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SEC Proposes Capital, Margin Rules for Swap Dealers

Large swap dealers would need to hold more capital, post collateral against riskier trades and take steps to protect their customers' money under new rules proposed by U.S. securities regulators on Wednesday.

Large swap dealers would need to hold more capital, post collateral against riskier trades and take steps to protect their customers' money under new rules proposed by U.S. securities regulators on Wednesday.

The Securities and Exchange Commission's 500-page proposal is a key piece of the 2010 Dodd-Frank Wall Street reform law, which aims to shed more light on the opaque $640 trillion over-the-counter derivatives market.

It would apply to market makers like Goldman Sachs and Morgan Stanley, as well as to firms that trade heavily in certain over-the-counter derivatives.

SEC Commissioner Luis Aguilar, a Democrat, said the proposal will affect the economics of entering into security-based swaps that are not cleared, but it was important to remember why such rules were being contemplated.

"We are considering these rules because a grave financial crisis - in which unregulated derivatives played a central role - imposed immense costs on the American economy, with tragic effects on American workers and families," said Aguilar.

The SEC is far behind compared with other federal regulators in its progress on the capital and margin rules.

The Dodd-Frank law requires regulators, including the SEC and U.S. Commodity Futures Trading Commission, to propose their own versions of the rules and then coordinate them.

The SEC's version would apply to firms dealing in securities-based swaps, such as certain credit and equity derivatives.

Banking regulators - including the Federal Reserve, the Federal Deposit Insurance Corp and the Office of the Comptroller of the Currency - along with the CFTC, initially proposed their versions of the capital and margin rules last year.

Banking regulators re-opened the public comment period last month, however, to allow consideration of an international paper released this summer by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions.

The CFTC also previously re-opened the comment period on its rule.

The SEC's proposed capital rule is largely modeled after rules in place today for securities broker-dealers.

Essentially, brokerages engaged in swap dealing and stand-alone swap dealers would both need to hold a minimum of $20 million in net capital, plus an additional 8 percent of the total margin they collect.

That 8 percent requirement is intended to ensure that firms engaged heavily in derivatives trading will have their capital requirements rise in proportion to the size of their business and the risks they are taking.

The SEC's proposal also aims to update net capital rules for the country's largest brokerages that today rely on internal modeling to meet their net capital rules by raising the fixed minimum requirement from $500 million to $1 billion.

Currently, there are six firms that rely on internal modeling to meet the SEC's capital rules, all of which are large banks.


The SEC is also proposing to spare companies known as "end-users" that rely on swaps to hedge their business risks from having to post margin, such as some asset managers.

Instead, the margin rules are targeting trades between dealers or large swap traders.

Wednesday's proposal also lays out steps that swap dealers would need to take to protect their customers' money.

Modeled after rules for brokers today, it would require dealers to keep control over customers' fully paid and excess margin securities, and also to maintain a reserve in a bank account that is equal to the net cash owed to customers.

Exactly how the margin rules will work, however, is still unclear because the SEC's plan calls for two possible scenarios.

One is modeled after the banking regulators' and CFTC's proposal. That would require firms to collect both variation margin, which is based on daily market fluctuations, and initial margin - an extra cash cushion posted up front.

An alternative would not require firms to post initial margin. That is similar to how things work in today's market, and it marks a departure from the other financial regulators' thinking.

"These rules reflect both similarities and differences with those advanced by the other regulators," SEC Chairman Mary Schapiro said. "Some differences may be justified by differences in the markets or the types of entities to which the various rules apply."

Copyright 2010 by Reuters. All rights reserved.

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