, what are they and how are they likely to
affect security-based swap clearing agencies?
The conflicts of interest discussed in part stem from the current
concentrated market structure for security-based swaps. How is the
current market structure likely to evolve over time? What effect will
that evolution have on the consideration of conflicts of interest? Are
there any other conflicts of interest that may result due to expected
changes in the security-based swaps market or the clearing of security-
based swaps that the Commission should consider? If so, what are they
and how are they likely to affect security-based swap clearing
agencies?
The central clearing of security-based swaps is still developing
and may change significantly as the market for security-based swaps
develops. In particular, the new provisions in the Dodd-Frank Act
relating to the central clearing of security-based swaps are not yet
effective. Once they become effective, security-based swap clearing
agencies will be subject to substantially more regulation, which may
have an effect on conflicts of interest. How are conflicts of interest
likely to change as the central clearing of security-based swaps, and
security-based swap clearing agencies, become more established? What
potential new conflicts of interest could arise that the Commission
should consider? How will potential changes in the trading of security-
based swaps affect conflicts of interest at security-based swap
clearing agencies? In addition, competitive forces within the security-
based swaps market may help to mitigate conflicts of interest, for
example, by increasing the number of institutions that trade in
security-based swaps and creating a broader market in security-based
swaps. How might competition issues affect or change current conflicts
of interest? Will competition potentially create different or
additional conflicts of interest that the Commission should consider?
Will competition potentially mitigate conflicts of interest?
What other parties may have conflicts of interest that would affect
whether they should control or participate in the governance of a
security-based swap clearing agency? In what circumstances do these
conflicts of interest arise? Under certain circumstances, there is the
potential that incentives of shareholders to maximize profits could
compromise prudent risk management by a security-based swap clearing
agency. For example, shareholders could seek to increase revenue from
clearing fees by increasing the number of products cleared by the
clearing agency beyond those that can be appropriately risk managed or
by having the clearing agency expand its services or engage in new
lines of business that would expose the security-based swap clearing
agency to increased risk. Shareholders that are not users of a
security-based swap clearing agency may also not have the same
incentives to keep the costs of clearing low. The Commission requests
comment on the conflicts of interest that non-participant shareholders
may have and the effect such conflicts could have on a security-based
swap clearing agency. What are the differences in conflicts of interest
between participants and non-participants? What are the different
effects these conflicts could have on a security-based swap clearing
agency? Which conflicts of interest could potentially cause the
greatest harm to the security-based swap clearing agency?
Do persons who are selected to be directors of a security-based
swap clearing agency by participants have a conflict of interest based
on their status as directors that would affect their ability to act in
the best interest of the clearing agency, to act in conformity with the
Exchange Act, or to act to meet the policy objectives in Section 765 of
the Dodd-Frank Act? Would directors be less likely to act to meet the
policy objectives in Section 765 of the Dodd-Frank Act if they are
selected by shareholders seeking to maximize the profits of the
security-based swap clearing agency? What effect would they likely have
on security-based swap clearing agencies? How do participants'
conflicts of interest that affect risk management and open access
issues compare with non-participants' interests regarding these issues?
How do participants' incentives with respect to risk management compare
with the incentives of non-participant shareholders or directors? How
do the incentives of independent directors differ from the non-
independent directors in terms of considering the potential for
conflicts of interest?
The Commission also requests comment on the interplay of the
identified conflicts of interest, and any additional conflicts of
interest identified by commenters, and how that may affect a security-
based swap clearing agency. For example, there may at times be a trade-
off between risk management standards and open access to the clearing
agency. What is the best way to balance these and other potential
conflicts of interest in order to assure that the clearing agency has
both robust risk management and fair and open access to clearing
services? Are there any other conflicts of interest that pose similar
trade-offs? What conflicts are these and how should the Commission
balance the related concerns?
The Commission recognizes that other conflicts of interest may
arise in the governance of security-based swap clearing agencies--for
example, there may be a conflict between the interests of certain
shareholders. The rules the Commission is proposing today focus on the
conflicts of interest presented by the potential influence of
participants in the security-based swaps market because, as described
above, the Commission believes those conflicts may be most relevant to
the development of security-based swap clearing agencies. The
Commission recognizes that conflicts of interest may also arise with
respect to independent directors and has attempted to achieve a balance
between the different incentives of participant-related and non-
participant-related directors and the potential benefits each might
bring to the Board of a security-based swap clearing agency.
[[Page 65890]]
B. Security-Based Swap Execution Facilities and National Securities
Exchanges
The Commission has also reviewed the potential for conflicts of
interest at SB SEFs and SBS exchanges in accordance with Section 765 of
the Dodd-Frank Act and has identified those conflicts that it believes
may be mitigated by rules designed to improve the governance of a SB
SEF or SBS exchange, promote competition, or mitigate conflicts of
interest in connection with the operation of a SB SEF or SBS exchange
by a security-based swap execution facility participant (``SB SEF
participant'') \48\ or a member of an SBS exchange (``SBS exchange
member'') \49\ that has an ownership interest in the SB SEF or SBS
exchange. As with security-based swap clearing agencies, the Commission
preliminarily believes that conflicts of interest that may have an
adverse affect on the statutory goals of Section 765 are those that
arise when a small number of market participants, including
participants that are Specified Entities and including related persons
of participants,\50\ exercise control or undue influence over a SB SEF
or SBS exchange. This influence may be exercised either through
ownership of voting interests \51\ or participation in the governance
of the SB SEF or SBS exchange.
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\48\ The term ``security-based swap execution facility
participant'' means a person permitted to directly effect
transactions on the security-based swap execution facility. See
proposed Rule 700(z) under Regulation MC.
\49\ A ``member'' when used with respect to a national
securities exchange means (i) any natural person permitted to effect
transactions on the floor of the exchange without the services of
another person acting as broker, (ii) any registered broker or
dealer with which such a natural person is associated, (iii) any
registered broker or dealer permitted to designate as a
representative such a natural person, and (iv) any other registered
broker or dealer which agrees to be regulated by such exchange and
with respect to which the exchange undertakes to enforce compliance
with the provisions of the Exchange Act, the rules and regulations
thereunder, and its own rules. See Section 3(a)(3)(A) of the
Exchange Act, 15 U.S.C. 78c(a)(3)(A).
\50\ See infra Section V.A. for a discussion of ``related
person'' in the context of a SB SEF and SBS exchange or facility
thereof.
\51\ See infra Section V.A. for a discussion of the ownership
and voting limits of proposed Rule 702 under Regulation MC.
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The Commission believes that through ownership of voting interests
or ability to influence governance, market participants could exercise
influence with respect to the services provided by SB SEFs or SBS
exchanges, the rules and policies applicable to participants or members
of such entities, and, more generally, the security-based swaps market.
When a small group of those same market participants also dominate much
of the trading in security-based swaps, control of a SB SEF or SBS
exchange by these participants raises a heightened concern. If a SB SEF
or a SBS exchange is controlled by a small group of dealers who also
dominate trading in the market for security-based swaps, the dealers
may have competitive incentives to exert undue influence to control the
level of access to the SB SEF or SBS exchange and thus impede
competition by other market participants. In other words, participants
or members in a SB SEF or SBS exchange, as applicable, might seek to
limit the number of direct participants in the trading venue in order
to limit competition and increase their ability to maintain higher
profit margins. Given such incentives, a SB SEF or SBS exchange that is
controlled by a limited number of participants or members might adopt
policies and procedures that are designed to restrict access.
Participants or members also might be motivated to restrict the
scope of security-based swaps that are eligible for trading at SB SEFs
or SBS exchanges if there is a strong economic incentive to keep such
swaps in the OTC market. On the other hand, this concern may be
mitigated by competitive forces if a greater number and variety of
facilities where security-based swaps can be traded are available. A
small number of firms currently dominate trading in the OTC derivatives
market.\52\ Centralized trading of security-based swaps likely would
result in lower spreads and lower transaction costs for end-users,
particularly as a result of increased pre-trade and post-trade
transparency of prices, assuming sufficient trading volume and
liquidity.\53\ As noted above, increased price transparency might help
to eliminate much of the basis for asymmetrical information, reduce
spreads, and reduce the profit per trade for firms that dominated the
OTC security-based swaps market. As a result, this might create an
incentive for participants or members in a SB SEF or SBS exchange, as
applicable, to seek to limit the number of security-based swaps that
are made available for trading by such venues. The Commission
recognizes, however, that there could in certain circumstances be
legitimate concerns regarding liquidity or other trading
characteristics of a security-based swap that reasonably might justify
the decision of participants in a SB SEF or members of a SBS exchange
not to make a particular product available for trading on a SB SEF or a
SBS exchange. However, decisions regarding the eligibility of security-
based swaps for trading on a SB SEF or SBS exchange should not be
subject to undue influence by parties that have a financial interest in
keeping such products from being centrally traded on a facility or
exchange.
---------------------------------------------------------------------------
\52\ See supra note 40.
\53\ The Commission will address the issue of transparency of
security-based swap pricing and transaction data in a separate
rulemaking.
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Finally, the Commission also believes that a SB SEF or SBS exchange
could have potential conflicts of interest between the commercial
interests of the SB SEF or SBS exchange or the SB SEF's or SBS
exchange's owners and the SB SEF's or SBS exchange's market oversight
responsibilities.\54\ With respect to these kinds of conflicts of
interest, the Commission's proposal is informed, in part, by its
experience overseeing national securities exchanges. The Commission
notes, however, that a SB SEF's regulatory obligations under Section
763(c) of the Dodd-Frank Act are not identical to those of a national
securities exchange's obligations under Section 6 of the Exchange Act.
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\54\ An entity that registers as a SB SEF will have oversight
responsibility over its market pursuant to the Exchange Act (as
amended by the Dodd-Frank Act) and rules adopted thereunder. See
Section 763(c) of the Dodd-Frank Act, Public Law 111-203, Section
763(c). Similarly, all national securities exchanges, including
those that may post or make available for trading security-based
swaps, have oversight responsibilities over their markets and their
members pursuant to the Exchange Act. See Section 6 of the Exchange
Act, 15 U.S.C. 78(f).
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National securities exchanges are self-regulatory organizations
(``SROs'') and are statutorily required to comply, and enforce
compliance by their members and their associated persons, with the
Federal securities laws, the rules and regulations thereunder, and
their own rules.\55\ Exchanges also generally operate for-profit
markets and, as a result, are concerned with preserving and enhancing
their competitive positions vis-[agrave]-vis other exchanges.\56\
Consequently, exchanges have potential conflicts of interest between
carrying out their regulatory obligations to vigorously oversee their
members and marketplace and promoting their and their shareholders'
economic interests. For example, an exchange could put its interest and
that of its members or
[[Page 65891]]
shareholders ahead of its regulatory responsibilities by failing to
take regulatory or enforcement actions or to adequately fund self-
regulation. Further, the commercial interests of the shareholders of an
exchange may conflict with the regulatory obligations of an exchange. A
shareholder may be incentivized to maximize profits through the
economic stake it has in the exchange or, if the shareholder is also a
member of the exchange, to more directly further its own commercial
interests.\57\ For example, a shareholder could promote the
distribution of the exchange's revenues in a manner that could result
in inadequate funding of the exchange's regulatory operations or, if
also an exchange member, could use the exchange's disciplinary process
potentially to harass or penalize a competitor.
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\55\ See Sections 6(b)(1) of the Exchange Act, 15 U.S.C.
78f(b)(1).
\56\ Historically, national securities exchanges were structured
as not-for-profit or similar organizations owned by their members.
Exchanges, however, have more recently evolved to become
shareholder-owned. See supra note 49 for the definition of
``member'' as applicable to national securities exchanges.
\57\ See SRO Governance Proposing Release, 69 FR 71126, infra
note 59.
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The Commission has considered the conflicts between an exchange's
regulatory responsibilities and its commercial interests in operating a
marketplace for the trading of securities. To address these types of
concerns, the Commission has developed, consistent with the
requirements of Section 6 of the Exchange Act,\58\ an approach to
mitigate conflicts of interest for national securities exchanges.\59\
Specifically, through its review of proposals filed by exchanges with
respect to changes to their ownership and governance structures
(generally from member-owned to shareholder-owned organizations)
pursuant to Section 19 of the Exchange Act \60\ or of applications
filed by entities to register as national securities exchanges pursuant
to Section 6 of the Exchange Act,\61\ the Commission examines the way
in which an exchange applies ownership and voting limits and addresses
certain governance principles.\62\ Namely, the Commission looks to
ensure that there are limits on the ability of persons to own and
control exchanges by, for example, requiring at a minimum that no
person, alone or together with its related persons,\63\ be permitted to
own more than 40%, and no member, alone or together with its related
persons, be permitted to own more than 20%, of the ownership interests
of the exchange or be entitled to vote shares in excess of 20%.\64\
Further, the Commission also looks to ensure that an exchange provide
fair representation of members in the selection of directors and the
administration of its affairs, consistent with the requirement in
Section 6(b)(3) of the Exchange Act,\65\ that an exchange is organized
in a manner that allows it to carry out the purposes of the Exchange
Act pursuant to Section 6(b)(1) of the Exchange Act,\66\ and that it
provides fair procedures for disciplining members, consistent with the
requirements in Sections 6(b)(6) and 6(b)(7) of the Exchange Act.\67\
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\58\ See Section 6(b) of the Exchange Act, 15 U.S.C. 78f(b).
\59\ See, e.g., Securities Exchange Act Release Nos. 61698
(March 12, 2010), 75 FR 13151 (March 18, 2010) (In the Matter of the
Applications of EDGX Exchange, Inc., and EGDA Exchange, Inc. for
Registration as National Securities Exchanges; Findings, Opinion,
and Order of the Commission) (``Exchange Act Release No. 61698'');
58375 (August 18, 2008), 73 FR 49498 (August 21, 2008) (In the
Matter of the Application of BATS Exchange, Inc. for Registration as
a National Securities Exchange; Findings, Opinion, and Order of the
Commission) (``Exchange Act Release No. 58375''). In 2004, the
Commission proposed rules relating to: the fair administration and
governance of SROs; disclosure and regulatory reporting by SROs;
recordkeeping requirements by SROs; ownership and voting limitations
for SROs; and listing and trading of affiliated securities by SROs.
The Commission has not taken action on these proposed rule changes.
See Securities Exchange Act Release No. 50699 (November 18, 2004),
69 FR 71126 (December 8, 2004) (``SRO Governance Proposing
Release'').
\60\ 15 U.S.C. 78s.
\61\ 15 U.S.C. 78f.
\62\ See, e.g., Securities Exchange Act Release Nos. 62158 (May
24, 2010), 75 FR 30082 (May 28, 2010) (order approving the
demutualization of the Chicago Board Options Exchange, Incorporated
(``CBOE'')) and 53382 (February 27, 2006), 71 FR 11251 (March 6,
2006) (order approving the merger of New York Stock Exchange, Inc.
(``NYSE'') and Archipelago and NYSE's demutualization).
\63\ Generally, a ``related person'' means, with respect to any
person, any other person, directly or indirectly, controlling,
controlled by, or under common control with such person or any
person acting in concert with such person.
\64\ See, e.g., Exchange Act Release No. 61698, 75 FR at 13156,
supra note 59. The exchange's Board may waive the voting and
ownership limits if it makes certain findings, including a finding
that such a waiver would be consistent with the exchange's self-
regulatory obligations. The board, however, may not waive these
limits for any exchange members. Moreover, the exchange must file
such waiver with the Commission as a proposed rule change for
approval before it could be implemented.
The ownership limits currently in place for exchanges generally
apply to any ownership interest. See, e.g., Exchange Act Release No.
61698, 75 FR 13151, supra note 59; Amended and Restated Certificate
of Incorporation of BATS Global Markets, Inc., Article FIFTH. In
contrast, proposed Rule 702 would apply ownership limits only with
respect to those shares or other interests entitled to vote. See
infra Section V.A. for a discussion of the differences between the
ownership and voting limits in proposed Rule 702 and those limits
currently in place for exchanges.
\65\ 15 U.S.C. 78f(b)(3). Pursuant to Section 6(b)(3), the
Commission generally requires, at a minimum, that at least 20% of
the directors on the board be selected by exchange members. The
Commission also requires that exchange members be permitted to
participate in the nomination process of such representative
directors and that they have the right to petition for alternative
candidates. See, e.g., Securities Exchange Act Release No. 58375, 73
FR at 49500, supra note 59.
\66\ 15 U.S.C. 78f(b)(1). Pursuant to Section 6(b)(1), the
Commission generally requires, at a minimum, that the number of non-
industry directors on the exchange's board equal or exceed the
number of industry directors. Generally, a ``non-industry director''
is someone who is not subject to regulation by the exchange, is not
a broker or dealer or an officer, director, or employee of a broker
or dealer, is not associated with an entity that is affiliated with
a broker or dealer, and has neither a material ownership interest
nor investment in a broker or dealer. See, e.g., CBOE By-Laws,
Article III, Section 3.1. Some exchanges also have ``independent
directors.'' Typically, an independent director has no material
relationship with the exchange or an exchange member. See, e.g.,
Amended and Restated By-Laws of BATS Exchange, Inc., Article I(m).
For example, an officer or director of a listed issuer generally is
considered a non-industry director rather than an independent
director. The definitions of ``non-industry'' and ``independent''
do, however, differ across exchanges.
\67\ 15 U.S.C. 78f(b)(6) and (7). To find an exchange's
disciplinary rules to be consistent with the Exchange Act, the
Commission generally requires that disciplinary processes be
balanced and include industry member participation. See, e.g.,
Exchange Act Release No. 61698, 75 FR at 13160, n. 124, supra note
59.
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The Commission's recognition of potential conflicts of interest at
exchanges and its approach to date in reviewing and approving measures
designed to mitigate those conflicts of interest are a useful point of
reference as the Commission identifies, and develops proposals to
mitigate, the conflicts of interest potentially faced by SB SEFs and
SBS exchanges as the trading of security-based swaps moves to regulated
markets. However, as noted above, the Commission recognizes that a SB
SEF's regulatory obligations are not the same as a national securities
exchange's regulatory obligations.
The Commission in 2004 proposed rules to promote the fair
administration and governance of, and to impose ownership and voting
limitations on, national securities exchanges and registered national
securities associations.\68\ Among other things, the proposal would
have required an exchange to: Have a Board composed of a majority of
independent directors; maintain fully independent nominating,
compensation, and audit committees; separate its regulatory obligations
and business functions by establishing a fully independent regulatory
oversight committee (``ROC'') or equivalent structure; and limit
ownership and voting control by members.\69\ This proposal was intended
to improve the governance of certain SROs by establishing independence
standards for the board of directors (``Board'') and key committees and
by minimizing conflicts of interest by instituting ownership and voting
limitations and the separation of the exchange's regulatory obligations
and commercial interests. Although the
[[Page 65892]]
Commission has not acted further on this proposal, a number of
exchanges have adopted some of the governance concepts on their own
initiative \70\ and all of the exchanges registered under Section 6 of
the Exchange Act have adopted ownership and/or voting limitations, with
the Commission's approval.\71\
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\68\ See SRO Governance Proposing Release, 69 FR 71126, supra
note 59.
\69\ Id.
\70\ See, e.g., CBOE By-Laws, Article III, Board of Directors
(``Board of Directors'' must have a majority of ``Non-Industry
Directors'') and Article IV, Committees (``Regulatory Oversight
Committee'' must consist of at least three directors, all of whom
shall be ``Non-Industry Directors''); By-Laws of the NASDAQ Stock
Market LLC (``Nasdaq''), Article III, Board of Directors, Section 2,
Qualifications (``Board of Directors'' must have a majority of
``Non-Industry Directors'') and Section 5, Committees Composed
Solely of Directors (Regulatory Oversight Committee must consist of
at least three members, each of whom shall be a ``Public Director''
and an ``independent director'' as defined in Nasdaq Rule 4200).
\71\ See, e.g., Amended and Restated Certificate of
Incorporation of BATS Global Markets, Inc., Article FIFTH.
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Each potential conflict of interest identified in this Section
III.B. could limit the benefits of centralized trading in the security-
based swaps market and potentially undermine the mandatory trading
requirement in new Section 3C(h) of the Exchange Act, thereby
negatively affecting efficiency and competition in the security-based
swaps market.\72\ Further, while the Commission believes that its past
application of statutory requirements has been appropriate to improve
the governance of, and mitigate the conflicts of interest for,
exchanges, given the difference in the structure of the OTC derivatives
market and the markets for exchange-listed securities, it also believes
that potential conflicts of interest in SBS exchanges can and should be
further examined.\73\ Namely, unlike exchange-listed securities,
trading in the OTC derivatives market is currently dominated by a small
group of dealers.\74\ Although mechanisms in place to address conflicts
of interest among members, shareholders, and exchanges would help
mitigate some concerns about conflicts of interest that could result
from dealer control of the current security-based swaps market, the
Commission believes that additional measures may be necessary to
effectively mitigate conflict of interest concerns. For example,
applying standards approved for exchanges to SB SEFs and SBS exchanges,
as described above, may not alone adequately address the potential
concern that a small group of dealers could gain control over such
entities and limit security-based swaps from trading on, and
participant or member access to, a centralized market. Accordingly, the
Commission is proposing rules for SB SEFs and SBS exchanges that are
designed to mitigate the potential conflicts of interest that it has
identified in the context of the security-based swaps market, including
ownership limitations and governance requirements, as more fully
described below.\75\
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\72\ See Public Law 111-203, Section 763(a). Section 3C(h) of
the Exchange Act imposes a mandatory trading requirement, which
provides that counterparties shall execute a transaction in a
security-based swap subject to the clearing requirement of Section
3C(a)(1) on an exchange or a registered SB SEF or a SB SEF that is
exempt from registration pursuant to Section 3D(e) of the Exchange
Act.
\73\ Within the past several years, the Commission has reviewed
and assessed comprehensively the governance structure of each
national securities exchange, either in connection with a
significant transaction by the exchange or as part of its
application for registration as a national securities exchange. See,
e.g., Securities Exchange Act Release Nos. 58324 (August 7, 2008),
73 FR 46936 (August 12, 2008) (order approving The NASDAQ OMX Group,
Inc.'s (``Nasdaq OMX'') acquisition of the Boston Stock Exchange,
Inc. (``BSE'')); 58179 (July 17, 2008), 73 FR 42874 (July 23, 2008)
(order approving Nasdaq OMX's acquisition of the Philadelphia Stock
Exchange, Inc. (``Phlx'')); 55293 (February 14, 2007), 72 FR 8033
(February 22, 2007) (order approving the business combination
between NYSE and Euronext N.V.); 56955 (December 13, 2007), 72 FR
71979 (December 19, 2007) (order approving acquisition of
International Securities Exchange, Inc. (``ISE'') by Eurex Frankfurt
AG); Exchange Act Release No. 58375, 73 FR at 49500, supra note 59;
61152 (December 10, 2009), 74 FR 66699 (December 16, 2009) (order
approving application of C2 Options Exchange, Incorporated to
register as a national securities exchange); Exchange Act Release
No. 61698, 75 FR at 13156, supra note 59; 53128 (January 13, 2006),
71 FR 3550 (January 23, 2006) (order approving Nasdaq's application
to register as a national securities exchange).
\74\ See supra note 40.
\75\ As of the date of this release, the Commission has not
proposed rules regarding the scope, registration requirements, and
operation of a SB SEF, including the types of entities that would
qualify for registration as a SB SEF.
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The Commission has considered the mechanisms in place to mitigate
conflicts of interest at national securities exchanges in developing
its proposals to mitigate conflicts of interest for SB SEFs and SBS
exchanges. The Commission notes that there are similarities and
differences between the exchange-listed markets and the market for
security-based swaps that merit consideration in crafting appropriate
proposals to mitigate conflicts of interest for SB SEFs and SBS
exchanges. National securities exchanges list and trade cash equity
securities and options pursuant to a well-developed body of their own
rules, as well as Commission rules, and compete actively with each
other and with other non-exchange trading venues for market share and
revenues associated with trading volume. The markets for cash equity
securities and listed options are generally liquid, trading is widely
dispersed, and there are numerous trading venues and market
participants. Unlike the well-established cash equity and options
markets, the security-based swaps market is at an earlier stage of
development and, as noted above, is currently dominated by a small
number of dealers. Further, the regulatory structure governing the
security-based swaps market will not be completely realized until all
provisions of the Dodd-Frank Act and any rules promulgated thereunder
are fully implemented. However, like exchanges, SB SEFs may have
shareholder-owners who also may be SB SEF participants and may compete
with any other SB SEF to the extent that they trade the same security-
based swaps. In addition, although SB SEFs would not be SROs and
therefore would not be subject to the same obligations under the
Exchange Act as SROs, they nonetheless will be subject to regulatory
responsibilities under Section 763(c) of the Dodd-Frank Act and, as a
result, will have to establish rules and enforce compliance with those
rules by their participants.\76\ Thus, the conflicts of interest that
the Commission has experienced with exchanges may be similar, although
not necessarily identical, to the conflicts of interest that SB SEFs
and SBS exchanges may face. The Commission nevertheless is mindful of
the need to mitigate conflicts of interest for SB SEFs and SBS
exchanges without unduly restricting the ability of trading facilities
to be formed or the emergence of a competitive market for the trading
of security-based swaps.
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\76\ See Section 763(c) of the Dodd-Frank Act, Public Law 111-
203, Section 763(c).
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The Commission requests comment on the types of conflicts of
interest it has identified with respect to SB SEFs and SBS exchanges,
including the listing and trading of security-based swaps on SB SEFs
and SBS exchanges. Has the Commission identified all of the significant
potential conflicts concerns? Do commenters disagree with any potential
conflicts concerns that the Commission has identified? What other
conflicts concerns may exist, if any?
As discussed above, the Commission seeks to minimize the conflicts
of interest for national securities exchanges through ownership
limitations and governance requirements. Are the conflicts of interest
relating to exchanges, which could elect to trade swaps and thus become
SBS exchanges, different than the conflicts of interest relating to SB
[[Page 65893]]
SEFs, and, if so, how? To what extent, if any, should the Commission
draw on its experience with conflicts of interest that may arise in the
exchange context and with efforts to mitigate those conflicts and apply
that experience in assessing conflicts of interest that may arise in
the context of SB SEFs and SBS exchanges? What are the differences and
similarities between the conflicts of interest that the Commission has
encountered with respect to national securities exchanges and the
conflicts of interest that it has identified with respect to SB SEFs
and SBS exchanges?
Further, are the conflicts of interest relating to SBS exchanges
different than the conflicts of interest relating to exchanges that do
not post or make available for trading security-based swaps? If there
are no differences, should the Commission propose to adopt rules to
mitigate conflicts of interest with respect to national securities
exchanges that are not SBS exchanges or are the existing approaches to
mitigating conflicts of interest for such exchanges sufficient?
The Commission also requests comment on potential changes in these
conflicts of interest. The Commission recognizes that the conflicts of
interest that may exist today with respect to the trading of security-
based swaps by SB SEFs and SBS exchanges may evolve over time and that,
as this market evolves, the conflicts of interest that the Commission
has identified for SB SEFs and SBS exchanges may change. The
centralized trading of security-based swaps is still developing and may
change significantly as the market for security-based swaps develops.
In particular, the provisions in the Dodd-Frank Act relating to the
centralized trading of security-based swaps are not yet effective. Once
they become effective, market participants that trade security-based
swaps will be subject to substantially more regulation, which may have
an effect on the conflicts of interest at SB SEFs and SBS exchanges.
What are commenters' views on whether and how conflicts of interest for
SB SEFs and SBS exchanges may evolve over time and how the Commission
should respond to such changes? How are conflicts of interest likely to
change as the centralized trading of security-based swaps and SB SEFs
and SBS exchanges become more established? Are the conflicts of
interest identified by the Commission likely to change as the trading
of security-based swaps moves to regulated markets that must provide
for impartial access and, if so, how? What potential new conflicts of
interest could arise that the Commission should consider? How will
potential changes in the clearing of security-based swaps affect
conflicts of interest at SB SEFs and SBS exchanges? In addition,
competitive forces within the security-based swaps market may help to
mitigate conflicts of interest, for example, by increasing the number
of institutions that trade security-based swaps and creating a broader
market for security-based swaps. How will competition issues affect or
change current or identified conflicts of interest? Will competition
potentially create different or additional conflicts of interest that
the Commission should consider? Would the Commission's proposal to
apply to SB SEFs and SBS exchanges standards to mitigate conflicts of
interest that are similar to those approved for national securities
exchanges influence whether those conflicts of interest will increase,
diminish, or remain unchanged over time?
Are there any other conflicts of interest that warrant examination?
What other parties may have conflicts of interest that would affect
whether they should control or participate in the governance of a SB
SEF or SBS exchange? In what circumstances would these conflicts of
interest arise? For example, might non-participant or non-member
shareholders have a conflict of interest? What would be the differences
in conflicts of interest between participants and non-participants or
members and non-members that would affect the SB SEF or SBS exchange?
Would persons who are selected to be directors of a SB SEF or SBS
exchange by participants or members have conflicts of interest based on
their status as directors that would affect their ability to act in the
best interest of the entity or in conformity with the Exchange Act, or
to act to meet the policy objectives in Section 765 of the Dodd-Frank
Act? Would directors be less likely to act to meet the policy
objectives in Section 765 of the Dodd-Frank Act if they are selected by
shareholders seeking to maximize the profits of the SB SEF or SBS
exchange? How would participants' or members' potential conflicts of
interest concerning open access and products traded compare to non-
participants' or non-members' conflicts on such issues? How do the
incentives of independent directors differ from those of non-
independent directors with respect to increasing access or promoting
competition?
IV. Discussion of Proposed Regulation MC: Mitigation of Conflicts of
Interest of Security-Based Swap Clearing Agencies
Section 765 directs the Commission to adopt rules to mitigate
conflicts of interest, which rules may include numerical limits on
control of, or voting rights with respect to, any security-based swap
clearing agency. The Commission preliminarily believes that
requirements applicable to both governance and voting interests can
play an essential role in mitigating conflicts of interests. However,
the Commission recognizes that the nature of the governance, ownership
and voting requirements to mitigate conflicts may differ depending on
the conflicts of interest of the persons making decisions on behalf of
the security-based swap clearing agency. In particular, the nature of
the ownership and voting power of stockholders of the security-based
swap clearing agency plays a role in determining the nature of the
conflicts of interest that directors of the security-based swap
clearing agency will face.
As previously noted, the Commission preliminarily believes that
conflicts of interest may arise when a small number of participants
exercise control or undue influence over a security-based swap clearing
agency. Conflicts of interest may also arise, however, simply because
directors and other decision-makers at a security-based swap clearing
agency have multiple interests and goals, including maximizing profit
for the benefit of shareholders and imposing risk restraints that may
limit short-term profits, among others.
In seeking to address conflicts of interests, the imposition of
governance restrictions may lessen the need to impose certain voting
limitations, while the imposition of certain voting limitations may
alleviate the need to impose certain governance restrictions.
Accordingly, the Commission is proposing two alternative approaches
with respect to voting limitations and governance that would place
differing levels of emphasis on each of these factors.\77\
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\77\ See proposed Rule 701(a) and (b) of Regulation MC.
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The proposed rule would allow the security-based swap clearing
agency to elect between the two alternatives. The first alternative
places an emphasis on voting limitations while also imposing certain
governance restrictions (``Voting Interest Focus Alternative'').\78\
The second alternative places an emphasis on governance restrictions
while also
[[Page 65894]]
imposing certain voting limitations (``Governance Focus
Alternative'').\79\ Although the Commission is proposing two separate
alternatives, the Commission may also consider adopting only one
alternative as the final rule or may combine aspects of each proposed
alternative and adopt it as a single rule.\80\
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\78\ See proposed Rule 701(a) under Regulation MC.
\79\ See proposed Rule 701(b) under Regulation MC.
\80\ See infra Section VIII requesting comment on whether
alternatives with or without modifications should be allowed and
whether certain requirements in each alternative should be combined
to form a single approach.
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In addition, the existing standards in Section 17A of the Exchange
Act also help to mitigate conflicts of interest at registered clearing
agencies and will be applied in addition to any standards adopted by
the Commission under the Dodd-Frank Act.\81\
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\81\ See discussion infra Section IV.C. Security-based swap
clearing agencies will be required to be registered with the
Commission under Section 17A of the Exchange Act upon the effective
date of Title VII and, as a result, must comply with the standards
in Section 17A that are applicable to all registered clearing
agencies.
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A. Alternative I: Voting Interest Focus Alternative
As more fully described below, under the Voting Interest Focus
Alternative, the Commission is proposing limitations on the voting
interests held by individual participants of a security-based swap
clearing agency and by participants acting collectively as a group. In
addition, the Commission is proposing certain requirements related to
governance that would give independent directors a strong role in
overseeing the security based-swap clearing agency.
1. Voting Interest Focus Alternative: Individual Voting Limitation
The Voting Interest Focus Alternative would provide that a
security-based swap clearing agency may not permit a participant,
either alone or together with its related persons, to (1) beneficially
own, directly or indirectly, any interest in the security-based swap
clearing agency that exceeds 20% of any class of securities, or other
ownership interest, entitled to vote of such security-based swap
clearing agency or (2) directly or indirectly vote, cause the voting
of, or give any consent or proxy with respect to the voting of, any
interest in the security-based swap clearing agency that exceeds 20% of
the voting power of any class of securities or other ownership interest
of such security-based swap clearing agency.\82\ This proposed
limitation on individual participant voting interest is designed to
prevent any individual participant from owning, on a direct or indirect
basis, a voting interest that would allow it to act on conflicts of
interest in the security-based swap clearing agency to the detriment of
such security-based swap clearing agency and the security-based swaps
market.
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\82\ See proposed Rule 701(a)(1)(i) and (ii) under Regulation
MC.
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The terms ``beneficial ownership,'' ``beneficially owns'' or any
derivatives thereof would be defined in reference to Rule 13d-3 under
the Exchange Act, Determination of Beneficial Ownership.\83\ The
concept of beneficial ownership in Rule 13d-3 is designed to encompass
any person or group of persons that may be able to act to influence or
control an issuer. The Commission proposes to use the same definition
of beneficial ownership in this rule because it also would describe
those persons or groups of persons that may be able to act to influence
or control a security-based swap clearing agency. However, to the
extent any participant beneficially owns any security or other
ownership interest solely because such participant is a member of a
group within the meaning of Section 13(d)(3) of the Exchange Act, such
participant would not be deemed to beneficially own such security or
other ownership interest for purposes of this section, unless such
person had the power to direct the vote of such security or other
ownership interest. The Commission proposes to exclude beneficial
ownership that results solely from being a member of a group to provide
more certainty to those that would be required to comply with the
limitations, in light of the effect of exceeding the ownership limit--
i.e., that the participant will be divested of the excess interest.
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\83\ See proposed Rule 700(b) under Regulation MC, which
provides that the terms ``beneficial ownership,'' ``beneficially
owns,'' or any derivative thereof would be defined as having the
same meaning, with respect to any security or other ownership
interest, as set forth in Sec. 240.13d-3, as if (and whether or
not) such security or other ownership interest were a voting equity
security registered under Section 12 of the Exchange Act (15 U.S.C.
78l); provided that to the extent any person beneficially owns any
security or other ownership interest solely because such person is a
member of a group within the meaning of Section 13(d)(3) of the
Exchange Act (15 U.S.C. 78m(d)(3)), such person shall not be deemed
to beneficially own such security or other ownership interest,
unless such person has the power to direct the vote of such security
or other ownership interest.
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While the Commission has not previously adopted voting interest
limitations for registered clearing agencies in the other securities
markets, the security-based swaps market presents a different potential
concern with respect to conflicts of interests. In the securities
markets for which clearing agencies currently registered with the
Commission provide clearance and settlement services,\84\ there are
significantly more dealers and participants. The incentives of
participant-owners of these registered clearing agencies are generally
aligned with those of the clearing agency: To accept for clearing as
many participants that can meet reasonable participation standards and
as many transactions that fit into the clearing agencies' risk
management structure. Furthermore, the OTC derivatives market has a
relatively high concentration of market activity among a limited number
of dealers \85\ that earn significant revenues from the currently
opaque OTC market.\86\ The existing cash equities and listed options
markets, on the other hand, are transparent and widely disbursed over a
range of market participants. As previously discussed, participants in
a security-based swap clearing agency may have incentives to limit
participation in the clearing agency and to limit the scope of products
cleared. Moreover, the Commission's experience regulating security-
based swap clearing agencies along with the views expressed by market
participants suggest that security-based swap clearing agencies may be
particularly susceptible to conflicts of interest.\87\ The Commission
preliminarily believes that prohibiting a participant and its
affiliates and related persons from having more than a 20% voting
interest in a security-based swap clearing agency, taking into account
the other requirements under the Voting Interest Focus Alternative as
described below, would establish a sufficiently high threshold to
preclude any one participant from exerting undue influence over the
security-based swap clearing agency. The 20% threshold proposed for
participant voting interests in a security-based swap clearing agency
is similar to the threshold that the Commission previously proposed for
national securities exchanges and national securities associations, is
the same as the threshold now being proposed for SBS exchanges and SB
SEFs, and is consistent with the limits
[[Page 65895]]
currently in place with respect to national securities exchanges.\88\
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\84\ The four clearing agencies registered with the Commission
that have active business operations include: The Depository Trust
Company, The National Securities Clearing Corporation, The Fixed
Income Clearing Corporation, and The Options Clearing Corporation.
\85\ See supra note 40.
\86\ Id. (stating that U.S. commercial banks reported trading
revenues of $8.3 billion in the first quarter of 2010).
\87\ See supra notes 26 and 34.
\88\ As previously noted, national securities exchanges
generally prohibit exchange members, alone or together with their
related persons, from owning more than 20% of the exchange or being
entitled to vote shares in excess of 20%. See, e.g., Securities
Exchange Act Release No. 61698, 75 FR at 13156, supra note 59.
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2. Voting Interest Focus Alternative: Aggregate Voting Limitation
The Voting Interest Focus Alternative would provide that a
security-based swap clearing agency may not permit a participant,
either alone or together with its related persons, to in the aggregate
with any other security-based swap clearing agency participants and
their related persons (1) beneficially own, directly or indirectly, any
interest in the security-based swap clearing agency that exceeds 40% of
any class of securities, or other ownership interest, entitled to vote
of such security-based swap clearing agency or (2) directly or
indirectly vote, cause the voting of, or give any consent or proxy with
respect to the voting of, any interest in the security-based swap
clearing agency that exceeds 40% of the voting power of any class of
securities or other ownership interest of such security-based swap
clearing agency.\89\ Under the individual participant voting limitation
and without this aggregate limitation on voting interest, five entities
that have voting interests of 20% could control the security-based swap
clearing agency. Since a small number of dealers currently control the
OTC derivatives market,\90\ the Commission preliminarily believes that
this aggregate limitation on voting interest is a necessary corollary
to the individual participant voting limitation. The 40% aggregate
limitation on voting interest, which is consistent with limits used in
similar contexts,\91\ would restrict participants' ability to
collectively acquire a majority voting interest, while maintaining the
integrity of the 20% individual participant limitation.
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\89\ See proposed Rule 701(a)(1)(iii) and (iv) under Regulation
MC.
\90\ See supra note 40.
\91\ As previously noted, the Commission has generally
prohibited any person, alone or together with its related persons,
from owning more than 40% of a national securities exchange. See,
e.g., Securities Exchange Act Release No. 61698, 75 FR at 13156,
supra note 59.
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3. Voting Interest Focus Alternative: Indirect or Affiliate Ownership
and Ownership Through Related Persons
The Voting Interest Focus Alternative would also address conflicts
of interest created by indirect voting interests of the security-based
swap clearing agency because a rule that limits only direct voting
interests could be circumvented by holding the interest through an
affiliated party or by holding an interest in a controlling entity. For
purposes of determining a security-based swap clearing agency
participant's voting interest, the proposed rule would, as indicated in
the description of the rules above, combine such person's interest with
those of its ``related persons.'' \92\
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\92\ See proposed Rule 700(u) of Regulation MC.
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The Commission proposes to define the term ``related person'' to
include persons whose relationship with respect to a participant would
likely cause them to have the same conflicts of interest with respect
to the security-based swap clearing agency (e.g., ``affiliate,''
``immediate family member,'' and ``person associated with a participant
in a security-based swap clearing agency''). Specifically, proposed
Rule 700(u) would define ``related person'' as that term relates to
security-based swap clearing agencies as: (i) Any affiliate \93\ of a
participant in a security-based swap clearing agency; (ii) any person
associated with a participant in a security-based swap clearing agency;
\94\ (iii) any immediate family member \95\ of a participant in the
security-based swap clearing agency that is a natural person, or any
immediate family member of the spouse of such person, who, in each
case, has the same home as the participant in the security-based swap
clearing agency, or who is a director or officer of the security-based
swap clearing agency or any of its parents or subsidiaries; and (iv)
any immediate family member of a person associated with a participant
in the security-based swap clearing agency that is a natural person, or
any immediate family member of the spouse of such person, who, in each
case, has the same home as the person associated with the participant
in the security-based swap clearing agency, or who is a director or
officer of the security-based swap clearing agency, or any of its
parents or subsidiaries.
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\93\ The term ``affiliate'' would be defined as any person that,
directly or indirectly, controls, is controlled by, or is under
common control with, the person. See proposed Rule 700(a) under
Regulation MC. ``Control'' would be defined as the possession,
direct or indirect, of the power to direct or cause the direction of
the management and policies of a person, whether through the
ownership of voting securities, by contract, or otherwise. Any
person that (i) is a director, general partner, or officer
exercising executive responsibility (or having similar status or
function); (ii) directly or indirectly has the right to vote 25% or
more of a class of voting securities or has the power to sell or
direct the sale of 25% or more of a class of voting securities; or
(iii) in the case of a partnership, has the right to receive, upon
dissolution, or has contributed, 25% or more of the capital, is
presumed to control that person. See proposed Rule 700(e) under
Regulation MC.
\94\ There is currently not a definition for a ``person
associated with a participant in a clearing agency'' in the Exchange
Act or in Commission rules. However, the Commission believes that
the definition for the term ``person associated with a member'' in
Section 3(a)(21) of the Exchange Act should be used as the basis for
the definition of the term ``person associated with a participant in
a security-based swap clearing agency,'' as the purposes of the two
defined terms are similar. Accordingly, the Commission proposes to
define the term ``person associated with a participant in a
security-based swap clearing agency'' as (1) any partner, officer,
director, or branch manager of such security-based swap dealer or
major security-based swap participant (or any person occupying a
similar status or performing similar functions); (2) any person
directly or indirectly controlling, controlled by, or under common
control with such security-based swap dealer or major security-based
swap participant; or (3) any employee of such security-based swap
dealer or major security-based swap participant. This term does not
include any person associated with a participant in a security-based
swap clearing agency whose functions are solely clerical or
ministerial. See proposed Rule 700(r) of Regulation MC.
\95\ The term ``immediate family member'' would be defined in
the proposed rules as a person's spouse, parents, children, and
siblings, whether by blood, marriage, or adoption, or anyone
residing in such person's house. See proposed Rule 700(i) under
Regulation MC.
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A voting interest limitation of 20% for an individual participant
of a security-based swap clearing agency and an aggregate voting
interest limitation of 40% for all participants of a security-based
swap clearing agency is intended to restrict the ability of security-
based swap clearing agency participants to exercise undue influence
over the governance of a security-based swap clearing agency for their
own self-interest. At the same time, these voting limitations would
still permit participants to hold significant economic interests in a
security-based swap clearing agency.
4. Voting Interest Focus Alternative: Divestiture and Voting
Restriction Requirement
In order to assure that a security-based swap clearing agency
maintains the proposed voting interest limitations, the Commission is
proposing to require security-based swap clearing agencies to have
rules in place for the divestiture of voting interests that exceed the
prescribed limitations.\96\ The Commission preliminarily believes that
in order for the voting limitations to be effective, the rule must
require security-based swap clearing agencies to take action to reduce
participants' and participants' related persons' voting interests.
---------------------------------------------------------------------------
\96\ See proposed Rule 701(a)(2) under Regulation MC.
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The Commission is proposing to provide security-based swap clearing
agencies flexibility in determining how
[[Page 65896]]
to implement this divesture requirement. Any rules adopted by a
security-based swap clearing agency must assure that the security-based
swap clearing agency has a viable, enforceable mechanism to divest a
participant and its related persons of any voting interest owned in
excess of the 20% limitation, and not to give effect to the portion of
any voting interest in excess of the 20% individual limitation or the
40% aggregate limitation. The Commission is also proposing to require a
security-based swap clearing agency's procedures to provide a mechanism
for the security-based swap clearing agency to obtain information
relating to the voting interests in the security-based swap clearing
agency held by its participants and their related persons.\97\ The
Commission believes that this requirement is essential to a security-
based swap clearing agency's ability to monitor the voting interest
held by its participants and their related persons in relation to the
proposed voting limitations.
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\97\ Id.
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5. Voting Interest Focus Alternative: Independent Directors on Board
The Commission's Voting Interest Focus Alternative would impose
substantive requirements on the governance of security-based swap
clearing agencies that are designed to address the concern that
participants' conflicts of interest may lead them to take actions that
would potentially limit fair and open access and product eligibility
for central clearing, as well as potentially weaken the risk management
of security-based swap clearing agencies. The proposed governance
provisions, as discussed below, are intended to help mitigate potential
conflicts of interest and assure the fair administration and governance
of a security-based swap clearing agency by limiting the control that
any one participant or group of participants may exercise over the
security-based swap clearing agency.
The Commission proposes under the Voting Interest Focus Alternative
to require the Board \98\ of a security-based swap clearing agency to
be composed of at least 35% independent directors.\99\ The presence of
a significant number of independent directors on the Board of a
security-based swap clearing agency should provide the addition of
strong and independent oversight within the security-based swap
clearing agency to serve as a potential check against conflicts of
interest that could pose a detriment to the security-based swap
clearing agency, other firms, or the security-based swaps market
generally. The Commission preliminarily believes that a level below 35%
independent directors may not be sufficient to assure that independent
directors have a significant voice.\100\ A requirement lower than 35%
would potentially place independent directors in a small enough
minority that, relative to the remaining director slots that could
potentially be filled by participant or management directors, the views
of the independent directors would not be given enough consideration.
While independent directors would have less than a majority
representation on the Board under the Voting Interest Focus
Alternative, they would have a meaningful opportunity to contribute to
determinations made by the Board and the various Board committees. The
Commission is proposing to require at least 35% independent directors
combined with the proposal to limit participant voting interests in a
security-based swap clearing agency, both on an individual and
aggregate basis, as a means of effectively mitigating conflict of
interest concerns while also permitting a greater proportion of
participants to serve on the Board of a security-based swap clearing
agency.\101\ This aspect of the proposal may address potential concerns
that requiring a majority independent Board would affect the Board's
ability to effectively perform risk management functions.
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\98\ The term ``Board'' would be defined as the Board of
Directors or Board of Governors of the SB SEF, SBS exchange or
facility thereof that posts or makes available for trading security-
based swaps, or security-based swap clearing agency, as applicable,
or any equivalent body. See proposed Rule 700(c) under Regulation
MC.
\99\ The term ``director'' would be defined as any member of the
Board. See Proposed Rule 700(f) under Regulation MC.
\100\ Other regulators have previously chosen 35% as an
appropriate level for independent representation on the Board of
self-regulatory organizations. See 72 FR 6936 (February 14, 2007),
which adopts final rules to address conflicts of interest at self-
regulatory organizations regulated by the CFTC. Specifically, the
final rules establish acceptable practices under Core Principle 15
applicable to DCMs and that provide that the Board is composed of at
least 35% public directors.
\101\ Proposed Rule 700(c) under Regulation MC does not
prescribe the number of participant directors that are required to
be on the Board. A security-based swap clearing agency may choose to
have the majority of the Board be composed of independent directors.
---------------------------------------------------------------------------
The Commission also proposes that no director may qualify as an
independent director unless the Board affirmatively determines that the
director does not have a material relationship with the security-based
swap clearing agency or any affiliate of the security-based swap
clearing agency, or a participant in the security-based swap clearing
agency, or any affiliate of a participant in the security-based swap
clearing agency. The purpose of this proposal is to provide assurance
that an independent director candidate does not have any relationships
or affiliations that would prevent the candidate from being independent
of the security-based swap clearing agency. Accordingly, the Commission
proposes to define the term ``independent director,'' as it is used
with respect to a security-based swap clearing agency, as a director
who has no material relationship with:
(1) The security-based swap clearing agency;
(2) Any affiliate of the security-based swap clearing agency;
(3) A participant in the security-based swap clearing agency; or
(4) Any affiliate of a participant in the security-based swap
clearing agency.\102\
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\102\ See proposed Rule 700(j) under Regulation MC.
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Some relationships or affiliations would clearly exclude a director
from qualifying as independent of a security-based swap clearing
agency. For example, a director would not be considered independent if
any of the following circumstances exists:
The director, or an immediate family member, is employed
by or otherwise has a material relationship with the security-based
swap clearing agency or any affiliate thereof; or within the past three
years was employed by or otherwise had a material relationship with the
security-based swap clearing agency or any affiliate thereof;
The director is a participant in the security-based swap
clearing agency or within the past three years was employed by or
affiliated with a participant or any affiliate thereof, or the director
has an immediate family member that is, or within the past three years
was, an executive officer of a participant in the security-based swap
clearing agency or any affiliate thereof;
The director, or an immediate family member, has received
during any twelve-month period within the past three years payments
that reasonably could affect the independent judgment or decision-
making of the director from the security-based swap clearing agency or
any affiliate thereof or from a participant in the security-based swap
clearing agency or any affiliate thereof, other than the following:
[cir] Compensation for Board or Board committee services;
[cir] Compensation to an immediate family member who is not an
executive officer of the security-based swap clearing agency or any
affiliate thereof or of a participant in the security-based
[[Page 65897]]
swap clearing agency or any affiliate thereof; or
[cir] Pension and other forms of deferred compensation for prior
services, not contingent on continued service.
The director, or an immediate family member, is a partner
in, or controlling shareholder or executive officer of, any
organization to or from which the security-based swap clearing agency
or any affiliate thereof made or received payments for property or
services in the current or any of the past three full fiscal years that
exceed 2% of the recipient's consolidated gross revenues for that year,
other than the following:
[cir] Payments arising solely from investments in the securities of
the security-based swap clearing agency or affiliate thereof; or
[cir] Payments under non-discretionary charitable contribution
matching programs.
The director, or an immediate family member, is, or within
the past three years was, employed as an executive officer of another
entity where any executive officers of the security-based swap clearing
agency serve on that entity's compensation committee;
The director, or an immediate family member, is a current
partner of the outside auditor of the security-based swap clearing
agency or any affiliate thereof, or was a partner or employee of the
outside auditor of the security-based swap clearing agency or any
affiliate thereof who worked on the audit of the security-based swap
clearing agency or any affiliate thereof, at any time within the past
three years; or
In the case of a director that is a member of the audit
committee, such director (other than in his or her capacity as a member
of the audit committee, the Board, or any other Board committee),
accepts, directly or indirectly, any consulting, advisory, or other
compensatory fee from the security-based swap clearing agency or any
affiliate thereof or a participant in the security-based swap clearing
agency or any affiliate thereof, other than fixed amounts of pension
and other forms of deferred compensation for prior service, provided
such compensation is not contingent in any way on continued
service.\103\
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\103\ See proposed Rule 700(j)(2) under Regulation MC.
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Under the proposed rule, the term ``material relationship'' would
be defined as a relationship, whether compensatory or otherwise, that
reasonably could affect the independent judgment or decision-making of
the director.\104\ This definition is intended to encompass all
significant instances in which a director's independence is
compromised.\105\ In determining whether a ``material relationship''
exists, security-based swap clearing agencies should consider the known
relationships between a director and the security-based swap clearing
agency to determine whether the relationship is likely to impair the
independence of the director in making decisions that affect the
security-based swap clearing agency. The proposed definitions of
``independent director'' and ``material relationship'' should help to
reduce the potential that the independent directors on the Board of the
security-based swap clearing agency are subject to conflicts of
interest.
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\104\ See proposed Rule 700(l) under Regulation MC.
\105\ See Securities Exchange Act Release No. 48745 (November 4,
2003), 68 FR 64154 (November 12, 2003) (order approving SRO rules
that would find a director independent only where that director does
not have a relationship with the company that would impair her
independence).
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Under the Voting Interest Focus Alternative, the security-based
swap clearing agency would be required to establish policies and
procedures to require each director, on his or her own initiative or
upon request of the security-based swap clearing agency, to inform the
security-based swap clearing agency of the existence of any
relationship or interest that may reasonably be considered to bear on
whether such director is an independent director.\106\ The security-
based swap clearing agency would be expected to take reasonable
measures to confirm the accuracy of the information provided. This
requirement should help the security-based swap clearing agency to
assure that it is informed of the existence of any relationship or
interest that may reasonably be considered to bear on whether a
director is independent as soon as possible and without requiring the
security-based swap clearing agency to investigate for such
information.
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\106\ See proposed Rule 701(a)(3)(iii) under Regulation MC.
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6. Voting Interest Focus Alternative: Board Committees
a. Nominating Committee
The Voting Interest Focus Alternative would require security-based
swap clearing agencies to create and maintain a nominating committee
for the selection of Board members, and would require that such
nominating committee be composed of a majority of independent
directors.\107\ Directors serving on the nominating committee that are
not independent may be more likely to select Board candidates whose
views align with such directors' interests instead of the interests of
the security-based swap clearing agency or the markets generally.
Having a nominating committee that is composed of majority independent
directors should help to address and facilitate the selection of
independent directors.
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\107\ See proposed Rule 701(a)(4)(i) under Regulation MC.
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The Voting Interest Focus Proposal would also require that the
nominating committee identify candidates for Board membership through a
consultative process with the participants of the security-based swap
clearing agency consistent with criteria approved by the Board.\108\
This should help assure that the selection of directors of the Board is
conducted in a prudent manner while at the same time allowing for the
participants of the security-based swap clearing agency to have fair
representation in the selection of the directors of the Board.\109\
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\108\ See proposed Rule 701(a)(4)(ii) under Regulation MC.
\109\ Section 17A(a)(3)(C) of the Exchange Act requires fair
representation among participants of a clearing agency by providing
them with a meaningful opportunity to participate in the selection
of directors. 15 U.S.C. 78q-1(a)(3)(C).
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b. Other Board Committees
The Voting Interest Focus Alternative would require that other
Board committees of a security-based swap clearing agency that are
delegated authority to act on the Board's behalf, including but not
limited to the risk committee, consist of at least 35% independent
directors similar to the requirement that would be imposed on the Board
itself.\110\ This requirement should give independent directors a
meaningful voice, similar to the one they would have in the Board
itself, within Board committees that essentially perform the functions
of a Board. The proposed requirement would also apply to an ``advisory
committee'' to the extent that the committee is authorized to act on
behalf of the Board, including instances where the Board is required to
seek approval from the committee before making a determination.
However, the Commission preliminarily believes that the independence
requirement should not extend to a committee that functions in a purely
advisory role, because members of those committees are not in a
position to exercise powers of the
[[Page 65898]]
Board or exert influence over the Board by dictating how the Board will
act.
---------------------------------------------------------------------------
\110\ See proposed Rule 701(a)(5) under Regulation MC.
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c. Disciplinary Panels
The Commission's Voting Interest Focus Alternative would impose
special requirements on the composition of disciplinary panels (or
their equivalents) of security-based swap clearing agencies that have
not been delegated authority to act on the Board's behalf.\111\ The
Commission believes that participants of a security-based swap clearing
agency should be appropriately disciplined for failure to comply with
the rules of a security-based swap clearing agency, particularly as
they relate to the ongoing risk management related requirements
applicable to participants. Accordingly, the Commission is proposing
that the disciplinary processes of a security-based swap clearing
agency preclude any group or class of persons that are participants in
the security-based swap clearing agency from exercising
disproportionate influence on any disciplinary panels. In other words,
to the extent that there is more than one type of group or class of
persons that are participants in a security-based swap clearing agency,
the composition of the disciplinary panel shall include representation
of each group or class and shall not allow one group or class to have
representation on the disciplinary panel that is out of proportion as
compared to other groups or classes of persons that are participants in
the security-based swap clearing agency. Furthermore, the disciplinary
panel of the security-based swap clearing agency would include at least
one person who would qualify as an independent director.
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\111\ See proposed Rule 701(a)(6) under Regulation MC. If the
security-based swap clearing agency does not have a disciplinary
panel, these requirements should be interpreted as applying to the
equivalent of a disciplinary panel in the security-based swap
clearing agency's internal processes, unless the disciplinary panel
(or its equivalent) has been delegated authority to act on the
Board's behalf, in which case it would be subject to the 35%
independent director requirement.
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7. Voting Interest Focus Alternative: Request for Comment
The Commission requests comment on all aspects of the voting
limitations under the Voting Interest Focus Alternative, including
whether the 20% limitations on individual participant voting interest
and the 40% aggregate limitation on participant voting interest are
sufficient to limit the ability of a participant or a group of
participants to exercise undue influence or control over the governance
of a security-based swap clearing agency. Should the 20% and 40%
limitations be lower given the existing concentration of the industry
in a small number of large dealers? If so, what limitations would be
appropriate and why? Are there other conflicts of interest not
discussed in this release that the Commission should consider generally
and specifically with respect to voting limitations? Would the proposed
restrictions have an effect on the ability to form new security-based
swap clearing agencies or to effectively operate existing security-
based swap clearing agencies?
The Commission also requests comment on whether there may be other
ways to structure the interests in a security-based swap clearing
agency to mitigate potential conflicts of interest. Are there other
thresholds for voting limitations or approaches that the Commission
should consider? Are there other methods for mitigating conflicts of
interest the Commission should consider, such as limitations on holding
non-voting interests in a security-based swap clearing agency? How
would non-voting interests affect the potential for conflicts of
interests?
Section 765 enumerates Specified Entities for the Commission to
consider in its rulemaking. The proposed rule would apply only to
Specified Entities that are participants of the security-based swap
clearing agency and not to other Specified Entities, because the
Commission preliminarily believes that those entities that are
participants of a clearing agency are most likely to have a conflict of
interest that would affect the access, product eligibility, and risk
management issues discussed in this release. However, the Commission
requests comment on whether all Specified Entities, regardless of
participant status, should be subject to the proposed restrictions on
voting interests. What are the potential conflicts of interest
associated with Specified Entities that are not participants? Might
Specified Entities that are not participants in a security-based swap
clearing agency have an interest in limiting the number or type of
security-based swaps that are accepted for clearing to the extent that
they may profit from trading security-based swaps that are not
centrally cleared? Are there any other classes of persons, such as
participants or members of SB SEFs or SBS exchanges, that should also
be subject to the proposed restrictions even though they are not
participants of a security-based swap clearing agency? What effect
would such restrictions have on mitigating conflicts of interest at
security-based swap clearing agencies? What effect would such
restrictions have on the ability to form new security-based swap
clearing agencies?
The Voting Interest Focus Alternative would require that voting
limitations be determined by including interests held directly by a
participant in the security-based swap clearing agency, by including
indirect interests of a participant in the security-based swap clearing
agency, and by including interests held by related persons of a
participant in the security-based swap clearing agency. The Commission
requests comment on whether its formulation for calculating the
aggregate and individual limits is appropriate. Specifically, the
Commission requests comment on whether the scope of the definitions of
``affiliate,'' ``immediate family member,'' and ``related person'' are
over-inclusive or under-inclusive and, if either, why? Is there a
different methodology to reach the interest of any person with whom a
security-based swap clearing agency participant may be able to act in
concert with to unduly influence or control a security-based swap
clearing agency that the Commission should consider?
The Commission seeks comment on whether requiring the Board of a
security-based swap clearing agency to be composed of at least 35%
independent directors would improve governance of the security-based
swap clearing agency and mitigate potential conflicts of interest. Is
35% sufficient to give independent directors a meaningful voice within
the Board, or would a higher or lower level be appropriate? Should the
Commission require that a majority of the Board be composed of
independent directors? How are these independent directors likely to
affect the activities of the security-based swap clearing agency? What
are their incentives to assure open and fair access, increased product
eligibility, and sound risk management at a security-based swap
clearing agency? Do independent directors have any conflicts of
interest that would affect their ability to facilitate these
objectives?
The Commission also requests comment on whether other measures
concerning governance should be used to mitigate conflicts of interest
at security-based swap clearing agencies, either in addition to or
instead of the proposals outlined in this release. In particular, what
other approaches would improve governance and mitigate conflicts of
interest for security-based swap clearing agencies? For example, would
State laws governing the fiduciary duty owed by the Board to a
corporation help to mitigate conflicts of interest? Should the
Commission
[[Page 65899]]
consider any additional requirements related to fiduciary duties? The
policies and charter documents of individual corporations also often
impose additional responsibilities and obligations on directors. Should
security-based swap clearing agencies be required to put in place
specific policies or charters to address conflicts of interest by the
Board? What policies or charters would be necessary to provide
assurance that participant directors will act in the best interests of
the security-based swap clearing agency? What other requirements, if
any, should be in place with respect to the duties owed by the Board in
order to mitigate conflicts of interest at security-based swap clearing
agencies?
In addition, the Commission requests comment on its proposed
definitions, including the definitions of ``independent director'' and
``material relationship.'' Are there other ways to define ``independent
director'' or ``material relationship?'' If so, what are they? Should
the Commission adopt other provisions that contain particular
circumstances that would preclude a finding that a director is
independent or that would deem a relationship material? Should the
Commission take into account a director's salary or benefits he or she
receives for being a director in order to consider whether an interest
in keeping the directorship could make a director more likely to act
favorably toward those that control the Board? Should the Commission
adopt a specific look-back period within which to determine whether a
``material relationship'' exists? Should additional terms used in the
proposed rule be defined?
The Commission requests comment on the proposed compositional
requirements of committees of the Board under the Voting Interest Focus
Alternative. Is the requirement that Board committees that are
delegated authority to act on behalf of the Board be composed of at
least 35% independent directors appropriate? The Commission also
requests comment on whether there may be other ways to structure
governance restrictions for security-based swap clearing agencies to
mitigate potential conflicts of interest. In particular, the Commission
requests comment on the proposed compositional requirements of the
nominating committee. What is the potential effect of requiring a
security-based swap clearing agency to have a majority independent
nominating committee? Are there other processes for the selection of
independent directors and the fair representation of the participants
and shareholders of a security-based swap clearing agency that the
Commission should consider with respect to the nominating committee?
Should end-users or any other group be given guaranteed rights of
participation in the governance of the security-based swap clearing
agency? Should the Commission participate in the Board selection
process, such as by requiring consultation on appointments? Should the
Commission consider an alternative to a compositional requirement for a
nominating committee, such as allowing a security-based swap clearing
agency to have a board of trustees responsible for nominating
candidates for the Board? If this were a viable alternative, should
there be compositional requirements or other limits imposed on the
board of trustees? How should such a board of trustees be appointed?
Would the alternative of a board of trustees to nominate directors
provide greater assurance that independent directors are truly
independent not only at the time of their nomination but during their
service on the Board as well?
With respect to governance as it relates to the risk committee,
should there be special requirements relating to the risk committee, or
its equivalent, of the Board? For instance, one possible alternative
approach could be to provide separate requirements applicable only to
the risk committee that reflect the highly specialized risk management
expertise required of directors serving on that committee. For example,
instead of requiring that the risk committee be composed of at least
35% independent directors (where such committee is delegated authority
to act on the Board's behalf), the requirement could apply to a smaller
number of independent directors, and also explicitly require that other
interested persons, such as customers of participants, be represented
on the risk committee. The Commission requests comment on whether a
more prescriptive approach such as the one described above would be
appropriate for the risk committee and what levels of participation by
participants, customers of participants, or others would be
appropriate. Are there factors that warrant treating the risk committee
differently from other Board committees? Should the Commission require
the Board to report to the Commission if the Board disagrees with a
recommendation of the risk committee? Is the risk committee more or
less prone to conflict of interest issues? Are there factors other than
conflicts of interest that should be taken into consideration? Is it
desirable to have an explicit requirement with respect to customers of
participants? If so, how many customers should serve on the risk
subcommittee relative to independent directors and participant
directors? What definition of customer should be used for these
purposes? Are there distinctions that should be made between the
different types of customer firms for this purpose?
Another possible alternative approach could be to limit the
applicable restrictions on the risk committee to circumstances where a
specific range of topics is being addressed. For example, restrictions
on participation in a risk committee could be limited to only those
circumstances in which a determination about issues such as participant
standards and product eligibility were being made. What are the
potential advantages or disadvantages of such an approach? Would it be
possible to separate activities of a committee based on topics? Are
there certain issues that pose more or less of a concern with respect
to conflicts of interests?
The Commission also requests comment regarding whether any
requirements should be imposed on advisory committees. Would an
independence requirement on a purely advisory committee mitigate
potential conflicts of interest? Are there circumstances in which a
purely advisory committee exercises substantial power over the Board?
The Commission requests comment on the composition of the
disciplinary panel of the security-based swap clearing agency. Would
the proposed rule be sufficient to address potential conflicts of
interest that may interfere with the fair and effective disciplinary
processes of a security-based swap clearing agency? Should different
restrictions be imposed?
Although independent directors may address some of the conflicts of
interest concerns that underlie Section 765 of the Dodd-Frank Act, they
may not effectively eliminate all conflicts. The Commission, however,
believes that effective governance via a partially independent Board is
compatible with the characteristics of security-based swap clearing
agencies, and the types of conflicts that may be inherent with respect
to such entities.
B. Alternative II: Governance Focus Alternative
As more fully described below, under the Governance Focus
Alternative, the Commission is proposing governance restrictions
including requiring a majority of independent directors on the Board
and voting restrictions that would be applicable only to individual
[[Page 65900]]
participants of a security-based swap clearing agency. The Governance
Focus Alternative differs from the Voting Interest Focus Alternative in
that it provides greater emphasis on requirements regarding the
governance arrangements of a security-based swap clearing agency as the
primary means to mitigate conflicts of interest. As with the Voting
Interest Focus Alternative, the Commission is proposing rules related
to the governance of a security-based swap clearing agency and the
voting interests held by participants because the Commission believes
each contributes to conflict of interest concerns. However, the Voting
Interest Focus Alternative places greater emphasis on the ability of
participants to hold voting interests in the security-based swap
clearing agency than it does on participants' ability to participate in
the governance of the security-based swap clearing agency, while the
Governance Focus Alternative, as described in more detail below, places
greater emphasis on the ability of participants to participate in the
governance of the security-based swap clearing agency than it does on
the ability of participants on a collective basis to hold a voting
interest in the security-based swap clearing agency.
1. Governance Focus Alternative: Voting Limitation
The Governance Focus Alternative would require that a security-
based swap clearing agency may not permit a participant, either alone
or together with its related persons, to (1) beneficially own, directly
or indirectly, any interest in the security-based swap clearing agency
that exceeds 5% of any class of securities, or other ownership
interest, entitled to vote of such security-based swap clearing agency
or (2) directly or indirectly vote, cause the voting of, or give any
consent or proxy with respect to the voting of, any interest in the
security-based swap clearing agency that exceeds 5% of the voting power
of any class of securities or other ownership interest of such
security-based swap clearing agency.\112\ The 5% limitation on
participant voting interest is intended to help mitigate conflicts of
interest because each individual participant's voting interest would be
substantially limited and, therefore, its ability to control the
security-based swap clearing agency would also be limited.\113\ As
discussed previously, the Voting Interest Focus Alternative would
permit a higher individual participant voting interest of 20%, but
would limit the aggregate voting interests held by all participants to
40%. However, the Voting Interest Focus Alternative would allow a
security-based swap clearing agency to have a Board with a majority of
directors selected by participants. The Commission believes that the 5%
limit per participant, in combination with the requirements related to
governance arrangements described below, is sufficiently low that there
is no need for the 40% aggregate cap on the voting interests held by
all participants.
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\112\ See proposed Rule 701(b)(1) under Regulation MC.
\113\ The 5% threshold level for ownership has previously been
found by the Commission in other contexts to trigger reporting
requirements to the Commission related to the ability to control an
organization. See Rule 13d-1(a) under the Exchange Act, 17 CFR
240.13d-1(a) (``Any person who, after acquiring directly or
indirectly the beneficial ownership of any equity security of a
class which is specified in paragraph (i) of this section, is
directly or indirectly the beneficial owner of more than 5% of the
class shall, within 10 days after the acquisition, file with the
Commission, a statement containing the information required by
Schedule 13D''). In addition, investors acquiring more than a 5%
interest in a company must file a form certifying that they acquired
that interest without ``the effect of changing or influencing the
control of the issuer * * *'' Rule 13d-1(c)(1) under the Exchange
Act, 17 CFR 240.13d-1(c)(1). See, also, Gaf Corp. v. Milstein, 453
F.2d 709 (2d Cir. N.Y. 1971), stating that ``[T]he purpose of
section 13(d) is to alert the marketplace to every large, rapid
aggregation or accumulation of securities, regardless of technique
employed, which might represent a potential shift in corporate
control. * * *'' Id. at 717.
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Furthermore, the Commission notes that the 40% aggregate cap on
participant voting interests proposed in the Voting Interest Focus
Alternative may restrict the potential formation of participant-owned
security-based swap clearing agencies. Some clearing agencies currently
registered with the Commission are user-owned or user-controlled
institutions that function as quasi-utilities. This structure may
provide certain benefits to the participants and the securities markets
generally because such clearing agencies generally seek to match the
fees charged to participants to the clearing agency's costs and not to
maximize profits.\114\
---------------------------------------------------------------------------
\114\ See, e.g., ``The US Model for Clearing and Settlement: An
Overview of DTCC,'' available at: http://www.dtcc.com/downloads/about/US%20Model%20for%20Clearing%20and%20Settlement.pdf.
(``[O]wnership and governance of [The National Securities Clearing
Corporation] and [The Depository Trust Company] were from the outset
those typical of market utilities.'').
---------------------------------------------------------------------------
In addition, potential users may have a strong incentive to form a
new clearing agency if they believe an existing clearing agency is not
effectively serving the security-based swaps market. Not imposing an
aggregate cap on participant voting interests in a security-based swap
clearing agency could help encourage the formation of new security-
based swap clearing agencies and thereby increase the potential for
competition among security-based swap clearing agencies. In addition,
the 5% voting interest limitation may encourage open access by creating
incentives for a larger number of participants to acquire a voting
interest in the security-based swap clearing agency. While the
Commission has not previously adopted voting limitations or governance
rules for registered clearing agencies in the other securities markets,
as previously discussed under the Voting Interest Focus Alternative,
the security-based swaps market presents different concerns with
respect to potential conflicts of interests that warrant additional
scrutiny and efforts to mitigate such conflicts.
2. Governance Focus Alternative: Indirect or Affiliate Ownership and
Ownership Through Related Persons
The Commission believes that a rule that limits only direct voting
interests could be circumvented by holding the interest through an
affiliated party or by holding an interest in a controlling entity.
Accordingly, similar to the Voting Interest Focus Alternative,\115\ the
Governance Focus Alternative would address conflicts of interest
created by indirect voting interests of the security-based swap
clearing agency and would require aggregation of a security-based swap
clearing agency participant's voting interest with its related persons'
\116\ voting interests.\117\
---------------------------------------------------------------------------
\115\ See supra Section I.A.3.
\116\ See supra note 92 and accompanying text.
\117\ See proposed Rule 701(b)(1) under Regulation MC.
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3. Governance Focus Alternative: Divestiture and Voting Restriction
Requirement
Similar to the Voting Interest Focus Alternative,\118\ the
Governance Focus Alternative would require security-based swap clearing
agencies to have rules in place for the divestiture of voting interests
that exceed the 5% limitation and a mechanism to not give effect to the
portion of any voting interest held by a participant in excess of the
5% voting limitation.\119\ The Commission believes that this
requirement is essential to a security-based swap clearing agency's
ability to monitor voting interests by its participants in relation to
the proposed voting limitations.
---------------------------------------------------------------------------
\118\ See supra Section I.A.4.
\119\ See proposed Rule 701(b)(2) under Regulation MC.
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[[Page 65901]]
4. Governance Focus Alternative: Majority Independent Board
As discussed previously, the Governance Focus Alternative differs
from the Voting Interest Focus Alternative by placing greater emphasis
on the governance arrangements of the security-based swap clearing
agency. Each alternative approach seeks to strike a balance between the
appropriate restrictions imposed on a security-based swap clearing
agency relating to governance and voting rights held by participants.
Under the Governance Focus Alternative, participants on a collective
basis could potentially own all voting interests in a security-based
swap clearing agency. While this option allows for potential benefits
in terms of participants' ability to form new clearing agencies, it
also allows participants' to control 100% of the voting interest in a
security-based swap clearing agency, in contrast to the Voting Interest
Focus Alternative, which would limit participants to holding no more
than 40% of the voting interest. Accordingly, in order to balance the
increased voting interest that may be held by participants
collectively, the Commission proposes that a greater proportion of the
Board be composed of independent directors under the Governance Focus
Alternative.
The Governance Focus Alternative is intended to mitigate conflicts
of interest by limiting the influence participants may have in the
determinations of the Board or in the administration of a security-
based swap clearing agency. Specifically, the Governance Focus
Alternative would require the Board \120\ of a security-based swap
clearing agency to be composed of a majority of independent
directors.\121\ The presence of a majority of independent directors on
the Board of a security-based swap clearing agency is intended to
reduce the ability of non-independent directors to influence the
operation of the security-based swap clearing agency in favor of their
own self-interests and to promote open and fair access, product
eligibility, and sufficient risk management standards. This should in
turn benefit non-participant firms that enter into correspondent
clearing arrangements with participants, and SBS exchanges and SB SEFs
who will rely on the availability of a security-based swap clearing
agency. A majority independent Board requirement is consistent with
accepted corporate governance ``best practices.'' \122\ Furthermore,
requiring a majority of the Board of a security-based swap clearing
agency to be independent would still permit the security-based swap
clearing agency to provide participants with fair representation in the
selection of directors and the administration of the affairs of the
security-based swap clearing agency as required under the Exchange
Act.\123\
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\120\ See supra note 98.
\121\ See proposed Rule 701(b)(3)(i) under Regulation MC. See
supra note 99 for the definition of ``director.''
\122\ See, e.g., James H. Cheek III, et al., Report of the
American Bar Association Task Force on Corporate Responsibility
(2003); and The Business Roundtable, Principles of Corporate
Governance (May 2010).
\123\ Section 17A(b)(3)(C) of the Exchange Act requires that the
rules of a registered clearing agency assure a fair representation
of its shareholders (or members) and participants in the selection
of its directors and administration of its affairs. 15 U.S.C. 78q-
1(b)(3)(C).
---------------------------------------------------------------------------
The Commission also proposes that no director may qualify as an
independent director unless the Board affirmatively determines that the
director does not have a material relationship with the security-based
swap clearing agency or any affiliate of the security-based swap
clearing agency,\124\ or a participant in the security-based swap
clearing agency, or any affiliate of a participant in the security-
based swap clearing agency.\125\ The proposed definitions of
``independent director'' and ``material relationship'' are designed to
reduce the potential that the Board of the security-based swap clearing
agency is controlled by persons who are subject to conflicts of
interest.
---------------------------------------------------------------------------
\124\ See supra note 102 and accompanying text.
\125\ See proposed Rule 701(b)(3)(ii) under Regulation MC.
---------------------------------------------------------------------------
While the proposal that a majority of the Board be composed of
independent directors should help to mitigate certain conflicts of
interest, and particularly those conflicts that are most likely to
result in an adverse effect on the security-based swap clearing agency,
the Commission recognizes that it would not completely eliminate
conflicts of interest. Participant directors would still be permitted
to serve on the Board. The Commission believes that participants may
have operational, risk management, and market expertise that may be
useful for effective oversight of a security-based swap clearing
agency.
In addition, independent directors themselves may not be free of
conflicts of interest. Although the independent directors would not
have a material relationship with the clearing agency or any of its
participants, they could still be influenced by other sources such as
non-participant shareholders of the security-based swap clearing
agency. The presence of independent directors may be an effective
mechanism to address certain types of conflicts in certain types of
institutions but not necessarily in all instances nor for all
institutions. The Commission, however, believes that effective
governance via a majority independent Board is compatible with the
characteristics of security-based swap clearing agencies, and the types
of conflicts that may be inherent with respect to such entities.
To help address these concerns, the proposed rules would require
each security-based swap clearing agency to establish policies and
procedures to require each director, on his or her own initiative or
upon request of the security-based swap clearing agency, to inform the
security-based swap clearing agency of the existence of any
relationship or interest that may reasonably be considered to bear on
whether such director is an independent director.\126\ This requirement
should keep the security-based swap clearing agency informed of the
existence of any relationship or interest that may reasonably be
considered to bear on whether a director is independent as soon as
possible without requiring the security-based swap clearing agency to
investigate for such relationships or interest.
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\126\ See proposed Rule 701(b)(3)(iii) under Regulation MC.
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5. Governance Focus Alternative: Board Committees
a. Nominating Committee
The Governance Focus Alternative would require security-based swap
clearing agencies to create and maintain a nominating committee
composed entirely of independent directors.\127\ This is consistent
with the purpose of the Governance Focus Alternative to place enhanced
requirements on the governance arrangements of a security-based swap
clearing agency, including the composition of the Board and Board
committees, with less emphasis on the requirements with respect to the
voting interests held by participants. Non-independent directors on the
nominating committee could circumvent the majority independence
requirement by nominating a candidate that is subject to their
influence. Specifically, directors serving on the nominating committee
that are not independent may be more likely to select Board candidates
whose views align with such directors' interests instead of the
interests of the security-based swap clearing agency or the markets
generally. A requirement that
[[Page 65902]]
all directors serving on the nominating committee be independent of
participants would address these concerns by limiting participants'
control over the nomination process. A fully independent nominating
committee may be warranted under the Governance Focus Alternative
because the lack of an aggregate cap in this proposal means that
participants may collectively hold greater voting interests in
selecting the independent directors.
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\127\ See proposed Rule 701(b)(4)(i) under Regulation MC.
---------------------------------------------------------------------------
The Governance Focus Alternative would also require that the
nominating committee identify candidates for Board membership through a
consultative process with the participants of the security-based swap
clearing agency consistent with criteria approved by the Board.\128\
This should assure that the selection of the independent directors of
the Board is conducted in a prudent manner while at the same time
allowing participants of the security-based swap clearing agency to
have a fair voice in the selection of the directors of the Board.\129\
---------------------------------------------------------------------------
\128\ See proposed Rule 701(b)(4)(ii) under Regulation MC.
\129\ See supra note 123.
---------------------------------------------------------------------------
b. Other Board Committees
The Governance Focus Alternative would require that other Board
committees of a security-based swap clearing agency that are delegated
authority to act on the Board's behalf, including but not limited to
the risk committee, consist of a majority of independent directors
similar to the requirement that would be imposed on the Board
itself.\130\ This requirement should prevent the dilution of the
majority Board independence requirement that may result if Board
committees that essentially perform the functions of a Board are not
themselves subject to a similar requirement. The proposed requirement
would also apply to an ``advisory committee'' to the extent that such a
committee is authorized to act on behalf of the Board, including
instances where the Board is required to seek approval from the
committee before making a determination. However, the Commission
preliminarily believes that this majority independence requirement
should not extend to a committee that functions in a purely advisory
role, because members of those committees are not in a position to
exercise powers of the Board or exert influence over the Board by
dictating the actions of the Board.
---------------------------------------------------------------------------
\130\ See proposed Rule 701(b)(5) under Regulation MC.
---------------------------------------------------------------------------
c. Disciplinary Panels
Similar to the Voting Interest Focus Alternative,\131\ the
Governance Focus Alternative would impose special requirements on the
composition of disciplinary panels (or their equivalents) of security-
based swap clearing agencies that have not been delegated authority to
act on the Board's behalf.\132\
---------------------------------------------------------------------------
\131\ See supra Section I.A.8.d. and accompanying text.
\132\ See proposed Rule 701(b)(6) under Regulation MC.
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6. Governance Focus Alternative: Request for Comment
The Commission requests comment on all aspects of the 5%
participant voting interest limitation. Is the 5% voting limitation
appropriate, or should the Commission consider a higher or lower
limitation? How does the relative concentration of the security-based
swaps market among a small number of large dealers affect whether a 5%
limitation is appropriate? Would 5% still allow a relatively small
number of participants to effectively dominate the Board of a clearing
agency? Should the Commission consider any form of an aggregate cap
under this alternative? How likely is it that a security-based swap
clearing agency would adopt a utility model, given the status of the
security-based swaps market? Would the 5% limit impede the ability of a
clearing agency to adopt a utility model? What advantages or
disadvantages would such a model have? Are there other conflicts of
interest, not discussed in this release, that the Commission should
consider generally and specifically with respect to voting interest
limitations? Would the proposed restrictions have an effect on the
ability to form new security-based swap clearing agencies?
Are there other ways to more narrowly target voting limitations?
Should the Commission impose voting restrictions on only the largest
participants because those participants control the majority of the
security-based swaps market (based on either the volume of transactions
cleared at the security-based swap clearing agency or the notional
value of the participant's outstanding security-based swap positions)?
If such an approach is preferable, what should the threshold be for
determining whether a participant is ``large''? Should the Commission
require the security-based swap clearing agency to consider the
participant's volume of cleared transactions at the security-based swap
clearing agency, the notional value of the participant's outstanding
security-based swap positions at the security-based swap clearing
agency, or both? Should the Commission require the security-based swap
clearing agency to consider either volume or outstanding notional value
of a participant's positions held outside of a security-based swap
clearing agency? How often should the Commission require the security-
based swap clearing agency to reevaluate its standard? How effectively
would such an approach address conflict of interest concerns? What
would be the advantages and disadvantages of this approach compared to
the approach proposed above? Are there administrative complexities
associated with determining and monitoring the point at which a firm
reaches large participant status? Are the conflicts of interest
concerns regarding all large participants similar or should there be
differences in the voting limitations among large participants?
Should the restrictions on voting interests apply to other large
entities, such as the Specified Entities listed in Section 765, even if
they are not participants in a security-based swap clearing agency?
What potential conflicts of interest could result if Specified Entities
that are not large participants controlled the voting interest in a
security-based swap clearing agency? How should such potential
conflicts of interest be addressed?
Should the Commission consider a limitation on the non-voting
interests owned by participants? Should the Commission consider a
limitation on the voting and non-voting interests held by Specified
Entities?
The Commission seeks comment on whether requiring the Board of a
security-based swap clearing agency to be composed of a majority of
independent directors would improve governance of the security-based
swap clearing agency and mitigate potential conflicts of interest.
Would a majority independent Board be helpful in mitigating conflicts
of interest if the voting interest of a security-based swap clearing
agency is owned by participants? If a majority independent Board is not
appropriate to mitigate conflicts, what percentage of the Board should
be independent? What are the costs and benefits of requiring the Boards
of security-based swap clearing agencies to be composed of a majority
of independent directors? How do these costs and benefits differ from
the proposal that 35% of the Board be composed of independent
directors? Would independent directors be likely to have the necessary
experience and
[[Page 65903]]
expertise to serve on the Board? Could less experience or expertise
negatively affect risk management practices or the efficiency of the
clearing agency and, if so, how? If any such experience or efficiency
issues exist, how could they be overcome? What are the independent
directors' incentives regarding fair and open access, product
eligibility, and sound risk management? How are these incentives
different from those of participants? Do they result in conflicts of
interest? If so, how are the conflicts of interest different from those
of participants? How should they be addressed by the Commission?
Should the Commission consider alternative limits, or alternative
combinations of limits, on voting interests or independent directors?
For example, should the voting interest restrictions of 20% on
individual interests and 40% in the aggregate be combined with the
requirements for a majority independent Board and a 100% independent
nominating committee? Would an alternative combination of requirements
related to voting interests and independent directors be more
effective? For example, would a higher requirement in each case (e.g.,
a 10% limit on individual voting interests and a requirement for 60%
independent directors) be more effective? Or would other combinations
be more effective? Should the Commission reduce the restrictions over
time if conflict of interest concerns are lessened as the security-
based swaps market develops? For example, if participation in the
security-based swaps market becomes more open and includes a broader
range of participants, the interests of the participants may become
more aligned with those of the clearing agency and the markets
generally. Would restrictions on voting interests and governance still
be needed in this circumstance? Are there other circumstances where the
voting interest and governance restrictions may be reduced or
eliminated altogether? If, over time, the security-based swaps market
does not become more competitive, should the Commission consider
additional governance and voting measures to promote open access and
competition? What measures would be appropriate? What standards should
the Commission use to determine whether additional restrictions should
or should not be imposed?
Could restrictions regarding the governance structure of a
security-based swap clearing agency alone be sufficient to address
conflict of interest concerns or are both restrictions on governance
and voting interests needed? Would participants of a security-based
swap clearing agency be able to exercise undue influence over a
security-based swap clearing agency through a voting interest even if a
majority of the Board is independent? Are requirements related to the
governance structure of a security-based swap clearing agency more or
less effective than voting limitations at addressing conflicts of
interest?
The Commission requests comment on the proposed compositional
requirements of the nominating committee. What is the potential effect
of requiring a security-based swap clearing agency to have an entirely
independent nominating committee? Would requiring an entirely
independent nominating committee, which is required to consult with
participants of the security-based swap clearing agency, be consistent
with the fair representation requirement under the Exchange Act? Should
end-users or any other group be given guaranteed rights of
participation in the governance of the security-based swap clearing
agency? Should the Commission have some oversight of the Board
selection process? Should the Commission consider an alternative to a
compositional requirement for a nominating committee, such as allowing
a security-based swap clearing agency to have a board of trustees
responsible for nominating candidates for the Board? If this were a
viable alternative, should there be compositional requirements or other
limits imposed on the board of trustees? How should such a board of
trustees be appointed? Would the alternative of a board of trustees to
nominate directors provide greater assurance that independent directors
are truly independent not only at the time of their nomination but
during their service on the Board as well?
The Commission requests comment on the proposed compositional
requirements of committees of the Board under the Governance Focus
Alternative. Is the requirement that Board committees that are
delegated authority by the Board be composed of a majority of
independent directors appropriate? Should there be special requirements
relating to the risk committee, or its equivalent, of the Board? The
Commission requests comment on the possible alternatives for risk
committee governance as discussed in Section IV.A.7. Would the possible
alternatives for the risk committee be more or less desirable with
respect to the Governance Focus Alternative? Under the Governance Focus
Alternative, should the percentage of directors on the risk committee
be higher or lower than what is proposed? The Commission also requests
comment on whether there are other ways to structure governance
arrangements for security-based swap clearing agencies to mitigate
potential conflicts of interest.
The Commission requests comment on the composition of the
disciplinary panel of the security-based swap clearing agency. Would
the proposed rule be sufficient to address potential conflicts of
interest that may interfere with the fair and effective disciplinary
processes of a security-based swap clearing agency? Should different
restrictions be imposed?
C. Existing Standards for Registered Clearing Agencies
In addition to any new rules adopted by the Commission with respect
to conflicts of interest at security-based swap clearing agencies, the
standards in the Exchange Act that apply to all securities clearing
agencies registered with the Commission will apply to security-based
swap clearing agencies. The Dodd-Frank Act requires security-based swap
clearing agencies to be registered as clearing agencies with the
Commission under Section 17A of the Exchange Act.\133\ Thus, security-
based swap clearing agencies will be required to comply with the
standards in Section 17A of the Exchange Act. Some of these standards
may be used to address concerns related to conflicts of interest,
regardless of whether a security-based swap clearing agency elects the
Voting Interest Focus Alternative or the Governance Focus Alternative.
As a result, the standards in Section 17A would be used in addition to
specific conflict of interest rules adopted under Section 765 of the
Dodd-Frank Act.\134\
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\133\ Depository institutions or derivatives clearing
organizations that have previously cleared swaps pursuant to an
exemption from registration as a clearing agency will be deemed to
be registered with the Commission under Section 17A of the Exchange
Act. See Public Law 111-203, Section 763(l).
\134\ See Section 17A(b)(3) of the Exchange Act, which sets
forth the standards for registered clearing agencies. 15 U.S.C. 78q-
1(b)(3). See also Securities Exchange Act Release No. 16900
(``Standards Release'') (June 17, 1980), 20 FR 416 (July 1, 1980).
The Standards Release provides guidance on the standards to be used
by the Commission's Division of Trading and Markets in connection
with the registration of clearing agencies. The standards also serve
as staff guidelines to assist clearing agencies in modifying their
organizations, capacities, and rules to comply with the clearing
agency registration provisions of the Exchange Act.
The Commission is also considering matters related to conflicts
of interests as part of broader standards that would be applicable
to clearing agencies in association with requirements under Sections
763(b) and 805(a) of the Dodd-Frank Act.
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The Section 17A standards may be used to mitigate conflicts of
interest or the effects of conflicts of interest in a
[[Page 65904]]
number of ways. As part of the initial registration process, the
Commission approves the organizational structure of a clearing
agency.\135\ The Commission also reviews and approves significant
changes to a clearing agency's governance structure after it is
registered.\136\ In addition, a clearing agency must admit persons such
as banks and broker-dealers, and other entities that the Commission may
designate by rule, as participants,\137\ subject to the participation
standards of the clearing agency.\138\
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\135\ Section 17A(b)(3)(A) provides in full a clearing agency
shall not be registered unless the Commission determines that the
``clearing agency is so organized and has the capacity to facilitate
the prompt and accurate clearance and settlement of securities
transactions and derivative agreements, contracts, and transactions
for which it is responsible, to safeguard securities and funds in
its custody or control or for which it is responsible, to comply
with the provisions of [the Exchange Act] and the rules and
regulations thereunder, to enforce (subject to any rule or order of
the Commission pursuant to section 17(d) or 19(g)(2) of [the
Exchange Act]) compliance by its participants with the rules of the
clearing agency, and to carry out the purposes of [Section 17A of
the Exchange Act].'' 15 U.S.C. 78q-1(a)(3)(C).
\136\ See Securities Exchange Act Release Nos. 612194 (December
22, 2009), 74 FR 68883 (December 22, 2009) (File No. SR-FICC-2009-
10); 61215 (December 22, 2009), 74 FR 68888 (December 29, 2009)
(File No. SR-NSCC-2009-10); and 61216 (December 22, 2009), 74 FR
68877 (December 29, 2009) (File No. SR-DTC-2009-16), notice and
order granting accelerated approval of proposed rule changes filed
by the clearing agency subsidiaries of the Depository Trust and
Clearing Corporation (DTC, NSCC, and FICC) to permit DTCC to
nominate non-participant candidates for election to its Board.
\137\ 15 U.S.C. 78q-1(b)(3)(B).
\138\ Id. See also Section 17A(b)(4)(B), which provides that a
registered clearing agency may deny participation to, or condition
the participation of, any person if such person does not meet such
standards of financial responsibility, operational capability,
experience, and competence as are prescribed by the rules of the
clearing agency. A registered clearing agency may examine and verify
the qualifications of an applicant to be a participant in accordance
with procedures established by the rules of the clearing agency. 15
U.S.C. 78q-1(b)(4)(B).
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Clearing agencies also may not permit unfair discrimination in the
admission of participants or among participants in the use of the
clearing agency.\139\ These standards in Section 17A help to mitigate
concerns related to conflicts of interest by promoting access to and
use of a clearing agency by all qualified persons on an equivalent
basis.\140\ The Section 17A standards also help to prevent a
participant from using its influence to amend the rules of the clearing
agency in a manner that favors its own institution to the disadvantage
of other participants because the rules of a clearing agency may not be
applied on a discriminatory basis.\141\
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\139\ 15 U.S.C. 78q-1(b)(3)(F).
\140\ See Standards Release, supra note 134, at 419. All
participants utilizing similar clearing agency services, with the
exception of participants that are registered clearing agencies for
which specialized requirements apply, should be required to comply
fully with the clearing agency's internal financial and operational
rules such as clearing fund deposits, mark-to-market payments, and
margin deposits related to the services used.
\141\ Id at 418. The provisions in Section 17A recognize that a
clearing agency may discriminate among persons in the admission to,
or the use of, the clearing agency, by requiring that participants
meet certain financial, operational, and other fitness standards.
However, Section 17A also requires that sanctioned discriminations
must not be unfair. In addition, the Commission must find that
clearing agency rules embodying any discriminations are in the
public interest and are consistent with the requirements of the
Exchange Act.
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Finally, the Section 17A standards help to mitigate conflict of
interest concerns by providing that the rules of a registered clearing
agency may not impose a burden on competition that is not necessary or
appropriate in furtherance of the purposes of the Exchange Act. This
helps assure that the clearing agency operates in a manner that is
consistent with the public interest and is not used by participants or
other interested parties to gain an unfair competitive advantage.\142\
The Commission staff has previously interpreted these standards as
requiring that a clearing agency must justify any anticompetitive
effect of membership criteria and that it will evaluate an
anticompetitive effect in light of the following factors: (1) The
essential nature of the service; (2) the number and type of potential
participants denied access to clearance and settlement services; (3)
the number of entities providing comparable clearance and settlement
services; and (4) the availability of correspondent clearing
arrangements to provide indirect access to a clearing agency's
services.\143\ The Commission believes these factors should also be
used to evaluate the anticompetitive effect of the membership standards
of security-based swap clearing agencies once they are registered
clearing agencies under Section 17A of the Exchange Act.
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\142\ The standard does not prohibit all burdens on competition.
However, if a proposed rule of a clearing agency would impose a
burden on competition, the burden must be weighed against the
benefits of the rule in achieving the purposes of the Exchange Act.
For example, a clearing agency may impose participation standards
that have an anticompetitive effect as long as any such
anticompetitive effect is justified.
\143\ See Standards Release, supra note 134, at 419.
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The Commission requests comment on the application of the standards
under Section 17A to security-based swap clearing agencies in
conjunction with the proposed rules to address conflicts of interest.
Will the proposed rules effectively build on the Section 17A standards?
Should the Commission take a more targeted approach by focusing new
requirements under Section 765 of the Dodd-Frank Act on Section 17A
standards alone, such as by having requirements addressing only
membership standards and determinations whether to clear products?
Would such an approach sufficiently address conflicts of interests? If
not, are the proposed rules sufficient to address potential gaps in the
way Section 17A alone would address conflicts of interest with respect
to security-based swap clearing agencies? Should additional rules be
proposed under Section 17A to further address conflict of interest
concerns? Should the Commission extend the application of the proposed
rules for security-based swap clearing agencies to all registered
clearing agencies? To what extent would competitive pressures in the
security-based swaps market, particularly as it continues to develop,
help to mitigate conflicts of interest? Would the standards under
Section 17A help to promote competition in a way that would help to
mitigate conflicts of interest? To what extent does the Commission's
oversight of clearing agencies pursuant to the standards under Section
17A alleviate the need for ownership limitations and governance
requirements?
V. Discussion of Proposed Rule 702 Under Regulation MC for Security-
Based Swap Execution Facilities and National Securities Exchanges That
Post or Make Available for Trading Security-Based Swaps
A. Ownership and Voting Limitations
Section 765 requires the Commission to adopt rules to mitigate
conflicts of interest, which may include numerical limits on control
of, or the voting rights with respect to, any clearing agency that
clears security-based swaps, or on the control of any SB SEFs or SBS
exchanges. Pursuant to this directive, the Commission is proposing
ownership and voting limits for a SB SEF that would apply to any SB SEF
participant and for a SBS exchange or facility of a national securities
exchange that posts or makes available for trading security-based swaps
(``SBS exchange facility'') that would apply to any SBS exchange
member. Specifically, the Commission proposes that a SB SEF, SBS
exchange, or SBS exchange facility shall not permit any SB SEF
participant or SBS exchange member, as applicable, either alone or
together with its related persons, to: (1) Beneficially own, directly
or indirectly, any interest in the SB SEF, SBS exchange, or SBS
exchange facility, as applicable, that exceeds 20% of any class of
securities, or other
[[Page 65905]]
ownership interest, entitled to vote of such SB SEF, SBS exchange, or
SBS exchange facility; or (2) directly or indirectly vote, cause the
voting of, or give any consent or proxy with respect to the voting of,
any interest in the SB SEF, SBS exchange, or SBS exchange facility, as
applicable, that exceeds 20% of the voting power of any class of
securities or other ownership interest of such SB SEF, SBS exchange, or
SBS exchange facility.\144\
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\144\ See proposed Rule 702(b) under Regulation MC.
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The Commission is concerned that if a SB SEF participant or SBS
exchange member, either alone or together with its related persons,
were to own a significant stake in the SB SEF, SBS exchange, or SBS
exchange facility, respectively, the SB SEF participant or SBS exchange
member could use its significant ownership interest to influence the
operations of the SB SEF, SBS exchange, or SBS exchange facility to
unduly derive benefits at the expense of other owners and market
participants. The Commission is particularly concerned that a SB SEF
participant or SBS exchange member may have financial incentives to
limit the level of access to, and the scope of products traded on,
these trading venues as a means to impede competition from other market
participants. For example, the Commission understands that many of the
electronic multi-dealer trading platforms that exist today for OTC
derivatives or fixed income products limit the number of dealers from
which a customer can request a quote. The Commission believes that a
fewer number of dealers participating on a platform or exchange could
result in less competition on pricing. The Commission believes that
imposing ownership and voting limits, as described above, could
mitigate potential conflicts of interest with respect to the level of
access to the market and determinations as to which products are traded
by limiting the ability of a small group of persons (such as dealers)
to control the Board \145\ and thus the governance of the SB SEF, SBS
exchange, or SBS exchange facility.\146\
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\145\ See supra note 98 for the proposed definition of
``Board.''
\146\ The Commission also believes that such limits would
further the ability of the SB SEF and SBS exchange to effectively
carry out its obligations. Section 763(c) of the Dodd-Frank Act and
Section 6 of the Exchange Act, respectively, and, in particular,
provide market participants with impartial access to SB SEFs. See
Section 763(c) of the Dodd-Frank Act, Public Law 111-203, Section
763(c), and 15 U.S.C. 78f.
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Unlike the Voting Interest Focus Alternative or the Governance
Focus Alternative for security-based swap clearing agencies, the
Commission is not proposing an aggregate 40% voting interest limit
collectively on all SB SEF participants (with respect to SB SEFs) and
SBS exchange members (with respect to SBS exchanges) or a 5% individual
voting interest limit, respectively. The Commission recognizes that, as
with security-based swap clearing agencies, the proposed rule would
limit, but not eliminate, the ability of a small group of SB SEF
participants or SBS exchange members, as applicable, to own a SB SEF,
SBS exchange, or SBS exchange facility. Specifically, as few as five
entities could own SB SEFs, SBS exchanges, and SBS exchange facilities
under this proposal. However, the Commission's concerns with respect to
concentration of ownership in security-based swap clearing agencies and
SB SEFs, SBS exchanges, and SBS exchange facilities are informed by the
differences in the structure for clearing and trading of security-based
swaps. The Commission's experience has been that the central clearing
model in the securities markets historically has tended toward
convergence to a single clearing agency for each type of cleared
product, while the market structure for securities trading historically
has not necessarily tended toward a similar model.\147\ The Commission
also notes that security-based swap clearing agencies perform a
critical function in mitigating financial risk for security-based swaps
market participants. Although SB SEFs, SBS exchanges, and SBS exchange
facilities are critical to promoting price transparency and therefore
market efficiency, the Commission does not believe that the operation
of SB SEFs, SBS exchanges, and SBS exchange facilities would pose the
same level of systemic risk as security-based swap clearing agencies.
There generally will be a lower barrier to entry with respect to
trading platforms because participants of a SB SEF or members of an SBS
exchange would not incur the margin, guaranty fund, or other
obligations that members of a clearing agency would incur, and thus
multiple venues for the trading of security-based swaps are more likely
to emerge. Thus, the Commission is not proposing identical ownership
requirements for security-based swap clearing agencies and SB SEFs, SBS
exchanges, and SBS exchange facilities.
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\147\ The Commission has not made any determinations about
whether security-based swap clearing agencies will also tend to
converge to a single clearing agency or even a small number of
clearing agencies, as the central clearing of security-based swaps
is still a developing area.
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For purposes of calculating a SB SEF participant's or SBS exchange
member's ownership and voting interests, the proposed rule would
aggregate such person's ownership and voting interests with those of
its related persons. When used with respect to a SB SEF, proposed Rule
700(u) under Regulation MC would define the term ``related person'' to
mean: (1) Any affiliate of a security-based swap execution facility
participant; (2) any person associated with a security-based swap
execution facility participant; (3) any immediate family member of a
security-based swap execution facility participant or any immediate
family member of the spouse of such person, who, in each case, has the
same home as the security-based swap execution facility participant or
who is a director or officer of the security-based swap execution
facility or any of its parents or subsidiaries; or (4) any immediate
family member of a person associated with a security-based swap
execution facility participant or any immediate family member of the
spouse of such person, who, in each case, has the same home as the
person associated with the security-based swap execution facility
participant or who is a director or officer of the security-based swap
execution facility or any of its parents or subsidiaries.
Further, when used with respect to a SBS exchange or SBS exchange
facility, proposed Rule 700(u) under Regulation MC would define the
term ``related person'' to mean: (1) Any affiliate of a member of the
national securities exchange that posts or makes available for trading
security-based swaps; (2) any person associated with a member of the
national securities exchange that posts or makes available for trading
security-based swaps; (3) any immediate family member of a member of
the national securities exchange that posts or makes available for
trading security-based swaps or any immediate family member of the
spouse of such person, who, in each case, has the same home as the
member of the national securities exchange that posts or makes
available for trading security-based swaps or who is a director or
officer of the national securities exchange or facility thereof that
posts or makes available for trading security-based swaps, or any of
its parents or subsidiaries; or (4) any immediate family member of a
person associated with a member of the national securities exchange
that posts or makes available for trading security-based swaps or any
immediate family member of the spouse of such person, who, in each
case, has the same home as the person associated with the
[[Page 65906]]
national securities exchange that posts or makes available for trading
security-based swaps or who is a director or officer of the national
securities exchange or facility thereof that posts or makes available
for trading security-based swaps or any of its parents or subsidiaries.
To further the purpose of the proposed limits, the Commission
preliminarily believes that it would be important to aggregate the SB
SEF participant's or SBS exchange member's ownership and voting
interests with the interest of any person with whom such person may be
able to act together to influence or control the SB SEF, SBS exchange,
or SBS exchange facility.
The proposed rule would restrict indirect as well as direct
ownership and voting of a SB SEF, SBS exchange, or SBS exchange
facility. Because the proposed rule could be easily circumvented if the
Commission were to limit solely direct ownership and voting, the
Commission preliminarily believes it would be important to further the
purpose of imposing ownership and voting limits to also restrict the
indirect ownership and voting interests of SB SEF participants and SBS
exchange members. For example, if the Commission simply proposed to
prohibit a SB SEF participant from directly owning or voting shares,
the participant could hold its ownership interests in the SB SEF
through a holding company, thus easily circumventing the intent of the
proposed rule. Accordingly, the ownership and voting limits would apply
to ownership and voting of interests in a parent company of the SB SEF,
SBS exchange, or SBS exchange facility. For example, if the SB SEF were
wholly-owned by a holding company, a SB SEF participant would be
prohibited from owning or voting more than 20% of the voting interest
in the parent company. Finally, the proposed limits also would apply to
a SB SEF participant or SBS exchange member that beneficially owns more
than 25% of an entity that itself owns more than 20% of a SB SEF, SBS
exchange, or SBS exchange facility.\148\
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\148\ See supra note 93 for the proposed definition of
``control.''
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To assure that SB SEFs, SBS exchanges, and SBS exchange facilities
maintain an ownership structure consistent with the proposed ownership
and voting limits, the Commission proposes that these entities have
rules that (1) provide an effective mechanism to divest a SB SEF
participant's or SBS exchange member's ownership that, alone or
together with its related persons, exceeds 20% and (2) are reasonably
designed not to give effect to a SB SEF participant's or SBS exchange
member's voting interest that, alone or together with its related
persons, exceeds 20%.\149\ The Commission believes that in order for
the ownership and voting limits to be effective, each SB SEF, SBS
exchange, and SBS exchange facility must take measures to reduce a SB
SEF participant's or member's ownership interest or not give effect to
any voting interest that exceeds the proposed limits. The Commission
intends to provide SB SEFs, SBS exchanges, and SBS exchange facilities
flexibility in determining how to implement these requirements. Any
rules adopted by these trading venues, however, must assure that they
have a viable, enforceable mechanism to divest a SB SEF participant or
SBS exchange member of any interest held in excess of the 20% limit and
to not give effect to the portion of voting interest held in excess of
the 20% limit. The Commission also proposes to require each SB SEF, SBS
exchange, or SBS exchange facility to have rules to provide a mechanism
to obtain information relating to its ownership and voting
interests.\150\ The Commission believes that a requirement to collect
information regarding ownership and voting interests of SB SEF
participants and SBS exchange members is essential for registered
trading venues to monitor and comply with the proposed ownership and
voting limits.\151\
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\149\ See proposed Rules 702(c)(1) and (2) under Regulation MC.
\150\ See proposed Rule 702(c)(3) under Regulation MC.
\151\ See supra Section IV.A.4.
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The Commission believes that an ownership and voting limit of 20%
is an appropriate threshold. On the one hand, the restriction would
limit the ability of a SB SEF participant or SBS exchange member to
exert undue influence over the governance of a SB SEF, SBS exchange, or
SBS exchange facility, respectively. On the other hand, such an
ownership and voting limit should not overly interfere in such an
entity's organizational structure or the ability of a SB SEF
participant or SBS exchange member to acquire a substantial equity
interest in a SB SEF, SBS exchange, or SBS exchange facility, as
applicable.\152\ Thus, the proposed ownership and voting limits should
strike an appropriate balance between the objectives of mitigating
conflicts of interest and refraining from unnecessarily hindering the
ability of entities to form new trading venues. In addition, there may
be incentives to create a new SBS exchange or SB SEF because a SBS
exchange or SB SEF may draw significant new business by making
available to trade a security-based swap that is required to be cleared
under Section 763(a).\153\ Furthermore, the risk management and
economies of scale issues that may create a barrier to entry with
respect to new security-based swap clearing agencies generally would
not affect the creation of SBS exchanges or SB SEFs.
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\152\ National securities exchanges that may trade security-
based swaps currently prohibit a member from owning or voting more
than 20% of the exchange, although an exchange's method of
calculating the 20% interest, aggregated with any person with whom
such person may be able to act together to influence or control an
exchange, may vary from the Commission's proposal. See, e.g.,
Amended and Restated Certificate of Incorporation of BATS Global
Markets, Inc., Article FIFTH; Amended and Restated Certificate of
Incorporation of NYSE Euronext, Article V.
\153\ The counterparties to a transaction in a security-based
swap that is required to be cleared under Section 763(a)(2) of the
Dodd-Frank Act will be required to execute the transaction on a SBS
exchange or on a SB SEF. There is an exception from the execution
requirement if no SBS exchange or SB SEF makes the security-based
swap available to trade. See Public Law 111-203, Section 763(h). The
exception from trade execution is also available if the exception
from mandatory clearing under Section 763(g) applies. See Public Law
111-203, Section 763(g).
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While the Commission believes that the proposed 20% ownership and
voting limits are appropriate, it also understands that the movement of
trading of security-based swaps onto SB SEFs, SBS exchanges, or SBS
exchange facilities will foster enhanced transparency and market
efficiency. The Commission does not intend to unnecessarily impede the
emergence of what could be vital sources of, among other things,
liquidity and pricing transparency for security-based swaps. However,
imposing on SB SEFs and SBS exchanges ownership and voting limits
similar to those that shareholder-owned cash equities and options
exchanges have in place could have the unintended consequence of
deterring new, competitive trading venues at a time when organized
markets for security-based swaps are just beginning to develop. A
trading platform that currently trades security-based swaps in the OTC
market but would not meet the proposed ownership and voting limits
would need to revise its ownership structure if it chooses to become a
SB SEF. There could be costs and delays as the potential SB SEF seeks
to find one or more additional owners to satisfy the proposed limits,
with a possible diminution in the value of the original owner(s)'
investment. Moreover, it is possible that imposing these limits may
affect the security-based swaps market differently than the cash
equities and listed options markets. Ownership and
[[Page 65907]]
voting limits were implemented at national securities exchanges at a
time when the trading of exchange-listed securities was fairly well
established and competitive. Consequently, a 20% ownership and voting
limit may not negatively affect the ability of cash equity and options
exchanges to promote competing trading venues but, if applied to the
security based-swaps market that is in its infancy, could retard market
development.
The Commission is sensitive to arguments against imposing ownership
and voting limits for SB SEFs, SBS exchanges, and SBS exchange
facilities, some of which were articulated at the Conflicts Roundtable.
However, it also understands that the OTC derivatives market is highly
concentrated and dealer dominated. Although ownership and voting limits
arguably may have a less negative effect on new entrants to the cash
equities and options markets and their ability to compete, there may
also be less need for such limitations in those markets. In contrast,
although ownership and voting limits may more directly affect the
ability of SB SEFs and SBS exchanges to start up, the lack of market
characteristics to promote competing trading venues for security-based
swaps may emphasize the greater need for ownership and voting limits.
If the market characteristics for security-based swaps naturally
promote dealer domination without robust competing trading venues,
there is more need to mitigate the types of concerns that underlie
Section 765, such as by imposing ownership and voting limits.\154\
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\154\ In the equities market a small group of broker-dealers or
single-dealer proprietary firms can and do own alternative trading
systems (``ATSs'') and thus it can be argued that SB SEFs and SBS
exchanges should be permitted to operate similarly. See Securities
Exchange Act Release No. 60997 (November 13, 2009), 74 FR 61208
(November 23, 2009) (as of November 2009, there were approximately
73 ATSs that are subject to Regulation ATS). However, ATSs exist in
the context of a marketplace with robust competition among numerous
trading venues. Therefore, ATSs that are owned by one broker-dealer
or a small group of broker-dealers, by virtue of their ownership
structure alone, generally do not present a concern that they could
lessen price competition or market efficiency.
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The Commission must weigh the potential implications of imposing
ownership and voting limits against imposing other requirements that
would allow a dealer-dominated security-based swaps market to continue.
As part of the balance between mitigating conflicts of interest without
unduly restricting the ability of a competitive market for trading of
security-based swaps to emerge, the Commission proposes to limit
ownership in SB SEFs, SBS exchanges, and SBS exchange facilities
specifically to those interests entitled to vote.\155\ Consequently, a
SB SEF participant or SBS exchange member would not be prohibited from
owning any percentage of a nonvoting interest in a SB SEF, SBS
exchange, or SBS exchange facility. In contrast, national securities
exchanges generally limit their members from owning more than 20% of
any interest, voting or otherwise. However, as discussed above, trading
venues for exchange-listed securities are well established and highly
competitive. In this regard, the Commission does not believe that it is
necessary to propose the same ownership limits as those currently in
place at national securities exchanges. Further, the proposed 20% limit
on ownership and voting would still allow as few as five entities to
own a SB SEF, SBS exchange, or SBS exchange facility. Thus, the
proposed limit by itself would not completely prohibit a small number
of entities from potentially exerting undue influence over SB SEFs, SBS
exchanges, or SBS exchange facilities in a way that could benefit the
few to the detriment of others.
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\155\ See supra note 64.
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The Commission requests comment on all aspects of the proposed
ownership and voting limits, including whether it is necessary and
appropriate to have ownership and voting limits at all. If commenters
believe that it is necessary and appropriate to impose ownership and
voting limits to mitigate conflicts of interest, the Commission
requests comment on whether the proposed limits are appropriate, or
whether they would unduly hinder the development of SB SEFs without
serving to mitigate any conflicts.\156\ Should the Commission require a
voting limit, but not an ownership limit or a different limit for
ownership versus voting? Even with the prohibition against owning more
than 20% of any interest entitled to vote, a SB SEF participant or SBS
exchange member could have sufficient ownership of nonvoting interest,
either alone or in addition to voting interest, to exert influence on
these trading venues. Should the Commission require the ownership limit
to apply to any class of equity securities or other ownership interest
rather than any class of securities, or ownership interest, entitled to
vote? \157\ Would the proposed limits impede the number or types of SB
SEFs from being established? Should the proposed ownership and voting
limits be phased in for SB SEFs to provide a grace period for those
entities that would not meet the requirements under Regulation MC?
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\156\ In the SRO Governance Proposing Release, the Commission
proposed a similar 20% ownership and voting limit for members of a
national securities exchange. A number of commenters favored this
proposal, including several commenters that were national securities
exchanges or a facility of a registered securities association. See,
e.g., letter from Michael J. Simon, Secretary, ISE, to Jonathan G.
Katz, Secretary, Commission, dated March 8, 2005 (``ISE Comment
Letter'') (``[The ownership limitation] provides SROs with
flexibility, yet recognizes the unique conflicts that could arise if
a member were to own a controlling interest in an SRO with
regulatory responsibility for the member.''); letter from Meyer S.
Frucher, Chairman and Chief Executive Officer, Phlx, to Jonathan G.
Katz, Secretary, Commission, dated March 8, 2005 (``Phlx Comment
Letter'') (``The Exchange unequivocally agrees with the Commission
that a significant shareholder could use its voting power to
influence the operations of an exchange in a way that adversely
affects the mission, integrity or regulatory capacity of the
exchange, or otherwise is detrimental to the public interest.'');
letter from Philip D. DeFeo, Chairman and Chief Executive Officer,
Pacific Exchange, Inc. (``PSX''), to Jonathan G. Katz, Secretary,
Commission, dated March 8, 2005 (``PSX Comment Letter''); letter
from Edward S. Knight, Executive Vice President and General Counsel,
Nasdaq Stock Market, Inc., to Jonathan G. Katz, Secretary,
Commission, dated March 8, 2005 (``Nasdaq Comment Letter''). The
Commission notes, however, that the SRO Governance Proposing Release
related to national securities exchanges that trade equity
securities and listed options and registered securities
associations, and the comments received did not address potential
conflicts in other contexts.
\157\ The CFTC has proposed similar ownership and voting limits
for DCMs and registered SEFs, and applies the ownership limit only
to any class of equity securities entitled to vote. See http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister_governance.pdf.
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The Commission also seeks comment on whether the proposed ownership
and voting limits would continue to be important as the market for
security-based swaps evolves. If multiple SB SEFs emerge as this market
develops, would competitive pressures alleviate any of the conflicts of
interest that are the basis for the Commission's proposals? In that
case, would it be appropriate for the Commission to impose different
limits? Should the Commission reduce the restrictions over time, if
conflict of interest concerns are lessened as the security-based swaps
market develops? For example, if participation in the trading of
security-based swaps becomes more open and includes a broader range of
participants, and multiple SB SEFs or SBS exchanges evolve to trade the
same security-based swaps, would there still be a need to retain
ownership and voting limits or are there factors that would allow such
limits to be revised? What factors should the Commission consider in
assessing whether any ownership and voting limits it may impose on SB
SEFs should be revisited?
As mentioned above, each national securities exchange currently
prohibits
[[Page 65908]]
its members from owning an interest, voting or otherwise, or voting
more than 20% (or less) of the exchange or a facility of the
exchange.\158\ Therefore, the Commission preliminarily does not believe
that the proposed rules would have a material effect on an exchange's
ability to post or make available for trading security-based swaps.
Nevertheless, the Commission requests comment on whether the proposed
limits in this rulemaking could affect a national securities exchange's
ability or decision to post or make available for trading security-
based swaps. Also, given that national securities exchanges currently
have limits on ownership and voting by members, would codifying the
proposed limits help to further mitigate the types of conflicts of
interest that underlie the Dodd-Frank Act for SBS exchanges? Would
there be any effect on the willingness of entities to register to
become a national securities exchange and trade security-based swaps?
What would be the implication, if any, on an exchange that chose to
trade security-based swaps through a facility that is a separate legal
entity? More generally, for SB SEFs and SBS exchanges or SBS exchange
facilities, should ownership and voting be limited to the same
threshold or should they be different? If the Commission should take a
different approach for ownership and voting, what should that approach
be?
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\158\ A member has in the past been permitted on a pilot basis
to own more than 20% of a facility of an exchange subject to certain
terms and conditions. See Securities Exchange Act Release Nos. 59281
(January 22, 2009), 74 FR 5014 (January 28, 2009) (order approving
on a pilot basis 50% ownership of the New York Block Exchange, a
trading facility of NYSE, by BIDS ATS, a member of NYSE). This pilot
has since been extended for an additional year and will expire on
January 22, 2011 unless further extended or permanently approved.
See Securities Exchange Act Release No. 61409 (January 22, 2010), 75
FR 4889 (January 29, 2010).
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As described above, Section 765 enumerates Specified Entities that
the Commission should consider in its rulemaking. The Commission
understands that, depending on who may be permitted to directly effect
transactions on a SB SEF (or is a SBS exchange member), limits on
ownership and voting that apply only to SB SEF participants or SBS
exchange members could be either over-inclusive or under-inclusive or
both, with respect to the Specified Entities. For example, restricting
control of a SB SEF based on an entity's direct participation on the SB
SEF could capture a person who is not one of the Specified Entities or,
conversely, fail to take into consideration a Specified Entity.
Accordingly, the Commission requests comment on whether the scope of
the proposed ownership and voting limits is appropriate. Should the
limits on ownership and voting extend to all or some of the Specified
Entities, regardless of their direct participation on the SB SEF or SBS
exchange? If so, why? What are the potential conflicts concerns that
such Specified Entities may pose? How are conflicts concerns posed by
such Specified Entities different from those posed by SB SEF
participants or SBS exchange members who are not also Specified
Entities? In this regard, the Commission notes that the definition of
``related person'' would encompass any such entity that is affiliated
with such a SB SEF participant or SBS exchange member, although it may
not itself be a SB SEF participant or SBS exchange member.
In addition, national securities exchanges generally limit
ownership and voting by non-members, as well as members.\159\
Specifically, exchanges generally limit each non-member to no more than
40% ownership of the exchange. The limit on ownership by non-members of
an exchange is designed in part to provide the Commission and the
exchange with the proper tools (such as access to books and records)
necessary to carry out the Commission's and the exchange's respective
regulatory oversight responsibilities, as well as to mitigate more
general conflict concerns between owners' commercial interests and the
exchange's regulatory obligations. The Commission requests comment on
whether it should impose, as part of this rulemaking, similar limits on
ownership and voting. Such an ownership limit would apply to the
Specified Entities, to the extent they are not subject to the proposed
ownership limit described above. In addition to the requirements of
Section 765, the Dodd-Frank Act more generally requires a SB SEF to
establish and enforce rules to minimize conflicts of interest in its
decision-making process and establish a process for resolving the
conflicts of interest. What are the types of conflicts that a person
who is not a SB SEF participant or SBS exchange member may pose?
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\159\ See supra Section III.B.
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The Commission also requests comment on whether its formulation for
calculating the 20% threshold is appropriate. Specifically, the
Commission requests comment on all prongs of the definition of
``related person,'' including whether the definition is over-inclusive
or under-inclusive. What other method could the Commission use to reach
the interest of any person with whom a SB SEF participant or SBS
exchange member may be able to act together to influence or control a
SB SEF or SBS exchange? Finally, the Commission expects a SB SEF, SBS
exchange, and SBS exchange facility to have in place an effective
mechanism for enforcing the ownership and voting limits. The Commission
requests comment on whether the proposed rules related to divesture of
ownership and voting limits are appropriate. Should the Commission
explicitly require in the proposed rules specific ways to divest
ownership and voting interest of SB SEF participants and SBS exchange
members who violate the ownership and voting limits? Is the proposed
rule pertaining to obtaining information on ownership and voting
interest of SB SEFs, SBS exchanges, and SBS exchange facilities
appropriate? Should the Commission require that trading venues collect
information pertaining to certain ownership or voting thresholds?
B. Governance Requirements
The Commission is proposing substantive requirements with respect
to the governance of SB SEFs, SBS exchanges, and SBS exchange
facilities that are designed to address the conflict of interest
concerns identified above, including the concern that dealer-owners
could unduly influence the governance and operation of a SB SEF or SBS
exchange. These governance provisions, as discussed below, should help
mitigate conflicts of interest as directed by Section 765 of the Dodd-
Frank Act.
1. Board
The Commission proposes that the Board of a SB SEF, SBS exchange,
or SBS exchange facility be composed of a majority of independent
directors.\160\ The presence of a majority of independent directors on
the Board should reduce the ability of owner-directors of a SB SEF, SBS
exchange, or SBS exchange facility to improperly influence the
operation of such entity to their own advantage and to the detriment of
other users or potential users of the facility or exchange. A majority
independent director requirement should help foster a greater degree of
independent decision-making consistent with the objectives of the Dodd-
Frank Act and the Exchange Act and should reduce the ability of owners
that are participants or members to control key decisions regarding the
operation of the SB SEF or SBS exchange and thereby potentially limit
[[Page 65909]]
access to, or limit the products made available for trading on, the SB
SEF or SBS exchange, which could adversely affect the trading of
security-based swaps in regulated markets. Further, the definition of
independent director is designed to assure that the independent
director would not have a direct economic stake in the SB SEF or SBS
exchange, or other relationship that would call into question the
impartiality of the director, and thus would not be subject to the
conflicts of interest identified above.
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\160\ See proposed Rule 702(d)(1) under Regulation MC. See also
supra note 102 and accompanying text for the proposed definition
``independent director.''
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SB SEFs and SBS exchanges are intended to serve important roles in
providing centralized, transparent trading of security-based swaps and,
under Section 763(c) of the Dodd-Frank Act or existing Section 6 of the
Exchange Act, as applicable, will have a number of
responsibilities.\161\ Requiring a majority independent Board should
help assure that SB SEFs and SBS exchanges would operate in an
impartial manner with respect to these (and other) mandated duties.
Moreover, requiring a majority independent Board for SB SEFs and SBS
exchanges would be commensurate with the manner in which national
securities exchanges generally are governed today \162\ and comports
with the listing rules of exchanges, which are approved by the
Commission.\163\
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\161\ For SB SEFs, these responsibilities include establishing
and enforcing rules with respect to the terms and conditions of the
security-based swaps traded or processed on or through the facility
and any limitation on access to the facility; trading procedures to
be used in entering and executing orders traded on SB SEFs; and
monitoring trading in SB SEFs to prevent manipulation, price
distortion, and disruptions of the settlement process through
surveillance, compliance and disciplinary practices and procedures.
See Section 763(c) of the Dodd-Frank Act, Public Law 111-203,
Section 763(c).
\162\ See supra Section III.B. Currently, the governance
structure of a facility of an exchange that is a separate legal
entity from the exchange and that is not a wholly-owned subsidiary
of the exchange is not subject to any specific board or committee
compositional requirements. Given the nature of the conflict
concerns for the trading of security-based swaps and the structure
of the security-based swaps market--namely, the dominance by a small
group of dealers and the concern with respect to undue influence in
the operation of the SB SEF or SBS exchange--the Commission believes
that it is necessary and appropriate to impose the same board and
committee compositional requirements on a facility of an exchange if
that facility posts or makes available for trading security-based
swaps.
\163\ See Securities Exchange Act Release No. 48745 (November 4,
2003), 68 FR 64154 (November 12, 2003) (order approving File Nos.
SR-NYSE-2002-33, SR-NASD-2002-77, SR-NASD-2002-80, SR-NASD-2002-138,
SR-NASD-2002-139, and SR-NASD-2002-141).
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One of the alternatives the Commission proposes for security-based
swap clearing agencies is to require the Board of any security-based
swap clearing agency be composed of 35% independent directors. The
Commission proposes this 35% independence alternative to address
potential concerns that requiring a majority independent Board for
security-based swap clearing agencies would affect the Board's ability
to effectively perform risk management functions. Security-based swap
clearing agencies perform a critical function in mitigating financial
risk for security-based swaps market participants. Although critical to
promoting price transparency and therefore market efficiency, as noted
above, the Commission does not believe that the operation of SB SEFs,
SBS exchanges, and SBS exchange facilities would pose the same level of
systemic risk as security-based swap clearing agencies because they do
not assume the risk of managing open positions or of guaranteeing the
settlement of transactions. Thus, the Commission is not making the same
proposal with respect to SB SEFs, SBS exchanges, and SBS exchange
facilities.
Although a majority independent Board may address conflicts of
interest concerns that underlie Section 765 of the Dodd-Frank Act, it
may not effectively eliminate all conflicts. The presence of
independent directors may be an effective mechanism to address certain
types of conflicts in certain types of institutions but not necessarily
in all instances nor for all institutions. The Commission, however,
does not believe that the characteristics of SB SEFs and SBS exchanges,
and the types of conflicts that may be inherent with respect to such
entities, pose a set of circumstances that are incompatible with an
effective governance via a majority independent Board.
Taking into account these and other concerns, the Commission has
considered a less prescriptive governance rule to address conflicts of
interest for venues that trade security-based swaps. However,
especially because SB SEFs are not SROs and thus their rules are not
subject to Commission approval pursuant to Section 19 of the Exchange
Act,\164\ a principles-based approach to governance may not give the
Commission sufficient ability to address potential conflicts in the
operation of SB SEFs. Although the Commission, through its authority to
approve applications to register as a SB SEF, may be able to ascertain
that a SB SEF at the time of its registration has a governance
structure that sufficiently would mitigate conflicts of interest, a
less prescriptive approach could make it more difficult for the
Commission to assure that the SB SEF's governance structure continues
to meet the proposed requirements over time.
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\164\ 15 U.S.C. 78s.
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The Commission welcomes commenters' insights to inform its
understanding of the governance of trading venues for security-based
swaps. As discussed above, a majority independent Board may not
effectively address all conflicts. The Commission therefore seeks
comment on all aspects of its proposal for a majority independent
Board. Should the Commission adopt a less prescriptive approach to
mitigating conflicts of interest in the governance of SB SEFs and SBS
exchanges? Are there other approaches that would improve governance and
mitigate conflicts of interest? For example, would State laws governing
the fiduciary duty owed by corporate board members help to mitigate
conflicts of interest or, as noted above, would such laws potentially
aggravate the types of conflicts of interest that the Commission is
trying to address? Should the Commission consider any additional
requirements related to fiduciary duties to either enhance mitigation
of conflicts or address deficiencies?
Further, the Commission requests comment on whether requiring the
Board of a SB SEF, SBS exchange, or SBS exchange facility to be
composed of a majority of independent directors would improve the
governance of the SB SEF, SBS exchange, or SBS exchange facility, as
applicable, and mitigate conflicts of interest that could arise. The
Commission specifically requests comment on whether there are other
Board structures that could help mitigate conflicts of interest. If
having a majority independent Board is not necessary to mitigate
conflicts, but some lesser percentage of independent directors would
help address such concerns, what percentage of Board members should be
required to be independent? What are the benefits and costs of
requiring Boards of SB SEFs, SBS exchanges, and SBS exchange facilities
to be composed of a majority of independent directors? Would a majority
independent Board help to mitigate conflicts of interest if the
ownership of a SB SEF, SBS exchange, or SBS exchange facility is
concentrated in a small group of owners (e.g., five owners) rather than
a larger group (e.g., greater than ten owners)? Would a majority
independent Board help to mitigate conflicts of interest that could
arise between the commercial interests of a SB SEF, SBS exchange, or
SBS exchange facility or the owners of the SB SEF, SBS exchange or SBS
exchange
[[Page 65910]]
facility and the regulatory responsibilities of the SB SEF or SBS
exchange? Are there experience or efficiency issues if a majority of
the Board must be composed of independent directors? Are there remedies
for overcoming any such experience or efficiency issues? \165\
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\165\ The SRO Governance Proposing Release proposed that the
board of a national securities exchange or national securities
association be composed of a majority of independent directors. See
SRO Governance Proposing Release, supra note 59. A number of
commenters, particularly national securities exchanges, favored this
proposal. See, e.g., PSX Comment Letter, supra note 156; Letter from
Anthony K. Stankiewicz, Esq., Vice President, Legal and Governance,
BSE, to Jonathan G. Katz, Secretary, Commission, dated March 8, 2005
(supporting the majority independent board requirement but objecting
to the definition of independence) (``BSE Comment Letter''); Letter
from Mary Yeager, Assistant Secretary, NYSE, to Jonathan G. Katz,
Secretary, Commission, dated March 8, 2005 (``NYSE Comment
Letter''). A few commenters objected to it as being an unnecessary
requirement to mandate for all exchanges. See, e.g., ISE Comment
Letter, supra note 156; Letter from William J. Brodsky, Chairman and
Chief Executive Officer, Chicago Board Options Exchange,
Incorporated, to Jonathan G. Katz, Secretary, Commission, dated
March 8, 2005 (``CBOE Comment Letter''). The Commission notes,
however, that the SRO Governance Proposing Release related to
national securities exchanges that trade equity securities and
listed options and registered securities associations, and the
comments received did not address potential conflicts in other
contexts.
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The Commission also notes that currently, for national securities
exchanges, at a minimum, the number of non-industry directors should
equal or exceed the number of industry directors.\166\ The Commission
requests comment on whether requiring a majority independent Board
could further mitigate conflicts for SBS exchanges or whether the
current standards exchanges have in place would sufficiently address
the conflict concerns with respect to exchanges that would post or make
available for trading security-based swaps. Further, the Commission
requests comment as to whether the requirement for Board composition
should be different for SB SEFs and SBS exchanges and, if so, why and
how?
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\166\ See supra Section III.B.
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The Commission also requests comment on the proposed definitions of
``independent director'' and ``material relationship.'' \167\ Are the
definitions of ``independent director'' and ``material relationship''
appropriate? If not, how should they be defined? The proposed rule
provides circumstances that would preclude a finding that a director is
independent.\168\ The Commission requests comment on whether this
approach is appropriate or whether the Commission should take a less
prescriptive approach. The Commission also notes that the proposed rule
precludes a director from being deemed independent if he or she has
received from the SB SEF, SBS exchange, or SBS exchange facility within
the past three years payments that reasonably could affect his or her
independent judgment or decision-making, excluding remunerations for
Board or Board committee services. The Commission requests comment on
whether it is appropriate to exclude compensation for Board or Board
committee service from disqualifying a director as an independent
director. Are there circumstances or levels of compensation that should
disqualify a candidate from being deemed independent? The Commission
also requests comment on whether, instead of independence requirements,
it should require that the number of ``non-industry'' directors equal
or exceed the number of ``industry'' directors, as such terms are
generally defined by the exchanges.\169\ Are there other types of
affiliations that the Commission should be concerned about that are not
addressed by the proposed definitions of ``independent director'' or
``material relationship''?
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\167\ See proposed Rules 700(j) and (l) under Regulation MC.
\168\ See Section 303A.02 of the NYSE Listed Company Manual and
Nasdaq Rule 5605(a)(2), both of which contain specific circumstances
that, if satisfied, would preclude a determination that the director
is independent.
\169\ See supra note 66.
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The Commission is not proposing that the Board composition
requirement apply to parent companies of a SB SEF, SBS exchange, or SBS
exchange facility.\170\ In other words, the Commission is not proposing
to require a holding company that wholly owns, or entities that
control, a SB SEF, SBS exchange, or SBS exchange facility to have a
majority independent Board.\171\ The Commission preliminarily believes
that the composition of the Board of a parent that wholly owns or
controls a SB SEF, SBS exchange, or SBS exchange facility does not
raise conflicts concerns that require Commission rulemaking. The
Commission, however, requests comment on whether the majority
independent Board requirement should apply to an entity that owns and
controls a SB SEF, SBS exchange, or SBS exchange facility.
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\170\ If the parent company of a SB SEF, SBS exchange or SBS
exchange facility was itself a regulated entity that is subject to
the Exchange Act and rules and regulations thereunder, then it would
comply with any requirements that it is subject to in that capacity.
\171\ The CFTC has proposed to apply a ``public director''
requirement to parent companies that operate DCMs and SEFs. See
http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/federalregister_governance.pdf.
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2. Regulatory Oversight Committee
In addition to a majority independent Board, the Commission
proposes that a SB SEF or SBS exchange establish a ROC that is composed
solely of independent directors to oversee the SB SEF's obligations
under Section 763(c) of the Dodd-Frank Act or the SBS exchange's
regulatory oversight responsibilities under Section 6 of the Exchange
Act, respectively.\172\ This requirement also would apply to a national
securities exchange that posts or makes available for trading security-
based swaps through a facility of the exchange.\173\ The ROC would
oversee the regulatory program on behalf of the Board. Specifically,
the Commission expects that a ROC, among other things, would monitor a
SB SEF's or SBS exchange's regulatory program for sufficiency,
effectiveness, and independence; oversee all facets of the regulatory
program; review the size and allocation of the regulatory budget and
resources; and review regulatory proposals and advise the Board as to
whether and how such changes may affect regulation. The proposed rule
also would require that any recommendation of the ROC that is not
adopted or implemented by the Board be reported promptly to the
Commission.\174\
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\172\ See Section 763(c) of the Dodd-Frank Act, Public Law 111-
203, Section 763(c), and 15 U.S.C. 78(f). See also proposed Rule
702(e)(1) under Regulation MC.
\173\ Proposed Rule 702(e) under Regulation MC does not
explicitly include a SBS exchange facility. A facility that posts or
makes available for trading a security-based swap would do so under
the registration of an exchange of which it is a facility.
Therefore, the exchange is deemed the statutory entity posting or
making available for trading the security based swap and is
responsible for the regulatory oversight of the facility.
Accordingly, the exchange whose facility posts or makes available
for trading a security-based swap must itself establish the
requisite ROC.
\174\ See proposed Rule 702(e)(2) under Regulation MC.
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The proposed provisions relating to the ROC should help limit the
ability of owners of the SB SEF and SBS exchange to unduly influence
the operation of these entities, and thus would further the objectives
of good governance and mitigation of conflicts of interest that
underlie Section 765 of the Dodd-Frank Act. A ROC is intended to have
an important role in assuring that a SB SEF or SBS exchange carries out
its obligations in an even-handed and effective manner and that its
oversight functions are adequately funded.
Although the Commission encourages national securities exchanges to
have a wholly independent ROC, it has not in
[[Page 65911]]
the past required them to do so.\175\ As mentioned above, however, the
conflict concerns that Section 765 is intended to address are not
entirely analogous to those posed by national securities exchanges.
Rather, there is a heightened concern regarding conflicts of interest
for trading venues of security-based swaps because a small group of
dealers may exert undue influence to control the level of access to,
and the scope of products traded on such venues. Further, while SB SEFs
do not possess the full range of self-regulatory obligations that
exchanges have, they nonetheless have a number of regulatory duties
that are set forth in the core principles for SB SEFs contained in
Section 763(c) of the Dodd-Frank Act.\176\ Thus, it appears that a need
for a wholly independent ROC may be greater for SB SEFs and SBS
exchanges than for other registered national securities exchanges.\177\
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\175\ In the SRO Governance Proposing Release, the Commission
proposed to require SROs to have a ROC and to require that all
members of such committee be independent. See SRO Governance
Proposing Release, supra note 59. Some commenters generally favored
the requirement of a ROC. See, e.g., PSX Comment Letter, supra note
156; CBOE Comment Letter, supra note 165. However, a number of
commenters objected to the requirement that certain board
committees, including the ROC, be composed solely of independent
directors. See, e.g., Phlx Comment Letter, supra note 156 (``To
impose this requirement on all Standing Committees would potentially
exclude persons with the most experience and knowledge from serving
on these committees.''); CBOE Comment Letter, supra note 165; letter
from Neal Wolkoff, Acting Chief Executive Officer, the American
Stock Exchange LLC, to Jonathan G. Katz, Secretary, Commission,
dated March 8, 2005 (``[A] number of the exchanges may find it
difficult to find enough qualified independent directors with
sufficient expertise to satisfy all of these committees.''); letter
from the Archipelago Exchange, BSE, the Chicago Stock Exchange, ISE,
the Nasdaq Stock Market, and Phlx, to Jonathan G. Katz, Secretary,
Commission, dated March 8, 2005 (``[As] a result of the potential
loss of flexibility, we disagree with the mandated requirement for
specific committees composed exclusively of directors that meet the
[Commission's] proposed definition of independence.''). The
Commission notes, however, that the SRO Governance Proposing Release
related to national securities exchanges that trade equity
securities and listed options and registered securities
associations, and the comments received did not address potential
conflicts in other contexts.
\176\ See supra note 54.
\177\ Some exchanges have voluntarily created ROCs. See, e.g.,
Securities Exchange Act Release Nos. 51149 (February 8, 2005), 70 FR
7531 (February 14, 2005) (order approving demutualization of the
Chicago Stock Exchange (``CHX'')) (at the time of the
demutualization, CHX proposed to have, and currently has, majority
public directors on its ROC) and 62158 (May 24, 2010), 75 FR 30082
(May 28, 2010) (order approving the demutualization of CBOE) (CBOE's
ROC is composed solely of non-industry directors).
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The Commission also recognizes that, as mentioned above, an
independent director, who by definition would be outside the management
of a SB SEF or SBS exchange and not a SB SEF participant or SBS
exchange member may not have access to the same amount or types of
information as non-independent directors. Therefore, a ROC composed
solely of independent directors may need to rely on management or non-
independent directors for information, with attendant biases of
information from such sources. If directors on a ROC, moreover, lack
necessary information or are otherwise not sufficiently knowledgeable,
the committee's effectiveness as a whole may be compromised. Such ROC
may defer to management's expertise or the expertise of non-independent
directors on the Board. Further, as mentioned above, independent
directors may have their own biases that could compromise the
structural protections intended by a wholly independent ROC. Therefore,
the Commission seeks comment on the proposal relating to the
composition and duties of the ROC. Would the establishment of a fully
independent ROC help mitigate the identified conflicts of interest? Are
there particular circumstances under which a ROC should be permitted to
have non-independent directors? If so, please identify them.
Separately, the Commission requests comment on whether it should
specify in the proposed rule the duties of the ROC. If so, what should
be the scope of the ROC's duties? For example, should a ROC be required
to oversee decisions as to which entities have access to the trading
facility and under what circumstances, or which products are made
available for trading? Is it appropriate to require that the Board
submit to the Commission any recommendation of the ROC that it does not
adopt or implement? Would this requirement help assure good governance
that may mitigate conflicts? Should such reports be required to be
submitted promptly to the Commission? Would a different time period be
more appropriate? For instance, should such reports instead be required
to be submitted semi-annually or, for SB SEFs, should they be
incorporated as part of the annual report of the Chief Compliance
Officer, which is required pursuant to core principle 14 under Section
763(c) of the Dodd-Frank Act? Are there reasons, consistent with
mitigation of conflicts, why SB SEFs and SBS exchanges should be
treated differently with respect to the proposal to require a fully
independent ROC? Are there other ways in which material information
pertaining to the ROC's ability to carry out its duties effectively can
be brought to the Commission's attention?
3. Other Board Committees
The Commission is proposing compositional and other requirements
with respect to various other Board committees. In this regard,
proposed Rule 702(f)(1) under Regulation MC would require that the
nominating committee of a SB SEF, SBS exchange, or SBS exchange
facility be composed solely of independent directors. The proposed
requirement for the Board of the SB SEF, SBS exchange, or SBS exchange
facility to be composed of a majority of independent directors could be
undercut if the nominating committee were dominated by persons that had
an ownership interest in these entities, were affiliated with such
owners, or were selected by the owner-directors or their affiliates.
Further, the proposed rule would require that any committee of the
Board that is delegated the authority to act on the Board's behalf,
such as any executive committee, also must be composed of a majority of
independent directors.\178\ This proposed provision extends to Board
committees that are authorized to act on behalf of the Board the
compositional requirement proposed for the full Board and is designed
to assure that the SB SEF, SBS exchange or SBS exchange facility would
not subvert the proposed majority Board independence standard by
delegating the Board's duties to a committee that does not have the
same majority independence standard.
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\178\ See proposed Rule 702(f) under Regulation MC. This
proposed provision would not apply to the ROC or the nominating
committee since the proposals would require the ROC and the
nominating committee to be composed solely of independent directors.
---------------------------------------------------------------------------
With respect to a wholly independent nominating committee, the
Commission recognizes that the proposal may not sufficiently mitigate
concerns that certain shareholders may be able to influence or control
the director nominating process and thus undermine the intent of a
majority independent Board. As discussed above, an independent director
may not truly be independent from the influence of, or bias toward, a
large shareholder or group of shareholders, other non-independent
directors, or even from management. Consequently, if the nominating
committee is composed of enough directors who are subject to such
influence or bias, the palliative purpose of requiring a wholly
independent nominating committee could be compromised. Accordingly, the
Commission requests comment on
[[Page 65912]]
whether it should prescribe or limit the manner in which a SB SEF, SBS
exchange, or SBS exchange facility could appoint the nominating
committee. Should the Commission consider an alternative to a
compositional requirement for a nominating committee, such as allowing
a SB SEF, SBS exchange, or SBS exchange facility to have a board of
trustees responsible for nominating candidates for the Board? If this
were a viable alternative, should there be compositional requirements
or other limits imposed on the board of trustees? How should such a
board of trustees be appointed? Would the alternative of a board of
trustees to nominate directors provide greater assurance that
independent directors are truly independent not only at the time of
their nomination but during their service on the Board as well?
Conversely, the Commission also notes that dealer-owners that are
Board members would not be able to serve on a wholly independent
nominating committee and thus would not have a voice in the process of
nominating candidates for Board seats. This would mean that the
nominating committee would not have access to the dealer-owners'
potentially valuable insights with respect to qualified candidates for
either independent or non-independent director positions. Accordingly,
the Commission invites commenters to suggest the appropriate
compositional requirements for the nominating committee and explain
their views. Should the Commission instead require a majority
independent nominating committee? Would a majority independent
nominating committee be consistent with the proposal's goal to mitigate
conflicts for SB SEFs and SBS exchanges? \179\
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\179\ The SRO Governance Proposing Release proposed that certain
committees, including the nominating committee, be composed solely
of independent directors. See SRO Governance Proposing Release,
supra note 59. Some commenters favored this requirement. See, e.g.,
PSX Comment Letter, supra note 156. A number of commenters,
particularly national securities exchanges, objected to the
requirement that certain board committees be composed solely of
independent directors. See supra note 175.
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SB SEFs are not subject to ``fair representation'' requirements,
like national securities exchanges, which must assure their members
``fair representation'' in the selection of directors and the
administration of the exchange's affairs.\180\ Should the Commission
adopt additional compositional requirements to provide SB SEF
participants a guaranteed voice in the selection of the SB SEF's
directors and the administration of its affairs? \181\ For example,
should the Commission require that the nominating committee consult
with participants in the SB SEFs or SBS exchanges, as applicable? Or,
should the Commission require that the participants in the SB SEFs or
SBS exchanges select a certain percentage of directors? If so, should
the Commission also limit the ability of owner participants (such as
dealers) to participate in this process? If that is the case, should
any such limitation depend on whether ownership is concentrated in a
small number of dealers? Should end users also be given guaranteed
rights of participation in the governance of the SB SEF?
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\180\ See Section 6(b)(3) of the Exchange Act, 15 U.S.C.
78f(b)(3).
\181\ As discussed above, Section 763(c) of the Dodd-Frank Act
sets forth 14 core principles that SB SEFs must satisfy, including
one relating to conflicts of interest, and provides the Commission
with rulemaking authority with respect to implementation of these
core principles. As the Commission has not yet proposed rules
regarding the requirements and operation of a SB SEF, including the
scope of trading on and which entities would be allowed to directly
access a SB SEF, the Commission may determine that it is more
appropriate to propose participant representation requirements, if
any, in its broader rulemaking relating to SB SEFs.
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The Commission also seeks comment on whether the proposed
compositional requirements relating to any committee that is delegated
the authority to act on behalf of the Board are appropriate and whether
there are any other areas in which the Commission should propose
compositional requirements for SB SEF and SBS exchange committees. For
example, the Commission requests comment on whether it should require
any SB SEF, SBS exchange, or SBS exchange facility committee that
determines which security-based swaps will trade on the SB SEF or SBS
exchange, respectively, be composed of majority independent directors,
or require participation by other groups on such committee. Should the
ROC be required to oversee decisions regarding access to the SB SEF and
regarding which security-based swaps are made available to trade on the
SB SEF?
4. Disciplinary Process
As noted above, the Commission historically has required that
national securities exchanges' disciplinary panels be balanced and
include industry member representation.\182\ Proposed Rule 702(g) under
Regulation MC would require that any disciplinary process of a SB SEF
and SBS exchange shall preclude any group or class of persons that is a
SB SEF participant or SBS exchange member from dominating or exercising
disproportionate influence. In other words, to the extent that there is
more than one type of group or class of persons that are participants
or members in a SB SEF or SBS exchange, as applicable, the composition
of any disciplinary panel should not allow one group or class to have
representation on the disciplinary panel that is out of proportion as
compared to other groups or classes of persons that are participants in
the SB SEF or SBS exchange. In addition, any panel that is responsible
for disciplinary decisions, and any appeals body, must include at least
one independent director.\183\ These proposed provisions should help
mitigate conflicts of interest in the SB SEF's and SBS exchange's
disciplinary process. This requirement also would apply to a national
securities exchange that posts or makes available for trading a
security-based swap through its facility.\184\
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\182\ See supra Section III.B.
\183\ See proposed Rule 702(h) under Regulation MC.
\184\ See supra note 173. Similar to the requirement pertaining
to the ROC, the exchange, not the facility, bears the responsibility
of disciplining its members. See Section 6 of the Exchange Act.
Consequently, proposed Rule 702(h) does not explicitly mention SBS
exchange facility. However, a national securities exchange that
posts or makes available for trading a security-based swap through
its facility must also comply with the requirements of proposed Rule
702(h) under Regulation MC.
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The Commission seeks comment on the proposal relating to
requirements of the disciplinary process, including the compositional
requirements. Should any disciplinary panel also be required to include
representatives selected by SB SEF participants or SBS exchange
members, as applicable? Would the proposed provisions help to mitigate
the identified conflicts of interest? Should any other persons be
precluded from dominating the disciplinary process? Are there any
additional provisions that should be proposed to mitigate conflicts of
interest in the disciplinary process? \185\ The Commission also
requests comment on whether the Commission's proposal would
meaningfully supplement or enhance the requirements that SBS exchanges,
as national securities exchange, already have in place with respect to
the disciplinary process.
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\185\ See supra note 181.
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VI. Discussion of Exemptive Authority Pursuant to Section 36 of the
Exchange Act
The Commission pursuant to Section 36 of the Exchange Act may grant
an exemption from any rule or any provision of any rule under
Regulation MC. Any such exemption could be subject to conditions and
could be revoked by the Commission at any time.
[[Page 65913]]
Generally, the Commission would consider granting an exemption where
the exemption is necessary or appropriate in the public interest and
consistent with the protection of investors. For example, the SBS
exchange, SB SEF, or security-based swap clearing agency might be
unable, on a temporary basis and for reasons beyond its control, to
comply with one of the rules under Regulation MC. The Commission could
also grant an exemption where the SBS exchange, SB SEF, or security-
based swap clearing agency demonstrated that it established alternative
means to effectively mitigate conflicts of interest as contemplated
under Regulation MC and that it would otherwise be unable to comply
with the requirements under Regulation MC, including as a start-up SB
SEF, SBS exchange, or security-based swap clearing agency. The
Commission in its sole discretion would determine whether to grant or
deny a request for an exemption. In addition, the Commission could
revoke an exemption at any time, including if the SBS exchange, SB SEF,
or security-based swap clearing agency could no longer demonstrate that
such exemption is necessary or appropriate in the public interest, or
is consistent with the protection of investors.
The Commission requests comment on all aspects of the exemptive
authority. Would such exemptive authority be useful to facilitate the
purposes of Section 765? If so, in what circumstances should the
Commission grant exemptions? Should exemptions only be granted in
limited circumstances? Should the Commission potentially consider
granting exemptions from all rules under Regulation MC or are
exemptions only warranted for specific rules or specific entities? For
example, should exemptions only be available with respect to the voting
interest restrictions applicable to security-based swap clearing
agencies? What specific factors should the Commission consider in
determining whether to grant an exemption? Are there cases where
exemptions may not be appropriate and should not be considered?
VII. Effective and Compliance Date
The Commission is required to adopt rules under Section 765 within
180 days of enactment of Title VII. However, certain of the rules the
Commission is proposing today would apply to SB SEFs, which will be the
subject of new definitional rules that are required under the Dodd-
Frank Act to be completed by July 15, 2011. Accordingly, the Commission
is proposing that provisions of Regulation MC as applicable to SB SEFs
would become effective sixty (60) days after July 15, 2011. All other
provisions of the rules under Regulation MC would become effective
sixty (60) days after the final rules are published in the Federal
Register.
The Commission recognizes that existing entities may need a
transitional period to implement any final rules. Accordingly, the
Commission is proposing to permit the phase-in implementation of the
rules under Regulation MC over two (2) years or two regularly-scheduled
Board elections. The phase-in implementation would apply to existing
exchanges, clearing agencies, or other institutions that apply to
register as a SBS exchange, SB SEF, or security-based swap clearing
agency. However, the Commission expects that entities that are newly
created in order to establish a SBS exchange, SB SEF, or security-based
swap clearing agency would fully comply with the final rules.
The Commission requests comment on (i) the timing of effectiveness
for the final rules, and (ii) the length and applicability of the
implementation period.
VIII. General Request for Comments
The Commission seeks comment on the proposed rules that are
intended to mitigate conflicts of interest with respect to security-
based swap clearing agencies, SB SEFs, SBS exchanges, and SBS exchange
facilities, on any additional or different provisions that would
mitigate conflicts of interest for these entities, and on any other
matters that might have an implication on the proposals. The Commission
particularly requests comment from the point of view of entities that
plan to register as security-based swap clearing agencies or SB SEFs
and from national securities exchanges that plan to become SBS
exchanges or create SBS exchange facilities; entities operating
platforms that currently trade or clear security-based swaps; broker-
dealers, financial institutions, major security-based swap
participants, and other persons that trade security-based swaps; and
end-users generally.
The Commission invites commenters to address whether the proposed
rules are appropriately tailored to achieve the goal of mitigating
conflicts of interest in the ownership and governance of security-based
swap clearing agencies, SB SEFs, SBS exchanges, and SBS exchange
facilities, including with respect to the administration of these
entities' regulatory activities. The Commission also requests comment
on the necessity and appropriateness of mandating ownership and voting
limitations for security-based swap clearing agencies, SB SEFs, SBS
exchanges, and SBS exchange facilities and on whether there are other
means to achieve the statutory mandate of Section 765 of the Dodd-Frank
Act.
The Commission is proposing governance requirements for security-
based swap clearing agencies, SB SEFs, SBS exchanges, and SBS exchange
facilities that are designed to mitigate conflicts of interest. The
Commission requests comment on whether the governance requirements, by
themselves, would be enough to mitigate conflicts.
The Commission requests comment on the two alternative proposals
for security-based swap clearing agencies. Are there other alternatives
that would more effectively mitigate conflicts of interest? Should
security-based swap clearing agencies be permitted to choose between
alternatives at all? The Commission may determine to adopt only one of
the proposed alternatives as a final rule. If only one alternative were
to be adopted as a final rule, which one should it be? Should any of
the provisions of the proposed alternatives be revised? The Commission
may combine aspects of each proposed alternative rule (with or without
modifications) and adopt them as a single final rule. If that approach
is taken, which aspects of each alternative should be combined? For
example, should the voting interest restrictions in Rule 701(a) be
combined with the governance restrictions in Rule 701(b) to create a
stronger rule to mitigate conflicts of interest at security-based swap
clearing agencies? As compared to each other, how is each alternative
likely to affect access and risk management at security-based swap
clearing agencies? How will each alternative affect and be affected by
developments in the market, including the prospect of future
competition?
The Commission also requests comment on the impact on competition
the two alternative proposals might have. The Voting Interest Focus
Alternative and the Governance Focus Alternative are designed to
address the unique conflict of interest issues at security-based swap
clearing agencies. The Commission requests comment on whether imposing
voting interest and governance limitations could have the unintended
consequence of deterring new, competitive security-based swap clearing
agencies at a time when central clearing for security-based swaps is
still developing. A security-based swap clearing agency that currently
clears security-based swaps but would not
[[Page 65914]]
meet the proposed voting interest limits would need to revise its
ownership structure. There could be costs and delays as the security-
based swap clearing agency seeks to find one or more additional owners
to satisfy the proposed limits, with a possible diminution in the value
of the original owner(s)' investment.
The Commission is sensitive to arguments against imposing ownership
and voting limits for security-based swap clearing agencies, some of
which were articulated at the Conflicts Roundtable. However, it also
understands that the OTC derivatives market is highly concentrated and
dealer dominated. As a result, voting interest and governance
restrictions may be necessary at security-based swap clearing agencies
where they have not been necessary at other securities clearing
agencies. Access to central clearing services will be crucial for most
firms that will actively trade in security-based swaps that are
required to be cleared. Although the proposed restrictions may have the
effect of creating barriers to potential security-based swap clearing
agencies (and thus market participants could have fewer clearing
agencies to choose from) the incentives of independent directors will
likely promote increased access to central clearing for market
participants. In contrast, although ownership and voting limits may
more directly affect the ability of SB SEFs and SBS exchanges to start
up, the lack of market characteristics to promote competing trading
venues for security-based swaps may emphasize the greater need for
ownership and voting limits. If the market characteristics for
security-based swaps naturally promote dealer domination without robust
competing trading venues, there is more need to mitigate the types of
concerns that underlie Section 765, such as by imposing ownership and
voting limits.\186\
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\186\ In the equities market a small group of broker-dealers or
single-dealer proprietary firms can and do own alternative trading
systems (``ATSs'') and thus it can be argued that SB SEFs and SBS
exchanges should be permitted to operate similarly. See Securities
Exchange Act Release No. 60997 (November 13, 2009), 74 FR 61208
(November 23, 2009) (as of November 2009, there were approximately
73 ATSs that are subject to Regulation ATS). However, ATSs exist in
the context of a marketplace with robust competition among numerous
trading venues. Therefore, ATSs that are owned by one broker-dealer
or a small group of broker-dealers, by virtue of their ownership
structure alone, generally do not present a concern that they could
lessen price competition or market efficiency.
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The CFTC is adopting rules to mitigate conflicts of interest for
derivatives clearing organizations that clear swaps, swap execution
facilities and boards of trade designated as a contract markets that
post swaps or make swaps available for trading as required under
Section 726 of the Dodd-Frank Act. Understanding that the Commission
and the CFTC regulate different products and markets and, as such,
appropriately may be proposing alternative regulatory requirements, the
Commission requests comments on the impact of any differences between
the Commission and CFTC approaches to the mitigation of conflicts of
interest. Specifically, would the regulatory approaches under the
Commission's proposed rulemaking pursuant to Section 765 of the Dodd-
Frank Act and the CFTC's proposed rulemaking pursuant to Section 726 of
the Dodd-Frank Act result in duplicative or inconsistent efforts on the
part of market participants subject to both regulatory regimes or
result in gaps between those regimes? If so, in what ways do commenters
believe that such duplication, inconsistencies, or gaps should be
minimized? Do commenters believe the approaches proposed by the
Commission and the CFTC to mitigate conflicts of interest are
comparable? If not, why? Do commenters believe there are approaches
that would make the mitigation of conflicts of interest more
comparable? If so, what? Do commenters believe that it would be
appropriate for the Commission to adopt an approach proposed by the
CFTC that differs from the Commission's proposal? Is so, which one? The
Commission requests commenters to provide data, to the extent possible,
supporting any such suggested approaches.
In addition, the Commission seeks comment regarding any potential
implication of the proposals on users of any security-based swap
clearing agencies, SB SEFs, and SBS exchanges, other market
participants, and the public generally. The Commission seeks comment on
the proposals as a whole, including their interaction with the other
provisions of the Dodd-Frank Act. The Commission seeks comment on
whether the proposals would help achieve the broader goals of
increasing transparency and accountability in the OTC derivatives
market.
Commenters should, when possible, provide the Commission with
empirical data to support their views. Commenters suggesting
alternative approaches should provide comprehensive proposals,
including any conditions or limitations that they believe should apply,
the reasons for their suggested approaches, and their analysis
regarding why their suggested approaches would satisfy the statutory
mandate contained in Section 765 of the Dodd-Frank Act regarding
mitigation of conflicts of interest.
IX. Paperwork Reduction Act
The proposed rules contain ``collection of information''
requirements within the meaning of the Paperwork Reduction Act of 1995
(``PRA'').\187\ The titles for these collections are Rule 701 of
Regulation MC, both in the Voting Interest Focus Alternative and the
Governance Focus Alternative, and Rule 702 of Regulation MC.
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\187\ 44 U.S.C. 3501 et seq.
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The Commission has submitted the information to the Office of
Management and Budget (``OMB'') for review in accordance with 44 U.S.C.
3507 and 5 CFR 1320.11.
A. Summary of Collection of Information
1. Security-Based Swap Clearing Agencies
Proposed alternative Rule 701(a)(2) under Regulation MC would
require security-based swap clearing agencies to have rules that would:
(1) Provide for an effective mechanism to divest any participant of any
interest owned in excess of the proposed 20% ownership limit; (2) not
give effect to the portion of any voting interest held by one
participant in excess of the proposed 20% voting limit; (3) not give
effect to the portion of any voting interest among all security-based
swap clearing agency participants owned in the aggregate in excess of
the proposed 40% ownership limit; and (4) provide an effective
mechanism for the security-based swap clearing agency to obtain
information relating to the voting interests in such entity.
Alternative Rule 701(b)(2) under Regulation MC would require security-
based swap clearing agencies to have rules that would: (1) Provide for
an effective mechanism to divest any participant of any interest owned
in excess of the proposed 5% ownership limit; (2) not give effect to
the portion of any voting interest held by one participant in excess of
the proposed 5% voting limit; and (3) provide an effective mechanism
for the security-based swap clearing agency to obtain information
relating to the voting interests in such entity. Each security-based
swap clearing agency must comply with one of the alternatives.
Establishing such rules would result in a paperwork burden for a
security-based swap clearing agency. In addition, if the security-based
swap clearing agency was to request to receive ownership and voting
information from participants
[[Page 65915]]
pursuant to Rule 701(a) or (b), the request would be a collection of
information.
2. SB SEFs, SBS Exchanges, and SBS Exchange Facilities
Proposed Rule 702(c) under Regulation MC would require SB SEFs, SBS
exchanges, and SBS exchange facilities to have rules that would: (1)
Provide for an effective mechanism to divest any participant or member,
as applicable, of any interest owned in excess of the proposed 20%
ownership limit; (2) not to give effect to the portion of any voting
interest help by one or more participants or members, as applicable, in
excess of the proposed 20% voting limit; and (3) provide an effective
mechanism for the SB SEF, SBS exchange or SBS exchange facility to
obtain information relating to ownership and voting interests in such
entity. Establishing such rules would result in a paperwork burden for
a SB SEF, SBS exchange, or SBS exchange facility, as applicable. In
addition, if a SB SEF, SBS exchange, or SBS exchange facility were to
request to receive ownership and voting information from participants
or members pursuant to Rule 702(c) that would be a collection of
information.
Proposed Rule 702(e) under Regulation MC would require SB SEFs and
SBS exchanges to establish a ROC that is composed solely of independent
directors,\188\ to oversee the SB SEF's and SBS exchange's obligations
under Section 763(c) of the Dodd-Frank Act and Section 6 of the
Exchange Act, respectively.\189\ The proposed rule would require that
any recommendation of the ROC that is not adopted or implemented by the
SB SEF's or SBS exchange's Board be reported promptly to the
Commission.
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\188\ Proposed Rule 702(e) under Regulation MC does not
explicitly include SBS exchange facilities because the exchange
whose facility posts or makes available for trading a security-based
swap must itself establish the requisite ROC. See supra note 173.
\189\ See Section 763(c) of the Dodd-Frank Act, Public Law 111-
203, Section 763(c). Specifically, the ROC would oversee the SBS
exchange's and SB SEF's regulatory program on behalf of the Board
and the Board would be required to delegate sufficient authority,
dedicate sufficient resources, and allow sufficient time for the ROC
to fulfill its mandate.
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B. Proposed Use of Information
1. Security-Based Swap Clearing Agencies
The purpose of the collection of information in proposed Rule
701(a) or (b) under Regulation MC is to enable a security-based swap
clearing agency to monitor voting interests with respect to the
security-based swap clearing agency, and enable the security-based swap
clearing agency to take necessary action if the voting interests by a
participant or group of participants in the security-based swap
clearing agency exceed those allowed under proposed Rule 701(a) or (b).
2. SB SEFs, SBS Exchanges, and SBS Exchange Facilities
The purpose of the collection of information in proposed Rule
702(c) under Regulation MC is to enable a SB SEF, SBS exchange, or SBS
exchange facility to monitor voting interests with respect to such
entity, and enable the SB SEF, SBS exchange, or SBS exchange facility,
as applicable, to take necessary action if the ownership or voting
rights by a participant or member or group of participants or members,
as applicable, exceed those allowed under proposed Rule 702(b).
The purpose of the collection of information in proposed Rule
702(e) under Regulation MC is to provide the Commission with
information regarding the instances in which the SB SEF or SBS exchange
does not adopt or implement a recommendation of the ROC, which would
help the Commission in its oversight of SB SEFs and SBS exchanges. The
information collection also should promote sound regulatory policies
and foster the effectiveness of the ROC by putting the SB SEF or SBS
exchange on notice that the Commission must be apprised promptly of any
recommendation that is made by the ROC that is not adopted or
implemented.
C. Respondents
1. Security-Based Swap Clearing Agencies
The collection of information associated with the proposed Rule
701(a) and (b) under Regulation MC would apply to security-based swap
clearing agencies. Currently, four clearing agencies are authorized to
clear credit default swaps, including security-based swaps,\190\
pursuant to temporary conditional exemptions under Section 36 of the
Exchange Act.\191\ The obligation to centrally clear security-based
swap transactions is a new requirement under Title VII of the Dodd-
Frank Act. Based on the fact that there are currently four clearing
agencies authorized to clear security-based swaps and that there could
conceivably be one or two more in the future,\192\ the Commission
preliminarily estimates that four to six clearing agencies may seek to
clear security-based swaps and be subject to the information collection
requirements in proposed Rule 701(a) or (b). The Commission is using
the higher estimate of six for the PRA analysis.
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\190\ Of the four clearing agencies granted temporary exemptions
from registration, only three have cleared products that are
classified as security-based swaps under Title VII of the Dodd-Frank
Act.
\191\ 15 U.S.C. 78mm.
\192\ The Commission does not expect there to be a large number
of clearing agencies that clear security-based swaps, based on the
significant level of capital and other financial resources necessary
for the formation of a clearing agency.
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2. SB SEFs, SBS Exchanges, and SBS Exchange Facilities
The collection of information associated with the proposed Rule
702(c) under Regulation MC would apply to SB SEFs, SBS exchanges, and
SBS exchange facilities. In the Dodd-Frank Act, Congress defined for
the first time a SB SEF and mandated the registration of these new
facilities.\193\ Based on conversations with the CFTC and industry
sources, the Commission preliminarily believes that approximately 10-20
entities could seek to become SB SEFs and thus be subject to the
collection of information requirement of proposed Rule 702(c). The
Commission is using the higher estimate of 20 SB SEFs for this PRA
analysis. In addition, there are currently 15 national securities
exchanges that could be subject to the collection of information
requirement of Rule 702(c).\194\ To provide an estimate that is not
under-inclusive, the Commission preliminarily estimates that all 15 of
the currently registered national securities exchanges could become SBS
exchanges or could create a separate legal entity that would be a
facility of the exchange to trade security-based swaps.
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\193\ See Sections 763(a) and 763(c) of the Dodd-Frank Act,
Public Law 111-203, Section 763(a) and (c).
\194\ The 15 national securities exchanges are: BATS Exchange,
Inc.; BATS Y-Exchange, Inc.; Chicago Board Options Exchange,
Incorporated; Chicago Stock Exchange, Inc.; C2 Options Exchange,
Incorporated, EDGA Exchange, Inc., EDGX Exchange, Inc.,
International Securities Exchange, LLC; The NASDAQ Stock Market LLC;
NASDAQ OMX BX, Inc.; NASDAQ OMX PHLX, Inc.; National Stock Exchange
Inc.; New York Stock Exchange LLC; NYSE Amex LLC; and NYSE Arca,
Inc.
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The collection of information associated with the proposed Rule
702(e) under Regulation MC would apply to SB SEFs and SBS exchanges.
Based on the estimates noted above, to provide an estimate that is not
under-inclusive, the Commission preliminarily believes that 20 SB SEFs
and 15 SBS exchanges or SBS exchange facilities would be subject to the
collection of information requirement of Rule 702(e).
[[Page 65916]]
D. Total Annual Reporting and Recordkeeping Burdens
1. Security-Based Swap Clearing Agencies
Proposed Rule 701(a) would require security-based swap clearing
agencies to have rules that would: (1) Provide for an effective
mechanism to divest any participant of any interest owned in excess of
the proposed 20% ownership limit; (2) not give effect to the portion of
any voting interest held by one participant in excess of the proposed
20% voting limit; (3) not give effect to the portion of any voting
interest among all security-based swap clearing agency participants
owned in the aggregate in excess of the proposed 40% ownership limit;
and (4) provide an effective mechanism for the security-based swap
clearing agency to obtain information relating to the voting interests
in such entity. Proposed Rule 701(b) would require security-based swap
clearing agencies to have rules that would: (1) Provide for an
effective mechanism to divest any participant of any interest owned in
excess of the proposed 5% ownership limit; (2) not give effect to the
portion of any voting interest held by one participant in excess of the
proposed 5% voting limit; and (3) provide an effective mechanism for
the security-based swap clearing agency to obtain information relating
to the voting interests in such entity. Each security-based swap
clearing agency must comply with one of the alternatives.
Establishing such rules would result in a paperwork burden for a
security-based swap clearing agency. The Commission preliminarily
believes that there would be a one-time paperwork burden of 15 hours
per entity associated with the drafting and implementation of any such
rules by the security-based swap clearing agency for a total of 90
hours (15 hours x 6 respondents).
Any collection of information by a security-based swap clearing
agency from a participant that has a voting interest in the security-
based swap clearing agency would differ depending upon the number of
shareholders or other owners of voting interests that are participants
in the security-based swap clearing agency. Accordingly, the number of
responses per year that would be generated by proposed Rule 701(a) or
(b) under Regulation MC would vary by security-based swap clearing
agency. At this point, however, currently only the largest fourteen
dealer firms are participants that clear security-based swaps at such
clearing agencies. The Commission believes that it would be reasonable
for security-based swap clearing agencies to collect information
related to the voting interests held by participants on a quarterly
basis. This would provide the security-based swap clearing agency with
sufficiently current information regarding participants' voting
interests in the security-based swap clearing agency and allows the
security-based swap clearing agency to review the information at a
single point in time. Accordingly, the Commission preliminarily
estimates that each security-based swap clearing agency would request
information approximately 4 times per year from approximately 14
participants.
The Commission also estimates that the preparation and sending of
each of the 4 requests for information would require approximately 4
hours and reviewing the responses to each of the 4 requests for
information would require 10 hours. This would result in a total annual
reporting and recordkeeping burden of 56 hours ((4 requests x 4 hours)
+ (4 requests x 10 hours)) for each security-based swap clearing
agency, and a total annual burden for all security-based swap clearing
agencies of 336 hours (56 hours x 6 clearing agencies). The Commission
preliminarily estimates that each participant would require 1 hour to
prepare and send the security-based swap clearing agency its response
to the request, for a total annual reporting and recordkeeping burden
for each participant of each security-based swap clearing agency of 4
hours (4 requests x 1 hour) and a total annual burden for all
participants in all 6 security-based swap clearing agencies of 336
hours (14 participants x 4 hours x 6 security-based swap clearing
agencies) thereby resulting in a total estimated annual burden for all
security-based swap clearing agencies and participants of 672 hours
(336 hours for all participants + 336 hours for all security-based swap
clearing agencies). The Commission requests comment on these estimates.
The Commission estimates that the total paperwork burden resulting
from the proposals relating to security-based swap clearing agencies is
762 hours for an initial paperwork burden and 672 hours
thereafter.\195\
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\195\ The aggregate initial paperwork burden is calculated as
follows: 90 hours (one time paperwork burden for security-based swap
clearing agencies to establish rules to divest any ownership
interest in excess of the limit and not to give effect to any
portion of the voting interests in excess of the limit) + 336 hours
(annual burden for security-based swap clearing agencies to prepare
and send requests for voting information) + 336 hours (annual burden
for participants of security-based swap clearing agencies to prepare
and send responses to requests for voting information) = 762 hours.
After the initial year, the paperwork burden is calculated as
follows: 762 hours (total paperwork burden resulting from the
proposals relating to security-based swap clearing agencies) - 90
hours (one-time paperwork burden for security-based swap clearing
agencies) = 672 hours.
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2. SB SEFs, SBS Exchanges, and SBS Exchange Facilities
Proposed Rule 702(c) would require SB SEFs, SBS exchanges, and SBS
exchange facilities to have rules that would provide for an effective
mechanism to divest any participant or member, as applicable, of any
interest owned in excess of the proposed 20% ownership limit; that
would not give effect to the portion of any voting interest held by one
or more participants or members, as applicable, in excess of the
proposed 20% voting limit; and that would provide an effective
mechanism for the SB SEF, SBS exchange, or SBS exchange facility to
obtain information relating to ownership and voting interests in such
entity. Establishing such rules or policies and procedures, as
applicable, would result in a paperwork burden for a SB SEF, SBS
exchange, or SBS exchange facility, as applicable. The Commission
preliminarily believes that there would be a one-time paperwork burden
of 15 hours per entity associated with the drafting and implementation
of any such rules by the SB SEF, SBS exchange, or SBS exchange
facility, as applicable, for a total of 525 hours (15 hours x 35
respondents).
The number of responses per year that would be generated by
requests by a SB SEF, SBS exchange, or SBS exchange facility, as
applicable, for ownership or voting information from participants or
members that are owners of securities entitled to vote or otherwise
have a voting interest in the SB SEF, SBS exchange, or SBS exchange
facility would depend upon the number of owners of voting securities
that are participants or members. Assuming that all classes of
securities entitled to vote are owned or otherwise controlled by
participants or members, the minimum number per SB SEF, SBS exchange,
or SBS exchange facility would be 5. Based on the Commission's
understanding of the ownership structures and voting rights of existing
entities that may register as SB SEFs, and its understanding of the
ownership structures and voting rights of existing national securities
exchanges, the Commission preliminarily estimates that each SB SEF, SBS
exchange, or SBS exchange facility on average would request information
from approximately 20 participants or members, as applicable. The
Commission believes that it would be reasonable for a SB
[[Page 65917]]
SEF, SBS exchange, or SBS exchange facility to collect information on
ownership and voting rights on a quarterly basis. Accordingly, the
Commission preliminarily estimates that each SB SEF, SBS exchange, or
SBS exchange facility would request information approximately 4 times
per year from approximately 20 participants or members.
The Commission estimates that the preparation and sending of each
of the 4 requests for information would require approximately 4 hours,
and reviewing the responses to each of the 4 requests for information
would require 10 hours. This would result in a total annual reporting
and recordkeeping burden of 56 hours ((4 requests x 4 hours) + (4
requests x 10 hours)) for each SB SEF, SBS exchange, or SBS exchange
facility, as applicable, and a total annual burden for all SB SEFs, SBS
exchanges, and SBS exchange facilities of 1,960 hours (56 hours x 35
respondents). The Commission preliminarily estimates that each
participant or member would require 1 hour to prepare and send the
response to the request, for a total annual reporting and recordkeeping
burden for each participant or member of 4 hours (4 requests x 1 hour)
and a total annual burden for all participants or members of 2,800
hours (700 participants or members x 4 hours). The Commission requests
comment on these estimates.
The Commission preliminarily believes that the collection of
information burden imposed by proposed Rule 702(e) under Regulation MC
would be minimal. The Commission estimates that a representative of the
Board of a SB SEF or SBS exchange would spend no more than one hour to
complete the required notice to the Commission. This figure includes
the time to prepare, review, and electronically submit such notice to
the Commission. The Commission expects to establish an electronic
mailbox for these notices and would identify the address if the
Commission were to adopt this specific proposal. Although the
Commission preliminarily believes that the Board of a SB SEF or SBS
exchange often would adopt or implement the recommendations of its ROC,
the Commission preliminarily believes that the Board of a SB SEF or SBS
exchange could occasionally decide not to adopt such recommendations.
Although the Commission expects that this would be an infrequent
occurrence, the Commission preliminarily estimates that a Board could
decide not to adopt a ROC recommendation up to 12 times per year. This
estimate assumes that the Board of a SB SEF or SBS exchange would meet
at least once per month and would decide each time that it meets not to
adopt a ROC recommendation. Therefore, the Commission estimates that
the total reporting burden under the proposed Rule 702(e) for all SB
SEFs and SBS exchanges combined would be 420 hours.\196\
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\196\ (20 (estimated number of SB SEFs subject to the collection
of information under the proposed Rule 702(e)) + 15 (estimated
number of SBS exchanges subject to the collection of information
under the proposed Rule 702(e))) x 12 (estimated number of notices
prepared annually by each SB SEF pursuant to the proposed Rule
702(e)) x 1 hour (estimate of total time to complete, review, and
prepare required notice) = 420 hours.
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The Commission estimates that the total paperwork burden resulting
from the proposals relating to SB SEFs, SBS exchanges or SBS exchange
facilities is 5,705 for an initial paperwork burden and 5,180
thereafter.\197\
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\197\ The aggregate initial paperwork burden is calculated as
follows: 525 hours (one-time paperwork burden for SB SEFs, SBS
exchanges and SBS exchange facilities to establish rules to divest
any ownership interest in excess of, and to not give effect to any
portion of voting interests in excess of, the proposed 20% limit) +
1,960 hours (annual burden for SB SEFs, SBS exchanges and SBS
exchange facilities to prepare and send requests for ownership and
voting information) + 2,800 hours (annual burden for participants to
prepare and send responses to requests for ownership and voting
information) + 420 hours (annual burden for SB SEFs and SBS
exchanges to prepare and submit notices pursuant to proposed Rule
702(e)(2)) = 5,705 hours. After the initial year, the paperwork
burden is calculated as follows: 5,705 hours (total paperwork burden
resulting from the proposals relating to SB SEFs, SBS exchanges and
SBS exchange facilities)--525 hours (one-time paperwork burdens for
SB SEFs, SBS exchanges and SBS exchange facilities) = 5,180 hours.
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E. Retention Period of Recordkeeping Requirements
1. Security-Based Swap Clearing Agencies
Security-based swap clearing agencies will be required to be
registered with the Commission following the effective date of Title
VII of the Dodd-Frank Act.\198\ Accordingly, once registered with the
Commission, security-based swap clearing agencies would be required to
retain any collection of information pursuant to proposed Rules 701(a)
or (b) under Regulation MC as applicable, in accordance with, and for
the periods specified in Rule 17a-1 under the Exchange Act.\199\
Retention and recordkeeping requirements have not been established for
security-based swap clearing agencies before the effective date of
Title VII; however, security-based swap clearing agencies may be
required to retain records and information collected pursuant to
proposed Rules 701(a) or (b) similar to the current recordkeeping
requirements in Rule 17a-1.
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\198\ New Exchange Act Section 17A(g) provides that it shall be
unlawful for a clearing agency, unless registered with the
Commission, directly or indirectly to make use of the mails or any
means or instrumentality of interstate commerce to perform the
functions of a clearing agency with respect to a security-based
swap. 15 U.S.C. 78q-1(g).
\199\ 17 CFR 240.17a-1.
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2. SB SEFs, SBS Exchanges, and SBS Exchange Facilities
Although recordkeeping and retention requirements have not yet been
established for SB SEFs under new Exchange Act provisions added by the
Dodd-Frank Act, the Commission is authorized to adopt such rules.\200\
In addition, the recordkeeping and reporting core principle applicable
to SB SEFs, as set forth in Section 763(c) of the Dodd-Frank Act,
requires a SB SEF to maintain records of all activities relating to the
business of the facility, including a complete audit trail, in a form
and manner acceptable to the Commission for a period of five
years.\201\ Therefore, for purposes of this PRA, the Commission assumes
that a SB SEF would be required to retain any collection of information
pursuant to proposed Rules 702(c) and 702(e) under Regulation MC, as
applicable, for a period of not less than five years. Should the
Commission propose rules to implement the recordkeeping and reporting
core principle for SB SEFs, it would include any collection of
information burden with respect to any proposed recordkeeping and
retention rules for SB SEFs in such rulemaking.
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\200\ As discussed above, Section 763(c) of the Dodd-Frank Act
sets forth 14 core principles that SB SEFs must satisfy, including
one relating to recordkeeping and reporting, and provides the
Commission with rulemaking authority with respect to implementation
of these core principles. See Section 763(c) of the Dodd-Frank Act,
Public Law 111-203, Section 763(c).
\201\ See Section 763(c) of the Dodd-Frank Act, Public Law 111-
203, Section 763(c).
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All registered national securities exchanges must currently comply
with the recordkeeping and reporting requirements in Rule 17a-1 under
the Exchange Act.\202\ Therefore, SBS exchanges would be required to
retain any collection of information pursuant to proposed Rules 702(c)
and 702(e), as applicable, in accordance with, and for the periods
specified in, Rule 17a-1 under the Exchange Act.
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\202\ 17 CFR 240.17a-1.
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F. Collection of Information Is Mandatory
1. Security-Based Swap Clearing Agencies
The collection of information under proposed alternative Rules
701(a) and (b) under Regulation MC would be
[[Page 65918]]
mandatory. The collection of information under proposed Rules 701(a)
and (b) would be required from participants in a security-based swap
clearing agency upon request from the security-based swap clearing
agency. The collection of information would allow the security-based
swap clearing agency and the Commission to determine whether the
requirements in proposed Rules 701(a) and (b) regarding limitations on
voting interests are met.
2. SB SEFs, SBS Exchanges, and SBS Exchange Facilities
The collection of information under proposed Rule 702(c) under
Regulation MC would be mandatory. The collection of information would
allow the SB SEF, SBS exchange, or SBS exchange facility as applicable,
and the Commission to determine whether the requirements in proposed
Rule 702(c) regarding limitations on ownership and voting rights are
met and enable the SB SEF, SBS exchange, or SBS exchange facility, as
applicable, to take necessary action if the ownership or voting rights
by a participant or group of participants exceed those allowed under
proposed Rule 702(b).
The collection of information under proposed Rule 702(e) under
Regulation MC would be mandatory and permit the Commission to collect
accurate information about the regulatory program of SB SEFs and SBS
exchanges. Specifically, the collection of information would allow the
Commission to stay informed about the recommendations of the ROC that
are not followed by the SB SEF or SBS exchange and the SB SEF's or SBS
exchange's reasons for not adopting such recommendations.
G. Responses to Collection of Information Will Not Be Kept Confidential
1. Security-Based Swap Clearing Agencies
Other than information for which a security-based swap clearing
agency requests confidential treatment and which may be withheld from
the public in accordance with the provisions of 5 U.S.C. 522, the
collection of information pursuant to the proposed Rules 701(a) and (b)
would not be confidential and would be publicly available.
2. SB SEFs, SBS Exchanges, and SBS Exchange Facilities
Other than information for which a SB SEF, SBS exchange or SBS
exchange facility requests confidential treatment and which may be
withheld from the public in accordance with the provisions of 5 U.S.C.
522, the collection of information pursuant to the proposed Rules
702(c) and (e) would not be confidential and would be publicly
available.
H. Request for Comment
Pursuant to 44 U.S.C. 3505(c)(2)(B), the Commission solicits
comment to:
1. Evaluate whether the proposed collection of information is
necessary for the performance of the functions of the agency, including
whether the information shall have practical utility;
2. Evaluate the accuracy of the agency's estimate of the burden of
the proposed collection of information;
3. Enhance the quality, utility, and clarity of the information to
be collected; and
4. Minimize the burden of collection of information on those who
are to respond, including through the use of automated collection
techniques or other forms of information technology.
Persons wishing to submit comments on the collection of information
requirements should direct them to the following persons: (1) Desk
Officer for the Securities and Exchange Commission, Office of
Information and Regulatory Affairs, OMB, Room 3208, New Executive
Office Building, Washington, DC 20503; and (2) Secretary, Securities
and Exchange Commission, Station Place, 100 F Street, NE., Washington,
DC 20549-1090 with reference to File No. S7-27-10. OMB is required to
make a decision concerning the collection of information between 30 and
60 days after publication, so a comment to OMB is best assured of
having its full effect if OMB receives it within 30 days of
publication. The Commission has submitted the proposed collection of
information to OMB for approval. Requests for the materials submitted
to OMB by the Commission with regard to this collection of information
should be in writing, refer to File No. S7-27-10, and be submitted to
the Securities and Exchange Commission, Office of Investor Education
and Advocacy, Station Place, 100 F Street, NE., Washington, DC 20549-
0213.
X. Cost-Benefit Analysis
Congress has required the Commission to implement rules under
Section 765 of the Dodd-Frank Act to mitigate conflicts of interest in
the security-based swaps market. The proposed rules under Regulation MC
are designed to enhance, through mitigation of conflicts of interest,
the benefits of having security-based swaps cleared through a security-
based swap clearing agency and traded on a SB SEF or SBS exchange. The
proposed rules, however, are also likely to impose costs on security-
based swap clearing agencies, SB SEFs, and SBS exchanges. The
Commission is sensitive to the costs and benefits that would result
from the proposed rules and has identified certain costs and benefits
of these proposals, as described below.
A. Background
The proposed governance and ownership and voting rules are intended
to reduce conflicts of interest in security-based swap clearing
agencies, SB SEFs, and SBS exchanges. Ownership and voting limitations
and other governance rules are designed to limit the influence of any
single market participant or a group of participants in the operation
of security-based swap clearing agencies, SB SEFs, and SBS exchanges
and thus reduce the risk that conflicts of interest would negatively
affect the operation of these entities and the security-based swaps
market.\203\ However, since the OTC swaps marketplace regulated under
Title VII likely would change significantly after the effective date of
the Dodd-Frank Act and the Commission's rules promulgated thereunder,
it is difficult to quantify the costs and benefits that the proposed
rules may create. These issues are discussed more fully below.
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\203\ The Commission pursuant to Section 36 of the Exchange Act
may grant an exemption from any rule or any provision of any rule
under Regulation MC. Any such exemption could be subject to
conditions and could be revoked by the Commission at any time. See
supra Section VI for a discussion of the Commission's exemptive
authority under Section 36 of the Exchange Act.
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B. Security-Based Swap Clearing Agencies
The Commission has granted exemptions from Section 17A of the
Exchange Act to five entities to act as clearing agencies for security-
based swaps.\204\ The first cleared CDS transaction pursuant to the
exemptive orders was cleared on March 9, 2009. Security-based swap
clearing is, therefore, in an emergent stage and empirical evidence on
how the security-based swaps market will develop following the
effective date of the Dodd-Frank Act and rules thereunder is scarce.
However, the number of security-based swap clearing agencies may
converge in the long run to a very small number or even a single
security-based swap clearing agency.\205\ This is
[[Page 65919]]
because of the potential for efficiency gains through convergence given
that central clearing of securities is characterized by large fixed
costs and benefits to participants associated with consolidating
portfolios. Alternatively, competitive forces may result in use of a
larger number of security-based swap clearing agencies, particularly if
the security-based swap clearing agencies specialize in clearing
particular types of security-based swaps or if they clear security-
based swaps only in certain jurisdictions.\206\
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\204\ See CDS Clearing Exemption Orders, supra note 17.
\205\ See, e.g., Darrell Duffie and Haoxiang Zhu, ``Does a
Central Clearing Counterparty Reduce Counterparty Risk?'' Stanford
University Working Paper, March 2010; Craig Pirrong, 2009, ``The
Economics of Clearing in Derivatives Markets: Netting, Asymmetric
Information, and the Sharing of Default Risks Through a Central
Counterparty,'' Working paper, University of Houston.
\206\ The central clearing of security-based swaps is still
developing and the Commission has not made any determinations about
the number of security-based swap clearing agencies that may be used
by market participants. However, it is important that emerging
security-based swap clearing agencies have the opportunity to
compete with existing security-based swap clearing agencies.
---------------------------------------------------------------------------
1. Costs and Benefits Related to Ownership Restrictions in Security-
Based Swap Clearing Agencies
Restrictions on the voting interests held by clearing participants
may affect the number of potential clearing participants and may also
affect the level of their participation in clearing security-based
swaps. The 20% individual voting limitation on security-based swap
clearing agencies and the 40% aggregate voting limitation on security-
based swap clearing agencies, under the proposed Voting Interest Focus
Alternative, and the 5% individual voting limitation under the
Governance Focus Alternative, are intended to keep participants from
exercising undue influence over the security-based swap clearing agency
and to lessen the likelihood of anti-competitive behavior. One
particular concern is that without a limitation on voting interests,
large dealers may control a security-based swap clearing agency and set
standards--such as a heightened capital threshold for participation or
a requirement that participants have execution capabilities--to limit
participation by non-owner dealers or brokers and increase or protect
their market share and potentially influence market prices. Hence, a
potential benefit of voting limitations may be the preservation of non-
owner dealers' access to central clearing and promotion of competition
that results in lower costs to market participants. The proposed
limitations in both the Voting Interest Focus Alternative and the
Governance Focus Alternative are designed to achieve this result.
Another potential benefit of the imposition of a limitation on
voting interests is the chance that a broader group of participants
would have the ability to reduce their risk exposure as greater levels
of central clearing is encouraged if the risks at the clearing agency
are managed appropriately. Clearing agencies decrease systemic risk by
mutualizing losses \207\ and netting otherwise bilateral obligations.
There may, however, at times be a trade-off between a clearing agency's
risk management and its participation standards. It likely would be
beneficial if the voting restrictions proposed by Rules 701(a) and (b)
under Regulation MC in each of the Voting Interest Focus Alternative
and the Governance Focus Alternative lead to increased market
participation. Conversely though, to the extent that such market
participation goes beyond prudent levels, it may create more systemic
risk at the security-based swap clearing agency. For example, lessening
capital requirements to increase participation beyond a prudent level
may increase the overall risk of clearing operations, while increasing
capital requirements for clearing members without an adequate basis may
needlessly exclude some smaller dealers or other firms from
participation and thereby create market inefficiencies.\208\
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\207\ See, e.g., Ice Trust Overview, p. 7 (available at https://www.theice.com/publicdocs/clear_us/ICE_Trust_Overview.pdf).
\208\ See supra Section II.A.2.a.
---------------------------------------------------------------------------
Non-participant shareholders may also have an incentive to permit
more clearing agency participation than clearing agency participant
shareholders would. Non-participant shareholders benefit from increased
membership to the extent that additional revenues are generated and
therefore have an incentive to promote increased use of central
clearing both in terms of number of participants and the scope of
products cleared. This could potentially reduce systemic risk by making
more OTC products eligible for central clearing. In addition, non-
shareholder participants have an incentive to promote appropriate risk
management because a financial loss to the clearing agency would
devalue their investment. For example, security-based swap clearing
agencies may put their own capital or surplus funds at risk in the
event of a default. In addition, clearing agencies face reputational
risk associated with a member default that would likely negatively
affect the value of shareholders' shares. This aligns the interests of
shareholders with appropriate risk management of a clearing agency.
However, non-participant shareholders may not face the same potential
of downside risk as clearing agency participants. For example, non-
participant shareholders do not bear certain costs associated with
increased risk since the clearing agency losses are shared by the
clearing agency participants. To the extent that non-participant
shareholders use their control to maximize revenues of the clearing
agency without full consideration of the total clearing agency risks,
the potential cost is that suboptimal clearing agency participation
standards will be developed. All directors have a fiduciary duty to the
security-based swap clearing agency and its shareholders, however, they
also have a duty to oversee the security-based swap clearing agency's
compliance with the requirements in the Exchange Act and the rules and
regulations thereunder. In certain circumstances, independent directors
could give greater emphasis to profit-maximizing initiatives and fail
to give sufficient consideration to the related risk management issues.
Another potential cost of ownership and voting limitations,
notwithstanding the fact that the market structure may converge in the
long-run to a single security-based swap clearing agency, is the
potential effect on competition among alternative security-based swap
clearing agency venues. Under the Voting Interest Focus Alternative, a
20% individual participant voting limit and a 40% aggregate participant
voting limit restricts the ability of any single dealer or small group
of dealers to own a security-based swap clearing agency, but it may
also reduce the potential number of investors that would be willing to
devote resources to form a security-based swap clearing agency. This
potentially diminishes the likelihood for a long-term market structure
with multiple clearing agencies. Conversely, the Governance Focus
Alternative would not impose an aggregate cap and would allow the
voting interests in a security-based swap clearing agency to be owned
entirely by participants. This would facilitate the formation of
security-based swap clearing agencies by potential users and promote
greater competition among security-based swap clearing agencies.
In addition, if a participant is subject to restrictions regarding
the amount of voting interest it may own in a security-based swap
clearing agency, then it may forgo a potential investment opportunity,
unless it is willing to invest in non-voting shares of the security-
based swap clearing agency. The effect of these restrictions is
[[Page 65920]]
different with respect to individual participants under the Governance
Focus Alternative, which limits any one participant's voting interest
in a security-based swap clearing agency to 5%, than it is under the
Voting Interest Focus Alternative, which limits any one participant's
voting interests to 20% and has an aggregate voting interest limit of
40%. In the case of an ownership position in excess of regulator's
restrictions, the owner would have to divest a portion of its voting
shares in order to meet the regulatory requirement. The potential
foregone benefits include profits generated from clearing activities
that are distributed to owners as well as any private ownership
benefits from directing the clearing operations, which include
activities discussed above with respect to conflicts of interest. While
it is difficult to assess the value of these investment opportunities,
the 2010 six-month data from consolidated reports of condition and
income from the Federal Financial Institutions Examinations Council of
the largest security-based swap clearing agency provides a snapshot of
the magnitude of current profits being generated.\209\
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\209\ ICE Trust's profits for the first six months of 2010 were
$1,325,000, which would represent an annual profit of $2,650,000.
FFIEC Central Data Repository's Public Data Distribution, https://cdr.ffiec.gov/public/Default.aspx.
---------------------------------------------------------------------------
Moreover, as previously discussed in the PRA section, proposed
Rules 701(a) and (b) under Regulation MC would require a security-based
swap clearing agency to have an effective mechanism to obtain
information relating to voting interests in the security-based swap
clearing agency by any participant in the security-based swap clearing
agency. It was estimated that these obligations would result in a total
annual burden for all security-based swap clearing agencies of 336
hours plus a total annual reporting and recordkeeping burden for all
participants of 336 hours. It was also estimated that there would be a
90 hour one-time paperwork burden for security-based swap clearing
agencies to establish rules to divest any ownership interest in excess
of the limit and not to give effect to any portion of the voting
interests in excess of the limit. Assuming an hourly cost of $291 for a
compliance attorney \210\ to meet these requirements, this would result
in an overall estimated initial annual cost of $221,742 and an annual
cost thereafter of $195,552 for participants and security-based swap
clearing agencies collectively.\211\
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\210\ The hourly rate for the compliance attorney is from
SIFMA's Management & Professional Earnings in the Securities
Industry 2009, modified by the Commission's staff to account for an
1,800-hour work-year and multiplied by 5.35 to account for bonuses,
firm size, employee benefits and overhead.
\211\ Overall initial annual cost for participants and clearing
agencies information requirements = (336 hours + 336 hours + 90
hours) x $291 = $221,742. Overall subsequent annual cost for
participants and clearing agencies information requirements = (336
hours + 336 hours) x $291 = $195,552.
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Under the Voting Interest Focus Alternative, proposed Rule 701(a)
in Regulation MC would require the security-based swap clearing agency
to have rules requiring a participant to divest voting interest greater
than the 20% threshold and rules reasonably designed not to give effect
to a voting interest of a participant greater than the 20% threshold or
voting interests of participants considered in the aggregate with any
other participants greater than the 40% threshold. This proposed rule
would impose a cost on the security-based swap clearing agency to
initiate the divestiture or not give effect to the voting rights that
surpass the stated threshold. Particularly in the case of the aggregate
participant voting limitation, the security-based swap clearing agency
would have to develop standards regarding how to allocate the voting
interest for which it will give effect if the aggregate voting interest
is above the 40 percent threshold.
Similarly, under the Governance Focus Alternative, proposed Rule
701(b) in Regulation MC would impose a cost on the security-based swap
clearing agency to require the divestiture or not give effect to the
voting rights that surpass the stated threshold of 5 percent. However,
because there is not a proposed limit on participants' aggregate voting
interests under the Governance Focus Alternative, the security-based
swap clearing agency would not have to adopt rules for allocating
voting interests in the case of a divestiture.
2. Costs and Benefits Related to Independence Requirements for
Security-Based Swap Clearing Agencies
Potential conflicts of interest also exist between participants of
a security-based swap clearing agency and the public interest. Even
when the influence of any single dealer is limited through voting
restrictions, economic incentives could align several dealer
participants in a way that may be costly to investors. For instance, in
order for a product to be required to trade through an SB SEF or SBS
exchange, it must be deemed eligible for clearing at a clearing agency.
A dealer-controlled security-based swap clearing agency may have an
incentive to limit the products deemed eligible for clearing because
then such a product would remain viable in the OTC markets, in which
the dealers have a significant financial stake.\212\ Products that are
eligible for clearing that are not cleared do not have the price
transparency or investor accessibility that they would otherwise have,
increasing market participant costs paid by investors. As a result,
there are potential incentives for security-based swap clearing agency
participants to coordinate in ways that voting restrictions cannot
address. Representation by independent directors would provide views
and influence that by design are not subject to these conflicts.
---------------------------------------------------------------------------
\212\ See, generally, Darrell Duffie, ``How Should We Regulate
Derivatives Markets?'' Pew Financial Reform Project, Briefing Paper
5, 2009.
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Proposed Rule 701(b)(3) in Regulation MC of the Governance Focus
Alternative would require that a majority of directors must be
independent. As a result, participants could not directly control the
Board regardless of their voting interests. To further the goal of
majority independence on the Board, proposed Rule 701(b)(4) under
Regulation MC in the Governance Focus Alternative would require a
security-based swap clearing agency to establish a nominating committee
composed solely of independent directors. Since many of the Board
decisions come from committees and conflicts may be prevalent or even
more pronounced in these situations, proposed Rule 701(b)(5) under
Regulation MC in the Governance Focus Alternative would require that if
any committee, including but not limited to a risk committee, has
authority to act on behalf of the Board, that committee must also be
composed of a majority of independent directors. This would help
prevent important decisions from escaping the view of a majority of
independent directors. To the extent that independent directors reduce
the likelihood that one group of participants coordinate decision-
making in such a way that is detrimental to the security-based swap
clearing agency as a whole, it would serve to benefit the security-
based swap clearing agency and the market generally.
The Voting Interest Focus Alternative would require 35%, rather
than a majority, of the Board be composed of independent directors.
While director independence is widely believed to be a catalyst for
improved governance, there is no conclusive empirical evidence to
support the view that a majority of independent directors benefits
shareholder profits.\213\ It also is often argued that the presence of
inside
[[Page 65921]]
affiliated board members is important in facilitating the flow of
material information to independent directors so that they may come to
informed decisions.\214\ This may be especially important for a
security-based swap clearing agency because it provides highly
specialized and technical services. The imposition of a Board structure
that precludes the likely owners of a security-based swap clearing
agency--dealers--from gaining a majority may have a negative effect on
the operations of the security-based swap clearing agency if
independent directors do not have commensurate qualifications or skills
as participant directors. There could be significant costs associated
with educating independent directors about the clearance and settlement
process and the complex risk management issues that must be considered
by the Board. This could slow the Board or committee processes, at
least initially. Clearing and settlement is a highly specialized area
and it may be difficult to find independent directors with relevant
experience. As a result, independent directors may defer to industry
directors or to the officials of the clearing agency, who have more
knowledge and experience, thereby undermining the benefits of requiring
independence.
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\213\ However, the Commission recognizes that the industry
widely accepts a majority of independent directors as ``best
practices.'' See supra note 122.
\214\ See M. Harris and A. Raviv, 2007, ``A Theory of Board
Control and Size,'' The Journal of Finance; R. Adams and D.
Fererria, 2008, ``A Theory of Friendly Boards,'' The Journal of
Finance, vol. 62(1) pp. 217-250.
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In the context of wholly independent committees, such as a
nominating committee, the independent directors may become reliant on
executive directors and other employees of the security-based swap
clearing agency to inform their decision-making due to their lack of
expertise in clearing and settlement. If management fails to keep the
directors on wholly independent committees fully informed, the
independent directors on such committees fail to seek sufficient
information from management to make informed decisions, or management
fails to give independent directors adequate resources to make
effective decisions, there could be costs to the security-based swap
clearing agency. On the other hand, if management fully apprises the
directors on wholly independent committees of necessary information and
the independent directors have sufficient resources and are fully
engaged with respect to their duties, there would be benefits to the
security-based swap clearing agency.
In addition, the effectiveness of the Board can depend on the
personalities and personal traits, as well as the qualifications, of
the persons serving on the Board. Independent directors that take the
time to understand the operations and programs of a security-based swap
clearing agency and to ask probing questions of management are more
likely to be effective independent directors. However, independent
directors would unlikely be able to acquire the specific risk
management expertise related to clearance and settlement if they do not
have relevant experience prior to serving on the Board. In addition,
because independent directors would not be employed by or participants
in the security-based swap clearing agency, they may often need to rely
on management or other directors to keep fully informed. There could be
costs to the security-based swap clearing agency if one or more
independent directors is ineffectual because he or she did not fully
understand the operations or risk management procedures of the
security-based swap clearing agency. Thus, imperfect decisions by
independent directors could result in costs to the security-based swap
clearing agency. This may potentially be more likely where the majority
of the Board is required to be independent. On the other hand,
independent directors who have relevant expertise, are engaged in
carrying out their director duties, and who grasp the issues
confronting the security-based swap clearing agency could be very
beneficial to the security-based swap clearing agency because they
could bring an outside perspective and fresh insights and ideas to the
security-based swap clearing agency.
The proposed governance requirements under both the Voting Interest
Focus Alternative and the Governance Focus Alternative could impose
other costs on security-based swap clearing agencies. An entity that
plans to register as a security-based swap clearing agency may need to
revise the composition of its Board if the Board currently is not
composed of 35% or a majority of independent directors. Moreover,
security-based swap clearing agencies may have to restructure their
nominating committees as well as other committees that are authorized
to act for the Board. In this regard, security-based swap clearing
agencies could face difficulties locating qualified individuals to
serve as independent directors, particularly because security-based
swaps trading is complex and the pool of qualified candidates may be
limited. There also may be costs in educating independent directors to
become familiar with the manner in which these security-based swaps are
traded and the new regulatory structure governing security-based swaps,
which could slow Board processes at least initially. These costs would
be greater under the Governance Focus Alternative, which requires a
higher percentage of independent directors on the Board and on the
committees.
The proposed governance requirements could impose other costs on
security-based swap clearing agencies. A security-based swap clearing
agency may incur costs as a result of the requirement to include 35% or
a majority of independent directors on its Board and a similar or
heightened requirement with respect to committees authorized to act on
behalf of the Board. Any such costs are likely to be incurred in
connection with conducting a search for independent directors with the
necessary qualifications and expertise to serve on the Board of a
security-based swap clearing agency. The actual cost for each security-
based swap clearing agency may vary based on the current governance
arrangements and practices of the security-based swap clearing
agencies. In addition, if a security-based swap clearing agency is
required to conduct a search for independent directors, the costs
incurred by the security-based swap clearing agency may vary based on
whether it has the resources to conduct its own search or has to retain
an outside consultant. The Commission preliminarily estimates that
those security-based swap clearing agencies that must rely on a
recruitment specialist to secure an independent director could incur a
cost of approximately $68,000 per director.\215\
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\215\ The Commission is basing this estimate on a recent study
noting that the retainer fee for outside directors is on average
$67,624. See http://www.hewittassociates.com/_MetaBasicCMAssetCache_/Assets/Articles/2010/2010_Outside_Director_Compensation.pdf. The Commission believes that this amount
could serve as a proxy for the amount of any fee to be charged by a
recruitment firm that would conduct a national search for an
independent director.
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C. SB SEFs and SBS Exchanges
Currently, there are no trading venues that are registered with the
Commission as SB SEFs, and no national securities exchanges that
currently post or make available for trading security-based swaps.
Based on the Dodd-Frank Act's definition, a SB SEF could include a
trading platform with participating dealers.\216\ SB SEFs are
conceptually
[[Page 65922]]
similar to alternative trading systems and national securities
exchanges in the equity and options markets and designated contract
markets in the futures markets in that they will provide a centralized
trading facility for the trading of security-based swaps. To the extent
that SB SEFs would organize and form in a similar manner to these
structures, the Commission preliminarily anticipates that SB SEFs and
SBS exchanges would be significantly more competitive than security-
based swap clearing agencies. In particular, barriers to entry in terms
of capital are likely to be lower, and many existing dealers, national
securities exchanges and other entities of various sizes currently have
electronic trading capabilities that could allow them to enter this
market readily.
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\216\ Section 763(c) of the Dodd-Frank Act sets forth 14 core
principles that SB SEFs must satisfy and provides the Commission
with rulemaking authority with respect to implementation of these
core principles. The Commission expects to address the issue of what
is a SB SEF in a separate rulemaking under Section 763(c) of the
Dodd-Frank Act. See Section 763(c) of the Dodd-Frank Act, Public Law
111-203, Section 763(c).
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1. Costs and Benefits Related to Ownership Requirements of SB SEFs and
SBS Exchanges
The 20% ownership and voting limits contained in proposed Rule
702(b) under Regulation MC would prohibit any SB SEF participant or SBS
exchange member or small group thereof from owning or otherwise
controlling any class of voting securities or other interests of a SB
SEF, SBS exchange or SBS exchange facility, as applicable. The intent
of this requirement, as with security-based swap clearing agencies, is
to limit the influence of any single dealer or a small group of dealers
in a single SB SEF, SBS exchange or SBS exchange facility and thus
reduce the likelihood that smaller non-owner dealers would be
unfavorably treated and the ability of dealer-owners to influence
market prices of security-based swaps. It is hard to predict, however,
what entities will be SB SEFs or SBS exchanges or whether there will be
any market power from owning or controlling a SB SEF or SBS exchange as
discussed above. If the concern, as with central clearing, is that a
single SB SEF or SBS exchange emerges as the dominant trading platform,
then ownership and voting restrictions may be an important
consideration. For example, the NYSE was the dominant exchange for
trading equity securities for a long period, and even today U.S.
futures markets are characterized by a dominant exchange connected to a
single clearing agency.
However, evidence from the current cash equity and options markets
shows that several trading platforms with different business models and
clienteles often emerge.\217\ Hence, SB SEFs, SBS exchanges, and SBS
exchange facilities that are controlled by a single dealer may not
necessarily result in unfair trading practices if market participants
have alternative comparable venues to execute the same security-based
swaps and those venues are able to compete effectively with single
dealer platforms. Allowing SB SEFs, SBS exchanges and SBS exchange
facilities that are controlled by a single dealer may in fact increase
the level of competition, which would benefit investors. A 20%
restriction on ownership of voting securities could require a dealer to
partner with either other dealers or a non-dealer majority owner, or to
hold a non-voting ownership interest, which could reduce incentives to
start up a new venue, potentially limiting innovative alternatives to
security-based swap execution and security-based swap products.\218\
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\217\ For example, there are currently 15 registered national
securities exchanges with varying platforms and business models that
compete for clients and order flow in the equities and/or options
markets.
\218\ As noted above, Section 763(c) of the Dodd-Frank Act sets
forth 14 core principles that SB SEFs must satisfy, including one
relating to conflicts of interest, and provides the Commission with
rulemaking authority with respect to implementation of these core
principles. The Commission may determine that it is appropriate to
propose additional rules to mitigate conflicts of interest with
respect to SB SEFs, including incorporating ownership and/or voting
limits and other requirements with respect to ownership of a SB SEF
by persons other than SB SEF participants. The Commission also may
consider proposals such as providing for the fair representation of
SB SEF participants in the selection of the SB SEF's directors and
the administration of its affairs as part of its broader rulemaking
relating to SB SEFs.
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The Commission anticipates that the proposed ownership and voting
limitations may impose costs on SB SEFs, SBS exchanges and SBS exchange
facilities. Entities planning to register as SB SEFs and SBS exchanges
would have to ensure that they are in compliance with the proposed
ownership and voting limitations and thus would need to spend time and
incur costs to design or modify their ownership structure and internal
processes, as well as take the necessary steps to draft or amend their
governing documents and rules to comply with such ownership and voting
limitations. Designing or modifying internal processes and drafting or
revising governing documents and rules would impose costs on SB SEFs,
SBS exchanges and SBS exchange facilities. The Commission estimates
that it would take a compliance attorney approximately 15 hours to
revise the relevant governing documents and to file them with the
appropriate authorities. Assuming an hourly cost of $291 for a
compliance attorney,\219\ these requirements would result in an overall
annual cost per SB SEF, SBS exchange or SBS exchange facility of
$4,365, or $152,775 in the aggregate for all SB SEFs, SBS exchanges,
and SBS exchange facilities.\220\
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\219\ See supra note 210.
\220\ Overall annual cost per SB SEF, SBS exchange, or SBS
exchange facility = 15 hours x $291 = $4,365; aggregate annual cost
for all SB SEFs, SBS exchanges, and SBS exchange facilities = $4,365
x 35 = $152,775.
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As previously discussed in the PRA section, proposed Rule 702(c)
would require SB SEFs, SBS exchanges, or SBS exchange facilities, as
applicable, to have an effective mechanism to obtain information
relating to ownership and voting interest in the SB SEF, SBS exchange,
or SBS exchange facility, by any participant or member of the SB SEF,
SBS exchange or SBS exchange facility.\221\ It was estimated that these
obligations would result in a total annual burden for all SB SEFs, SBS
exchanges, and SBS exchange facilities of 1,960 hours. It was also
estimated that there would be a total annual reporting and
recordkeeping burden for all participants or members of 2,800 hours.
Assuming an hourly cost of $291 for a compliance attorney \222\ to meet
these requirements, this would result in an overall annual cost of
$1,385,160 for participants or members and SB SEFs, SBS exchanges, and
SBS exchange facilities collectively.\223\ To the extent that certain
participants or members may be required to file ownership or voting
information with a domestic or international government authority
pursuant to securities laws, and such information is made available to
the SB SEF, SBS exchange, or SBS exchange facility, this cost would be
reduced.
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\221\ See supra Section IX.
\222\ See supra note 210.
\223\ Overall annual cost for participants or members and SB
SEFs, SBS exchanges and SBS exchange facilities = (1,960 hours +
2,800 hours) x $291 = $1,385,160.
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Proposed Rule 702(c) under Regulation MC also would require a SB
SEF, SBS exchange or SBS exchange facility to have rules to divest a
participant or member of an ownership interest that violates the
proposed ownership limits, and to not give effect to a voting interest
of a participant or member that violates the proposed voting limits. As
previously discussed in the PRA section, this requirement is estimated
to result in an initial paperwork burden for all SB SEFs, SBS
exchanges, or SBS exchange facilities of 525 hours. Assuming an hourly
cost of $291 for a compliance attorney \224\ to meet these
requirements, this would
[[Page 65923]]
result in an initial cost of $152,775 for all SB SEFs, SBS exchanges,
and SBS exchange facilities.\225\
---------------------------------------------------------------------------
\224\ See supra note 210.
\225\ This initial cost is estimated as follows: 15 hours x 35
respondents x $291 per hour = $152,775.
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This proposed rule also would impose costs on SB SEFs, SBS
exchanges, or SBS exchange facilities to initiate the divestiture or
not give effect to the voting rights that surpass the stated threshold.
For example, a SB SEF, SBS exchange, or SBS exchange facility could
incur costs involved with redeeming shares held in excess of the
proposed limits if such entity chooses to provide in its rules that any
such excess shares would be purchased by the entity. A SB SEF, SBS
exchange, or SBS exchange facility also could adopt rules to limit
voting by any participant or member that owns more than 20% of
outstanding interests. Thus, a SB SEF, SBS exchange, or SBS exchange
facility also could incur costs associated with monitoring votes cast
at any shareholder meeting to determine that no SB SEF participant or
SBS exchange member and its related persons subject to the voting
limits exceeds those limits.
The Commission recognizes that entities that are currently in
existence and plan to become SB SEFs, SBS exchanges or SBS exchange
facilities could incur costs if they do not meet the proposed ownership
and voting limitations. For example, if a single or small group of
market participants that would be direct participant(s) in a SB SEF
plans to register a platform as a SB SEF, it or they potentially would
need to secure additional owners to meet the 20% limitation on
ownership of voting securities of a SB SEF. This could impose costs on
an entity that has a single owner-participant or a small number of
owner-participants and that plans to register a platform as a SB SEF,
from the costs of finding other owners or the sharing of potential
profits with a larger group of owners. As noted above, currently there
are no trading venues that are registered with the Commission as SB
SEFs. Based on initial discussions with market participants that have
indicated an interest in registering as a SB SEF, the Commission
preliminarily believes that few entities that may register as a SB SEF
currently have ownership structures that would conflict with the
proposed ownership and voting limitations for SB SEFs. In addition, as
discussed above, national securities exchanges that may potentially
register as SBS exchanges or create a facility that will be a SBS
exchange facility should already be in compliance with the proposed
ownership and voting limitations. Based on these factors, the
Commission preliminarily believes that the aggregate costs imposed by
the ownership and voting limitations on entities initially seeking to
register as SB SEFs, SBS exchanges or SBS exchange facilities would not
be significant.
2. Costs and Benefits Related to Independence Requirements in SB SEFs
and SBS Exchanges
Proposed Rule 702(d) under Regulation MC would require the Boards
of SB SEFs and SBS exchanges or SBS exchange facilities to be composed
of at least a majority of independent directors to mitigate conflicts
of interest and help ensure that the entity does not advance the
interests of its owners, some of which may be dealer-participants or
their affiliates. By mandating a structure that would require a
majority of Board members to be independent, the governance of SB SEFs,
SBS exchanges and SBS exchange facilities should be less susceptible to
promoting the self-interests of such participants. The majority
independent directors should help foster a greater degree of
independent decision-making consistent with the objectives of the Dodd-
Frank Act and the Exchange Act. Further, a Board whose independent
directors constitute at least a majority of the Board should help
ensure that the views of independent directors are taken into account
and should help strengthen the hand of independent directors when
dealing with management. In the Commission's preliminary view,
requiring the Boards of SB SEFs, SBS exchanges and SBS exchange
facilities to have a majority of independent directors should help
reduce the possibility of damaging conflicts of interest that otherwise
might arise when persons who do not meet the definition of independent
director at the SB SEF, SBS exchange or SBS exchange facility are
involved in key decisions, such as which products will be made
available for trading and the access levels of potential market
participants. To the extent that independent directors would reduce the
likelihood that one group of participants could coordinate decision-
making in such a way that would be detrimental to the SB SEF, SBS
exchange or SBS exchange facility as a whole, this would be a benefit.
In addition, proposed Rule 702(f) under Regulation MC would require
that the nominating committee of a SB SEF, SBS exchange or SBS exchange
facility be composed solely of independent directors. This proposed
requirement should foster a process for nominating independent
directors that would help to assure that such directors are independent
and not likely to be unduly influenced by an owner of the SB SEF, SBS
exchange or SBS exchange facility who is possibly a SB SEF participant-
dealer or SBS exchange member or affiliate thereof. In addition, the
requirement in proposed Rule 702(g) under Regulation MC that any
committee that would have the authority to act on behalf of the Board
be composed of a majority of independent directors is designed to
prevent important decisions from escaping the view of a majority of
independent directors. Many Board decisions come from committees and
conflicts may be similarly prevalent or even more pronounced in these
situations.
Proposed Rule 702(e) under Regulation MC also would require the
Board of any SB SEF and SBS exchange to establish a ROC consisting
solely of independent directors to oversee the entity's regulatory
obligations.\226\ The Commission preliminarily believes that this
requirement should be effective in managing the conflicts of interest
inherent in the Board's oversight of whether a SB SEF or SBS exchange
satisfies its regulatory obligations. The proposed provision relating
to the establishment of an independent ROC should help promote greater
accountability on the part of SB SEFs and SBS exchanges with respect to
the obligations placed on them by the Exchange Act, including as
amended by the Dodd-Frank Act, and strengthen their ability to meet
those obligations. A ROC composed solely of independent directors
should result in a greater degree of objective decision-making with
respect to the SB SEF's or SBS exchange's regulatory obligations.
Vigilant and informed oversight by a strong, effective and independent
ROC may increase investor confidence in the operation of SB SEFs and
SBS exchanges, and the security-based swaps market generally. National
securities exchanges that currently have a ROC composed of independent
directors have noted the benefits of such a governance mechanism.\227\
In
[[Page 65924]]
addition, requiring the Board to report promptly to the Commission any
recommendation of the ROC that the Board does not implement should
provide the Commission with information on a timely basis regarding the
Board's decision not to take certain actions.
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\226\ Proposed Rule 702(e) under Regulation MC does not
explicitly include SBS exchange facilities because the exchange
whose facility posts or makes available for trading a security-based
swap must itself establish the requisite ROC. See supra note 173.
\227\ See CBOE Comment Letter, supra note 165 (``CBOE also
implemented other changes that are similar to the proposals
contained in the Release, for example establishing a Regulatory
Oversight Committee, composed solely of public directors * * *. As a
result, CBOE believes that its existing governance structure and
practices serve not only to protect investors and the public
interest and assure the integrity of CBOE's regulatory activities,
but also to enhance the ability of CBOE to develop and implement
sound business strategies''); NYSE Comment Letter, supra note 165
(``As an important part of the reform process of 2003, the NYSE
formalized the effective functional separation of regulatory
programs from the competitive business functions, under a Chief
Regulatory Officer (``CRO'') reporting to a Regulatory Oversight
Committee (``ROC'') of the Board of Directors consisting of all
independent directors * * *. We agree with the Commission that this
structure, with a separate regulatory executive reporting to an
empowered, qualified and independent board, amply funded and
professionally staffed, assures the integrity of the regulatory
process.'')
---------------------------------------------------------------------------
The governance proposals for SB SEFs, SBS exchanges and SBS
exchange facilities would complement the proposed ownership and voting
limits for these entities. Five or more dealer-participants or members
could still own 100% of the voting securities of a SB SEF, SBS exchange
or SBS exchange facility, as applicable, under the proposed voting and
ownership limits. In addition, even when the influence of any single
dealer is limited through ownership and voting restrictions, economic
incentives can align several dealer participants in a way that may be
costly to investors. As a result, there are potential incentives for SB
SEF participant-dealers and SBS exchange member-dealers to coordinate
in ways that ownership and voting restrictions could not address.
Requiring independence on the Board and certain key Board committees
should further reduce the ability of the participant-owners of the SB
SEF or member-owners of the SBS exchange or SBS exchange facility to
unduly influence decision-making at the Board level in a way that
advances their interests. Representation by independent directors would
provide views and influence that by design are not subject to these
conflicts.
As noted in the discussion relating to security-based swap clearing
agencies, while director independence is widely believed to be a
catalyst for improved governance and the Commission recognizes that the
industry widely accepts a majority of independent directors as ``best
practices,'' \228\ there is no conclusive empirical evidence to support
the view that a majority of independent directors benefits shareholder
profits. However, the Model Business Corporation Act recognizes the
important role of independent directors.\229\
---------------------------------------------------------------------------
\228\ See supra note 122.
\229\ MODEL BUS. CORP. ACT Sec. 8.01(c) (4th ed. 2008).
---------------------------------------------------------------------------
The proposed governance requirements could impose costs on SB SEFs,
SBS exchanges and SBS exchange facilities. Entities planning to
register as SB SEFs and SBS exchanges may need to draft or amend their
governing documents and design or modify their governance processes to
comply with the proposed governance requirements, which would impose
costs on SB SEFs, SBS exchanges and SBS exchange facilities. The
Commission estimates that it would take a compliance attorney
approximately 15 hours to revise the relevant governing documents and
to file them with the appropriate authorities, for a total estimated
cost per SB SEF, SBS exchange or SBS exchange facility of $4,365, or
$152,775 in the aggregate for all SB SEFs or SBS exchanges, and SBS
exchange facilities.\230\
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\230\ Assuming an hourly cost of $291 for a compliance attorney,
the overall annual cost per SB SEF, SBS exchange or SBS exchange
facility and aggregate cost for all SB SEFs, SBS exchanges, and SBS
exchange facilities was calculated as follows: per entity annual
cost = 15 hours x $291 = $4,365; aggregate annual cost = $4,365 x 35
= $152,775. See supra note 210.
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An entity that plans to register as a SB SEF or a SBS exchange may
need to revise the composition of its Board (or that of its SBS
exchange facility, in the case of an exchange that posts or makes
available for trading security-based swaps through a facility with a
separate governance structure), if the Board currently is not composed
of a majority of independent directors. SB SEFs and SBS exchanges or
SBS exchange facilities also would need to establish wholly independent
nominating committees, and SB SEFs and SBS exchanges would need to
establish wholly independent ROCs. In this regard, SB SEFs, SBS
exchanges and SBS exchange facilities could face difficulties in
locating qualified individuals to serve as independent directors,
particularly because security-based swaps trading is complex and some
potential candidates may decline to serve as a director if they believe
that they lack sufficient expertise.
The Commission preliminarily believes that the cost of securing
independent directors to serve on the Board of the SB SEF, SBS exchange
or SBS exchange facility could range from a relatively low cost for
those entities that have the contacts and resources to be able to
search for one or more independent directors on their own; to a
moderate cost for those entities that can undertake the search on their
own but would incur some expenditures, such as placing advertisements
in national media; to a higher cost for those entities that must secure
the services of a recruitment firm that specializes in the placement of
independent directors. The Commission preliminarily estimates that
those SB SEFs, SBS exchanges or SBS exchange facilities that must rely
on a recruitment specialist to secure an independent director could
incur a cost of approximately $68,000 per director.\231\ The Commission
preliminarily estimates that 10-20 entities could seek to register as
SB SEFs and notes that there are 15 national securities exchanges;
however, the number of Board members could vary widely among SB SEFs,
SBS exchanges and SBS exchange facilities. Therefore, the Commission
provides an estimate of a maximum recruitment cost of $68,000 per
independent director.\232\
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\231\ The Commission is basing this estimate on a recent study
noting that the retainer fee for outside directors is on average
$67,624. See http://www.hewittassociates.com/_MetaBasicCMAssetCache_/Assets/Articles/2010/2010_Outside_Director_Compensation.pdf. The Commission believes that this amount
could serve as a proxy for the amount of any fee to be charged by a
recruitment firm that would conduct a national search for an
independent director.
\232\ As discussed above, since 2004 when the Commission
proposed rules to promote the fair administration and governance of,
and to impose ownership and voting limitations on, national
securities exchanges, a number of exchanges have adopted governance
structures which meet many of the requirements of proposed Rule 702.
Thus, the costs for complying with the proposed governance rules
would be decreased for some SBS exchanges.
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The imposition of a Board structure that precludes the likely
participants in SB SEFs, SBS exchanges or SBS exchange facilities--
dealers--from gaining a majority or having representation on certain
Board committees may have a negative effect on the operations of the SB
SEF, SBS exchange or SBS exchange facility if independent directors do
not have commensurate qualifications or skills as affiliated directors
or do not engage actively in their Board or committee duties. There
could be costs in educating independent directors to become familiar
with the manner in which security-based swaps are traded and in the new
regulatory structure that would govern them, which could slow Board or
committee processes at least initially. In addition, independent
directors may yield to industry directors who have more knowledge and
experience, thereby undermining the benefits of requiring independence.
In the context of wholly independent committees, such as a nominating
[[Page 65925]]
committee or ROC, the independent directors may become reliant on
executive officers and other employees of the SB SEF or SBS exchange to
inform their decision-making due to their lack of expertise in the
industry. If management fails to keep the directors on wholly
independent committees fully-informed, if the independent directors on
such committees fail to seek sufficient information from management to
make informed decisions or if management fails to give independent
directors adequate resources to make effective decisions, there could
be costs to the SB SEF, SBS exchange or SBS exchange facility. On the
other hand, if management fully apprises the directors on wholly
independent committees of necessary information and the independent
directors have sufficient resources and are fully engaged with respect
to their duties, there would be benefits to the SB SEF, SBS exchange or
SBS exchange facility.
In addition, the effectiveness of majority independent Boards can
depend on the personalities and personal traits, as well as the
qualifications, of the persons serving on the Board. Independent
directors that take the time to understand the operations and programs
of a SB SEF, SBS exchange or SBS exchange facility and to ask probing
questions of management are more likely to be effective independent
directors. However, because independent directors would not be employed
by the SB SEF, SBS exchange, or SBS exchange facility or be
participants or members of such entity, they often may need to rely on
management or other directors to keep them fully informed. There could
be costs to the SB SEF, SBS exchange, or SBS exchange facility if one
or more independent directors is ineffectual because he or she did not
fully understand the operations of the SB SEF or SBS exchange, either
because the independent directors did not take the necessary initiative
or management failed to keep the independent directors fully apprised
of information that would lead to their effective decision-making.
Thus, imperfect decisions by independent directors could result in
costs to the SB SEF, SBS exchange, or SBS exchange facility. On the
other hand, independent directors who have expertise in areas that
could be helpful to the SB SEF, SBS exchange or SBS exchange facility,
who are engaged in carrying out their director duties, and who grasp
the issues confronting the SB SEF, SBS exchange or SBS exchange
facility could be very beneficial to the SB SEF, SBS exchange or SBS
exchange facility because they could bring fresh insights and ideas to
these entities.
Finally, under the proposed Rule 702(e)(2) under Regulation MC, SB
SEFs and SBS exchanges would need to report promptly to the Commission
any recommendation of the ROC that the Board does not adopt or
implement, which would result in costs to SB SEFs and SBS exchanges. As
discussed above, the Commission preliminarily estimates that the annual
information collection burden for each SB SEF or SBS exchange under
this provision of the proposed rules would be 12 hours.\233\
Accordingly, the Commission's staff estimates that it would cost each
SB SEF or SBS exchange $3,492 annually to comply with this provision of
the proposed rules.\234\
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\233\ See supra Section IX.D.
\234\ 12 hours (estimated annual information collection burden
for each SB SEF and SBS exchange) x $291 (hourly cost for a
compliance attorney) = $3,492. The hourly rate for the compliance
attorney is from SIFMA's Management & Professional Earnings in the
Securities Industry 2009, modified by the Commission's staff to
account for an 1,800-hour work-year and multiplied by 5.35 to
account for bonuses, firm size, employee benefits and overhead.
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D. Request for Comments
The Commission requests that commenters provide views and
supporting information regarding the costs and benefits associated with
the proposals. The Commission seeks estimates of these costs and
benefits, as well as any costs and benefits not already identified. The
Commission also requests comment regarding the relative costs and
benefits of pursuing alternative regulatory approaches that are
consistent with Section 765 of the Dodd-Frank Act. In addition, the
Commission requests comment on whether other provisions of the Dodd-
Frank Act for which Commission rulemaking is required are likely to
have an effect on the costs and benefits of the proposed rules.
XI. Consideration of Burden on Competition, and Promotion of
Efficiency, Competition, and Capital Formation
Section 3(f) of the Exchange Act \235\ requires the Commission,
whenever it engages in rulemaking and is required to consider or
determine whether an action is necessary or appropriate in the public
interest, to consider, in addition to the protection of investors,
whether the action would promote efficiency, competition, and capital
formation. In addition, Section 23(a)(2) of the Exchange Act \236\
requires the Commission, when adopting rules under the Exchange Act, to
consider the effect such rules would have on competition. Section
23(a)(2) of the Exchange Act also prohibits the Commission from
adopting any rule that would impose a burden on competition not
necessary or appropriate in furtherance of the purposes of the Exchange
Act.
---------------------------------------------------------------------------
\235\ 15 U.S.C. 78c(f).
\236\ 15 U.S.C. 78w(a)(2).
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Security-based swaps are currently executed and traded in the OTC
market, with five large commercial banks representing 97% of the total
U.S. banking industry national amounts outstanding of derivatives.\237\
The gross notional amount of CDS as of the end of 2009 was
approximately $30 trillion.\238\
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\237\ See Office of the Comptroller of the Currency, Quarterly
Report on Bank Trading and Derivatives Activities, First Quarter
2010.
\238\ Data available at http://www.isda.org/statistics/pdf/ISDA-Market-Survey-results1987-present.xls.
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As discussed above, the Commission has granted exemptions to five
entities to act as security-based swap clearing agencies for CDS.\239\
Four of the exemptions are currently active. SB SEFs and SBS exchanges
are expected to register to trade security-based swaps in connection
with the implementation of rules under Title VII of the Dodd-Frank Act.
---------------------------------------------------------------------------
\239\ See CDS Clearing Exemption Orders, supra note 17.
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As discussed above, the intent of the ownership and voting
limitations and governance proposed rules is to mitigate potential
conflicts of interests of market participants in the clearing and
trading of security-based swaps. These proposed rules may have a
significant effect on the level of competition within the marketplace.
The voting restrictions on security-based swap clearing agencies
that limit the influence of any single participant or group of
participants could increase the level of competition at the participant
level if they preserve access to central clearing and trading by other
participants. Without these voting restrictions, it may be possible for
a dominant participant owner to use its voting interest to set rules,
fees, or capital requirements that engender an uncompetitive
environment. For instance, a heightened capital threshold for
participation might prevent some firms from qualifying as participants
and thus deny them access to clearing. However, the proposed voting
limitations among participants may also impede competition at the
security-based swap clearing agency level, since
[[Page 65926]]
there are likely a limited number of firms with the expertise,
resources and desire to have an ownership interest in a security-based
swap clearing agency.\240\
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\240\ The Commission pursuant to Section 36 of the Exchange Act
may grant an exemption from any rule or any provision of any rule
under Regulation MC. See supra Section VI.
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As previously noted, evidence from the securities markets suggests
that clearing agencies over the long-run tend to converge to a small
number of entities or even a single entity. Clearing activities are
characterized by high start-up costs and low marginal costs such that
there are large economies of scale. For example, all trades executed on
the eight U.S. based options exchanges are cleared at the Options
Clearing Corporation, and trades executed on the U.S. equity markets,
composed of exchanges, alternative trading platforms, and OTC trading,
are cleared at the National Securities Clearing Corporation, a wholly-
owned subsidiary of the Depository Trust and Clearing Corporation.\241\
A single security-based swap clearing agency may also be more efficient
in that it would facilitate the fungibility of contracts across
multiple execution facilities and exchanges.
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\241\ The central clearing of security-based swaps is still
developing and the Commission has not made any determinations about
the number of security-based swap clearing agencies that may be used
by market participants.
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Whether the differences in the Voting Interest Focus Alternative
and the Governance Focus Alternative would result in substantially
different effects on efficiency, capital formation, and competition
remains uncertain. Preliminarily, the Commission believes that the
aggregate cap on participant voting interests may limit the formation
of new clearing agencies and, consequently, limit the opportunity for
competition among security-based swap clearing agencies. However, the
aggregate cap under the Voting Interest Focus Alternative may also be
more effective at mitigating conflicts of interest than the rules
proposed under the Governance Focus Alternative, and could result in
greater access to central clearing and a higher volume of security-
based swap products made eligible for clearing. As discussed
previously, central clearing would facilitate improved transparency,
risk management, and competition in the security-based swaps market.
This in turn should have a positive effect on efficiency, capital
formation, and competition.
The Commission preliminarily believes that the start-up costs for a
SB SEF, SBS exchange or SBS exchange facility, or for an existing
national securities exchange to post or make available for trading
security-based swaps, will be low. If a SB SEF, SBS exchange or SBS
exchange facility would not provide the desired level of access to a
market participant, and the start-up costs of setting up a competing SB
SEF, SBS exchange or SBS exchange facility are low, then this would
encourage the entrance of alternate trading venues for market
participants and allow competition to discipline harmful practices by
any single SB SEF, SBS exchange, or SBS exchange facility. However, if
ownership restrictions are such that dealers must coordinate ownership
among a group, then there may be fewer potential owners available, and
thus there could be less incentive to form competing SB SEFs, SBS
exchanges, or SBS exchange facilities. In this case, ownership
limitations would impede competition.\242\
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\242\ See supra note 240.
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The proposed rules under Regulation MC relating to Board and
committee independence may also increase the level of participant
competition by making it more difficult for a small group of dealer-
owners to influence a security-based swap clearing agency, SB SEF or
SBS exchange even in light of the proposed ownership and voting
restrictions. This is necessary because economic incentives could align
the interests of participants against the interest of the security-
based swap clearing agency, SB SEF or SBS exchange as a whole
irrespective of whether those participants are owners. For example, if
the Board of a dealer-controlled security-based swap clearing agency
determines to refuse to clear a proposed security-based swap product,
then such a product would not be required to be traded on a SB SEF or
SBS exchange and would likely trade OTC, reducing price transparency
and likely resulting in higher revenue for the dealers in the OTC
market than if the product was available through a SB SEF, SBS exchange
or SBS exchange facility. Majority independence requirements for the
Board and committees that have the authority to act on behalf of the
Board are an additional tool to address this potential conflict of
interest. Given the size of the security-based swaps market and its
non-competitive tendencies, the benefits with respect to efficiency and
competition that ownership, voting, and director representation
requirements would provide are likely to be substantial.
The Commission requests comment on the possible effects of the
proposed rules under Regulation MC on efficiency, competition, and
capital formation. The Commission requests that commenters provide
views and supporting information regarding any such effects. The
Commission notes that such effects are difficult to quantify. The
Commission seeks comment on possible anti-competitive effects of the
proposed rules under Regulation MC not already identified. The
Commission also requests comment regarding the competitive effects of
pursuing alternative regulatory approaches that are consistent with
Section 765 of the Dodd-Frank Act. In addition, the Commission requests
comment on how the other provisions of the Dodd-Frank Act for which
Commission rulemaking is required will interact with and influence the
competitive effects of the proposed rules under Regulation MC.
XII. Consideration of Impact on the Economy
For purposes of the Small Business Regulatory Enforcement Fairness
Act of 1996, or ``SBREFA,'' \243\ the Commission must advise the OMB as
to whether proposed Regulation MC and the rules proposed thereunder
constitute a ``major'' rule. Under SBREFA, a rule is considered
``major'' where, if adopted, it results or is likely to result in: (1)
An annual effect on the economy of $100 million or more (either in the
form of an increase or a decrease); (2) a major increase in costs or
prices for consumers or individual industries; or (3) significant
adverse effect on competition, investment or innovation.
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\243\ Public Law 104-121, Title II, 110 Stat. 857 (1996)
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note
to 5 U.S.C. 601).
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The Commission requests comment on the potential impact of proposed
Regulation MC and the rules proposed thereunder on the economy on an
annual basis. Commenters are requested to provide empirical data and
other factual support for their view to the extent possible.
XIII. Regulatory Flexibility Act Certification
Section 603(a) of the Regulatory Flexibility Act \244\ (``RFA'')
requires the Commission to undertake an initial regulatory flexibility
analysis of the proposed rules under Regulation MC on small entities,
unless the Commission certifies that the proposed rules, if adopted,
would not have a significant economic impact on a substantial number of
small entities.\245\
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\244\ 5 U.S.C. 603(a).
\245\ 5 U.S.C. 605(b).
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[[Page 65927]]
A. Security-Based Swap Clearing Agencies
Proposed Rule 701 under Regulation MC would apply to all security-
based swap clearing agencies. Four entities are currently exempt from
registration as a clearing agency under section 17A of the Exchange Act
to provide central clearing services for CDS, a class of security-based
swaps.\246\ The Commission believes, based on its understanding of the
market, that likely no more than six security-based swap clearing
agencies could be subject to the requirements of proposed Rule 701.
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\246\ See CDS Clearing Exemptions, supra note 17.
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For purposes of Commission rulemaking in connection with the RFA,
an issuer or person, other than an investment company, is a small
business if its total assets on the last day of its most recent fiscal
year were $5 million or less.\247\ The Commission believes that the
entities likely to register as security-based swap clearing agencies
will not be small entities, but rather part of large business entities
that have assets in excess of $5 million and total capital in excess of
$500,000.\248\
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\247\ 17 CFR 230.157. See also 17 CFR 240.0-10(a).
\248\ Commission staff based this determination on its review of
various public sources of financial information about the current
registered clearing agencies and entities currently exempt from
clearing agency registration under Section 17A of the Exchange Act.
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B. SB SEFs
Proposed Rule 702 under Regulation MC would apply to all SB SEFs.
In the Dodd-Frank Act, Congress defined for the first time what
activity would constitute a SB SEF and mandated the registration of
these new facilities. The Commission preliminarily believes that
approximately 10 to 20 SB SEFs could be subject to the requirements of
proposed Rule 702.
For purposes of Commission rulemaking in connection with the RFA,
an issuer or person, other than an investment company, is a small
business if its total assets on the last day of its most recent fiscal
year were $5 million or less.\249\ The Commission preliminarily
believes that the entities likely to register as SB SEFs will not be
considered small entities because most, if not all, of the SB SEFs will
be part of large business entities, and that all SB SEFs will have
assets in excess of $5 million.\250\
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\249\ 17 CFR 230.157. See also 17 CFR 240.0-10(a).
\250\ Commission staff based this determination on its review of
various public sources of financial information about the entities
likely to register as SB SEFs.
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C. SBS Exchanges
Proposed Rule 702 under Regulation MC would apply to all SBS
exchanges. All of the 15 currently registered national securities
exchanges could become SBS exchanges, and therefore, subject to the
requirements of Rule 702.\251\
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\251\ See supra note 194.
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For purposes of Commission rulemaking in connection with the RFA, a
national securities exchange is a small business if it has been
exempted from the reporting requirements of Rule 601 of Regulation NMS
\252\ (Dissemination of Transaction Reports and Last Sale Data with
Respect to Transactions in NMS Stocks) and is not affiliated with any
person (other than a natural person) that is not a ``small business.''
\253\ None of the currently registered national securities exchanges is
a small entity. Therefore, the Commission preliminarily believes that
none of the SBS exchanges will be considered small entities.
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\252\ 17 CFR 242.601.
\253\ 17 CFR 240.0-10(e).
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D. Certification
For the reasons stated above, the Commission certifies that the
proposed rules under Regulation MC would not have a significant
economic impact on a substantial number of small entities. The
Commission requests comments regarding this certification. The
Commission requests that commenters describe the nature of any impact
on small entities, including national securities exchanges, clearing
agencies or other small businesses or small organizations that may
register as SB SEFs, SBS exchanges or security-based swap clearing
agencies, and provide empirical data to support the extent of the
impact.
XIV. Statutory Basis and Rule Text
Pursuant to the Exchange Act, 15 U.S.C. 78a et seq., and
particularly, Sections 3, 3D, 6, 11A, 17A, 19, and 23(a) thereof, and
Section 765 of the Dodd-Frank Act, the Commission is proposing to adopt
Regulation MC under the Exchange Act.
List of Subjects in 17 CFR Part 242
Reporting and recordkeeping requirements, Securities.
Text of Proposed Rule Amendments
For the reasons stated in the preamble, the Commission is proposing
to amend Title 17, Chapter II of the Code of the Federal Regulations as
follows:
PART 242--REGULATIONS M, SHO, ATS, AC, NMS, AND MC AND CUSTOMER
MARGIN REQUIREMENTS FOR SECURITY FUTURES
1. The authority citation for part 242 is amended by adding
authorities for Sections 242.700, 242.701 and 242.702 to read as
follows:
Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78f,
78g(c)(2), 78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c),
78o(g), 78q-1, 78q(a), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29,
and 80a-37.
* * * * *
Section 242.700 is also issued under sec. 943, Public Law 111-
203, Section 765.
Section 242.701 is also issued under sec. 943, Public Law 111-
203, Section 765.
Section 242.702 is also issued under sec. 943, Public Law 111-
203, Sections 763 and 765.
2. The part heading for part 242 is revised to read as set forth
above.
3. Sections 242.700, 242.701 and 242.702 are added to read as
follows:
Sec. 242.700 Definitions.
(a) The term affiliate means any person that, directly or
indirectly, controls, is controlled by, or is under common control
with, the person.
(b) The terms beneficial ownership, beneficially owns or any
derivative thereof shall have the same meaning, with respect to any
security or other ownership interest, as set forth in Sec. 240.13d-3,
as if (and whether or not) such security or other ownership interest
were a voting equity security registered under section 12 of the
Exchange Act (15 U.S.C. 78l); provided that to the extent any person
beneficially owns any security or other ownership interest solely
because such person is a member of a group within the meaning of
section 13(d)(3) of the Exchange Act (15 U.S.C. 78m(d)(3)), such person
shall not be deemed to beneficially own such security or other
ownership interest for purposes of this section, unless such person has
the power to direct the vote of such security or other ownership
interest.
(c) The term Board means the Board of Directors or Board of
Governors of the security-based swap execution facility or national
securities exchange or facility thereof that posts or makes available
for trading security-based swaps, or security-based swap clearing
agency, as applicable, or any equivalent body.
(d) The term clearing agency has the same meaning as set forth in
section 3(a)(23) of the Exchange Act (15 U.S.C. 78c(a)(23)).
(e) The term control means the possession, direct or indirect, of
the
[[Page 65928]]
power to direct or cause the direction of the management and policies
of a person, whether through the ownership of voting securities, by
contract, or otherwise. A person is presumed to control another person
if the person:
(1) Is a director, general partner or officer exercising executive
responsibility (or having similar status or functions);
(2) Directly or indirectly has the right to vote 25 percent or more
of a class of voting securities or has the power to sell or direct the
sale of 25 percent or more of a class of voting securities; or
(3) In the case of a partnership, has the right to receive, upon
dissolution, or has contributed, 25 percent or more of the capital.
(f) The term director means any member of the Board.
(g) The term Exchange Act means the Securities Exchange Act of 1934
(15 U.S.C. 78a et seq.).
(h) The term facility has the same meaning as set forth in section
3(a)(2) of the Exchange Act (15 U.S.C. 78c(a)(2)).
(i) The term immediate family member means a person's spouse,
parents, children and siblings, whether by blood, marriage or adoption,
or anyone residing in such person's home.
(j) The term independent director means:
(1) A director who has no material relationship with:
(i) The security-based swap execution facility or national
securities exchange or facility thereof that posts or makes available
for trading security-based swaps, or security-based swap clearing
agency, as applicable;
(ii) Any affiliate of the security-based swap execution facility or
national securities exchange or facility thereof that posts or makes
available for trading security-based swaps, or security-based swap
clearing agency, as applicable;
(iii) A security-based swap execution facility participant, a
member of a national securities exchange that posts or makes available
for trading security-based swaps, or a participant in the security-
based swap clearing agency, as applicable; or
(iv) Any affiliate of a security-based swap execution facility
participant, a member of a national securities exchange that posts or
makes available for trading security-based swaps, or a participant in
the security-based swap clearing agency, as applicable.
(2) A director is not an independent director if any of the
following circumstances exists:
(i) The director, or an immediate family member, is employed by or
otherwise has a material relationship with the security-based swap
execution facility or national securities exchange or facility thereof
that posts or makes available for trading security-based swaps, or
security-based swap clearing agency, as applicable, or any affiliate
thereof, or within the past three years was employed by or otherwise
had a material relationship with the security-based swap execution
facility or national securities exchange or facility thereof that posts
or makes available for trading security-based swaps, or security-based
swap clearing agency, as applicable, or any affiliate thereof;
(ii) (A) The director is a security-based swap execution facility
participant, a member of a national securities exchange that posts or
makes available for trading security-based swaps, or a participant in
the security-based swap clearing agency, as applicable, or within the
past three years was employed by or affiliated with such participant or
member or any affiliate thereof; or
(B) The director has an immediate family member that is, or within
the past three years was, an executive officer of a security-based swap
execution facility participant, a member of a national securities
exchange that posts or makes available for trading security-based
swaps, or a participant in the security-based swap clearing agency, as
applicable, or any affiliate thereof;
(iii) The director, or an immediate family member, has received
during any twelve month period within the past three years payments
that reasonably could affect the independent judgment or decision-
making of the director from the security-based swap execution facility
or national securities exchange or facility thereof that posts or makes
available for trading security-based swaps, or security-based swap
clearing agency, as applicable, or any affiliate thereof or from a
security-based swap execution facility participant, a member of a
national securities exchange that posts or makes available for trading
security-based swaps, or a participant in the security-based swap
clearing agency, as applicable, or any affiliate thereof, other than
the following:
(A) Compensation for Board or Board committee services;
(B) Compensation to an immediate family member who is not an
executive officer of the security-based swap execution facility or
national securities exchange or facility thereof that posts or makes
available for trading security-based swaps, or security-based swap
clearing agency, as applicable, or any affiliate thereof or of a
security-based swap execution facility participant, a member of a
national securities exchange that posts or makes available for trading
security-based swaps, or a participant in the security-based swap
clearing agency, as applicable, or any affiliate thereof; or
(C) Pension and other forms of deferred compensation for prior
services, not contingent on continued service.
(iv) The director, or an immediate family member, is a partner in,
or controlling shareholder or executive officer of, any organization to
or from which the security-based swap execution facility or national
securities exchange or facility thereof that posts or makes available
for trading security-based swaps, or security-based swap clearing
agency, as applicable, or any affiliate thereof made or received
payments for property or services in the current or any of the past
three full fiscal years that exceed two percent of the recipient's
consolidated gross revenues for that year, other than the following:
(A) Payments arising solely from investments in the securities of
the security-based swap execution facility or national securities
exchange or facility thereof that posts or makes available for trading
security-based swaps, or security-based swap clearing agency, as
applicable, or affiliate thereof; or
(B) Payments under non-discretionary charitable contribution
matching programs.
(v) The director, or an immediate family member, is, or within the
past three years was, employed as an executive officer of another
entity where any executive officers of the security-based swap
execution facility or national securities exchange or facility thereof
that posts or makes available for trading security-based swaps, or
security-based swap clearing agency, as applicable, serve on that
entity's compensation committee;
(vi) The director, or an immediate family member, is a current
partner of the outside auditor of the security-based swap execution
facility or national securities exchange or facility thereof that posts
or makes available for trading security-based swaps, or security-based
swap clearing agency, as applicable, or any affiliate thereof, or was a
partner or employee of the outside auditor of security-based swap
execution facility or national securities exchange or facility thereof
that posts or makes available for trading security-based swaps, or
security-based swap clearing agency, as applicable, or any affiliate
thereof who worked on the audit of the security-based swap execution
facility or national securities exchange or facility thereof that posts
or makes
[[Page 65929]]
available for trading security-based swaps, or security-based swap
clearing agency, as applicable, or any affiliate thereof, at any time
within the past three years; or
(vii) In the case of a director that is a member of the audit
committee, such director (other than in his or her capacity as a member
of the audit committee, the Board, or any other Board committee),
accepts, directly or indirectly, any consulting, advisory, or other
compensatory fee from the security-based swap execution facility or
national securities exchange or facility thereof that posts or makes
available for trading security-based swaps, or security-based swap
clearing agency, as applicable, or any affiliate thereof or a security-
based swap execution facility participant, a member of a national
securities exchange that posts or makes available for trading security-
based swaps, or a participant in the security-based swap clearing
agency, as applicable, or any affiliate thereof, other than fixed
amounts of pension and other forms of deferred compensation for prior
service, provided such compensation is not contingent in any way on
continued service.
(k) The term major security-based swap participant has the same
meaning as set forth in section 3(a)(65) of the Exchange Act (15 U.S.C.
78c(a)(65)) or any rules or regulations thereunder.
(l) The term material relationship means a relationship, whether
compensatory or otherwise, that reasonably could affect the independent
judgment or decision-making of the director.
(m) The term member has the same meaning as set forth in section
3(a)(3) of the Exchange Act (15 U.S.C. 78c(a)(30)).
(n) The term national securities exchange means any exchange
registered pursuant to section 6 of the Exchange Act (15 U.S.C. 78f).
(o) The term participant when used with respect to a clearing
agency has the same meaning set forth in section 3(a)(24) of the
Exchange Act (15 U.S.C 78c(a)).
(p) The term person has the same meaning as set forth in section
3(a)(9) of the Exchange Act (15 U.S.C. 78c(a)(9)).
(q) The term person associated with a member has the same meaning
as set forth in section 3(a)(21) of the Exchange Act (15 U.S.C.
78c(a)(21)).
(r) The term person associated with a participant in a security-
based swap clearing agency means:
(1) Any partner, officer, director, or branch manager of such
security-based swap dealer or major security-based swap participant (or
any person occupying a similar status or performing similar functions);
(2) Any person directly or indirectly controlling, controlled by,
or under common control with such security-based swap dealer or major
security-based swap participant; or
(3) Any employee of such security-based swap dealer or major
security-based swap participant. This term does not include any person
associated with a participant in a security-based swap clearing agency
whose functions are solely clerical or ministerial.
(s) The term person associated with a security-based swap dealer or
major security-based swap participant has the same meaning as set forth
in section 3(a)(70) of the Exchange Act (15 U.S.C. 78c(a)(70)) or any
rules or regulations thereunder.
(t) The term person associated with a security-based swap execution
facility participant means any partner, officer, director, or branch
manager of such security-based swap execution facility participant (or
any person occupying a similar status or performing similar functions),
any person directly or indirectly controlling, controlled by, or under
common control with such security-based swap execution facility
participant, or any employee of such security-based swap execution
facility participant.
(u) The term related person means:
(1) When used with respect to a security-based swap clearing
agency:
(i) Any affiliate of a security-based swap clearing agency
participant;
(ii) Any person associated with a security-based swap clearing
participant;
(iii) Any immediate family member of a security-based swap clearing
agency participant that is a natural person or any immediate family
member of the spouse of such person, who, in each case, has the same
home as the security-based swap clearing agency participant or who is a
director or officer of the security-based swap clearing agency or any
of its parents or subsidiaries; or
(iv) Any immediate family member of a person associated with a
security-based swap clearing agency participant that is a natural
person or any immediate family member of the spouse of such person,
who, in each case, has the same home as the person associated with the
security-based swap clearing agency participant or who is a director or
officer of the security-based swap clearing agency or any of its
parents or subsidiaries;
(2) When used with respect to a security-based swap execution
facility:
(i) Any affiliate of a security-based swap execution facility
participant;
(ii) Any person associated with a security-based swap execution
facility participant;
(iii) Any immediate family member of a security-based swap
execution facility participant or any immediate family member of the
spouse of such person, who, in each case, has the same home as the
security-based swap execution facility participant or who is a director
or officer of the security-based swap execution facility or any of its
parents or subsidiaries; or
(iv) Any immediate family member of a person associated with a
security-based swap execution facility participant or any immediate
family member of the spouse of such person, who, in each case, has the
same home as the person associated with the security-based swap
execution facility participant or who is a director or officer of the
security-based swap execution facility or any of its parents or
subsidiaries; and
(3) When used with respect to a national securities exchange or
facility thereof that posts or makes available for trading security-
based swaps:
(i) Any affiliate of a member of the national securities exchange
that posts or makes available for trading security-based swaps;
(ii) Any person associated with a member of the national securities
exchange that posts or makes available for trading security-based
swaps;
(iii) Any immediate family member of a member of the national
securities exchange that posts or makes available for trading security-
based swaps or any immediate family member of the spouse of such
person, who, in each case, has the same home as the member of the
national securities exchange that posts or makes available for trading
security-based swaps or who is a director or officer of the national
securities exchange or facility thereof that posts or makes available
for trading security-based swaps, or any of its parents or
subsidiaries; or
(iv) Any immediate family member of a person associated a member of
the national securities exchange that posts or makes available for
trading security-based swaps or any immediate family member of the
spouse of such person, who, in each case, has the same home as the
person associated with the national securities exchange that posts or
makes available for trading security-based swaps or who is a director
or officer of the national securities exchange or facility thereof that
posts or makes available for trading security-based swaps or any of its
parents or subsidiaries.
[[Page 65930]]
(v) The term security-based swap has the same meaning as set forth
in section 3(a)(68) of the Exchange Act (15 U.S.C. 78c(a)(68)) or any
rules or regulations thereunder.
(w) The term security-based swap dealer has the same meaning as set
forth in section 3(a)(71) of the Exchange Act (15 U.S.C. 78c(a)(71)) or
any rules or regulations thereunder.
(x) The term security-based swap clearing agency means a clearing
agency that clears security-based swaps.
(y) The term security-based swap execution facility has the same
meaning as set forth in section 3(a)(77) of the Exchange Act (15 U.S.C.
78c(a)(77)) or any rules or regulations thereunder.
(z) The term security-based swap execution facility participant
means a person permitted to directly effect transactions on the
security-based swap execution facility.
Sec. 242.701 Mitigation of conflicts of interest of security-based
swap clearing agencies.
Each security-based swap clearing agency must comply with the
provisions of either paragraphs (a) or (b) this section, and must have
the capacity to carry out the purposes of paragraphs (a) or (b) of this
section, respectively.
(a)(1) Limits on voting interest. A security-based swap clearing
agency shall not permit any security-based swap clearing agency
participant, either alone or together with its related persons, to:
(i) Beneficially own, directly or indirectly, any interest in the
security-based swap clearing agency that exceeds 20 percent of any
class of securities, or other ownership interest, entitled to vote of
such security-based swap clearing agency;
(ii) Directly or indirectly vote, cause the voting of, or give any
consent or proxy with respect to the voting of, any interest in the
security-based swap clearing agency that exceeds 20 percent of the
voting power of any class of securities or other ownership interest of
such security-based swap clearing agency;
(iii) In the aggregate with any other security-based swap clearing
agency participants and their related persons, beneficially own,
directly or indirectly, any interest in the security-based swap
clearing agency that exceeds 40 percent of any class of securities, or
other ownership interest, entitled to vote of such security-based swap
clearing agency; or
(iv) In the aggregate with any other security-based swap clearing
agency participants and their related persons, directly or indirectly
vote, cause the voting of, or give any consent or proxy with respect to
the voting of, any interest in the security-based swap clearing agency
that exceeds 40 percent of the voting power of any class of securities
or other ownership interest of such security-based swap clearing
agency.
(2) Divestiture. (i) The rules of the security-based swap clearing
agency must provide an effective mechanism to divest any participant of
any voting interest owned in excess of the limitation in paragraph
(a)(1) of this section.
(ii) The rules of the security-based swap clearing agency must be
reasonably designed not to give effect to the portion of any voting
interest held by one or more participants in excess of the limitations
in paragraph (a)(1) of this section.
(iii) The rules of the security-based swap clearing agency must
provide an effective mechanism for it to obtain information relating to
voting interests in the security-based swap clearing agency by any
participant in the security-based swap clearing agency and its related
persons.
(3) Board. (i) The Board of each security-based swap clearing
agency must be composed of at least 35 percent independent directors.
(ii) No director may qualify as an independent director unless the
Board affirmatively determines that the director does not have a
material relationship with the security-based swap clearing agency or
any affiliate of the security-based swap clearing agency, or a
participant in the security-based swap clearing agency, or any
affiliate of a participant in the security-based swap clearing agency.
(iii) The security-based swap clearing agency must establish
policies and procedures to require each director, on his or her own
initiative or upon request of the security-based swap clearing agency,
to inform the security-based swap clearing agency of the existence of
any relationship or interest that may reasonably be considered to bear
on whether such director is an independent director.
(4) Nominating committee. (i) A Board of any security-based swap
clearing agency shall establish a nominating committee composed of a
majority of independent directors.
(ii) The nominating committee of any security-based swap clearing
agency must identify individuals qualified to become Board members
through a consultative process with the participants of the security-
based swap clearing agency consistent with criteria approved by the
Board and consistent with the provisions of this section, and
administer a process for the nomination of individuals to the Board.
(5) Other committees of the Board. A security-based swap clearing
agency may establish such other committees of the Board, including a
risk committee, as it deems appropriate. However, if such committee has
the authority to act on behalf of the Board, the committee must be
composed of at least 35 percent independent directors.
(6) Disciplinary panels. The disciplinary processes of a security-
based swap clearing agency shall preclude any group or class of persons
that is a participant from dominating or exercising disproportionate
influence on the disciplinary process. Any disciplinary panel of a
security-based swap clearing agency shall also include at least one
person who would qualify as an independent director. If the security-
based swap clearing agency provides for a process of an appeal to the
Board, or to a committee of the Board, then that appellate body also
shall include at least one person who would qualify as an independent
director.
(b)(1) Limits on voting interests. A security-based swap clearing
agency shall not permit any security-based swap clearing agency
participant, either alone or together with its related persons, to:
(i) Beneficially own, directly or indirectly, any interest in the
security-based swap execution facility that exceeds 5 percent of any
class of securities, or other ownership interest, entitled to vote of
such security-based swap clearing agency; or
(ii) Directly or indirectly vote, cause the voting of, or give any
consent or proxy with respect to the voting of, any interest in the
security-based swap clearing agency that exceeds 5 percent of the
voting power of any class of securities or other ownership interest of
such security-based swap clearing agency.
(2) Divestiture. (i) The rules of the security-based swap clearing
agency must provide an effective mechanism to divest any participant of
any voting interest owned in excess of the limitation in paragraph
(b)(1) of this section.
(ii) The rules of the security-based swap clearing agency must be
reasonably designed not to give effect to the portion of any voting
interest held by one or more participants in excess of the limitations
in paragraph (b)(1) of this section.
(iii) The rules of the security-based swap clearing agency must
provide an effective mechanism for it to obtain information relating to
voting interests
[[Page 65931]]
in the security-based swap clearing agency or its holding company by
any participant in the security-based swap clearing agency.
(3) Board. (i) The Board of each security-based swap clearing
agency must be composed of a majority of independent directors.
(ii) No director may qualify as an independent director unless the
Board affirmatively determines that the director does not have a
material relationship with the security-based swap clearing agency or
any affiliate of the security-based swap clearing agency, or a
participant in the security-based swap clearing agency, or any
affiliate of a participant in the security-based swap clearing agency.
(iii) The security-based swap clearing agency must establish
policies and procedures to require each director, on his or her own
initiative or upon request of the security-based swap clearing agency,
to inform the security-based swap clearing agency of the existence of
any relationship or interest that may reasonably be considered to bear
on whether such director is an independent director.
(4) Nominating committee. (i) A Board of any security-based swap
clearing agency shall establish a nominating committee composed solely
of independent directors.
(ii) The nominating committee of any security-based swap clearing
agency must identify individuals qualified to become Board members
through a consultative process with the participants of the security-
based swap clearing agency consistent with criteria approved by the
Board and consistent with the provisions of this section, and
administer a process for the nomination of individuals to the Board.
(5) Other committees of the Board. A security-based swap clearing
agency may establish such other committees of the Board, including a
risk committee, as it deems appropriate. However, if such committee has
the authority to act on behalf of the Board, the committee must be
composed of a majority of independent directors.
(6) Disciplinary panels. The disciplinary processes of a security-
based swap clearing agency shall preclude any group or class of persons
that is a participant from dominating or exercising disproportionate
influence on the disciplinary process. Any disciplinary panel of a
security-based swap clearing agency shall also include at least one
person who would qualify as an independent director. If the security-
based swap clearing agency provides for a process of an appeal to the
Board, or to a committee of the Board, then that appellate body also
shall include at least one person who would qualify as an independent
director.
Sec. 242.702 Mitigation of conflicts of interest of security-based
swap execution facilities and national securities exchanges that post
or make available for trading security-based swaps.
(a) General. Each security-based swap execution facility and
national securities exchange or facility thereof that posts or makes
available for trading security-based swaps must comply with the
provisions of this section and must have the capacity to carry out the
purposes of this section.
(b) Limits on ownership and voting. (1) A security-based swap
execution facility shall not permit any security-based swap execution
facility participant, either alone or together with its related
persons, to:
(i) Beneficially own, directly or indirectly, any interest in the
security-based swap execution facility that exceeds 20 percent of any
class of securities, or other ownership interest, entitled to vote of
such security-based swap execution facility; or
(ii) Directly or indirectly vote, cause the voting of, or give any
consent or proxy with respect to the voting of, any interest in the
security-based swap execution facility that exceeds 20 percent of the
voting power of any class of securities or other ownership interest of
such security-based swap execution facility.
(2) A national securities exchange or facility thereof that posts
or makes available for trading security-based swaps shall not permit
any member, either alone or together with its related persons, to:
(i) Beneficially own, directly or indirectly, any interest in the
national securities exchange or facility thereof that posts or makes
available for trading security-based swaps that exceeds 20 percent of
any class of securities, or other ownership interest, entitled to vote
of such national securities exchange or facility thereof that posts or
makes available for trading security-based swaps; or
(ii) Directly or indirectly vote, cause the voting of, or give any
consent or proxy with respect to the voting of, any interest in the
national securities exchange or facility thereof that posts or makes
available for trading security-based swaps that exceeds 20 percent of
the voting power of any class of securities or other ownership interest
of such national securities exchange or facility thereof that posts or
makes available for trading security-based swaps.
(c) Divestiture. (1) The rules of a security-based swap execution
facility or national securities exchange or facility thereof that posts
or makes available for trading security-based swaps must provide an
effective mechanism to divest any security-based swap execution
facility participant or member, as applicable, of any interest owned in
excess of the ownership limitations in paragraphs (b)(1)(i) and (2)(i)
of this section.
(2) The rules of a security-based swap execution facility or
national securities exchange or facility thereof that posts or makes
available for trading security-based swaps must be reasonably designed
not to give effect to the portion of any voting interest held by one or
more security-based swap execution facility participant or member, as
applicable, in excess of the limitations in paragraphs (b)(1)(ii) and
(b)(2)(ii) of this section.
(3) The rules of a security-based swap execution facility or
national securities exchange or facility thereof that posts or makes
available for trading security-based swaps must provide an effective
mechanism for it to obtain information relating to ownership and voting
interests in the security-based swap execution facility or national
securities exchange or facility thereof that posts or makes available
for trading security-based swaps by any security-based swap execution
facility participant or member, as applicable.
(d) Board. (1) The Board of any security-based swap execution
facility or national securities exchange or facility thereof that posts
or makes available for trading security-based swaps must be composed of
a majority of independent directors.
(2) No director may qualify as an independent director of a
security-based swap execution facility unless the Board affirmatively
determines that the director does not have a material relationship with
the security-based swap execution facility, any affiliate of the
security-based swap execution facility, a security-based swap execution
facility participant, or any affiliate of a security-based swap
execution facility participant.
(3) No director may qualify as an independent director of a
national securities exchange or facility thereof that posts or makes
available for trading security-based swaps unless the Board
affirmatively determines that the director does not have a material
relationship with the national securities exchange or facility thereof,
any affiliate of the national securities exchange or
[[Page 65932]]
facility thereof, a member of the national securities exchange, or any
affiliate of such member.
(e) Regulatory oversight committee. (1) A Board of any security-
based swap execution facility or national securities exchange that
posts or makes available for trading security-based swaps shall
establish a regulatory oversight committee, composed solely of
independent directors, to assist it in minimizing actual and potential
conflicts of interest. The regulatory oversight committee shall oversee
the security-based swap execution facility's obligations under section
3D of the Exchange Act or the national securities exchange's obligation
under section 6 of the Exchange Act (15 U.S.C. 78f), as applicable, on
behalf of the Board. The Board shall delegate sufficient authority,
dedicate sufficient resources, and allow sufficient time for the
regulatory oversight committee to fulfill its mandate.
(2) The Board shall promptly report to the Commission any
recommendations of the Regulatory Oversight Committee that the Board
does not adopt or implement.
(f) Nominating committee. (1) The nominating committee of a
security-based swap execution facility or national securities exchange
or facility thereof that posts or makes available for trading security-
based swaps must be composed solely of independent directors.
(2) The nominating committee of a security-based swap execution
facility or national securities exchange or facility thereof that posts
or makes available for trading security-based swaps must identify
individuals qualified to become directors, consistent with criteria
approved by the Board and consistent with the provisions of this
section, and administer a process for the nomination of individuals to
the Board.
(g) Other committees of the Board. A security-based swap execution
facility or national securities exchange or facility thereof that posts
or makes available for trading security-based swaps may establish such
other committees of the Board, including an executive committee, as it
deems appropriate. However, if such committee has the authority to act
on behalf of the Board, the committee must be composed of a majority of
independent directors.
(h) Disciplinary panels. The disciplinary processes of a security-
based swap execution facility or national securities exchange that
posts or makes available for trading security-based swaps shall
preclude any group or class of security-based swap execution facility
participants or group or class of members of the national securities
exchange that posts or makes available for trading security-based
swaps, as applicable, from dominating or exercising disproportionate
influence on the disciplinary process. Any disciplinary panel of a
security-based swap execution facility or national securities exchange
that posts or makes available for trading security-based swaps shall
also include at least one person who would qualify as an independent
director. If the security-based swap execution facility or national
securities exchange that posts or makes available for trading security-
based swaps provides for a process of an appeal to the Board, or to a
committee of the Board, then that appellate body also shall include at
least one person who would qualify as an independent director.
Dated: October 14, 2010.
By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2010-26315 Filed 10-25-10; 8:45 am]
BILLING CODE 8011-01-P