2012-21414

Federal Register, Volume 77 Issue 176 (Tuesday, September 11, 2012)[Federal Register Volume 77, Number 176 (Tuesday, September 11, 2012)]

[Rules and Regulations]

[Pages 55903-55966]

From the Federal Register Online via the Government Printing Office [www.gpo.gov]

[FR Doc No: 2012-21414]

[[Page 55903]]

Vol. 77

Tuesday,

No. 176

September 11, 2012

Part II

Commodity Futures Trading Commission

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17 CFR Part 23

Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap

Trading Relationship Documentation Requirements for Swap Dealers and

Major Swap Participants; Final Rule

Federal Register / Vol. 77, No. 176 / Tuesday, September 11, 2012 /

Rules and Regulations

[[Page 55904]]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Part 23

RIN 3038-AC96

Confirmation, Portfolio Reconciliation, Portfolio Compression,

and Swap Trading Relationship Documentation Requirements for Swap

Dealers and Major Swap Participants

AGENCY: Commodity Futures Trading Commission.

ACTION: Final rule.

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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)

is adopting regulations to implement certain provisions of Title VII of

the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-

Frank Act). Section 731 of the Dodd-Frank Act added a new section 4s(i)

to the Commodity Exchange Act (CEA), which requires the Commission to

prescribe standards for swap dealers (SDs) and major swap participants

(MSPs) related to the timely and accurate confirmation, processing,

netting, documentation, and valuation of swaps. These regulations set

forth requirements for swap confirmation, portfolio reconciliation,

portfolio compression, and swap trading relationship documentation for

SDs and MSPs.

DATES: The rules will become effective November 13, 2012. Specific

compliance dates are discussed in the SUPPLEMENTARY INFORMATION.

FOR FURTHER INFORMATION CONTACT: Frank N. Fisanich, Chief Counsel, 202-

418-5949, cftc.gov">[email protected], Ward P. Griffin, Associate Chief Counsel,

202-418-5425, cftc.gov">[email protected] Division of Swap Dealer and

Intermediary Oversight, and Hannah Ropp, Economist, 202-418-5228,

cftc.gov">[email protected], Office of the Chief Economist, Commodity Futures

Trading Commission, Three Lafayette Centre, 1155 21st Street NW.,

Washington, DC 20581.

SUPPLEMENTARY INFORMATION

Table of Contents

I. Background

II. Comments on the Notices of Proposed Rulemaking

A. Regulatory Structure

B. Swap Trading Relationship Documentation

C. End User Exception Documentation

D. Swap Confirmation

E. Portfolio Reconciliation

F. Portfolio Compression

III. Effective Dates and Compliance Dates

A. Comments Regarding Compliance Dates

B. Compliance Dates

IV. Cost Benefit Considerations

A. Statutory Mandate to Consider the Costs and Benefits of the

Commission's Action

B. Background

C. Swap Confirmation

D. Portfolio Reconciliation

E. Portfolio Compression

F. Swap Trading Relationship Documentation

G. Swap Valuation Methodologies

V. Related Matters

A. Regulatory Flexibility Act

B. Paperwork Reduction Act

I. Background

The Commission is hereby adopting Sec. 23.500 through Sec. 23.505

\1\ setting forth standards for the timely and accurate confirmation of

swaps, requiring the reconciliation and compression of swap portfolios,

and setting forth requirements for documenting the swap trading

relationship between SDs, MSPs, and their counterparties. These

regulations are being adopted by the Commission pursuant to the

authority granted under sections 4s(h)(1)(D), 4s(h)(3)(D), 4s(i), and

8a(5) of the CEA. Section 4s(i)(1) of the CEA, requires SDs and MSPs to

``conform with such standards as may be prescribed by the Commission by

rule or regulation that relate to timely and accurate confirmation,

processing, netting, documentation, and valuation of all swaps.''

Documentation of swaps is a critical component of the bilaterally-

traded, over-the-counter (OTC) derivatives market, while confirmation,

portfolio reconciliation, and portfolio compression have been

recognized as important post-trade processing mechanisms for reducing

risk and improving operational efficiency. Each of these processes has

been the focus of significant domestic and international attention in

recent years by both market participants and their regulators.

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\1\ Commission regulations referred to herein are found at 17

CFR Ch. 1.

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II. Comments on the Notices of Proposed Rulemaking

The final rules adopted herein were proposed in three separate

notices of proposed rulemaking.\2\ Each proposed rulemaking was subject

to an initial 60-day public comment period and a re-opened comment

period of 30 days.\3\ The Commission received a total of approximately

62 comment letters directed specifically at the proposed rules.\4\ The

Commission considered each of these comments in formulating the final

regulations.\5\

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\2\ See 75 FR 81519 (Dec. 28, 2010) (Confirmation, Portfolio

Reconciliation, and Portfolio Compression Requirements for Swap

Dealers and Major Swap Participants (Confirmation NPRM)); 76 FR 6715

(Feb. 8, 2011) (Swap Trading Relationship Documentation Requirements

for Swap Dealers and Major Swap Participants (Documentation NPRM));

and 76 FR 6708 (Feb. 8, 2011) (Orderly Liquidation Termination

Provision in Swap Trading Relationship Documentation for Swap

Dealers and Major Swap Participants (Orderly Liquidation NPRM)).

\3\ See 76 FR 25274 (May 4, 2011) (extending or re-opening

comment periods for multiple Dodd-Frank proposed rulemakings).

\4\ Comment files for each proposed rulemaking can be found on

the Commission Web site, www.cftc.gov.

\5\ The Commission also reviewed the proposed rule of the

Securities and Exchange Commission concerning trade acknowledgement

and verification of security-based swap transactions. See 76 FR 3859

(Jan. 21, 2011).

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The Chairman and Commissioners, as well as Commission staff,

participated in numerous meetings with representatives of potential SDs

and MSPs, trade associations, public interest groups, traders, and

other interested parties. In addition, the Commission has consulted

with other U.S. financial regulators including: (i) The Securities and

Exchange Commission (SEC); (ii) the Board of Governors of the Federal

Reserve System; (iii) the Office of the Comptroller of the Currency;

and (iv) the Federal Deposit Insurance Corporation. Staff from each of

these agencies has had the opportunity to provide oral and/or written

comments to this adopting release, and the final regulations

incorporate elements of the comments provided.

The Commission is mindful of the benefits of harmonizing its

regulatory framework with that of its counterparts in foreign

countries. The Commission has therefore monitored global advisory,

legislative, and regulatory proposals, and has consulted with foreign

regulators in developing the final regulations. Specifically,

Commission staff has consulted with the European Securities and Markets

Authority (ESMA), which has recently released a consultation paper for

the regulation of OTC derivatives containing draft technical standards

that are substantially similar to some of the rules adopted by the

Commission in this release, as further noted below.\6\

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\6\ See ESMA Consultation Paper 2012/379, Draft Technical

Standards for the Regulation of OTC Derivatives, CCPs and Trade

Repositories (June 25, 2012) (ESMA Draft Technical Standards).

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A. Regulatory Structure

Several commenters raised general concerns with the legal authority

for or structure of the proposed rules, or their possible effect on

existing transactions.

1. Statutory Authority for the Proposed Rules

The Working Group of Commercial Energy Firms (The Working Group)

[[Page 55905]]

commented that many of the specific provisions in the proposed rules

are not required by section 731 of the Dodd-Frank Act and that such

provisions are not ``reasonably necessary'' to achieve the goals of the

CEA. The Working Group believes that the Commission could meet its

statutory mandate by publishing principle-based rules, rather than the

detailed approach of the proposed rules. Dominion Resources, Inc.

(Dominion) also asserted that the proposed rules would achieve a

regulatory scope beyond what is required by section 4s(i) and may

require end users to change their business practices. Dominion

requested that the proposed rules be further tailored to ensure the

effect of the rules is limited to SDs and MSPs.

The Commission notes that section 731 of the Dodd-Frank Act added a

new section 4s(i) to the CEA that states that each registered SD and

MSP shall conform with such standards as may be prescribed by the

Commission by rule or regulation that relate to timely and accurate

confirmation, processing, netting, documentation, and valuation of all

swaps. Section 4s(i) also states that the Commission shall adopt rules

governing documentation standards for SDs and MSPs.

Swaps and swap trading relationship documentation are contractual

arrangements that necessarily involve more than a single party. The

Commission believes that the statutory requirement that the Commission

adopt rules governing documentation standards relating to confirmation,

processing, netting, documentation, and valuation of all swaps reflects

the intent of Congress to have the Commission adopt rules that

necessarily effect SDs, MSPs, and their swap counterparties. The

Commission also believes the rules establish a set of documentation

standards for prudent risk management for registered SDs and MSPs while

minimizing the burdens on non-SDs and non-MSPs.

2. Application to Existing Swaps and Documentation

In response to a request for comment in the Documentation NPRM

asking how long SDs and MSPs should have to bring existing swap

documentation into compliance with the proposed rules and whether a

safe harbor should be provided for dormant trade documentation, the

International Swaps and Derivatives Association (ISDA) and the

Securities Industry and Financial Markets Association (SIFMA), in a

joint comment letter (ISDA & SIFMA), strongly urged the Commission to

specify that only new transactions entered into after the effective

date of the rules are subject to the rules' requirements, and that it

is not mandatory to amend terms or agreements that apply to

transactions entered into prior to such date. ISDA & SIFMA further

argued that Commission rules relating to business conduct, the

confirmation process, confidentiality and privacy, collateral

segregation requirements, and margin and capital may all directly or

indirectly require registrants to make amendments to existing

relationship documentation, and that it would be extremely inefficient,

time consuming and costly for registrants to engage in separate rounds

of amendments with their trading counterparties for each set of Dodd-

Frank Act rulemakings. ISDA & SIFMA recommended that registrants be

permitted to develop plans to update their agreements in an integrated

manner for the full range of Dodd-Frank Act requirements, and

implementation timelines should reflect the requirements of such an

approach, keeping in mind that those requirements will not be known

until the scope and terms of all of the relevant Commission regulations

(and those of the SEC) are more clearly delineated.

The Working Group and the Financial Services Roundtable (FSR) also

urged the Commission to apply the rules to new swaps only, arguing that

renegotiation of existing documentation would take significantly longer

than six months; may be impossible in some cases; and is not a good use

of limited resources of market participants that will already be taxed

with the necessary changes mandated by the Dodd-Frank Act and the

Commission's other rules. Likewise, the Coalition for Derivatives End-

Users urged the Commission to exempt trades entered into before the

enactment of the Dodd-Frank Act from the requirements of the rules and

the Managed Funds Association (MFA) strongly objected to the Commission

applying any of these requirements to existing contracts. MFA argued

that section 739(5) of the Dodd-Frank Act specifically provides that

the Dodd-Frank Act shall not constitute a ``regulatory change, or

similar event * * * that would permit a party to terminate,

renegotiate, modify, amend, or supplement one or more transactions

under the swap.'' MFA believes that imposing these requirements on

existing agreements would clearly require that existing agreements be

``renegotiated.''

The Federal Home Loan Banks (FHLBs) noted on the other hand that

netting of pre-existing transactions with new transactions is critical

to efficient hedging, and thus documentation for pre-existing swaps

will need to be modified to maintain the benefits of netting.

Having considered these comments, the Commission agrees with

commenters that the rules should not apply retrospectively and will

require compliance with the rules only with respect to swaps entered

after the date on which compliance with the rules is required, as

discussed below. With respect to the comment of the FHLBs, the

Commission notes that the rules would not prohibit parties from

arranging their documentation to maintain the benefits of netting

between pre-existing swaps and swaps entered after the date compliance

with the rules is required if they so choose. In addition, with regard

to ISDA & SIFMA's argument that swap trading documentation would need

to be amended when rules relating to segregation and margin are

finalized, the Commission observes that those rules are likely to

provide for additional time for documentation to be brought into

compliance.

3. Legal Certainty

With respect to the validity of transactions where the parties fail

to comply with the rules, The Working Group argued that for the sake of

legal certainty, a failure to comply with the proposed rules should not

result in invalidation of swaps entered into under deficient swap

trading relationship documentation. The Coalition of Physical Energy

Companies (COPE) recommended that the Commission make clear that

section 739 of the Dodd-Frank Act, regarding legal certainty, applies

to the proposed regulations so that SD or MSP noncompliance with the

rules will not otherwise affect the enforceability of a swap. MFA and

the International Energy Credit Association (IECA) also believe that it

is imperative that the Commission affirmatively clarify that defects in

required regulatory documentation do not render a contract void or

voidable by one of the parties or constitute a breach of the swap

documentation. IECA added that a party should not have a private right

of action with respect to documentation that does not comply with the

rules. IECA further requested that the Commission add specific language

to proposed Sec. 23.504. The FHLBs made the same argument as IECA,

adding that the Commission can enforce the provisions through penalties

for SDs and MSPs.

Upon consideration of these comments, the Commission is clarifying

that it is not the intent of the rules to provide swap counterparties

with a

[[Page 55906]]

basis for voiding or rescinding a swap transaction based solely on the

failure of the parties to document the swap transaction in compliance

with the rules. However, the Commission believes it does not have the

authority to immunize SDs or MSPs from private rights of action for

conduct within the scope of section 22 of the CEA, i.e., for violations

of the CEA. In the interest of legal certainty, to avoid disruptions in

the swaps market, and to reduce compliance costs, the Commission has

determined that it will, in the absence of fraud, consider an SD or MSP

to be in compliance with the rules if it has complied in good faith

with its policies and procedures reasonably designed to comply with the

requirements of each rule.

4. Standing of the ISDA Agreements

Several commenters requested that the Commission clarify the

standing under the rules of the ISDA Master Agreement and Credit

Support Annex (the ISDA Agreements), which are prevalent in the swaps

market. Specifically, ISDA & SIFMA commented that the proposed rules

could create uncertainty as to the level of documentation required

because the proposed rules require that ``all terms'' governing the

swap trading relationship be documented. ISDA & SIFMA thus requested

that the Commission acknowledge the general adequacy of the ISDA

Agreements for purposes of the rule to enhance legal certainty and

market stability. Similarly, COPE argued that many end users have

already negotiated existing documentation under the ISDA architecture

and thus requested that the Commission make clear that: (1) ISDA

Agreements or any substantially similar master agreements satisfy the

documentation requirements of the final rules; (2) in accordance with

the ISDA Agreements and applicable state law, swaps are binding when

made orally; and (3) long-form confirmations that contain all requisite

legal terms to establish a binding agreement also satisfy the

requirements of the rules. IECA also recommended that the Commission

expressly state that the ISDA Agreements satisfy the documentation

requirements of the final rules or state how the ISDA Agreements are

deficient to eliminate any confusion. Finally, the Coalition for

Derivatives End-Users argued that, given that the ISDA Agreements are

used by nearly all end users and that such documentation substantially

complies with the proposed rules, the Commission should expressly state

that the ISDA Agreements satisfy the documentation requirements of the

rules.

On the other hand, the Committee on the Investment of Employee

Benefit Assets (CIEBA) anticipates that ISDA may initiate a uniform

protocol to conform existing ISDA Agreements to the requirements of the

rules. In this regard, CIEBA stated that ISDA protocols, which in the

past have typically been developed by dealer-dominated ISDA committees,

are not form documents that can be revised by the parties. Rather,

CIEBA argues, end users may only adopt these protocols on a ``take it

or leave it'' basis, which may not be in their best interests.

Accordingly, CIEBA recommended that the Commission not, either

explicitly or implicitly, require market participants to consent to

ISDA protocols in order to comply with the Dodd-Frank Act or the

Commission's regulations.

The Commission notes that many comments received with respect to

this and other rulemakings stated that swaps are privately negotiated

bilateral contracts. Although the Commission recognizes that the ISDA

Agreements in their pre-printed form as published by ISDA are capable

of compliance with the rules, such agreements are subject to

customization by counterparties. In addition, the Commission notes that

while the pre-printed form of the ISDA Master Agreement is capable of

addressing the requirements of proposed Sec. 23.504(b)(1), it is not

possible to determine if the pre-printed form of the ISDA Credit

Support Annex will comply with proposed Sec. 23.504(b)(3), because

that section requires that the documentation include credit support

arrangements that comply with the Commission's rules regarding initial

and variation margin and custodial arrangements, which have been

proposed but not yet finalized. Further, the Commission does not

believe that the standard ISDA Agreements address the swap valuation

requirements of Sec. 23.504(b)(4), the orderly liquidation termination

provisions of Sec. 23.504(b)(5), or the clearing records required by

Sec. 23.504(b)(6). Given the foregoing, the Commission declines to

endorse the ISDA Agreements as meeting the requirements of the rules in

all instances.

5. Identical Rules Applicable to SDs and MSPs

The proposed regulations did not differentiate between SDs and

MSPs, but, rather, applied identical rules to both types of entities.

In this regard, BlackRock commented that MSPs are buy-side entities,

yet many of the proposed documentation standards are designed to

regulate dealing activity. BlackRock believes these requirements should

not apply to MSPs because they are unnecessary and will cause both MSPs

and the Commission to use resources inefficiently.

The Commission is not modifying the regulations to differentiate

between SDs and MSPs. The Commission observes that section 4s(i) of the

CEA, as added by the Dodd-Frank Act, does not differentiate between SDs

and MSPs. The Commission thus has determined that the intent of section

4s(i) is to apply the same requirements to MSPs and SDs, and the

Commission is taking the same approach in the final regulations.

B. Swap Trading Relationship Documentation--Sec. 23.504

Section 4s(i)(1) requires swap dealers and major swap participants

to ``conform with such standards as may be prescribed by the Commission

by rule or regulation that relate to timely and accurate confirmation,

processing, netting, documentation, and valuation of all swaps.'' Under

section 4s(i)(2), the Commission is required to adopt rules ``governing

documentation standards for swap dealers and major swap participants.''

OTC derivatives market participants typically have relied on the

use of industry standard legal documentation, including master netting

agreements, definitions, schedules, and confirmations, to document

their swap trading relationships. This industry standard documentation,

such as the widely used ISDA Master Agreement and related definitions,

schedules, and confirmations specific to particular asset classes,

offers a framework for documenting the transactions between

counterparties for OTC derivatives products.\7\ The standard

documentation is designed to set forth the legal, trading, and credit

relationship between the parties and to facilitate netting of

transactions in the event that parties have to close-out their position

with one another or determine credit exposure for margin and collateral

management. Notwithstanding the standardization of such documentation,

some or all of the terms of the master agreement and other documents

are subject to negotiation and modification.

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\7\ The International Swaps and Derivatives Association (ISDA)

is a trade association for the OTC derivatives industry (http://www.isda.org).

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To promote the ``timely and accurate * * * documentation * * * of

all swaps'' under section 4s(i)(1) of the CEA, in the Documentation

NPRM, the Commission proposed Sec. 23.504(a), which required that swap

dealers and major swap participants establish,

[[Page 55907]]

maintain, and enforce written policies and procedures reasonably

designed to ensure that each swap dealer or major swap participant and

its counterparties have agreed in writing to all of the terms governing

their swap trading relationship and have executed all agreements

required by proposed Sec. 23.504. The Commission received

approximately 31 comment letters in response to the Documentation NPRM

and considered each comment in formulating the final rules, as

discussed below.

1. Application to Swaps Executed on a SEF or DCM, or Cleared by a DCO

In response to a request for comment in the Documentation NPRM

regarding whether proposed Sec. 23.504 should include a safe harbor

for swaps entered into on, or subject to the rules of, a board of trade

designated as a contract market, ISDA & SIFMA, as well as the American

Benefits Counsel and the Committee on Investment of Employee Benefit

Assets (jointly, ABC & CIEBA), recommended that the Commission provide

such a safe harbor for swaps executed on a swap execution facility

(SEF) or designated contract market (DCM). ISDA & SIFMA commented that

the safe harbor is especially needed for those transactions where the

SD or MSP will not know the identity of its counterparty until just

before or after execution. ISDA & SIFMA also urged the Commission to

clarify that the term ``swap trading relationship documentation'' is

used to describe only bilateral documentation between parties to

uncleared swaps. MFA also recommended that the Commission clarify that

exchange traded or cleared swaps, which will be subject to standard

contract terms, are not subject to the documentation rules. The Working

Group commented that the swap trading relationship requirement in Sec.

23.504(a) includes a carve-out for swaps cleared with a DCO, but Sec.

23.504(b)(6) includes express requirements for the swap trading

relationship documentation with respect to cleared swaps. Given the

apparent contradiction, The Working Group requested that the Commission

clarify whether the other requirements of Sec. 23.504 apply to swaps

that are intended to be cleared contemporaneously with execution or

that are executed on a SEF or DCM.

In response to The Working Group's comment expressing confusion

about whether Sec. 23.504 applies to swaps that are cleared by a DCO

and to ISDA & SIFMA's comment regarding applicability to cleared swaps,

as well as the applicability to pre-existing swaps per the discussion

above, the Commission is modifying Sec. 23.504 to clarify the overall

applicability of the rule by adding a new paragraph (a)(1) as set forth

in the regulatory text of this rule.

This revision clarifies the circumstances under which the rule

applies. The proviso in Sec. 23.504(a)(1)(ii) would achieve the rule's

goal of avoiding differences between the terms of a swap as carried at

the DCO level and at the clearing member level, which could compromise

the benefits of clearing. Any such differences raise both customer

protection and systemic risk concerns. From a customer protection

standpoint, if the terms of the swap at the customer level differ from

those at the clearing level, then the customer will not receive the

full transparency and liquidity benefits of clearing, and legal and

basis risk will be introduced into the customer position. Similarly,

from a systemic perspective, any differences could diminish overall

price discovery and liquidity and increase uncertainties and

unnecessary costs into the insolvency resolution process. The cross

reference to Sec. 39.12(b)(6) imports the specific requirements that

had been included in proposed Sec. 23.504(b)(6)(v). See below for a

more complete discussion of Sec. 23.504(b)(6).

In response to the comment from ISDA & SIFMA, the Commission

clarifies that swaps executed anonymously on a SEF or traded on a DCM

prior to clearing by a DCO are not subject to the requirements of Sec.

23.504. For those swaps that are not executed anonymously, the swap

trading relationship documentation requirements of Sec. 23.504 would

apply.

2. Viability of Long-Form Confirmations as Swap Trading Relationship

Documentation--Sec. 23.504(a) & (b)

Proposed Sec. 23.504(b) required that all terms governing the

trading relationship between an SD or MSP and its counterparty be

documented in writing. Proposed Sec. 23.504(a) required that SDs and

MSPs establish policies and procedures reasonably designed to ensure

that the required swap trading relationship documentation be executed

prior to or contemporaneously with entering into a swap transaction

with any counterparty. The Commission notes the industry practice

whereby counterparties enter into a ``long-form confirmation'' after

execution of transaction, where the long-form confirmation contains

both the terms of the transaction and many, if not all, terms usually

documented in a master agreement until such time as a complete master

agreement is negotiated and executed.

The Office of the Comptroller of the Currency (OCC) commented that

the proposed rule may require master agreements between all

counterparties even if a ``long-form'' confirmation would sufficiently

address legal risks, creating a significant expense and burden for end

users. Similarly, IECA commented that long form confirmations that

incorporate the terms of a standard master agreement are useful for

certain new transaction relationships. In this respect, IECA recommends

that Sec. 23.504(b)(1) be modified to make clear that terms can be

incorporated by reference.

In response to these comments, the Commission has determined that

so long as a ``long-form'' confirmation includes all terms of the

trading relationship documented in writing prior to or

contemporaneously with the assumption of risk arising from swap

transactions, the ``long-form'' confirmation would comply with the

rules. However, the Commission is not modifying the rule to permit

execution of a long-form confirmation subsequent to the execution of a

swap transaction, which the Commission believes results in some period,

however short, in which the terms of the trading relationship between

the parties are not in written form. In response to the comment of

IECA, the rule does not prohibit incorporation of terms by reference.

Thus, so long as the terms incorporated by reference are in written

form, the documentation would be in compliance with the rule.

3. Confirmation Execution Timing and Swap Trading Relationship

Documentation--Sec. 23.504(a) & (b)(2)

Proposed Sec. 23.504(b)(2) states that swap trading relationship

documentation includes transaction confirmations. Proposed Sec.

23.504(a) requires swap trading relationship documentation to be

executed prior to or contemporaneously with entering into any swap with

a counterparty. However, proposed Sec. 23.501 provides for specific

post-execution time periods for confirming swaps. This apparent

contradiction was identified by a number of commenters.

In order to reconcile the apparent contradiction, ISDA & SIFMA

recommended that confirmations be excluded from swap trading

relationship documentation and be treated solely in Sec. 23.501. MFA

also recommended that confirmations be treated solely in Sec. 23.501,

noting that if forced to choose between quick execution and the

negotiation of all

[[Page 55908]]

terms, the proposed rule's timing requirements might substantially

limit end users' ability to engage in proper risk management using

tailored swaps. MFA also commented that unless modified, the rule might

decrease the number of transactions in the markets, thereby decreasing

liquidity and increasing volatility.

IECA noted that many short term transactions are executed orally

and often documented by recording, ending before a written confirmation

can be completed. IECA also stated that if all confirmations must be in

writing, the additional employee time cost for each market participant

would be substantial and is not included in the annual cost analysis.

The Working Group also commented that in some instances, it may take

longer to negotiate a written confirmation for a swap or complete the

necessary mid- and back-office processes than the planned duration of

the swap at issue. IECA recommended that proposed Sec. 23.504(b)(2) be

modified by adding at the end, ``which confirmations need not be in

writing.''

MetLife commented that the requirement to document ``all'' terms of

a trading relationship is overly burdensome. MetLife believes the

documentation subject to regulation should be clarified to mean two

sets of documents: A master agreement, credit support arrangement and

master confirmation agreement and second, transaction specific

confirmations. The confirmations can include any trade specific terms

including specific valuation methodologies or inputs not already

contained in the master documentation. Differentiation would assist

with clarity for policies and procedures and with the audit

requirements.

The Coalition for Derivatives End-Users and The Working Group

commented that the rule may require pre-trade negotiation and

disadvantage the party that is most sensitive to the timing of the swap

in such negotiations. The Working Group believes such party may have to

accept less than favorable terms in order to execute within its desired

time frame, and that the rule would make it very difficult for parties

to enter into short-term swaps. The Coalition for Derivatives End-Users

point out that end-users often trade by auction and given the low

probability of winning, SDs will not want to incur the expense of

negotiating documents in advance. The Coalition for Derivatives End-

Users also point out that even where established relationships exist,

newly formed affiliates may trade based on existing expectations, but

without the documents fully executed.

On the other hand, CIEBA commended the Commission for including all

terms in swap trading relationship documentation. CIEBA believes this

approach will minimize the potential for disputes over swap terms

during the confirmation process caused by the introduction of new

``standard'' terms after the swap is executed, which CIEBA stated is a

frequent occurrence. CIEBA recommended that the Commission confirm in

its final rules that the requirement that documentation ``shall include

all terms governing the trading relationship between the swap dealer or

major swap participant and its counterparty'' would require all terms

to be in writing prior to or at the time of entering into the swap

transaction, except for terms such as price, quantity and tenor, that

are customarily agreed to contemporaneously with entering into a swap

transaction. CIEBA recommended that the rule require these remaining

terms to be documented in writing contemporaneously with entering into

the swap transaction.

Having considered these comments, the Commission has determined

that proposed Sec. 23.504(a) should be clarified with respect to the

inclusion of swap confirmations in swap trading relationship

documentation. The Commission is therefore modifying the proposed rule

to make clear that the timing of confirmations of swap transactions is

subject to Sec. 23.501, and that swap trading relationship

documentation other than confirmations of swap transactions is required

to be executed prior to or contemporaneously with entering into any

swap transaction.

The Commission does not, however, agree with commenters suggesting

that terms governing a swap or a trading relationship need not be in

writing. The Commission recognizes that binding swap contracts may be

created orally under applicable law and the rule does not affect

parties' ability to enforce such contracts. However, an orderly swap

market and the goal of reducing operational risk require that such oral

contracts be appropriately documented as soon as possible. In response

to the comments of CIEBA, the Commission believes the modifications to

the confirmation time periods in Sec. 23.501 discussed below

adequately address CIEBA's concerns. Given the foregoing, the

Commission is modifying proposed Sec. 23.504(a) to read as set forth

in the regulatory text of this rule

4. Swap Trading Relationship Documentation Among Affiliates

The proposed regulations did not include an exemption or different

rules for documenting swap trading relationships between affiliates.

Shell Energy North America (Shell) commented that an end user trading

with an affiliated SD/MSP does not have valuation, trade, and

documentation risks that nonaffiliated entities may have, that such

transactions only allocate risk within the legal entity, and,

accordingly, affiliate transactions should be exempted from the

documentation rules.

The Commission is not persuaded that the risk of undocumented (and

therefore objectively indiscernible) terms governing swaps is obviated

because the trading relationship is with an affiliate. The Commission

has regulatory interests in knowing or being able to discover the full

extent of a registered SD's or MSP's risk exposure, whether to external

or affiliated counterparties, and is not modifying the rule in response

to this comment. The Commission observes that to the extent certain

risks are not present in affiliate trading relationships, the

documentation of the terms related to such risks should be non-

controversial and easily accomplished. For example, because affiliates

are generally under common control, the documentation of an agreement

on valuation methodologies should not require extensive negotiation as

it may between non-affiliated counterparties.

5. Use of ``Enforce'' in Proposed Sec. 23.504(a)

Proposed Sec. 23.504(a) required that each SD and MSP establish,

maintain, and enforce policies and procedures designed to ensure that

prior to or contemporaneously with entering into a swap transaction, it

executes swap trading relationship documentation that complies with the

rules.

CEIBA questions what is intended by the requirement for SDs and

MSPs to ``enforce policies and procedures'' in Sec. 23.504(a). CEIBA

believes the use of the term ``enforce'' with respect to SDs' and MSPs'

procedures is contrary to the Dodd-Frank Act, because it implies that

such procedures have the force of law and can be imposed on

counterparties absent mutual agreement. CIEBA recommended that the word

``enforce'' should be deleted.

Having considered this comment, the Commission is modifying the

proposed rule by replacing the term ``enforce'' with the term

``follow.'' The intent of the term ``enforce'' in the proposed rule was

to require SDs and MSPs to in fact follow the policies and procedures

established to meet the requirements of the proposed rule, rather than

to enforce

[[Page 55909]]

its internal policies and procedures against third parties.

6. Payment Obligation Terms--Sec. 23.504(b)

In the Documentation NPRM, the Commission asked whether the

proposed rules should specifically delineate the types of payment

obligation terms that must be included in the trading relationship

documentation.

CIEBA commented that the Commission need not dictate every term

that must appear in swap trading relationship documentation, and that

it is important to defined benefit plans to be able to negotiate

payment obligation terms in their documentation.

The Commission agrees with CIEBA on this issue and has not modified

the rule to further define the types of payment obligation terms

required to be specified in swap trading relationship documentation.

7. Additional Requirements for Events of Default and Termination Events

In the Documentation NPRM, the Commission asked whether the

requirement for agreement on events of default or termination events

should be further defined, such as adding provisions related to cross

default.

The Coalition for Derivatives End-Users commented that the ISDA

documentation sufficiently addresses these issues and that parties

should be allowed to negotiate these terms bilaterally so the

Commission need not further define such terms. CIEBA agreed that

parties should be allowed to negotiate these terms bilaterally so the

Commission need not further define such terms.

The Commission agrees with the commenters on this point and has not

modified the rule to further define the types of events of defaults and

termination events required to be specified in swap trading

relationship documentation.

8. Senior Management Approval of Documentation Policies and

Procedures--Sec. 23.504(a)

Proposed Sec. 23.504(a) required SDs' and MSPs' documentation

policies and procedures to be approved in writing by senior management

of the SD or MSP.

The Working Group raised a concern that this requirement will be

used to the negotiating advantage by SDs and MSPs who will claim that

the form of documentation had been approved for regulatory purposes and

cannot be changed without a prohibitively lengthy internal approval

process. In addition, The Working Group argued that rigid documentation

standards that must be approved by senior management could severely

limit the flexibility of SDs, ending the ability of end users to obtain

customized swaps in a timely manner. The Working Group recommended that

the Commission allow current practice to continue where trading

managers can authorize deviations from standard trade documentation so

long as such amendment does not violate the overarching policies and

procedures set by internal management authorized by the governing body.

MFA similarly commented that the senior management approval

requirement, together with the cumulative effect of the proscriptive

documentation rules, may lead to the institutionalization of the terms

favored by SDs and MSPs. As a result, MFA is concerned that SDs and

MSPs will compel their customers to accept unfavorable terms or forego

time-sensitive market opportunities. Accordingly, MFA recommended that

each party should be free to assess requisite approval levels for

various kinds of swap activity based on its unique organizational

structure.

IECA commented that review by senior management is an unnecessary

use of management time. Most SDs and MSPs have risk management policies

that provide a framework for elevating issues through levels of

management as applicable. By requiring senior management to review too

many modifications, many that can be reviewed by lower levels with

appropriate expertise, it is likely that senior management may actually

miss the major issues that should get attention. Also, IECA argued that

the chilling effect of the rule could stifle risk management efforts,

innovation, and increase counterparty risk as review processes become

too rigid in order to comply with regulatory requirements.

The Commission is not modifying the rule based on these comments.

The commenters' concerns are overly broad because the rule requires

senior management of SDs and MSPs to approve the ``policies and

procedures'' governing swap trading documentation practices, not to

approve each agreement, transaction, or modifications thereto. The rule

does not prohibit SDs and MSPs from establishing policies and

procedures instituting a framework for elevating issues through a

hierarchy of management as each sees fit, so long as such framework has

been approved in writing by senior management.

9. Dispute Resolution Procedures--Sec. 23.504(b)(1)

Proposed Sec. 23.504(b)(1) required SDs' and MSP's swap trading

relationship documentation to include dispute resolution procedures. In

the Documentation NPRM preamble, the Commission asked whether the

proposed rules should include specific requirements for dispute

resolution (such as time limits), and if so, what requirements are

appropriate for all swaps.

ISDA & SIFMA objected that the requirement that the parties agree

to dispute resolution procedures is not authorized by the Dodd-Frank

Act and that denying parties to a swap access to the judicial system is

not a measure that should be taken lightly or without Congressional

consideration. Similarly, IECA believes the proposed regulations for

dispute resolution are too specific and could violate separation of

powers under the Constitution.

On the other hand, CIEBA responded that the rules should not

include specific requirements, with the exception of requiring the

availability of independent valuation agents that are agreed upon by

the parties. CIEBA recommended that the Commission propose only a set

of fair and even-handed principles for resolving disputes.

In response to these comments, the Commission is modifying the

proposed rule to delete the term ``procedures'' from the requirement

that swap trading relationship documentation include ``terms addressing

* * * dispute resolution procedures.'' The Commission notes that the

rule as proposed was not intended to require SDs and MSPs to agree with

their counterparties on specific procedures to be followed in the event

of a dispute, but rather to require that dispute resolution be

addressed in a manner agreeable to both parties, whether it be in the

form of specific procedures or a general statement that disputes will

be resolved in accordance with applicable law. The Commission believes

that some form of agreement on the handling of disputes between SDs,

MSPs, and their counterparties will be essential to ensuring the

orderly operation of the swaps market.

10. Documentation of Credit Support Arrangements--Sec. 23.504(b)(3)

Proposed Sec. 23.504(b)(3) required that the swap trading

relationship documentation include certain specified details of the

credit support arrangements of the parties.

Better Markets recommended that the Commission revise the proposed

rule to

[[Page 55910]]

require documentation of the terms under which credit may be extended

to a counterparty by a registrant in the form of forbearance from

funding of margin and the cost of such credit extension, arguing that

such credit extension and the cost thereof, which is embedded in the

price of a swap, seriously impairs the transparency of the market by

concealing the true price of a swap divorced from the cost of credit.

Michael Greenberger commented that leaving terms and rules

regarding credit extension and transactional fees to subjective desires

of market participants will be counterproductive. Mr. Greenberger

supports the comment letter by Better Markets, Inc., which urges the

Commission to propose definitive rules requiring documentation of

credit extension and transactional fees.

COPE asked the Commission to clarify that the rule requires trading

documentation to include any applicable margin provisions and related

haircuts, but does not require margining and haircuts unless agreed by

the parties. IECA echoed the COPE comment, stating that the proposed

rule is unclear whether parties can enter into a swap that requires no

margin, as is contemplated in the Dodd Frank Act.

CIEBA commented that proposed Sec. 23.504(b)(3) should be

clarified by adding the words ``if any'' to the end of each of

subsections (i) through (iv) to make clear that end users are not

required to post initial margin or allow rehypothecation.

Having considered these comments, the Commission is of the view

that the proposed rule was not intended to require margin or related

terms where such are not required pursuant to other Commission

regulations or the applicable regulations adopted by prudential

regulators. The proposed rule was intended to require written

documentation of any credit support arrangement, whether that be a

guarantee, security agreement, a margining agreement, or other

collateral arrangement, but only to require written documentation of

margin terms if margin requirements are imposed by Commission

regulations, the regulations of prudential regulators, or are otherwise

agreed between SDs, MSPs, and their counterparties. Thus, in response

to commenters' requests for clarification, the Commission is modifying

the proposed rule as recommended by CIEBA by adding ``if any'' at the

end of each of subsections (i) through (iv) of Sec. 23.504(b)(3). The

Commission expects that other forms of credit support arrangements will

be documented in accordance with the rule as well.

However, the Commission is not revising the rule to enumerate the

terms of any extension of credit that are required to be included in

the documentation, as recommended by Better Markets. The Commission

believes that the rule, as proposed and as adopted by this release,

already requires documentation of initial and variation margin

requirements, which necessarily will entail documentation of any

extension of credit, i.e., the documentation will reflect whether

margining is subject to any credit extension threshold. Thus, to the

extent applicable, credit support arrangements must include, at a

minimum, the maximum amount of credit to be extended, the method for

determining how much credit has been extended, and any term of the

facility and early call rights. During negotiations regarding credit

support arrangements, counterparties would be well served to address

issues related to the embedded cost of credit. The Commission also

observes that transactional fees are required to be disclosed under

Sec. 23.431 of the Business Conduct Standards for SDs and MSPs Dealing

with Counterparties.\8\

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\8\ See Subpart H of Part 23 of the Commission's Regulations,

Business Conduct Standards for Swap Dealers and Major Swap

Participants with Counterparties, 77 FR 9734, 9824 (Feb. 17, 2012).

In addition, to the extent that any cost of credit may be embedded

in the price of a swap, the Commission believes that the disclosure

of the mid-market mark, which must be disclosed when an SD or MSP

discloses the price of a swap, will facilitate greater transparency

concerning the embedded cost of credit. Id. at 9765-66 (discussing

new Sec. 23.431(a)(3)(i)).

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11. Legal Enforceability of Netting and Collateral Arrangements--Sec.

23.504

The proposed regulations did not require SDs and MSPs to document

the legal enforceability of netting and collateral arrangements in the

swap trading relationship documentation.

In this regard, Volvo Financial Services Europe (Volvo) recommended

that the Commission adopt a rule that states clearly that credit

support arrangements should include legal opinions (updated annually)

verifying the perfection of security interests in collateral supporting

net exposures. Volvo argued that lack of legal certainty contributed to

losses in the 2008 financial crisis where counterparties discovered

that un-perfected security interests resulted in the unenforceability

of pledged collateral. Specifically, Volvo recommended that the

Commission revise the proposed rules to require: (i) Mandatory

collateralization, (ii) robust legal opinions (updated annually) on

enforceability of collateral arrangements, (iii) zero risk weighting if

robust legal opinions are obtained, and (iv) regular collateral audits

by the Commission to ensure that market participants perform the

perfection formalities of security interests.

Although the Commission agrees with the commenter that SDs and MSPs

should support their collateral arrangements with all necessary legal

analysis, the Commission has not made any changes to the proposed rule

based on this comment because the Commission believes (1) Volvo's

concerns regarding margining of uncleared swaps are addressed in the

Commission's proposed margin rules, or the prudential regulators'

proposed margin rules, as applicable, and (2) Volvo's concerns

regarding the legal enforceability of collateral arrangements is

addressed in risk management rules adopted by the Commission in

February, 2012.\9\

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\9\ See 17 CFR 23.600(c)(4)(v)(A) requiring SDs and MSPs to

establish policies and procedures to monitor and manage legal risk,

including policies and procedures that take into account

determinations that transactions and netting arrangements entered

into have a sound legal basis. 77 FR 20128, 20206 (Apr. 3, 2012).

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12. Valuation Methodology Requirement--Sec. 23.504(b)(4)

Proposed Sec. 23.504(b)(4) required that the swap trading

relationship documentation of each SD and MSP with their counterparties

include an agreement in writing on the methods, procedures, rules, and

inputs for determining the value of each swap at any time from

execution to the termination, maturity, or expiration of such swap.

a. Comments Received

Twenty of the comment letters received by the Commission addressed

the proposed valuation requirement in Sec. 23.504(b)(4). Many of those

comments raised similar concerns about the proposal, as summarized

thematically, below:

The Working Group, ISDA & SIFMA, FSR, White & Case, Morgan Stanley,

COPE, MFA, IECA, FHLBs, Hess Energy Trading Company, LLC (Hess),

Riverside Risk Advisors LLC, and Edison Electric Institute (EEI)

commented that valuation disputes provide valuable information to both

market participants and regulators about pricing dislocations and

associated credit risks and a static, rigid valuation methodology

necessarily produces values that become increasingly outdated over time

and could impede

[[Page 55911]]

the transmission of this important risk information.

The Working Group, ISDA & SIFMA, FSR, Markit, Freddie Mac, COPE,

MFA, FHLBs, CIEBA, EEI, and the Coalition of Derivatives End Users

commented that requiring agreement on valuation methodologies and set

alternative methods will materially increase the pre-execution

negotiating burden without an offsetting benefit and agreement on

models for complex swaps would require negotiations that could take

sophisticated professionals months to complete, if such could be

completed at all.

The Working Group, FSR, OCC, and Markit commented that it is

impossible to state valuation methodologies with the required

specificity without disclosing proprietary information about the

parties' internal models.

OCC and Hess commented that requiring agreement on valuation

methodologies may discourage development of more refined, dynamic swap

valuation models, which would lead to use of less sophisticated or

vanilla models that are less accurate than their proprietary

counterparts.

ISDA & SIFMA and IECA commented that agreeing on a methodology that

could survive the loss of any input to the valuation is wholly

unworkable, will diminish standardization as parties negotiate bespoke

approaches to valuation, and will undermine legal certainty if the

valuation methodology is determined not to be adaptable to all

circumstances.

COPE, FHLBs, MFA, EEI, and Markit commented that there is no

business need for swap-by-swap valuation formulas because valuation of

exposures with counterparties is usually conducted on a portfolio basis

and documented in a master agreement, and that agreement on swap-by-

swap valuation formulas also is likely to disrupt trading.

Several commenters also recommended alternative approaches to the

valuation requirement. The Working Group, Morgan Stanley, MFA, IECA,

FHLBs, CIEBA, and MetLife suggested that the focus of the rule should

be on the valuation dispute resolution process rather than valuation

methodologies that include fallback alternatives and other static

terms. MetLife specifically recommended that the Commission establish

``mandatory dispute resolution guidelines'' that include a requirement

for a third party arbiter after a set period of time.

With respect to valuation methodologies, CIEBA and Chris Barnard

recommended that the rule require SDs to value swaps on the basis of

transparent models that can be replicated by their counterparty. The

Working Group requested that the Commission clarify that parties are

permitted to use different valuation methodologies under different

circumstances (i.e., mid-market valuation for collateral purposes and

replacement cost valuation for terminations). Markit and MFA requested

that the Commission clarify that parties may rely on a more general set

of inputs, models, and fallbacks for valuation purposes, rather than

the exhaustive fallbacks required by the rule. White & Case and IECA

recommended that the Commission permit parties to change the valuation

method and inputs as the market changes over time. Freddie Mac

suggested that the rule should provide that the valuation methodology

requirement can be satisfied by executing industry standard

documentation that provides for a commercially reasonable valuation

methodology. The Coalition of Derivatives End Users, IECA, and Chris

Barnard recommended that proprietary inputs be allowed under the rule.

More generally, FSR recommended that the Commission withdraw the

proposed valuation requirement until the Commission has the time to

conduct a thorough study, including a comprehensive cost-benefit

analysis, whereas Markit recommended that the rule be modified to

explicitly allow parties to comply with the rule by agreeing that an

independent third party may provide any or all of the elements required

to agree upon the valuation of swaps. The Coalition of Derivatives End

Users recommended that the Commission change the rule to require SDs

and MSPs to provide commercially reasonable information to substantiate

its valuations upon an end user's request, instead of requiring

extensive pre-trade documentation of valuation methodology.

The Working Group recommended that the Commission modify the rule

to provide that the valuation requirements for cleared swaps or swaps

executed on a trading facility should be satisfied by referencing the

price provided by the relevant DCO or facility, while Markit

recommended that the Commission clarify that neither prices of recently

executed transactions or any other single pricing input should be

regarded as preferable inputs for the valuation of swaps and explicitly

permit parties to use pricing sources other than DCOs, even for cleared

swaps.

A number of commenters supported the rule. Chris Barnard strongly

supported the requirement that the agreed methods, procedures, rules

and inputs constitute a ``complete and independently verifiable

methodology for valuing each swap entered into between the parties,''

and that the methodology must include alternatives ``in the event that

one or more inputs to the methodology become unavailable or fail.'' Mr.

Barnard also supported the requirement for SDs and MSPs to ``resolve a

dispute over the valuation of a swap within one business day.'' Michael

Greenberger generally supported the valuation methodology rule to

promote transparency and financial integrity. MetLife agreed with the

proposal that parties should determine upfront what the valuation

methodologies will be to help mitigate disputes, but believes that

disputes will not be eliminated by the rule.

CIEBA commended the Commission for requiring objective and specific

valuation mechanisms in swaps documentation and believes that this

requirement will limit the potential for valuation disputes. However,

CIEBA believes requiring objective and specific valuation mechanisms is

not enough. In addition to requiring SDs to value swaps using

transparent models that can be replicated by their counterparties,

CIEBA recommended that the Commission require the mechanisms or

procedures by which disputes are resolved to be fair and even-handed

and should not override existing contractual protections negotiated by

the parties.

b. Commission Response

Having considered these comments, the Commission is modifying and

clarifying the proposal in a number of ways. First, in response to

concerns from non-financial entities regarding the cost and the

challenges of pre-execution negotiation, the Commission is modifying

the rule to require valuation documentation only at the request of non-

financial entities. In other words, non-financial entities will have

the ability, but not the obligation, to enter into negotiations on

valuation with their SD or MSP counterparties. As discussed below, the

rule will continue to apply to SDs, MSPs, and financial entities.

While the Commission agrees with commenters regarding the

importance of using transparent models that can be replicated, the

Commission recognizes concerns about protecting proprietary information

used in internal valuation models. Thus, the Commission has modified

the rule to clarify the requirement that the agreement on valuation use

objective criteria, such as recently-executed transactions and

valuations provided by independent third parties. In this regard, the

[[Page 55912]]

Commission agrees with The Working Group that the valuation

requirements for cleared swaps or swaps executed on a trading facility

would be satisfied by referencing the price provided by the relevant

DCO, SEF, or DCM.

Additionally, the Commission confirms commenters' understanding

that proprietary models may be used for purposes of valuation, provided

that both parties agree to the use of one party's confidential,

proprietary model. An agreement by the parties to use one party's

confidential, proprietary model is sufficient to satisfy the

requirements of Sec. 23.504(b)(4)(i), including the requirement that

the parties agree on the methods, procedures, rules and inputs for

determining the value of each swap. On the other end of the spectrum

from simply agreeing to use one party's model, counterparties may, if

they choose, elect to negotiate precisely which model and inputs will

govern the valuation of their swaps. Counterparties would be free to

elect either of these options or many other possibilities under the

terms of Sec. 23.504(b)(4) so long as the resulting valuations are

sufficient to comply with the margin requirements under section 4s(e)

of the CEA and the risk management requirements under section 4s(j) of

the CEA, and there is a dispute resolution process in place or a viable

alternative method for determining the value of the swap. Moreover, the

Commission is modifying proposed Sec. 23.504(b)(4)(iii) to clarify

that confidential, proprietary model information is protected under the

rule.

To address concerns that the use of the phrase ``methods,

procedures, rules, and inputs'' could be interpreted as requiring

agreement on the precise model and all inputs for valuing a swap, the

Commission is modifying the rule text to require that parties agree on

``the process, including methods, procedures, rules, and inputs for

determining the value of each swap.''

Importantly, the Commission is responding to commenters' concerns

about the requirement that the valuation documentation be stated with

sufficient specificity to allow the SD, MSP, the Commission, and any

prudential regulator to value the swap ``independently in a

substantially comparable manner.'' Commenters viewed this standard as

problematic because they read it to require disclosure of proprietary

information or to prevent the updating or revising of models, among

other things. Accordingly, the Commission has determined to remove this

provision from the final rule. So long as the valuation documentation

is stated with sufficient specificity to determine the value of the

swap for purposes of complying with the requirements of the rule--

namely, the margin and risk management requirements under section 4s of

the CEA and Part 23 of Commission regulations--the requirements of

Sec. 23.504(b)(4)(i) would be met.

Under this approach, parties may rely on a general set of methods,

inputs, models, and fallbacks for valuation purposes so long as the

process is sufficient to determine the value of a swap. In response to

concerns that the proposal would require a methodology that would be

static or rigid over time, the Commission is further modifying the rule

to make explicitly clear that the parties may agree on a process,

including methods or procedures for modifying or amending the valuation

process as circumstances require and as the market changes over

time.\10\

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\10\ To the extent that one or both parties foresee that the

valuation method or inputs agreed for a swap or a class or category

of swaps will likely require modification, parties would be well-

served to agree in advance in their swap trading relationship

documentation on an appropriate arrangement for accommodating such

modifications.

---------------------------------------------------------------------------

The Commission does not disagree with commenters that differences

in valuations can provide valuable information to both market

participants and regulators about pricing dislocations and associated

credit risks. Moreover, the objective is not to produce values that

become increasingly outdated over time. Rather, the Commission believes

that by requiring agreement between counterparties on the methods and

inputs for valuation of each swap, Sec. 23.504(b)(4) will assist SDs

and MSPs and their counterparties to arrive at valuations necessary for

margining and internal risk management, and to resolve valuation

disputes in a timely manner, thereby reducing risk.

Agreement between SDs, MSPs, and their financial entity

counterparties on the proper daily valuation of the swaps in their swap

portfolio is an essential component of the Commission's margin

proposal. Under proposed Sec. 23.151, non-bank SDs and MSPs must

document the process by which they will arrive at a valuation for each

swap for the purpose of collecting initial and variation margin in

compliance with the requirements of Sec. 23.504. All non-bank SDs and

MSPs must collect variation margin from their non-bank SD, MSP, and

financial entity counterparties for uncleared swaps on a daily basis.

Variation margin requires a daily valuation for each swap. For swaps

between non-bank SDs and MSPs and non-financial entities, no margin is

required to be exchanged under Commission regulation, but the non-bank

SDs and MSPs must calculate a hypothetical variation margin requirement

for each uncleared swap for risk management purposes under proposed

Sec. 23.154(b)(6).\11\ The daily valuation agreed to by the

counterparties is necessary for compliance with the margin requirements

proposed by the Commission and the prudential regulators under section

4s(e) of the CEA.

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\11\ SDs and MSPs that are banks are subject to the requirements

of section 4s(i). In addition, under the prudential regulators'

margin proposal, SDs and MSPs that are banks would be required to

have documentation in place that specifies the ``(1) [t]he methods,

procedures, rules, and inputs for determining the value of each swap

* * * for purposes of calculating variation margin requirements; and

(2) [t]he procedures by which any disputes concerning the valuation

of swaps * * * or the valuation of assets collected or posted as

initial margin or variation margin, may be resolved.'' Margin and

Capital Requirements for Covered Swap Entities, 76 FR 27564, 27589

(May 11, 2011).

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In addition to the fact that arriving at a daily valuation is one

of the building blocks for the margin rules, timely and accurate

valuations are essential for the risk management of swaps by SDs and

MSPs. Under Sec. 23.600(c)(4)(i), the Commission required that SDs and

MSPs have risk management policies and procedures that take into

account the daily measurement of market exposure, along with timely and

reliable valuation data. The valuation documentation requirements under

Sec. 23.504(b) and the risk management provisions of Sec. 23.600 work

together to ensure that SDs and MSPs have the most accurate and

reliable valuation data available for internal risk management and for

collateralization of risk exposures with counterparties. This is not to

say that valuation disputes can be prevented entirely or that these

disputes do not, at times, offer useful insight into the marketplace.

Indeed, risk management personnel and management within the SD or MSP

should pay particular attention to different valuations for the same

swap originating within their organization or from outside the entity.

For these purposes, the Commission expects that valuation disputes that

are not resolved in accordance with these rules be elevated to senior

management in the firm.\12\ However, the final rule reflects the

recognition that accurate and

[[Page 55913]]

reliable valuations are the foundation of margining and risk

management.

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\12\ Under Sec. 23.600(c)(1)(1)(iii), the risk management

program requires SDs and MSPs to have policies and procedures for

detecting breaches of risk tolerance limits set by an SD or MSP, and

alerting supervisors within the risk management unit and senior

management, as appropriate.

---------------------------------------------------------------------------

The Commission also agrees with commenters that the trading

documentation should be permitted to focus on the valuation dispute

resolution process rather than exclusively on fallback methodologies,

and has further modified the rule to allow for either fallback

methodologies or agreement on a dispute resolution process, but does

not think it necessary or desirable to specify a standard dispute

resolution process at this time, as requested by MetLife.

Lastly, the Commission wishes to distinguish its use of the terms

``valuation'' under section 4s(i) of the CEA and ``daily mark'' under

section 4s(h). In its final rules for Business Conduct Standards for

SDs and MSPs with Counterparties, the Commission explained that the

daily mark for uncleared swaps represented the mid-market mark of a

swap provided by an SD or MSP to its counterparty.\13\ The mid-market

mark of the swap represents an objective value that provides

counterparties with a baseline to assess swap valuations for other

purposes.\14\ By contrast, in Sec. 23.504(b)(4), the Commission is

requiring that SDs, MSPs, and their counterparties agree to a process

for determining the current market value or net present value of a swap

for purposes of collateralizing the risk posed by the swap and internal

risk management. The critical difference being the agreement of both

counterparties to the process for determining the value of a swap,

rather than just the SD's or MSP's calculation of the mid-market value

of the swap.

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\13\ See 77 FR 9734, 9767-68 (Feb. 17, 2012); see also Swap Data

Recordkeeping and Reporting Requirements, 77 FR 2136, (Jan. 13,

2012) (defining ``valuation data'' by reference to section

4s(h)(3)(B)(iii) of the CEA and Sec. 23.431.

\14\ See Sec. 23.431(d). SDs and MSPs must provide a daily mark

for uncleared swaps that is the mid-market mark of the swap which

does not include amounts for profit, credit reserve, hedging,

funding, liquidity, or any other costs or adjustments.

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13. Application to Cleared Swaps--Sec. 23.504(b)(6)

Proposed Sec. 23.504(b)(6) required the swap trading relationship

documentation of SDs and MSPs to include certain items upon acceptance

of a swap for clearing by a DCO, including documentation of each

counterparty's clearing member, the date and time the swap was cleared,

that the swap conforms to the terms of the DCO's templates, and that

the clearing member's books reflect the terms of the swap at the DCO.

The proposed regulation also required the documentation to contain a

statement that the original swap is extinguished and replaced by a swap

subject to the rules of the DCO.

ISDA & SIFMA urged the Commission to clarify that the term ``swap

trading relationship documentation'' is used to describe only bilateral

documentation between parties to uncleared swaps. ISDA & SIFMA

recommend that the Commission not finalize Sec. 23.504(b)(6) because

ISDA & SIFMA (1) Saw no need to record the identity of its

counterparty's clearing member; (2) recommended that the obligation to

provide notice of the date and time of clearing and the identity of the

DCO is deemed satisfied when the counterparty receives a clearing

report from the DCO; (3) objected to notifying the counterparty of the

SD's or MSP's clearing member as that information may be sensitive and

is not material to the counterparty; and (4) saw no need to state facts

about the counterparty's cleared swap in trading relationship

documentation.

CME commented that existing clearing houses use an agency model

with FCMs acting as the agent and guarantor for customers, providing

numerous benefits. To preserve the agency structure, CME requested that

Sec. 23.504(b)(6)(v)(B) be changed to read ``The original swap is

replaced by equal and opposite swaps with the derivatives clearing

organization.''

CME further commented that under the rule the anonymity of the

customer of the clearing member on the other side of the trade to the

clearing member will be lost. CME does not believe the anonymity needs

to be lost to serve the purposes of the documentation rules.

MFA commented that one of the benefits of central clearing is

anonymity, such that once parties submit a swap for central clearing,

it need not retain or know any information about the counterparty. MFA

recommended that the final rule not require any identifying information

about the parties and their firms.

The Commission has considered the commenters' recommendation to

delete the clearing record provisions of Sec. 23.504(b)(6)(iii) and

(iv) and agrees that there is no need to include in the trading

documentation a record of the names of the clearing members for the SD,

MSP, or counterparty. The Commission notes that the new applicability

provision added to Sec. 23.504(a)(1) provides that the swap trading

relationship documentation rule does not apply to swaps executed

anonymously on a DCM or SEF, but believes that anonymity may also be

important in the execution of swaps executed off-facility, such as in

the execution of block trades with asset managers where allocation may

take place following acceptance of the block trade for clearing by a

DCO. Once a swap is accepted for clearing, the identity of a

counterparty's clearing member is no longer relevant and requiring such

a record has the possibility to undermine the anonymity of central

clearing. Therefore, those provisions have been deleted from the final

rule. Similarly, Sec. 23.504(b)(6)(i) and (ii) have been removed

because those records will be captured under the SD and MSP

recordkeeping requirement, Sec. 23.201(a)(3), and the Commission

believes those records are sufficient.

With regard to proposed Sec. 23.504(b)(6)(v), the Commission has

retained but streamlined the provision, as recommended by ISDA & SIFMA

and CME, to include only the text in Sec. 23.504(b)(6) set forth in

the regulatory text of this rule.

The Commission continues to believe that swap trading relationship

documentation should make clear the effects of clearing a trade with a

DCO; i.e., that the original swap is extinguished and replaced with a

swap facing the DCO that conforms to the terms established under the

DCO's rules. The Commission has determined that an orderly swap market

requires this notice to clarify that the terms of the swap under a

DCO's rules are definitive and trump any contradictory terms that may

have been included in the swap as executed between an SD or MSP and its

counterparty.\15\

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\15\ This provision corresponds to Sec. 39.12(b)(6), which

establishes parallel requirements for DCOs clearing swaps. Both

proposals have been modified in a similar manner for the final

rules.

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14. Annual Audit of 5 Percent of Swap Trading Relationship

Documentation--Sec. 23.504(c)

Proposed Sec. 23.504(c) required that SDs and MSPs, at least once

during each calendar year, have an independent internal or external

auditor examine no less than 5 percent of the swap trading relationship

documentation created during the previous twelve month period to ensure

compliance with Commission regulations and the written policies and

procedures established pursuant to Sec. 23.504.

In response to the proposal, ISDA & SIFMA, FSR, and Hess urged the

Commission to adopt a principles-based approach to the audit

requirement and only require SDs and MSPs to conduct periodic audits

sufficient to identify material weaknesses in their documentation

policies and procedures.

[[Page 55914]]

Similarly, IECA recommended that the Commission require an audit of a

random sample, rather than 5 percent, which IECA found too costly.

Commenting on a different aspect of the proposal, Michael Greenberger

thought that allowing internal audits, as opposed to external, could

undermine transparency and accountability.

In response to commenters and as a cost-saving measure, the

Commission is modifying the proposed rule in accordance with the

alternative recommended by ISDA & SIFMA, FSR, and Hess by removing the

5 percent audit requirement and replacing it with a more general

requirement that SDs and MSPs conduct periodic audits sufficient to

identify material weaknesses in their documentation policies and

procedures. With respect to Mr. Greenberger's comment, the Commission

continues to believe that internal auditors are sufficient as a record

of the results of each audit will be retained and can be reviewed by

Commission staff during examinations of the SD or MSP or investigations

by Commission enforcement staff.

15. Dispute Reporting--Sec. 23.504(e)

The proposed regulations required SDs and MSPs to notify the

Commission and any applicable prudential regulator or the SEC of any

swap valuation dispute not resolved within one business day, if the

dispute is with a counterparty that is an SD or MSP, or within five

business days if the dispute is with any other counterparty.

In response to the proposal, ISDA & SIFMA recommended that the

Commission should limit reporting to material disputes at the portfolio

level, urging the Commission to accept the materiality thresholds for

reporting established by the OTC Derivatives Supervisors' Group

process, which require reporting of disputes above a certain dollar

threshold and only after such disputes have had a proper time to

mature. ISDA & SIFMA argued that rule as proposed will be overly

burdensome and the over-reporting will cause substantial informational

``noise.''

MFA strongly agreed that the Commission should adopt rules related

to valuation disputes and their timely resolution, but questioned

whether regulators need notice of every unresolved dispute regardless

of their materiality from a systemic risk or regulatory perspective.

MFA also commented that the proposed dispute resolution period of one

business day for unresolved disputes among SDs and MSPs is too short,

arguing that valuation disputes may require discussion and negotiation

by and among several levels of management and many different

operational teams at an SD or MSP. MFA thus recommended that the

Commission provide for five business days to resolve a valuation

dispute in an account before they must give regulators notice and only

require notice to regulators where the amount in dispute exceeds either

(a) $100 million, or (b) both 10 percent of the higher of the parties'

valuation and $50 million. In addition, MFA strongly believes that any

notices of disputes should be treated confidentially by regulators, and

not be subject to public access.

IECA argued that the proposed rule should be removed because it

creates an unlevel playing field by creating pressure on a party that

wants to avoid reporting to concede in any dispute.

MetLife agreed that the Commission should establish strict

timelines for reporting disputes, but argued that the periods proposed

are too short to allow parties to resolve disputes on their own.

MetLife recommended that disputes between SD/MSPs should be given 3

days before reporting is required and be subject to a materiality

condition of 10 percent of the calculated valuation of the swap in

dispute.

Hess recommended that the Commission limit reporting to material

disputes dependent on the risk the dispute may pose to the financial

system taking into account the size of the dispute relative to the size

of the trade, the collateral involved, and the size of the parties

involved.

For the reasons submitted by these commenters, the Commission has

determined that only material swap valuation disputes should be

reported to the Commission, any applicable prudential regulator, and

the SEC (with regard to swaps defined in section 1a(47)(A)(v) of the

Act). Thus, the Commission is modifying the rule to provide that SDs

and MSPs shall provide notice of any swap valuation dispute in excess

of $20,000,000 (or its equivalent in any other currency).\16\ The

Commission has determined that the $20,000,000 materiality threshold

for reporting is sufficiently high to eliminate unnecessary ``noise''

from over-reporting, but not so high as to eliminate reporting that the

Commission may find of regulatory value, such as a large number of

relatively small disputes that in aggregate could provide the

Commission with information regarding a widespread market disruption.

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\16\ Compare with ESMA Draft Technical Standards, Article 4 RM,

subsection 2, (stating that ``counterparties shall report to the

competent authority * * * any disputes between counterparties

relating to an OTC derivative contract, its valuation or the

exchange of collateral for an amount or a value higher than EUR 15

million and outstanding for at least 15 business days.'')

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In addition, the Commission is modifying the requirement for SDs

and MSPs to report unresolved valuation disputes within one business

day if the dispute is with a counterparty that is a SD or MSP. SDs and

MSPs now will be required to report unresolved valuation disputes

within three business days. For disputes with counterparties that are

not SDs or MSPs, the rule is unchanged from the proposal, requiring

that unresolved disputes be reported within five business days.

The Commission has also determined that the reporting requirement

of the rule better fits with the resolution requirement under the

portfolio reconciliation rule at Sec. 23.502 and has renumbered the

rule as Sec. 23.502(c). The Commission notes that the reporting

requirement under the rule as adopted is distinct from the swap

valuation methodology requirement under Sec. 23.504(b)(4), discussed

above, and the time period requirement for SDs and MSPs to resolve swap

valuation disputes in Sec. 23.502, discussed below.

16. Orderly Liquidation Termination--Sec. 23.504(b)(5)

Proposed Sec. 23.504(b)(5) required SDs and MSPs to include in

their swap trading relationship documentation an agreement with their

counterparties that, in the event a counterparty is a covered financial

company (as defined in section 201(a)(8) of the Dodd-Frank Act) or an

insured depository institution (as defined in 12 U.S.C. 1813) for which

the Federal Deposit Insurance Corporation (FDIC) has been appointed as

a receiver (the ``covered party''), the non-covered party is subject to

certain limitations specified by law following the appointment of the

FDIC as receiver of the covered party and the non-covered party

acknowledges that the FDIC may take certain actions with respect to the

transactions governed by such documentation.

In response to the proposal, ISDA & SIFMA and FSR argued that

because the rule language is not identical to section 210 of the Dodd-

Frank Act, the proposed rule requiring an agreement between

counterparties in swap trading relationship documentation could

inadvertently expand FDIC powers beyond limits set by Congress by

creating a discrepancy between the FDIC's actual powers under Title II

of the Dodd-Frank Act and the treatment consented to by the parties.

ISDA & SIFMA believe that any discrepancy could operate to strip

parties of legal

[[Page 55915]]

rights to challenge their treatment under Title II of the Dodd-Frank

Act. This, in turn, could raise questions about whether the rule is a

proper exercise of the Commission's rulemaking authority. ISDA & SIFMA

recommended that the Commission revise the rule to only require a

notice of the relevant provisions of Title II.

CIEBA also noted that the proposed language is similar to, but not

the same as, the statutory text in the Dodd-Frank Act and the FDIA, and

could harm its constituents. By substituting terms and apprising

parties of some, but not all, of their rights, the proposed rule

increases the risk of disputes and creates uncertainty as to what will

be required to comply with both the statute and the regulatory regime.

As an example, CIEBA cited section 210(c)(9)(A)(i) of the Dodd-Frank

Act, which states that, in the context of orderly liquidation, the FDIC

may elect to ``transfer to one financial institution, (i) all qualified

financial contracts * * * or (ii) transfer none of the qualified

financial contracts, claims, property or other credit enhancement

referred to in clause (i) (with respect to such person and any

affiliate of such person).'' In contrast to this statutory language,

the proposed rule uses ``may,'' which suggests that the FDIC has the

discretion to transfer less than all qualified financial contracts in

contrast to its statutory requirement to transfer all or none. CIEBA

also notes that the proposed regulation would remain effective even if

the statutory provision it implements is repealed or amended. This

could result in parties being forced to waive rights that protect their

financial interest in times of market turmoil. In the alternative,

CIEBA recommended that the Commission require the documentation to

include a written statement in which the counterparties agree that they

will comply with the requirements, if any, of section 210(c)(10)(B) of

the Dodd-Frank Act and section 11(e)(10)(B) of the Federal Deposit

Insurance Act, or instead, require an SD or MSP to include a statement

thereof in its risk disclosure documents. At the least, CIEBA requests

that the Commission add an additional section to proposed Sec.

23.504(b)(5) to reflect a counterparty's right to suspend payments to

the covered party for the period of the stay, as provided in section

210(c)(8)(F)(ii) of the Dodd-Frank Act.

EEI & NRECA also objected to the proposed rule, arguing that a

statutory provision intended to encourage cooperation between the FDIC

and the Commission does not provide the Commission with authority to

unilaterally establish new jurisdiction for itself and that the

Commission should allow the FDIC to take the lead as contemplated by

Title II of the Dodd-Frank Act. EEI & NRECA stated that energy end

users would be particularly harmed by the proposed rule because swaps

would be covered by the rule, but not physical transactions, causing

energy end users to separately collateralize swaps and physical

transactions, eliminating their ability to cost-effectively hedge

commercial risks using swaps.

The FHLBs acknowledged the potential applicability of the orderly

liquidation provisions of the Dodd-Frank Act, but also objected to the

inclusion of the provisions in the swap documentation as the provisions

would apply notwithstanding such inclusion and doing so could create

legal uncertainty since other liquidation regimes are not listed in the

documents.

MetLife objected specifically to the requirement to include consent

to FDIC liquidation, arguing that such consent may foreclose a party's

right to appeal or challenge the FDIC's actions. MetLife also raised

concerns that blanket consent could place the remaining party in a

position where it has unwanted excessive credit exposure to the new

counterparty, resulting in violation of state law requirements with

respect to credit ratings and other credit quality requirements.

MetLife requested that the section be removed or that a provision be

added to allow a party to object to any proposed transfer.

Hess argued that the provision is not appropriate because the large

majority of SDs and MSPs will likely not be ``covered financial

companies'' and as of now, the actual application of Title II is

unclear. Hess recommended that the rule only require SDs and MSPs to

provide notice of the possibility of FDIC liquidation.

Chris Barnard commented that the authority of the FDIC is statutory

in nature, and so would automatically apply to the relevant swaps,

overriding any current practice. Given this point, Mr. Barnard believes

the provision is redundant.

In contrast to the foregoing, Better Markets fully supported the

proposed rule, stating that the proposed rule represents a

clarification of a fundamental feature of swaps; the consequences of a

default by an SD or MSP. Better Markets stated that a basic premise of

derivatives in bankruptcy is the exemption from the automatic stay such

that the non-defaulting party may immediately terminate and apply

collateral post insolvency. Better Markets agreed that the proposed

rule documents an important exception to that right newly created in

the Dodd-Frank Act. Better Markets believes that clarity, both at

inception of a swap and at default, is the foundation of the Dodd-Frank

Act, because lack of clarity contributed heavily to the financial

crisis and caused much harm.

The Commission has carefully considered each of the comments

received on the proposal. At the outset, the Commission believes that,

in the context of the proposed rules, it is not possible to track the

statutory language of Title II of the Dodd-Frank Act any more closely.

Given the imperfectability of reproducing such statutory language and

the context in which it appears in the rule, the Commission is

sensitive to commenters' concerns that the rule could have a different

legal effect in application as compared to application of the statutory

language. The Commission is also aware that the statutory provisions

will apply to covered financial companies and insured depository

institutions placed into FDIC receivership even if not included in this

rule. Therefore, the Commission has determined that the best course is

to revise the proposed rule to require that swap trading relationship

documentation contain only a notice as to whether the SD or MSP or its

counterparty is an insured depository institution or financial company

and that the orderly liquidation provisions of the Dodd-Frank Act and

the FDIA may limit the rights of the parties under their trading

relationship documentation in the event either party is deemed a

``covered financial company'' or is otherwise subject to having the

FDIC appointed as a receiver.

C. End User Exception Documentation--Sec. 23.505

1. Overlap With Proposed Sec. 39.6

The proposed regulation required SDs and MSPs, when transacting

with market participants claiming the exception to clearing under

section 2(h)(7) of the CEA, to obtain documentation sufficient to

provide a reasonable basis on which to believe that its counterparty

meets the statutory conditions required for the exception. Various

requirements for the documentation were listed in the proposed rule.

In response to the proposal, The Working Group and Encana Marketing

(USA), Inc. (Encana) argued that because proposed Sec. 39.6 would

require SDs and MSPs to collect and report the information relevant to

the section 2(h)(7) clearing exception, the proposed rule should be

revised to impose no

[[Page 55916]]

documentation obligations with regard to this exception. Encana also

commented that in the alternative, Sec. 23.505 should only require

that SDs and MSPs obtain ``documentation'' that the counterparty

qualifies as an end user in the transaction documents, but did not

specify what form such documentation should take. COPE also commented

that the proposed rule is burdensome and redundant to proposed Sec.

39.6 and believes that the attestation required by proposed Sec. 39.6

should be sufficient.

Michael Greenberger, on the other hand, believes a check-the-box

approach is insufficient, and recommended enhanced reporting

requirements ensuring that the calculation methodology and the

effectiveness of the hedged position are well documented. Better

Markets also recommended enhanced reporting, suggesting that end users

report their hedging transactions to SDRs as provided in proposed Sec.

39.6. Requiring end users to provide information for each transaction

to SDs and MSPs separately is overly burdensome whereas direct

reporting to SDRs would amount to only a slight change from current

prudent practice at many end users.

Having considered these comments, the Commission is adopting the

rule as proposed with one exception. The Commission has permitted

entities that qualify for the exception to the clearing requirement

under section 2(h)(7) of the Act to report information directly to an

SDR regarding how they generally expect to meet their financial

obligations associated with non-cleared swaps on an annual basis in

anticipation of electing the exception for one or more swaps.\17\ Thus,

an electing counterparty could be directly reporting the information

necessary for SD and MSP compliance with proposed Sec. 23.505(a)(3)

through (5). Therefore, the Commission has modified the proposed rule

to clarify that SDs and MSPs need not obtain documentation from any

counterparty that claims an exception from required clearing if that

counterparty is reporting directly to an SDR regarding how it generally

expects to meet its financial obligations associated with its non-

cleared swaps, and the SD or MSP has confirmed that the counterparty

has made its annual submission.

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\17\ See End-User Exception to the Clearing Requirement for

Swaps, 77 FR 42560, 42590 (July 19, 2012).

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2. Reasonable Basis--Sec. 23.505(a)

The proposed regulation required that SDs or MSPs have a reasonable

basis to believe its counterparty meets the statutory conditions

required for an exception from a clearing requirement.

In response to the proposal, ISDA & SIFMA requested that the

Commission clarify that the ``reasonable basis to believe'' standard in

the proposed rule may be satisfied by reliance on written

representations from the counterparty, absent facts that reasonably

should have put the swap dealer or major swap participant on notice

that its counterparty may be ineligible for the end user exception.

ISDA & SIFMA argued that registrants should not have to investigate

their counterparty's representations or obtain detailed representations

as to the facts underlying the company's qualifications.

The Coalition for Derivatives End-Users supports the ``check-the-

box'' approach in proposed Sec. 39.6 for end users to use to qualify

for the clearing exception, and is therefore concerned that the

``reasonable basis'' obligation in proposed Sec. 23.505(a) could

undermine the simplicity of the check-the-box approach. The Coalition

for Derivatives End-Users argues that if SDs and MSPs must verify end

user information, they may start to require unnecessary and costly

documentation from end users such as legal opinions or other documents,

rather than serving as passive conduits of information.

After considering these comments, the Commission has determined to

adopt the rule as proposed on this issue. The Commission is of the view

that, contrary to commenters' concerns, the ``reasonable basis''

standard in the proposed rule does not require independent

investigation of information or documentation provided by a

counterparty electing the exception from required clearing. The

Commission believes that so long as an SD or MSP has obtained

information, documentation, or a representation that on its face

provides a reasonable basis to conclude that the counterparty qualifies

for the exception under section 2(h)(7), then, in the absence of facts

that reasonably should have put the SD or MSP on notice that its

counterparty may be ineligible for the exception, no further

investigation would be necessary. The Commission does not believe that

the rule requires legal certainty on the part of SDs or MSPs.

3. Disclosure of Information by End Users

The proposed regulation required SDs and MSPs to obtain

documentation that its counterparty seeking to qualify for the clearing

exception generally meets its financial obligations associated with

non-cleared swaps.

Better Markets argued that the proposed rule should require

documentation in accordance with the Dodd-Frank Act, i.e.,

documentation as to how the counterparty generally meets its

obligations associated with non-cleared swaps, including how it would

meet any obligation to immediately fund margin upon the occurrence of a

credit trigger.

ISDA & SIFMA commented that the Dodd-Frank Act merely requires a

counterparty to notify the Commission as to how it generally meets its

financial obligations. ISDA & SIFMA recommended that Sec. 23.505(a)(5)

be deleted or clarified such that a registrant can satisfy the

requirement by obtaining a representation from its counterparty or by

obtaining the documentation only with respect to swap-related

obligations to the particular SD or MSP.

In the view of COPE, EEI, and CIEBA, the requirement for the SD/MSP

to get information from end users is anti-competitive and inappropriate

as it requires an end user to inform its SD or MSP counterparty, a

potential competitor, of proprietary details about its business,

including its hedging activities. Each recommended that no more than a

representation from the end user should be required. COPE also objects

to the rule placing the SD or MSP in the role of regulator responsible

for determining if the information received is sufficient.

As explained above, the Commission is modifying the proposed rule

to clarify that SDs and MSPs need not obtain documentation from any

counterparty that claims an exception from required clearing if that

counterparty is reporting directly to an SDR under Sec. 39.6(b)

regarding how it generally expects to meet its financial obligations

associated with its non-cleared swaps, and the SD or MSP has confirmed

that the counterparty has made its annual submission. Thus, any entity

seeking to claim the exception from clearing may avoid revealing any

information it considers sensitive to its SD or MSP counterparty by

self-reporting directly to an SDR under Sec. 39.6(b). The Commission

notes that protections against release of reported proprietary

information are addressed in the SDR rules finalized by the Commission.

[[Page 55917]]

D. Swap Confirmation--Sec. 23.501

Confirmation has been recognized as an important post-trade

processing mechanism for reducing risk and improving operational

efficiency by both market participants and their regulators. Prudent

practice requires that, after coming to an agreement on the terms of a

transaction, parties document the transaction in a complete and

definitive written record so there is legal certainty about the terms

of their agreement.

Over the past several years, OTC derivatives market participants

and their regulators have paid particular attention to the timely

confirmation of swaps. The Government Accountability Office (GAO) found

that the rapid expansion of the trading volume of swaps, such as credit

derivatives since 2002, caused stresses on the operational

infrastructure of market participants. These stresses in turn caused

the participants' back office systems to fail to confirm the increased

volume of trades for a period of time.\18\ The GAO found that the lack

of automation in trade processing and the purported assignment of

positions by transferring parties to third parties without notice to

their counterparties were factors contributing to this backlog. If

transactions, whether newly executed or recently transferred to another

party, are left unconfirmed, there is no definitive written record of

the contract terms. Thus, in the event of a dispute, the terms of the

agreement must be reconstructed from other evidence, such as email

trails or recorded trader conversations. This process is cumbersome and

may not be wholly accurate. Moreover, if purported transfers of swaps,

in whole or in part, are made without giving notice to the remaining

parties and obtaining their consent, disputes may arise as to which

parties are entitled to the benefits and subject to the burdens of the

transaction.

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\18\ U.S. Government Accountability Office, ``Credit

Derivatives: Confirmation Backlogs Increased Dealers' Operational

Risks, But Were Successfully Addressed After Joint Regulatory

Action,'' GAO-07-716 (2007) at pages 3-4.

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The Commission believes the work of the OTC Derivatives Supervisors

Group (ODSG) demonstrates that the industry is capable of swift

movement to contemporaneous execution and confirmation. A large back-

log of unexecuted confirmations in the credit default swap (CDS) market

created by prolonged negotiations and inadequate confirmation

procedures were the subject of the first industry commitments made by

participating dealers to the ODSG.\19\ In October 2005, the

participating dealers committed to reduce by 30 percent the number of

confirmations outstanding more than 30 days within four months. In

March 2006, the dealers committed to reduce the number of outstanding

confirmations by 70 percent by June 30, 2006. By September 2006, the

industry had reduced the number of all outstanding CDS confirmations by

70 percent, and the number of CDS confirmations outstanding more than

30 days by 85 percent. The industry achieved these targets largely by

moving 80 percent of total trade volume in CDS to confirmation on

electronic platforms, eliminating backlogs in new trades.

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\19\ See October 4, 2005 industry commitment letter to the

Federal Reserve Bank of New York, available at http://www.newyorkfed.org/newsevents/news_archive/markets/2005/an050915.html.

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By the end of 2011, the largest dealers were electronically

confirming over 95 percent of OTC credit derivative transactions, and

90 percent were confirmed on the same day as execution (T+0). For the

same period, the largest dealers were electronically confirming over 70

percent of OTC interest rate derivatives (over 90 percent of trades

with each other), and over 80 percent were confirmed T+0. The rate of

electronic confirmation of OTC commodity derivatives was somewhat

lower--just over 50 percent, but over 90 percent for transactions

between the largest dealers.\20\

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\20\ See G15 Industry Confirmation Data dated April 4, 2012

provided by ISDA, available at www.cftc.gov.

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The Commission further recognizes the ODSG supervisory goal for all

transactions to be confirmed as soon as possible after the time of

execution. Ideally, this would mean that there would be a written or

electronic document executed by the parties to a swap for the purpose

of evidencing all of the terms of the swap, including the terms of any

termination (prior to its scheduled maturity date), assignment,

novation, exchange, or similar transfer or conveyance of, or

extinguishing of rights or obligations.

The Commission believes that timely and accurate confirmation of

swaps is critical for all downstream operational and risk management

processes, including the correct calculation of cash flows, margin

requirements, and discharge of settlement obligations as well as

accurate measurement of counterparty credit exposures. Timely

confirmation also allows any rejections, exceptions, and/or

discrepancies to be identified and resolved more quickly. To this end,

in the Confirmation NPRM, the Commission proposed Sec. 23.501, which

prescribed standards for the timely and accurate confirmation of swap

transactions. The Commission received approximately 27 comment letters

in response to the Confirmation NPRM and considered each in formulating

the final rules, as discussed below.

1. Uniform Application of Proposed Rules to All Asset Classes

In the Confirmation NPRM, the Commission solicited comments on

whether certain provisions of the proposed regulations should be

modified or adjusted to reflect the differences among asset classes.

In response to the request for comments, ISDA noted that the work

done by the industry with the ODSG led to customization of

documentation and confirmation timeframes to account for the

differences between asset classes, and even between products within

asset classes, but the proposed confirmation requirements do not allow

for this same flexibility. However, ISDA did not suggest specific

timeframes for the Commission's rules.

The FHLBs recommended that the Commission exercise caution in

applying rules to all swap asset classes equally as procedures that are

appropriate for interest rate swaps may be insufficient or unnecessary

for other types of swaps.

The Global Foreign Exchange Division of AFME, SIFMA, and ASIFMA

(GFED) commented that the Commission should take into account the high

volume of transactions and wider universe of participants in the

foreign exchange industry when promulgating its final rules.

The Working Group requested that the Commission revise the rules to

permit current practice in the energy swap market where one party sends

an acknowledgement to the other party and the acknowledgement is deemed

a legally binding confirmation if the receiving party does not object

within three business days. The Working Group believes this practice is

efficient because (i) It eliminates the risk of open confirmations,

(ii) dealers need not chase for a physically signed confirmation, and

(iii) counterparties need not respond if terms are acceptable.

BG Americas & Global LNG (BGA) commented that energy commodity

trading companies typically extract trading data in a batched cycle at

the end of the day and generate confirmations the following day. BGA

does not believe it is clear that expedited confirmation would enhance

[[Page 55918]]

transparency or reduce systemic risk and is therefore outweighed by the

enormous cost for registrants that would have to add resources to

perform rolling confirmations and correct errors.

As discussed further below, in section III.B.2, the Commission has

made every effort to tailor the confirmation requirements by asset

class based on data provided by major market participants. The

Commission has achieved such tailoring by modifying the time periods

for confirmation by asset class along with a generous compliance phase-

in period, but has retained an otherwise uniform rule across asset

classes. The Commission believes the uniform standard with appropriate

differences in time periods and compliance periods will lead to

efficient use of limited regulatory resources, while also reducing

implementation costs for affected market participants.

2. Use of ``Enforce'' in Proposed Rules Sec. 23.501(a)(3), Sec.

23.502(b), Sec. 23.502(b)(4), and Sec. 23.503(d)

The proposed regulations require SDs and MSPs to establish,

maintain, and enforce written policies and procedures to accomplish a

number of requirements, including confirmation with financial entities

and non-financial entities; portfolio reconciliation; valuation dispute

resolution; and bilateral and multilateral compression and termination

of fully offsetting swaps.

In regard to the use of ``enforce'' in these provisions, ABC &

CIEBA requested that the Commission delete the term wherever it appears

because SDs and MSPs are not ``registered entities'' under section

1(a)(40) of the CEA and therefore Congress did not intend for SDs and

MSPs to have the self-regulatory authority to enforce compliance with

their internal policies and procedures. Similarly, Freddie Mac

commented that the requirement in the proposed rules that SDs enforce

policies designed to ensure confirmation with non-SD, non-MSP

counterparties within the short deadlines mandated by the proposed

rules could result in SDs exerting undue pressure on such

counterparties to quickly assent to the terms of a trade as framed by

the SD in the form of a condition to execution of a swap, with the risk

that the swap could become void or otherwise fail.

The Commission is sensitive to these concerns, and has accordingly

modified the proposed rules by replacing each instance of the term

``enforce'' with the term ``follow.'' The Commission observes that the

intent of the term ``enforce'' in the proposed rules was to require SDs

and MSPs to in fact follow the policies and procedures established to

meet the requirements of the proposed rules, rather than to require an

SD or MSP to enforce its internal policies and procedures against third

parties.

3. Definition of ``Acknowledgement''--Sec. 23.500(a)

The proposed regulations defined ``acknowledgement'' to mean ``a

written or electronic record of all of the terms of a swap signed and

sent by one counterparty to the other.''

Commenting on this definition, GFED requested that the Commission

clarify whether an ``acknowledgement'' is the same as a ``trade

affirmation'' in the FX market, which is matching of economic fields

only, and MFA recommended that the Commission revise the definition to

provide that an acknowledgement need only specify the primary economic

terms of a swap (rather than all terms).

Despite these comments, the Commission is adopting the definition

of acknowledgement as proposed. The intent of the definition was to

make clear that an SD or MSP must provide its non-SD, non-MSP

counterparties with a complete record of all terms of an executed swap

transaction. The Commission believes that to achieve the timely

confirmation goals of Sec. 23.501, mistaken, misunderstood, or

disputed terms must be identified quickly. To do so, a counterparty

needs to see documentation reflecting all of the terms of the swap

transaction as the SD or MSP understands them. The Commission therefore

does not agree with commenters that an acknowledgement need contain

only the primary economic terms of a swap transaction. In reaching this

conclusion, the Commission recognizes that requiring delivery of an

acknowledgement containing all terms may require the parties to agree

to more terms at execution than are agreed under some current market

practices, but, given the critical role confirmation plays in all

downstream operational and risk management processes, the Commission

believes that any additional pre-execution burden imposed is justified.

4. Definition of ``Confirmation''--Sec. 23.500(c)

The proposed regulations defined ``swap confirmation'' to mean

``the consummation (electronically or otherwise) of legally binding

documentation (electronic or otherwise) that memorializes the agreement

of the parties to all the terms of the swap. A confirmation must be in

writing (whether electronic or otherwise) and must legally supersede

any previous agreement (electronically or otherwise).''

Reacting to this definition, ABC & CIEBA explained that where a

lead fiduciary for a pension fund negotiates ISDA documentation on a

relationship basis, there sometimes will be a provision that the master

agreement's terms legally supersede the confirmation's terms unless the

fiduciary entering the plan into the swap represents that inconsistent

terms in the confirmation are more beneficial to the plan. ABC & CIEBA

therefore requested that the Commission clarify that the phrase

``legally supersede any previous agreement'' is only intended to apply

to prior agreements outside the scope of the package of documentation

that makes up the master agreement between the parties (i.e., master

agreements, credit support agreements, all confirmations, etc.).

Similarly, the Asset Management Group of SIFMA (AMG) explained that

in current practice, some clients to asset managers require that terms

in the confirmation of a swap cannot supersede conflicting terms in a

client's master agreement. AMG therefore also recommended that the

Commission clarify the proposed rule to provide that a confirmation

will not legally supersede the contractual arrangements agreed on by

the parties.

On a different tack, GFED requested clarification as to whether

``confirmation'' means only actual legal confirmation execution or

whether it may also include matching services that do not provide a

legally binding confirmation of all terms, but merely affirmation of

trade economics, and ISDA requested clarification that confirmation may

be accomplished by use of matching services under which some buy-side

firms ``affirm'' trades.

Jason Copping offered an alternative definition of ``confirmation''

under which a swap is confirmed when all parties accept the terms and

no change to the terms would be legally binding until all parties agree

to such changes.

In response to these comments, the Commission reiterates that the

intent of the proposed rule was to require the terms of a confirmation

to include all of the binding terms of the swap. This definition is the

same definition adopted by the Commission in the Swap Data

Recordkeeping and Reporting rules in part 45 of the Commission's

regulations.\21\ In addition, under the Swap Data Recordkeeping and

Reporting rules, all terms agreed in a

[[Page 55919]]

confirmation must be reported to an SDR.\22\ Therefore, in addition to

the need for all terms to be confirmed for purposes of downstream

operational processing and risk management, the Commission has a strong

interest in consistent rules for the swap market. For these reasons,

the Commission is adopting the definition of confirmation as proposed.

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\21\ See 17 CFR 45.1.

\22\ See 17 CFR 45.3.

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With respect to the comments of ABC & CIEBA and AMG, the Commission

understands the practice explained by these commenters to mean that

some confirmations of swaps incorporate by reference certain terms that

are delineated in master agreements and that the parties have agreed

that such terms trump any inconsistent terms that may appear in a

confirmation. The Commission clarifies that the rules adopted herein do

not prohibit the practice of incorporation by reference. Therefore, if

counterparties want to include certain standard provisions in their

master agreements that will control each swap transaction executed,

this approach would be acceptable so long as they ensure that their

books and records and the confirmation data reported to an SDR reflects

the actual terms of each swap transaction. Given the Commission's

interest in ensuring the integrity of data reported to an SDR,

contradictory or conflicting swap transaction terms in an SD's or MSP's

books and records or in data reported to an SDR when reconciled with an

SD's or MSP's books and records could indicate non-compliance with the

both the confirmation rule adopted herein and the swap data reporting

rules under part 45 of the Commission's regulations.

Moreover, the Commission clarifies that any specific agreed-upon

collateral requirements in a confirmation, which may go beyond what

exists in the collateral support arrangements under the swap trading

relationship documentation, would be required to be confirmed according

to the timeframes discussed below.

5. Definition of Financial Entity-Sec. 23.500(e)

The Commission proposed to define ``financial entity'' to have the

same meaning as given to the term in section 2(h)(7)(C) of the Act,

excepting SDs and MSPs. Subsequent to the proposal, the Commission

proposed a number of rules that contained slightly differing

definitions of the term.\23\ The Commission has therefore determined to

revise the definition of ``financial entity'' for purposes of the rules

adopted herein to be consistent with its other rules applicable to SDs

and MSPs. Thus, ``financial entity'' has been defined in the rule

adopted in this release to mean ``a counterparty that is not a swap

dealer or a major swap participant and that is one of the following.

(1) A commodity pool as defined in section 1a(5) of the Act, (2) A

private fund as defined in section 202(a) of the Investment Advisers

Act of 1940, (3) An employee benefit plan as defined in paragraphs (3)

and (32) of section 3 of the Employee Retirement Income and Security

Act of 1974, (4) A person predominantly engaged in activities that are

in the business of banking, or in activities that are financial in

nature as defined in section 4(k) of the Bank Holding Company Act of

1956, and (5) a security-based swap dealer or a major security-based

swap participant.''

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\23\ See e.g., Margin Requirements for Uncleared Swaps for Swap

Dealers and Major Swap Participants, 76 FR 23732, 23744 (Apr. 28,

2011).

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6. Electronic Execution and Processing--Sec. 23.501(a)(1) & (2);

Definition of ``Processed Electronically''--Sec. 23.500(j)

The proposed regulations prescribed trade acknowledgement delivery

and confirmation deadlines for swap transactions that are executed and

processed electronically, and different deadlines for swaps that are

not executed electronically but are processed electronically. The

proposed regulations provided that ``processed electronically'' means

``to be entered into a swap dealer or major swap participant's

computerized processing systems to facilitate clearance and

settlement.'' In addition, the Commission requested comment on whether

the term ``processed electronically'' required more clarification, and,

if so, what definition would be effective and flexible enough to

accommodate future market innovation.

In response to the proposal, ABC & CIEBA urged the Commission to

ensure that the proposed confirmation rule does not indirectly impose

on benefit plans processes that will require third-party service

providers or new technology by expressly stating that a party to an

uncleared swap that is not an SD or MSP has the right to determine

whether the confirmation will occur electronically or manually. AMG

also recommended that a party to an uncleared swap that is not an SD or

MSP should have the right to determine whether the confirmation will

occur electronically or manually.

The Working Group and MFA warned that the Commission should not

mandate confirmation through an electronic matching platform because

electronic matching is unlikely to be able to capture all terms of

customized transactions. Chatham Financial Corp. (Chatham) also argued

that the Commission should not mandate confirmation through an

electronic matching platform, because such a mandate could preclude

end-users from entering into swaps not yet available on matching

platforms and could increase costs for end-users that do not engage in

the volume of swaps necessary to justify the additional costs of

connecting to electronic matching platforms.

ISDA commented that electronic execution and processing standards

should be phased and aspirational because development by the industry

will be required to meet the timelines of the proposed rules. ISDA also

argued that the proposed life cycle confirmation requirement will

undermine the move to electronic execution and processing, because not

all life cycle events are currently supported by electronic platforms

across asset classes.

MarkitSERV supports the Commission's goal of having as many

transactions as possible be executed on electronic platforms, and

recommended that the Commission require all swap transaction

information to be communicated electronically if a registrant has the

ability to do so, and encourage (but not require in all cases) the use

of electronic matching and confirmation platforms.

Many commenters raised questions regarding what would constitute

electronic processing. MFA requested that the Commission clarify if

``processed electronically'' only refers to swaps confirmed through

electronic confirmation or matching services, or whether ``processed

electronically'' could refer to a registrant entering trade information

into its trade capture system, the generation of an acknowledgement

from such system and the forwarding of such acknowledgement to a

counterparty by facsimile, email, or other electronic method, while

GFED requested that the Commission clarify whether a SWIFT confirmation

would meet the definition of ``processed electronically'' under the

proposed rules. The Working Group also questioned whether confirming a

swap via email would constitute electronic processing. The FHLBs

requested that the Commission clarify if ``processed electronically''

only refers to swaps confirmed through electronic confirmation or

matching services, while ISDA recommended that the Commission not

define ``processed electronically'' to include all

[[Page 55920]]

transactions for which some element of the transaction is captured or

processed through electronic means, but define it with reference to a

firm or platform's ``middleware,'' which will actually drive the

process. Finally, MetLife recommended that the Commission more clearly

define the terms ``processed electronically'' and ``executed

electronically'' because MetLife needs more information to determine

whether the proposed time frames for confirmation are realistic within

current market capabilities.

Having considered these comments, the Commission acknowledges the

concerns expressed by market participants regarding the coerced use of

matching platforms and is accordingly modifying the proposed rule to

delete the definition of ``processed electronically'' and delete the

provisions of the rule mandating acknowledgement and confirmation

deadlines for swaps that are executed or processed electronically. In

place of these provisions, the rule has been modified to provide that

swap transactions among SDs and MSPs or between such registrants and

financial entities should be confirmed as soon as technologically

practicable, but in any event by the end of the first business day

following the day of execution (as modified for time zone and business

day differences, discussed in detail below). The Commission believes

this change will eliminate any confusion as to whether a method of swap

execution and confirmation qualifies as ``electronic.'' As explained

further below, the modified rule would provide a single deadline for

confirmation of swap transactions among registrants, a single deadline

for confirmation of swap transactions between registrants and financial

entities, and a single deadline for confirmation of swap transactions

between registrants and all other entities, with appropriate

adjustments of the compliance deadlines by swap asset class for

implementation of the rule.

7. Delivery of Draft Acknowledgement to Non-SD, Non-MSP Counterparties

Sec. 23.501(a)(3)

Proposed Sec. 23.501(a)(3) required SDs and MSPs to establish a

procedure such that, prior to execution of any swap with a non-SD or

non-MSP, the registrant furnish to a prospective counterparty a draft

acknowledgment specifying all terms of the swap transaction other than

the applicable pricing and other relevant terms that are to be

expressly agreed at execution.

Commenting on the proposal, ISDA argued that the requirement to

provide a draft acknowledgement prior to execution may cause loss of

timely execution opportunities, and may require end-users to engage

significant legal resources for review of all proposed transactions,

rather than just executed transactions. ISDA recommended that non-

dealer counterparties be permitted to waive the delivery of draft

acknowledgements. MFA similarly argued that the proposed rule will (i)

Prevent end users from executing promptly when the market is favorable;

(ii) cause end users to concede on terms in order to get timely

execution; (iii) cause a decrease in the number of transactions, which

will decrease liquidity and increase volatility; and (iv) cause wider

bid/ask spreads or less market-making because of an increase in risk

between pricing and execution. Freddie Mac also believes that the

proposed rule would delay prompt execution of hedging transactions

because end users will be required to review draft acknowledgements.

MarkitSERV argued that requiring a draft acknowledgement is

unnecessarily burdensome because (i) multiple SDs competing for a trade

would all be required to furnish a draft acknowledgement, and (ii) many

transactions executed through automated electronic systems can complete

a confirmation promptly after execution. MarkitSERV recommended that

the Commission require draft acknowledgements to contain only terms

necessary to determine price (rather than all terms) and only require

delivery of draft acknowledgements for swaps that cannot be processed

electronically and where confirmation is not reasonably expected to be

completed within 24 hours.

On the other hand, ABC & CIEBA agreed with the Commission's

proposal to require all terms, except terms related to price, be

disclosed in writing prior to the time of execution. AMG also supported

the proposed rule, but recommended that the Commission revise the rule

to provide an exception for swaps where the parties have previously

agreed to non-pricing-related terms.

Finally, MetLife recommended that the Commission revise the

proposed rule to specifically indicate which party is responsible for

delivery of an acknowledgement and which party is responsible for the

return confirmation.

Having considered the commenters' concerns, but cognizant of the

support for the proposed rule by some commenters, the Commission is

modifying the proposed rule to require delivery of a draft

acknowledgement, but only upon request of an SD's or MSPs' non-SD, non-

MSP counterparty prior to execution.

With respect to MetLife's comment, the Commission believes the rule

as proposed clearly states that it is the SD's or MSP's responsibility

to deliver an acknowledgement when trading with a counterparty that is

not an SD or MSP. The SD or MSP is required to have policies and

procedures reasonably designed to ensure that its counterparty returns

a confirmation or otherwise completes the confirmation process. With

respect to trades solely among SDs and MSPs, the Commission does not

believe it is necessary to prescribe responsibility for delivery of an

acknowledgement because both parties would be required to comply with

the confirmation deadline set forth in the rule as adopted herein.

8. Time Period for Confirmation--Sec. 23.501(a)(1) & (3)

Proposed Sec. 23.501 provided time periods for confirmation as set

forth at 75 FR 81519, 81531 (Dec. 28, 2010).

The Commission received 27 comments with respect to the proposed

rule's time periods for confirmation. Below, the comments are described

according to the following categories:

(A) General comments on the proposed time periods;

(B) Comments on proposed time periods for confirmation with non-SDs

and non-MSPs;

(C) Comments on time periods for confirmation with financial

entities;

(D) Comments on confirmation of swaps between parties in different

time zones; and

(E) Comments on confirmation of swaps executed near end of trading

day.

(A) Comments on Time Periods Generally

ISDA stated that the proposed rules place an unnecessary burden

upon the inception of transactions, may increase risk by leading to

needless disputes and operational lapses, and require substantially

more than is necessary to create an initial record of a legally binding

agreement. ISDA also argued that: (i) The time periods proposed are

impractical as certain terms required to be included in a confirmation

may not be known on the same calendar day as execution (e.g., initial

rates may follow trade commitment by days); and (ii) valuation

methodologies required to be agreed prior to execution pursuant to

proposed Sec. 23.504(b)(4), may also slow down the confirmation

process to the extent such methodologies are required to be reflected

in the confirmation. ISDA recommended an alternative framework:

[[Page 55921]]

Execution of a swap on a SEF or DCM or clearing a swap

should be deemed to satisfy any confirmation requirements.

Electronic execution and processing standards should be

phased and aspirational as development by the industry will be

required.

The Commission should conduct a study in order to better

understand the potential barriers to complying with the proposed

timelines for confirmation in each asset class.

The Commission should institute an approach similar to

that utilized by the ODSG; an ongoing dialogue between the Commission

and leaders in the industry to obtain a commitment from the industry to

tighten confirmation timeframes over an extended period, with existing

risk mitigants to address Commission concerns in the interim.

The Working Group also objected to the time periods between

execution and confirmation in the proposed rules because: (i) The time

periods effectively will require all terms of a swap to be negotiated

prior to execution, and that such requirement will disadvantage the

party that is most sensitive to timing of market conditions and may

force that party to accept less optimal economic terms or reduced

negotiating leverage in order to meet the confirmation deadline; and

(ii) the Commission has not articulated any benefit from the

requirement that non-registrants confirm a swap no later than the day

after execution that would outweigh the cost for most non-registrants

to comply with the rule.

MarkitSERV commented that the time periods specified in the

proposed rules for confirmation are not feasible in many cases and

recommended the following alternative:

The time period within which confirmation is required to

be completed should not begin with execution, but only from the point

when all relevant data and information to define the swap has been

obtained (e.g., allocations).

Acknowledgements should be sent within a time period after

all information has been obtained and confirmation should be completed

within a time period after an acknowledgement has been received.

Non-electronically executed and non-electronically

processed transactions should be confirmed within 24 hours of

execution, rather than within the same calendar day.

The confirmation requirement should consist of ``economic

tie-out'' of key economic terms rather than confirmation of all terms.

Electronic processing should be defined to include the

capability for electronic communication.

AMG argued that same calendar day or next business day confirmation

may not be appropriate for complex or customized uncleared swaps,

including swaps entered by asset managers that must allocate block

trades among their clients. AMG also recommended that the Commission

revise the proposed rules to provide for a delay in confirmation for

legitimate disputes between the parties if the parties are seeking to

resolve the dispute in a timely fashion.

BGA commented that the 15 minute and 30 minute deadlines for

confirmation or acknowledgement in the proposed rules are unworkable

and inconsistent with current practice. BGA stated that energy

commodity trading companies typically extract trading data in a batched

cycle at the end of the day and generate confirmations the following

day. BGA does not believe it is clear that expedited confirmation would

enhance transparency or reduce systemic risk and is therefore

outweighed by the enormous cost for registrants that would have to add

resources to perform rolling confirmations and correct errors. BGA also

argued that swaps executed on electronic platforms and through broker/

dealers as clearing agents should not require a confirmation.

Chatham argued that the proposed timeframes for confirmation could

result in decreased accuracy as parties will rush to complete

transaction documentation without thorough review.

The FHLBs stated that currently available electronic swap

processing systems do not support customized terms in swaps used by the

FHLBs and therefore the same business day deadline is not sufficient

for swaps that require manual processing. The FHLBs also stated that

for some swaps (e.g., forward settling interest rate swaps), all terms

may not be known when the swap is executed.

MetLife requested that the Commission extend the timeframe for

delivery and return of confirmations for transactions not executed on a

SEF or DCM as such are often highly structured and customized and it is

unreasonable to expect parties to generate a confirmation within the

timeframe set forth in the proposed rules. MetLife recommended that the

Commission revise the proposed rules to provide three business days

following execution for delivery of an acknowledgement for such

transactions and at least two business days following receipt of an

acknowledgement to review and return a confirmation.

GFED stated that the various deadlines are significantly too short

for many FX swap trades and inappropriately rely on both parties

complying with the proposed rules. GFED recommends that the Commission

revise the proposed rules, as such are applied to FX swap trades,

taking into account: (i) The method of confirmation (electronic/paper);

(ii) the complexity of the underlying transaction (e.g., vanilla

options vs. basket options); and (iii) the counterparty type.

MFA recommended that the Commission specify no timeframe for

confirmation, allowing parties to execute whenever market conditions

are favorable with the expectation that they may negotiate non-economic

terms later.

(B) Comments on Time Periods for Confirmation With Non-SDs and Non-MSPs

With respect to the proposed confirmation time periods for swaps

between an SD or MSP and a non-SD or non-MSP specifically, ISDA

commented that the rule lacks clarity on how non-registrant

counterparties can be required to comply with the confirmation

requirements. The FHLBs echoed ISDA's comment, arguing that the

proposed timeframe may lead SDs and MSPs to put undue pressure on end

users to execute confirmations before such parties have had an

opportunity to fully review such confirmations. To alleviate this

concern, the FHLBs argued that the proposed rules should allow SDs and

MSPs at least 48 hours to provide end users with an acknowledgement, at

least two business days for end users to review acknowledgements and

execute confirmations, and provide for an exception from the

confirmation deadlines for complex or unique swap transactions (as

determined by the parties) upon notice to the Commission detailing the

unique or complex aspects of the swap and the date by which a

confirmation will be executed.

Chatham recommended an alternative confirmation requirement for

swaps with non-SDs and non-MSPs:

For electronically confirmed swaps, an acknowledgement

would be required to be submitted electronically on the same or next

business day after execution, and swap terms would be required to be

affirmed, matched or otherwise confirmed or a notice of discrepancy

provided within three business days; any discrepancy would be required

to be resolved and the swap confirmed within five business days

[[Page 55922]]

after the discrepancy was communicated.

For non-electronically confirmed swaps, an acknowledgement

would be required to be issued within one business day of execution; a

notice of discrepancy provided within five business days; and

confirmation required within 30 days.

Dominion commented that the energy industry standard is to achieve

confirmation of uncleared swaps not executed on an electronic platform

within three business days, and that such standard is often documented

in participants' existing master agreements. Dominion thus argued that

the proposed next business day confirmation requirement may conflict

with end user contractual rights and obligations, and may cause end

users to incur costs even though the Commission has not articulated a

justifiable benefit to end users or the market.

(C) Comments on Time Periods for Confirmation With Financial Entities

Specifically with respect to confirmation of swap transactions

between an SD or MSP and a financial entity, ABC & CIEBA stated that

the ``same business day'' confirmation requirement would impose costly

increases in operational capacity for pension funds, which may

discourage use of swaps or limit trading to earlier parts of the

trading day. ABC & CIEBA recommended that the Commission provide for a

``close of next business day'' time limit for benefit plans and other

non-SD, non-MSP counterparties. AMG also argued that financial entities

should not be subject to shorter time periods for confirmation than

non-financial end-users because many may not have the operational

resources to meet the demands of the proposed rules. Similarly, Freddie

Mac argued that it often takes several business days to correct and

execute confirmations, and the proposed rules would not permit

sufficient time for correction of draft confirmations or resolution of

disputes over trade terms.

While MFA agreed with the proposed longer time period for

confirmation for swap transactions between an SD or MSP and

counterparties that are not SDs or MSPs, but objected to a shorter time

period for financial entity end users as compared to other end users.

MFA argued that designation as a financial entity does not necessarily

correlate with a large swap portfolio or being highly sophisticated

with respect to swaps, and the short time period for confirmation

applicable to financial entities under the proposed rules may cause

unwarranted disadvantages in negotiation of swap terms with SDs and

MSPs.

Finally, the OCC believes that the same calendar day trade

confirmation requirement for financial entities would eliminate or

significantly reduce customized transactions between registrants and

such entities, leading to less effective risk management. The OCC

argued that the short confirmation deadline will require the parties to

negotiate all terms prior to execution, leading to the unnecessary

expenditure of resources for transactions that are never executed. The

OCC further argued that negotiation prior to execution will delay

execution, which itself can create risks in fast moving markets.

(D) Comments on Confirmation of Swaps Between Parties in Different Time

Zones

The Commission received several comments concerned with the

proposed time periods for confirmation as applied to swap transactions

between parties in different time zones.

Commenting on this aspect of the proposed rule, ISDA stated that

cross-border transactions frequently require more than one day to

confirm due to business day and time zone differences; Chatham and GFED

also commented that the proposed timeframes fail to account for

coordination across time zones.

(E) Comments on Confirmation of Swaps Executed at End of Day

The Commission also received several comments concerned with the

proposed same day confirmation requirement for swap transactions among

SDs and MSPs and between an SD or MSP and a financial entity as applied

to swap transactions executed near the end of the trading day.

In this regard, ISDA, Chatham, the FHLBs, AMG, and GFED each

commented that the rules should account for transactions executed

toward the end of the business day that leave little or no time for

same-day confirmation. To account for this issue, AMG recommended that

parties should be given no less than 24 hours to confirm trades, while

the FHLBs recommended that swap transactions executed after 3:00 p.m.

EST should be considered executed on the immediately following business

day.

Commission Response

The Commission has considered the many comments with respect to the

proposed time periods for confirmation and has decided to revise the

proposed rule in a number of ways to better attune the rule to the

intention of the Commission's proposal, the concerns raised by

commenters, and the needs of the market. The Commission has revised the

proposed rule as discussed below.

The proposed time periods for swaps executed or processed

electronically have been replaced in their entirety by a requirement

that, subject to a compliance phase-in schedule, all swaps among SDs

and MSPs or between SDs, MSPs, and financial entities be confirmed ``as

soon as technologically practicable,'' but no later than the end of the

first business day following the day of execution.\24\ The Commission

believes this change still requires electronically executed or

processed trades to be confirmed quickly, but is responsive to

commenters that have provided examples of processing operations that

contain some electronic elements but are not ``straight-through'' in

the sense intended by the proposed rules and therefore are incapable of

meeting the proposed 15 or 30 minute deadlines.

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\24\ Compare with ESMA Draft Technical Standards, Article 1 RM,

subsection 2, (stating that uncleared OTC derivatives ``shall be

confirmed, where available via electronic means, as soon as possible

and at the latest by the end of the same business day.'').

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In revising the rule, the Commission also was persuaded by the

comments of market participants that are concerned with the possibility

of pressure by their dealer counterparties to make costly changes to

their operating systems in order to meet the required confirmation

deadlines. The Commission notes that these changes also make the

confirmation rule consistent with the real-time public reporting rules

and the rules mandating deadlines for the reporting of swap data to

SDRs, both of which use ``as soon as technologically practicable'' as

the applicable standard.\25\

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\25\ See 17 CFR 43.2, Real-Time Public Reporting of Swap

Transaction Data, 77 FR 1182, 1243-44 (Jan. 9, 2012); 17 CFR 45.3,

Swap Data Recordkeeping and Reporting Requirements, 77 FR 2136,

2199-2200 (Jan. 13, 2012).

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With respect to the proposed time periods for swaps executed

between SDs and MSPs and counterparties that are not SDs, MSPs, or

financial entities, the Commission has modified the rule to require,

subject to a compliance phase-in schedule, policies and procedures

reasonably designed to ensure that a confirmation is executed no later

than the end of second business day after execution.\26\ The Commission

believes this change will afford SDs and MSPs an

[[Page 55923]]

extra business day to confirm their swap transactions with non-

financial entities and is more consistent with the time periods

suggested by commenters.

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\26\ Compare with ESMA Draft Technical Standards, Article 1 RM,

subsection 3, (stating that uncleared OTC derivatives ``shall be

confirmed as soon as possible and at the latest by the end of the

second business day following the date of execution.'').

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In response to commenters, as discussed above, the Commission is

revising the proposed rule to state explicitly that swaps executed on a

SEF or DCM, and swaps cleared by a DCO, will be deemed to have met the

confirmation requirements so long as: (i) confirmation of all terms of

the transaction takes place at the same time as execution on a SEF or

DCM; or (ii) the parties submit the swap for clearing no later than the

time that confirmation would otherwise be required and the DCO confirms

the terms of the swap upon acceptance for clearing. To ensure that no

swap transaction goes unconfirmed, the modified rule also contains a

backstop requirement for SDs and MSPs to confirm a swap for which the

registrant receives notice that a SEF, DCM, or DCO has failed to

provide a confirmation on the same day as it receives such notice.

Based on the comments received, the Commission is also modifying

the proposed rule to adjust the confirmation deadline for swaps among

SDs and MSPs and between SDs, MSPs, and financial entities whenever the

parties (i) execute a swap near the end of the trading day (i.e., after

4 p.m.), or (ii) execute a swap with a counterparty located in a

different time zone. The Commission has been persuaded by commenters

that registrants should not be required to maintain back-office

operations 24 hours a day or 7 days a week in order to meet the

proposed confirmation deadlines. The Commission has been particularly

sensitive to comments stating that the proposed confirmation deadlines

may discourage trade execution late in the day. Specifically, the

Commission has made the following changes to the proposed rule:

To account for time-zone issues, the ``day of execution''

has been defined to be the calendar day of the party to the swap that

ends latest, giving the parties the maximum amount of time to confirm

the transaction within the deadlines required by the rule.

To account for end-of-day trading issues, the definition

of ``day of execution'' deems such day to be the next succeeding

business day if execution occurs after 4:00 p.m. in the place of either

counterparty.

To account for non-business day trading, the ``day of

execution'' is also deemed to be the next succeeding business day if

execution occurs on a day that is not a business day.\27\

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\27\ Compare with ESMA Draft Technical Standards, Article 1 RM,

subsection 3, (stating that where an uncleared OTC derivative

transaction ``is concluded after 16.00 local time, or when the

transaction is concluded with a counterparty that is located in a

different time zone that does not allow for same day confirmation,

the confirmation shall take place as soon as possible and at the

latest by the end of the next business day.'')

---------------------------------------------------------------------------

The Commission notes that this approach is consistent with the

business day definition in the Swap Data Recordkeeping and Reporting

Rules finalized by the Commission in December 2011.\28\

---------------------------------------------------------------------------

\28\ See 71 CFR 45.1, Swap Data Recordkeeping and Reporting, 77

FR 2136, 2197 (Jan. 13, 2012).

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Despite several commenters' concerns, however, the Commission has

declined to modify the proposed requirement that SDs and MSPs establish

policies and procedures reasonably designed to ensure that swaps with

financial entities meet the same confirmation deadlines as swaps among

SDs and MSPs. While the Commission recognizes that an SD or MSP may not

be able to ensure that a non-registrant financial entity abides by the

confirmation deadline in each and every instance, it believes that

``policies and procedures reasonably designed to ensure'' is not the

same as requiring a guarantee of compliance. Therefore, the Commission

believes that the rule contains sufficient flexibility because it only

requires that the SDs and MSPs make reasonable efforts to confirm swaps

with financial entities by the stated deadline.

As discussed below in section III.B.2, the Commission is phasing in

compliance with each of the time periods required under Sec. 23.501.

This compliance schedule is set forth in the rule text and seeks to

further address concerns from market participants regarding the timing

of compliance.

9. Allocation of Block Trades

The proposed regulations did not address confirmation in the

context of block trades that must be allocated prior to confirmation.

With respect to the allocation of block trades, ISDA argued that

the proposed confirmation rule will be difficult for asset managers to

implement because asset managers often execute block trades and then

allocate the block to two or more clients, a process than can take

significantly longer than the confirmation time periods because the

allocation process hinges on compliance processes or receipt by

investment managers of instructions from their clients. In ISDA's view,

if finalized as proposed, the rule could force investment managers to

execute individual trades for their clients, increasing pricing and

operational costs. AMG echoed this point.

Intercontinental Exchange, Inc. (ICE) also pointed out that the

confirmation deadlines in the proposed rules may make it impossible for

asset managers to make post-execution allocation of trades. ICE stated

that its own trade processing service for CDS requires that trades be

allocated within two hours of execution and recommended that the

Commission adopt a similar standard.

While the Commission acknowledges that allocation of block trades

is required to achieve confirmation, it notes that the modifications to

the rule outlined above replaces the 15 and 30 minute confirmation

deadlines with a requirement that swaps be confirmed ``as soon as

technologically practicable, or in any event by the end of the first

business day following the day of execution.'' The Commission thus

believes that the rule as modified allows registrants and the asset

managers for their counterparties the flexibility to work out an

efficient and timely allocation process within the deadlines for

confirmation as adopted in this release. The Commission also notes that

recent amendments to Commission regulation Sec. 1.35 address the

allocation issue by requiring that account managers must provide

allocation information to the counterparty no later than the end of the

calendar day that the swap was executed.\29\

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\29\ See Customer Clearing Documentation, Timing of Acceptance

for Clearing, and Clearing Member Risk Management, 77 FR 21278,

21306 (Apr. 9, 2012) (providing that ``Orders eligible for post-

execution allocation must be allocated by an eligible account

manager in accordance with the following: (A) Allocations must be

made as soon as practicable after the entire transaction is

executed, but in any event no later than the following times: For

cleared trades, account managers must provide allocation information

to futures commission merchants no later than a time sufficiently

before the end of the day the order is executed to ensure that

clearing records identify the ultimate customer for each trade. For

uncleared trades, account managers must provide allocation

information to the counterparty no later than the end of the

calendar day that the swap was executed.'').

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10. Time Period for Delivery of Acknowledgement--Sec. 23.501(a)(2)

Proposed Sec. 23.501(a)(2) set forth at 75 FR 81519, 81531 (Dec.

28, 2010) required SDs and MSPs to send an acknowledgement containing

all of the terms of a swap transaction to each counterparty that is not

an SD or MSP.

In response to the proposal, ISDA asserted that the time periods

proposed are impractical because: (i) Certain terms required to be

included in an acknowledgement may not be known on

[[Page 55924]]

the same calendar day as execution (e.g., initial rates may follow

trade commitment by days); and (ii) valuation methodologies required to

be agreed prior to execution pursuant to proposed Sec. 23.504(b)(4)

may also slow down the acknowledgement process to the extent such

methodologies are required to be reflected in the acknowledgement.

Similarly, MarkitSERV recommended that acknowledgements be sent within

a time period after all information has been obtained (rather than

after execution), while AMG argued that the time periods are

unnecessarily short and do not bear a reasonable relationship to the

systemic risk goals of the Dodd-Frank Act, would be burdensome for

uncleared swaps which merit more individualized treatment, and could

impose excessive costs on swap market participants.

Based on these comments and other considerations discussed above,

the Commission has revised the proposed rule to delete the 15 and 30

minute acknowledgement delivery deadlines and replace them with a

requirement, subject to a compliance phase-in schedule, that an

acknowledgement be provided ``as soon as technologically practicable,

but in any event by the end of the day of execution;'' to state

explicitly that the acknowledgement requirement will be deemed

satisfied by executing a swap on a DCM or SEF, or clearing the swap

through a DCO; and to provide for an adjustment to the ``day of

execution'' to account for time-zone differences and end-of-day trading

issues. The Commission believes these changes are responsive to the

foregoing comments. However, in response to the comments of ISDA and

MarkitSERV regarding terms that may not be known until after the

acknowledgement delivery deadline has passed, the Commission believes

that an acknowledgement could meet the requirement that all terms be

included by describing where and when the ``to be determined'' terms

will be obtained and provide for incorporation by reference once the

terms are known.

As discussed below in section III.B.2, the Commission is phasing in

compliance with each of the time periods required under Sec. 23.501,

including the acknowledgement requirement.

11. Confirmation Through Execution on a SEF or DCM and/or Clearing on a

DCO

The proposed regulations did not contain specific provisions

regarding confirmation through execution on a SEF or DCM, or clearing

on a DCO. However, in the Confirmation NPRM, the Commission stated:

``It is important to note at the outset, that the Commission expects

that swap dealers and major swap participants would be able to comply

with each of the proposed rules by executing a swap on a swap execution

facility (SEF) or on a designated contract market (DCM), or by clearing

the swap through a derivatives clearing organization (DCO). For swaps

executed on a SEF or a DCM, the SEF or DCM will provide the

counterparties with a definitive written record of the terms of their

agreement, which will serve as a confirmation of the swap. Similarly,

if a swap is executed bilaterally, but subsequently submitted to a DCO

for clearing, the DCO will require a definitive written record of all

terms to the counterparties' agreement prior to novation by the DCO;

this too would serve as a confirmation of the swap.'' \30\

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\30\ See Confirmation NPRM at 81520.

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Commenting on this aspect of the proposal, Chris Barnard supported

the idea that SDs and MSPs will be able to comply with the proposed

rule by executing a swap on a SEF, a DCM, or by clearing the swap

through a DCO, and supported the greater use of these facilities. Each

of ISDA, CME, ICE, The Working Group, the FHLBs, MetLife, MFA, and

Chatham recommended that the Commission explicitly clarify in the final

rules that the confirmation processes of SEFs, DCMs, and DCOs satisfy

the requirements of the confirmation rules.

MarkitSERV however asserted that the Commission should not presume

that execution on a SEF will automatically result in confirmation of a

swap because the execution and confirmation of a swap are separate and

distinct activities, and it is possible that SEFs and DCMs may offer

execution services without necessarily providing confirmation services.

MarkitSERV recommended that the Commission prescribe standards for any

confirmation service that may be offered to ensure that SEFs and DCMs

produce a complete, legally binding record of each swap based on a

recognized legal framework. MarkitSERV also recommended that SEFs and

DCMs be permitted to allow qualified third parties to perform the

confirmation function after swap execution.

Based on these comments and other considerations discussed above,

the Commission has revised the proposed rules to state explicitly that

swaps executed on a SEF or DCM, and swaps cleared by a DCO, will be

deemed to have met the confirmation requirements so long as: (i)

confirmation of all terms of the transaction takes place at the same

time as execution on a SEF or DCM; or (ii) the parties submit the swap

for clearing no later than the time that confirmation would otherwise

be required and the DCO confirms the terms of the swap upon acceptance

for clearing. Under Sec. 39.12(b)(8), DCOs are required to provide a

confirmation of all the terms of each cleared swap, and this

confirmation is required to take place at the same time the swap is

accepted for clearing.\31\ Under Core Principle 11 for DCMs and Sec.

38.601, DCMs must clear all transactions executed on or through the DCM

through a Commission-registered DCO.\32\ In essence, confirmation for

DCM-executed swaps will occur either at the same time as execution or

upon submission to a DCO. The Commission's rules for SEFs, including

the proposed confirmation rule, Sec. 37.6(b), have yet to be

finalized.\33\ However, to the extent that a SEF offers confirmation

services upon execution or provides for the timely submission of a swap

for clearing, SDs and MSPs would be able to take advantage of the

provisions of Sec. 23.501(a)(4).

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\31\ See Derivatives Clearing Organization General Provisions

and Core Principles, 76 FR 69334, 69438 (Nov. 8, 2011). Under Sec.

39.12(b)(7), DCOs are required to accept or reject for clearing as

quickly after execution as would be technologically practicable if

fully automated systems were used all contracts that are listed for

clearing by the DCO and are executed on or subject to the rules of a

DCM or a SEF. See Customer Clearing Documentation, Timing of

Acceptance for Clearing, and Clearing Member Risk Management, 77 FR

21278, 21309 (April 9, 2012).

\32\ See Core Principles and Other Requirements for Designated

Contract Markets, 77 FR 36612, 36705 (June 19, 2012).

\33\ See Core Principles and Other Requirements for Swap

Execution Facilities, 76 FR 1214, 1240 (Jan. 7, 2011).

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With respect to MarkitSERV's comments, the Commission notes that if

a SEF or DCM does not provide confirmation services, the confirmation

deadlines of the rule will control. The standards for confirmation by

SEFs and the ability of a SEF to allow a third party to provide the

confirmation service are outside the scope of this adopting release.

12. Confirmation of Swap Transaction and Ownership Modifications--Sec.

23.500(m)

The proposed regulations required SDs and MSPs to comply with the

confirmation requirements for all ``swap transactions.'' The proposed

regulations defined ``swap transaction'' as any event that results in a

new swap or in a change to the terms of a swap, including execution,

termination, assignment, novation, exchange, transfer, amendment,

conveyance, or

[[Page 55925]]

extinguishing of rights or obligations of a swap.

In response to this requirement, ISDA stated that some ``market''

life cycle events (e.g., option exercise notices, various notices sent

by calculation agent, etc.) captured by the definition of ``swap

transaction'' are already described in the original confirmation and

sees no benefit to confirming those events. ISDA distinguished

``market'' from ``legal'' life cycle events (e.g., novations and

terminations), which currently are confirmed. ISDA stated that industry

methodologies have been developed around the confirmation of legal life

cycle events at great time and expense and recommends that the

Commission defer to industry standards and to allow market participants

to bilaterally agree that certain life cycle events do not require

subsequent confirmation. ISDA believes that the proposed life cycle

confirmation requirement will undermine the move to electronic

execution and processing, because not all life cycle events are

currently supported by electronic platforms across asset classes.

BGA recommended that the Commission revise the proposed definition

of ``swap transaction'' to include only those life-cycle events that

impact the economics or settlement of the trade, as current practice of

energy commodity trading companies is not to send new confirmations for

events like novations.

GFED believes that the Commission should exclude FX swaps from any

life-cycle event confirmation requirement. GFED states that efficient

processes around trade events already exist (e.g., option exercises

confirmed as new trades), and that ISDA has developed a novation

protocol in wide use that is moving the industry toward novation

without confirmation.

While MFA supports confirmation of life-cycle events, it

recommended that the Commission not mandate specific timing

requirements for the confirmation of life-cycle events. MFA states that

once a life-cycle event occurs, parties to a swap may need to

renegotiate certain trade terms and a timing requirement is likely to

disadvantage end users in such negotiation with SDs.

The Working Group recommended that confirmation of changes to

material economic or legal terms of a swap should be confirmed, but the

confirmation should only be required within a reasonable period of

time, rather than the time periods imposed for newly executed swaps.

The Working Group also argued that events related to the underlying

exposure of a swap should not be subject to any confirmation

requirement as they are generally addressed in master trading

agreements or the applicable confirmation.

Having considered these comments, the Commission has determined not

to modify the proposed rule with respect to this issue. In reaching

this conclusion, the Commission observes that the definition of ``swap

transaction'' would require confirmation of changes to the terms of a

swap that have been agreed between the parties or that change the

ownership of a swap. However, the definition does not require

confirmation of events that may impact the economics of the swap. To

the extent that the documented terms of a swap are agreed to in advance

and provide for automatic changes to terms upon the occurrence of a

defined event, the Commission believes that such change would not

require confirmation pursuant to the rule.

13. Legal Uncertainty for Swaps Following Failure to Comply With Swap

Confirmation Rules

The proposal did not address the issue of the legal standing or

enforceability of a swap transaction that is not confirmed within the

time periods mandated by the proposed rules.

In respect of this issue, the FHLBs commented that such failure

should not affect the enforceability of the swaps because such an

outcome would lead to legal uncertainty in the swap market, and The

Working Group recommended that the Commission clearly indicate the

regulatory and legal consequences of one or more parties to a swap

failing to meet the timing requirements for acknowledgement and

confirmation, asserting its view that a swap should not be invalidated

for the failure to meet the timing requirements of the proposed rules.

MFA also argued that legal certainty of trade execution is vital

for all market participants and the proposed rules may lead to

uncertainty as to the enforceability of transactions that fail to be

confirmed in compliance with the requirements of the proposed rules. To

avoid this result, MFA recommended that the rule be revised to require

only that an SD or MSP deliver an acknowledgement specifying the

primary economic terms of a swap (rather than all terms), and specify

no timeframe for confirmation.

Recognizing the concerns raised by commenters with respect to legal

certainty, the Commission notes that it is not the intent of the

confirmation rule to provide swap counterparties with a basis for

voiding or rescinding a swap transaction based solely on the failure of

the parties to confirm the swap transaction in compliance with the

proposed rules. In the absence of fraud, the Commission will consider

an SD or MSP to be in compliance with the confirmation rule if it has

complied in good faith with its policies and procedures reasonably

designed to comply with the requirements. However, the Commission notes

that it does not have the authority to immunize SDs or MSPs from

private rights of action for conduct within the scope of section 22 of

the CEA, i.e., violations of the CEA.

14. Recordkeeping Requirements for Acknowledgements and Confirmation--

Sec. 23.501(b)

Proposed Sec. 23.501(b) required SDs and MSPs to keep a record of

the date and time of transmission of acknowledgements and

confirmations, a record of the length of time between acknowledgement

and confirmation, and a record of the length of time between execution

and confirmation.

Commenting on the proposal, The Working Group recommended that only

a time stamp on acknowledgements and confirmations be required as the

remainder of the required records in the proposed rules could be

determined from the timestamps on these documents. The Working Group

also requested that the Commission clarify how the recordkeeping

requirements in the proposed confirmation rule apply to lifecycle

events because timestamps for some lifecycle events would not make

sense.

MarkitSERV recommended that the Commission clarify that an SD's or

MSP's recordkeeping requirements may be delegated to a third-party

confirmation platform and the conditions under which such delegation

may be done.

BGA argued that energy commodity traders place orders with broker/

dealers and may be unaware of the time at which a trade is actually

executed, and unable to keep accurate records of the length of time

between execution and confirmation of a swap. BGA therefore recommended

that the Commission remove the recordkeeping requirements from the

proposed rules.

GFED commented that the time stamp requirements of the proposed

recordkeeping rules would require significant technology investment as

current systems typically do not time stamp at issuance or receipt.

Having considered these comments, the Commission is modifying the

recordkeeping requirement. First, the Commission is removing the

[[Page 55926]]

requirement that SDs and MSPs keep records of the length of time

between the acknowledgment and confirmation of a swap, as well as the

time between execution and confirmation, as this information can be

readily ascertained by reviewing other records. Second, the cross-

reference to Sec. 1.31 has been changed to refer to the record

retention rule applicable to SDs and MSPs, Sec. 23.203. Apart from

these modifications, the Commission believes the records required to be

made and maintained under Sec. 23.501(b) are the minimum necessary to

monitor compliance with the rule. In addition, the Commission notes

that certain items in the recordkeeping requirement is information that

will be required for compliance with other Commission rules, such as

the time of execution for real-time public reporting of pricing and

transaction data and for reporting to an SDR.

In response to MarkitSERV, the rule does not prohibit SDs and MSPs

from relying on third-party service providers to achieve compliance

with the rule, although the responsibility for compliance cannot be

delegated. Finally, in response to The Working Group's comment, the

Commission is not persuaded that it is impossible to keep time-stamped

records of key changes in ownership including such significant events

as execution, termination, assignment, novation, exchange, transfer,

amendment, conveyance, or extinguishing of rights or obligations. The

Commission believes that its clarification of the ``swap transaction''

definition above alleviates any concern that the rule imposes an

impossible recordkeeping requirement.

E. Portfolio Reconciliation--Sec. 23.502

Portfolio reconciliation is a post-execution processing and risk

management technique that is designed to: (i) Identify and resolve

discrepancies between the counterparties with regard to the terms of a

swap either immediately after execution or during the life of the swap;

(ii) ensure effective confirmation of all the terms of the swap; and

(iii) identify and resolve discrepancies between the counterparties

regarding the valuation of the swap. In some instances, portfolio

reconciliation also may facilitate the identification and resolution of

discrepancies between the counterparties with regard to valuations of

collateral held as margin. Accordingly, in the Confirmation NPRM, the

Commission proposed Sec. 23.502, which required SDs and MSPs to

reconcile their swap portfolios with one another and provide

counterparties who are not registered as SDs or MSPs with regular

opportunities for portfolio reconciliation. In order for the

marketplace to realize the full risk reduction benefits of portfolio

reconciliation, the Commission also proposed to expand portfolio

reconciliation to all transactions, whether collateralized or

uncollateralized. For the swap market to operate efficiently and to

reduce systemic risk, the Commission believed that portfolio

reconciliation should be a proactive process that delivers a

consolidated view of counterparty exposure down to the transaction

level. By identifying and managing mismatches in key economic terms and

valuation for individual transactions across an entire portfolio, the

Commission's proposal sought to require a process in which overall risk

can be identified and reduced. The Commission received numerous

comments to the portfolio reconciliation proposal and considered each

in formulating the final rules, as discussed below.

1. Statutory Basis for Portfolio Reconciliation

The proposed portfolio reconciliation regulations were proposed

pursuant to section 4s(i) of the CEA, as added by section 731 of the

Dodd-Frank Act, which directs the Commission to prescribe regulations

for the timely and accurate confirmation, processing, netting,

documentation, and valuation of all swaps entered into by SDs and MSPs.

The Working Group commented that the Commission should delete the

reconciliation requirements from the proposed rule because section 731

of the Dodd-Frank Act does not require the Commission to issue rules on

portfolio reconciliation and the Commission has not fully analyzed the

potential effect on the market.

In response to The Working Group's comment, the Commission notes

that portfolio reconciliation involves both confirmation and valuation

and serves as a mechanism to ensure accurate documentation. Thus, the

reconciliation requirements finalized herein are within the scope of

section 4s(i) of the CEA. Moreover, the Commission reiterates its

statement in the Confirmation NPRM that disputes related to confirming

the terms of a swap, as well as swap valuation disputes impacting

margin payments, have long been recognized as a significant problem in

the OTC derivatives market, and portfolio reconciliation is considered

an effective means of identifying and resolving these disputes.

2. General Comments to Portfolio Reconciliation--Sec. 23.502

Proposed Sec. 23.502 required SDs and MSPs to engage in periodic

swap portfolio reconciliation with their swap counterparties. Swap

portfolio reconciliation is defined in the proposed rule as a process

by which the two parties to one or more swaps: (i) Exchange the terms

of all swaps in the portfolio between the parties; (ii) exchange each

party's valuation of each swap in a portfolio between the parties as of

the close of business on the immediately preceding business day; and

(iii) resolve any discrepancy in material terms and valuations.

While Chris Barnard supported the proposed reconciliation

requirements, several commenters objected to certain aspects of the

rule.

GFED commented that the portfolio reconciliation requirements are

likely to be onerous, require significant investment in new

infrastructure, and have few benefits for shorter dated FX swaps. GFED

therefore recommended that the rules require only: (i) Reconciliation

of portfolio valuations (as opposed to differences in valuation or

trade specifics at the transaction level) because there is existing

market infrastructure in place for this purpose; and (ii)

reconciliation on a weekly basis with longer timeframes for resolving

discrepancies that reflect the global nature of the FX market.

MFA stated that current market practice is for market participants

to engage in portfolio reconciliation at the transactional level only

if there are portfolio-level discrepancies that result in margin

disputes, and MFA recommended that the Commission only require

portfolio reconciliation upon the occurrence of a material dispute

regarding margin to avoid unnecessary expense. MFA also believes the

Commission should accommodate participants with differing policies,

procedures, business models, structures, and types of swaps by

providing general principles and guidelines as to what constitutes best

practices, but not prescriptive rules.

ISDA stated that current portfolio reconciliation processes in the

industry are a means of identifying the source of a material collateral

dispute at the portfolio level. ISDA believes the draft 2011 Convention

on Portfolio Reconciliation and the Investigation of Disputed Margin

Calls and the draft 2011 Formal Market Polling Procedure, developed

pursuant to industry commitments to the ODSG, which ISDA believes will

be widely adopted by OTC derivatives market participants, should

[[Page 55927]]

play a more significant role in shaping the proposed reconciliation

rules. Specifically, ISDA believes that portfolio reconciliation should

be defined by reference to generally-accepted industry standards, as

instituted through the ODSG process, and reflected in data standards

and best practices as published by ISDA.

While TriOptima supports the regular reconciliation of all

portfolios and believes that this will identify issues that can

minimize counterparty credit exposure and operational risk, TriOptima

also believes that the Commission should not require registrants to

agree on reconciliation procedures, but should encourage the use of

industry-wide practices and protocols.

The Commission has not modified the rule based on these comments,

but certain elements of the rule have been modified based on specific

comments received, as discussed below. The Commission believes that

regular portfolio reconciliation will prevent most disputes from

arising and therefore does not recommend that portfolio reconciliation

be performed only on an ad hoc basis in response to a material margin

dispute at the portfolio level. The Commission notes that portfolio

reconciliation is not required for cleared swaps where the DCO holds

the definitive record of the trade and determines a binding daily

valuation for each swap cleared by the DCO. Therefore the Commission

believes that portfolio reconciliation will become less burdensome as

the bilateral portfolios of SDs and MSPs become significantly smaller

over time as a result of required clearing of swaps. In addition, the

need for portfolio reconciliation may be obviated at such time as all

swaps are reported to SDRs. For example, if an SDR record of a swap is,

by agreement of the parties, the legally operative documentation of the

swap, the parties need only consult the SDR record to reconcile their

portfolios.\34\

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\34\ For example, DTCC's Trade Information Warehouse maintains

the centralized global electronic database for virtually all CDS

contracts outstanding in the marketplace. The repository maintains

the most current credit default swap contract details on the

official legal, or gold record, for both cleared and bilateral CDS

transactions.

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3. Reconciliation of Material Terms--Sec. 23.502(a)(4) & (b)(4)

The proposed regulations required SDs and MSPs to resolve any

discrepancy in material terms of swaps in a swap portfolio discovered

during the process of portfolio reconciliation.

Commenting on this aspect of the proposal, ISDA stated that current

portfolio reconciliation processes in the industry are not meant to

resolve swap terms that do not lead to a material collateral dispute

and that the proposed rule would cause reconciliation to become a

replacement for the confirmation process. Similarly, The Working Group

stated that the Commission should not require reconciliation of terms

other than valuations to avoid imposing substantial costs on market

participants in the absence of any immediate need.

MarkitSERV asserted that the purpose of portfolio reconciliation is

the resolution of disputes that materially impact collateralization at

the portfolio level, and thus it is unnecessarily burdensome to require

any discrepancy in material terms to be resolved. MarkitSERV

recommended that the Commission only require reconciliation of terms

that could have a material impact on the valuation or collateralization

of a swap.

The FHLBs commented that it is not necessary to repeatedly

reconcile all terms of swaps that have been reported to a SDR as most

if not all such terms will not change from day-to-day or even month-to-

month. The FHLBs believe that SDRs will be in the best position to

efficiently and effectively detect and manage discrepancies in the

material terms of a swap transaction. Likewise, MetLife recommended

that the Commission revise the proposed reconciliation rule to require

only the reconciliation of variable economic terms, as the repeated

review of static terms confirmed during the confirmation process would

be an undue burden and expense.

TriOptima, on the other hand, recognized that the Commission's

proposal focuses on reconciliation of material terms in portfolios.

TriOptima believes that this is appropriate because the priority in

reconciliation is on completeness of trade population, rather than

granularity in trade details.

Having considered these comments, the Commission is not making any

change to the proposed requirement that all discrepancies in material

terms be resolved. The Commission is not persuaded by commenters that a

discrepancy in the terms of individual swaps would not be material to

the swap portfolio as a whole unless such discrepancies impact

collateralization at the portfolio level. Rather, the Commission

believes that a discrepancy in the material terms of a swap indicates a

failure in the confirmation process or a failure in a trade input or

processing system. As noted in the preamble to the proposed rules, the

Commission believes that the requirement that all swaps be reported to

an SDR will reduce the burden imposed by the rule by facilitating

efficient, electronic reconciliation for SDs, MSPs, and their

counterparties. Accordingly, the two requirements are consistent and

mutually reinforcing.

4. Frequency of Portfolio Reconciliation--Sec. 23.502(b)

Proposed Sec. 23.502(b) required SDs and MSPs to reconcile swap

portfolios with other SDs or MSPs with the following frequency: Daily

for portfolios consisting of 300 or more swaps, at least weekly for

portfolios consisting of 50 to 300 swaps, and at least quarterly for

portfolios consisting of fewer than 50 swaps. For portfolios with

counterparties other than SDs or MSPs, the proposed regulations

required SDs and MSPs to establish policies and procedures for

reconciling swap portfolios: Daily for swap portfolios consisting of

500 or more swaps, weekly for portfolios consisting of more than 100

but fewer than 500 swaps, and at least quarterly for portfolios

consisting of fewer than 100 swaps.

Several commenters supported the frequency of reconciliation

required by the proposed rule. Chris Barnard supported the frequency of

the proposed reconciliation requirements, while TriOptima stated that a

large number of SDs and MSPs already regularly reconcile their

portfolios with each other and with other entities and that the

increased frequency and inclusion of smaller portfolios as proposed

should prove no obstacle to such entities.

However, several commenters recommended alternatives. ISDA

recommended that the Commission accept the portfolio size/frequency

gradation established by the ODSG process, as that may change over

time, which ISDA believes provides an internationally consistent and

flexible standard. ISDA does not believe the proposed rule should

distinguish between counterparty types for determining frequency of

reconciliation because transaction population is an adequate guide. The

Working Group argued that the frequency of portfolio reconciliation

should be left up to the counterparties because they have the

sophistication necessary to determine whether and with what frequency

reconciliation is required in their own circumstances, which may be

daily, weekly, upon discovery of a dispute, or not at all. In the

alternative, The Working Group recommended that portfolio

reconciliation be required quarterly with any counterparty with which a

registrant has more than 100 swaps, and annually with all other

[[Page 55928]]

counterparties. Finally, Chatham recommended that the Commission revise

the proposed rules to provide that reconciliation with end users is

only required for swaps with maturities greater than one year and at

the following frequency: Weekly for portfolios of 500 or more swaps;

quarterly for portfolios of 100 to 500 swaps; annually for portfolios

of 50 to 100 swaps; and optional reconciliation for portfolios of 50 or

less swaps.

Still other commenters objected more generally to the required

frequency of reconciliation. Dominion argued that the rule should not

override any contractual right that end users may have regarding

reconciliation, including frequency and the process for resolving

disputes, while AMG argued that reconciliation required under the

proposed rules is unnecessarily frequent and imposes excessive costs

that do not bear a reasonable relationship to the systemic risk goals

of the Dodd-Frank Act.

Finally, the OCC stated that many SDs will not be among the G-14

largest OTC derivatives dealers and, given the incremental progression

that was necessary for the G-14 OTC derivatives dealers to develop the

infrastructure necessary to increase reconciliation amongst themselves

from weekly reconciliation for portfolios with 5,000 or more trades in

2008 to the current daily reconciliation for portfolios of 500 or more

trades, the Commission should provide sufficient time for all

registrants to develop required infrastructure.

Having considered these comments, the Commission is modifying the

proposed rule to require daily reconciliation of swap portfolios among

SDs and MSPs only for swap portfolios of 500 or more swaps. The

Commission continues to believe that the requirement that all swaps be

reported to an SDR will lead to efficient, electronic reconciliation

for SDs and MSPs, but, at the urging of commenters, has reduced the

required frequency of reconciliation to match the frequency of

reconciliation currently undertaken by the largest prospective SDs.\35\

In addition, the daily reconciliation requirement for swap portfolios

among SDs and MSPs of 500 or more swaps brings the rule into

conformance with international regulatory efforts.\36\

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\35\ In December 2008, the ODSG's group of 14 major dealers

committed to execute daily portfolio reconciliations for

collateralized portfolios in excess of 500 trades between

participating dealers by June of 2009. See June 2, 2009 summary of

industry commitments, available at http://www.isda.org/c_and_a/pdf/060209table.pdf. As of May 2009, all participating dealers were

satisfying this commitment. The ODSG dealers expanded their

portfolio reconciliation commitment in March 2010 to include monthly

reconciliation of collateralized portfolios in excess of 1,000

trades with any counterparty.

\36\ Compare with ESMA Draft Technical Standards, Article 2 RM,

subsection 4, (stating that ``In order to identify at an early

stage, any discrepancy in a material term of the OTC derivative

contract, including its valuation, the portfolio reconciliation

shall be performed: * * * each business day when the counterparties

have 500 or more OTC derivative contracts outstanding with each

other; * * * once per month for a portfolio of fewer than 300 OTC

derivative contracts outstanding with a counterparty; * * * once per

week for a portfolio between 300 and 499 OTC derivative contracts

outstanding with a counterparty.'')

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For portfolios with counterparties other than SDs or MSPs, the

Commission is adopting the recommendation proposed by The Working

Group--that portfolio reconciliation be required quarterly with any

counterparty with which a registrant has more than 100 swaps, and

annually with all other counterparties. The Commission believes this

approach is largely consistent with that recommended by Chatham, and it

responds, in part, to concerns expressed by AMG. The Commission

believes it also will serve to lower the costs of the rule. Despite

this change in the frequency of reconciliation required for portfolios

with non-SD, non-MSP counterparties, the Commission reiterates its

belief that periodic reconciliation with all counterparties is a best

practice for those using swaps.

In response to Dominion's concern about the rule overriding

contractual rights of market participants, the Commission wishes to

clarify that parties are free to negotiate and elect whatever dispute

resolution mechanisms they so choose. The reconciliation rule merely

sets forth the minimum requirements and timing for reconciliation of

swap portfolios. The rule is not intended to override contractual

rights so long as SDs and MSPs are in compliance with these limited

provisions.

5. Exchange of Swap Data for Portfolio Reconciliation--Sec. 23.500(i)

& Sec. 23.502(b)

The preamble to the proposed regulations stated that portfolio

reconciliation could consist of one party reviewing the trade details

and valuations delivered by the other party and either affirming or

objecting to such details and valuations. MarkitSERV recommended that

the Commission clarify the circumstances in which both parties would be

required to exchange swap data and circumstances in which only one

party would be required to send swap data to its counterparty for

verification. Consistent with its prior statement, the Commission

prefers to permit maximum flexibility and innovation in the process and

thus will leave the circumstances of exchange or verification to the

discretion of SDs, MSPs, and their counterparties.

6. Portfolio Reconciliation With Non-SDs/MSPs--Sec. 23.502

The proposed regulation required SDs and MSPs to establish written

policies and procedures for engaging in portfolio reconciliation with

non-SDs and non-MSPs, which includes the reconciliation of valuations

for each swap in the parties' portfolio.

Commenting on the proposal, MarkitSERV stated that buy-side firms

view valuation data as private information. To allow for

confidentiality, MarkitSERV recommends that the Commission permit non-

SDs and non-MSPs to perform portfolio reconciliation via third parties

in a process that would only disclose valuation data when a discrepancy

exceeds the threshold set forth in the proposed rules.

Dominion asserted that section 4s(i) of the CEA required the

Commission to adopt regulations for netting and valuation for SDs and

MSPs, but not end users, and objects that the proposed rules require

SDs and MSPs to establish policies for reconciliation with end users

and for resolution of valuation disputes with end users in a timely

fashion. Dominion is concerned that an end user will be required to

provide SDs with proprietary market valuations that could be used

against the interests of the end user. Dominion therefore recommended

that the Commission clarify that an SD's or MSP's written procedures

may not require end users to disclose any proprietary market

information for purposes of dispute resolution.

The FHLBs argued that end users should not be subject to the same

reconciliation requirements as SDs and MSPs because the swap portfolios

of end users do not pose a significant risk to the overall financial

system and the reconciliation requirements may increase the costs of

swaps for end users. Chatham similarly argued that non-SDs and non-MSPs

using swaps to hedge risk do not pose systemic risk so daily or weekly

reconciliation is not necessary.

As discussed above, the Commission is modifying the proposed rule

to change the word ``enforce'' to ``follow.'' Based on commenters'

concerns that an SD or MSP cannot force a non-registrant to abide by

the portfolio reconciliation requirements, the Commission is further

modifying the proposed rule to require

[[Page 55929]]

only that SDs and MSPs establish policies and procedures reasonably

designed to ensure that they engage in portfolio reconciliation with

non-registrants with the modified frequency discussed above. The

Commission believes that ``reasonably designed to ensure'' is not the

same as requiring a guarantee of compliance. Therefore, the Commission

believes that the rule, as modified, would require that the SDs and

MSPs make reasonable efforts to engage in portfolio reconciliation with

non-registrants, but would not give SDs or MSPs the authority to

require it of their non-registrant counterparties.

In addition, the Commission is modifying the proposed rule to

clarify that discrepancies in material terms or valuation disputes that

become known to the parties before the quarterly or annual

reconciliation with non-SDs, non-MSPs, should be resolved in a timely

fashion. With this change, the Commission notes that non-SD, non-MSP

counterparties may bring a discrepancy or dispute to an SD's or MSP's

attention and the SD or MSP counterparty must work to resolve those

identified discrepancies and disputes.

7. Portfolio Reconciliation With DCOs for Cleared Swaps--Sec.

23.502(c)

The proposed regulations stated that the portfolio reconciliation

requirements will not apply to swaps cleared by a DCO.

With respect to this provision, MarkitSERV recommended that the

Commission require SDs and MSPs to regularly reconcile their positions

in cleared swaps against SDRs, DCOs, and clearing brokers to correct

discrepancies between the DCO record and a firm's internal records.

The Commission has determined not to follow MarkitSERV's

recommendation on this point. DCOs maintain the definitive record of

the positions of each of their clearing members (both house and

customer) and mark those positions to a settlement price at least once

a day.\37\ Accordingly, the Commission believes that cleared swaps do

not present the same documentation and valuation issues that uncleared

swaps do. The Commission notes that reconciliation of swap data between

DCOs and SDRs is beyond the scope of this rulemaking, which is adopting

regulations with respect to SDs and MSPs only.

---------------------------------------------------------------------------

\37\ Under typical DCO rules, clearing members are bound by the

settlement price of the DCO and the product specifications of

cleared swaps are set by the DCO.

---------------------------------------------------------------------------

8. Portfolio Reconciliation by ``Qualified Third Parties''--Sec.

23.502(b)

The proposed regulations permitted portfolio reconciliation to be

performed on behalf of SDs, MSPs, and their counterparties by a

qualified third party.

Commenting on this proposal, ABC & CIEBA and AMG separately

recommended that the Commission not require use of ``qualified'' third

parties for portfolio reconciliation, but, rather should explicitly

require that use of any third party service provider must be agreed by

both parties and recognize that each party may use a different third

party for reconciliation. Specifically, ABC & CIEBA recommended that

Sec. 23.502(b)(1) and (2) be revised to read as follows:

``(1) Each swap dealer or major swap participant shall agree in

writing with each of its counterparties on the terms of the

portfolio reconciliation, including agreement on the selection of

any third party.

(2) The portfolio reconciliation may be performed on a bilateral

basis by the counterparties or by one or more third parties selected

by the counterparties in accordance with Sec. 23.502(b)(1).''

In response to these comments, the Commission is modifying the

proposed rule to delete the word ``qualified,'' to require that the use

of a third-party service provider be subject to agreement of the

parties, and to provide that each party may use a different third party

so long as the provisions of the rule are met. Further, per AMG's

comments, the Commission expects that parties will determine if the

third-party is qualified based on their own policies.

9. Reconciliation Discrepancy Resolution Procedures--Sec. 23.502(b)(4)

The proposed regulations required that SDs and MSPs establish

procedures reasonably designed to resolve any discrepancies in the

material terms or valuation of each swap identified in the portfolio

reconciliation process.

Commenting on this aspect of the proposal, ABC & CIEBA recommended

that the Commission revise Sec. 23.502(b)(4) in order to ensure that

reconciliation dispute resolution by SDs and MSPs is fair, impartial,

and even-handed.

The Commission agrees that reconciliation dispute resolution should

be fair, impartial, and even-handed as recommended by ABC & CIEBA, but

believes that the commenter's concern will be addressed by deleting the

word ``enforce'' as discussed above. The Commission expects that SDs

and MSPs will cooperate with their counterparties and any applicable

third-party service provider in resolving discrepancies brought to

light through portfolio reconciliation.

10. Time Period for Resolution of Discrepancies in Material Terms--

Sec. 23.502(a)(4) & (b)(4)

With regard to portfolio reconciliation among SDs and MSPs, the

proposed regulations required that any discrepancy in material terms be

resolved immediately.

Freddie Mac stated that in some cases it may be impossible to

resolve a discrepancy in material terms immediately, as required under

Sec. 23.502(a)(4). Freddie Mac recommended that the Commission should

revise the proposed rules to provide that the timely and accurate

processing and valuation requirements of the Dodd-Frank Act will be

deemed satisfied whenever swaps are subject to a master netting

agreement and collateral pledge agreement under which the parties mark

net portfolio value to market and exchange collateral on the basis of

such valuation as promptly as commercially reasonable.

Having considered Freddie Mac's comment, the Commission is adopting

the rule as proposed with respect to immediate resolution of

discrepancies in material terms in swaps among SDs and MSPs. Given the

timely confirmation requirements of all terms of a swap as established

under Sec. 23.501, the Commission believes an immediate resolution of

any material term discrepancy is appropriate. Additionally, the

Commission believes that a longer period is not justified because

resolution of a discrepancy in a material term will likely require an

amendment of the trade record in the relevant SDR, which, for

regulatory oversight purposes, should be as accurate as possible.

11. Resolution of Valuation Disputes in Portfolio Reconciliation--Sec.

23.502(a)(5) & (b)(4)

With regard to portfolio reconciliation among SDs and MSPs, the

proposed regulations required that any discrepancy in the valuation of

a swap be resolved within one business day. With regard to portfolio

reconciliation between SDs or MSPs and non-registrants, the proposed

regulations required that SDs and MSPs have policies and procedures

reasonably designed to resolve any discrepancy in the valuation of a

swap in a timely fashion.

With respect to this aspect of the proposal, ISDA commented that

parties to a good-faith dispute should have a commercially reasonable

timeframe in which to consult in order to find an

[[Page 55930]]

appropriate resolution of the dispute. ISDA believes the draft 2011

Convention on Portfolio Reconciliation and the Investigation of

Disputed Margin Calls and the draft 2011 Formal Market Polling

Procedure, developed pursuant to industry commitments to the ODSG,

which ISDA believes will be widely adopted by OTC derivatives market

participants, should play a more significant role in shaping the

proposed reconciliation rules. The Working Group, the FHLBs, and AMG

also recommended that the Commission support the valuation dispute

resolution methodology sponsored by ISDA.

In addition to its general comments, ISDA made specific

recommendations:

Resolution is labor intensive and to avoid undue costs,

discrepancies in terms and valuations should only require resolution if

such are causing material portfolio-level collateral transfer disputes,

rather than on a transaction by transaction basis, as it allows for the

possibility that material but offsetting differences may exist in a

portfolio.

Again to avoid undue costs, a materiality standard should

apply to any mandated resolution requirement, because, in the absence

of a collateralization requirement or a live dispute as to

collateralization, discrepancies in valuation may be allowed to subsist

as potentially harmless and may disappear through changes in portfolio

composition over time. ISDA recommends that the ODSG resolution

tolerances be adopted by the Commission, as such tolerances may be

amended over time.

Resolution of a valuation dispute should mean that the

discrepancy in a portfolio-level margin dispute is reduced such that it

is within the applicable resolution tolerance, rather than requiring

exact agreement.

Resolution of a valuation dispute should not require

parties to make adjustments to their books and records.

Parties should be free to agree to accept that there is a

difference in opinion as to value, so long as appropriate capital is

held against any potential collateral shortfall.

With respect to the proposal to require valuation disputes to be

resolved within one business day, ISDA stated that a one-day timeframe

for resolution of valuation discrepancies is infeasible, especially

when applied to parties across vastly different global time zones, due

to the need to analyze reconciliation results, escalate for trader-to-

trader discussion or to senior management. Further, ISDA argued that

some disputes prove to be intractable and must be resolved through a

market poll, which requires time to build and populate a valuation

model, which may take hours or even days. AMG also argued that the time

periods are unnecessarily short and do not bear a reasonable

relationship to the systemic risk goals of the Dodd-Frank Act, noting

that the time periods are not consistent with recent ISDA dispute

resolution protocols or other methodologies incorporated in master

agreements, and could impose excessive costs on swap market

participants.

AMG recommended that the Commission clarify the consequences of

failing to resolve a valuation dispute within the mandated timeframe.

Freddie Mac stated that in some cases it may be impossible to resolve a

discrepancy in valuation within one business day, while BGA does not

believe that registrants should be penalized for failing to meet the

one business day resolution deadline. BGA argued that (i) SDs and MSPs

do not have control over their counterparties so resolution may take

more than a day; and (ii) a hard deadline may disadvantage SDs and MSPs

in negotiating a resolution with a counterparty that is not subject to

a deadline. Finally, The Working Group argued that the proposed

requirement that valuation disputes between registrants be resolved

within one business day is not workable due to the complex calculations

required, involvement of multiple functional groups within a

registrant, and possibility that resolution of a dispute may require

modifications to a valuation model that could create further

discrepancies for other swaps that are valued using the same model. The

Working Group believes the Commission should require only that

registrants begin the valuation dispute resolution process upon

discovery of a dispute, but permit counterparties to resolve the

dispute within a reasonable time period.

The FHLBs requested that the Commission specify the meaning of ``in

a timely fashion'' as it relates to discrepancy resolution with end

users.

The Working Group also had a number of recommendations with respect

to the proposed rule:

The Commission should not adopt valuation dispute

resolution rules that may be burdensome for markets where no problem

exists, such as swap markets with underlying physical markets that

provide an objective basis for swap valuations.

The proposed reconciliation rules should apply only to

valuation disputes on a portfolio basis, and not on a transaction

basis, as it would be unnecessarily burdensome to analyze the valuation

of individual swaps unless there is a material dispute as to the

portfolio level exposure between the parties.

Parties should have the right to continue to exchange

collateral without resolving a discrepancy exceeding 10 percent if they

conclude that the discrepancy is not material in their particular

circumstances.

With respect to the proposed 10 percent threshold before a dispute

would require resolution, Chatham argued that a percentage threshold of

10 percent difference is insufficient because it will impose a

significant burden in cases where the absolute value of the swap is

small, such as just after a swap is executed and in the period just

before maturity. MFA also recommended that the Commission revise the

proposed rule to provide that a valuation discrepancy must not only

exceed 10 percent, but must also exceed some reasonable dollar

threshold, and must result in one party being unwilling to satisfy a

collateral call from the other party. On the other hand, MetLife

supported the 10 percent buffer for designation of valuation

discrepancies, but recommended that the Commission extend the deadline

for valuation dispute resolution from 1 to at least 3 business days

with respect to highly structured and customized swaps.

TriOptima provided context with respect to valuation dispute

resolution in the swaps market. TriOptima commented that swaps are

valued using internal models, which use inputs derived from observable

sources or internal calculations and reflect a party's view on the

market; that for many swaps, there is only sparse or episodic liquidity

in similar contracts, which can be used to calibrate internal valuation

models; and that there is valuable information for regulators in a

spectrum of differing valuations of a swap. As an example, TriOptima

hypothesized that regulators could have had an early warning sign in

the run up to the 2008 financial crisis when some market participants

realized earlier than others that the price of credit risk was too low

and raised the price in their internal valuations as opposed to

counterparties that did not recognize the change in credit risk. With

respect to the proposal, TriOptima argued that forcing convergence on

swap valuations between parties could be detrimental to the stability

and resilience of the financial system by creating a disincentive for

firms to use their own judgment in setting market values, removing a

valuable diagnostic tool for regulators. TriOptima further stated that

there is a difference between an internal

[[Page 55931]]

valuation used for regulatory capital purposes and a valuation agreed

with a counterparty for use in calculating margin. If the agreed

valuation is lower than the internal valuation, a party must reserve

capital for the unsecured exposure. Therefore, TriOptima argued that if

the Commission requires the parties to agree on a valuation for

internal purposes, the unsecured exposure disappears and less capital

will be reserved, reducing stability and resilience in the financial

markets. TriOptima recommended that the Commission focus on

establishing principles for how to determine the margining amount on a

portfolio level, rather than forcing parties to agree on valuation of

individual transactions, with a key element in such principles being

consistency. For valuation differences that persist after excluding

errors and inconsistencies, TriOptima believes the parties should be

allowed to agree to disagree and face the credit risk and capital

consequences of having unsecured exposures.

The Commission recognizes the view that there is valuable

information for market participants and regulators in a spectrum of

differing valuations of a swap. The Commission also is cognizant of the

ongoing efforts by industry and ISDA to improve the existing valuation

dispute resolution process. Based on meetings between Commission staff

and ISDA's Collateral Steering Committee, the Commission understands

that ISDA's draft 2011 Convention on Portfolio Reconciliation and the

Investigation of Disputed Margin Calls and the draft 2011 Formal Market

Polling Procedure has reduced valuation dispute resolution to a 30-day

process.

Issues related to swap valuations are woven through a number of

Commission rule proposals. For instance, Sec. 23.504(e), as adopted in

this release, requires SDs and MSPs to report valuation disputes in

excess of $20,000,000 lasting longer than three business days to the

Commission, while under Sec. 23.504(b)(4) SDs and MSPs are required to

agree on valuation methodologies with their counterparties. The

Commission believes that by requiring agreement with each counterparty

on the methods and inputs for valuation of each swap, it is expected

that Sec. 23.504(b)(4) will assist SDs and MSPs to resolve valuation

disputes in a timely manner, thereby reducing risk.

Agreement between SDs, MSPs, and their counterparties on the proper

daily valuation of the swaps in their swap portfolio also is essential

for the Commission's margin proposal. As discussed above, under

proposed rule Sec. 23.151, non-bank SDs and MSPs must document the

process by which they will arrive at a valuation for each swap for the

purpose of collecting initial and variation margin. All non-bank SDs

and MSPs must collect variation margin from their non-bank SD, MSP, and

financial entity counterparties for uncleared swaps on a daily basis.

Variation margin requires a daily valuation for each swap. For swaps

between non-bank SDs and MSPs and non-financial entities, no margin is

required to be exchanged under Commission regulation, but the non-bank

SDs and MSPs must calculate a hypothetical variation margin requirement

for each uncleared swap for risk management purposes under proposed

Sec. 23.154(b)(6).

Given that arriving at a daily valuation is one of the building

blocks for the margin rules and is essential for the mitigation of risk

posed by swaps, the Commission expects that SDs and MSPs as a matter of

best practice will work to resolve valuation disputes for swaps with

other SDs and MSPs within one business day. However, the Commission is

modifying this provision to require that valuation disputes be subject

to policies and procedures reasonably designed to ensure that such

disputes are resolved within five business days, as discussed further

below. The Commission has determined to make no change to the

requirement that valuation disputes between SDs, MSPs, and non-SDs or

non-MSPs be subject to policies and procedures reasonably designed to

ensure that such disputes are resolved ``in a timely fashion.''

The Commission is persuaded by commenters that some valuation

disputes may be difficult to resolve within the one-day timeframe and

is therefore modifying the rule such that it no longer requires

resolution, but instead requires that SDs and MSPs establish procedures

reasonably designed to ensure that swap valuation disputes are resolved

within five business days.\38\ Thus SDs and MSPs will not violate the

rule if they fail to resolve a particular dispute within five business

days, so long as they have followed their reasonably designed

procedures. In addition, the rule will require SDs and MSPs to have

policies and procedures identifying how they will comply with any

variation margin requirements pending resolution of a valuation

dispute. The rule already requires SDs and MSPs to establish procedures

to resolve valuation disputes with non-SD/MSP counterparties in a

timely fashion.

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\38\ Compare with ESMA Draft Technical Standards, Article 4 RM,

subsection 2, (stating that ``counterparties shall, when concluding

OTC derivative contracts with each other have agreed detailed

procedures and processes in relation to * * * resolution of disputes

in a timely manner; * * * resolution of disputes that are not

resolved within five business days, including third party

arbitration or a market polling mechanism.'')

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Regarding the safe harbor for valuation differences of less than 10

percent, the Commission believes the 10 percent threshold is

appropriate as it provides certainty as to which disputes must be

resolved. The Commission believes the efficiency of a bright line rule,

as opposed to the formulas and discretion in the alternatives presented

by commenters, will better serve the operational processes of SDs and

MSPs and the regulatory oversight of the Commission.

12. Reporting of Valuation Disputes to the Commission

The proposed regulations required SDs and MSPs to keep records of

valuation disputes and the time to resolution of such disputes, but did

not require SDs or MSPs to report such disputes to the Commission.

However, as noted by the New York City Bar Committee on Futures and

Derivatives (NYCB), proposed Sec. 23.504(e) required valuation

disputes among SDs and MSPs outstanding for more than one business day,

or five business days for disputes between an SD or MSP and a non-SD,

non-MSP counterparty to be reported to the Commission.

In this regard, ISDA recommended that the Commission require

monthly reporting of margin disputes outstanding more than 15 days that

exceed the applicable tolerances, which is consistent with current ODSG

commitments. MetLife recommended a period of 90 days before reporting

is required.

As discussed above, the Commission is modifying this provision to

require reporting within three business days, and it has added a

$20,000,000 threshold for reporting of disputes. The Commission

believes the less frequent reporting provided by the threshold will

alleviate the concerns of the commenters.\39\

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\39\ Compare with ESMA Draft Technical Standards, Article 4 RM,

subsection 2, (stating that ``counterparties shall report to the

competent authority * * * any disputes between counterparties

relating to an OTC derivative contract, its valuation or the

exchange of collateral for an amount or a value higher than EUR 15

million and outstanding for at least 15 business days.'')

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[[Page 55932]]

13. Recordkeeping Requirement for Portfolio Reconciliation--Sec.

23.502(d)

The proposed regulations required SDs and MSPs to make and retain a

record of each portfolio reconciliation, including a record of each

discrepancy and the time to resolution of each discrepancy.

ISDA objected to the recordkeeping requirement for portfolio

reconciliation, arguing that it should consist only of disputes, and

not of the entire process. Specifically, ISDA recommended that records

be kept of the date of the initial dispute, the resolution of the

dispute, the date of resolution, and the net portfolio valuations of

the two parties. Further, ISDA requested an explicit statement that

access to third party reconciliation services' records will satisfy the

obligation to permit inspection of the records by supervisors.

Similarly, The Working Group requested that the Commission clarify that

the records required to be kept in relation to valuation dispute

resolution pertain only to discrepancies that exceed the 10 percent

buffer.

The Commission notes that its recordkeeping rule for SDs and MSPs

includes a recordkeeping requirement that SDs and MSPs make and keep a

record of each portfolio reconciliation, including the number of

portfolio reconciliation discrepancies and the number of swap valuation

disputes (including the time-to-resolution of each valuation dispute

and the age of outstanding valuation disputes, categorized by

transaction and counterparty).\40\ In the interests of streamlining

regulatory requirements, the Commission is modifying Sec. 23.502(d) to

cross reference Sec. 23.202 and delete the substantive requirements.

The Commission has also revised the cross-reference to Sec. 1.31 to a

cross-reference to the SD and MSP record retention rule, Sec. 23.203.

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\40\ See 17 CFR 23.202(a)(3)(iii), Reporting, Recordkeeping, and

Daily Trading Records Requirements for Swap Dealers and Major Swap

Participants, 77 FR 20128, 20201 (April 3, 2012).

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In response to comments of ISDA and The Working Group, the

Commission believes that the level of detail included in portfolio

reconciliation records is left to the reasonable discretion of SDs and

MSPs so long as the basic requirements of the rule are met.

F. Portfolio Compression--Sec. 23.503

Section 4s(i) of the CEA directs the Commission to prescribe

regulations for the timely and accurate processing and netting of all

swaps entered into by swap dealers and major swap participants.

Portfolio compression is an important, post-trade processing and

netting mechanism that can be an effective and efficient tool for the

timely and accurate processing and netting of swaps by market

participants. Portfolio compression is a mechanism whereby

substantially similar transactions among two or more counterparties are

terminated and replaced with a smaller number of transactions of

decreased notional value in an effort to reduce the risk, cost, and

inefficiency of maintaining unnecessary transactions on the

counterparties' books. Because portfolio compression participants are

permitted to establish their own credit, market, and cash payment risk

tolerances and to establish their own mark-to-market values for the

transactions to be compressed, the process does not alter the risk

profiles of the individual participants beyond a level acceptable to

the participant. The usefulness of portfolio compression as a risk

management tool has been acknowledged widely.

In 2008, the PWG identified frequent portfolio compression of

outstanding trades as a key policy objective in the effort to

strengthen the OTC derivatives market infrastructure.\41\ Similarly,

the 2010 staff report outlining policy perspectives on OTC derivatives

infrastructure issued by the FRBNY identified trade compression as an

element of strong risk management and recommended that market

participants engage in regular, market-wide portfolio compression

exercises.\42\

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\41\ See ``Policy Objectives for the OTC Derivatives Markets,''

President's Working Group on Financial Markets (Nov. 14, 2008).

\42\ See Federal Reserve Bank of New York Staff Report No. 424:

``Policy Perspectives on OTC Derivatives Market Infrastructure,''

Jan. 2010 (revised Mar. 2010).

---------------------------------------------------------------------------

Based upon these considerations, the Commission proposed Sec.

23.503, which imposed certain portfolio compression requirements upon

SDs and MSPs. The Commission received numerous comments to the

portfolio compression proposal and considered each in formulating the

final rules, as discussed below.

1. Statutory Basis for Portfolio Compression

The proposed portfolio compression regulations were proposed

pursuant to section 4s(i) of the CEA, which directs the Commission to

prescribe regulations for the timely and accurate confirmation,

processing, netting, documentation, and valuation of all swaps entered

into by SDs and MSPs.

Commenting on the proposal, ISDA stated that the portfolio

compression requirements lack an explicit statutory basis in the Dodd-

Frank Act, and should be left to the judgment of market participants.

Likewise, The Working Group stated that section 731 of the Dodd-Frank

Act does not require the Commission to issue rules on portfolio

compression and believes the final rules should not include portfolio

compression requirements.

In response to these comments, section 4s(i) of the CEA clearly

authorizes the Commission to prescribe standards for the netting of

swaps. As explained in the Confirmation NPRM, portfolio compression is

a post-trade processing and netting mechanism whereby substantially

similar transactions among two or more counterparties are terminated

and replaced with a smaller number of transactions of decreased

notional value.

2. Definition of ``Multilateral Portfolio Compression Exercise''--Sec.

23.500(h)

The proposed regulations defined ``multilateral portfolio

compression exercise'' as an exercise in which multiple swap

counterparties wholly or partially terminate some or all of the swaps

outstanding among those counterparties and replace the swaps with a

smaller number of swaps whose combined notional value is less than the

combined notional value of the original swaps included in the exercise.

The replacement swaps may be with the same or different counterparties.

With respect to this definition, TriOptima commented that the

proposed definition of ``multilateral portfolio compression exercise''

is too narrow and recommends that the Commission revise the definition

to read: ``an exercise in which multiple swap counterparties wholly

terminate or change the notional value of some or all of the swaps

submitted by the counterparties for inclusion in the portfolio

compression and, depending on the methodology employed, replace the

terminated swaps with other swaps whose combined notional value (or

some other measures of risk) is less than the combined notional value

(or some other measure of risk) of the terminated swaps in the

compression exercise.'' ISDA recommended the same changes as those

recommended by TriOptima for the same reasons.

Based on the explanations of commenters, the Commission is

persuaded that the proposed definition was unnecessarily narrow and the

Commission has accordingly modified the definition of ``multilateral

portfolio compression exercise'' in the manner recommended by

commenters. In addition, for the sake of consistency, the

[[Page 55933]]

definition of ``bilateral portfolio compression exercise'' has also

been modified in a consistent manner.

3. Mandatory Portfolio Compression--Sec. 23.503

The proposed regulations required SDs and MSPs to engage in

bilateral and multilateral portfolio compression exercises with respect

to all swaps in which their counterparty is also an SD or MSP. In

contrast, the proposed regulations required SDs and MSPs to establish

policies and procedures for engaging in portfolio compression with swap

counterparties that are not SDs or MSPs.

On this issue, The Working Group argued that portfolio compression

is only beneficial in markets where there is a high degree of

transaction standardization and a high volume of redundant trades, and

therefore recommended that the Commission only impose mandatory

compression exercises on markets where the ratio of gross market value

to notional size (which is a rough estimation of the level of redundant

trades) shows that the benefits of compression outweigh the substantial

cost of engaging in the exercise. The Working Group also recommended

that the Commission not impose mandatory compression in markets where

compression platforms have not yet been designed, tested, and approved

by the Commission.

Markit pointed out that portfolio compression was recently

attempted in the commodities and foreign exchange asset classes, but

was not pursued further because the trial cycles had limited success,

and is concerned that mandatory participation under the proposed rules

might lead to compression for a range of uncleared swaps where the

potential benefits do not justify the cost of the exercise,

particularly for the large number of potential SDs and MSPs that

currently do not participate in compression cycles. Costs identified by

Markit include changes to participant's risk systems and connectivity

enhancements that would allow for the booking and processing of a large

volume of swaps (thousands) in as short a period as a single day.

Markit recommended an alternative to the proposal in which the

Commission would establish thresholds for determining whether a

category of non-cleared swaps should be subject to any mandatory

compression exercise and the frequency of such exercises. Markit

believes such thresholds should be related to the minimum number of

swaps, number of participants, number of swaps per participant, amount

of ongoing trading activity, degree of standardization in the product,

and the notional amount of transactions that must be compressed.

With respect to compression between SDs and MSPs and non-SDs, non-

MSPs, Markit believes that there will be no noteworthy benefit from

requiring non-dealer counterparties to participate in portfolio

compression exercises for uncleared swaps, as such entities have

portfolios with a very small number of offsetting transactions and

often have complicated arrangements with prime brokers making

compression more difficult and costly.

Freddie Mac commented that mandatory portfolio compression should

be limited to swaps that match and offset cash flows exactly, and that

any compression requirement allow for exceptions for end users relying

on swaps for hedging purposes or that otherwise believe the termination

of an existing swap would have an adverse effect on remaining trades.

Providing the view of a portfolio compression vendor, TriOptima

stated that for many smaller institutions and for larger institutions

trading illiquid swaps, the net to gross ratio of a portfolio is

sometimes close to 100 percent, meaning that all swaps in the portfolio

are in the same market-risk direction. TriOptima argued that it would

not be productive for such institutions to take part in multilateral

compression as many transactions designated as hedges for accounting

purposes must be excluded from compression, and either no transactions

could be compressed or the resulting notional reduction would be

minimal. TriOptima therefore recommended that the Commission remove any

mandatory compression requirement from the proposed rule and instead

focus on creating incentives for institutions to take part in portfolio

compression. TriOptima noted that most capital requirements are based

on net risk positions and therefore recommended that the Commission

create capital or other incentives to reduce gross risk positions.

Based on the comments received, the Commission has concluded that

it may be premature to require SDs and MSPs to engage in mandatory

bilateral and multilateral compression exercises for all asset classes

at this time. Although the Commission agrees with Markit's comment that

compression opportunities should be based on an analysis of the market,

including the number of swaps, number of participants, number of swaps

per participant, amount of ongoing trading activity, degree of

standardization in the product, and the notional amount of transactions

that could be compressed, it does not foresee that it will have the

resources to make such a determination or to set thresholds for

mandatory compression. In addition, as discussed more fully below, the

Commission is modifying the bilateral offset requirement for swaps

between SDs and MSPs that are ``fully offsetting.''

Accordingly, the Commission has modified the proposed rules to

remove the mandatory bilateral and multilateral compression

requirements and has replaced them with a requirement that SDs and MSPs

establish policies and procedures for periodically engaging in

portfolio compression exercises with counterparties that are also SDs

or MSPs and for engaging in portfolio compression with all other

counterparties upon request.\43\ In this regard, the Commission

anticipates that in order to be in compliance with the rule, an SD's or

MSP's policies and procedures would include procedures for engaging in

periodic evaluation of compression opportunities, written policies

establishing when the SD or MSP would consider a compression

opportunity to be materially beneficial, and procedures for engaging in

those opportunities when such arise. These policies and procedures

would also be required to address how the SD and MSP would determine

which swaps to include and exclude from compression exercises and what

risk tolerances it would accept.

---------------------------------------------------------------------------

\43\ Compare with ESMA Draft Technical Standards, Article 3 RM,

subsection 2, (stating that ``counterparties with 500 or more OTC

derivative contracts outstanding which are not centrally cleared

shall have procedures to regularly, and at least twice a year,

analyse the possibility to conduct a portfolio compression exercise

in order to reduce their counterparty credit risk and engage in such

portfolio compression exercise.'')

---------------------------------------------------------------------------

The Commission has also modified the rule to clarify that (1) non-

SDs/MSPs are not required to engage in portfolio compression exercises

with SDs and MSPs, but (2) that SDs and MSPs must engage in portfolio

compression exercises with non-SDs/MSPs upon request.

As further support for the modifications, the Commission notes that

in the proposed DCO rules, the Commission proposed that DCOs must offer

multilateral compression, but the final DCO rule provided that

participation in compression exercises by clearing members and their

customers would be voluntary.\44\

---------------------------------------------------------------------------

\44\ See 17 CFR 39.13(h)(4), Derivatives Clearing Organization

General Provisions and Core Principles, 76 FR 69334, 69383 (Nov. 8,

2011).

---------------------------------------------------------------------------

[[Page 55934]]

4. Swaps Eligible for Compression--Sec. 23.503

Proposed Sec. 23.503 required SDs and MSPs to include all swaps in

their compression exercises with other SDs and MSPs and swaps with

other counterparties to the extent that the swaps are able to be

terminated through a portfolio compression exercise.

With respect to this aspect of the proposal, BlackRock recommended

that the Commission revise the proposed compression rules to more fully

promote the compression of substantially similar, but not fully

offsetting, swaps.

The Commission believes that the concerns underlying BlackRock's

comment is addressed by the changes to the proposed rule as discussed

above, specifically the modification requiring SDs and MSPs to engage

in compression with non-SDs and non-MSPs at the request of such

parties. The Commission believes it is prudent to permit the parties to

agree on the method and venue of compression, rather than having the

Commission prescribe the method and venue.

5. Application of Portfolio Compression to Non-SD/MSPs

In the Confirmation NPRM, the Commission requested comment on

whether it should require SDs and MSPs to engage in compression

exercises with counterparties that are not SDs or MSPs. The Commission

also requested comment on whether financial entities as defined in

proposed Sec. 23.500 should be subject to the same compression

requirements as SDs and MSPs.

In response to this request for comments, Markit stated that there

will be no noteworthy benefit from requiring non-dealer counterparties

to participate in portfolio compression exercises for uncleared swaps

because such entities have portfolios with a very small number of

offsetting transactions and often have complicated arrangements with

prime brokers making compression more difficult and costly.

ISDA also identified several issues with the proposal to apply

compression requirements to non-SDs:

Current portfolio compression exercises only achieve

successful results by limiting exercises to a single asset-class and a

relatively small and homogeneous group of participants (i.e., the G14

dealers), which limits the difficulty and range of attendant risks.

Multilateral compression cycles are typically managed with

automated tools to support tear up and new trade creation that end-

users usually do not possess, and the costs of obtaining such tools

cannot be justified by the benefits.

The requirement for bilateral netting of swaps not covered

by multilateral or cleared compression processes will impose onerous

tasks with only limited benefit for end-users who engage in trades that

are typically more bespoke.

ABC & CIEBA commented that benefit plans should not be subject to

the proposed portfolio compression rule because every swap of a benefit

plan serves a business purpose and benefit plan swap portfolios contain

no redundant positions. ABC & CIEBA also argued that benefit plans may

have multiple investment advisers with individual mandates and

portfolio compression could result in losses if market movements that

had been previously hedged are undone by compression. ABC & CIEBA thus

urged the Commission to require SDs and MSPs to obtain explicit consent

of end user counterparties prior to compression of any swap.

AMG, Dominion, the FHLBs, and Chatham echoed the concerns of ABC &

CIEBA, commenting that non-SDs and non-MSPs (including financial

entities) should not be subject to mandatory or involuntary portfolio

compression due to legitimate reasons for offsetting, but beneficial

swap positions, such as hedging specific assets. Thus, AMG, Dominion,

and the FHLBs recommended that the Commission revise the proposed rules

to require SDs and MSPs to obtain the explicit consent of its end user

counterparties prior to compression of any swap. BlackRock recommended

that the Commission require SDs and MSPs to engage in bilateral and

multilateral compression exercises with counterparties that are not SDs

or MSPs, if such parties chose to do so.

MFA similarly recommended that portfolio compression be an option

for end users, but not an obligation as portfolio compression is only

appropriate for entities with portfolios large enough to yield

meaningful benefits that outweigh the expense of a compression

exercise. MFA further stated that end users should not be required to

engage in multilateral portfolio compression for cleared swaps. GFED

believes that portfolio compression is unnecessary for non-dealer end

users as volumes are too small.

With respect to compression with financial entities, the FHLBs

commented that financial entities should not be subject to the same

compression requirements as SDs and MSPs as the swap portfolios of such

entities do not, by definition, pose a significant risk to the overall

financial system, such requirements could have adverse effects for such

entities because their tax and accounting treatment may differ

significantly from those of SDs, and such requirements may discourage

financial entities from using swaps for hedging or risk mitigation.

Freddie Mac believes that mandatory portfolio compression should be

limited to swaps that match and offset cash flows exactly, and that any

compression requirement allow for exceptions for end users relying on

swaps for hedging purposes or that otherwise believe the termination of

an existing swap would have an adverse effect on remaining trades.

With respect to insurers, NAIC stated that state insurance laws

require insurers to ``tag'' each swap position to specific hedging,

replication, or income generation transactions, giving insurance

regulators complete transparency into the swap position carried by

insurers. NAIC is concerned that the proposed compression requirements,

despite the exception in Sec. 23.503(c)(3)(i), may require SDs and

MSPs to terminate fully offsetting swaps that include swaps held by

insurers for hedging of specific assets and liabilities, hindering

state regulators' ability to regulate insurers. NAIC requested that the

Commission modify the rule so that any swap position of an insurer that

is specifically designated as a hedge as required by state insurance

statutory accounting rules be allowed to remain outstanding and not be

subject to portfolio compression rules.

MetLife also strongly opposed any mandated compression of

offsetting swap positions. MetLife believes that the safe harbor in the

proposed rules for exclusion of swaps ``likely to increase

significantly the risk exposure'' of a party is not sufficiently broad

to protect a party's essential hedging transactions. MetLife

recommended that MSPs and other end users be permitted to opt out of

compression for transactions that are bona fide hedges. Specifically,

MetLife stated that the compression requirements may conflict with

state insurance laws governing allocation of hedging transactions to

specific assets and liabilities. MetLife concurred with other

commenters in urging the Commission to exclude insurance companies from

any mandatory portfolio compression requirement.

On the other hand, Eris Exchange stated that it has clearly heard

that the swap trading community welcomes the Commission's proposed

compression rule. Eris Exchange believes the end user community is

optimistic that financial reform will lead to greater position netting

and the ability to more

[[Page 55935]]

freely unwind aged swap trades without having to go through a

cumbersome novation process involving substantial operational burden

and negotiated up-front payments.

Having considered these comments, the Commission notes that, as

discussed above, the rule has been modified to require SDs and MSPs to

establish policies and procedures for engaging in portfolio compression

with non-SDs and non-MSPs when requested by such counterparties. The

Commission believes this change addresses the comments of non-SDs and

non-MSPs discussed above.

6. Application of Portfolio Compression by Asset Class

Proposed Sec. 23.503 applied uniformly to all swaps, regardless of

asset class. The Commission requested comment regarding whether the

compression requirement should be restricted to particular asset

classes.

ISDA commented that compression in asset classes other than credit

and interest rates would be extremely costly and the benefits would be

limited. ISDA stated that the industry will need to develop practices

for each additional asset class because methods used in one asset class

are not portable to other asset classes with distinct characteristics.

ISDA specifically recommended that the following asset classes be

excluded from any compression requirements:

Foreign exchange swaps, which achieve compression through

daily trade aggregation in CLS and have short tenors;

Equity derivatives, because they are broadly positional in

nature, there is a lack of standardization, and they are broadly

hedged; and

Commodity derivatives, because notional amounts are low

and compression may only be worthwhile for oil and precious metals.

GFED also recommended that the Commission exclude foreign exchange

swaps from the portfolio compression requirements as most foreign

exchange swaps are short dated (i.e., three to six months average, one

month for options) and the costs of implementation likely outweigh the

limited benefits.

As noted above, Markit stated that portfolio compression was

recently attempted in the commodities and foreign exchange asset

classes, but was not pursued further because the trial cycles had

limited success.

As discussed above, the Commission has modified the rule to remove

the mandatory compression requirement and replace it with a requirement

that SDs and MSPs establish policies and procedures for the regular

evaluation of compression opportunities with other SDs and MSPs, when

appropriate, and for engaging in compression with non-SDs and non-MSPs

upon request. The Commission believes this change addresses commenters'

concerns regarding the inappropriate or inefficient application of

portfolio compression to certain asset classes.

7. Bilateral Uncleared Swap Portfolio Compression--Sec. 23.503(b)

Proposed Sec. 23.503(b) required SDs and MSPs to engage in

bilateral portfolio compression exercises at least once every calendar

year with their swap counterparties that were also SDs or MSPs, unless

the SD or MSP participated in a multilateral compression exercise in

which such counterparties also participated.

With respect to this proposal, ISDA commented that the move to

clearing will reduce the need for bilateral/uncleared trade compression

because most fungible, liquid products in the credit and rates markets

will be in DCOs.

The Commission believes that the changes to the proposed rule

discussed above will address commenters' concerns regarding the

inefficient application of portfolio compression to uncleared swaps.

Specifically, the rule as adopted will not require SDs and MSPs to

engage in bilateral compression, but only require that registrants

establish policies and procedures for periodically engaging in such

compression where appropriate.

8. Termination of Fully-Offsetting Bilateral Swaps--Sec. 23.503(a)

Proposed Sec. 23.503(a) required SDs and MSPs to terminate fully

offsetting swaps with other SDs or MSPs no later than the close of

business on the business day following the day the fully offsetting

swap was executed.

Commenting on this proposal, The Working Group stated that an SD or

MSP with a regulatory requirement for functional separation may have

legitimate reasons for maintaining offsetting long and short positions,

thus the Commission should not mandate termination of fully-offsetting

swaps, but only require that registrants have policies and procedures

for termination of such swaps in appropriate circumstances. The Working

Group also argued that requiring registrants to run and monitor daily

systems for the detection of completely offsetting swaps where there

are likely to be none is unnecessarily burdensome. Finally, The Working

Group believes that the one business day time period for terminating

fully-offsetting swaps is unnecessarily burdensome and should be

revised to allow for one week.

ISDA believes the requirement for registrants to terminate fully-

offsetting swaps between registrants to be unnecessary because such

swaps are not sources of material risk. ISDA believes compliance with

the rule would be extremely difficult and expensive to implement as

compliance will require new processes to identify single offsetting

trades. In addition, ISDA stated that perfectly offsetting swaps are

not common and recommends the Commission clarify whether only perfect

offsets are required to be terminated.

The Commission finds these comments persuasive and is modifying the

rule to require only that SDs and MSPs establish policies and

procedures to terminate fully offsetting swaps with other SDs and MSPs

in a timely fashion, where appropriate. The Commission believes this

modification allows SDs and MSPs to design policies and procedures that

permit the maintenance of offsetting long and short positions for

legitimate business reasons.\45\ The Commission has also determined to

remove the one-day termination requirement as a cost-saving measure and

to replace it with the phrase ``in a timely fashion.''

---------------------------------------------------------------------------

\45\ Compare with ESMA Draft Technical Standards, Article 3 RM,

subsection 3, (stating that ``counterparties shall terminate each of

the fully offset OTC derivative contracts not later than when the

compression exercise is finalized.'')

---------------------------------------------------------------------------

9. Compression of Cleared Swaps

The proposed regulation did not differentiate between cleared swaps

and uncleared swaps.

In this respect, ISDA believes that no compression requirement

should attach to cleared trades, but, in the alternative, ISDA

recommended the Commission clarify that complying with a DCOs

compression requirements will satisfy the compression requirements of

the proposed rule. Likewise, MFA stated that end users should not be

required to engage in multilateral portfolio compression for cleared

swaps.

Having considered these comments, and in light of the portfolio

compression requirements under the Commission's regulations for

DCOs,\46\ the Commission has concluded that it is unnecessary to apply

the requirements of this rule to swaps that are cleared by a DCO and

has modified the rule accordingly. The Commission notes that this

change is parallel to the portfolio reconciliation

[[Page 55936]]

rule, which also does not apply to swaps cleared by a DCO.

---------------------------------------------------------------------------

\46\ See 17 CFR 39.13(h)(4), Derivatives Clearing Organization

General Provisions and Core Principles, 76 FR 69334, 69383 (Nov. 8,

2011).

---------------------------------------------------------------------------

10. Mandatory Multilateral Compression Offered by a DCO or SRO--Sec.

23.503(c)(2)

Proposed Sec. 23.503(c)(2) required SDs and MSPs to participate in

all multilateral portfolio compression exercises offered by a DCO of

which the SD or MSP is a member or an SRO of which the SD or MSP is a

member.

Commenting on this aspect of the proposal, both ISDA and TriOptima

stated that mandating compression offered by a DCO or SRO will inhibit

competition among providers of compression services. ISDA is concerned

that members of DCOs and SROs may become bound to compression services

with inadequate transparency, insufficient testing and lack of price

competition. ISDA recommends that the Commission permit registrants to

select the compression service provider, including for DCO or SRO-

mandated compression exercises.

As discussed above, the Commission has removed the mandatory

compression requirements from the rule as adopted. Nonetheless, in

response to these comments, the Commission agrees that the rule should

not demonstrate a preference for any type of compression services

provider and has accordingly modified the rule to require SDs and MSPs

to evaluate multilateral compression exercises initiated, offered, or

sponsored by any third party. This change also comports with the

decision to change the final DCO rules to provide for voluntary

participation in compression exercises.

11. Risk Tolerances in Multilateral Portfolio Compression--Sec.

23.503(c)(3)(ii)

Proposed Sec. 23.503(c)(3)(ii) permitted SDs and MSPs to establish

counterparty, market, cash payment, and other risk tolerances, and to

exclude specific potential counterparties for the purposes of

multilateral compression exercises.

Commenting on this aspect of the proposal, The Working Group

recommended that the Commission grant market participants broad

discretion when setting ``risk tolerances'' for multilateral

compression exercises, including:

A broad array of risks for which swaps may be excluded

from the exercise (e.g., regulatory risk, financial statement risk);

The ability to express preference for preserving swaps

with one counterparty over another for credit risk management purposes;

and

The ability to require that only identical swaps and not

substantially similar swaps can be compressed.

Having removed the mandatory multilateral compression requirement

from the rule, the Commission has also removed the portions of the rule

related to setting risk tolerances. However, under the revised rule,

SDs and MSPs must establish policies and procedures for engaging in

multilateral compression exercises, and the Commission expects that

these policies and procedures will address how the SD and MSP would

determine which swaps to include and exclude from compression exercises

and what risk tolerances it would accept. The Commission believes that

this change addresses commenters' concerns regarding the discretion to

determine risk tolerances in multilateral compression exercises.

12. Portfolio Compression Service Provider Standards

The proposed regulations did not prescribe standards for portfolio

compression service providers, and Markit recommended that, due to the

complexity of multilateral compression exercises, the Commission

establish standards for compression service providers to ensure

competency, timely service, and sufficient resources. The process for

choosing compression service providers should be fair and open. Freddie

Mac urged the Commission to closely scrutinize the necessity and

propriety of the terms of business demanded by prospective service

providers (including SDRs, SEFs and DCOs) and disapprove overreaching

terms such as open-ended indemnification, disclaimer of liability,

assertions of ownership over transactional data, and other intellectual

property of service users.

Given that the rule as adopted no longer contains a mandatory

compression requirement, the Commission believes that these comments

regarding standards for service providers and overreaching terms are

best addressed by competition in the market for providers of

compression services.

13. Recordkeeping Requirement for Portfolio Compression--Sec.

23.503(e)

Propose Sec. 23.503(e) required SDs and MSPs to maintain records

of each bilateral and multilateral compression exercise, including

dates, the swaps included in the exercise, the eligible swaps excluded

from the exercise and the reason for such exclusion, the counterparty

and risk tolerances specified for the exercise, and the results of the

exercise. ISDA commented that the recordkeeping requirement for

portfolio compression is too prescriptive in its detail. The Commission

is modifying the rule to require simply that SDs and MSPs maintain

complete and accurate records of all compression exercises. As a matter

of good practice, the Commission anticipates that market participants

will make and maintain all necessary records of any swaps that are

netted down, new swaps entered into, and any swaps that are submitted

for compression but not compressed. In addition, the Commission

observes that the rule does not prohibit SDs and MSPs from relying on

third-party service providers to achieve compliance with the rule,

although the responsibility for compliance cannot be delegated.

III. Effective Dates and Compliance Dates

In the Documentation NPRM and Confirmation NPRM, the Commission

requested comment on the length of time necessary for registrants to

come into compliance with the proposed rules. As discussed further

below, the Commission also proposed a compliance schedule, Sec.

23.575, for swap trading relationship documentation, Sec. 23.504, in a

separate release in September 2011.

A. Comments Regarding Compliance Dates

1. Documentation NPRM

With respect to Sec. 23.504, The Working Group recommended that

the Commission delay promulgating rules on swap documentation until it

has finalized all required rules to be issued under the Dodd-Frank Act

and can fully analyze the potential effect of documentation rules on

the swap markets, or, in the alternative, adopt a general framework

with an extended period of time for implementation to allow market

participants to design appropriate documentation standards. Further, if

the Commission should decide to make the proposed rules applicable to

existing transactions, then The Working Group recommended that the

Commission provide a short term safe-harbor for existing transactions

and give the market 36 months to come into compliance. If the

Commission should decide not to make the proposed rules applicable to

existing transactions, then The Working Group recommended that the

Commission give the market 12 months to come into compliance.

ISDA & SIFMA requested that the Commission defer proposing an

implementation timeline until the

[[Page 55937]]

Commission's rules and the SEC's rules relating to trading

documentation are fully developed and the industry has been given the

opportunity to address implementation issues with the Commission at

that time.

FSR believes that the renegotiation of existing documentation would

take significantly longer than six months and urged the Commission to

recognize that negotiation of new credit support arrangements,

including third-party custody arrangements, will be particularly time-

consuming and thus requested that the Commission provide an

appropriately long implementation timeframe. The Coalition of

Derivatives End-Users proposed a period of not less than two years for

implementation for end users because it is unclear how each SD and MSP

would seek to implement changes to comply with swap documentation rules

for both existing and new swaps. The Coalition believes this period of

time will allow for discussions and negotiations across all swap

counterparty relationships.

IECA recommended that a long implementation period be provided.

Otherwise, SDs will have an advantage because they have more resources

to apply than end users and it is likely that any standard amendment

would come from industry groups such as ISDA, which primarily

represents the interests of SDs. CIEBA is also concerned that a

deadline for SDs and MSPs to bring their documentation into compliance

would allow SDs and MSPs to present buy-side participants with a newly

standardized set of documentation, and would result in buy-side

participants having insufficient input into the substance of the

documentation. CIEBA also noted that a number of its members reported

that it is not uncommon for SDs to take up to a year to finalize an

ISDA agreement with a pension plan fiduciary. If SDs were required to

revise all their swap agreements, CIEBA believes that it could take

years.

In contrast to the foregoing comments, Michael Greenberger

commented that since many dealers already use documentation that will

comply with the regulations, allowing a maximum of thirty days to

comply with the rules following adoption should suffice.

In addition to the foregoing comments, the Commission received

comments with respect to proposed compliance schedules for a number of

proposed rules, including Sec. 23.504.\47\ In September 2011, the

Commission proposed four compliance schedules for four separate

provisions of the Dodd-Frank Act, including: (i) The clearing

requirement; (ii) the trade execution requirement; (iii) trading

documentation under section 4s; and (iv) margining requirements for

uncleared swaps.\48\ In its proposal, Swap Transaction Compliance and

Implementation Schedule: Trading Documentation and Margining

Requirements under Section 4s of the CEA, (Implementation Schedule

NPRM), the Commission stated that the proposed compliance schedule for

Sec. 23.504 was designed to afford affected market participants a

reasonable amount of time to bring their transactions into compliance

with the requirements of the rule and to provide relief in the form of

additional time for compliance. The schedule was intended to facilitate

the transition to the new regulatory regime established by the Dodd-

Frank Act in an orderly manner that does not unduly disrupt markets and

transactions. To this end, the Commission proposed Sec. 23.575, under

which an SD or MSP would be afforded ninety (90), one hundred eighty

(180), or two hundred and seventy (270) days to bring its swap trading

relationship documentation with its various counterparties into

compliance with the requirements of Sec. 23.504, depending on the

identity of each such counterparty. In the proposal, market

participants that are financial entities, as defined in section

2(h)(7)(C) of the CEA, were grouped into the following four categories:

---------------------------------------------------------------------------

\47\ See Swap Transaction Compliance and Implementation

Schedule: Trading Documentation and Margining Requirements under

Section 4s of the CEA, 76 FR 58176 (Sept. 20, 2011) (Implementation

Schedule NPRM).

\48\ The trading documentation and margining requirements

compliance schedules were proposed in one release. See id. The

clearing requirement and trade execution requirement were proposed

in another release, Swap Transaction Compliance and Implementation

Schedule: Clearing and Trade Execution Requirements under Section

2(h) of the CEA, 76 FR 58186 (Sept. 20, 2011). The Commission

finalized the compliance schedule for the clearing requirement on

July 24, 2012. See Swap Transaction Compliance and Implementation

Schedule: Clearing Requirement Under Section 2(h) of the CEA, 77 FR

44441 (July 30, 2012). The compliance schedules for margin for

uncleared swaps and the trade execution requirement will be

finalized separately.

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Category 1 Entities included SDs, security-based swap

dealers, MSPs, major security-based swap participants, and active funds

(defined as any private fund as defined in section 202(a) of the

Investment Advisers Act of 1940), that is not a third-party subaccount

and that executes 20 or more swaps per month based on a monthly average

over the 12 months preceding this adopting release.

Category 2 Entities included commodity pools; private

funds as defined in section 202(a) of the Investment Advisers Act of

1940 other than active funds; employee benefit plans identified in

paragraphs (3) and (32) of section 3 of the Employee Retirement Income

and Security Act of 1974; or persons predominantly engaged in

activities that are in the business of banking, or in activities that

are financial in nature as defined in section 4(k) of the Bank Holding

Company Act of 1956, provided that the entity is not a third-party

subaccount.

Category 3 Entities include Category 2 Entities whose

positions are held as third-party subaccounts.

Category 4 Entities includes any person not included in

Categories 1, 2, or 3.

Proposed Sec. 23.575 required SDs and MSPs to be in compliance

with Sec. 23.504 no later than 90 days after publication of the final

rule in the Federal Register for swap transactions with a Category 1

Entity, no later than 180 days after publication for swap transactions

with a Category 2 Entity, and no later than 270 days after publication

for swap transactions with a Category 3 Entity or Category 4 Entity.

The Commission received approximately 19 comments with respect to

the compliance phasing proposal, each of which it considered in

finalizing the compliance dates for the rule, as discussed below.

a. Definition of ``Active Fund''

The proposal defined ``active fund'' as ``any private fund as

defined in section 202(a) of the Investment Advisers Act of 1940, that

is a not a third party subaccount and that executes 20 or more swaps

per month based on a monthly average over the 12 months preceding * *

*.''

Commenting on this definition, the Association of Institutional

Investors (AII) stated that basing the definition on an average of 20

swap transactions per month is arbitrary. AII believes that the

Commission should collect data under swap transaction reporting rules

and then make a determination, but, in the alternative, AII recommended

that the threshold be higher and that the definition specify the type

of swaps that count towards the threshold. FIA/ISDA/SIFMA and Vanguard

also commented that the average monthly threshold should be raised, and

recommended that the threshold be raised to include only those funds

averaging more than 200 transactions per month.

MFA recommended that the definition be eliminated because it is

over-inclusive, difficult to administer, and unnecessarily divides the

class of buy-side market participants. Under MFA's view, all private

funds should be Category 2 Entities. If the Commission does not delete

the definition, MFA

[[Page 55938]]

requested clarification regarding those swaps that are to be included

in the calculation, e.g., novations, amendments, partial tear-ups, etc.

On a different tack, FSR stated that the definition of ``active

fund'' is unclear and needs further clarification to distinguish

between active fund and ``third-party subaccount.'' FSR represented

that its fund manager members believe that most (if not all) entities

that would fall into the term ``active fund'' would also constitute

``third-party subaccounts.''

The American Council of Life Insurers (ACLI) commented that the

frequency of trading is not an appropriate indicator of experience or

available resources for determining which entities can comply most

quickly. Similarly CDE recommended a minimum notional amount monthly

average threshold to avoid capturing smaller end-users and excluding

hedges and inter-affiliate swaps from the monthly average threshold.

On the other hand, Better Markets and Chris Barnard supported the

proposal, stating that average monthly trading volume is the

appropriate proxy for determining an entity's ability to comply with

the proposed implementation schedule and is better than notional

volume.

The Alternative Investment Management Association (AIMA) also

believes that the average number of swaps executed during the previous

12 months is a good proxy for determining what is an active fund, but

recommended that the definition should include private funds regardless

of whether they are a third party subaccount or not. Otherwise, private

funds that are not subaccounts will be disadvantaged relative to those

that are, in terms of the cost of entering into swaps during the course

of the implementation schedule. AIMA considered alternatives to the

definition but believes that instituting an ``assets under management''

threshold for the definition of active fund may be problematic, as

notwithstanding such a threshold, a manager may invest in other types

of financial instruments such that they do not in fact have the

experience or resources to more quickly comply with the regulations.

AIMA also believes that commodity pools that are not private funds, but

that execute 20 or more swaps on average per month, should be included

in the definition.

Having considered the comments received, the Commission believes

that the definition of ``active fund'' appropriately uses a

transaction-based trigger to distinguish between funds more active in

the swaps market and those that are less so. However, in response to

comments that an average of 20 transactions per month may be overly

inclusive and may cause some smaller entities, less well-positioned for

compliance with shorter implementation timeframes, to fall within the

definition. Accordingly, the Commission has determined to raise the

threshold to 200 swap transactions on average per month so as to ensure

only more active participants in the market are included within the

definition. The Commission also agrees with commenters that

establishing an appropriate minimum notional amount applicable to all

participants in the swap market, or assets under management standard,

to be impracticable.

However, the Commission does not believe it is appropriate to

create exclusions for the types of swap transactions within the

definition given the administrative burdens of monitoring such

distinctions for purposes of the proposed implementation schedule. In

response to commenters seeking clarification of what types of swap

transactions are to be included in the monthly calculation, the

Commission notes that the proposed implementation schedule, and the

compliance dates adopted in this release, both refer to ``swaps'' and

not ``swap transactions.'' ``Swap transaction'' is defined in Sec.

23.500 to include assignments, novations, amendments, and other events

that Sec. 23.501 requires to be documented by confirmation. Therefore,

in response to commenter's concerns, the Commission confirms that the

active fund threshold of 200 swaps per month refers to ``swaps'' as

defined in section 1a(47) of the CEA and Commission regulations, but

would not include assignments, novations, amendments, or like events

that occur with respect to existing swaps.

b. Definition of ``Third-party Subaccount''

The Implementation Schedule NPRM defined ``third-party subaccount''

to mean ``a managed account that requires the specific approval by the

beneficial owner of the account to execute documentation necessary for

executing, confirming, margining or clearing swaps.'' Third-party

subaccounts were designated as Category 3 Entities, whereas other funds

were designated Category 1 or Category 2 Entities.

With respect to this definition, AII commented that the definition

is too narrow given the administrative work required in managing an

account, regardless of the execution authority. Further, AII stated

that execution authority is not an industry standard, and thus divides

the universe of separate accounts inappropriately. Similarly, the

Investment Company Institute (ICI) stated that third party subaccounts,

whether subject to the specific execution authority of the beneficiary

or not, require managers to work closely with clients when entering

into trading agreements on the customer's behalf. As such, no

distinction should be made based on specific execution authority or

lack thereof, and that all third party accounts should be uniformly

classified as Category 3 Entities, allowing for a 270 day compliance

period.

FIA/ISDA/SIFMA also recommended that all accounts managed for third

parties, regardless of the execution authority, should be in the

Category 3 Entity implementation phase. FIA/ISDA/SIFMA recommended that

the Commission adopt a definition of ``third-party fund'' that is any

fund that is not a private fund and is sub-advised by a subadvisor that

is independent of and unaffiliated with the fund sponsor. A ``third-

party subaccount'' would be defined as any account that is not a fund

and is managed by an asset manager, irrespective of the level of

delegation granted by the account owner by the account owner to the

asset manager.

Based on the comments received, the Commission is revising the

definition of Third-Party Subaccount to mean an account that is managed

by an investment manager that (1) is independent of and unaffiliated

with the account's beneficial owner or sponsor, and (2) is responsible

for the documentation necessary for the account's beneficial owner to

document swaps as required under section 4s(i) of the CEA. In modifying

this definition, the Commission is taking into account the point made

by AII, FIA/ISDA/SIFMA, and ICI that all investment managers will need

additional time to comply with the trading documentation requirements

regardless of whether they have explicit execution authority. However,

the definition retains the nexus between the investment manager and the

documentation needed for swaps under section 4s(i) of the CEA. In other

words, if the investment manager has no responsibility for documenting

the swap trading relationships, then that account would be required to

come into compliance with the documentation requirements within 180

days. For those accounts under the revised definition, however, the

Commission believes that the 270-day deadline is more appropriate.

Given the general notice that investment managers have had

[[Page 55939]]

about the Dodd-Frank Act's documentation requirements for SDs and MSPs

since the enactment of the statute in July, 2010, managers should have

been able to consider and plan the infrastructure and resources that

are necessary for all of their accounts, including Third-Party

Subaccounts, to comply with the documentation requirements. Thus, the

180- and 270-day deadlines should provide adequate time to accommodate

all managed accounts.

c. Definitions of Categories of Entities

The Commission received several comments with respect to the

definitions of the categories of entities to which the proposed

implementation schedules applied.

Encana and EEI, National Rural Electric Cooperative Association,

and Electric Power Supply Association (Joint Associations) believe that

the definition of Category 4 Entity under the proposed implementation

schedules should expressly include non-financial end users.

The Coalition for Derivatives End-Users argued that financial end-

users should be treated identically to non-financial end-users because

they do not pose systemic risk, and therefore, should be given the most

time to comply with the requirements.

ICI requested clarification that a market participant can determine

whether it is an MSP for purposes of the proposed implementation

schedules at the same time that it is required to review its status as

an MSP under other Commission and SEC rules.

CIEBA requested that in-house ERISA funds should be in the group

with the longest compliance time, and not Category 2 Entities, arguing

that these funds are not systemically risky, and they typically rely

upon third-party managers for some portion of their fund management.

Splitting in-house and external accounts (i.e., those accounts meeting

the Implementation Schedule NPRM's definition of third-party subaccount

and which are therefore Category 3 Entities) of the same ERISA plan

will impact risk management given different implementation schedules.

The distinction will also cause pension funds to bear the costs of

compliance because they will need to comply prior to their third party

managers who would be better positioned to provide insight and services

in this regard.

The Commission considered the foregoing comments, and has

determined to modify the category definitions in certain respects. In

response to Encana and the Joint Associations, non-financial entities

are clearly included amongst Category 4 Entities and SDs and MSPs are

given 270 days to comply with the documentation requirement with

respect to such entities.

With respect to issues raised by the Coalition for Derivatives End-

Users regarding those financial entities included in Category 2, the

Commission believes that those entities have been correctly categorized

based upon the distinction between financial and non-financial entities

under section 2(h)(7) of the CEA. The Commission believes that, just as

Congress has required financial entities to be subject to required

clearing due to their importance to the financial system, SDs and MSPs

should be required to meet the documentation requirements of Sec.

23.504 with such entities prior to being required to meet such

documentation requirements with non-financial entities. However, the

definition of Category 2 Entity is modified by removing the reference

to ERISA plans. The Commission recognizes the concerns raised by CIEBA

regarding splitting in-house and external accounts (i.e., those

accounts meeting the definition of Third-Party Subaccount and permitted

270 days) of the same ERISA plan. In response to these concerns, the

Commission is removing the reference to employee benefit plans as

defined in paragraphs (3) and (32) of section 3 of the Employee

Retirement Income and Security Act of 1974. As a result, these ERISA

plans will be afforded the longest compliance period (270 days).

In response to the comment from ICI, the Commission confirms that a

potential MSP may be able to review its obligation to register as an

MSP at the same time it is reviewing where it fits under the compliance

dates adopted in this release depending on the nature and scope of an

MSP's swaps activities. The Commission notes that its rule further

defining MSP was published on May 23, 2012, and its rule further

defining ``swap'' was published on August 13, 2012, so potential MSPs

will necessarily have to review their registration obligations ahead of

complying with the compliance dates adopted herein. However, if an

entity discovers that it has crossed the threshold established under

the MSP rules and is required to register during the 90-day period for

Category 1 Entities, the Commission would permit that entity to

petition for additional time to come into compliance with the Sec.

23.504.\49\

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\49\ Similarly, the Commission would consider allowing entities

to petition for additional time to comply to the extent that they

discover that they have exceeded the de minimis threshold under the

swap dealer definition and are required to register during the 90-

day period for Category 1.

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d. Proposed Implementation Schedule

As outlined above, proposed Sec. 23.575 required SDs and MSPs to

be in compliance with Sec. 23.504 no later than 90 days after

publication of the final rule in the Federal Register for swap

transactions with a Category 1 Entity, no later than 180 days after

publication for swap transactions with a Category 2 Entity, and no

later than 270 days after publication for swap transactions with a

Category 3 Entity or Category 4 Entity.

With respect to the proposed schedule, FIA/ISDA/SIFMA believes that

the proposed implementation schedule should be lengthened because of

the significant burden associated with the documentation requirements.

FIA/ISDA/SIFMA argued that it would be impossible to begin complying

with all of the documentation requirements of Sec. 23.504 at the same

time.

AII stated that the proposed implementation schedule does not

provide enough time for institutional investment advisors to comply

given the volume of document negotiations that will need to occur

concurrently, as well as operational changes required by the Commission

and other regulators under the Dodd-Frank Act. AII argued that

institutional investment advisers also will face special challenges

trying to allocate block trades across multiple categories of

counterparty, and managing multiple implementation schedules. AII

believes that tight timeframes will create an imbalance in negotiations

with smaller counterparties at risk of being ``shut out of the market''

if they do not accept terms of the dealer community. AII therefore

recommended that all market participants should have 18 months to come

into compliance after the rules have been finalized.

Encana believes non-financial end users should get more time to

comply with the regulations given less familiarity with Commission

regulations and the need to develop and implement policies and

procedures.

CDE stated that it is unlikely that end-users and other entities

relied on by end-users will be able to meet the requirements Sec.

23.504 if the requirements are imposed on all swaps at the same time.

Chris Bernard generally agreed with the proposed implementation

schedule, though he believes that documentation relating to the swap

valuation provisions of Sec. 23.504(b)(4) should be prioritized within

the compliance schedule.

[[Page 55940]]

The California Public Employees' Retirement System, the Colorado

PERA, the Missouri State Employees' Retirement System, the Teacher

Retirement System of Texas, and the State of Wisconsin Investment Board

recommended a one year phase-in for pension funds because the strict

procedures that exist to protect their participants may hamper their

ability to more quickly make the required changes to documents and

procedures.

FSR commented that compliance periods should be substantially

longer, with Category 2 lasting at least a year, and not starting until

a significantly longer Category 1 has completed. As smaller market

participants face the risk of accepting unsuitable terms or being shut

out of the market given the tight timeframes and lack of resources,

additional time should be granted to entities hedging in the ordinary

course of business.

ICI stated that implementation should be longer, such as 18-24

months to accommodate all of the changes that are necessary in the

market, arguing that too short a deadline will disadvantage smaller

market participants who may be shut out of the market. ICI also

recommended that the proposed implementation schedules should only

begin after all related rules are finalized.

ACLI stated that 180 days for Category 2 Entities is insufficient

for insurance companies that will need to work with state regulators on

changes to operations, to negotiate documents of first impression,

especially given the scope of the documentation to be negotiated or

changed.

The Commission acknowledges the concerns of commenters regarding

negotiation imbalances if the scope of documentation to be changed is

large, but believes that, with the modifications to the rules outlined

above, most market participants will have documentation already in

place that either meets the requirements of the rule or could meet such

requirements with relatively modest amendments. Thus, the Commission

believes that these changes plus the staggered timeframes of the

compliance dates adopted in this release adequately address the

concerns of commenters regarding the time and effort necessary to

complete the necessary documentation.

2. Confirmation NPRM

With respect to Sec. Sec. 23.501, 23.502, and 23.503 generally,

GFED argued that the Commission should not implement the proposed rules

prior to Treasury determining which foreign exchange products are

subject to the proposed rules to avoid unnecessary costs and burdens,

while MFA believes that the Commission should evaluate the notable

differences in experience and resources of market participants related

to post-trade processes prior to publishing final rules. MFA believes

that the Commission's goals would be best served, and market disruption

avoided, by providing market participants with additional time to

design, test, and implement processes required to comply with the

proposed rules.

Specifically with respect to Sec. 23.501, MarkitSERV believes that

the rules should be phased in based on a product-by-product analysis of

complexity and average time to confirm similar transactions, while

Chatham believes the confirmation requirements should be phased-in over

6 to 12 months and that non-SDs and non-MSPs should be the last

participants required to comply with the rules. In addition, ISDA

provided the Commission with details of the current percentage of

transactions electronically traded and confirmed, voice traded and

electronically confirmed, voice traded and manually confirmed, and

electronically traded and manually confirmed by eight large dealers in

the five major swap asset classes (credit, rates, commodities, foreign

exchange, and equity derivatives). ISDA provided the Commission with a

break-down of this data showing time to confirmation by asset class,

and the differences between electronic confirmation in dealer-to-dealer

transactions versus transactions with other counterparty types.

Specifically with respect to Sec. 23.502, Chatham recommended that

the Commission provide end-users with at least six months to one year

to comply with the proposed reconciliation rules, while the OCC stated

that many SDs will not be among the G-14 largest OTC derivatives

dealers and, given the incremental progression that was necessary for

the G-14 OTC derivatives dealers to develop the infrastructure

necessary to increase reconciliation amongst themselves from weekly

reconciliation for portfolios with 5,000 or more trades in 2008 to the

current daily reconciliation for portfolios of 500 or more trades, the

Commission must provide sufficient time for all registrants to develop

the required infrastructure.

With respect to Sec. 23.503, ISDA urged the Commission to consider

a long phase-in period for any compression requirement due to

significant administrative and logistical issues.

B. Compliance Dates

Having considered the comments received, the Commission is adopting

the effective and compliance dates as set forth below.

1. Swap Trading Relationship Documentation--Sec. 23.504

The effective date of Sec. 23.504 will be the date that is 60 days

after publication of the final rules in the Federal Register.

The Commission proposed a compliance schedule, Sec. 23.575, but

has determined not to finalize its schedule in the form of a rule.

Rather, compliance periods are outlined below. With respect to swap

transactions with SDs, security-based swap dealers, MSPs, major

security-based swap participants, or any private fund, as defined in

section 202(a) of the Investment Advisers Act of 1940, that is not a

third-party subaccount (defined below) and that executes 200 or more

swaps per month based on a monthly average over the 12 months preceding

this adopting release (active funds), SDs and MSPs must comply with

Sec. 23.504 by January 1, 2013.

With respect to swap transactions with commodity pools; private

funds as defined in section 202(a) of the Investment Advisers Act of

1940 other than active funds; or persons predominantly engaged in

activities that are in the business of banking, or in activities that

are financial in nature as defined in section 4(k) of the Bank Holding

Company Act of 1956, provided that the entity is not an account that is

managed by an investment manager that (1) is independent of and

unaffiliated with the account's beneficial owner or sponsor, and (2) is

responsible for the documentation necessary for the account's

beneficial owner to document swaps as required under section 4s(i) of

the CEA (third-party subaccounts), SDs and MSPs must comply with Sec.

23.504 by April 1, 2013.

With respect to swap transactions with any other counterparty, SDs

and MSPs must comply with Sec. 23.504 by July 1, 2013.

2. Swap Confirmation--Sec. 23.501

The effective date of Sec. Sec. 23.500 and 23.501 will be the date

that is 60 days after publication of the final rules in the Federal

Register.

With respect to confirmation, the Commission is establishing an

implementation schedule in the rule, differentiated by swap asset

class. For credit swaps and interest rate swaps (including cross-

currency swaps), SDs and MSPs will be required to confirm swap

transactions with other SDs and MSPs as soon as technologically

practicable, but in any event by the end of the second day after the

day of execution until February 28, 2014. After

[[Page 55941]]

February 28, 2014, SDs and MSPs must comply with the requirements of

paragraph (a)(1).

For equity swaps, foreign exchange swaps, and other commodity

swaps, SDs and MSPs will be required to confirm swap transactions with

other SDs and MSPs as soon as technologically practicable, but in any

event by the end of the third day after the day of execution until

August 31, 2013. For the period between September 1, 2013 and August

31, 2014, SDs and MSPs will be required to confirm equity, foreign

exchange, and other commodity swap transactions with other SDs and MSPs

as soon as technologically practicable, but in any event by the end of

the second day after the day of execution. After August 31, 2014, SDs

and MSPs must comply with the requirements of paragraph (a)(1).

For credit and interest rate swap transactions (including cross-

currency swaps) with counterparties that are not SDs or MSPs, SDs and

MSPs will be required to send an acknowledgement of swap transactions

as soon as technologically practicable, but in any event by the end of

the first day after the day of execution until February 28, 2014. After

February 28, 2014, SDs and MSPs must comply with the requirements of

paragraph (a)(2).

For equity, foreign exchange, and other commodity swap transactions

with counterparties that are not SDs or MSPs, SDs and MSPs will be

required to send an acknowledgement of swap transactions as soon as

technologically practicable, but in any event by the end of the second

day after the day of execution until August 31, 2013. For the period

between September 1, 2013 and August 31, 2014, SDs and MSPs will be

required to send an acknowledgement of equity, foreign exchange, and

other commodity swap transactions with counterparties that are not SDs

or MSPs as soon as technologically practicable, but in any event by the

end of the first day after the day of execution. After August 31, 2014,

SDs and MSPs must comply with the requirements of paragraph (a)(2).

For credit and interest rate swap transactions (including cross-

currency swaps) with financial entities, SDs and MSPs will be required

to establish policies and procedures reasonably designed to ensure that

they confirm swap transactions as soon as technologically practicable,

but in any event by the end of the second day after the day of

execution until February 28, 2014. After February 28, 2014, SDs and

MSPs must comply with the requirements of paragraph (a)(3)(i).

For equity, foreign exchange, and other commodity swap transactions

with financial entities, SDs and MSPs will be required to establish

policies and procedures reasonably designed to ensure that they confirm

swap transactions as soon as technologically practicable, but in any

event by the end of the third day after the day of execution until

August 31, 2013. For the period between September 1, 2013 and August

31, 2014, SDs and MSPs will be required to establish policies and

procedures reasonably designed to ensure that they confirm equity,

foreign exchange, and other commodity swap transactions with financial

entities as soon as technologically practicable, but in any event by

the end of the second day after the day of execution. After August 31,

2014, SDs and MSPs must comply with the requirements of paragraph

(a)(3)(i).

For credit and interest rate swap transactions (including cross-

currency swaps) with counterparties that are not SDs, MSPs, or

financial entities, SDs and MSPs will be required to establish policies

and procedures reasonably designed to ensure that they confirm swap

transactions as soon as technologically practicable, but in any event

by the end of the fifth day after the day of execution until August 31,

2013. For the period between September 1, 2013 and August 31, 2014, SDs

and MSPs will be required to establish policies and procedures

reasonably designed to ensure that they confirm credit and interest

rate swap transactions with counterparties that are not SDs, MSPs, or

financial entities as soon as technologically practicable, but in any

event by the end of the third day after the day of execution. After

August 31, 2014, SDs and MSPs must comply with the requirements of

paragraph (a)(3)(ii).

For equity, foreign exchange, and other commodity swap transactions

with counterparties that are not SDs, MSPs, or financial entities, SDs

and MSPs will be required to establish policies and procedures

reasonably designed to ensure that they confirm swap transactions as

soon as technologically practicable, but in any event by the end of the

seventh day after the day of execution until August 31, 2013. For the

period between September 1, 2013 and August 31, 2014, SDs and MSPs will

be required to establish policies and procedures reasonably designed to

ensure that they confirm equity, foreign exchange, and other commodity

swap transactions with counterparties that are not SDs, MSPs, or

financial entities as soon as technologically practicable, but in any

event by the end of the fourth day after the day of execution. After

August 31, 2014, SDs and MSPs must comply with the requirements of

paragraph (a)(3)(ii).

Solely for purposes of the implementation schedule applicable to

Sec. 23.501, swaps are divided into the following asset classes:

Credit swap means any swap that is primarily based on instruments

of indebtedness, including, without limitation: Any swap primarily

based on one or more broad-based indices related to instruments of

indebtedness; and any swap that is an index credit swap or total return

swap on one or more indices of debt instruments.

Equity swap means any swap that is primarily based on equity

securities, including, without limitation: Any swap primarily based on

one or more broad-based indices of equity securities; and any total

return swap on one or more equity indices.

Foreign exchange swap has the meaning set forth in section 1a(25)

of the CEA. It does not include swaps primarily based on rates of

exchange between different currencies, changes in such rates, or other

aspects of such rates (sometimes known as ``cross-currency swaps'').

Interest rate swap means any swap which is primarily based on one

or more interest rates, such as swaps of payments determined by fixed

and floating interest rates; or any swap which is primarily based on

rates of exchange between different currencies, changes in such rates,

or other aspects of such rates (sometimes known as ``cross-currency

swaps'').

Other commodity swap means any swap not included in the credit,

equity, foreign exchange, or interest rate asset classes, including,

without limitation, any swap for which the primary underlying item is a

physical commodity or the price or any other aspect of a physical

commodity.

3. Portfolio Reconciliation & Portfolio Compression

The effective date of Sec. Sec. 23.502 and 23.503 will be the date

that is 60 days after publication of the final rules in the Federal

Register.

With respect to Sec. 23.502 (Portfolio Reconciliation) and Sec.

23.503 (Portfolio Compression), SDs and MSPs that are currently

regulated by a U.S. prudential regulator or are registrants of the SEC

must comply with Sec. Sec. 23.502 and 23.503 by the date that is 90

days after publication of this final rule in the Federal Register. SDs

and MSPs that are not currently regulated by a U.S. prudential

regulator and are not registrants of the SEC must comply with

[[Page 55942]]

Sec. Sec. 23.502 and 23.503 by the date that is 180 days after

publication of this final rule in the Federal Register.

C. Compliance Date Extension for Certain Business Conduct Standards

With Counterparties

ISDA members have requested that the Commission align the

compliance dates for the provisions of subpart H of part 23 that

involve documentation \50\ with the trading relationship documentation

rules in this release. ISDA members have represented that industry-led

efforts are underway to facilitate compliance with new Dodd-Frank Act

documentation requirements and an alignment of compliance dates would

allow the most efficient transition to compliance with part 23's

documentation requirements.\51\

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\50\ Subpart H of Part 23 of the Commission's Regulations,

Business Conduct Standards for Swap Dealers and Major Swap

Participants with Counterparties, 77 FR 9734, 9824 (Feb. 17, 2012).

\51\ ISDA is partnering with Markit to launch a technology-based

solution enabling counterparties to amend their OTC derivatives

documentation quickly and efficiently to comply with Dodd-Frank

regulatory requirements. See http://www2.isda.org/dodd-frank-documentation-initiative/.

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The Commission has decided to defer the compliance dates for

certain provisions of subpart H until January 1, 2013. Compliance with

the following provisions will be deferred until January 1, 2013:

Sec. Sec. 23.402; 23.410(c); 23.430; 23.431(a)-(c); 23.432;

23.434(a)(2), (b), and (c); 23.440; and 23.450.\52\ Compliance with all

other provisions will continue to be required by October 15, 2012.

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\52\ The Commission's decision to defer compliance does not

reflect an endorsement of the industry-led effort, nor does it imply

that the Commission has reviewed the documentation protocol for

compliance with Commission rules. All market participants are

subject to the new compliance dates regardless of whether they

participate in the protocol.

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IV. Cost Benefit Considerations

Section 15(a) of the CEA \53\ requires the Commission to consider

the costs and benefits of its actions before promulgating a regulation

under the CEA or issuing certain orders. Section 15(a) further

specifies that the costs and benefits shall be evaluated in light of

five broad areas of market and public concern: (1) Protection of market

participants and the public; (2) efficiency, competitiveness, and

financial integrity of futures markets; \54\ (3) price discovery; (4)

sound risk management practices; and (5) other public interest

considerations. The Commission considers the costs and benefits

resulting from its discretionary determinations with respect to the

Section 15(a) factors.

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\53\ 7 U.S.C. 19(a).

\54\ Although by its terms section 15(a)(2)(B) of the CEA

applies to futures markets only, the Commission finds this factor

useful in analyzing regulations pertaining to swap markets as well.

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Under section 731 of the Dodd-Frank Wall Street Reform and Consumer

Protection Act (Dodd-Frank Act), Congress directed the Commission to

``adopt rules governing documentation standards for swap dealers and

major swap participants.'' The statutory provision in question, section

4(s)(i)(1) of the CEA, laid out a broad and general directive relating

to ``timely and accurate confirmation, processing, netting,

documentation, and valuation of all swaps.'' In promulgating the final

rules subject to this release, the Commission has taken its direction

from the statutory text, but is exercising its discretion with regard

to the specific requirements set forth in the rules--namely, to require

SDs and MSPs to meet certain confirmation deadlines for their swap

transactions with other SDs and MSPs, to have policies and procedures

for confirming swap transactions with financial entities and non-

financial entities within certain time periods, to engage in regular

portfolio reconciliation and portfolio compression, and to ensure that

their swaps are governed by appropriate trading relationship

documentation.

In exercising its discretion, the Commission has taken into account

a series of voluntary industry initiatives, including efforts to

improve the confirmation, reconciliation, compression, documentation,

and valuation of swaps, as well as the overarching goals of the Dodd-

Frank Act: reducing systemic risk, increasing transparency, and

promoting integrity within the financial system. As discussed below,

these industry efforts provide a useful reference point for considering

the Commission's action.

In the context of the relevant statutory provision and ongoing

industry initiatives, in the sections that follow, the Commission

discusses each requirement individually in light of cost-benefit issues

raised by commenters and suggested alternatives. The Commission also

summarizes and considers costs and benefits collectively for the set of

confirmation, portfolio reconciliation, and portfolio compression

rules, and separately for the swap trading relationship documentation

rules.

A. Background

In the fall of 2008, an economic crisis threatened to freeze U.S.

and global credit markets. The federal government intervened to

buttress the stability of the U.S. financial system.\55\ The crisis

revealed the vulnerability of the U.S. financial system and economy to

wide-spread systemic risk resulting from, among other things, poor risk

management practices of financial firms and the lack of supervisory

oversight for certain financial institutions as a whole.\56\ More

specifically, the crisis and the attendant failure of a series of large

financial institutions demonstrated the need for direct regulation of

the OTC derivatives markets.\57\

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\55\ On October 3, 2008, President Bush signed the Emergency

Economic Stabilization Act of 2008, which was principally designed

to allow the U.S. Treasury and other government agencies to take

action to restore liquidity and stability to the U.S. financial

system (e.g., the Troubled Asset Relief Program--also known as

TARP--under which the U.S. Treasury was authorized to purchase up to

$700 billion of troubled assets that weighed down the balance sheets

of U.S. financial institutions). See Pub. L. 110-343, 122 Stat. 3765

(2008).

\56\ See Financial Crisis Inquiry Commission, ``The Financial

Crisis Inquiry Report: Final Report of the National Commission on

the Causes of the Financial and Economic Crisis in the United

States,'' Jan. 2011, at xxvii, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf [hereinafter the FCIC Report].

\57\ See id. at 25 (concluding that ``enactment of * * * [the

Commodity Futures Modernization Act of 2000 (``CFMA'')] to ban the

regulation by both the federal and state governments of over-the-

counter (OTC) derivatives was a key turning point in the march

toward the financial crisis.''). See also id. at 343 (``Lehman, like

other large OTC derivatives dealers, experienced runs on its

derivatives operations that played a role in its failure. Its

massive derivatives positions greatly complicated its bankruptcy,

and the impact of its bankruptcy through interconnections with

derivatives counterparties and other financial institutions

contributed significantly to the severity and depth of the financial

crisis.'') and id. at 353 (``AIG's failure was possible because of

the sweeping deregulation of [OTC] derivatives, [* * *] including

capital and margin requirements that would have lessened the

likelihood of AIG's failure. The OTC derivatives market's lack of

transparency and of effective price discovery exacerbated the

collateral disputes of AIG and Goldman Sachs and similar disputes

between other derivatives counterparties.'').

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American International Group (AIG) is an example of how the

stability of a large financial institution could be undermined by

certain failures in risk management, internal controls with respect to

trading positions, documentation, and valuation, AIG was a regulated

U.S. insurance company nearly undone by its collateral posting

obligations under swaps entered into by its subsidiary, AIG Financial

Products (AIGFP). AIGFP suffered enormous losses from credit default

swaps that it issued on certain underlying securities, which, because

AIGFP's performance on such credit default swaps had been guaranteed by

its parent, caused credit agencies to downgrade the credit rating of

the entire AIG corporation. The downgrade triggered collateral calls

and induced a liquidity crisis at AIG, which

[[Page 55943]]

resulted in over $85 billion of indirect assistance from the Federal

Reserve Bank of New York to prevent AIG's default.\58\

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\58\ The Federal Reserve Bank of New York explained its

intervention as a means of preventing contagion concerns resulting

from an AIG default from spreading financial losses to other firms.

The FCIC argued and Gretchen Morgenson reported that the entire U.S.

financial system might have been threatened by such a large default.

See FCIC Report at 200-02 and 344-52 and Gretchen Morgenson,

``Behind Insurer's Crisis, Blind Eye to a Web of Risk,'' N.Y. Times,

Sept. 27, 2008 [hereinafter Morgenson Article]. Corrected version

published Sept. 30, 2008, available at http://www.nytimes.com/2008/09/28/business/28melt.html?pagewanted=all.

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The inability to value its portfolio accurately and agree on

valuations with its counterparties posed a serious problem for AIG

during the financial crisis.\59\ Swap valuation disputes were common,

because, among other things, there was widespread market opacity for

many of the inputs needed to properly value many swaps.\60\ As reported

during the fall of 2008, ``the methods that A.I.G. used to value its

derivatives portfolio began to come under fire from trading partners.''

\61\ As explained by a Congressional panel, ``the threats within

[AIG's] businesses emanated from outsized exposure to the deteriorating

mortgage markets, owing to grossly inadequate valuation and risk

controls, including insufficient capital buffers as losses and

collateral calls mounted'' (emphasis added).\62\

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\59\ See Testimony Before the Financial Crisis Inquiry

Commission, including AIG/Goldman Sachs Collateral Call Timeline,

available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0701-AIG-Goldman-supporting-docs.pdf (timeline

documenting valuation disputes and collateral calls); Testimony of

Joseph Cassano, available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0630-Cassano.pdf; and AIG Statement

Summary, available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0630-AIG-Statement-Summary.pdf.

\60\ The failure of the market to set a price for mortgage-

backed securities led to wide disparities in the valuation of CDS

referencing mortgage-backed securities (especially collateralized

debt obligations). ``The illiquid market for some structured credit

products, auction rate securities, and other products backed by

opaque portfolios led to major write-downs across the industry in

2008. The resulting depletion of capital led to credit downgrades,

which in turn drove counterparty collateral calls and sales of

illiquid assets. This further depleted capital balances. Widening

CDS spreads have become widely viewed as a leading indicator of a

bank's financial health and viability.'' PriceWaterhouseCoopers,

``Lehman Brothers' Bankruptcy: Lessons learned for the survivors,''

Informational presentation for clients, August 2009, at 12,

available at http://www.pwc.com/en_JG/jg/events/Lessons-learned-for-the-survivors.pdf. In addition, such wide disparities led to

large collateral calls from dealers on AIG, hastening its downfall.

See CBS News, ``Calling AIG? Internal Docs Reveal Company Silent

About Dozens Of Collateral Calls,'' Jun. 23, 2009, available at:

http://www.cbsnews.com/stories/2009/06/23/cbsnews_investigates/main5106672.shtml.

\61\ See Morgenson Article.

\62\ Congressional Oversight Panel, June Oversight Report: The

AIG Rescue, Its Impact on Markets, and the Government's Exit

Strategy, June 10, 2010, at 24, available at http://cybercemetery.unt.edu/archive/cop/20110402010341/cop.senate.gov/documents/cop-061010-report.pdf.

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The financial crisis also highlighted the significance of

substandard or missing legal documentation. For example, the Lehman

Brothers Holding Inc. (LBHI) bankruptcy offers another stark lesson on

how failures in risk management, documentation, and valuation can

contribute to the ultimate collapse of an entire financial institution.

During the days leading up the LBHI's bankruptcy, potential buyers were

stymied by the state of Lehman's books.\63\ As recognized by

PriceWaterhouseCoopers in a lessons learned document put together after

the Lehman bankruptcy, effective risk management requires the existence

of sound documentation, daily reconciliation of portfolios, rigorously

tested valuation methodologies, and sound collateralization

practices.\64\

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\63\ See In re Lehman Brothers Holdings Inc., 08-13555, and

Giddens v. Barclays Capital Inc., 09-01732, U.S. Bankruptcy Court,

Southern District of New York; see also Linda Sandler, ``Lehman

Derivatives Records a `Mess,' Barclays Executive Says,'' Bloomberg,

Aug. 30, 2010, available at http://www.bloomberg.com/news/2010-08-30/lehman-derivatives-records-a-mess-barclays-executive-says.html

(reporting on testimony provided in previously cited Lehman

bankruptcy proceeding).

\64\ See PriceWaterhouseCoopers, ``Lehman Brothers' Bankruptcy:

Lessons learned for the survivors,'' Informational presentation for

clients, August 2009, at 12-24, available at http://www.pwc.com/en_JG/jg/events/Lessons-learned-for-the-survivors.pdf.

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More broadly, the President's Working Group (PWG) on Financial

Policy noted shortcomings in the OTC derivative markets as a whole

during the crisis. The PWG identified the need for an improved

integrated operational structure supporting OTC derivatives,

specifically highlighting the need for an enhanced ability to manage

counterparty risk through ``netting and collateral agreements by

promoting portfolio reconciliation and accurate valuation of trades.''

\65\

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\65\ The President's Working Group on Financial Markets,

``Policy Statements on Financial Market Developments,'' Mar. 2008,

available at http://www.treasury.gov/resource-center/fin-mkts/Documents/pwgpolicystatemktturmoil_03122008.pdf.

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Congress sought to address the deficiencies in the regulatory

system that contributed to the financial crisis through the enactment

of the Dodd-Frank Act, which was signed by President Obama on July 21,

2010.\66\ Title VII of the Dodd-Frank Act amended the CEA \67\ to

overhaul the structure and oversight of the OTC market that previously

had been subject to little or no oversight.\68\ One of the cornerstones

of this legislation is the establishment of a new statutory framework

for comprehensive regulation of financial institutions that participate

in the swaps market as SDs or MSPs, which must register and are subject

to greater oversight and regulation.\69\ This new framework for SDs and

MSPs seeks to reduce the potential for the recurrence of the type of

financial and operational stresses that contributed to the 2008 crisis.

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\66\ Pub. L. 111-203, 124 Stat. 1376 (2010). The text of the

Dodd-Frank Act is available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/file/hr4173_enrolledbill.pdf.

\67\ 7 U.S.C. 1, et seq.

\68\ Prior to the adoption of Title VII, swaps and security-

based swaps were by and large unregulated. The CFMA excluded

financial OTC swaps from regulation under the CEA, provided that

trading occurred only among ``eligible contract participants.''

Swaps based on exempt commodities--including energy and metals--

could be traded among eligible contract participants without CFTC

regulation, but certain CEA provisions against fraud and

manipulation continued to apply to these markets. No statutory

exclusions were provided for swaps on agricultural commodities by

the CFMA, although they could be traded under certain regulatory

exemptions provided by the CFTC prior to its enactment. Swaps based

on securities were subject to certain SEC enforcement authorities,

but the SEC was prohibited from prophylactic regulation of such

swaps.

\69\ The provisions of the CEA relating to swaps that were

enacted by Title VII of the Dodd-Frank Act are also referred to

herein as ``the Dodd-Frank requirements.''

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Efforts to regulate the swaps market are underway not only in the

United States but also abroad in the wake of the 2008 financial crisis.

In 2009, leaders of the Group of 20 (G-20)--whose membership includes

the European Union (EU), the United States, and 18 other countries--

agreed that: (i) OTC derivatives contracts should be reported to trade

repositories; (ii) all standardized OTC derivatives contracts should be

cleared through central counterparties and traded on exchanges or

electronic trading platforms, where appropriate, by the end of 2012;

and (iii) non-centrally cleared contracts should be subject to higher

capital requirements. In line with the G-20 commitment, much progress

has been made to coordinate and harmonize international reform efforts,

but the pace of reform varies among jurisdictions and disparities in

regulations remain due to differences in cultures, legal and political

traditions, and financial systems.\70\

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\70\ Legislatures and regulators in a number of foreign

jurisdictions are undertaking significant regulatory reforms over

the swaps market and its participants. See CFTC and SEC, Joint

Report on International Swap Regulation Required by Section 719(c)

of the Dodd-Frank Wall Street Reform and Consumer Protection Act,

Jan. 31, 2012, at 23, available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/file/dfstudy_isr_013112.pdf. For example,

the European Parliament adopted the substance of the European Market

Infrastructure Regulation (``EMIR'') on March 29, 2012. As discussed

below, ESMA has proposed regulations that are very similar to those

being adopted by the Commission in this release.

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[[Page 55944]]

Even before the passage of the Dodd-Frank Act, market participants

and regulators had been paying particular attention to the post-trade

processing of swaps. For example, operational issues associated with

the OTC derivatives market have been the focus of reports and

recommendations by the PWG.\71\ In response to the financial crisis in

2008, the PWG called on the industry to improve trade matching and

confirmation and to promote portfolio reconciliation.

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\71\ See, e.g., Press Release, ``President's Working Group on

Financial Markets, Progress Summary on OTC Derivatives Operational

Improvements'' (Nov. 2008).

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Significantly, beginning in 2005, the Federal Reserve Bank of New

York (FRBNY) undertook a targeted, supervisory effort to enhance

operational efficiency and performance in the OTC derivatives market,

by increasing automation in processing and by promoting the timely

confirmation of trades. Known as the OTC Derivatives Supervisors' Group

(ODSG), the FRBNY led an effort with OTC derivatives dealers' primary

supervisors, trade associations, industry utilities, and private

vendors, through which market participants (including buy-side

participants) regularly set goals and commitments to bring

infrastructure, market design, and risk management improvements to all

OTC derivatives asset classes. Over the years, the ODSG expanded its

focus from credit derivatives to include interest rate derivatives,

equity derivatives, foreign exchange derivatives, and commodity

derivatives. Along with this expanded focus came increased engagement

with market participants on cross-asset class issues. Specifically, the

ODSG encouraged the industry to commit itself to a number of reforms,

including improved operational performance with respect to the OTC

derivatives confirmation process, portfolio reconciliation, and

portfolio compression. The regulations being adopted by the Commission

in this adopting release build upon the ODSG's work.\72\ The specific

operational performance enhancements upon which each of the

Commission's rules included in this adopting release expressly build,

the comments to the rule proposals related to the costs and benefits of

such rules, and the Commission's consideration of the costs and

benefits of such rules are discussed below.

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\72\ ``No more Fed letter commitments expected, says Dudley,''

Risk Magazine, May 16, 2012, available at http://www.risk.net/risk-magazine/news/2174981/fed-letter-commitments-expected-dudley

(William Dudley, president of the Federal Reserve Bank of New York,

stated ``Now we're moving to a new regime, where the OTC derivatives

market is being regulated for the first time. As we do that, and the

SEC and CFTC stand up in terms of regulation, it's completely

appropriate for us to stand down.'').

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This final rule implements Dodd-Frank Act section 731, which is an

important component of the comprehensive set of reforms passed by

Congress to protect the American public and ``promote the financial

stability of the United States'' in the wake of a financial crisis and

the resulting recession that was caused in part by the lack of adequate

regulation of financial markets.\73\ The damage to the American public

has been tremendous. According to the U.S. Department of the Treasury,

over $19 trillion in household wealth and over 8.8 million jobs were

lost during the recession that began in late 2008.\74\ Between

September 2008 and May 2012 there have been approximately 3.6 million

completed home foreclosures across the country.\75\ The U.S. Census

Bureau estimates that the number of households living below the poverty

level rose 2.6 percent from 2007 to 2010.\76\ The overarching purpose

and benefit of this final rule, together with the other rules the

Commission is implementing under Title VII of the Dodd-Frank Act is to

identify and fix the structural weaknesses that contributed to the

financial crisis in an effort to avoid a repeat of the same.

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\73\ Dodd-Frank Act, Preamble.

\74\ See U.S. Department of the Treasury, ``The Financial Crisis

Response--In Charts,'' April 2012, available at http://www.treasury.gov/resource-center/data-chart-center/Documents/20120413_FinancialCrisisResponse.pdf. See also Congressional Budget

Office, The Budge and Economic Outlook: Fiscal Years 2012-2022, at

26 (Jan. 2012) (explaining gross domestic product (GDP) has fallen

dramatically and it is not expected to return to normal levels until

at least 2018. At that time, the cumulative shortfall in GDP

relative to potential GDP is expected to reach $5.7 trillion).

\75\ See CoreLogic, ``CoreLogic Reports 66,000 Completed

Foreclosures Nationally,'' May 2012, available at http://www.corelogic.com/about-us/news/corelogic-reports-66,000-completed-foreclosures-nationally-in-april.aspx.

\76\ See U.S. Census Bureau, ``Income, Poverty, and Health

Insurance Coverage in the United States: 2010,'' at 14 (Sept. 2010),

available at http://www.census.gov/prod/2011pubs/p60-239.pdf.

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B. Swap Confirmation

The Government Accountability Office (GAO) found that the rapid

expansion of the trading volume of swaps, such as credit derivatives,

since 2002, caused stresses on the operational infrastructure of market

participants. These stresses, in turn, caused the participants' back

office systems to fail to confirm the increased volume of trades for a

period of time.\77\ The GAO found that the lack of automation in trade

processing and the purported assignment of positions by transferring

parties to third parties without notice to their counterparties were

factors contributing to this backlog. If transactions, whether newly

executed or recently transferred to another party, are left

unconfirmed, there is no definitive written record of the contract

terms. Thus, in the event of a dispute, the terms of the agreement must

be reconstructed from other evidence, such as email trails or recorded

trader conversations. This process is cumbersome and may not be wholly

accurate. Moreover, if purported transfers of swaps, in whole or in

part, are made without giving notice to the remaining parties and

obtaining their consent, disputes may arise as to which parties are

entitled to the benefits and subject to the burdens of the transaction.

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\77\ U.S. Government Accountability Office, ``Credit

Derivatives: Confirmation Backlogs Increased Dealers' Operational

Risks, But Were Successfully Addressed After Joint Regulatory

Action,'' GAO-07-716 (2007) at 3-4.

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As the work of the ODSG demonstrates, the industry is capable of

swift movement to contemporaneous execution and confirmation. A large

back-log of unexecuted confirmations in the CDS market created by

prolonged negotiations and inadequate confirmation procedures were the

subject of the first industry commitments made by participating dealers

to ODSG.\78\ In October 2005, the participating dealers committed to

reduce by 30 percent the number of confirmations outstanding more than

30 days within four months. In March 2006, the dealers committed to

reduce the number of outstanding confirmations by 70 percent by June

30, 2006. By September 2006, the industry had reduced the number of all

outstanding CDS confirmations by 70 percent, and the number of CDS

confirmations outstanding more than 30 days by 85 percent. The industry

achieved these targets largely by moving 80 percent of total trade

volume in CDS to confirmation on electronic platforms, eliminating

backlogs in new trades.

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\78\ See October 4, 2005 industry commitment letter to the

Federal Reserve Bank of New York, available at http://www.newyorkfed.org/newsevents/news_archive/markets/2005/an050915.html.

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By the end of 2011, the largest dealers were electronically

confirming over 95

[[Page 55945]]

percent of OTC credit derivative transactions, and 90 percent were

confirmed on the same day as execution (T+0). For the same period, the

largest dealers were electronically confirming over 70 percent of OTC

interest rate derivatives (over 90 percent of trades with each other),

and over 80 percent were confirmed T+0. The rate of electronic

confirmation of OTC commodity derivatives was somewhat lower--just over

50 percent, but over 90 percent for transactions between the largest

dealers.\79\ These statistics provide some confidence that, over time,

timely confirmation rates will continue to improve.

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\79\ See G15 Industry Confirmation Data dated April 4, 2012

provided by ISDA, available at www.cftc.gov.

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The primary benefit of timely and accurate confirmation is that the

parties to a swap know what their deal is. In other words, a

confirmation definitively memorializes all of the terms of the swap

transaction, which is critical for all downstream operational and risk

management processes. If transactions, whether newly executed or

recently transferred to another party, are left unconfirmed, there is

no definitive written record of the contract terms. Risk management

processes dependent on the trade terms (such as collateral management,

and payment and settlement systems) may be inaccurate, and, in the

event of a dispute, the terms of the agreement must be reconstructed

from other evidence, such as email trails or recorded trader

conversations.

Recognizing the laudable gains in electronic confirmation

processing by the industry and the risk reduction in the shortening of

time periods between execution and confirmation, the Commission

proposed a confirmation rule that would have required SDs and MSPs

trading with each other to confirm their swap transactions within 15

minutes if the swap transaction was executed and processed

electronically, within 30 minutes if the swap transaction was only

processed electronically, and within the same calendar day if the swap

transaction could not be processed electronically. Similarly, the

Commission proposed that SDs and MSPs have policies and procedures for

confirming swap transactions with financial entities within the same

calendar day, and with counterparties that are not SDs, MSPs, or

financial entities not later than the next business day.

Several commenters recognized the benefits of the Commission's

confirmation proposal and wrote in support of the approach. Chris

Barnard wrote that the proposal would increase transparency and promote

legal certainty for swaps. CME stated that it supported the goals of

improving the post-trade processing of swaps and ensuring timely and

accurate confirmation of such data among counterparties. CME agreed

with the overall approach taken by the Commission on this subject and

with the goal of promulgating confirmation requirements that are

effective, not duplicative and cost and time efficient to the industry.

CME noted the cost-savings to market participants of confirming their

swaps through DCOs, which is explicitly permitted under the swap

confirmation rule.

On the other hand, multiple commenters objected to the Commission's

proposal on cost grounds. Some read the proposal as detrimentally

mandating electronic confirmation.\80\ Other commenters argued that the

short time periods permitted for confirmation would effectively require

all terms of a swap to be negotiated prior to execution, increasing

costs for the party that is most sensitive to timing of market

conditions and increasing risk by leading to needless disputes and

operational lapses.\81\ Still others argued that financial entities

should not be subject to shorter confirmation deadlines than non-

financial entities.\82\ Finally, some commenters stated that the rule

would require changes in current market practice and it was unclear

that the cost of additional resources to meet the requirements of the

rule was outweighed by any enhanced transparency or reduction in

systemic risk.\83\ No commenter provided quantitative data on the

comprehensive compliance costs of the rule as proposed, but ISDA and

The Working Group enumerated costs related to adopting electronic

confirmation procedures. ISDA stated that each asset class uses

different electronic confirmation platforms, so a trader conducting

trades in multiple asset classes would need to build the infrastructure

necessary to integrate multiple platforms. Such expenditures are

routine for dealers, says ISDA, but for smaller entities, the

operational costs may impede their ability to hedge risk. The Working

Group estimated that electronic confirmation could cost an SD or MSP in

excess of $1,000,000 annually, citing that one third-party confirmation

service charges $6.00 per trade. However, The Working Group cited no

source for the proposition that potential SDs or MSPs currently execute

the more than 166,000 trades annually that would be required to reach a

$1,000,000 annual confirmation cost at $6.00 per trade.

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\80\ Chatham argued that the Commission should not mandate

confirmation through an electronic matching platform, because such a

mandate could preclude end-users from entering into swaps not yet

available on matching platforms and could increase costs for end-

users that do not engage in the volume of swaps necessary to justify

the additional costs of connecting to electronic matching platforms.

ABC & CIEBA also argued that the proposed rule could impose

processes that require third-party service providers or new

technology.

\81\ The Working Group; ISDA; Chatham.

\82\ CIEBA stated that the rule would impose costly increases in

operational capacity for pension funds and recommended that the

Commission provide for a ``close of next business day'' time limit

for benefit plans, along with a requirement that SDs and MSPs

provide an acknowledgement at the time of execution as well as a

draft acknowledgement prior to execution. AMG argued that financial

entities should not be subject to shorter time periods for

confirmation because many may not have the operational resources to

meet the deadlines. MFA stated that designation as a financial

entity does not necessarily correlate with a large swap portfolio or

being highly sophisticated, and thus the short time period for

confirmation in the proposed rules may cause unwarranted economic

disadvantages.

\83\ BGA; MetLife; MFA; GFED; the FHLBs; AMG.

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The Commission carefully considered each of these comments in

formulating the final rule and has responded to the cost concerns of

commenters where doing so was in keeping with the benefit of timely and

accurate memorialization of all the terms of a swap transaction between

an SD or MSP and its counterparties. First, the final rule does not

apply to swap transactions that are executed on a SEF or DCM or that

are submitted for clearing to a DCO by the required confirmation

deadline, so market participants that mostly transact in standardized

swaps may not be affected by the rule, or will have their costs greatly

reduced. This fact was highlighted by both CME and ICE in their

comments to the proposed rule.

Second, the Commission notes that the final rule affirmatively does

not mandate electronic confirmation. Instead, the final rule sets an

ultimate deadline for confirmation of swap transactions among SDs and

MSPs, while also requiring that if technologically practicable, such

swap transactions be confirmed sooner. The deadline of ``the end of the

first business day following the day of execution'' is modified to

allow for more time if registrants are trading near the end of the

trading day or if such registrants are in different time zones. With

respect to swap transactions with non-SDs and non-MSPs, SDs and MSPs

are only required to have policies and procedures in place that are

reasonably designed to ensure confirmation by the end of the first

business day following the day of execution (modified for end of day

trading and time zone differences) for financial entities, or by

[[Page 55946]]

the end of the second business day following the day of execution for

non-financial entities, rather than the next business day as proposed.

The Commission would expect an SD's or MSP's policies and procedures to

require sufficient pre-trade agreement on repetitive terms such that

non-SD, non-MSP counterparties are able to execute in a timely manner

without protracted pre-trade negotiations that may prove costly for

market participants sensitive to execution timing. The requirement for

policies and procedures (as opposed to hard deadlines) recognizes that

SDs and MSPs cannot force their non-SD, non-MSP counterparties to adopt

particular electronic confirmation processes, but must accommodate the

needs of their counterparties while ensuring, to the extent possible,

that confirmation is achieved within the rule's time periods.

In addition, to further reduce the burden of the rule on those

market participants that are least able to quickly adapt to the rule's

requirements, the Commission notes that compliance with the rule is

implemented on a staggered basis. As discussed above under section

III.B.2, compliance is required first for swaps in the credit and

interest rate asset class, and, within that asset class, first for

swaps among SDs, MSPs, and financial entities with a longer compliance

period for swaps between SDs or MSPs and non-financial entities.

Compliance is staggered similarly with respect to all other swaps, but

with longer compliance periods.

The Commission understands that, for certain asset classes, the low

number of transactions does not seem to justify increased expenditure

on faster confirmations; however, the Commission is committed to

decreasing the length of time between execution and confirmation in

order to improve the efficiency of bilateral markets and decrease

overall systemic risk resulting from outstanding unconfirmed trades

among many participants. The Commission maintains that such benefits

are significant and important regardless of asset class. Thus, the

Commission has applied the same general timeframes to all asset

classes, but has extended the compliance deadlines for commodity,

equity, and foreign exchange asset classes in order to allow

participants in those asset classes sufficient time to integrate faster

confirmations without an immediate and potentially overwhelming burden.

Finally, the Commission notes that ESMA has proposed confirmation

requirements that are substantially similar to those adopted by the

Commission in this release.\84\ By closely aligning confirmation

requirements through consultation with ESMA, the Commission believes

that SDs and MSPs will benefit from a largely unitary regulatory regime

that does not require separate compliance and operational policies and

procedures.

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\84\ See ESMA Draft Technical Standards, Article 1 RM,

subsection 2 (stating that uncleared OTC derivatives ``shall be

confirmed, where available via electronic means, as soon as possible

and at the latest by the end of the same business day.''), and ESMA

Draft Technical Standards, Article 1 RM, subsection 3 (stating that

uncleared OTC derivatives ``shall be confirmed as soon as possible

and at the latest by the end of the second business day following

the date of execution'').

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C. Portfolio Reconciliation

Disputes related to confirming the terms of a swap, as well as swap

valuation disputes, have long been recognized as a significant problem

in the OTC derivatives market.\85\ Portfolio reconciliation is

considered an effective means of identifying and resolving these

disputes. The Commission recognizes that the industry has made

significant progress in adopting the use of portfolio reconciliation to

decrease the number of swap disputes.\86\ In December 2008, the ODSG's

group of 14 major dealers committed to execute daily portfolio

reconciliations for collateralized portfolios in excess of 500 trades

between participating dealers by June of 2009.\87\ As of May 2009, all

participating dealers were satisfying this commitment. In October 2009,

the ODSG committed to publishing a feasibility study on market-wide

portfolio reconciliation that would set forth how regular portfolio

reconciliation could be extend beyond the ODSG dealers to include

smaller banks, buy-side participants, and derivative end users.

Consistent with this publication, the ODSG dealers expanded their

portfolio reconciliation commitment in March 2010 to include monthly

reconciliation of collateralized portfolios in excess of 1,000 trades

with any counterparty. Most recently, the industry has been preparing a

new ``Convention on the Investigation of Disputed Margin Calls'' and a

new ``Formal Market Polling Procedure'' that are intended to ``create a

consistent and predictable process * * * that eliminates present

uncertainties and delays.'' \88\

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\85\ See ISDA Collateral Committee, ``Commentary to the Outline

of the 2009 ISDA Protocol for Resolution of Disputed Collateral

Calls,'' June 2, 2009 (stating ``Disputed margin calls have

increased significantly since late 2007, and especially during 2008

have been the driver of large (sometimes > $1 billion) un-

collateralized exposures between professional firms.'').

\86\ The Commission also recognizes and encourages the industry

practice of immediately transferring undisputed collateral amounts.

\87\ See June 2, 2009 summary of industry commitments, available

at http://www.isda.org/c_and_a/pdf/060209table.pdf.

\88\ See ``ISDA 2010 Convention on the Investigation of Disputed

Margin Calls'' and ``ISDA 2010 Formal Market Polling Procedure.''

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In light of these efforts the Commission proposed Sec. 23.502,

which required SDs and MSPs to reconcile their swap portfolios with one

another and provide counterparties that are not registered as SDs or

MSPs with regular opportunities for portfolio reconciliation.

Specifically, proposed Sec. 23.502 required SDs and MSPs to reconcile

swap portfolios with other SDs or MSPs with the following frequency:

daily for portfolios consisting of 300 or more swaps, at least weekly

for portfolios consisting of 50 to 300 swaps, and at least quarterly

for portfolios consisting of fewer than 50 swaps. For portfolios with

counterparties other than SDs or MSPs, the proposed regulations

required SDs and MSPs to establish policies and procedures for

reconciling swap portfolios: daily for swap portfolios consisting of

500 or more swaps, weekly for portfolios consisting of more than 100

but fewer than 500 swaps, and at least quarterly for portfolios

consisting of fewer than 100 swaps. In order for the marketplace to

realize the full risk reduction benefits of portfolio reconciliation,

the Commission also proposed to expand portfolio reconciliation to all

transactions, whether collateralized or uncollateralized. For the swap

market to operate efficiently and to reduce systemic risk, the

Commission believes that portfolio reconciliation should be a proactive

process that delivers a consolidated view of counterparty exposure down

to the transaction level. By identifying and managing mismatches in key

economic terms and valuation for individual transactions across an

entire portfolio, the Commission proposal sought to require a process

in which overall risk can be identified and reduced.

Agreement between SDs, MSPs, and their counterparties on the proper

daily valuation of the swaps in their swap portfolio also is essential

for the Commission's margin proposal. Under proposed rule Sec. 23.151,

non-bank SDs and MSPs must document the process by which they will

arrive at a valuation for each swap for the purpose of collecting

initial and variation margin.\89\

[[Page 55947]]

All non-bank SDs and MSPs must collect variation margin from their non-

bank SD, MSP, and financial entity counterparties for uncleared swaps

on a daily basis. Variation margin requires a daily valuation for each

swap. For swaps between non-bank SDs and MSPs and non-financial

entities, no margin is required to be exchanged under Commission

regulation, but the non-bank SDs and MSPs must calculate a hypothetical

variation margin requirement for each uncleared swap for risk

management purposes under proposed Sec. 23.154(b)(6).

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\89\ See Margin Requirements for Uncleared Swaps for Swap

Dealers and Major Swap Participants, 76 FR 23732, 23744 (April 28,

2011). Bank SDs and MSPs will also be required to document the

process by which they will arrive at a valuation for each swap for

the purpose of collecting margin under the margin rules proposed by

the OCC, the Federal Reserve Board, and the FDIC. See Margin and

Capital Requirements for Covered Swap Entities, 76 FR 27564, 27589

(May 11, 2011).

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Several commenters articulated the benefits of portfolio

reconciliation and supported the Commission's proposal. TriOptima

supported the regular reconciliation of all portfolios as a process

that will identify issues that can minimize counterparty credit

exposure and operational risk. Chris Barnard also supported the rule,

stating that the rule should increase transparency, promote market

integrity and reduce risk by establishing procedures that will promote

legal certainty concerning swap transactions, assist with the early

resolution of valuation disputes, reduce operational risk, and increase

operational efficiency.

Conversely, multiple commenters objected to proposed Sec. 23.502

on cost grounds. Some commenters argued that the rule would require

significant investment in new infrastructure and some argued that the

rule would have few benefits for SDs and MSPs that trade in shorter

dated swaps.\90\ Others asserted that portfolio reconciliation at the

transactional level was only necessary if there are portfolio level

discrepancies that result in margin disputes, and argued that routine

reconciliation at the proposed frequency was unnecessarily costly.\91\

Some argued that the swap portfolios of non-SDs, non-MSPs do not pose

significant risk to the financial system and the rule may increase the

costs of swaps for such entities.\92\ Still others argued that the

Commission must provide sufficient time for all registrants to develop

the infrastructure required to meet the frequency of reconciliation

required by the rule.

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\90\ GFED.

\91\ MFA; ISDA; The Working Group; MarkitSERV; AMG.

\92\ Dominion; FHLBs; Chatham.

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In relation to the one business day valuation dispute resolution

requirement, many commenters stated that parties to a good-faith

dispute should have a commercially reasonable timeframe in which to

consult in order to find an appropriate resolution of the dispute.

These commenters supported ISDA's 2011 Convention on Portfolio

Reconciliation and the Investigation of Disputed Margin Calls and the

2011 Formal Market Polling Procedure, developed pursuant to industry

commitments to the ODSG, which ISDA believes will be widely adopted by

OTC derivatives market participants, and believed these industry

efforts should play a more significant role in shaping the proposed

reconciliation rules.\93\ Other commenters argued that SDs and MSPs

should not have to expend resources to resolve valuation disputes

exceeding the proposed 10 percent threshold if they conclude that the

discrepancy is not material in their particular circumstances.\94\

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\93\ ISDA; The Working Group; FHLBs; AMG.

\94\ Chatham; The Working Group; MFA; ISDA.

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The Commission carefully considered each of the foregoing comments

in formulating the final rule.

It should be noted that the Confirmation NPRM stated that the

Commission anticipated that SDs and MSPs will be able to efficiently

reconcile their internal records with their counterparties by reference

to data in SDRs. The Commission received no comments disputing this

assertion, and one commenter noted that SDRs would be in the best

position to detect and manage discrepancies in the material terms of a

swap transaction both efficiently and effectively.\95\ The Commission

has thus determined to adopt the portion of the rule that requires SDs

and MSPs to reconcile the material terms of each swap in their swap

portfolios in addition to reconciling the valuation of each swap but,

at the urging of commenters, has reduced the required frequency of

reconciliation to match the frequency of reconciliation currently

undertaken by the largest prospective SDs.\96\ The final rules require

SDs and MSPs to reconcile portfolios with other SDs and MSPs at the

following frequencies: daily for portfolios comprising 500 or more

swaps; weekly for portfolios comprising 51 to 499 swaps; and quarterly

for portfolios comprising one to 50 swaps. The Commission believes that

the frequency of reconciliation of material terms and valuations of

each swap required by the rule as modified will ensure the risk-

reducing benefits of reconciliation by presenting a consolidated view

of counterparty exposure down to the transaction level, and that these

benefits are especially noteworthy when considered in light of the

efficiencies possible through use of SDR data in the reconciliation

process.

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\95\ FHLBs.

\96\ In December 2008, the ODSG's group of 14 major dealers

committed to execute daily portfolio reconciliations for

collateralized portfolios in excess of 500 trades between

participating dealers by June of 2009. See June 2, 2009 summary of

industry commitments, available at http://www.isda.org/c_and_a/pdf/060209table.pdf. As of May 2009, all participating dealers were

satisfying this commitment. The ODSG dealers expanded their

portfolio reconciliation commitment in March 2010 to include monthly

reconciliation of collateralized portfolios in excess of 1,000

trades with any counterparty.

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Having considered comments that the frequency of reconciliation

with non-SD, non-MSP counterparties required by the rule was

unnecessary to achieve the benefits of portfolio reconciliation

outlined above, the Commission is also reducing the frequency of

reconciliation required for non-registrant counterparties and is

modifying the final rule to require reconciliation with such

counterparties quarterly for swap portfolios of more than 100 swaps,

and annually for all other swap portfolios. This level was recommended

by commenters, including The Working Group.

With respect to the proposed rule's one business day deadline for

valuation dispute resolution among SDs and MSPs, the Commission

observes that daily valuation is critical for the appropriate operation

of the Commission's proposed rules on margin, which is itself essential

for the mitigation of risk posed by swaps. Issues related to swap

valuations are woven through a number of Commission rule proposals. For

instance, Sec. 23.504(e), as adopted in this release, requires SDs and

MSPs to report valuation disputes with SD or MSP counterparties in

excess of $20,000,000 and lasting longer than three business days to

the Commission, while under Sec. 23.504(b)(4) SDs and MSPs are

required to agree on valuation methodologies with their counterparties.

However, the Commission recognizes that valuation dispute

resolution may be labor intensive and therefore costly. For this

reason, the Commission modified the rule to provide for a five-day

resolution process. In addition to this change, the Commission notes

that, the costs of valuation dispute resolution are mitigated by the

operation of several other parts of the new regulatory regime for

swaps. First, the reconciliation requirements, and thus the valuation

dispute resolution requirement, does not apply to cleared swaps,

because DCOs establish settlement prices for each cleared swap every

business day. It is likely that a large part of the swap

[[Page 55948]]

portfolios of SDs and MSPs will consist of cleared swaps \97\ to which

the reconciliation requirements will not apply; valuation disputes will

therefore only arise in bilateral, uncleared portfolios. Second, the

reconciliation requirements of Sec. 23.503 are expected to avoid

disputes from arising in the first instance through the regular

comparison of material terms and valuations. Third, the Commission

expects that Sec. 23.504(b)(4), by requiring agreement with each

counterparty on the methods and inputs for valuation of each swap, will

assist SDs and MSPs to resolve valuation disputes within five business

days.

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\97\ ``It is expected that the standardized, plain vanilla, high

volume swaps contracts--which according to the Treasury Department

are about 90 percent of the $600 trillion swaps market--will be

subject to mandatory clearing.'' 156 Cong. Rec. S5921 (daily ed.

Jul. 15, 2010) (statement of Sen. Lincoln). The Tabb group estimates

that 60-80 percent of the swaps market measured by notional amount

will be cleared within five years of the time that the Dodd-Frank

Act is implemented. See Tabb Group, ``Technology and Financial

Reform: Data, Derivatives and Decision Making.''

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SDs and MSPs need not resolve every valuation dispute, but only

those where the difference in valuation is 10 percent or more. The

Commission believes the 10 percent threshold is appropriate as it

provides certainty as to which disputes must be resolved. The

Commission believes the efficiency of a bright line rule, as opposed to

the formulas and discretion in the alternatives suggested by

commenters, will better serve the operational processes of SDs and MSPs

and the regulatory oversight of the Commission. Thus, to maintain the

risk mitigation benefits of the rule outlined above, the Commission has

determined to retain the requirement that swap valuation disputes among

SDs and MSPs be resolved within five business days.

As a further cost reduction measure, the Commission notes that it

has extended the compliance dates for those SDs and MSPs that have not

been previously regulated by a prudential regulator, and thus are least

likely to have the infrastructure in place to begin regular

reconciliation with their counterparties. As stated in section III.B.3

above, SDs and MSPs that have been previously regulated need not comply

with the rule for three months after publication of the final rule in

the Federal Register. SDs and MSPs that have not been previously

regulated need not comply for six months after publication.

Finally, the Commission notes that ESMA has proposed portfolio

reconciliation requirements that are substantially similar to those

adopted by the Commission in this release.\98\ By closely aligning

portfolio reconciliation requirements through consultation with ESMA,

the Commission believes that SDs and MSPs will benefit from a largely

unitary regulatory regime that does not require separate compliance and

operational policies and procedures.

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\98\ See ESMA Draft Technical Standards, Article 2 RM,

subsection 4, (stating that ``In order to identify at an early

stage, any discrepancy in a material term of the OTC derivative

contract, including its valuation, the portfolio reconciliation

shall be performed: * * * each business day when the counterparties

have 500 or more OTC derivative contracts outstanding with each

other; * * * once per month for a portfolio of fewer than 300 OTC

derivative contracts outstanding with a counterparty; * * * once per

week for a portfolio between 300 and 499 OTC derivative contracts

outstanding with a counterparty.'').

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D. Portfolio Compression

Portfolio compression is a mechanism whereby substantially similar

transactions among two or more counterparties are terminated and

replaced with a smaller number of transactions of decreased notional

value in an effort to reduce the risk, cost, and inefficiency of

maintaining unnecessary transactions on the counterparties' books. In

many cases, these redundant or economically-equivalent positions serve

no useful business purpose, but can create unnecessary risk,\99\ as

well as operational and capital inefficiencies.

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\99\ Federal Reserve Bank of New York Staff Report No. 424:

``Policy Perspectives on OTC Derivatives Market Infrastructure,''

Jan. 2010 (revised Mar. 2010).

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The usefulness of portfolio compression as a risk management tool

has been acknowledged widely. In 2008, the PWG identified frequent

portfolio compression of outstanding trades as a key policy objective

in the effort to strengthen the OTC derivatives market

infrastructure.\100\ Similarly, the 2010 staff report outlining policy

perspectives on OTC derivatives infrastructure issued by the FRBNY

identified trade compression as an element of strong risk management

and recommended that market participants engage in regular, market-wide

portfolio compression exercises.\101\

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\100\ ``Policy Objectives for the OTC Derivatives Markets,''

President's Working Group on Financial Markets (Nov. 14, 2008).

\101\ Federal Reserve Bank of New York Staff Report No. 424:

``Policy Perspectives on OTC Derivatives Market Infrastructure,''

Jan. 2010 (revised Mar. 2010).

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The value of portfolio compression also is illustrated by existing

market participation in compression exercises. In March 2010, the

Depository Trust and Clearing Corporation (DTCC) explicitly attributed

the reduction in the gross notional value of the credit derivatives in

its warehouse to industry supported portfolio compression.\102\

TriOptima, which offers the TriReduce portfolio compression service,

estimates that it terminated $106.3 trillion gross notional of interest

rate swaps and $66.9 trillion gross notional of credit swaps between

2003 and 2010.\103\ Similarly, Creditex and Markit, which offer

portfolio compression exercises in single name credit default swaps,

enabled participating institutions to eliminate $4.5 trillion in

notional between late 2008 through 2009.\104\

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\102\ DTCC Press Release, ``DTCC Trade Information Warehouse

Completes Record Year Processing OTC Credit Derivatives'' (Mar. 11,

2010). Notably, beginning in August 2008, ISDA encouraged

compression exercises for credit default swaps by selecting the

service provider and defining the terms of service.

\103\ See www.trioptima.com. Between 2007 and 2008, TriOptima

reduced $54.7 trillion gross notional of interest rate swaps and

$49.1 trillion gross notional of credit swaps. In March of 2010, the

staff of the Federal Reserve Bank of New York estimated that since

2008 nearly $50 trillion gross notional of credit default swap

positions has been eliminated through portfolio compression. Federal

Reserve Bank of New York Staff Report No. 424: ``Policy Perspectives

on OTC Derivatives Market Infrastructure,'' Jan. 2010 (revised Mar.

2010).

\104\ See www.isdacdsmarketplace.com.

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In light of the recognized benefits of portfolio compression in

reducing the risk, cost, and inefficiency of maintaining unnecessary

transactions, the Commission proposed Sec. 23.503, which required SDs

and MSPs to participate in multilateral compression exercises that are

offered by those DCOs or self-regulatory organizations of which the SD

or MSP is a member, or as required by Commission regulation or order.

The Commission also proposed that SDs and MSPs be required to terminate

bilaterally all fully offsetting swaps between them by the close of

business on the business day following the day the parties entered into

the offsetting swap transaction and to engage annually in bilateral

portfolio compression exercises with counterparties that are also SDs

and MSPs to the extent that they have not participated in a

multilateral compression exercise. Proposed Sec. 23.503 did not

require portfolio compression exercises for swaps outstanding between

an SD or MSP and counterparties that are neither SDs nor MSPs. Instead,

SDs and MSPs were required to establish written policies and procedures

for periodically terminating all fully offsetting swaps and

periodically engaging in compression exercises with such

counterparties.

Several commenters supported the Commission's proposal and outlined

the benefits of the approach. For instance,

[[Page 55949]]

Blackrock wrote in support of the Commission's proposal and encouraged

the Commission to expand the proposal in order to achieve what

Blackrock believes to be the essential benefits of compression. In

addition, Eris Exchange wrote in support of compression and noted that

it should lead to greater position netting and the ability to more

freely unwind aged swap trades without having to go through a

cumbersome novation process involving substantial operational burden

and negotiated up-front payments.

On the other hand, multiple commenters objected to proposed Sec.

23.503 on cost grounds. Some commenters argued that resource-intensive

compression exercises should not be required in asset classes where

there is not a high degree of transaction standardization and a high

volume of redundant trades because the benefits would not outweigh the

costs.\105\ Similarly, many commenters argued that non-SD

counterparties should not be included in any mandatory compression

because such entities have portfolios with a very small number of

offsetting transactions (i.e., almost all swaps are in the same market

direction) and the cost of the exercise is not justified by the small

benefit derived.\106\ Other commenters noted that it is not cost

effective to establish and run daily systems to monitor for fully

offsetting swaps where there are likely to be none.\107\ On another

tack, some commenters argued against requiring participation in

compression exercises offered by DCOs and SROs to avoid lack of

competition and higher costs.

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\105\ ISDA; The Working Group; Markit.

\106\ TriOptima; Markit; ISDA; ABC & CIEBA; AMG; Chatham;

Dominion; FHLBs; Freddie Mac; MetLife; MFA; NAIC; GFED.

\107\ The Working Group.

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The Commission carefully reviewed the comments received with

respect to proposed Sec. 23.503 and considered each in formulating the

final rule. Partly in response to the comments received regarding the

costs imposed by the proposed rule, the Commission has revised the rule

to reduce the cost burden on market participants. First, the Commission

has determined to exclude swaps cleared by a DCO from the rule. As

noted above, each DCO is required to establish portfolio compression

procedures, but participation in such compression exercises by clearing

members is voluntary. Accordingly, the revisions to Sec. 23.503 are

consistent with the revised DCO final rules with respect to cleared

swaps. Second, the Commission was persuaded that the benefits of the

rule could be maintained without requiring SDs and MSPs to incur the

costs of mandatory compression. Thus, as discussed in more detail

above, the Commission is electing to adopt the alternative suggested by

commenters and is modifying the rule to replace the mandatory

compression requirement with a requirement that SDs and MSPs establish

policies and procedures for periodically engaging in portfolio

compression exercises with counterparties that are also SDs or MSPs and

for engaging in portfolio compression with all other counterparties

upon request. The Commission is qualifying the requirement that SDs and

MSPs terminate fully offsetting swaps by requiring instead that SDs and

MSPs establish policies and procedures for terminating fully offsetting

swaps in a timely fashion, but allowing SDs and MSPs to determine where

it is appropriate to do so. The Commission believes that these

modifications retain the benefits of portfolio compression while

reducing the compliance costs to SDs and MSPs and costs that otherwise

may have been incurred by other market participants.

Finally, the Commission notes that ESMA has proposed portfolio

compression requirements that are substantially similar to those

adopted by the Commission in this release.\108\ By closely aligning

portfolio compression requirements through consultation with ESMA, the

Commission believes that SDs and MSPs will benefit from a largely

unitary regulatory regime that does not require separate compliance and

operational policies and procedures.

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\108\ See ESMA Draft Technical Standards, Article 3 RM,

subsection 2, (stating that ``counterparties with 500 or more OTC

derivative contracts outstanding which are not centrally cleared

shall have procedures to regularly, and at least twice a year,

analyse the possibility to conduct a portfolio compression exercise

in order to reduce their counterparty credit risk and engage in such

portfolio compression exercise.'').

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E. Swap Trading Relationship Documentation

The OTC derivatives markets traditionally have been characterized

by privately negotiated transactions entered into by two

counterparties, in which each party assumes and manages the credit risk

of the other. While OTC derivatives are traded by a diverse set of

market participants, such as banks, hedge funds, pension funds, and

other institutional investors, as well as corporate, governmental, and

other end-users, a relatively few number of dealers are, by far, the

most significantly active participants. As such, the default of a

dealer may result in significant losses for the counterparties of that

dealer, either from the counterparty exposure to the defaulting dealer

or from the cost of replacing the defaulted trades in times of market

stress.\109\

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\109\ See Financial Stability Board, ``Implementing OTC

Derivatives Market Reforms: Report of the OTC Derivatives Working

Group,'' (Oct. 10, 2010), available at http://www.financialstabilityboard.org/publications/r_101025.pdf.

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OTC derivatives market participants typically have relied on the

use of industry standard legal documentation, including master netting

agreements, definitions, schedules, and confirmations, to document

their swap trading relationships. This industry standard documentation,

such as the widely used ISDA Master Agreement and related definitions,

schedules, and confirmations specific to particular asset classes,

offers a framework for documenting the transactions between

counterparties for OTC derivatives products.\110\ The standard

documentation is designed to set forth the legal, trading, and credit

relationship between the parties and to facilitate cross-product

netting of transactions in the event that parties have to close-out

their position with one another.

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\110\ The International Swaps and Derivatives Association (ISDA)

is a trade association for the OTC derivatives industry (http://www.isda.org).

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One important method of addressing the credit risk that arises from

OTC derivatives transactions is the use of bilateral close-out netting.

Parties seek to achieve enforceable bilateral netting by documenting

all of their transactions under master netting agreements.\111\

Following the occurrence of a default by one of the counterparties

(such as bankruptcy or insolvency), the exposures from individual

transactions between the two parties are netted and consolidated into a

single net ``lump sum'' obligation. A party's overall exposure is

therefore limited to this net sum. That exposure then may be offset by

the available collateral previously provided being applied against the

net exposure. As such, it is critical that the netting provisions

between the parties are documented and legally enforceable and that the

collateral may be used to meet the net exposure. In recognition of the

risk-reducing benefits of close-out netting, many jurisdictions provide

favorable treatment of netting

[[Page 55950]]

arrangements in bankruptcy,\112\ and favorable capital and accounting

treatment to parties that have enforceable netting agreements in

place.\113\

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\111\ Enforceable bilateral netting arrangements are a common

commercial practice and are an important part of risk management and

minimization of capital costs.

\112\ See e.g., 11 U.S.C. 561 (protecting contractual right to

terminate, liquidate, accelerate, or offset under a master netting

agreement and across contracts).

\113\ See 12 CFR part 3, Appendix C; 12 CFR part 208, Appendix

F; 12 CFR part 225, Appendix G; and 12 CFR part 325, Appendix D

(banking regulations regarding qualifying master netting

agreements).

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There is also a risk that inadequate documentation of open swap

transactions could result in collateral and legal disputes, thereby

exposing counterparties to significant counterparty credit risk. By way

of contrast, adequate documentation between counterparties offers a

framework for establishing the trading relationship between the

parties.

To ensure the risk-reducing benefits of adequate swap trading

relationship documentation, the Commission proposed Sec. 23.504.

Proposed Sec. 23.504 required SDs and MSPs to establish, maintain, and

enforce written policies and procedures reasonably designed to ensure

that each SD and MSP and its counterparties have agreed in writing to

all of the terms governing their swap trading relationship and have

executed all agreements required by proposed Sec. 23.504. These

included agreement on terms related to payment obligations, netting of

payments, events of default or other termination events, netting of

obligations upon termination, transfer of rights and obligations,

governing law, valuation, and dispute resolution procedures, as well as

credit support arrangements, including margin and segregation.

Agreement on valuation methodologies pursuant to Sec. 23.504(b)(4) is

discussed separately below. In addition, proposed Sec. 23.504 required

each SD and MSP to have an independent internal or external auditor

examine annually at least 5 percent of the swap trading relationship

documentation created during the year to ensure compliance with

Commission regulations and the SD's or MSP's policies and procedures

established pursuant to Sec. 23.504.

Several commenters supported the rule. One stated that clear and

thorough standards for documentation are essential to avoid the

situation that became apparent when AIG and Lehman Brothers failed: A

hopelessly tangled web of poorly documented transactions, with the

effort to sort it all out emerging as a separate threat to the

financial system.\114\ Others supported the goal of the rule to ensure

that the parties to a trade have in fact agreed on its economic and

legal terms prior to or contemporaneously with entering into a swap,

and are communicating and maintaining appropriate records memorializing

that agreement.\115\ However, many commenters also objected to the

proposed rule on cost grounds.

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\114\ Better Markets.

\115\ ISDA & SIFMA.

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Several commenters strongly urged the Commission not to make Sec.

23.504 retroactively applicable to existing swaps because the need to

make amendments to existing documentation would be time consuming and

costly.\116\ Having considered these comments, the Commission is

adopting the alternative presented by commenters and is modifying Sec.

23.504 to make clear that the rule does not apply to swaps executed

prior to the date on which SDs and MSPs are required to be in

compliance with Sec. 23.504. The Commission notes, however, that the

rule does not prohibit SDs and MSPs from agreeing with their

counterparties to amend existing swap trading relationship

documentation to bring such documentation into compliance with Sec.

23.504 (or any other Commission regulation) and ensure that netting

arrangements will apply to swaps executed prior to and after

promulgation of Sec. 23.504. The ability to combine netting sets in

this manner may reduce costs of collateralization for many SDs and

MSPs.

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\116\ The Working Group; ISDA & SIFMA; FSR; MFA; FHLBs; The

Coalition for Derivative End-Users.

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Several commenters were concerned that proposed Sec. 23.504 may

require market participants to incur the burden and expense of

negotiating master agreements even if a stand-alone agreement or

``long-form'' confirmation that incorporates terms of a standard master

agreement by reference would sufficiently address legal risks.\117\ The

Commission notes, however, that nothing in the rule prohibits

incorporation by reference so long as the terms so incorporated are in

written form, and therefore confirms that so long as a ``long-form''

confirmation includes all terms of the trading relationship and is

executed prior to or contemporaneously with entering into a swap

transaction, such would be in compliance with Sec. 23.504.

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\117\ OCC; IECA.

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A number of comments reflected a concern regarding the requirement

that SDs and MSPs audit no less than 5 percent of their trading

relationship documentation annually, arguing that the requirement is

burdensome and recommending that the Commission adopt an alternative,

principles-based approach requiring SDs and MSPs to conduct audits

sufficient to identify material weaknesses in their documentation

policies and procedures. The Commission was persuaded that the audit

requirement need not prescribe the percentage of agreements to be

audited to maintain the benefits of the rule, and has modified the rule

in accordance with the recommendations of commenters.

In addition, several commenters recommended that valuation dispute

reporting under Sec. 23.504(e) should be subject to a materiality

standard to avoid an overly-burdensome reporting requirement that will

result in substantial informational noise. The Commission agreed with

these commenters and reduced the burden of the reporting requirement by

revising the proposed rule to add a $20,000,000 threshold on the

reporting of valuation disputes.

Finally, the Commission recognizes that requiring implementation of

the documentation requirements of Sec. 23.504 immediately or within a

very compressed timeframe creates certain costs for industry

participants. Consequently, reducing these costs--enumerated below--by

extending the compliance schedule represents a benefit.

First, to meet timelines some firms will need to contract

additional staff or hire vendors to handle some necessary tasks or

projects. Additional staff hired or vendors contracted in order to meet

more pressing timelines represent an additional cost for market

participants. Moreover, as pointed out by commenters, a tightly

compressed timeframe raises the likelihood that more firms will be

competing to procure services at the same time; this could put firms

that conduct fewer swaps at a competitive disadvantage in obtaining

those services, making it more difficult for them to meet required

timelines.\118\ In addition, it could enable service providers to

command a pricing premium when compared to times of ``normal'' or

lesser competition for similar services. That premium represents an

additional cost when compared to a longer compliance timeline.

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\118\ See letter from CIEBA.

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Second, if entities are not able to comply with the documentation

requirements by a certain date, they may avoid transacting swaps

requiring compliance until such a time as they are able to comply. In

this event, liquidity

[[Page 55951]]

that otherwise would result from those foregone swaps would be reduced,

making the swaps more expensive for market participants taking the

other side. Moreover, firms compelled to withdraw from the market

pending compliance with required documentation measures will either

leave certain positions un-hedged--potentially increasing the firm's

own default risk, and therefore the risk to their counterparties and

the public. Alternatively, firms compelled to withdraw from the market

for a period of time could attempt to approximate their foregone swap

hedges using other, likely more expensive, instruments. Further, to the

extent the withdrawing entities are market makers, they will forsake

the revenue potential that otherwise would exist for the period of

their market absence.

Third, firms may have to implement technological solutions, sign

contracts, and establish new operational procedures before industry

standards have emerged that address new problems effectively. To the

extent that this occurs, it is likely to create costs. Firms may have

to incur additional costs later to modify their technology platforms

and operational procedures further, and to renegotiate contracts--

direct costs that a more protracted implementation schedule would have

avoided.\119\ Moreover, costs created by the adoption of standards that

fail to address certain problems, or attributable to undesired

competitive dynamics resulting from such standards, may be

longstanding.

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\119\ See e.g., ACLI letter.

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The Commission, informed by its consideration of comments and

alternatives, discussed in the sections above and below, believes that

the approach contained in this adopting release is reasonable and

appropriate in light of the tradeoffs described above. The compliance

dates discussed above give the Commission the opportunity to provide

additional time to entities in ways that generally align with: (1)

Their resources and expertise, and therefore their ability to comply

more quickly; and (2) their level of activity in the swap markets, and

therefore the possible impact of their swap activities on the stability

of the financial system. Entities with the most expertise in, and

systems capable to transact, swaps also are likely to be those whose

transactions represent a significant portion of all transactions in the

swap markets. They are more likely to be able to comply quickly, and

the benefits of requiring them to do so are greater than would be the

case for less active entities. On the other hand, entities with less

system capability and in-house swap expertise may need more time to

comply with documentation requirements, but it is also likely that

their activities represent a smaller proportion of the overall market,

and therefore are less likely to create or exacerbate shocks to the

financial system.\120\ The Commission believes that SDs, security-based

swap dealers, MSPs, major security-based swap participants, and active

funds (as defined above) are entities likely possessing more advanced

systems and expertise, and whose swap activities constitute a

significant portion of overall swap market transactions. On the other

hand, other market participants may be less likely to have highly

developed infrastructure and likely have swap activities that

constitute a less significant proportion of the market. Therefore, the

Commission has determined to stagger the compliance dates for Sec.

23.504, providing 90, 180, or 270 days for SDs and MSPs to bring their

swap trading relationship documentation into compliance with the rules,

depending on the identity of the counterparty as discussed more fully

in section III.B.1 above.

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\120\ OCC data demonstrates that among insured US commercial

banks, ``the five banks with the most derivatives activity hold 96

percent of all derivatives, while the largest 25 banks account for

nearly 100 percent of all contracts.'' The report is limited to

insured US commercial banks, and also includes derivatives that are

not swaps. However, swap contracts are included among the

derivatives in the report, constituting approximately 63 percent of

the total notional value of all derivatives. These statistics

suggest that a relatively small number of banks hold the majority of

swap positions that could create or contribute to distress in the

financial system. Data is insufficient, however, to generalize the

conclusions to non-banking institutions. See ``OCC's Quarterly

Report on Bank Trading and Derivatives Activities: Fourth Quarter

2011'' p. 11. http://www.occ.treas.gov/topics/capital-markets/financial-markets/trading/derivatives/dq411.pdf.

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F. Swap Valuation Methodologies

Swap valuation disputes have long been recognized as a significant

problem in the OTC derivatives market.\121\ The ability to determine

definitively the value of a swap at any given time lies at the center

of many of the OTC derivatives market reforms contained in the Dodd-

Frank Act and is a cornerstone of risk management. Swap valuation is

also crucial for determining capital and margin requirements applicable

to SDs and MSPs and therefore plays a primary role in risk mitigation

for uncleared swaps.

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\121\ See ISDA Collateral Committee, ``Commentary to the Outline

of the 2009 ISDA Protocol for Resolution of Disputed Collateral

Calls,'' June 2, 2009 (stating ``Disputed margin calls have

increased significantly since late 2007, and especially during 2008

have been the driver of large (sometimes > $1 billion) un-

collateralized exposures between professional firms.'').

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The Commission recognizes that swap valuation is not always an easy

task. In some instances, there is widespread agreement on valuation

methodologies and the source of formula inputs for frequently traded

swaps. Many of these swaps have been accepted for clearing for a number

of years (i.e., commonly traded interest rate swaps and CDS). However,

parties often dispute valuations of thinly traded swaps where there is

not widespread agreement on valuation methodologies or the source for

formula inputs. Many of these swaps are thinly traded either because of

their limited use as risk management tools or because they are simply

too customized to have comparable counterparts in the market. As many

of these swaps are valued by dealers internally by ``marking-to-

model,'' their counterparties may dispute the inputs and methodologies

used in the model. As uncleared swaps are bilateral, privately

negotiated contracts, on-going swap valuation for purposes of initial

and variation margin calculation and swap terminations or novations,

has also been largely a process of on-going negotiation between the

parties. The inability to agree on the value of a swap became

especially acute during the 2007-2009 financial crisis when there was

widespread failure of the market inputs needed to value many

swaps.\122\

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\122\ The failure of the market to set a price for mortgage-

backed securities led to wide disparities in the valuation of CDS

referencing mortgage-backed securities (especially collateralized

debt obligations). Such wide disparities led to large collateral

calls from dealers on AIG, hastening its downfall. See CBS News,

``Calling AIG? Internal Docs Reveal Company Silent About Dozens Of

Collateral Calls,'' Jun. 23, 2009, available at: http://www.cbsnews.com/stories/2009/06/23/cbsnews_investigates/main5106672.shtml.

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In light of these concerns, the Commission proposed Sec.

23.504(b)(4), which required SDs and MSPs to include in their swap

trading relationship documentation an agreement with their

counterparties on the methods, procedures, rules, and inputs for

determining the value of each swap at any time from execution to the

termination, maturity, or expiration of such swap. The Commission

believes that by requiring agreement between counterparties on the

methods and inputs for valuation of each swap, Sec. 23.504(b)(4) will

assist SDs and MSPs and their counterparties to arrive at valuations

necessary for margining and internal risk management, and to resolve

valuation disputes in a timely manner, thereby reducing risk.

[[Page 55952]]

Commenters supported the valuation proposal in light of the

benefits to risk management and adequate collateralization.\123\

Indeed, some commenters argued that the Commission should have been

more prescriptive in its approach to valuation.

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\123\ Better Markets; Michael Greenberger; Chris Barnard.

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Multiple commenters, however, objected to Sec. 23.504(b)(4) on

cost grounds. Specifically, commenters stated that the rule will

significantly increase the pre-execution swap negotiation burden on

SDs, MSPs, and their counterparties without an offsetting benefit.\124\

Some commenters also objected that the rule may discourage the

development of more refined, dynamic swap valuation models that are

more accurate, and therefore more efficient, than less sophisticated or

vanilla models.\125\

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\124\ The Working Group; ISDA & SIFMA; FSR; Markit; Freddie Mac;

COPE; MFA; FHLBs; CIEBA; EEI; Coalition of Derivatives End-Users.

Several of these commenters stated that such pre-execution

negotiations could take months to complete, if possible at all.

\125\ OCC; Hess.

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Other commenters offered alternatives to requiring SDs and MSPs to

agree on valuation methodologies with their counterparties. Many

recommended that the Commission focus its rules on the valuation

dispute resolution process, rather than valuation methodologies.\126\

One recommended that the rule include an explicit authorization for

parties to use the services of independent third parties to provide any

or all of the elements required to agree upon the valuation of swaps,

and not include any preferable inputs or pricing sources for the

valuation of swaps.\127\ Another recommended that the rule be deleted

and replaced with a requirement that SDs and MSPs provide information

to substantiate their valuations upon the request of a

counterparty.\128\

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\126\ The Working Group; Morgan Stanley; MFA; IECA; FHLBs;

CIEBA; MetLife.

\127\ Markit.

\128\ Coalition of Derivatives End-Users.

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As discussed above, the Commission is substantially modifying the

rule in response to concerns raised and alternatives suggested by

commenters. Many of the changes being made in the rule adopted by this

release address the cost concerns and alternatives outlined above.

First, the rule has been focused on the valuation needed to meet the

margin requirements under section 4s(e) of the CEA and the Commission's

regulations under part 23, and to meet the risk management requirements

under section 4s(j) of the Act and the Commission's regulations under

part 23. The Commission believes that this change, by focusing the use

of the agreed-upon valuation methodologies, will ease pre-execution

negotiation and improve internal risk management processes. In

addition, the Commission responded to concerns from market participants

who feared they would have to agree on precise models, by clarifying

that they had to agree on a process, which includes things such as

methods, procedures, rules and inputs. Parties are free to agree on a

model, agree to use one party's confidential proprietary model, rely on

third-party vendors, or a host of other possibilities.

Second, the rule has been modified such that SDs and MSPs need not

agree on swap valuation methodologies with counterparties that are not

SDs, MSPs, or financial entities, unless such counterparties request

such agreements. The Commission believes that this change will

alleviate the pre-execution negotiation burden on SDs, MSPs, and their

non-financial entity counterparties by limiting such negotiations to

counterparties that are more likely to use sophisticated valuation

methodologies akin to those in use by the SD or MSP itself.

Third, in response to commenters that objected that the rule may

discourage the development of more refined, dynamic swap valuation

models that are more accurate, and therefore more efficient, than less

sophisticated or vanilla models, the Commission is modifying the rule

to explicitly permit parties to agree on changes or procedures to

modify their valuation agreements at any time. This change allows

counterparties to determine an efficient means of changing the

agreement for each contract to allow for evolution of valuation

methodologies while maintaining the benefits of agreed-upon valuation

methodologies.

Fourth, in response to commenters' concerns regarding the

protection of proprietary information used in valuation, the Commission

is modifying the rules to make explicit that SDs and MSPs are not

required to disclose to the counterparty confidential, proprietary

information about any model it may use to value a swap. The Commission

believes this clarification will alleviate concerns that proprietary

information would have to be disclosed as a result of the valuation

agreement process.

Finally, the rule has been modified to allow for use of a valuation

dispute resolution process in place of the proposed requirement that

the documentation include alternative methods for determining the value

of a swap in the event of the unavailability or failure of any input

required to value the swap. The Commission believes this change lessens

the negotiation and operational burden on SDs and MSPs.

The Commission believes that the changes outlined above

substantially reduce the burden of the rule on SDs, MSPs, and their

counterparties without sacrificing the benefits of the rule. The rule

will serve to assist SDs and MSPs and their counterparties in arriving

at valuations necessary for margining and internal risk management, and

in resolving valuation disputes in a timely manner, thereby reducing

risk.

G. Summary of Cost and Benefit Considerations: Confirmation, Portfolio

Reconciliation, and Portfolio Compression

In the Confirmation NPRM, the Commission specifically requested

comment on its consideration of costs and benefits. The Commission

received a number of comments in addition to those discussed above.

ISDA commented that registrants will incur substantial initial one-

time costs to develop, test, and implement new procedures and

technology that are required in order to be compliant with the proposed

rules. With regard to confirmation costs, ISDA asserted that market

participants will have to invest in electronic platforms for

confirmation for each asset class in order to meet the expedited

timeframes for confirmation, which may be prohibitively expensive,

particularly for non-SDs and non-MSPs. However, ISDA did not provide

any quantitative data in support of this assertion despite multiple

requests from Commission staff.\129\

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\129\ See cftc.gov for information regarding staff meetings with

ISDA pertaining to these final rules.

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ISDA also argued that given the marked improvement in post-trade

processing, as well as continued industry efforts and commitments to

enhance post-trade processing in a targeted, efficient and safe manner,

it is unclear whether the incremental benefits of the Commission's

proposed standards applicable to all swap confirmations will outweigh

the significant compliance costs that the confirmation requirements

will entail.

To comply with the portfolio reconciliation requirement promptly,

ISDA believes firms that do not currently use an electronic platform or

vendor service will need to expend significant time and resources, and

even those firms that do use electronic platforms or vendor services to

reconcile their portfolios will need to make significant adjustments to

comply with the reconciliation requirement. ISDA believes that initial

compliance

[[Page 55953]]

with the proposed rules will cost each entity approximately $5-10

million and annual portfolio reconciliation expenses for a party with a

large portfolio may rival and perhaps even exceed this upfront cost.

The Working Group requested that the Commission address any

requirement for electronic matching of all or certain types of swaps in

a separate rulemaking that includes a careful study of the potential

costs imposed by such a rule. The Working Group estimated, based on the

$6.00 per trade fee of the ICE eConfirm service, that implementation of

an electronic matching requirement would cost each registrant in excess

of $1,000,000 annually. In addition, The Working Group asserted that

there would be additional opportunity costs associated with no longer

being able to enter into customized transactions.

The Working Group requested that the Commission evaluate the

proposed rules in light of its various recordkeeping and reporting

proposals, as such may cause firms to incur tremendous administrative

obligations to record changes to their swap portfolios, their

accounting records, treasury arrangements and capital allocations, as

well as incurring reporting obligations to SDRs on a swap-by-swap

basis. The Working Group also presented a report prepared by NERA

estimating that compliance with the proposed rules for some entities in

this category would entail annual incremental costs of $1,400,000.\130\

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\130\ NERA, Cost-Benefit Analysis of the CFTC's Proposed Swap

Dealer Definition Prepared for the Working Group of Commercial

Energy Firms, December 20, 2011. In the late-filed comment

supplement, NERA estimates these costs for entities ``engaged in

production, physical distribution or marketing of natural gas,

power, or oil that also engage in active trading of energy

derivatives''--termed ``nonfinancial energy companies'' in the

report. The figure cited includes costs to comply with the proposed

confirmation, portfolio reconciliation, and portfolio compression

requirements and is based on the survey response of only one member

of The Working Group. Elsewhere in the same report, NERA estimates

the costs of compliance with the confirmation requirements alone at

$235,000 for initial set-up and annual operating costs of $307,000.

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The FHLBs cautioned that SD compliance with the proposed rules

could adversely impact end users in a number of ways, including (i) SD

unwillingness to offer swaps important to end user risk management if

the SD cannot comply with the rules in an economic manner; (ii) passing

on of SD compliance costs to end user counterparties, discouraging some

end users from using cost-effective risk management tools and raising

overall system risk; and (iii) introduction of legal uncertainty as to

the enforceability of swaps that fail to meet the confirmation

deadlines of the proposed rules. The FHLBs also argued that certain

swap documentation requires review by legal staff and the short

deadline for confirmation would require pre-execution review by legal

staff, even for swaps that are discussed but never actually executed,

entailing costly and unnecessary legal expenditures.

As discussed in the above sections, the Commission has modified

many aspects of the proposed rules in order to mitigate the burden

placed on market participants as identified by commenters while still

achieving the important policy goals outlined above. The Commission

has:

Provided for a phased implementation plan, providing

longer periods for compliance with the rule for those entities for

which the rules will be most burdensome, with particularly long phasing

of confirmation deadlines; \131\

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\131\ This alternative was suggested by both ISDA and The

Working Group, and the Commission has adopted it for these final

rules.

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Expanded the definition of ``multilateral portfolio

compression exercise'' which increases flexibility of the rule;

Removed the 15 and 30 minute acknowledgement and

confirmation deadlines for swap transactions that are ``processed

electronically'';

Required draft trade acknowledgements only to be delivered

upon request of a counterparty prior to execution;

Adjusted confirmation deadlines for time zone differences

and end of day trading, providing relief from more stringent deadlines;

Provided a safe harbor from confirmation requirements for

swaps executed on a SEF or DCM, or cleared by a DCO;

Clarified which swap transactions require confirmation;

Reduced the frequency of required portfolio reconciliation

with non-SDs and MSPs;

Changed the valuation dispute resolution requirement from

``one business day'' to ``policies and procedures reasonably designed

to ensure that valuation disputes are resolved within five business

days;''

Required portfolio compression with non-SDs and non-MSPs

only upon request of the non-SD or non-MSP counterparty;

Changed the mandatory portfolio compression requirement

among SDs and MSPs to a requirement for policies and procedures for

engaging in regular portfolio compression, where appropriate;

Required fully-offsetting swaps to be terminated in a

timely fashion (rather than within one business day) and only where

appropriate; and

Clarified that the compression rule does not apply to

cleared swaps; compression of cleared swaps will be in accordance with

the rules of the DCO.

Through these changes, the Commission anticipates that many of the

concerns raised by commenters regarding the costs of the rules will be

mitigated.

Confirmation. The Commission anticipates that there will be a

significant adjustment for market participants to move to the faster

timeframes required by the confirmation rules, particularly in those

asset classes where the majority of transactions are manually

confirmed. SDs and MSPs will have to design, compose, and implement

policies and procedures reasonably designed to meet the confirmation

timeframes; SDs and MSPs must also compile and maintain any applicable

records. Participants may invest in electronic platforms for

confirmation for each asset class in order to meet the expedited

timeframes for confirmation. The Commission notes, however, that such

investment is not necessarily required by the rules as market

participants are able to confirm in any manner that meets the rule's

deadline of the first business day after the day of execution (or two-

business day timeframe, for swap transactions with non-financial non-

registrants).

With regard to confirmation, the historical context reveals that

market participants, including all major swap dealers, have been

working on achieving timely confirmation across all asset classes for

the past 5-7 years. Consequently, additional costs related to

confirmation technology for these entities would be minimal for those

SDs and MSPs already achieving timely confirmation of their swap

transactions. In addition, costs will be further minimized through a

significant phase-in period. For example, SDs and MSPs will have up to

two years to achieve compliance with the rules.

Moreover, the Commission has sought to gather additional

information about the costs of confirmation services from both ISDA and

major third party service providers of confirmation services.

Commission staff meetings with third party service providers have

revealed that per trade or event confirmations can cost anywhere from

$3 to $10 per transaction. It should be noted, however, that

confirmation fee schedules can be complex and dependent on a host of

idiosyncratic factors.

[[Page 55954]]

The Commission notes The Working Group's estimate of approximately

$1,000,000 per entity to implement an electronic matching requirement,

but observes that the deletion of the phrase ``processed

electronically'' from the rules should make clear to market

participants that there is no requirement to confirm electronically.

However, this estimate may be useful for individual entities to use as

a reference figure for investment in electronic platforms.\132\

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\132\ The Commission also notes the estimates provided by NERA,

but observes that NERA did not provide sufficient information for

the Commission to determine which portion of such estimates assumed

implementation of an electronic matching requirement. Thus the

Commission could not independently verify the estimates.

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The Commission is unable to provide more specific quantification of

the costs of confirmation given the unique characteristics of the swap

portfolios of SDs, MSPs, and their counterparties, as well as the

parties' discretion in choosing how to comply with the confirmation

timeframe.

As noted above, the Commission does not believe the rules requiring

SDs and MSPs to have policies and procedures to achieve confirmation

with their non-registrant counterparties should pose an unreasonable

burden on end users. The Commission extended the confirmation deadline

for non-financial, non-registrant counterparties to two business days

after execution, lessening the rush to review and approve

acknowledgements and/or confirmations while maintaining a relatively

quick turn-around for these market participants. In addition, the

Commission anticipates that the changed provisions regarding draft

acknowledgements and compression--which give the non-SD or MSP

counterparty the option as opposed to obligation--should ensure that

such entities are protected from unfair practices without overburdening

the operations of these entities.

The benefits associated with quicker confirmation, as noted in

sections III.C and IV.B of this release, include improvement of post-

execution operational and risk management processes, including the

correct calculation of cash flows and discharge of settlement

obligations as well as accurate measurement of counterparty credit

exposure. Timely confirmation also allows any discrepancies,

exceptions, and/or rejections of terms to be identified and resolved

more quickly, lessening the risk of a dispute that could disrupt

orderly market operations. In general, the rules regarding expedited

confirmation should improve the efficient and orderly operations of

bilateral markets through more effective risk management and dispute

resolution. The extended compliance timeframes should allow for a

smooth transition to the new rules as market participants prepare not

only to meet these standards, but others imposed by new regulations

under the Dodd-Frank Act.

Reconciliation. In response to ISDA's concern that the

reconciliation rules would require significant investment in electronic

platforms for reconciliation, especially for those entities with large

portfolios, the Commission reiterates its view that the advent of SDRs

will eventually ease some of those costs by providing a central data

location for most (if not all) the material terms that are required to

be reconciled.

Importantly, the Commission has not determined which processes for

reconciliation are the most appropriate, which means that each market

participant can choose the method for reconciliation that best fits its

own internal structure and cost-benefit analysis, provided such method

comports with the Commission's requirements. In addition, the changes

listed above--including the reduced frequency of reconciliation for

portfolios between SDs or MSPs and their non-SD or non-MSP

counterparties--should ease the burden of reconciling portfolios. While

the Commission has been unable to independently verify the $5-10

million estimate for portfolio reconciliation provided by ISDA, the

Commission expects that the changes herein as well as the increased use

of SDRs will lessen the estimated cost considerably.

In the Confirmation NPRM, the Commission asserted that the costs of

the proposed rules would be minimized by the fact that most SDs and

MSPs reconcile their swap portfolios as part of a prudent operational

processing regime that many, if not most, SDs and MSPs already

undertake as part of their ordinary course of business. In response to

these assertions, at least one commenter agreed that a large number of

SDs and MSPs already regularly reconcile their portfolios with each

other and with other entities and that the increased frequency and

inclusion of smaller portfolios as proposed should prove no obstacle to

such entities.\133\ Consequently, additional costs of the Commission's

final rule would be minimal for those SDs and MSPs already engaged in

regular portfolio reconciliation. In addition, the Commission's

decision to extend the valuation dispute resolution requirement from

one day responds to concerns from market participants about cost.

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\133\ TriOptima letter.

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Given the widespread benefits of portfolio reconciliation,

including increased risk management and fewer disputes to resolve, the

Commission believes its final rules regarding reconciliation are

appropriate notwithstanding the increased costs for some participants.

The Commission recognizes that certain costs will still arise despite

the changes the Commission has made. Such costs include (i) Increased

costs to include all material terms rather than some subset of terms;

(ii) the additional resources to design, compose, and implement the

required policies and procedures; (iii) the additional resources needed

to comply with the dispute resolution timeframes; and (iv) the

compilation and maintenance of applicable records. These costs,

however, are by nature specific to each entity's internal operations;

absent specific cost estimates from commenters (which were not

provided), the Commission cannot accurately provide estimations

regarding the resources needed to comply. As stated above and in the

NPRM, portfolio reconciliation is widely recognized as an effective

means of identifying and resolving disputes regarding terms, valuation,

and collateral. Reconciliation is beneficial not only to the parties

involved but also to the markets as a whole. By identifying and

managing disputed key economic terms or valuation for each transaction

across a portfolio, overall risk can be diminished. Registrants will be

able to identify and correct problems in their post-execution processes

(including confirmation) in order to reduce the number of disputes and

improve the integrity and efficiency of their internal processes.

Expanding the universe of participants subject to reconciliation,

therefore, can help to reduce the risk bilateral markets may pose to

the broader financial system.

Compression. Finally, the Commission believes its final rules

regarding portfolio compression dramatically reduce costs as compared

to the proposed rule; however, the Commission recognizes that costs

will necessarily increase from the current state of the market.

Participants will necessarily have to design, compose, and implement

policies and procedures to regularly evaluate compression opportunities

with their counterparties as well as those opportunities offered by

third parties. However, given the large risk management benefits

available from the regular compression of offsetting trades--benefits

including reduced risk

[[Page 55955]]

and enhanced operational efficiency--the Commission believes the final

rules are appropriate to ensure the fair and orderly operation of

bilateral derivatives markets.

In terms of quantification of the costs of compression, the

Commission notes that in its Confirmation NPRM, it stated that there

are a number of third-party vendors that provide compression, and some

of these providers charge fees based on results achieved (such as

number of swaps compressed). No commenter refuted this statement or

provided alternative information regarding quantification.

H. Section 15(a) Considerations: Confirmation, Portfolio

Reconciliation, and Portfolio Compression

1. Protection of Market Participants and the Public

The final rules relating to confirmation, portfolio reconciliation,

and portfolio compression protect market participants by improving

operational efficiency and mitigating legal risk. In turn, the

reduction of risk in bilateral markets can reduce risk across the

interconnected financial system, protecting the public from costly

market disruptions.

Timely confirmation protects market participants by providing

certainty as to obligations between SDs, MSPs, and their counterparties

while allowing a more efficient processing of disputed terms that may

become apparent during the confirmation process. Disputes regarding

terms and conditions, when left unresolved, can expose market

participants to significant counterparty credit risk. By diminishing

the number of these disputes that occur and by decreasing the length of

time in which they are resolved, the Commission believes these rules

protect participants from such unnecessary risk.

2. Efficiency, Competitiveness, and Financial Integrity of Derivatives

Markets

The final rules improve the efficiency of the market by decreasing

the amount of time trades remain outstanding, improving the processes

by which trades are confirmed, and requiring participants to eliminate

unnecessary trades. Trades that remain unconfirmed for extended periods

of time create inefficient backlogs that inhibit the orderliness of the

market. Proper confirmation, compression, and reconciliation policies

improve transparency in the market and increase efficiency by promoting

the exchange of important market information. Requirements regarding

confirmations and draft acknowledgements, as discussed above, provide

non-financial entities with information necessary for confirming

promptly. In addition, such draft acknowledgements may serve

counterparties insofar as they might compare and assess counterparties,

which should improve competition among SDs and MSPs.

3. Price Discovery

The timeliness of confirmations, as required under these rules,

should ensure that all terms including prices of transactions are

agreed upon quickly and efficiently. This linking of price terms with

all other swap terms should improve the information provided to the

public and regulators through SDRs and other means, thereby improving

the overall price discovery process. Periodic reconciliation and

compression also aid in ensuring that unnecessary and/or offsetting

trades are netted and that, should disputes arise, those disputes are

promptly and effectively resolved. In this way, the pricing information

communicated regarding trades conducted under these rules should be

accurate and timely, improving the price discovery function of

bilateral derivatives markets.

4. Sound Risk Management

As described throughout this release, the rules promulgated herein

are designed to mitigate the risk in bilateral derivatives markets by

ensuring the timely and accurate confirmation of trades, reconciliation

of portfolios, and compression of portfolios. The final rules require

actions, policies, and procedures on the part of SDs and MSPs to

diminish operational risk, legal risk, and counterparty credit risk.

The Commission believes these requirements will encourage sound risk

management on the part of SDs and MSPs; given the systemically

important nature of these entities, sound risk management by SDs and

MSPs should improve the risk management of the financial system as a

whole, lessening the risks associated with a major market crisis.

5. Other Public Interest Considerations

The Commission has not identified other public interest

considerations as a result of these rules.

I. Summary of Cost and Benefit Considerations: Swap Trading

Relationship Documentation

The Commission requested comment on its consideration of costs and

benefits under section 15(a) of the CEA. The Commission received a

number of responsive comments in addition to those discussed above.

The Working Group stated that the Commission should articulate the

public policy benefit of the proposed rule and present analysis that

demonstrates such benefit exceeds the cost imposed on market

participants and the Commission. IECA stated that the proposed

regulations would impose administrative and regulatory costs in excess

of any benefit gained. The Coalition for Derivatives End Users was

concerned that the valuation provision will increase costs without a

proportionate benefit. Markit stated that the proposed rule will make

the process of transaction documentation very expensive and time

consuming, and will lead to extremely technical and verbose swap

documentation, noting that the need to negotiate such terms may impede

effective trading. Markit thus believes the costs outweigh the

benefits, and urges the Commission to impose more realistic

requirements regarding valuation methodologies.

IECA believes the Commission's cost-benefit analysis did not

consider the legal review and management time expense for end users,

which could be significant for small entities. IECA focuses on the

Commission's estimates under the Paperwork Reduction Act, and

challenges the Commission's use of $125 per hour for legal fees. IECA

believes that $500 an hour is more appropriate for legal fees. IECA

also believes that the Commission's estimate of an average of 10 hours

per counterparty to negotiate the new documentation under Sec.

23.504(b) is low, as the time needed must include not only negotiation,

but also time for determining price points and inputs, decision-making

time, and senior management time.

The Working Group believes the Commission's implementation costs

substantially underestimate the potential impact because: (i) Margin

requirements have yet to be proposed and negotiation of credit support

arrangements currently can take months; (ii) market participants are

unlikely to agree to standardized valuation methodologies; (iii) the

Commission does not specifically discuss the potentially substantial

costs associated with the audit requirement under Sec. 23.504(e);

\134\ and (iv) the

[[Page 55956]]

proposed rules would significantly alter the process by which parties

enter into swaps, and such costs have not been considered.

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\134\ The Working Group presented a report prepared by NERA

estimating that compliance with the audit requirements in these and

other proposed rules for some nonfinancial energy companies would

entail annual incremental costs of $224,000. NERA, Cost-Benefit

Analysis of the CFTC's Proposed Swap Dealer Definition Prepared for

the Working Group of Commercial Energy Firms, December 20, 2011. In

the late-filed comment supplement, NERA estimates these costs for

entities ``engaged in production, physical distribution or marketing

of natural gas, power, or oil that also engage in active trading of

energy derivatives''--termed ``nonfinancial energy companies'' in

the report. The figure cited includes costs to maintain a risk

management program, quarterly audits of the program, and annual

audits of swap trading relationship documentation, the first two of

which are required under a separate rulemaking previously adopted by

the Commission.

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As discussed in the above sections, the Commission has modified

many provisions of the final rules in response to comments received and

in order to mitigate the burden imposed on market participants while

accomplishing the goals as laid out in the NPRM. The Commission has:

Provided for a phased implementation plan, providing

longer periods for compliance with the rule for those entities for

which the rules will be most burdensome;

Clarified that the rules will be applicable only to swaps

that are entered into after the rules become effective, and therefore

not requiring retroactive application to existing swaps;

Clarified that the rules do not apply to swaps executed on

a SEF or DCM and cleared by a DCO, subject to certain minimum

requirements;

Imposed no additional requirements regarding documentation

of events of default, termination events, or payment obligations;

Permitted parties to agree on either alternative methods

for determining the value of a swap or a valuation dispute resolution

process;

Reduced recordkeeping requirements under Sec.

23.504(b)(6);

Removed the 5 percent annual documentation audit

requirement in favor of a more general audit standard; and

Modified the swap valuation dispute reporting requirement

to reduce the number of disputes that must be reported to the

Commission, the SEC, and any applicable prudential regulator, and

replaced the one-day reporting requirement with a three-day requirement

for SDs and MSPs.

The Commission believes that these changes will reduce or eliminate

many of the burden concerns raised by commenters.

Still, the Commission anticipates that significant costs will be

incurred as a result of these documentation rules. Although the rules

do not apply retroactively--that is, concerns regarding the need to re-

negotiate already agreed-upon contracts are null--there will be costs

going forward for market participants. Registrants will have to (i)

Negotiate and document all terms of each trading relationship; (ii)

design, compose, and implement policies and procedures reasonably

designed to ensure the execution of swap trading relationship

documentation, including valuation documentation; (iii) obtain

documentation from counterparties who are claiming the end user

exception to clearing; (iv) periodically audit documentation; and (v)

keep records and/or make reports as required under Sec. Sec.

23.504(d)-(e) and 23.505(b).

In its Documentation NPRM, the Commission considered the costs of

its proposal and noted that memorializing the specific terms of the

swap trading relationship and swap transactions between counterparties

is prudent business practice and, in fact, many market participants

already use standardized documentation. Accordingly, it is believed

that many, if not most, SDs and MSPs currently execute and maintain

trading relationship documentation of the type required by proposed

Sec. 23.504 in the ordinary course of their businesses, including

documentation that contains several of the terms that would be required

by the proposed rules. Thus, the hour and dollar burdens associated

with the swap trading relationship documentation requirements may be

limited to amending existing documentation to expressly include any

additional terms required by the proposed rules.

The Commission also explained its belief that, to the extent any

substantial amendments or additions to existing documentation would be

needed, such revisions would likely apply to multiple counterparties,

thereby reducing the per counterparty burden imposed upon SDs and MSPs.

In addition, in its proposal, the Commission anticipated that

standardized swap trading relationship documentation will develop

quickly and progressively within the industry, dramatically reducing

the cost to individual participants.

Indeed, the Commission is aware of industry-led efforts already

underway to bring trading relationship documentation into compliance

with new Dodd-Frank Act requirements.\135\ These types of initiatives

are likely to lower overall costs to market participants.

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\135\ ISDA is partnering with Markit to launch a technology-

based solution enabling counterparties to amend their OTC

derivatives documentation quickly and efficiently to comply with

Dodd-Frank regulatory requirements. See http://www2.isda.org/dodd-frank-documentation-initiative/.

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The Commission further expects the per hour and dollar burdens to

be incurred predominantly in the first year or two after the effective

date of the final regulations. Once an SD or MSP has changed its pre-

existing documentation with each of its counterparties to comply with

the proposed rules, there likely will be little need to further modify

such documentation on an ongoing basis.

In terms of quantification, the Commission recognizes IECA's

comments indicating that the primary costs of the documentation and

valuation rules will be legal costs. In terms of a per hour fee, the

Commission has previously cited Bureau of Labor Statistics findings

that the mean hourly wage of an employee under occupation code 23-1011,

``Lawyers,'' that is employed by the ``Securities and Commodity

Contracts Intermediation and Brokerage Industry'' is $82.22.\136\ The

Commission has adjusted this amount upward to $100 per hour because SDs

and MSPs include large financial institutions whose employees' salaries

may exceed the mean wage provided. To account for the possibility that

the services of outside counsel may be required to satisfy the

requirements associated with negotiating, drafting, and maintaining the

required trading relationship documentation, the Commission used an

average salary of $125 per hour. In response to comments that the

hourly rate should be increased further, the Commission notes that any

determination to use outside counsel is at the discretion of the

registrant. Accordingly, the per-hour estimate for legal costs

associated with these rules is $125-500 per hour. In terms of the

number of hours required to amend documentation, whether the

requirement be ten hours or substantially more, the Commission notes

that industry-wide efforts could reduce this amount significantly.

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\136\ http.www.bls.gov/oes/2099/mayowe23.1011.htm.

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The Commission also notes the NERA report regarding the costs of an

annual audit. Given the alternative audit requirement finalized in

these rules, the Commission expects that the audit costs would be

reduced, perhaps significantly.

In conclusion, the Commission believes the final rules for

documentation of swap trading relationships are appropriate to ensure

the efficient and orderly operation of bilateral derivatives markets

and to

[[Page 55957]]

reduce the legal, operational, counterparty credit, and market risk

that can arise from undocumented terms. The final rules promote an

appropriate level of standardization; while the Commission does not

believe the rules prohibit customized terms, the manner in which they

are documented (i.e. written, pre-arranged terms that must include

certain types of agreements as applicable) will become standardized.

SDs, MSPs, and their counterparties alike will have certainty regarding

what their documentation must include, though the actual terms are

still readily negotiable. The Commission agrees with the Financial

Stability Oversight Board OTC Derivatives Working Group that increased

documentation standardization should improve the market in a number of

ways, including (i) Facilitating automated processing of transactions;

(ii) increasing the fungibility of contracts, which enables greater

market liquidity; (iii) improving valuation and risk management; (iv)

increasing the reliability of price information; (v) reducing the

number of problems in matching trades; and (vi) facilitating reporting

to SDRs.

J. Section 15(a) Considerations: Swap Trading Relationship

Documentation

1. Protection of Market Participants and the Public

The final documentation rules will protect market participants by

ensuring that every trading relationship and every transaction is

properly documented. Full and transparent documentation diminishes the

risk of unfair practices like valuing a swap to advantage one party at

the expense of the other. As such, documentation protects particularly

those parties most susceptible to being taken advantage of, such as

non-financial entities. In addition, the legal and credit certainty

provided by proper documentation provides protection to both sides of a

relationship by ensuring a clear understanding of options and

obligations, particularly in case of dispute or market crisis.

The provisions in the final rules related to valuation also provide

protection to market participants from costly disputes over the

collateralization of a swap; such disputes exacerbated the financial

crisis as proper collateralization for risk management purposes could

not be determined.

2. Efficiency, Competitiveness, and Financial Integrity of Derivatives

Markets

As proper documentation encourages orderly operations and

diminishes risk, the Commission believes the final rules improve the

efficiency of markets. Increased standardization should allow for

increased competition among SDs and MSPs, whose counterparties will be

better able to compare between swap trading relationships to determine

which relationships with which dealers best suit their needs. The

transparency and certainty provided by proper documentation, in

addition to the diminished risk of predatory trading practices, should

improve the integrity of bilateral derivatives markets. Overall, then,

the Commission considers the final rules to have a net positive impact

on the efficiency, competitiveness, and financial integrity of

derivatives markets.

3. Price Discovery

To the extent the final rules improve the process of valuing swap

transactions between counterparties, they should also increase the

reliability of pricing information; this increase in pricing

reliability should improve the price discovery function of bilateral

markets.

4. Sound Risk Management

Proper documentation of trading relationships and transactions is

essential to sound risk management; simply put, if a dealer is unaware

or unsure of agreed-upon terms and policies, it cannot be managing risk

as efficiently as possible. The final rules, because they require full

documentation of all facets of the relationship between counterparties,

mitigate (i) The legal risk inherent in poorly documented or oral

contracts; (ii) the counterparty credit risk that stems from improper

documentation of credit terms and the counterparty credit risk that

could occur based on false or misleading representations by either

counterparty; and (iii) the operational risk that arises when internal

operations personnel and systems do not have full or identical

information regarding a particular transaction or counterparty.

The final valuation rules also provide support for sound risk

management practices because they strive to ensure that two

counterparties are not disputing the value of a transaction where

margin or other cash flows are being exchanged. Limiting the risk that

unresolved disputes can create in the marketplace as a whole--again

considering the role valuation disputes played in the 2008 financial

crisis--should allow systemic risk management as well as improving the

risk management processes of individual market participants.

5. Other Public Interest Considerations

The Commission has not identified other public interest

considerations as a result of these rules.

V. Related Matters

A. Regulatory Flexibility Act

The Regulatory Flexibility Act (RFA) \137\ requires that agencies

consider whether the rules they propose will have a significant

economic impact on a substantial number of small entities and, if so,

provide a regulatory flexibility analysis respecting the impact. The

Commission has already established certain definitions of ``small

entities'' to be used in evaluating the impact of its rules on such

small entities in accordance with the RFA.\138\ SDs and MSPs are new

categories of registrant. Accordingly, the Commission noted in the

proposals that it had not previously addressed the question of whether

such persons were, in fact, small entities for purposes of the RFA.

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\137\ 5 U.S.C. 601 et seq.

\138\ 47 FR 18618 (Apr. 30, 1982).

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In this regard, the Commission explained that it previously had

determined that FCMs should not be considered to be small entities for

purposes of the RFA, based, in part, upon FCMs' obligation to meet the

minimum financial requirements established by the Commission to enhance

the protection of customers' segregated funds and protect the financial

condition of FCMs generally. Like FCMs, SDs will be subject to minimum

capital and margin requirements, and are expected to comprise the

largest global financial firms--and the Commission is required to

exempt from designation as an SD entities that engage in a de minimis

level of swaps dealing in connection with transactions with or on

behalf of customers. Accordingly, for purposes of the RFA for the

proposals and future rulemakings, the Commission proposed that SDs not

be considered ``small entities'' for essentially the same reasons that

it had previously determined FCMs not to be small entities.

The Commission further explained that it had also previously

determined that large traders are not ``small entities'' for RFA

purposes, with the Commission considering the size of a trader's

position to be the only appropriate test for the purpose of large

trader reporting. The Commission then noted that MSPs maintain

substantial positions in swaps, creating substantial counterparty

exposure that could have serious adverse effects on the financial

[[Page 55958]]

stability of the United States banking system or financial markets.

Accordingly, for purposes of the RFA for the proposals and future

rulemakings, the Commission proposed that MSPs not be considered

``small entities'' for essentially the same reasons that it previously

had determined large traders not to be small entities.

The Commission concluded its RFA analysis applicable to SDs and

MSPs as follows: ``The Commission is carrying out Congressional

mandates by proposing these rules. The Commission is incorporating

registration of SDs and MSPs into the existing registration structure

applicable to other registrants. In so doing, the Commission has

attempted to accomplish registration of SDs and MSPs in the manner that

is least disruptive to ongoing business and most efficient and

expeditious, consistent with the public interest, and accordingly

believes that these registration rules will not present a significant

economic burden on any entity subject thereto.''

The Commission did not receive any comments on its analysis of the

application of the RFA to SDs and MSPs. Moreover, during the time

period since the rule proposals were published in the Federal Register,

the Commission has issued final rules in which it determined that the

registration and regulation of SDs and MSPs would not have a

significant economic impact on a substantial number of small

entities.\139\ Accordingly, pursuant to Section 605(b) of the RFA, 5

U.S.C. 605(b), the Chairman, on behalf of the Commission, certifies

that these rules will not have a significant economic impact on a

substantial number of small entities.

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\139\ See, e.g., Registration of Swap Dealers and Major Swap

Participants, 77 FR 2613 (Jan. 19, 2012); Swap Dealer and Major Swap

Participant Recordkeeping, Reporting, and Duties Rules; Futures

Commission Merchant and Introducing Broker Conflicts of Interest

Rules; and Chief Compliance Officer Rules for Swap Dealers, Major

Swap Participants, and Futures Commission Merchants, 77 FR 20128

(Apr. 3, 2012).

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B. Paperwork Reduction Act

The Commission may not conduct or sponsor, and a registrant is not

required to respond to, a collection of information unless it displays

a currently valid Office of Management and Budget (OMB) control number.

The Commission's adoption of Sec. Sec. 23.500 through 23.505 (Swap

Confirmation, Portfolio Reconciliation, Portfolio Compression, Swap

Trading Relationship Documentation, and End User Exception

Documentation) imposes new information collection requirements on

registrants within the meaning of the Paperwork Reduction Act.\140\

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\140\ 44 U.S.C. 3501 et seq.

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Accordingly, the Commission requested and OMB assigned control

numbers for the required collections of information. The Commission has

submitted this notice of final rulemaking along with supporting

documentation for OMB's review in accordance with 44 U.S.C. 3507(d) and

5 CFR 1320.11. The title for these collections of information are

``Swap Trading Relationship Documentation Requirements for Swap Dealers

and Major Swap Participants, OMB control number 3038-0088,''

``Confirmation, Portfolio Reconciliation, and Portfolio Compression

Requirements for Swap Dealers and Major Swap Participants, OMB control

number 3038-0068,'' and ``Orderly Liquidation Termination Provision in

Swap Trading Relationship Documentation for Swap Dealers and Major Swap

Participants, OMB control number 3038-0083.'' \141\ Many of the

responses to this new collection of information are mandatory.

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\141\ These collections include certain collections required

under the Business Conduct Standards with Counterparties rulemaking,

as stated in that rulemaking. See Business Conduct Standards for

Swap Dealers and Major Swap Participants with Counterparties, 77 FR

9734 (Feb. 17, 2012).

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The Commission protects proprietary information according to the

Freedom of Information Act and 17 CFR part 145, ``Commission Records

and Information.'' In addition, Section 8(a)(1) of the CEA strictly

prohibits the Commission, unless specifically authorized by the Act,

from making public ``data and information that would separately

disclose the business transactions or market positions of any person

and trade secrets or names of customers.'' The Commission also is

required to protect certain information contained in a government

system of records according to the Privacy Act of 1974, 5 U.S.C. 552a.

The regulations require each respondent to furnish certain

information to the Commission and to maintain certain records. The

Commission invited the public and other Federal agencies to comment on

any aspect of the information collection requirements discussed in the

Documentation NPRM, the Confirmation NPRM, and the Orderly Liquidation

NPRM. Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicited

comments in order to: (i) Evaluate whether the proposed collections of

information were necessary for the proper performance of the functions

of the Commission, including whether the information will have

practical utility; (ii) evaluate the accuracy of the Commission's

estimates of the burden of the proposed collections of information;

(iii) determine whether there are ways to enhance the quality, utility,

and clarity of the information to be collected; and (iv) minimize the

burden of the collections of information on those who are to respond,

including through the use of automated collection techniques or other

forms of information technology.

It is not currently known how many SDs and MSPs will become subject

to these rules, and this will not be known to the Commission until the

registration requirements for these entities become effective. In its

rule proposals, the Commission took ``a conservative approach'' to

calculating the burden hours of this information collection by

estimating that as many as 300 SDs and MSPs would register.\142\ Since

publication of the proposals in late 2010 and early 2011, the

Commission has met with industry participants and trade groups,

discussed extensively the universe of potential registrants with NFA,

and reviewed public information about SDs active in the market and

certain trade groups. Over time, and as the Commission has gathered

more information on the swaps market and its participants, the estimate

of the number of SDs and MSPs has decreased. In its FY 2012 budget

drafted in February 2011, the Commission estimated that 140 SDs might

register with the Commission.\143\ After recently receiving additional

specific information from NFA on the regulatory program it is

developing for SDs and MSPs,\144\ however, the Commission believes that

approximately 125 SDs and MSPs, including only a handful of MSPs, will

register. While the Commission originally estimated there might be

approximately 300 SDs and MSPs, based on new estimates provided by NFA,

the Commission now estimates

[[Page 55959]]

that there will be a combined number of 125 SDs and MSPs that will be

subject to new information collection requirements under these

rules.\145\

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\142\ See 75 FR at 81528; 76 FR at 6713; 76 FR at 6723.

\143\ CFTC, President's Budget and Performance Plan Fiscal Year

2010, p. 13-14 (Feb. 2011), available at http://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/cftcbudget2012.pdf. The

estimated 140 SDs includes ``[a]pproximately 80 global and regional

banks currently known to offer swaps in the United States;''

``[a]pproximately 40 non-bank swap dealers currently offering

commodity and other swaps;'' and ``[a]pproximately 20 new potential

market makers that wish to become swap dealers.'' Id.

\144\ Letter from Thomas W. Sexton, Senior Vice President and

General Counsel, NFA to Gary Barnett, Director, Division of Swap

Dealer and Intermediary Oversight, CFTC (Oct. 20, 2011) (NFA Cost

Estimates Letter).

\145\ NFA Letter (Oct. 20, 2011) (estimating that there will be

125 SDs and MSPs required to register with NFA).

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For purposes of the PRA, the term ``burden'' means the ``time,

effort, or financial resources expended by persons to generate,

maintain, or provide information to or for a Federal Agency.''

For most of the provisions set forth in the NPRMs, the Commission

estimated the cost burden of the proposed regulations based upon an

average salary for Financial Managers of $100 per hour. In addition,

for certain provisions in the Documentation NPRM, the Commission

estimated the cost burden of the proposed regulations based upon an

average salary for Lawyers of $125 per hour. In response to these

estimates, The Working Group commented that, inclusive of benefit costs

and allocated overhead, the per-hour average salary estimate for

compliance and risk management personnel should be significantly higher

than $120. FIA and SIFMA stated that some of the compliance policies

required by the proposed regulations will be drafted by both in-house

lawyers and outside counsel, so the blended hourly rate should be

roughly $400.

The Commission notes that its wage estimates were based on recent

Bureau of Labor Statistics findings, including the mean hourly wage of

an employee under occupation code 23-1011, ``Lawyers,'' that is

employed by the ``Securities and Commodity Contracts Intermediation and

Brokerage Industry,'' which is $82.22. The mean hourly wage of an

employee under occupation code 11-3031, ``Financial Managers,'' (which

includes operations managers) in the same industry is $74.41.\146\

Taking these data, the Commission then increased its hourly wage

estimates in recognition of the fact that some registrants may be large

financial institutions whose employees' salaries may exceed the mean

wage. The Commission also observes that SIFMA's ``Report on Management

& Professional Earnings in the Securities Industry--2010'' estimates

the average wage of a compliance attorney and a compliance staffer in

the U.S. at only $46.31 per hour.

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\146\ See http://www.bls.gov/oes/2099/mayowe23.1011.htm and

http://www.bls.gov/oes/current/oes113031.htm.

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The Commission recognizes that some registrants may hire outside

counsel with expertise in the various regulatory areas covered by the

regulations discussed herein. While the Commission is uncertain about

the billing rates that registrants may pay for outside counsel, the

Commission believes that such counsel may bill at a rate of several

hundred dollars per hour. Outside counsel may be able to leverage its

expertise to reduce substantially the number of hours needed to fulfill

a requested assignment, but a registrant that uses outside counsel may

incur higher costs than a registrant that does not use outside counsel.

Any determination to use outside counsel is at the discretion of the

registrant. Having considered the comments received and having reviewed

the available data, the Commission has determined that $100 per hour

for Financial Managers, and $125 for Lawyers, remain reasonable

estimates of the per-hour average salary for purposes of its PRA

analysis. The Commission also notes that this determination is

consistent with the Commission's estimate for the hourly wage for CCOs

under the recently adopted final rules establishing certain internal

business conduct standards for SDs and MSPs.\147\

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\147\ See Swap Dealer and Major Swap Participant Recordkeeping,

Reporting, and Duties Rules; Futures Commission Merchant and

Introducing Broker Conflicts of Interest Rules; and Chief Compliance

Officer Rules for Swap Dealers, Major Swap Participants, and Futures

Commission Merchants, 77 FR 20128, 20196 (Apr. 3, 2012).

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The Commission received comments related to the PRA in response to

its notices of proposed rulemaking. Notably, none of these commenters

suggested specific revised calculations with regard to the Commission's

burden estimate.

IECA commented that if all confirmations must be in writing, the

additional employee time cost for each market participant would be

substantial and is not included in the annual cost analysis. IECA also

commented that the estimate of 10 hours per counterparty to negotiate

new documentation is too low. Because the rule requires transaction-by-

transaction valuation methodologies that will need to be newly

negotiated for many transactions, IECA believes the Commission should

calculate an aggregate amount based on the number of transactions.

Also, the time needed must include not only negotiation, but also time

for determining pricing points and inputs, executive decision-maker

time, and also senior management and board time for reviewing forms and

material modifications. Time will also be needed to reevaluate the ISDA

documentation if the Commission does not state that such are

acceptable.

The Working Group requested that the Commission evaluate the

proposed rules in light of its various recordkeeping and reporting

proposals, as such may cause firms to incur tremendous administrative

obligations to record changes to its swap portfolio, its accounting

records, treasury arrangements and capital allocations (including loss

of cash flow hedging treatment under hedge accounting rules), as well

as incurring reporting obligations to swap data repositories on a swap-

by-swap basis.

The Commission has considered the comments received concerning the

PRA-related burden estimates set forth in the notices of proposed

rulemaking. However, because none of the commenters suggested specific

revised calculations on the estimates, the only change that the

Commission is making to its estimation of annual burdens associated

with the rules is the change to reflect the new estimate of the number

of SDs and MSPs.

With respect to the rules proposed in the Documentation NPRM, the

Commission now estimates the initial burden to be 6,168 hours per year,

at an initial annual cost of $684,300, for each SD and MSP, and the

initial aggregate burden cost for all registrants is $85,537,500.\148\

With respect to the rules proposed in the Confirmation NPRM, the

Commission now estimates the burden to be 1,282.5 hours, at an annual

cost of $128,250 for each SD and MSP, and the aggregate burden cost for

all registrants is 160,312.5 burden hours and $16,031,250. With respect

to the rules set forth in the Orderly Liquidation NPRM, the Commission

now estimates the initial burden to be 270 hours per year, at an

initial annual cost of $27,000 for each SD and MSP, and the initial

aggregate burden cost for all registrants is 33,750 burden hours and

$3,375,000.\149\

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\148\ As noted in the Documentation NPRM, the Commission has

characterized the annual costs as initial annual costs, since the

Commission anticipates that the cost burdens will be reduced

dramatically over time as the agreements and other records required

by the proposed regulations become increasingly standardized within

the industry. 76 FR at 6722.

\149\ See id. (discussing the characterization of the annual

costs as initial annual costs). The Commission notes that the

substantive requirements under the Orderly Liquidation rule have

been reduced significantly. While the proposal required the parties

to negotiate and agree on documentation provisions, the final rules

requires only a simple notice. The Commission has elected not to

alter its PRA burden estimate, but observes that such estimates are

likely to overstate the actual burden significantly.

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In total, the Commission estimates that the rules set forth in this

Adopting Release will impose a burden of 7,720.5 hours per year, at an

initial annual cost of $839,550, for each SD and MSP, and

[[Page 55960]]

the aggregate burden cost for all registrants is $104,943,750.

In addition to the burden hours discussed above, the Commission

anticipates that SDs and MSPs may incur certain start-up costs in

connection with the proposed recordkeeping obligations. Such costs

would include the expenditures related to developing and installing new

technology and systems, or reprogramming or updating existing

recordkeeping technology and systems, to enable the SD or MSP to

collect, capture, process, maintain, and re-produce any newly required

records. The Commission received no comments with respect to the

estimated number of burden hours for these start-up costs, or with

respect to the programming wage estimate of $60 per hour. Accordingly,

the Commission estimates that the start-up costs would require 40

burden hours for the rules proposed in the Documentation NPRM and 40

hours for the rules proposed in the Confirmation NPRM.\150\ Thus, the

estimated start-up burden associated with the required technological

improvements would be $4,800 [$60 x 80 hours per affected registrant]

or $600,000 in the aggregate.\151\

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\150\ The Commission does not anticipate that SDs and MSPs will

incur any start-up costs in connection with the proposed

recordkeeping obligations in the rules proposed in the Orderly

Liquidation NPRM, other than those previously noted and accounted

for in the Documentation NPRM and Confirmation NPRM.

\151\ According to recent Bureau of Labor Statistics findings,

the mean hourly wages of computer programmers under occupation code

15-1021 and computer software engineers under program codes 15-1031

and 1032 are between $34.10 and $44.94. See http://www.bls.gov/oes/current/oes113031.htm. Because SDs and MSPs generally will be large

entities that may engage employees with wages above the mean, the

Commission has conservatively chosen to use a mean hourly

programming wage of $60 per hour.

---------------------------------------------------------------------------

List of Subjects in 17 CFR Part 23

Antitrust, Commodity futures, Conduct standards, Conflict of

Interests, Major swap participants, Reporting and recordkeeping, Swap

dealers, Swaps.

For the reasons stated in this release, the Commission amends 17

CFR part 23 as follows:

PART 23--SWAP DEALERS AND MAJOR SWAP PARTICIPANTS

0

1. The authority citation for part 23 continues to read as follows:

Authority: 7 U.S.C. 1a, 2, 6, 6a, 6b, 6b-1, 6c, 6p, 6r, 6s, 6t,

9, 9a, 12, 12a, 13b, 13c, 16a, 18, 19, 21.

0

2. Subpart I (consisting of Sec. Sec. 23.500, 23.501, 23.502, 23.503,

23.504, and 23.505) is added to read as follows:

Subpart I--Swap Documentation

Sec.

23.500 Definitions.

23.501 Swap confirmation.

23.502 Portfolio reconciliation.

23.503 Portfolio compression.

23.504 Swap trading relationship documentation.

23.505 End user exception documentation.

Subpart I--Swap Documentation

Sec. 23.500 Definitions.

For purposes of this subpart I, the following terms shall be

defined as provided.

(a) Acknowledgment means a written or electronic record of all of

the terms of a swap signed and sent by one counterparty to the other.

(b) Bilateral portfolio compression exercise means an exercise in

which two swap counterparties wholly terminate or change the notional

value of some or all of the swaps submitted by the counterparties for

inclusion in the portfolio compression exercise and, depending on the

methodology employed, replace the terminated swaps with other swaps

whose combined notional value (or some other measure of risk) is less

than the combined notional value (or some other measure of risk) of the

terminated swaps in the exercise.

(c) Confirmation means the consummation (electronically or

otherwise) of legally binding documentation (electronic or otherwise)

that memorializes the agreement of the counterparties to all of the

terms of a swap transaction. A confirmation must be in writing (whether

electronic or otherwise) and must legally supersede any previous

agreement (electronically or otherwise). A confirmation is created when

an acknowledgment is manually, electronically, or by some other legally

equivalent means, signed by the receiving counterparty.

(d) Execution means, with respect to a swap transaction, an

agreement by the counterparties (whether orally, in writing,

electronically, or otherwise) to the terms of the swap transaction that

legally binds the counterparties to such terms under applicable law.

(e) Financial entity means a counterparty that is not a swap dealer

or a major swap participant and that is one of the following:

(1) A commodity pool as defined in Section 1a(5) of the Act;

(2) A private fund as defined in Section 202(a) of the Investment

Advisors Act of 1940;

(3) An employee benefit plan as defined in paragraphs (3) and (32)

of section 3 of the Employee Retirement Income and Security Act of

1974;

(4) A person predominantly engaged in activities that are in the

business of banking, or in activities that are financial in nature as

defined in Section 4(k) of the Bank Holding Company Act of 1956; and

(5) A security-based swap dealer or a major security-based swap

participant.

(f) Fully offsetting swaps means swaps of equivalent terms where no

net cash flow would be owed to either counterparty after the offset of

payment obligations thereunder.

(g) Material terms means all terms of a swap required to be

reported in accordance with part 45 of this chapter.

(h) Multilateral portfolio compression exercise means an exercise

in which multiple swap counterparties wholly terminate or change the

notional value of some or all of the swaps submitted by the

counterparties for inclusion in the portfolio compression exercise and,

depending on the methodology employed, replace the terminated swaps

with other swaps whose combined notional value (or some other measure

of risk) is less than the combined notional value (or some other

measure of risk) of the terminated swaps in the compression exercise.

(i) Portfolio reconciliation means any process by which the two

parties to one or more swaps:

(1) Exchange the terms of all swaps in the swap portfolio between

the counterparties;

(2) Exchange each counterparty's valuation of each swap in the swap

portfolio between the counterparties as of the close of business on the

immediately preceding business day; and

(3) Resolve any discrepancy in material terms and valuations.

(j) Prudential regulator has the meaning given to the term in

section 1a(39) of the Commodity Exchange Act and includes the Board of

Governors of the Federal Reserve System, the Office of the Comptroller

of the Currency, the Federal Deposit Insurance Corporation, the Farm

Credit Association, and the Federal Housing Finance Agency, as

applicable to the swap dealer or major swap participant.

(k) Swap portfolio means all swaps currently in effect between a

particular swap dealer or major swap participant and a particular

counterparty.

(l) Swap transaction means any event that results in a new swap or

in a change to the terms of a swap, including execution, termination,

assignment, novation, exchange, transfer, amendment, conveyance, or

extinguishing of rights or obligations of a swap.

[[Page 55961]]

(m) Valuation means the current market value or net present value

of a swap.

Sec. 23.501 Swap confirmation.

(a) Confirmation. Subject to the compliance schedule in paragraph

(c) of this section:

(1) Each swap dealer and major swap participant entering into a

swap transaction with a counterparty that is a swap dealer or major

swap participant shall execute a confirmation for the swap transaction

as soon as technologically practicable, but in any event by the end of

first business day following the day of execution.

(2) Each swap dealer and major swap participant entering into a

swap transaction with a counterparty that is not a swap dealer or a

major swap participant shall send an acknowledgment of such swap

transaction as soon as technologically practicable, but in any event by

the end of the first business day following the day of execution.

(3) (i) Each swap dealer and major swap participant shall

establish, maintain, and follow written policies and procedures

reasonably designed to ensure that it executes a confirmation for each

swap transaction that it enters into with a counterparty that is a

financial entity as soon as technologically practicable, but in any

event by the end of the first business day following the day of

execution.

(ii) Each swap dealer and major swap participant shall establish,

maintain, and follow written policies and procedures reasonably

designed to ensure that it executes a confirmation for each swap

transaction that it enters into with a counterparty that is not a swap

dealer, major swap participant, or a financial entity not later than

the end of the second business day following the day of execution.

(iii) Such procedures shall include a requirement that, upon a

request by a prospective counterparty prior to execution of any such

swap, the swap dealer or major swap participant furnish to the

prospective counterparty prior to execution a draft acknowledgment

specifying all terms of the swap transaction other than the applicable

pricing and other relevant terms that are to be expressly agreed at

execution.

(4) Swaps executed on a swap execution facility, designated

contract market, or submitted for clearing by a derivatives clearing

organization.

(i) Any swap transaction executed on a swap execution facility or

designated contract market shall be deemed to satisfy the requirements

of this section, provided that the rules of the swap execution facility

or designated contract market establish that confirmation of all terms

of the transaction shall take place at the same time as execution.

(ii) Any swap transaction submitted for clearing by a derivatives

clearing organization shall be deemed to satisfy the requirements of

this section, provided that:

(A) The swap transaction is submitted for clearing as soon as

technologically practicable, but in any event no later than the times

established for confirmation under paragraphs (a)(1) or (3) of this

section, and

(B) Confirmation of all terms of the transaction takes place at the

same time as the swap transaction is accepted for clearing pursuant to

the rules of the derivatives clearing organization.

(iii) If a swap dealer or major swap participant receives notice

that a swap transaction has not been confirmed by a swap execution

facility or a designated contract market, or accepted for clearing by a

derivatives clearing organization, the swap dealer or major swap

participant shall execute a confirmation for such swap transaction as

soon as technologically practicable, but in any event no later than the

times established for confirmation under paragraphs (a)(1) or (3) of

this section as if such swap transaction were executed at the time the

swap dealer or major swap participant receives such notice.

(5) For purposes of this section:

(i) ``Day of execution'' means the calendar day of the party to the

swap transaction that ends latest, provided that if a swap transaction

is--

(A) Entered into after 4:00 p.m. in the place of a party; or

(B) Entered into on a day that is not a business day in the place

of a party, then such swap transaction shall be deemed to have been

entered into by that party on the immediately succeeding business day

of that party, and the day of execution shall be determined with

reference to such business day; and

(ii) ``Business day'' means any day other than a Saturday, Sunday,

or legal holiday.

(b) Recordkeeping. (1) Each swap dealer and major swap participant

shall make and retain a record of:

(i) The date and time of transmission to, or receipt from, a

counterparty of any acknowledgment; and

(ii) The date and time of transmission to, or receipt from, a

counterparty of any confirmation.

(2) All records required to be maintained pursuant to this section

shall be maintained in accordance with Sec. 23.203 and shall be made

available promptly upon request to any representative of the Commission

or any applicable prudential regulator, or with regard to swaps defined

in section 1a(47)(A)(v), to any representative of the Commission, the

Securities and Exchange Commission, or any applicable prudential

regulator.

(c) Compliance schedule. The requirements of paragraph (a) of this

section are subject to the following compliance schedule:

(1) For purposes of paragraph (a)(1) of this section, each swap

dealer and major swap participant entering into a swap transaction that

is or involves a credit swap or interest rate swap with a counterparty

that is a swap dealer or major swap participant shall execute a

confirmation for the swap transaction as soon as technologically

practicable, but in any event by:

(i) The end of the second business day following the day of

execution for the period from the effective date of this section to

February 28, 2014; and

(ii) The end of the first business day following the day of

execution from and after March 1, 2014.

(2) For purposes of paragraph (a)(1) of this section, each swap

dealer and major swap participant entering into a swap transaction that

is or involves an equity swap, foreign exchange swap, or other

commodity swap with a counterparty that is a swap dealer or major swap

participant shall execute a confirmation for the swap transaction as

soon as technologically practicable, but in any event by:

(i) The end of the third business day following the day of

execution for the period from the effective date of this section to

August 31, 2013;

(ii) The end of the second business day following the day of

execution for the period from September 1, 2013 to August 31, 2014; and

(iii) The end of the first business day following the day of

execution from and after September 1, 2014.

(3) For purposes of paragraph (a)(2) of this section, each swap

dealer and major swap participant entering into a swap transaction that

is or involves a credit swap or interest rate swap with a counterparty

that is not a swap dealer or a major swap participant shall send an

acknowledgment of such swap transaction as soon as technologically

practicable, but in any event by:

(i) The end of the second business day following the day of

execution for the period from the effective date of this section to

February 28, 2014; and

(ii) The end of the first business day following the day of

execution from and after March 1, 2014.

(4) For purposes of paragraph (a)(2) of this section, each swap

dealer and major

[[Page 55962]]

swap participant entering into a swap transaction that is or involves

an equity swap, foreign exchange swap, or other commodity swap with a

counterparty that is not a swap dealer or a major swap participant

shall send an acknowledgment of such swap transaction as soon as

technologically practicable, but in any event by:

(i) The end of the third business day following the day of

execution for the period from the effective date of this section to

August 31, 2013;

(ii) The end of the second business day following the day of

execution for the period from September 1, 2013 to August 31, 2014; and

(iii) The end of the first business day following the day of

execution from and after September 1, 2014.

(5) For purposes of paragraph (a)(3)(i) of this section, each swap

dealer and major swap participant shall establish, maintain, and follow

written policies and procedures reasonably designed to ensure that it

executes a confirmation for each swap transaction that is or involves a

credit swap or interest rate swap that it enters into with a

counterparty that is a financial entity as soon as technologically

practicable, but in any event by:

(i) The end of the second business day following the day of

execution for the period from the effective date of this section to

February 28, 2014; and

(ii) The end of the first business day following the day of

execution from and after March 1, 2014.

(6) For purposes of paragraph (a)(3)(i) of this section, each swap

dealer and major swap participant shall establish, maintain, and follow

written policies and procedures reasonably designed to ensure that it

executes a confirmation for each swap transaction that is or involves

an equity swap, foreign exchange swap, or other commodity swap that it

enters into with a counterparty that is a financial entity as soon as

technologically practicable, but in any event by:

(i) The end of the third business day following the day of

execution for the period from the effective date of this section to

August 31, 2013;

(ii) The end of the second business day following the day of

execution for the period from September 1, 2013 to August 31, 2014; and

(iii) The end of the first business day following the day of

execution from and after September 1, 2014.

(7) For purposes of paragraph (a)(3)(ii) of this section, each swap

dealer and major swap participant shall establish, maintain, and follow

written policies and procedures reasonably designed to ensure that it

executes a confirmation for each swap transaction that is or involves a

credit swap or interest rate swap that it enters into with a

counterparty that is not a swap dealer, major swap participant, or a

financial entity not later than:

(i) The end of the fifth business day following the day of

execution for the period from the effective date of this section to

August 31, 2013;

(ii) The end of the third business day following the day of

execution for the period from September 1, 2013 to August 31, 2014; and

(iii) The end of the second business day following the day of

execution from and after September 1, 2014.

(8) For purposes of paragraph (a)(3)(ii) of this section, each swap

dealer and major swap participant shall establish, maintain, and follow

written policies and procedures reasonably designed to ensure that it

executes a confirmation for each swap transaction that is or involves

an equity swap, foreign exchange swap, or other commodity swap that it

enters into with a counterparty that is not a swap dealer, major swap

participant, or a financial entity not later than:

(i) The end of the seventh business day following the day of

execution for the period from the effective date of this section to

August 31, 2013;

(ii) The end of the fourth business day following the day of

execution for the period from September 1, 2013 to August 31, 2014; and

(iii) The end of the second business following the day of execution

from and after September 1, 2014.

(9) For purposes of paragraph (c) of this section:

(i) ``Credit swap'' means any swap that is primarily based on

instruments of indebtedness, including, without limitation: Any swap

primarily based on one or more broad-based indices related to

instruments of indebtedness; and any swap that is an index credit swap

or total return swap on one or more indices of debt instruments;

(ii) ``Equity swap'' means any swap that is primarily based on

equity securities, including, without limitation: Any swap primarily

based on one or more broad-based indices of equity securities; and any

total return swap on one or more equity indices;

(iii) ``Foreign exchange swap'' has the meaning set forth in

section 1a(25) of the CEA. It does not include swaps primarily based on

rates of exchange between different currencies, changes in such rates,

or other aspects of such rates (sometimes known as ``cross-currency

swaps'');

(iv) ``Interest rate swap'' means any swap which is primarily based

on one or more interest rates, such as swaps of payments determined by

fixed and floating interest rates; or any swap which is primarily based

on rates of exchange between different currencies, changes in such

rates, or other aspects of such rates (sometimes known as ``cross-

currency swaps''); and

(v) ``Other commodity swap'' means any swap not included in the

credit, equity, foreign exchange, or interest rate asset classes,

including, without limitation, any swap for which the primary

underlying item is a physical commodity or the price or any other

aspect of a physical commodity.

Sec. 23.502 Portfolio reconciliation.

(a) Swaps with swap dealers or major swap participants. Each swap

dealer and major swap participant shall engage in portfolio

reconciliation as follows for all swaps in which its counterparty is

also a swap dealer or major swap participant.

(1) Each swap dealer or major swap participant shall agree in

writing with each of its counterparties on the terms of the portfolio

reconciliation.

(2) The portfolio reconciliation may be performed on a bilateral

basis by the counterparties or by a qualified third party.

(3) The portfolio reconciliation shall be performed no less

frequently than:

(i) Once each business day for each swap portfolio that includes

500 or more swaps;

(ii) Once each week for each swap portfolio that includes more than

50 but fewer than 500 swaps on any business day during any week; and

(iii) Once each calendar quarter for each swap portfolio that

includes no more than 50 swaps at any time during the calendar quarter.

(4) Each swap dealer and major swap participant shall resolve

immediately any discrepancy in a material term of a swap identified as

part of a portfolio reconciliation or otherwise.

(5) Each swap dealer and major swap participant shall establish,

maintain, and follow written policies and procedures reasonably

designed to resolve any discrepancy in a valuation identified as part

of a portfolio reconciliation or otherwise as soon as possible, but in

any event within five business days, provided that the swap dealer and

major swap participant establishes, maintains, and follows written

policies and procedures reasonably designed to identify how the swap

dealer or major swap participant will comply with any variation margin

requirements under section 4s(e) of the Act and regulations under this

part pending resolution of the discrepancy in

[[Page 55963]]

valuation. A difference between the lower valuation and the higher

valuation of less than 10 percent of the higher valuation need not be

deemed a discrepancy.

(b) Swaps with entities other than swap dealers or major swap

participants. Each swap dealer and major swap participant shall

establish, maintain, and follow written policies and procedures

reasonably designed to ensure that it engages in portfolio

reconciliation as follows for all swaps in which its counterparty is

neither a swap dealer nor a major swap participant.

(1) Each swap dealer or major swap participant shall agree in

writing with each of its counterparties on the terms of the portfolio

reconciliation, including agreement on the selection of any third-party

service provider.

(2) The portfolio reconciliation may be performed on a bilateral

basis by the counterparties or by one or more third parties selected by

the counterparties in accordance with paragraph (b)(1) of this section.

(3) The required policies and procedures shall provide that

portfolio reconciliation will be performed no less frequently than:

(i) Once each calendar quarter for each swap portfolio that

includes more than 100 swaps at any time during the calendar quarter;

and

(ii) Once annually for each swap portfolio that includes no more

than 100 swaps at any time during the calendar year.

(4) Each swap dealer or major swap participant shall establish,

maintain, and follow written procedures reasonably designed to resolve

any discrepancies in the material terms or valuation of each swap

identified as part of a portfolio reconciliation or otherwise with a

counterparty that is neither a swap dealer nor major swap participant

in a timely fashion. A difference between the lower valuation and the

higher valuation of less than 10 percent of the higher valuation need

not be deemed a discrepancy.

(c) Reporting. Each swap dealer and major swap participant shall

promptly notify the Commission and any applicable prudential regulator,

or with regard to swaps defined in section 1a(47)(A)(v) of the Act, the

Commission, the Securities and Exchange Commission, and any applicable

prudential regulator, of any swap valuation dispute in excess of

$20,000,000 (or its equivalent in any other currency) if not resolved

within:

(1) Three (3) business days, if the dispute is with a counterparty

that is a swap dealer or major swap participant; or

(2) Five (5) business days, if the dispute is with a counterparty

that is not a swap dealer or major swap participant.

(d) Reconciliation of cleared swaps. Nothing in this section shall

apply to a swap that is cleared by a derivatives clearing organization.

(e) Recordkeeping. A record of each swap portfolio reconciliation

consistent with Sec. 23.202(a)(3)(iii) shall be maintained in

accordance with Sec. 23.203.

Sec. 23.503 Portfolio compression.

(a) Portfolio compression with swap dealers and major swap

participants.

(1) Bilateral offset. Each swap dealer and major swap participant

shall establish, maintain, and follow written policies and procedures

for terminating each fully offsetting swap between a swap dealer or

major swap participant and another swap dealer or major swap

participant in a timely fashion, when appropriate.

(2) Bilateral compression. Each swap dealer and major swap

participant shall establish, maintain, and follow written policies and

procedures for periodically engaging in bilateral portfolio compression

exercises, when appropriate, with each counterparty that is also a swap

dealer or major swap participant.

(3) Multilateral compression. Each swap dealer and major swap

participant shall establish, maintain, and follow written policies and

procedures for periodically engaging in multilateral portfolio

compression exercises, when appropriate, with each counterparty that is

also a swap dealer or major swap participant. Such policies and

procedures shall include:

(i) Policies and procedures for participation in all multilateral

portfolio compression exercises required by Commission regulation or

order; and

(ii) Evaluation of multilateral portfolio compression exercises

that are initiated, offered, or sponsored by any third party.

(b) Portfolio compression with counterparties other than swap

dealers and major swap participants. Each swap dealer and major swap

participant shall establish, maintain, and follow written policies and

procedures for periodically terminating fully offsetting swaps and for

engaging in portfolio compression exercises with respect to swaps in

which its counterparty is an entity other than a swap dealer or major

swap participant, to the extent requested by any such counterparty.

(c) Portfolio compression of cleared swaps. Nothing in this section

shall apply to a swap that is cleared by a derivatives clearing

organization.

(d) Recordkeeping. (1) Each swap dealer and major swap participant

shall make and maintain a complete and accurate record of each

bilateral offset and each bilateral or multilateral portfolio

compression exercise in which it participates.

(2) All records required to be maintained pursuant to this section

shall be maintained in accordance with Sec. 23.203 and shall be made

available promptly upon request to any representative of the Commission

or any applicable prudential regulator, or with regard to swaps defined

in section 1a(47)(A)(v) of the Act, to any representative of the

Commission, the Securities and Exchange Commission, or any applicable

prudential regulator.

Sec. 23.504 Swap trading relationship documentation.

(a) (1) Applicability. The requirements of this section shall not

apply to:

(i) Swaps executed prior to the date on which a swap dealer or

major swap participant is required to be in compliance with this

section;

(ii) Swaps executed on a board of trade designated as a contract

market under section 5 of the Act or to swaps executed anonymously on a

swap execution facility under section 5h of the Act, provided that such

swaps are cleared by a derivatives clearing organization and all terms

of the swaps conform to the rules of the derivatives clearing

organization and Sec. 39.12(b)(6) of this chapter; and

(iii) Swaps cleared by a derivatives clearing organization.

(2) Policies and procedures. Each swap dealer and major swap

participant shall establish, maintain, and follow written policies and

procedures reasonably designed to ensure that the swap dealer or major

swap participant executes written swap trading relationship

documentation with its counterparty that complies with the requirements

of this section. The policies and procedures shall be approved in

writing by senior management of the swap dealer and major swap

participant, and a record of the approval shall be retained. Other than

confirmations of swap transactions under Sec. 23.501, the swap trading

relationship documentation shall be executed prior to or

contemporaneously with entering into a swap transaction with any

counterparty.

(b) Swap trading relationship documentation. (1) The swap trading

relationship documentation shall be in writing and shall include all

terms governing the trading relationship between the swap dealer or

major swap participant and its counterparty,

[[Page 55964]]

including, without limitation, terms addressing payment obligations,

netting of payments, events of default or other termination events,

calculation and netting of obligations upon termination, transfer of

rights and obligations, governing law, valuation, and dispute

resolution.

(2) The swap trading relationship documentation shall include all

confirmations of swap transactions under Sec. 23.501.

(3) The swap trading relationship documentation shall include

credit support arrangements, which shall contain, in accordance with

applicable requirements under Commission regulations or regulations

adopted by prudential regulators and without limitation, the following:

(i) Initial and variation margin requirements, if any;

(ii) Types of assets that may be used as margin and asset valuation

haircuts, if any;

(iii) Investment and rehypothecation terms for assets used as

margin for uncleared swaps, if any; and

(iv) Custodial arrangements for margin assets, including whether

margin assets are to be segregated with an independent third party, in

accordance with Sec. 23.701(e), if any.

(4) (i) The swap trading relationship documentation between swap

dealers, between major swap participants, between a swap dealer and

major swap participant, between a swap dealer or major swap participant

and a financial entity, and, if requested by any other counterparty,

between a swap dealer or major swap participant and such counterparty,

shall include written documentation in which the parties agree on the

process, which may include any agreed upon methods, procedures, rules,

and inputs, for determining the value of each swap at any time from

execution to the termination, maturity, or expiration of such swap for

the purposes of complying with the margin requirements under section

4s(e) of the Act and regulations under this part, and the risk

management requirements under section 4s(j) of the Act and regulations

under this part. To the maximum extent practicable, the valuation of

each swap shall be based on recently-executed transactions, valuations

provided by independent third parties, or other objective criteria.

(ii) Such documentation shall include either:

(A) Alternative methods for determining the value of the swap for

the purposes of complying with this paragraph in the event of the

unavailability or other failure of any input required to value the swap

for such purposes; or

(B) A valuation dispute resolution process by which the value of

the swap shall be determined for the purposes of complying with this

paragraph (b)(4).

(iii) A swap dealer or major swap participant is not required to

disclose to the counterparty confidential, proprietary information

about any model it may use to value a swap.

(iv) The parties may agree on changes or procedures for modifying

or amending the documentation required by this paragraph at any time.

(5) The swap trading relationship documentation of a swap dealer or

major swap participant shall include the following:

(i) A statement of whether the swap dealer or major swap

participant is an insured depository institution (as defined in 12

U.S.C. 1813) or a financial company (as defined in section 201(a)(11)

of the Dodd-Frank Act, 12 U.S.C. 5381(a)(11));

(ii) A statement of whether the counterparty is an insured

depository institution or financial company;

(iii) A statement that in the event either the swap dealer or major

swap participant or its counterparty is a covered financial company (as

defined in section 201(a)(8) of the Dodd-Frank Wall Street Reform and

Consumer Protection Act, 12 U.S.C. 5381(a)(8)) or an insured depository

institution for which the Federal Deposit Insurance Corporation (FDIC)

has been appointed as a receiver (the ``covered party''), certain

limitations under Title II of the Dodd-Frank Act or the Federal Deposit

Insurance Act may apply to the right of the non-covered party to

terminate, liquidate, or net any swap by reason of the appointment of

the FDIC as receiver, notwithstanding the agreement of the parties in

the swap trading relationship documentation, and that the FDIC may have

certain rights to transfer swaps of the covered party under section

210(c)(9)(A) of the Dodd-Frank Wall Street Reform and Consumer

Protection Act, 12 U.S.C. 5390(c)(9)(A), or 12 U.S.C. 1821(e)(9)(A);

and

(iv) An agreement between the swap dealer or major swap participant

and its counterparty to provide notice if either it or its counterparty

becomes or ceases to be an insured depository institution or a

financial company.

(6) The swap trading relationship documentation of each swap dealer

and major swap participant shall contain a notice that, upon acceptance

of a swap by a derivatives clearing organization:

(i) The original swap is extinguished;

(ii) The original swap is replaced by equal and opposite swaps with

the derivatives clearing organization; and

(iii) All terms of the swap shall conform to the product

specifications of the cleared swap established under the derivatives

clearing organization's rules.

(c) Audit of swap trading relationship documentation. Each swap

dealer and major swap participant shall have an independent internal or

external auditor conduct periodic audits sufficient to identify any

material weakness in its documentation policies and procedures required

by this section and Commission regulations. A record of the results of

each audit shall be retained.

(d) Recordkeeping. Each swap dealer and major swap participant

shall maintain all documents required to be created pursuant to this

section in accordance with Sec. 23.203 and shall make them available

promptly upon request to any representative of the Commission or any

applicable prudential regulator, or with regard to swaps defined in

section 1a(47)(A)(v) of the Act, to any representative of the

Commission, the Securities and Exchange Commission, or any applicable

prudential regulator.

Sec. 23.505 End user exception documentation.

(a) For swaps excepted from a mandatory clearing requirement. Each

swap dealer and major swap participant shall obtain documentation

sufficient to provide a reasonable basis on which to believe that its

counterparty meets the statutory conditions required for an exception

from a mandatory clearing requirement, as defined in section 2h(7) of

the Act and Sec. 39.6 of this chapter. Such documentation shall

include:

(1) The identity of the counterparty;

(2) That the counterparty has elected not to clear a particular

swap under section 2h(7) of the Act and Sec. 39.6 of this chapter;

(3) That the counterparty is a non-financial entity, as defined in

section 2h(7)(C) of the Act;

(4) That the counterparty is hedging or mitigating a commercial

risk; and

(5) That the counterparty generally meets its financial obligations

associated with non-cleared swaps. Provided, that a swap dealer or

major swap participant need not obtain documentation of paragraphs

(a)(3), (4), or (5) of this section if it obtains documentation that

its counterparty has reported the information listed in Sec.

39.6(b)(3) in accordance with Sec. 39.6(b)(4) of this chapter.

(b) Recordkeeping. Each swap dealer and major swap participant

shall maintain all documents required to be

[[Page 55965]]

obtained pursuant to this section in accordance with Sec. 23.203 and

shall make them available promptly upon request to any representative

of the Commission or any applicable prudential regulator, or with

regard to swaps defined in section 1a(47)(A)(v) of the Act, to any

representative of the Commission, the Securities and Exchange

Commission, or any applicable prudential regulator.

Issued in Washington, DC, on August 24, 2012, by the Commission.

Sauntia S. Warfield,

Assistant Secretary of the Commission.

Appendices to Confirmation, Portfolio Reconciliation, Portfolio

Compression, and Swap Trading Relationship Documentation Requirements

for Swap Dealers and Major Swap Participants--Commission Voting Summary

and Statements of Commissioners

NOTE: The following appendices will not appear in the Code of

Federal Regulations.

Appendix 1--Commission Voting Summary

On this matter, Chairman Gensler and Commissioners Sommers,

Chilton, O'Malia and Wetjen voted in the affirmative; no

Commissioner voted in the negative.

Appendix 2--Statement of Chairman Gary Gensler

I support the final rule implementing Congress' direction that

the Commission adopt rules for ``timely and accurate confirmation,

processing, netting, documentation, and valuation of all swaps.''

This direction was included in the swaps market reform provisions of

the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-

Frank Act).

Each of these requirements promotes crucial back office

standards that will reduce risk and increase efficiency in the swaps

market. These final rules are critical to the risk management of

swap dealers and major swap participants and lowering their risk to

the public.

The rules establish procedures to promote legal certainty by

requiring timely confirmation of all swap transactions, setting

forth documentation requirements for bilateral swap transactions,

and requiring timely resolutions of valuation disputes. In addition,

the rules enhance understanding of one counterparty's risk exposure

to another, and promote sound risk management through regular

reconciliation and compression of swap portfolios.

The 2008 financial crisis brought to light how large financial

institutions, including AIG, had valuation disputes and other

problems regarding documentation standards. These rules will

directly address many of those issues, highlighting issues for

senior management and regulators at an earlier stage.

The final rule builds upon extensive work by the Federal Reserve

Bank of New York (FRBNY) to improve standards in the back offices of

large financial institutions dealing in swaps. Beginning in 2005,

the FRBNY, along with U.S. and global prudential authorities,

undertook a supervisory effort to enhance operational efficiency and

lower risk in the swaps market by increasing automation in swaps

processing, improving documentation, and promoting the timely

confirmation of trades.

CFTC staff also consulted with other U.S. and foreign financial

regulators, and participated in numerous meetings with market

participants. CFTC staff worked to address the more than 60 public

comment letters responding to the three proposed rules comprising

this final rule.

Appendix 3--Statement of Commissioner Bart Chilton

I support this second package of internal business conduct

standard final rules. These rules establish a set of prudent

documentation standards for registered swap dealers (SDs) and major

swap participants (MSPs) while aiming to minimize the burdens on

non-SDs and non-MSPs. Vibrant and liquid financial markets are

necessary for economic prosperity. As shown by the 2007-2009

financial crisis, that prosperity itself is gravely threatened when

the rules governing financial markets fail to curb the build-up of

systemic risk. I am pleased that the preamble introducing these

rules appropriately refers to the tremendous cost of the financial

crisis; it is obvious that not implementing strong regulations

effectuating the intent of the Dodd-Frank Act, including these final

rules, would result in social costs to the American taxpayer and

consumer.\152\ In addition, I note that there are enormous and

ongoing social costs that taxed our economy as a result of the

reckless practices that became prevalent in the years before the

financial crisis.

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\152\ See infra above.

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The documentation and conduct standards set forth in this

release are designed to, most importantly in my opinion, reduce

valuation disputes: Disputes between parties about the value of a

swap or portfolio of swaps. Valuation disputes can delay the

exchange of collateral. The failure to exchange collateral in a

timely manner can have disastrous impacts on a firm's ability to

manage its risk and allocate capital efficiently. A large,

interconnected firm's inability to manage its risk and to properly

allocate capital can contribute to the generation of systemic risk.

All of these steps were vividly illustrated during the recent

financial crisis.

American International Group's (AIG) inability to value its

portfolio accurately and agree on valuations and collateral

exchanges with its counterparties posed a serious problem for AIG

and its counterparties during the financial crisis.\153\ According

to the Financial Crisis Inquiry Commission Report:

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\153\ See Testimony Before the Financial Crisis Inquiry

Commission, including AIG/Goldman Sachs Collateral Call Timeline,

available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0701-AIG-Goldman-supporting-docs.pdf (timeline

documenting valuation disputes and collateral calls); Testimony of

Joseph Cassano, available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0630-Cassano.pdf; and AIG Statement

Summary, available at http://fcic-static.law.stanford.edu/cdn_media/fcic-testimony/2010-0630-AIG-Statement-Summary.pdf.

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The OTC derivatives market's lack of transparency and of

effective price discovery exacerbated the collateral disputes of AIG

and Goldman Sachs and similar disputes between other derivatives

counterparties.\154\

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\154\ Financial Crisis Inquiry Commission, ``The Financial

Crisis Inquiry Report: Final Report of the National Commission on

the Causes of the Financial and Economic Crisis in the United

States,'' Jan. 2011, at 353, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf [hereinafter the FCIC Report.

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It is with the financial crisis in mind that I interpret the

Commission's authority generally and more specifically here, under

section 731 of the Dodd-Frank Act which added new section 4s(i) to

the Commodity Exchange Act (CEA).\155\ The portfolio reconciliation

rules in section 23.502 will ensure that SDs/MSPs have portfolio

valuations consistent with those of their counterparties. The

portfolio compression rules in section 23.503 will reduce

operational risks. The swap trading relationship documentation

requirements will 23.504 will ensure that documentation practices in

the swaps market cover a number of key terms. The documentation of

these terms will give counterparties greater certainty as to their

legal rights and responsibilities. These final rules, taken in

conjunction with the Commission's other Dodd-Frank Act-related

regulations, including part 43 regulations on real-time reporting

and subpart H of part 23 on Business Conduct Standards for Swap

Dealers and Major Swap Participants with Counterparties \156\ will

contribute substantially to encouraging early and effective dispute

resolution and will ensure the ``timely and accurate confirmation,

processing, netting, documentation, and valuation of all swaps.''

\157\

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\155\ Pub. L. 111 (2010). CEA section 4s(i) states that each

registered swap dealer and major swap participant shall conform with

such standards as may be prescribed by the Commission by rule or

regulation that relate to timely and accurate confirmation,

processing, netting, documentation, and valuation of all swaps.

\156\ See, specifically 17 CFR 23.431(a)(3)(i) requiring SDs and

MSPs to disclose ``the price of the swap and the mid-market mark of

the swap.''

\157\ CEA section 4s(i).

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While these rules represent considerable progress, I believe it

should not be viewed in a vacuum and that the Commission should

respond nimbly in responses to changes in the market that could

frustrate the underlying purpose of these final rules (and all other

Commission rules for that matter). Notwithstanding the progress the

Commission has made, I remain concerned that are still a number of

areas that this final rule touches upon that remain areas of

potential future concern:

1. Dispute resolution and the requirement to document

alternative methods for determining the value of a swap or a dispute

resolution process under regulation 23.504(b)(4)(iii).

This provision, combined with the provision in regulation

23.503(c) to report

[[Page 55966]]

``any valuation dispute in excess of $20,000,000'' within one

business day if the dispute is with another SD/MSP or five business

days for non-SDs/MSPs, should encourage the resolution of disputes.

These regulations are buttressed by efforts being made by certain

industry organizations. I encourage the Commission to remain

vigilant in this area and to monitor the disputes reported to the

Commission and to engage with the public to determine whether these

regulations have their intended effect.

2. The implied cost of credit and the requirement to document

credit support arrangements under regulation 23.504(b)(3).

I am concerned that these rules do not expressly require SDs and

MSPs to document the cost of credit if such costs are a factor in

the price a SD or MSP charges a counterparty. While this issue has

been discussed since the earliest days of the negotiations and

planning surrounding the drafting of the Dodd-Frank Act--and many

market participants acknowledged that added costs would be attendant

to engaging in non-cleared transactions--the Commission could

provide, in this rulemaking, an additional level of transparency to

transactions involving creditworthiness considerations.\158\ I

believe that requiring the documentation of the embedded cost of

credit as a transaction fee or credit premium would have deter the

practice of charging customers a price on a swap that depends on

creditworthiness. My concern is mitigated somewhat by regulation

23.431(d)(2) (a provision finalized in a previous rulemaking) which

requires that SDs and MSPs provide their non-SD/MSP counterparties

``with a daily mark, which shall be the mid-market mark of the

swap.'' \159\ Such a provision would assist an end-user to infer the

embedded cost of credit they were charged by their SD or MSP

counterparty. Armed with this information, I encourage market

participants to seek documentation of the embedded cost of credit as

a transaction fee or credit premium. As the Commission's regulations

become effective, I invite the public to alert the Commission if the

practice of charging a credit fee in the price (i.e., an embedded

cost of credit) for a swap becomes problematic by, for example,

diminishing the price discovery utility of real-time data published

to the public under part 43 of the Commission's rules.

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\158\ See Better Markets comment letter.

\159\ 77 FR 9733 (Feb. 17, 2012).

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3. Rehypothecation of uncleared swaps collateral and the

requirement to document rehypothecation terms for assets used as

margin for uncleared swaps under regulation 23.504(b)(3)(iii).

This requirement is consistent with section 724(c) of the Dodd-

Frank Act (adding section 4s(l)(1)(A) to the CEA) and is a welcome

inclusion in these rules.\160\ Rehypothecation occurs when a person

uses assets held as collateral for one counterparty in transactions

with another counterparty. This practice contributed to the

financial crisis in a number of ways, including: (1) Rehypothecated

collateral was particularly difficult to recover in bankruptcy \161\

and (2) rehypothecation increases leverage in the financial

system.\162\ While many buy-side firms are learning from the

financial crisis and requesting their collateral to be held in

segregated accounts, the potential for a dealer default that could

affect rehypothecated collateral still exists. In light of recent

events, the Commission and the public should keep a watchful eye on

the risks in this area.

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\160\ ``A swap dealer or major swap participant shall be

required to notify the counterparty of the swap dealer or major swap

participant at the beginning of a swap transaction that the

counterparty has the right to require segregation of the funds or

other property.''

\161\ This is because once the collateral is rehypothecated,

then the posting party could lose their proprietary interest in the

collateral and as a result in bankruptcy, such a party could fall

into the category of unsecured creditors. This can delay or prevent

recovery of collateral from a bankrupt counterparty.

\162\ IMF researchers recently estimated that off-balance sheet

funding for dealers from rehypothecation amounted to $4.5 trillion

during November 2007 and that it contributed substantially to the

size of the shadow banking system. See, The (sizeable) Role of

Rehypothecation in the Shadow Banking System, Manmohan Singh and

James Aitken, IMF Working Paper, July 2010, available at http://www.imf.org/external/pubs/ft/wp/2010/wp10172.pdf.

[FR Doc. 2012-21414 Filed 9-10-12; 8:45 am]

BILLING CODE 6351-01-P

 

Last Updated: September 11, 2012