2012-5317
Federal Register, Volume 77 Issue 64 (Tuesday, April 3, 2012)[Federal Register Volume 77, Number 64 (Tuesday, April 3, 2012)]
[Rules and Regulations]
[Pages 20128-20215]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-5317]
[[Page 20127]]
Vol. 77
Tuesday,
No. 64
April 3, 2012
Part II
Commodity Futures Trading Commission
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17 CFR Parts 1, 3, and 23
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; Final Rule
Federal Register / Vol. 77 , No. 64 / Tuesday, April 3, 2012 / Rules
and Regulations
[[Page 20128]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1, 3, and 23
RIN 3038-AC96
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
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). These regulations set forth reporting and recordkeeping
requirements and daily trading records requirements for swap dealers
(SDs) and major swap participants (MSPs). These regulations also set
forth certain duties imposed upon SDs and MSPs registered with the
Commission with regard to: Risk management procedures; monitoring of
trading to prevent violations of applicable position limits; diligent
supervision; business continuity and disaster recovery; disclosure and
the ability of regulators to obtain general information; and antitrust
considerations. In addition, these regulations establish conflicts-of-
interest requirements for SDs, MSPs, futures commission merchants
(FCMs), and introducing brokers (IBs) with regard to firewalls between
research and trading and between clearing and trading. Finally, these
regulations also require each FCM, SD, and MSP to designate a chief
compliance officer, prescribe qualifications and duties of the chief
compliance officer, and require that the chief compliance officer
prepare, certify, and furnish to the Commission an annual report
containing an assessment of the registrant's compliance activities.
DATES: The rules are effective June 4, 2012. Specific compliance dates
are discussed in the supplementary information.
FOR FURTHER INFORMATION CONTACT: Frank N. Fisanich, Chief Counsel, 202-
418-5949, [email protected], Division of Swap Dealer and Intermediary
Oversight, Ward P. Griffin, Counsel, 202-418-5425, [email protected],
Office of the General Counsel, and Hannah Ropp, Economist, 202-418-
5228, [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. Reporting, Recordkeeping, and Daily Trading Records
Requirements for SDs and MSPs
C. General Records Requirement--Sec. 23.201
D. Daily Trading Records--Sec. 23.202
E. Records; Retention and Inspection--Sec. 23.203
F. Duties of Swap Dealers and Major Swap Participants
G. Risk Management Program for SDs and MSPs--Sec. 23.600
H. Monitoring of Position Limits--Sec. 23.601
I. Diligent Supervision--Sec. 23.602
J. Business Continuity and Disaster Recovery--Sec. 23.603
K. General Information: Availability for Disclosure and
Inspection--Sec. 23.606
L. Antitrust Considerations--Sec. 23.607
M. Conflicts of Interest Policies and Procedures by SDs, MSPs,
FCMs, and IBs--Sec. 23.605, Sec. 1.71
N. Designation of a Chief Compliance Officer; Required
Compliance Policies; and Annual Report of an FCM, SD, or MSP
III. Effective Dates and Compliance Dates
A. Comments Regarding Compliance Dates
B. Compliance Dates
IV. Cost Benefit Considerations
A. Introduction
B. General Considerations
C. Comments Regarding the Scope of the Proposed Rules
D. Recordkeeping, Reporting, and Daily Trading Records
Requirements for SDs and MSPs
E. Duties and Risk Management Requirements of SDs and MSPs
F. Conflicts-of-Interest Policies and Procedures for SDs, MSPs,
FCMs, and IBs
G. Designation of a Chief Compliance Officer, Required
Compliance Policies, and Annual Report of an FCM, SD, or MSP
H. Conclusion
V. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
I. Background
The Commission is hereby adopting Sec. 23.200 through Sec. 23.205
\1\ setting forth reporting and recordkeeping requirements and daily
trading records requirements for SDs and MSPs, as required under
sections 4s(f) and 4s(g) of the Commodity Exchange Act (CEA); Sec.
23.600 through Sec. 23.607 setting forth certain duties imposed upon
SDs and MSPs with regard to: (1) Risk management procedures; (2)
monitoring of trading to prevent violations of applicable position
limits; (3) diligent supervision; (4) business continuity and disaster
recovery; (5) conflicts of interest policies and procedures; (6)
disclosure and the ability of regulators to obtain general information;
and (7) antitrust considerations, as required under section 4s(j) of
the CEA; Sec. 3.3 requiring FCMs, SDs, and MSPs to designate a chief
compliance officer, prescribing qualifications and duties of the chief
compliance officer, and requiring the chief compliance officer to
prepare, certify, and furnish to the Commission an annual report
containing an assessment of the registrant's compliance activities, as
required under sections 4d(d) and 4s(k) of the CEA; and Sec. 1.71
setting forth certain duties imposed on FCMs and IBs with regard to
implementing conflicts of interest policies and procedures, as required
under section 4d(c) of the CEA; as well as amendments to Sec. 3.1 to
add chief compliance officers to the definition of ``principal'' and to
add a new definition of ``board of directors.''
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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 five 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
114 comment letters directed specifically at the proposed rules.\4\ The
Commission considered
[[Page 20129]]
each of these comments in formulating the final regulations.\5\
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\2\ See 75 FR 76666 (Dec. 9, 2010) (Reporting, Recordkeeping,
and Daily Trading Records Requirements for Swap Dealers and Major
Swap Participants (Recordkeeping NPRM)); 75 FR 71397 (Nov. 23, 2010)
(Regulations Establishing and Governing the Duties of Swap Dealers
and Major Swap Participants (Duties NPRM)); 75 FR 70152 (Nov. 17,
2010) (Implementation of Conflicts of Interest Policies and
Procedures by Futures Commission Merchants and Introducing Brokers
(FCM/IB Conflicts NPRM)); 75 FR 71391 (Nov. 23, 2010)
(Implementation of Conflicts of Interest Policies and Procedures by
Swap Dealers and Major Swap Participants (SD/MSP Conflicts NPRM));
and 75 FR 70881 (Nov. 19, 2010) (Designation of a Chief Compliance
Officer; Required Compliance Policies; and Annual Report of a
Futures Commission Merchant, Swap Dealer, or Major Swap Participant
(CCO 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 business conduct
standards for security-based swap dealers and major security-based
swap participants. See 76 FR 42396 (July 18, 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, existing FCMs, 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 intends to work with the Federal Deposit Insurance
Corporation (FDIC) to establish appropriate information-sharing
arrangements to ensure that the FDIC has the information it needs to
exercise authority under Title II of the Dodd-Frank Act or the Federal
Deposit Insurance Act with regard to any SD or MSP registered with the
Commission.
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.
A. Regulatory Structure
The proposed regulations did not differentiate between SDs and MSPs
that may be a division of a larger entity or institution, but not a
separate legal entity. The proposed regulations also did not
differentiate between SDs and MSPs, but, rather, applied identical
rules to both types of entities. The proposals, however, solicited
comments on whether certain provisions of the proposed regulations
should be modified or adjusted to reflect the differences among SDs or
MSPs. In addition, the proposed regulations tracked the scope of the
statutory text, and did not, by their terms, apply only to the swap
activities of SDs and MSPs.
In its comment letter, Cargill, Incorporated (Cargill) argued that
the proposed rules should recognize Congressional intent to permit a
business with a swap dealing division to be subject to SD regulation
only for the activities of that division. Cargill recommended that the
Commission make clear that the Commission's regulations only apply to
the swap dealing business of an SD that is a division of a larger
company, and not to the other business activities of the company.
MetLife, Inc. (MetLife), the Managed Funds Association (MFA),
BlackRock, and the Asset Management Group of the Securities Industry
and Financial Markets Association (AMG) each argued that the Dodd-Frank
Act does not require that the Commission to apply the same rules to
MSPs as those applied to SDs and that MSPs should not be subject to the
same regulations as SDs because MSPs do not engage in market-making
activities.
The Securities Industry and Financial Markets Association (SIFMA)
and the Federal Home Loan Banks (FHLBs) each recommended that the
Commission's regulations should allow registrants that are regulated by
a prudential regulator to comply with the Commission's regulations on a
substituted compliance basis by complying with comparable regulations
of their prudential regulator.
In response to Cargill's comment, the Commission is including a new
definition of ``swaps activities'' in the final regulations, as
follows: ``Swaps activities means a registrant's activities related to
swaps and any product used to hedge such swaps, including, but not
limited to, futures, options, other swaps or security-based swaps, debt
or equity securities, foreign currency, physical commodities, and other
derivatives.''
The Commission is using this term in the final regulations to (i)
limit the scope of the risk management requirements in Sec. 23.600 to
only the swap activities of SDs and MSPs; (ii) define the extent of the
recordkeeping requirement in Sec. 23.201; and (iii) limit the scope of
the duties and responsibilities of the chief compliance officer of an
SD or MSP in Sec. 3.3 to the swaps activities of SDs and MSPs.\6\
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\6\ In addition, the Commission anticipates that under its
further definition of ``swap dealer,'' an SD that has applied for
and received a limited purpose designation from the Commission will
be subject to these regulations only for the categories or
activities for which the limited purpose designation is granted.
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The Commission is not modifying the regulations to differentiate
between SDs and MSPs. The Commission observes that no provision of
sections 4s(f), (g), (j), and (k) of the CEA, as added by the Dodd-
Frank Act, differentiates between the duties and requirements of SDs
and those of MSPs. The Commission thus has determined that the intent
of sections 4s(f), (g), (j), and (k) is to apply the same requirements
to MSPs and SDs, and the Commission is taking the same approach in the
final regulations. The Commission believes that to the extent the final
regulations are not applicable to an MSP's activities, the MSP is not
burdened by being subject to the regulations.
The Commission has considered but rejected a substituted compliance
regime with respect to the final rule for registrants subject to
regulation by a prudential regulator. The Commission notes that section
4s(e) of the CEA grants prudential regulators exclusive authority to
prescribe capital and margin requirements for SDs and MSPs that are
banks, but does not extend such authority to any other part of section
4s. Because SDs and MSPs will be registrants of the Commission, the
Commission has determined that its interest in ensuring that all
registrants are subject to consistent regulation outweighs any burden
that may be placed on registrants that are subject to regulation by a
prudential regulator. However, the Commission observes that many of its
final regulations are modeled on prudential regulations and
supervision. Thus the two regimes would be broadly consistent.
B. Reporting, Recordkeeping, and Daily Trading Records Requirements for
SDs and MSPs
As added by section 731 of the Dodd-Frank Act, sections 4s(f) and
4s(g) of the CEA established reporting and recordkeeping requirements
and daily trading records requirements for SDs and MSPs.
Section 4s(f)(1) requires SDs and MSPs to ``make such reports as
are required by the Commission by rule or regulation regarding the
transactions and positions and financial condition of the registered
swap dealer or major swap participant.'' In the Recordkeeping NPRM, the
Commission proposed regulations, pursuant to sections 4s(f)(1)(B)(i)
and (ii) of the CEA, prescribing the books and records requirements of
``all activities related to the business of swap dealers or major swap
participants,'' regardless of whether or not the entity has a
prudential regulator.
In addition, the Commission proposed regulations in the
Recordkeeping NPRM pursuant to section 4s(g)(1) of the CEA, requiring
that SDs and MSPs ``maintain daily trading records of the swaps of the
registered swap dealer and major swap participant and all related
records (including related cash and forward transactions) and recorded
[[Page 20130]]
communications, including electronic mail, instant messages, and
recordings of telephone calls.'' The Commission notes that section
4s(g)(3) requires that daily trading records for each swap transaction
be identifiable by counterparty, and section 4s(g)(4) specifies that
SDs and MSPs maintain a ``complete audit trail for conducting
comprehensive and accurate trade reconstructions.'' The Commission
received 14 comment letters in response to the Recordkeeping NPRM and
considered each in formulating the final rules.
C. General Records Requirement--Sec. 23.201
Proposed Sec. 23.201 set forth the records that SDs and MSPs must
maintain. The records required under the proposed rule included full
and complete swap transaction information, including all documents on
which swap information is originally recorded.
1. Additional Types of Records To Be Retained
In the Recordkeeping NPRM, the Commission requested comments
regarding whether additional types of records other than those
specified in the proposed rules should be required to be kept by SDs
and MSPs. The Commission also requested comment regarding whether
drafts of documents should be kept.
The Working Group of Commercial Energy Firms (The Working Group)
commented that the current proposal is sufficient and any additional
record retention requirements would be of little value to the
Commission. Chris Barnard, however, recommended that drafts of
documents should also be kept, arguing that the decision process
leading up to a final document can be very informative. In order to
regulate the use of high-frequency and algorithmic trading strategies,
Better Markets, Inc. (Better Markets) recommended that the Commission
require SDs and MSPs that employ high-frequency and algorithmic trading
strategies to maintain records of each strategy employed including a
description of the strategy and its objectives and the algorithms
employed, and to maintain a record of every order, cancellation, and
trade that occurs in the implementation of each strategy, indexed to
the electronic record of the strategy description and properly time
stamped.
Having considered these comments and the comments discussed below
regarding specific recordkeeping requirements, the Commission has
determined that the record retention requirements as proposed are
sufficient and has not included any additional requirements in the
final rules. With respect to Better Markets' comment, the Commission
notes that pursuant to Sec. 23.600(d)(9), as adopted in this release
and discussed further below, SDs and MSPs are required to ensure that
use of trading programs is subject to policies and procedures governing
their use, supervision, maintenance, testing, and inspection, and that
such policies and procedures are subject to a recordkeeping requirement
pursuant to Sec. 23.600(g).
2. Reliance on Records of Swap Data Repositories
The proposed regulations did not address whether an SD or MSP may
rely on reporting a swap to a swap data repository (SDR) as a means of
meeting their recordkeeping requirements. Proposed Sec. 23.203(b)(2)
required records of any swap to be kept for the life of the swap and
for a period of five years following the termination, maturity,
expiration, transfer, assignment, or novation date of the swap.
The International Swaps and Derivatives Association (ISDA) and
SIFMA (together, ISDA & SIFMA) requested that the Commission clarify
the extent to which SDs and MSPs may rely upon SDRs to retain records
beyond the time periods that registrants currently retain such records.
ISDA & SIFMA did not elaborate on the current retention periods for
swaps records, nor did they explain how this approach would work in the
absence of established SDRs for all types of swaps.
At this time, the Commission has determined not to permit SDs and
MSPs to rely solely on SDRs to meet their recordkeeping obligations
under the rules. The Commission believes that reliance on SDRs may be a
cost-efficient alternative in the future, but such reliance would be
premature at the present time. Additionally, the Commission believes
that SDs and MSPs must maintain complete records of their swaps for the
purposes of risk management. The data that is required to be reported
to an SDR may not be sufficient for these purposes.
3. Transaction Records Maintained in a Form and Manner Identifiable and
Searchable by Transaction and Counterparty--Sec. Sec. 23.201(a)(1),
23.202(a), and 23.202(b)
Proposed Sec. 23.201(a)(1) required SDs and MSPs to keep
transaction records in a form identifiable and searchable by
transaction and by counterparty. Proposed Sec. Sec. 23.202(a) and
23.202(b) also required SDs and MSPs to keep daily trading records for
each swap and any related cash or forward transaction as a separate
electronic file identifiable and searchable by transaction and
counterparty.
ISDA & SIFMA recommended that the decision whether to maintain each
transaction record as a separate electronic file be left to the
reporting counterparties. ISDA & SIFMA argued that SDs and MSPs
routinely store data across a number of systems, and that aggregating
transaction data from all systems into a single electronic file would
require enormous investment across market participants and would
require a substantial implementation period.
The Working Group argued that tying records of unfilled or
cancelled orders, correspondence (e.g., voice records, email, and
instant messages), journals, memoranda, and other records required by
proposed Sec. 23.201(a)(1) to each individual transaction in a manner
that is identifiable and searchable by transaction would create an
enormous technical burden, likely requiring the review, sorting, and
assignment of such data to each transaction manually by individual
employees. The Working Group recommended therefore that the Commission
allow SDs and MSPs to maintain records of the required information in
the form and manner currently employed by such firms, not in a single
comprehensive file, if such records would be readily accessible and
could be provided to the Commission within a reasonable amount of time
following a request.
The Commission agrees with the comments, in part, and is modifying
the proposed rules to remove the provision in Sec. 23.202(a) and Sec.
23.202(b) that requires each transaction record to be maintained as a
separate electronic file. The Commission believes that this
modification will make the requirement less burdensome for SDs and MSPs
because it will allow such registrants to maintain searchable databases
of the required records without the added cost and time needed to
compile records into individual electronic files. The Commission notes
that the rule, as modified, does not require the raw data in such
databases to be tagged with transaction and counterparty identifiers so
long as the SD or MSP can readily access and identify records
pertaining to a transaction or counterparty by running a search on the
raw data. In response to The Working Group's comments, the Commission
confirms that swap records can be maintained under current market
practice so long as the records are readily accessible, are
identifiable and searchable by transaction and counterparty, and
otherwise meet the
[[Page 20131]]
requirements of Sec. 1.31, as required under Sec. 23.203.
However, the Commission observes that section 4s(g)(3) of the CEA
requires registrants to ``maintain daily trading records for each
counterparty in a manner and form that is identifiable with each swap
transaction.'' In accordance with this statutory provision, the rules
clarify that such trading records should be searchable by transaction
and by counterparty. Maintaining records in this manner may prove
costly for some SDs and MSPs, but this approach is required by statute
and necessary for accurate audit trail construction, which is paramount
for successful enforcement of trade practice cases.
4. Business Records--Sec. 23.201(b)
As proposed, Sec. 23.201(b) required SDs and MSPs to keep full,
complete, and systematic business records, including records related to
corporate governance, financial records, complaints, and marketing and
sales materials.
The Working Group acknowledged that market participants presently
retain records that would qualify as business records under the
proposal, although not in a single comprehensive file. The Working
Group recommended that the Commission permit these records to be
retained as they currently are in the normal course of business, as
long as such records can be readily accessed and provided to the
Commission upon request. For example, many entities retain financial
records within their accounting departments, while marketing and sales
materials would be retained separately within another division. The
Working Group also recommended that the Commission clarify that when a
subsidiary is determined to be an SD or MSP, but its parent company is
not, business records should only be required to be retained for the
subsidiary.
In response to The Working Group's comments, the Commission
confirms that the rule does not require SDs and MSPs to keep the
required business records in a single comprehensive file. So long as
SDs and MSPs are keeping full, complete, and systematic business
records that are available for inspection or disclosure, the
requirements of Sec. 23.201(b) would be met. The Commission also notes
that the rule applies only to registered SDs and MSPs, and, therefore,
the rules would not apply to the parent company of a registrant unless
the parent company is also an SD or MSP.
5. Records of Complaints Received--Sec. 23.201(b)
Proposed Sec. 23.201(b) required SDs and MSPs to retain a record
of complaints received, certain identifying information about the
complainant, and a record of the disposition of the complaint.
MFA commented that the requirement to retain a record of complaints
is inappropriate for MSPs because, except in the event such entities
are registered as commodity trading advisors or commodity pool
operators: (a) Entities that may be classified as MSPs would not be
members of NFA or similar organizations; and (b) the filing of such
complaints against entities that may be classified as MSPs is neither
customary nor consistent with such entities' activities in the market.
Having considered MFA's comment, the Commission is adopting the
rule as proposed. MSPs are, by definition, market participants that
have a substantial position in swaps, that have outstanding swaps that
create substantial counterparty exposure that could have serious
adverse effects on the financial stability of the U.S. financial
markets, or that are highly leveraged. Consequently, the Commission
believes it is possible that a record of complaints, or a pattern of
complaints, made against an MSP could be of regulatory value to the
Commission. The Commission also notes that pursuant to the Commission's
MSP registration rule, each MSP registered with the Commission is also
required to be a member of at least one registered self-regulatory
organization (SRO).\7\
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\7\ See 17 CFR 170.16 Registration of Swap Dealers and Major
Swap Participants, 77 FR 2613 (Jan. 19, 2012) (stating ``Each person
registered as a swap dealer or a major swap participant must become
and remain a member of at least one futures association that is
registered under section 17 of the Act and that provides for the
membership therein of such swap dealer or major swap participant, as
the case may be, unless no such futures association is so
registered.''), available at www.cftc.gov.
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6. Records of Marketing and Sales Materials--Sec. 23.201(b)(4)
Proposed Sec. 23.201(b)(4) required SDs and MSPs to retain copies
of all marketing and sales presentations, advertisements, literature,
and communications, and a record of the SD's or MSP's compliance with
applicable Federal requirements, Commission regulations, and the rules
of any SRO related to marketing and sales materials.
MFA commented that because MSPs are not market makers, they do not
produce such materials for public dissemination. Therefore, MFA felt
that the concerns about SD marketing and sales materials that
necessitate the SDs' recordkeeping requirement are inapplicable to
MSPs.
The Commission has decided not to remove MSPs from the relevant
provisions of the rule because MSPs would need to comply with the
recordkeeping requirement only to the extent that they produce such
materials. To the extent that an MSP does not produce marketing or
sales materials, the requirements of the rule would be inapplicable.
7. Records of Date and Time of Reports To Swap Data Repositories and
Data Reported in Real-Time--Sec. 23.201(c) and Sec. 23.201(d)
Proposed Sec. 23.201(c) required SDs and MSPs to retain a record
of the date and time the SD or MSP reported data or information to SDRs
under proposed Part 45. Proposed Sec. 23.201(d) required SDs and MSPs
to retain a record of the date and time the SD or MSP reported
information for purposes of real-time public reporting under proposed
Part 43.
With regard to such records, The Working Group requested that the
Commission clarify that the record of the date and time of reports to
SDRs and for real-time public reporting be to the minute, and not to
the second.
The proposed rule did not specify the form of the depiction of time
in records of reports made under parts 43 or 45, other than to say that
the record must include the ``date and time.'' The Commission confirms
that SDs and MSPs may record time for the purpose of Sec. 23.201 in
their discretion, so long as they comply with any independent
requirements under Parts 43 and 45.
8. Records of a ``Rationale'' for Certain Swap Determinations--Sec.
23.201(d)(2) & (3)
Proposed Sec. 23.201(d)(2) and (3) required SDs and MSPs to retain
a record of the rationale for reporting a less specific data field than
is required under the proposed real-time public reporting requirements
in part 43, and a record of the rationale for determining that a swap
is a large notional swap as required under proposed part 43.
The Working Group requested clarification as to what the Commission
is seeking with respect to a ``rationale'' for these scenarios. The
Working Group questions what purpose this information would serve, or
what benefit the Commission hopes to derive for purposes of carrying
out its duties under the CEA.
[[Page 20132]]
The Commission has determined that any substantive recordkeeping
requirements necessary for compliance with Part 43 will be taken up in
that part and thus has deleted the proposed ``rationale'' requirements
from Sec. 23.201.
D. Daily Trading Records--Sec. 23.202
Section 4s(g)(1) of the CEA requires that SDs and MSPs maintain
daily trading records of their swaps and ``all related records
(including related cash and forward transactions).'' Section 4s(g)(1)
also requires that SDs and MSPs maintain recorded communications,
including electronic mail, instant messages, and recordings of
telephone calls. Section 4s(g)(2) provides that the daily trading
records shall include such information as the Commission shall require
by rule or regulation. Proposed Sec. 23.202 prescribed daily trading
record requirements, which would include trade information related to
pre-execution, execution, and post-execution data.
1. Records of Pre-Execution Trade Information--Sec. 23.202(a)(1)
Proposed Sec. 23.202(a)(1) required SDs and MSPs to make and keep
records of pre-execution trade information, including records of all
oral and written communications concerning quotes, solicitations, bids,
offers, instructions, trading, and prices that lead to the execution of
a swap, however communicated.
The Air Transport Association of America, Inc. (ATA) commented that
the current telephone recording systems in use by SDs and MSPs may not
meet all of the proposed rule's requirements, and that implementing
telephone recording systems that are compliant with the requirements
would impose a significant additional cost. The ATA's members
recognized that there may be benefits from the recording requirement,
but they are uncertain that those benefits outweigh the costs of
purchasing new, or upgrading existing, telephone phone recording and
retrieval systems. The ATA is concerned that the cost of complying with
all of the various rules proposed by the Commission will erect
unnecessarily high barriers to entry for SDs, foreclosing all but the
largest firms from acting as SDs.
MFA commented that it would be inappropriate to impose on MSPs the
additional burden of maintaining a record of all oral communications
made or received because the SDs with which MSPs enter into swaps would
record such information. For the same reasons, MFA commented that the
Commission should not require MSPs to create records of the date and
time of quotations received or the date and time of execution of each
swap and each related cash or forward transaction.
The Working Group argued that even if technology exists to record
the required data in a format searchable by transaction and
counterparty, it would not be possible to identify pre-execution data
specified by the Commission as being applicable to a specific trade
because traders and other commercial employees typically engage in
ongoing dialogue with counterparties over an extended period of time
and do not initiate communications specific to a single trade. The
Working Group commented that it would be extremely difficult and time
consuming to review manually each communication by a specific trader to
determine which conversations or documents ultimately led to the
execution of a particular swap and then assign that communication to a
unified file.
ISDA & SIFMA asserted that where pre-execution records are
maintained today they are captured prior to the execution of a swap and
as such they are not linked to a trade. ISDA & SIFMA argued that while
it may be possible potentially to search by counterparty with some
investment in additional technology, it would not be possible to search
by transaction because the infrastructure to link to a transaction is
not in place today and the procedural and technical feasibility to do
so has not been contemplated nor evaluated. ISDA & SIFMA strongly
recommended that the Commission limit the rule to a description of data
required as part of a trading record without dictating how such data
should be stored and, in particular, that the Commission exclude oral
communications from the electronic searchability requirement.
Having considered these comments, the Commission is modifying the
proposed rule to remove the requirement that each transaction record be
maintained as a separate electronic file, which should be less
burdensome for SDs and MSPs because it will allow these registrants to
maintain searchable databases of the required records without the added
cost and time needed to compile the required records into individual
electronic files. The Commission notes that section 4s(g)(3) of the CEA
requires registrants to ``maintain daily trading records for each
counterparty in a manner and form that is identifiable with each swap
transaction.'' The rule as adopted clarifies that such counterparty
records must be searchable by transaction and by counterparty.
Maintaining records in this form may prove costly for some registrants,
but such form is mandated by the CEA.
However, in light of commenters' concerns, the Commission is
adopting Sec. 23.206, which delegates to the Director of the Division
of Swap Dealer and Intermediary Oversight the authority to establish an
alternative compliance schedule for requirements of Sec. 23.202 that
are found to be technologically and economically impracticable for an
SD or MSP affected by Sec. 23.202. The purpose of Sec. 23.206 is to
facilitate the ability of the Commission to provide a technologically
practicable compliance schedule for affected SDs or MSPs that seek to
comply in good faith with the requirements of Sec. 23.202.
In order to obtain relief under Sec. 23.206, an affected SD or MSP
must submit a request for relief to the Director of the Division of
Swap Dealer and Intermediary Oversight. SDs and MSPs submitting
requests for relief must specify the basis in fact supporting their
claims that compliance with Sec. 23.202 would be technologically or
economically impracticable. Such a request may include a recitation of
the specific costs and technical obstacles particular to the entity
seeking relief and the efforts the entity intends to make in order to
ensure compliance according to an alternative compliance schedule.
Relief granted under Sec. 23.206 shall not cause a registrant to be
out of compliance or deemed in violation of any registration
requirements.
Such requests for an alternative compliance schedule shall be acted
upon by the Director of the Division of Swap Dealer and Intermediary
Oversight or designees thereto within 30 days from the time such a
request is received. If not acted upon within the 30 day period, such
request will be deemed approved.
The Commission notes that some commenters to a proposed Commission
rulemaking to amend Sec. 1.35,\8\ which would require voice recording
for futures and swap trading by FCMs and other registrants, raised
questions about statements made in the preamble of the Recordkeeping
NPRM. In that preamble, the Commission stated that proposed Sec.
23.202 ``would not establish an affirmative new requirement to create
recordings of all telephone conversations if the complete audit trail
requirement can be met through other means, such as electronic
messaging or trading.'' \9\ For avoidance of doubt, the Commission
notes that the rule requires
[[Page 20133]]
a record of ``all oral and written communications provided or received
concerning quotes, solicitations, bids, offers, instructions, trading,
and prices, that lead to the execution of a swap.'' Thus, to the extent
this pre-execution trade information does not include information
communicated by telephone, the Commission confirms that an SD or MSP is
under no obligation to create recordings of its telephone
conversations. If, however, any of this pre-execution trade information
is communicated by telephone, the SD or MSP must record such
communications.
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\8\ See Comments to Adaptation of Commission Regulations to
Accommodate Swaps, 76 FR 33066, 33088-89 (June 7, 2011), available
on the Commission's Web site: www.cftc.gov.
\9\ See Recordkeeping NPRM, 75 FR at 76668.
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With respect to MFA's comments, section 4s(g)(4) of the CEA applies
to both SDs and MSPs. Consequently, the audit trail requirements of the
proposed rules apply equally to both SDs and MSPs because it is
necessary that all Commission registrants have complete and accurate
daily trading records. Moreover, the Commission notes that MFA did not
provide any factual support for its assertion that every swap entered
by an MSP would have an SD as the counterparty.
2. Records of Source and Time of Quotations--Sec. 23.202(a)(1)(ii)
Proposed Sec. 23.202(a)(1)(ii) required SDs and MSPs to make and
keep a record of the date and time, using Coordinated Universal Time
(UTC), by timestamp or other timing device, for each quotation provided
to, or received from, a counterparty prior to execution of a swap.
The Working Group argued that the Commission should not require a
timestamp for every quote given or received, as the timestamp is
unnecessary, overly burdensome, and would not assist in trade
reconstruction. Further, The Working Group argued that most entities do
not currently capture or store this information, that it would be
difficult to do so, particularly given that quotations may be developed
by multiple sources, and retention of the time of quotations will add
additional compliance costs on market participants. The Working Group
also requested clarification as to the meaning of ``reliable timing
data for the initiation'' of a transaction.
MFA commented that the Commission should not require MSPs to create
records of the date and time of quotations received or the date and
time of execution of each swap and each related cash or forward
transaction. MFA argued that since SDs should keep such records in
connection with their market-making activities, to require an MSP
customer to maintain the same records would be duplicative and a
significant and unnecessary burden on MSPs.
Having considered these comments, the Commission is adopting the
rule as proposed. As noted above, the Commission observes that section
4s(g)(4) of the CEA requires both SDs and MSPs to maintain a complete
audit trail for conducting comprehensive and accurate trade
reconstructions. The Commission therefore believes that the audit trail
requirements of the rule should apply to both SDs and MSPs because it
is necessary that all Commission registrants have complete and accurate
daily trading records. As explained above, no support has been offered
for MFA's assertion that an SD will be the counterparty to every swap
executed with an MSP. Additionally, a comprehensive and accurate trade
reconstruction necessarily entails a reconstruction of the sequence of
events leading up to a trade and that this sequence cannot be
reconstructed accurately without reliable timing information. It is
noteworthy that commenters were unable to provide any alternative to
the timestamp requirement. Therefore, the Commission is retaining the
timestamp requirement in the final rule.
With respect to The Working Group's concern regarding the
``reliable timing data'' requirement, the Commission confirms that the
form of ``reliable timing data'' could be a timestamp, but the exact
form is left to the discretion of the registrant.
3. Timestamp for Quotations Using Universal Coordinated Time (UTC)--
Sec. 23.202(a)(1)(ii)
The proposed regulation required SDs and MSPs to record the time of
each quotation provided to or received from a counterparty prior to
execution using Universal Coordinated Time.
ISDA & SIFMA commented that the value derived by moving the
industry to UTC appears minimal when compared to the costs involved.
ISDA & SIFMA provided the Commission with no quantitative data
regarding these purported additional costs.
Having considered ISDA & SIFMA's comment, the Commission is
adopting the rule as proposed. The use of UTC in the rule reflects a
consistent approach taken by the Commission in this rule and the
Commission's final rules for real-time public reporting \10\ and the
swap data reporting rule.\11\ By requiring the use of UTC in Sec.
23.202, the Commission is ensuring that the requirements of Part 23,
Part 43, and Part 45 remain consistent to the extent possible.
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\10\ See Real-Time Public Reporting of Swap Transaction Data, 77
FR 1182, 1251 (Jan. 9, 2012).
\11\ See Swap Data Recordkeeping and Reporting Requirements, 77
FR 2136, 2212 (Jan. 13, 2012).
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4. Records of Time of Execution--Sec. 23.202(a)(2)(iv)
Proposed Sec. 23.202(a)(2)(iv) required SDs and MSPs to record the
date and time of execution of each swap to the nearest minute.
The Working Group argued that the proposed rule conflicts with both
the proposed real-time reporting rule and proposed swap data
recordkeeping and reporting rule, which required that the time of
execution be displayed to the second, rather than minute. The Working
Group requested that the Commission be consistent in all of the its
recordkeeping and reporting rules, and further requested that the
Commission adopt a minute requirement, rather than displaying to the
second.
The Commission is adopting the rule as proposed. The Commission
notes that the ``nearest minute'' standard is the standard for futures
orders under existing Sec. 1.35. The Commission also notes that the
final swap data recordkeeping and reporting rule does not require the
time of execution be displayed to the second.\12\ While the proposed
real-time reporting rule would require a registrant to record the time
of execution to the second in some instances, the Commission believes
recordkeeping to the nearest minute is sufficient for purposes of
maintaining daily trading records and is consistent with Sec. 1.35.
---------------------------------------------------------------------------
\12\ See Swap Data Recordkeeping and Reporting Requirements, 77
FR 2136, 2212, 2215 (Jan. 13, 2012).
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5. Records of Reconciliation Processes--Sec. 23.202(a)(3)(iii)
Proposed Sec. 23.202(a)(3)(iii) required SDs and MSPs to keep
records of portfolio reconciliation results, categorized by transaction
and counterparty.
ISDA & SIFMA commented that maintaining records of reconciliation
processes by transaction and counterparty may be particularly
problematic because this data is not required to be captured in other
markets, such as securities or bond markets, and significant additional
infrastructure development would thus be required before this data
could be captured and stored. ISDA & SIFMA recommended an ongoing
dialogue between the Commission and the industry to understand the
requirements for systems needed to meet the
[[Page 20134]]
requirements of the proposed rule, in particular the degree to which
retained data will need to be identifiable and searchable.
The records of portfolio reconciliation results required under the
rule are the minimum needed to monitor an SD's or MSP's compliance with
the Commission's proposed Sec. 23.502 on portfolio reconciliation.\13\
Thus, the Commission is adopting the rule as proposed.
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\13\ See Confirmation, Portfolio Reconciliation, and Portfolio
Compression Requirements for Swap Dealers and Major Swap
Participants, 75 FR 81519, 81531 (Dec. 28, 2010).
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6. Daily Trading Records for Cash and Forward Transactions Related to a
Swap--Sec. 23.202(b)
Proposed Sec. 23.202(b) required SDs and MSPs to keep daily
trading records, similar to those SDs and MSPs are required to keep for
swaps, for related cash and forward transactions, defined under
proposed Sec. 23.200 as ``a purchase or sale for immediate or deferred
physical shipment or delivery of an asset related to a swap where the
swap and the related cash or forward transaction are used to hedge,
mitigate the risk of, or offset one another.''
The Working Group urged the Commission to recognize that, although
participants in physical energy commodity markets use swaps and futures
to hedge underlying physical positions, they do not, as a general
matter, execute such transactions specifically for the purpose of
hedging a specified underlying physical position. Rather, according to
The Working Group, the predominant practice in physical energy markets
is to hedge underlying physical positions on a portfolio or aggregate
basis. Given the wide use of portfolio hedging in energy markets, The
Working Group believes it would be difficult for energy market
participants to link physical positions with arguably ``related'' swap
transactions. The Working Group believes that compliance with proposed
Sec. 23.202(b) would impose a large number of very expensive and
burdensome requirements on millions of physical transactions that are
undertaken by commercial energy firms that are also parties to swap
transactions.
ISDA & SIFMA commented that hedging and risk mitigation activities
referred to in the proposed daily trading records rule are typically
not executed with respect to specific trades; rather they are executed
against the overall positions of business units such as trading desks
and that it would not be possible to link cash and forward transactions
to a specific swap. ISDA & SIFMA also commented that the reference to
``hedge'' also requires clarity to know the extent to which it comports
with existing definitions in the CEA.
Having considered these comments, the Commission is adopting the
rule as proposed. The Commission notes that section 4s(g)(1) of the CEA
requires registrants to ``maintain daily trading records of their swaps
* * * and related records (including related cash and forward
transactions) * * *.'' Rule Sec. 23.200 defines ``related cash and
forward transactions'' as ``a purchase or sale for immediate or
deferred physical shipment or delivery of an asset related to a swap
where the swap and the related cash and forward transaction are used to
hedge, mitigate the risk of, or offset one another.'' The Commission
observes that the definition requires that a ``related cash and forward
transaction'' be related to at least one swap, but does not prohibit
such transaction from being related to more than one swap, or a swap
from being related to more than one related cash or forward
transaction. Therefore, the Commission believes the commenters'
concerns that compliance with the rule is not possible in the context
of portfolio hedging is misplaced. In addition, in response to the
comments received, the Commission confirms that this definition is used
solely for purposes of SD and MSP recordkeeping and is not intended to
define hedging transactions for any other purpose or any other
Commission regulation.
E. Records; Retention and Inspection--Sec. 23.203
1. Swap and Related Cash or Forward Record Retention Period--Sec.
23.203(b)(2)
Proposed Sec. 23.203(b)(2) required SDs and MSPs to retain records
of any swap or related cash or forward transaction until the
termination or maturity of the transaction and for a period of five
years after such date.
MFA commented that the vast majority of its members do not
currently keep records of transactions for five years following the
termination, expiration, or maturity of the transactions and compliance
with this rule would be burdensome and costly. MFA recommended that the
Commission not impose this record retention requirement on MSPs.
The Working Group argued that the long-term electronic storage of
significant amounts of pre-execution communications will prove costly
over the proposed five-year period. The Working Group recommended that
the Commission re-evaluate whether all records subject to the proposed
rule's retention requirements require a five year retention period.
ISDA & SIFMA recommended that further analysis and consultation be
performed on the costs and benefits of holding records of all oral and
written communications that lead to execution of a swap for the life of
a swap plus five years. ISDA & SIFMA commented that they would be
supportive of a voice recording obligation aligned to the rules of the
UK Financial Services Authority, which are to retain recordings for a
minimum period of six months.
By contrast, Chris Barnard recommended that records should be
required to be kept indefinitely rather than the general five years
under the proposal.
Having considered these comments, the Commission notes that
proposed revisions to Commission regulation Sec. 1.31 require
retention of swap transaction records for a period of five years
following the termination, expiration, or maturity of a swap,\14\ and
that Sec. 23.203 is consistent with retention requirements under the
final swap data reporting rule.\15\ However, in response to commenters'
concerns regarding retention of pre-execution trade information, the
Commission is revising the rule to require that voice recordings need
be kept for only one year. The Commission believes that the one-year
retention period for voice recordings will enable the Commission to
execute its enforcement responsibilities under the CEA adequately while
minimizing the costs imposed on SDs and MSPs.
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\14\ See Adaptation of Commission Regulations to Accommodate
Swaps, 76 FR 33066, 33088 (June 7, 2011).
\15\ See 17 CFR 45.2, Swap Data Recordkeeping and Reporting
Requirements, 77 FR 2136, 2198 (Jan. 13, 2012).
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2. ``Readily Accessible''--Sec. 23.203(b)(1) and (b)(2)
The proposed regulation required SDs and MSPs to have both general
records and swaps and related cash or forward transaction records
readily accessible for the first two years of the applicable retention
period.
The Working Group recommended that the Commission clarify whether
the requirement that retained records be ``readily accessible'' means
readily accessible by the registrant or by the Commission.
In response, the Commission observes that the term ``readily
accessible'' has been the operative standard in Sec. 1.31 of the
Commission's regulations for several years. Specifically, Sec. 1.31
requires that
[[Page 20135]]
``[a]ll books and records required to be kept by the Act or by these
regulations shall be kept for a period of five years from the date
thereof and shall be readily accessible during the first 2 years of the
5-year period.'' In response to The Working Group's request for
clarification, the Commission expects a registrant to be able to access
such records promptly, and such records ``shall be open to inspection
by any representative of the Commission or the United States Department
of Justice.'' \16\
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\16\ Regulation 1.31 further provides that ``[a]ll such books
and records shall be open to inspection by any representative of the
Commission or the United States Department of Justice.''
---------------------------------------------------------------------------
3. Records To Be Retained in Accordance With Commission Regulation
1.31--Sec. 23.203(b)
Proposed Sec. 23.203(b) required SDs and MSPs to maintain records
in accordance with existing Sec. 1.31.
The Working Group commented that Sec. 1.31 appears to apply to
written documents, including electronic images of such documents, and
does not seem suitable for electronic records such as those in a
trading system, that do not originate from a written document. To be
made workable for purposes of complying with the Commission's proposed
requirements, The Working Group recommended that Sec. 1.31 be revised
to reflect current technologies and industry practices relating to
digitized data storage.
The Commission has considered The Working Group's comment, but is
adopting the rule as proposed. The Commission believes that The Working
Group's concerns about Sec. 1.31 have been addressed by a subsequent
rule proposal to amend Sec. 1.31 to reflect current technologies and
industry practices related to digitized data storage.\17\ If these
amendments are finalized, the Commission believes that Sec. 1.31 will
be compatible with electronic records in a trading system and other
records that do not originate from a written document.
---------------------------------------------------------------------------
\17\ See Adaptation of Commission Regulations to Accommodate
Swaps, 76 FR 33066, 33088 (June 7, 2011).
---------------------------------------------------------------------------
F. Duties of SDs and MSPs
As part of an overall business conduct regime for SDs and MSPs,
section 4s(j) of the CEA, as added by section 731 of the Dodd-Frank
Act, sets forth certain duties for SDs and MSPs, including the duty to:
(1) Monitor trading to prevent violations of applicable position
limits; (2) establish risk management procedures adequate for managing
the day-to-day business of the SD or MSP; (3) disclose to the
Commission and to applicable prudential regulators \18\ general
information relating to swaps trading, practices, and financial
integrity; (4) establish and enforce internal systems and procedures to
obtain information needed to perform all of the duties prescribed by
Commission regulations; (5) implement conflict-of-interest systems and
procedures; and (6) refrain from taking any action that would result in
an unreasonable restraint of trade or impose a material anticompetitive
burden on trading or clearing. In its Duties NPRM, the Commission
proposed six regulations to implement section 4s(j), specifically
addressing risk management, monitoring of positions limits, diligent
supervision, business continuity and disaster recovery, the
availability of general information, and antitrust considerations. The
Commission's proposed conflicts of interest policies and procedures
were the subject of the separate SD/MSP Conflicts NPRM and are
discussed below. The Commission received 20 comment letters in response
to the Duties NPRM and considered each in formulating the final rules.
---------------------------------------------------------------------------
\18\ This term is defined for the purposes of this rulemaking
and has the same meaning as section 1(a)(39) of the CEA, which
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.
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G. Risk Management Program for SDs and MSPs--Sec. 23.600
The Commission proposed Sec. 23.600, which required SDs and MSPs
to establish and maintain a risk management program reasonably designed
to monitor and manage the risks associated with their business as an SD
or MSP. Proposed Sec. 23.600 specifically required the risk management
program established by SDs and MSPs to consist of written policies and
procedures; to have its risk management policies and procedures
approved by the governing body of the SD or MSP; and to establish a
risk management unit independent from the business trading unit to
administer the risk management program.
1. Definitions--Sec. 23.600(a)
The Commission proposed definitions of ``affiliate,'' ``business
trading unit,'' ``clearing unit,'' ``governing body,'' ``prudential
regulator,'' and ``senior management.'' \19\ The definitions set forth
in Sec. 23.600(a) will apply only to provisions contained in Sec.
23.600. The Commission is adopting the definitions largely as proposed,
with the exceptions discussed below.
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\19\ No comments were received on the proposed Sec. 23.600(a)
definitions of ``affiliate,'' ``clearing unit,'' or ``prudential
regulator.'' With the exception of one change to the definition of
``prudential regulator'', the Commission has decided to adopt those
definitions as proposed.
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a. Business Trading Unit--Sec. 23.600(a)(2)
SIFMA recommended that (i) the Commission modify the definition of
``business trading unit'' to delete the phrase ``or is involved in''
and replace it with ``directly engaged in'' to avoid inclusion of risk
management, legal, credit, and operations personnel, all of whom could
be deemed to be ``involved in'' business trading unit activities; and
(ii) the Commission clarify that independent financial control
functions that perform price verification for internal purposes (as
opposed to providing prices to clients) are excluded from the business
trading unit.
The Commission did not intend to include risk management, legal,
credit, and operations personnel in the definition and has revised the
definition to exclude such personnel. However, the Commission does not
believe that only those personnel ``directly engaged in'' pricing,
trading, sales, marketing, advertising, solicitation, structuring, or
brokerage activities sufficiently captures those personnel intended to
be included by the definition for purposes of the rule. Thus, the
Commission is modifying the proposed definition to exclude risk
management, legal, credit, and operations personnel, but also to
include specifically personnel exercising direct supervisory authority
over the performance of business trading unit functions. Per SIFMA's
recommendation, the Commission also has modified the definition to
exclude price verification for risk management purposes from the list
of business trading unit functions. The Commission believes that the
definition as revised will be less burdensome for registrants, but
retains the original intent of the definition.
b. Governing Body and Senior Management--Sec. 23.600(a)(3) and (4)
Cargill recommended that the Commission expand the definitions of
governing body and senior management to include the governing body or
senior management of the division of a larger company. Cargill, SIFMA,
and MetLife also recommended that the Commission permit a management
committee or board committee to serve the function of a governing body.
SIFMA further requested that the Commission confirm that governing body
and senior management approvals required under the proposed rules may
occur at the holding company level.
[[Page 20136]]
SIFMA recommended that the Commission not limit the definition of
``senior management'' to direct reports of the chief executive officer,
but include any other officer having supervisory or management
responsibility (including at the consolidated group level) for any
organizational unit, department or division. BG Americas & Global LNG
(BGA) argued that the requirement that the risk management unit report
directly to a senior officer that reports directly to the CEO is too
rigid and does not reflect the reality of most energy trading
companies.
In response to commenters, the Commission is modifying the proposed
definition of ``governing body'' to allow an SD or MSP to designate as
its governing body ``(1) a board of directors; (2) a body performing a
function similar to a board of directors; (3) any committee of a board
or body; or (4) the chief executive officer of a registrant, or any
such board, body, committee or officer of a division of a registrant,
provided that the registrant's swaps activities for which registration
with the Commission is required are wholly contained in a separately
identifiable division.'' The Commission believes that under this
definition the governing body of an SD or MSP could include a board
committee or the governing body or senior management of a division,
provided that the swaps activities of an SD or MSP are wholly contained
in a separately identifiable division.
Likewise, in response to commenters, the Commission is modifying
the proposed definition of ``senior management'' to provide increased
flexibility in registrant governance structures. The Commission is
revising the proposed definition to require only that senior management
consist of officers of the SD or MSP that have been ``specifically
granted the authority and responsibility by the registrant's governing
body to fulfill the requirements of senior management.''
The Commission believes that the increased flexibility permitted by
the revised definitions of ``governing body'' and ``senior management''
will be less burdensome for SDs and MSPs, but retains the Commission's
intent to have accountability at the highest level of management.
2. Scope of Risk Management Program--Sec. 23.600(b)
The proposed regulations required SDs and MSPs to establish,
document, maintain, and enforce a system of risk management policies
and procedures designed to monitor and manage the risks associated with
the business of the SD or MSP and the Risk Management Program to take
into account risks posed by affiliates and take an integrated approach
to risk management at the consolidated entity level.
The Working Group, MetLife, and the Office of the Comptroller of
the Currency argued that Sec. 23.600 should be limited to the risks
associated with swaps activities, and not other business lines in which
the SD or MSP may engage. The Working Group also recommended that the
rule be revised to require the risk management program to take into
account only swaps-related risks posed by affiliates and take an
integrated approach to risk management at the consolidated entity level
to the extent the SD or MSP deems necessary to enable effective risk
and compliance oversight.
Based on these comments, the Commission has determined that the
risk management rules will be limited in scope to apply only to the
swaps activities of SDs and MSPs and is modifying proposed Sec.
23.600(b)(1) as recommended by The Working Group.
On the other hand, the Commission has rejected The Working Group's
recommendation that SDs and MSPs consider only swaps-related risks
posed by affiliates. The Commission believes that an SD or MSP should
be aware of all risks posed by affiliates, and the rule should require
the SD's or MSP's Risk Management Program to be integrated into overall
risk management considerations at the consolidated entity level.
However, the Commission is modifying proposed Sec. 23.600(c)(1)(ii) to
reflect the fact that Risk Management Programs within an SD or MSP may
not have the authority to direct other divisions of a larger company.
Further, the Commission recognizes that some SDs and MSPs will be
part of a larger holding company structure that may include affiliates
that are engaged in a wide array of business activities. The Commission
understands with respect to these entities, that in some instances, the
top level company in the holding company structure is in the best
position to evaluate the risks that an affiliate of an SD or MSP may
pose to the enterprise, as it has the benefit of an organization-wide
view and because an affiliate's business may be wholly unrelated to
swaps activities. Therefore, to the extent an SD or MSP is part of a
holding company with an integrated risk management program, the SD or
MSP may address affiliate risks and comply with Sec. 23.600(c)(1)(ii)
through its participation in a consolidated entity risk management
program.
3. Flexibility To Design Risk Management Program--Sec. 23.600(b)
The proposed regulation required a registrant's risk management
program to include certain enumerated elements: identification of risks
and risk tolerance limits; periodic risk exposure reports; a new
product policy; policies and procedures to monitor and manage market
risk, credit risk, liquidity risk, foreign currency risk, legal risk,
operational risk, and settlement risk; use of central counterparties;
compliance with margin and capital requirements; and monitoring of
compliance with risk management program.
The Working Group and the Edison Electric Institute (EEI) commented
that proposed Sec. 23.600 requires a level of detail in the Risk
Management Program not provided for in the Dodd-Frank Act, and
recommended that the final rules be flexible enough to allow firms to
adapt their existing compliance and risk management measures, and not
cause firms to add entirely new compliance or risk management
infrastructure.
Having considered these comments, the Commission is adopting the
rule substantially as proposed. The Commission believes that the
requirements of the rules represent prudent risk management practices,
but do not prescribe rigid organizational structures. The Commission
also believes the ``policies and procedures'' approach provides an
adequate amount of flexibility that will allow registrants to rely upon
any existing compliance or risk management capabilities to meet the
requirements of the proposed rules. The Commission further believes
that nothing would prevent firms from relying upon existing compliance
and risk management programs to a significant degree.
4. Risk Management Policies and Procedures--Sec. 23.600(b)(2)
Proposed Sec. 23.600(b)(2) required that a registrant's risk
management program be described in written policies and procedures,
that such policies and procedures be approved in writing by the
registrant's governing body, and that such policies and procedures be
provided to the Commission upon registration and following any material
change.
SIFMA recommended that the Commission clarify that written risk
management policies and procedures need not be documented in a single,
consolidated set, so long as such policies and procedures address all
of the elements of the risk management program required by the proposed
rules. Cargill commented that registrants
[[Page 20137]]
should not be required to furnish risk management policies and
procedures to the Commission, as such policies and reports can be
obtained by the Commission by special call or reviewed during
examinations. By way of contrast, Chris Barnard recommended that the
Commission expand the reporting requirement to include public
disclosure to allow for market participants to assess a registrant's
approach to risk management and increase confidence in the swap
markets.
In response to SIFMA's and Cargill's comments, the Commission is
modifying the proposed rule to provide that an SD's or MSP's written
policies and procedures must be provided upon application for
registration to the Commission, or to a futures association registered
under section 17 of the CEA, if directed by the Commission, but
thereafter only upon request of the Commission. Additionally, the
Commission confirms that, so long as the required policies and
procedures are maintained in a reasonably useable and accessible
fashion, the rule is not intended to mandate the form or manner of
documentation or retention.
With respect to Mr. Barnard's recommendation, the Commission is not
adopting a public disclosure requirement because registrants' risk
management policies and procedures may contain sensitive or proprietary
information.
5. Risk Management Unit--Sec. 23.600(b)(5)
Proposed Sec. 23.600(b)(5) required SDs and MSPs to establish a
risk management unit that reports directly to senior management, that
is independent from the business trading unit, and that has sufficient
authority and resources to carry out the risk management program
required by the proposed regulations.
SIFMA recommended that the Commission clarify that different risk
management processes may be managed by independent control functions,
organized by relevant discipline or specialization, and that such
functions, so long as they comply with the independence and other
requirements applicable to the risk management unit, need not be part
of a single risk management unit. To facilitate a functional working
relationship, The Working Group recommended that the Commission clarify
that separation of the risk management unit and business trading unit
requires only separate and independent oversight of business unit and
risk management unit personnel, but not actual physical separation of
such personnel.
BGA recommends that the Commission allow the risk and trading units
to report to a shared senior officer, as long as the senior officer
does not participate in directing, organizing, or executing trades.
According to BGA, this would be consistent with the Federal Energy
Regulatory Commission's requirement for achieving independence between
franchised public utilities and their market-regulated power sales
affiliates, and would achieve the appropriate level of independence
without requiring companies to overhaul their existing management
structures.
Better Markets commented that simply requiring Risk Management Unit
independence is inadequate and recommends that the Commission ensure
independence with rules similar to those proposed to ensure
independence of research analysts in proposed Sec. 23.605, while
Cargill requested that the Commission provide greater flexibility in
how SDs arrange monitoring and compliance of their risk management
program, rather than rigidly requiring complete independence from the
business trading unit.
Having considered these comments, the Commission is adopting the
rule as proposed. While Sec. 23.600(b)(5) does not require a
registrant's risk management unit to be a formal division in the
registrant's organizational structure, the Commission expects that an
SD or MSP will be able to identify all personnel responsible for
required risk management activities as its ``risk management unit''
even if such personnel fulfill other functions in addition to their
risk management activities. In addition, Sec. 23.600(b)(5) permits SDs
and MSPs to establish dual reporting lines for risk management
personnel performing functions in addition to their risk management
duties, but the rule would not permit a member of the risk management
unit to report to any officer in the business trading unit for any non-
risk management activity. The Commission believes that such dual
reporting invites conflicts of interest and would violate the rule's
risk management unit independence requirement.
As requested by The Working Group, the Commission confirms that
independence of the risk management unit from the business trading unit
does not require physical separation.
The Commission notes that per the revised definition of ``senior
management'' discussed above, the risk management unit will not be
required to report to an officer that reports directly to the CEO, but
to ensure the independence of the risk management unit, the rule would
not permit the risk management unit and business trading unit to report
to a shared senior officer. The Commission also believes, however, that
reporting line independence is sufficient to ensure accountability for
the independence of the risk management unit, and, therefore, is not
requiring firewalls of the type required in Sec. 23.605 to ensure
research analysts are free from conflicts of interest, as proposed by
the Better Markets comment.
6. Risk Measurement Frequency--Sec. 23.600(c)(4)
Proposed Sec. 23.600(c)(4) required registrants to measure their
market, credit, liquidity, and foreign currency risk daily.
MetLife commented that the daily risk measuring required by the
proposed rule may be excessive for some MSPs, may require substantial
information technology and human capital investments, and recommended
that the frequency of risk measuring should be determined by an MSP's
risk management unit and governing body, rather than be mandated by the
Commission.
The Commission is adopting the rule as proposed. MSPs are, by
definition, market participants that have a substantial position in
swaps, and have outstanding swaps that create substantial counterparty
exposure that could have serious adverse effects on the financial
stability of the U.S. financial markets, or are highly leveraged.
Therefore, the Commission believes that it is entirely appropriate to
require such market participants to measure their market, credit,
liquidity, and foreign currency risk at least daily.
7. Approval of Exceptions to Risk Tolerance Limits--Sec.
23.600(c)(1)(i)
Proposed Sec. 23.600(c)(1)(i) required that risk tolerance limits
be approved by an SD's or MSP's senior management and governing body
and that exceptions to such limits be approved, at a minimum, by a
supervisor in the risk management unit.
SIFMA recommended that, subject to aggregate risk limits
established for the relevant trading supervisor's authority, trading
supervisors, rather than risk management personnel, should have the
authority to approve risk tolerance limit exceptions. SIFMA argued that
the required quarterly risk exposure reports provided to a registrant's
senior management and governing body are an adequate check on decision-
making by trading supervisors.
[[Page 20138]]
In response to SIFMA's comments, the Commission is revising
proposed Sec. 23.600(c)(1)(i) to remove the provision that requires
risk management personnel to approve exceptions to risk tolerance
limits. Instead, the Commission has determined that exceptions, along
with the risk tolerance limits, must be subject to written policies and
procedures. With this change, SDs and MSPs are free to grant discretion
to trading supervisors to approve risk tolerance limit exceptions
within the overall risk tolerance limits approved by the registrant's
senior management and governing body.
8. New Product Policy--Sec. 23.600(c)(3)
Proposed Sec. 23.600(c)(3) required SDs and MSPs to include a new
product policy in their risk management programs. The proposed
regulations required that such policies include an assessment of the
risks of any new product prior to engaging in transactions and
specifically required an assessment of potential counterparties; the
product's economic function; pricing methodologies; legal and
regulatory issues; market, credit, liquidity, foreign currency,
operational, and settlement risks; product risk characteristics; and
whether the product would alter the overall risk profile of the
registrant.
The Working Group recommended that the regulations require only
that (i) before an SD or MSP offers a new product, it must conduct due
diligence that is commensurate with the risks associated with such
product, and (ii) the decision to offer the product be approved by
appropriate risk management and business unit personnel. In addition,
the Working Group suggested that the Commission provide that the
determination as to whether a product is ``new'' should be left to the
SD or MSP.
SIFMA recommended that (i) the Commission clarify that a registrant
may structure its new product approval framework so as to focus on only
those risk elements that are deemed to be relevant to the product at
issue, rather than rigidly following the enumerated list in Sec.
23.600(c)(3); (ii) the Commission allow registrants to provide
contingent or limited preliminary approval of new products at a risk
level that would not be material to the registrant, in order to provide
registrants with the opportunity to obtain experience with the product
and to facilitate development of appropriate risk management processes
for such product; and (iii) the Commission harmonize its new product
policy rules with existing regulatory guidance in this area from
banking regulators, the SEC, and SROs.
In response to the commenters' suggestions, the Commission confirms
that the list of risks in Sec. 23.600(c)(3)(ii) only need be
considered if relevant to the new product, and the Commission is
modifying the first sentence of the proposed rule to include the phrase
``all relevant risks associated with the new product.''
In response to SIFMA's recommendation, the Commission also is
revising the proposed rule to permit SDs and MSPs to grant limited
preliminary approval of new products (i) at a risk level that would not
be material to the registrant, and (ii) solely for the purpose of
facilitating development of appropriate operational and risk management
processes for such product.
The Commission is not making any other changes to the rule as
proposed. The new product policy was adapted from existing banking and
SEC guidance in this area, and the Commission believes the rule as
proposed provides adequate guidance with respect to the factors to be
considered in determining whether a product is ``new'' and whether the
product presents new risks that should be addressed prior to engaging
in any transaction involving the new product.
9. Reporting of Risk Exposure Reports to the Commission--Sec.
23.600(c)(2)(ii)
Proposed Sec. 23.600(c)(2)(ii) required SDs and MSPs to provide
their senior management and governing body with quarterly Risk Exposure
Reports detailing the registrant's risk exposure and any
recommendations for changes to the risk management program, and copies
of these reports were required to be furnished to the Commission within
five business days of providing them to senior management.
The Working Group recommended that the Commission provide a
standard form of report for any report to be required under the
proposed rules, and to clarify what the governing body or senior
management is expected to do with information delivered under the
rules. The Working Group and Cargill also recommended that Risk
Exposure Reports should be required to be submitted to the Commission
only upon request so as not to drain Commission resources.
The Commission is not modifying the proposed rule to require SDs'
and MSPs' periodic Risk Exposure Reports to be submitted to the
Commission only upon request. As discussed below, the rule will require
SDs and MSPs to provide these reports to their senior management and
governing body no less than quarterly, thus the Commission believes
that also furnishing the reports to the Commission quarterly will not
be an additional burden.
In response to The Working Group, the Commission has determined not
to provide a standard, prescriptive form for the report; rather the
form of the report is left to the discretion of the registrant.
In response to The Working Group's request for clarification about
what management is supposed to do with Risk Exposure Reports, the
Commission believes these reports will serve important informational
purposes related to the key risks associated with the registrants'
swaps activities and help to ensure accountability at the highest
levels for those swap activities of registrants.
10. Reporting to Senior Management and/or Governing Body--Sec.
23.600(c)(2)(ii)
Proposed Sec. 23.600(c)(2)(ii) required SDs and MSPs to provide
their senior management and governing body with Risk Exposure Reports
detailing the registrant's risk exposure, and any recommendations for
changes to the risk management program, quarterly and upon any material
change in the risk exposure of the registrant.
The Working Group and Cargill each commented that Risk Exposure
Reports should be provided to senior management and governing body
annually. The Working Group argued that quarterly reporting would be
too costly and burdensome, would take resources away from risk
monitoring, and the frequency may force firms to disclose risk
exposures before remedial steps can be taken.
The Commission is adopting the rule as proposed. The Commission
does not believe that provision of Risk Exposure Reports to senior
management and the governing body of a registrant four times a year is
overly burdensome, but rather will provide management with the
information necessary to monitor and make adjustments to risk levels in
a timely manner.
11. Frequency of Review, Testing, and Audit--Sec. 23.600(e)
Proposed Sec. 23.600(e) required SDs and MSPs to review and test
their risk management programs quarterly using internal or external
auditors independent of the business trading unit.
The Working Group, Cargill, and MetLife each recommended that both
the frequency and the scope of audits of the risk management program be
left to the discretion of the registrant, so long
[[Page 20139]]
as such audits are effective and are conducted at least annually. The
Working Group and Cargill argued that this regime would provide the
desired results without the unnecessary cost and administrative burden
imposed by the proposed rules. The Working Group also recommended that
the Commission define or clarify what ``testing'' of the Risk
Management Program requires.
Having considered these comments, the Commission is modifying
proposed Sec. 23.600(e) to require only annual testing and audit of an
SD's or MSP's Risk Management Program. The Commission has determined
not to specify testing procedures at this time, but to leave the design
and implementation of testing procedures to the reasonable judgment of
each registrant.
12. Risk Categories--Sec. 23.600(c)(4)
As proposed, Sec. 23.600(c)(4) required SD and MSP risk management
programs to include, at a minimum, certain enumerated elements,
including policies and procedures to monitor and manage market risk,
credit risk, liquidity risk, foreign currency risk, legal risk, and
operational risk.
SIFMA recommended that the Commission clarify that so long as the
enumerated risks in Sec. 23.600(c)(4) are systematically monitored and
managed, the Commission does not intend to require that each enumerated
risk be subject to distinct risk management processes.
While the rule requires that each enumerated risk must be the
subject of distinct risk management policies and procedures, Commission
does not intend to mandate specific risk management processes. The
specific methods of monitoring and managing all risks associated with
the swaps activities of an SD or MSP are left to the discretion of the
registrant.
13. Market Risk--Sec. 23.600(c)(4)(i)
Proposed Sec. 23.600(c)(4)(i) required SDs and MSPs to measure
their market risk daily, including exposure due to unique product
characteristics, volatility of prices, basis and correlation risks,
leverage, sensitivity of option positions, and position concentration.
The proposed rule would require that if valuation data is derived from
pricing models, that such models be validated by qualified, independent
persons.
The Working Group recommended that metrics for options,
particularly the sensitivity for options, be required to be measured on
a frequency less than daily, as metrics can require complex
calculations, some of which must be done outside the trading or risk
management system. The Working Group also recommended that the
Commission clarify that models may be verified by independent, but
internal, qualified persons.
In response to The Working Group's comments, the Commission
clarifies that, to the extent that an input for measurement of market
risk has a reasonable degree of accuracy over a period longer than one
day, it would be permissible for a registrant's risk management
policies to reflect the conclusion that such an input would not need to
be calculated daily for purposes of the daily measurement of a
registrant's market risk. The Commission also is modifying the proposed
rule to clarify that pricing models may be verified by qualified,
independent internal persons.
14. General Ledger Reconciliation--Sec. 23.600(c)(4)(i)(C)
The proposed regulations required SDs and MSPs to reconcile profits
and losses resulting from valuations with the general ledger at least
once each business day.
The Working Group commented that, to the extent that transaction
valuations are tracked daily, they ordinarily would be tracked in the
firm's trading or risk management system, not the general ledger
system. The Working Group recommended that consolidation to the general
ledger only be required monthly.
Having considered these comments, the Commission has determined
that the rule need not require daily reconciliation to the general
ledger in order to address the need to manage the risk of a failure to
account properly for profits and losses. The Commission therefore is
revising the proposed rule to require only that SDs and MSPs have
policies and procedures to ensure ``periodic reconciliation of profits
and losses resulting from valuations with the general ledger.''
15. Establishment of Credit Limits Prior to Trading--Sec. 23.600(d)(2)
Proposed Sec. 23.600(d)(2) required that SDs and MSPs have
policies and procedures requiring traders to transact only with
counterparties for whom credit limits have been established.
The Working Group recommended that the Commission allow discretion
to make exceptions to the requirement that trades only be executed with
counterparties for which credit limits have been established for
certain limited risk transactions. Arguing that some transactions carry
no counterparty credit risk and that some SDs and MSPs may hedge their
counterparty credit risk, SIFMA recommended that, instead of requiring
establishment of credit limits prior to trading, the Commission require
only that a credit risk evaluation be made prior to trading.
The Commission is adopting the rule as proposed. The Commission
observes that the rule does not define ``credit limit'' and thus
provides sufficient discretion to SDs and MSPs to implement policies
addressing limited counterparty credit risk transactions.
16. Credit Risk Measurement--Sec. 23.600(c)(4)(ii)(A)
Proposed Sec. 23.600(c)(4)(ii)(A) required SDs and MSPs to have
credit risk policies and procedures providing for daily measurement of
overall credit exposure to ensure compliance with counterparty credit
limits.
Better Markets argued that the Commission's proposal for rules
relating to credit risk are inadequate insofar as they do not provide
guidance on how credit risk is to be measured. Better Markets
recommended that the Commission's rules relating to management of
credit risk require measurement of credit risk using the same
techniques employed by derivatives clearing organizations (DCOs)
registered with the Commission. Better Markets also specifically
recommended that the Commission require credit risk policies of SDs and
MSPs to address (i) the risk posed by collateral triggers (like credit
rating downgrades) that may require immediate funding under stressful
circumstances, and (ii) the credit risk of futures commission merchants
(FCMs) acting for the SD or MSP as its clearing member.
Having considered Better Market's comments, the Commission is
adopting the rule as proposed. The Commission believes it need not
specify a credit risk measurement methodology because the adequacy of a
registrant's individual credit risk measurement methodology will be
assessed upon a review of a registrant's policies and procedures during
registration or upon examination. The Commission also believes that
credit risk to FCMs would be covered by the required monitoring and
risk management of clearing members by DCOs and the Commission.
17. Liquidity Risk--Sec. 23.600(c)(4)(iii)(B)
The proposed rules required SDs and MSPs to test their procedures
for liquidating all non-cash collateral in a timely manner and without
significant effect on price.
SIFMA argued that firms assess the types of collateral that they
are willing to accept based on the risk, volatility,
[[Page 20140]]
liquidity, and other characteristics of the collateral and additionally
establish conservative haircuts for the valuation of collateral, not
through testing by actual or simulated disposition of collateral. SIFMA
therefore recommended that the Commission not require testing of
liquidation procedures by simulated disposition, but only require
policies and procedures for identifying acceptable collateral and
establishing appropriate haircuts, taking into account reasonably
anticipatable adverse price movements.
The proposed rule was not intended to impose a requirement that
registrants test collateral liquidation procedures by means of actual
or simulated disposition. However, to clarify this matter, the
Commission is revising the proposed rule to require policies and
procedures that ``assess'' rather than ``test'' procedures to liquidate
all non-cash collateral in a timely manner without significant effect
on price.
18. Foreign Currency Risk--Sec. 23.600(c)(4)(iv)
Proposed Sec. 23.600(c)(4) required SDs and MSPs to measure the
amount of capital exposed to fluctuations in the value of foreign
currency daily.
The Working Group recommended that the Commission permit the
frequency of measurement of capital exposed to fluctuations in the
value of foreign currency to be left to the discretion of the firm,
rather than mandating daily measurement.
The Commission believes that the foreign exchange markets are fluid
and quick moving, and, therefore, the requirement for daily measurement
is not excessive. Accordingly, the Commission is adopting the rule as
proposed with respect to foreign currency risk.
19. Legal Risk--Sec. 23.600(c)(4)(v)
Proposed Sec. 23.600(c)(4)(v) required SDs' and MSPs' risk
management policies and procedures to address determinations that
transactions and netting arrangements entered into by the registrant
have a sound legal basis and documentation tracking to ensure
completeness of transaction documentation.
SIFMA recommended that the Commission require only policies and
procedures to identify and evaluate the legal risks arising in
connection with the registrant's business.
The Commission is making no changes to the rule as proposed. The
Commission believes that the two enumerated requirements with respect
to legal risk are of special importance with respect to trade
processing and risk measurement, but are by no means exhaustive of the
legal risks arising in connection with a registrant's business, all of
which must be identified by the registrant's risk management policies
and procedures.
20. Operational Risk--Sec. 23.600(c)(4)(vi)
Proposed Sec. 23.600(c)(4)(vi) required SDs and MSPs to establish
policies and procedures for managing operational risks, including
procedures accounting for reconciliation of all operating and
information systems.
The Working Group and SIFMA recommended that the Commission clarify
what is meant by ``reconciliation of operating and information
systems,'' as information contained in systems may be reconciled, but
systems themselves may not be.
Chris Barnard recommended that the proposed rule be expanded and be
more specific about the types of operational risk to be monitored and
controlled, arguing that operational risk failures effectively allow
other types of risk, such as credit risk and market risk to be
excessive. Mr. Barnard also recommended that the proposed rule be
expanded to require management for the increased risks inherent in
using programs or models from external providers or vendors to avoid
using ``black boxes'' without controls and review.
The Commission agrees with commenters that data within operating
and information systems should be reconciled, rather than the systems
themselves. Consequently, the Commission is modifying the proposed rule
to refer to reconciliation of data within operating and information
systems. As modified, the Commission believes that the rule is
sufficiently specific to enable SDs and MSPs to establish policies and
procedures for adequately managing operational risks, and as such, the
Commission is making no changes to the rule based on Mr. Barnard's
comments. Nonetheless, the Commission notes that Mr. Barnard's concern
about black boxes is addressed, in part, by the requirement to have
policies and procedures governing the use and supervision of trading
programs under proposed Sec. 23.600(d)(9), as discussed further below.
21. Use of Central Counterparties--Sec. 23.600(c)(5)
Proposed Sec. 23.600(c)(5) required SDs and MSPs to establish
policies and procedures related to central clearing of swaps, including
policies that require the use of clearing when a swap is subject to a
mandatory clearing determination issued by the Commission, policies
setting forth conditions for the voluntary use of central clearing as a
means of mitigating counterparty credit risk, and policies requiring
diligent investigation into the adequacy of financial resources and
risk management procedures of any central counterparty through which
the registrant clears.
The Working Group argued that the adequacy of resources and risk
management at CCPs registered with the Commission should be monitored
by the Commission, not individual firms. EEI requested that the
Commission clarify that proposed Sec. 23.600(c)(5) is not seeking to
require SDs to use central clearing to mitigate risk if clearing is not
required under a valid exemption.
The Commission is adopting the rule regarding use of central
counterparties as proposed. The Commission's registration of a central
counterparty as a DCO is based on a determination that the applicant
meets core principles under the Commodity Exchange Act and Commission
regulations. It does not, however, serve as a substitute for the due
diligence of registrants who must evaluate the use of a central
counterparty in light of their own circumstances. In addition, SDs and
MSPs may elect to clear swaps that are not required to be cleared on a
voluntary basis through central counterparties that are not registered
with the Commission. In those instances, an SD or MSP engaging in some
manner of due diligence prior to submitting a swap for clearing would
be part of a prudent risk management program. In response to EEI's
comment, the Commission observes that the rule would require only that
registrants evaluate the use of central clearing as a means of
mitigating counterparty credit risk and as part of their overall risk
management strategy. Moreover, the rule expressly notes the exception
from mandatory clearing that is provided for under section 2(h)(7) of
the CEA.
22. Business Trading Unit--Sec. 23.600(d)
As proposed, Sec. 23.600(d) required SDs and MSPs to establish
policies and procedures that require all trading policies to be
approved by the governing body of the registrant.
The Working Group recommended that the governing body of an SD or
MSP be permitted to delegate approval of trading policies to those with
expertise.
The revisions to the definition of governing body discussed above,
which allows for a governing body to consist of a committee or the CEO,
sufficiently address the Working Group's concerns.
[[Page 20141]]
The Commission thus has made no changes to the rule.
23. Transaction Entry by Traders--Sec. 23.600(d)(5)
Proposed Sec. 23.600(d)(5) required SDs and MSPs to establish
policies and procedures that require each trader to follow established
policies and procedures for executing and confirming all transactions.
Further, in a discussion about the independence of the risk management
unit in the preamble to the proposal, the Commission stated that
``personnel responsible for recording transactions in the books of the
swap dealer or major swap participant cannot be the same as those
responsible for executing transactions.''
The Working Group requested clarification about requirements for
transaction entry based on the statements made in the preamble to the
proposal. The Working Group argued that if the reference to recording
transactions in the books of a firm is intended to refer to entries
into the general ledger system, then the Working Group agreed that this
process should be subject to the usual segregation of duties
requirements that protect the general ledger system, but that there is
no reasonable basis to prohibit individuals who execute transactions
from entering the information regarding such transactions into a firm's
trading or risk management system.
BGA commented that typical practice is for traders to enter the
trade into the deal monitoring system, and then the risk control group
performs a daily review of all new and amended trading activity. BGA
explained that the mid-office risk control review is followed by a
second review of the trade activity performed by the back-office
confirmations group, which generates confirmations and performs
portfolio reconciliations to match key trade attributes with
counterparties. BGA requested clarification that the reference to
``recording transactions in the books'' in the proposal preamble is not
intended to restrict the initial recording of the trade into the deal
capture system by the trader, but refers to the daily review and
confirmation and portfolio reconciliation processes performed by the
mid and back offices.
SIFMA requested that the Commission confirm that compliance with
the rule would not preclude trading personnel from entering the trades
they execute into a registrant's trade capture system, provided that
the registrant has appropriate policies and procedures reasonably
designed to identify the entry of fictitious trades or the failure to
accurately enter actual trades.
In response to these comments, the Commission confirms that the
rule is not intended to restrict the initial recording of trades into a
trade capture system by the trader. Rather, the rule requires traders
to follow established policies and procedures governing trade execution
and confirmation.
24. Monitoring of Trading--Sec. 23.600(d)(4) & (d)(9)
As proposed, Sec. 23.600(d)(4) required SDs and MSPs to establish
policies and procedures designed to monitor each trader throughout the
trading day to prevent the trader from exceeding any limit to which the
trader is subject, or from otherwise incurring undue risk. The proposed
regulations also require registrants to ensure that trade discrepancies
are brought to the immediate attention of senior management and are
documented.
The Working Group, with respect to internal limits, recommended
that daily monitoring should be at the product desk level, not the
trader level, as market practice is to set internal limits at the desk
level. Also, the Working Group and SIFMA requested that the Commission
clarify that ``monitor each trader throughout the trading day'' does
not mean continuous monitoring, and recommended that the Commission
remove the requirement that firms monitor traders to prevent traders
from ``incurring undue risk'' because the meaning of the phrase is
ambiguous. The Working Group also recommended that the Commission
define ``trade discrepancies'' and add a materiality standard to the
escalation requirement.
MetLife commented that intraday monitoring of traders may be
excessive for some MSPs, especially MSPs that use swaps only for
hedging purposes. MetLife recommended that the Commission allow the
type of monitoring and its frequency to be determined by an MSP's risk
management unit and governing body.
Having considered these comments, the Commission is revising the
proposed rule to require monitoring be performed to prevent the
incurrence of ``unauthorized risk'' rather than ``undue risk.'' The
Commission believes this formulation better reflects the intent of the
rule, which is to ensure that SDs and MSPs have instituted safeguards
against the risk of losses to the firm due to rogue trading.
In response to The Working Group's comment requesting a definition
of ``trade discrepancies,'' the Commission notes that the term ``trade
discrepancies'' is intended to refer to any discrepancies between the
SD or MSP and its counterparties and to any discrepancies in records or
systems of the SD or MSP. Also in response to The Working Group's
recommendation that the proposed rule be modified to add a materiality
standard for reporting of trade discrepancies to management, the
Commission is modifying the rule to require that only trade
discrepancies that are not immaterial, clerical errors be brought to
the immediate attention of management of the business trading unit. The
rule continues to require that all trade discrepancies be documented.
The Commission has made no other changes to the rule based on the
comments received. The Commission believes that prudent risk management
requires intraday monitoring of traders to detect prohibited activity
that may be otherwise undetectable. The Commission notes that the rule
requires monitoring of traders to prevent traders from ``exceeding any
limit to which the trader is subject'' but does not specify the types
of limits to be monitored. Thus, the Commission observes that the
setting of limits requiring intraday monitoring is left to the
discretion of each SD and MSP.
In addition, the Commission is finalizing the requirement that SDs
and MSPs have policies and procedures governing the use and supervision
of trading programs under proposed Sec. 23.600(d)(9), but deleting the
term ``algorithmic'' from the rule text. This rule is an important
measure for ensuring that SDs and MSPs monitor their trading
activities. In addition to the risk management requirements under this
rule, the Commission notes that the use of trading programs would be
subject to, among other things, any applicable prohibitions on
disruptive trading practices under the CEA and Commission regulations.
The Commission also anticipates addressing the related issues of
testing and supervision of electronic trading systems and mitigation of
the risks posed by high frequency trading.
25. Brokers--Sec. 23.600(d)(8)
Proposed Sec. 23.600(d)(8) required SDs and MSPs to establish
policies and procedures to ensure that the risk management unit reviews
broker's statements, reconciles brokers' charges to estimates, reviews
and monitors broker's commissions, and initiates payment to brokers.
The Working Group, SIFMA, and MetLife each recommended that the
risk management unit not be tasked with reviewing brokers' statements,
monitoring commissions or initiating broker payments, as these
functions are
[[Page 20142]]
currently handled by operations or other control units.
The Commission agrees with commenters that review of brokers'
statements, monitoring commissions or initiating broker payments need
not be performed by risk management personnel. The Commission is
revising the proposed rule to replace this requirement with a
requirement that risk management policies and procedures include
periodic audit of broker's statements and payments by persons
independent of the business trading unit. This change provides the
relief requested by commenters while maintaining the requirement that
risks connected to the use of brokers are adequately monitored and
managed.
H. Monitoring of Position Limits--Sec. 23.601
To implement section 4s(j)(1) of the CEA, the Commission proposed
Sec. 23.601 in the Duties NPRM, which required SDs and MSPs to
establish policies and procedures to monitor, detect, and prevent
violations of applicable position limits established by the Commission,
a designated contract market (DCM), or a swap execution facility (SEF),
and to monitor for and prevent improper reliance upon any exemptions or
exclusions from such position limits. Proposed Sec. 23.601 also
required SDs and MSPs to: (i) Convert all swap positions into
equivalent futures positions using the methodology set forth in
Commission regulations; (ii) provide training to all relevant personnel
on applicable position limits on an annual basis and promptly upon any
change to applicable position limits; (iii) test its procedure for
monitoring and preventing position limit violations for adequacy and
effectiveness each month; (iv) audit its position limit procedures
annually; (v) implement an early warning system designed to alert
senior management when position limits are in danger of being breached;
and (vi) report any detected violation of applicable position limits to
the registrant's governing body and to the Commission. Only four market
participants and trade groups provided comments on the Commission's
proposal.
1. Monitoring for Violations of Position Limits--Sec. 23.601(a)
The Working Group argued that it is not possible to determine
whether transactions that individual traders enter into violate
position limits without placing the transactions in the context of an
entire portfolio and any relevant hedge exemptions. The Working Group
requested clarification that the requirement for intraday monitoring of
traders under proposed Sec. 23.600(d)(4) does not require monitoring
of individual traders for violations of position limits, and that
monitoring for violations of position limits is only required in the
context of aggregate swaps and futures portfolios.
The Commission believes that The Working Group's request for
clarification is outside the scope of these rules. The level at which
monitoring for violations of position limits will be required is
subject to the final position limit rules,\20\ and the Commission
directs SDs and MSPs to review new Sec. 151.7 of the final position
limit rules for guidance when establishing the Position Limit
Procedures required by this rule.
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\20\ See 17 CFR 151.7, Position Limits for Futures and Swaps, 76
FR 71626, 71692 (Nov. 18, 2011) (adopting 17 CFR 151.7 pertaining to
the aggregation of positions).
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BGA expressed concern about the requirement that an SD or MSP
``prevent violations'' of position limits established by the
Commission. BGA argued that despite having a robust compliance program,
it is impossible for an SD or MSP to ``prevent violations'' because a
company cannot before-the-fact prevent a trader from entering a deal
that causes a position limit violation. Thus, BGA recommended that the
Commission clarify that as long as an SD or MSP provides training on
the position limits and establishes and enforces policies for
monitoring, detecting, and curing violations, they will have met the
obligation to ``prevent violations.''
The Commission agrees with BGA that SDs and MSPs should be held to
a standard of reasonableness in regard to efforts to prevent violations
of position limits. The Commission therefore is revising the proposed
rule to state that ``[e]ach swap dealer and major swap participant
shall establish and enforce written policies and procedures that are
reasonably designed to monitor for and prevent violations of applicable
position limits * * *'' (modification to rule text in italics).
2. Training on Applicable Position Limits--Sec. 23.601(c)
SIFMA recommended that the Commission revise Sec. 23.601(c) to
provide that a change in position limit levels will not trigger
``training,'' but only require effective notification. The Commission
agrees with SIFMA's view and is revising the proposed rule accordingly.
3. Diligent Monitoring and Diligent Supervision To Ensure Compliance--
Sec. 23.601(d)
SIFMA recommended that the Commission clarify that monitoring for
compliance with position limits need not be performed by risk
management personnel, but may be performed by independent compliance,
operations, or supervisory personnel.
The rule does not require that position limit monitoring be
performed by risk management personnel, nor was such a requirement
intended. The Commission confirms that monitoring procedures may be
conducted at the discretion of the SD or MSP.
4. Reporting Violations to the Governing Body and the Commission--Sec.
23.601(e)
The Working Group and MetLife doubted the utility of alerting the
governing body of nonmaterial violations of position limits as required
under proposed Sec. 23.601(e), and recommended that the Commission
require alerting the governing body only when a violation is material
and allow registrants to define escalation procedures based on
materiality in their Position Limit Procedures.
The Commission does not believe that reporting of position limit
violations to the governing body of the registrant should be subject to
a materiality standard and is adopting the rule as proposed. The
Commission intends the reporting rule to ensure accountability for
compliance with position limits at the highest levels of management and
believes applying a materiality standard to such reporting would
undermine the intention of the rule and introduce unnecessary
complication for registrants trying to determine how much of a breach
would amount to a material breach. However, the Commission observes
that a registrant's governing body could take into account the
magnitude of the breach and other facts and circumstances in
remediating its monitoring program. For instance, a governing body
would respond differently to small, inadvertent breaches that are
promptly corrected than larger, repeated violations.
With respect to reporting of position limit violations to the
Commission, The Working Group argued that the reporting of on-exchange
violations of position limits to the Commission is already done by DCMs
and will likely be the responsibility of SEFs as well, so SDs and MSPs
should not be required to report on-exchange violations to avoid
inundating the Commission with redundant information. The Working Group
conceded, however, that if
[[Page 20143]]
position limit rules require the aggregation of exchange-traded swaps
and over-the-counter swaps, then SDs and MSPs should be required to
report position limit violations that occur because of over-the-counter
swaps, but recommended that such reporting requirement be subject to a
materiality standard.
The Commission agrees that on-exchange position limit violations
need not be reported to the Commission by registrants, as they will be
reported by DCMs or SEFs and has modified the final rule accordingly.
5. Testing and Audit of Position Limit Procedures--Sec. 23.601(f) and
(h)
With respect to monthly testing of Position Limit Procedures
required under proposed Sec. 23.601(f) and annual audit required under
proposed Sec. 23.601(h), SIFMA recommended that testing and audit of
Position Limit Procedures be required only annually and not be required
to be done all at the same time, The Working Group recommended that
testing only be required on a semi-annual basis (or on a more frequent
basis as the firm might determine to be effective), and MetLife
requested that the Commission permit the frequency of testing to be
determined by an MSP based on the extent of its swap activities.
MetLife also recommended that there be a clear exemption from testing
requirements for MSPs that do not trade in swaps for which position
limits have been established. SIFMA requested that the Commission
clarify that testing should consist of testing for accurate capture of
all relevant desk positions by position reporting systems and that
Sec. 23.601(h) be revised to allow for ``agreed upon procedures'' for
external auditors.
Having considered these comments, the Commission has determined
that monthly testing of Position Limit Procedures by registrants may be
unduly burdensome, but believes that only annual or semi-annual testing
would be inadequate as such could allow violations to remain undetected
for long periods. The Commission therefore is modifying the proposed
rule to require quarterly testing, and, in response to the comment of
MetLife, only if the registrant trades in swaps for which position
limits have been established. The annual audit requirement is being
adopted as proposed. In response to the request of SIFMA, the
Commission confirms that testing of Position Limit Procedures is
expected to entail testing of the accuracy of capture of all relevant
desk positions by position reporting systems.
6. Quarterly Reporting of Compliance With Position Limits--Sec.
23.601(g)
With respect to quarterly reporting of compliance with position
limits to the chief compliance officer, senior management, and
governing body under proposed Sec. 23.601(g), The Working Group
recommended that the proposed rule should be revised to require only
annual reports to the entity's senior management and governing body.
As stated above, the Commission intends the reporting rule to
ensure accountability for compliance with applicable position limits at
the highest levels of management. The Commission believes that the
burden of quarterly reporting is outweighed by the benefit of timely
notification to decision makers within the SD and MSP of the entity's
record of compliance with applicable position limits, thus providing a
timely opportunity to adjust or revise Position Limit Procedures to
prevent future violations, if necessary.
I. Diligent Supervision--Sec. 23.602
Proposed Sec. 23.602 was intended to implement section 4s(h)(1)(B)
of the CEA, which requires each SD and MSP to conform with Commission
regulations related to diligent supervision of the business of the SD
and MSP. The proposed regulations required SDs and MSPs to establish a
system to supervise all activities relating to its business performed
by its partners, members, officers, employees, and agents, that such
system be reasonably designed to achieve compliance with the CEA and
Commission regulations, that such system designate a person with
authority to carry out the supervisory responsibilities of the SD or
MSP, and that all such supervisors meet qualification standards that
the Commission finds necessary or appropriate.
The Working Group recommended that the Commission not require
designation of a single individual with responsibility for supervision,
but should allow for designation of a reporting line and that
designated supervisors should be permitted to delegate supervisory
authority. The Working Group also recommended that SDs and MSPs be
given discretion to determine supervisor qualifications, rather than
meet ``qualification standards as the Commission finds necessary or
appropriate.''
MFA recommended that the Commission clarify that the rules do not
impose any new (a) fiduciary obligations or duties (i.e., duties beyond
those to which participants in the futures and derivatives markets
would otherwise be subject to by agreement or by operation of common
law), or (b) supervisory duties on market participants. MFA argued that
proposed Sec. 23.602 (Diligent Supervision) is similar to the NFA's
supervision rule for FCMs (Compliance Rule 2-9), and MFA is concerned
that Sec. 23.602 may impose fiduciary and supervisory obligations on
registrants similar to those that the NFA imposes on FCMs with respect
to third parties.
In response to The Working Group's first comment, the Commission is
revising the proposed rule to require ``at least one person'' rather
than ``a person'' be designated with authority to carry out supervisory
responsibilities, which should permit SDs and MSPs more flexibility in
designing and implementing the required supervisory system. With
respect to the remaining comments of The Working Group, the Commission
believes that full accountability for compliance with the CEA and
Commission regulations is best served by requiring designation of
individuals with supervisory responsibility and that reporting line
responsibility is not adequate.
With respect to MFA's comments, the Commission observes that the
rule relates generally to the supervision necessary to achieve
compliance with the CEA and Commission regulations by the registrant.
Many of the specific activities to be supervised are subject to the CEA
and other Commission rules that are outside the scope of this
rulemaking. The Commission does not intend that Sec. 23.602 impose a
fiduciary duty on SDs or MSPs beyond that which would otherwise exist.
Other than the foregoing, the Commission has adopted the rule as
proposed.
J. Business Continuity and Disaster Recovery--Sec. 23.603
Proposed Sec. 23.603 required SDs and MSPs to establish a business
continuity and disaster recovery plan that includes procedures for and
the maintenance of back-up facilities, systems, infrastructure,
personnel, and other resources to achieve the timely recovery of data
and documentation and to resume operations generally within the next
business day. The proposed regulations also required SDs and MSPs to
have their business continuity and disaster recovery plan tested
annually by qualified, independent internal audit personnel or a
qualified third party audit service.
Tellefsen and Company, L.L.C. (Tellefsen) commented that most, if
not all, of potential SDs have the technology and network
infrastructure in place to
[[Page 20144]]
achieve a next day recovery time objective. However, Tellefsen
recommended that the Commission carefully evaluate the business
continuity management capabilities of MSPs before establishing a hard
date by which these metrics must be in place, as the Commission may
have greatly underestimated the time and scope of work for firms to
develop, implement and test their business continuity management
capabilities (Tellefsen estimates 68-200 person days). The Working
Group also argued that the Commission should not require next business
day recovery for non-systemically important SDs or MSPs, but should
only require recovery ``reasonably promptly.''
The Working Group argued that the Commission should not require
staffing of back-up facilities to avoid the burden of requiring two
persons for the same job. The Working Group also recommended that the
Commission should not require annual testing of the business continuity
and disaster recovery plan by independent auditors because independent
audits would be too costly.
SIFMA recommended that the Commission clarify that an SD's or MSP's
business continuity and disaster recovery plan may be part of a
consolidated plan established for the various entities in a holding
company group if they share common personnel, premises, resources,
systems, and infrastructure. SIFMA also recommended that the Commission
permit SDs and MSPs subject to the business continuity and disaster
recovery requirements of a prudential regulator, or other regulator
determined to be comparable by the Commission, to comply with Sec.
23.603 on a substituted compliance basis.
The Commission believes that Tellefsen's concerns regarding the
ability of MSPs to comply with the required recovery period will be
addressed through the phased implementation of the rule, discussed
below.
In response to The Working Group's comment regarding staffing of
back-up facilities, the Commission is modifying the proposed rule to
clarify that, so long as prompt recovery is reasonably ensured, SDs and
MSPs may provide for alternative staffing of back-up facilities as
required under the circumstances. The Commission also agrees with the
Working Group that annual testing may be performed by qualified
internal personnel and is modifying the proposed rule accordingly.
However, the Commission believes that independent audits are required
to ensure that business continuity and disaster recovery plans remain
in compliance with the rule, but that annual audits would be
unnecessary and unduly burdensome and costly. Therefore, the Commission
is revising the proposed rule to require independent audits only every
three years.
The Commission believes that all SDs and MSPs may be critically
important to the proper functioning of the swaps market. SDs are
critical participants in the swap market and MSPs may, by definition,
have exposures that could have serious adverse effects on the financial
stability of the United States. Therefore, the Commission continues to
believe that a one business day recovery period is the necessary
objective for SDs' and MSPs' business continuity and disaster recovery
plans. Accordingly, the Commission is not modifying the final rule in
this respect.
In response to SIFMA's comments, the Commission confirms that so
long as a consolidated business continuity and disaster recovery plan
established for the various entities in a holding company group that
includes an SD or MSP, or any such plan that is required by a
prudential regulator of the SD or MSP, meets the requirements of the
rule, such SD or MSP would be in compliance with the Commission's rule.
The Commission believes that this result is contemplated by the rule as
proposed and so is not modifying the rule in this respect.
K. General Information: Availability for Disclosure and Inspection--
Sec. 23.606
Proposed Sec. 23.606 required SDs and MSPs to make available for
disclosure and inspection by the Commission and the SD's or MSP's
prudential regulator, all information required by, or related to, the
CEA and Commission regulations.
The Working Group recommended that the Commission clarify what is
meant by ``available for disclosure'' if such is different from
``available for inspection.'' The Working Group also argued that SDs
and MSPs should not be required to revise information systems to store
information specifically required by each Commission rule, because
storage would require extensive investigation that is unnecessary to
ensure compliance with the rule.
Having considered The Working Group's comments, the Commission is
adopting the rule as proposed. The Commission does not believe the rule
specifies or requires any particular storage medium or methodology, but
rather only requires SDs and MSPs to have information systems capable
of producing the required information promptly. The Commission also has
determined not to define further ``available for disclosure'' or
``available for inspection'' because it believes these terms as
employed in the rule have their plain meanings.
L. Antitrust Considerations--Sec. 23.607
Proposed Sec. 23.607 prohibited SDs and MSPs from adopting any
process or taking any action that results in any unreasonable restraint
of trade or imposes any material anticompetitive burden on trading or
clearing, unless necessary or appropriate to achieve the purposes of
the CEA. The proposed rule also required SDs and MSPs to adopt policies
and procedures to prevent such actions.
SIFMA agreed with the Commission's proposed policies and procedures
approach. SIFMA argued however that Sec. 23.607(a) goes further, by
imposing a blanket prohibition on a registrant adopting any process or
taking any action that results in any unreasonable restraint of trade,
or imposes any material anticompetitive burden on trading or clearing
(unless necessary or appropriate to achieve the purposes of the CEA).
SIFMA expressed concern that, given the counterparty rescission and
private right of action provisions of the CEA, this prohibition could
introduce additional private liability that is unnecessary in light of
the enforcement authority of the Commission and antitrust authorities
and existing private rights of action under the antitrust laws. SIFMA
therefore recommended that the Commission delete Sec. 23.607(a) and
instead rely upon the policies and procedures requirement included in
Sec. 23.607(b).
Having considered SIFMA's comments, the Commission is adopting the
rule as proposed. The blanket prohibition in Sec. 23.607(a) is taken
directly from the statutory provision and appropriately implements the
prohibition in section 4s(j)(6) of the CEA.
M. Conflicts of Interest Policies and Procedures by SDs, MSPs, FCMs,
and IBs--Sec. 23.605, Sec. 1.71
As discussed above, section 4s(j) of the CEA, as added by section
731 of the Dodd-Frank Act, sets forth certain duties for SDs and MSPs,
including the duty to implement conflict-of-interest systems and
procedures. Specifically, section 4s(j)(5) mandates that SDs and MSPs
implement conflict-of-interest systems and procedures that ``establish
structural and institutional safeguards to ensure that the activities
of any person
[[Page 20145]]
within the firm relating to research or analysis of the price or market
for any commodity or swap or acting in a role of providing clearing
activities or making determinations as to accepting clearing customers
are separated by appropriate informational partitions within the firm
from the review, pressure, or oversight of persons whose involvement in
pricing, trading, or clearing activities might potentially bias their
judgment or supervision and contravene the core principles of open
access and the business conduct standards described in this Act.''
Section 4s(j)(5) further requires that such systems and procedures
``address such other issues as the Commission determines to be
appropriate.'' Proposed Sec. 23.605, as set forth in the SD/MSP
Conflicts NPRM, addressed the statutory mandate of section 4s(j)(5).
In relevant part, section 732 of the Dodd-Frank Act amended section
4d of the CEA by creating a new subsection (c), which mandates that the
Commission ``require that futures commission merchants and introducing
brokers implement conflict-of-interest systems and procedures.'' New
section 4d(c) mandates that such systems and procedures ``establish
structural and institutional safeguards to ensure that the activities
of any person within the firm relating to research or analysis of the
price or market for any commodity are separated by appropriate
informational partitions within the firm from the review, pressure, or
oversight of persons whose involvement in trading or clearing
activities might potentially bias the judgment or supervision of the
persons.'' New section 4d(c) further requires that such systems and
procedures ``address such other issues as the Commission determines to
be appropriate.'' Proposed Sec. 1.71, as set forth in the FCM/IB
Conflicts NPRM, addressed the statutory mandate of section 4d(c).
As proposed, Sec. Sec. 23.605 and 1.71 were identical in all
material respects. The Commission received 29 comment letters to the
SD/MSP Conflicts NPRM and 26 comment letters to the FCM/IB Conflicts
NPRM. Many commenters provided comments addressing identical provisions
or issues in both proposed rules. The discussion below thus addresses
comments to both proposed rules unless otherwise indicated.
1. Compliance Oversight by Self-Regulatory Organizations (SROs)
Although proposed Sec. Sec. 23.605 and 1.71 prescribed the
implementation of conflict-of-interest policies and procedures by SDs,
MSPs, FCMs, and IBs, the proposal did not address compliance oversight
by SROs. Nonetheless, the Commission received comments on whether the
conflict-of-interest policies and procedures mandated under sections
4s(j)(5) and 4d(c) of the CEA should be prescribed by the Commission or
by an SRO.
The Futures Industry Association (FIA), ISDA, and SIFMA, in a joint
comment, argued that an SRO should oversee and enforce the conflict-of-
interest requirements on SDs, MSPs, FCMs, and IBs. FIA, ISDA, and SIFMA
stated that SROs would be in a better position than the Commission to
address the likely need for future amendments to the rule. The comment
suggested that the Commission establish a framework governing the
implementation of conflict-of-interest policies and procedures, and
instruct the appropriate SRO to write detailed compliance requirements
within that framework, including the execution of audit and compliance
functions, and the issuance of specific guidance that would be subject
to the Commission's review and approval. In a separate comment, JP
Morgan expressed a general agreement with the points raised in the FIA/
ISDA/SIFMA letter.
Michael Greenberger and UNITE HERE commented that the monitoring
and enforcement of the implementation of conflict-of-interest policies
and procedures for SDs and MSPs should be carried out by the
Commission, as opposed to SROs.
Having considered the comments, the Commission is adopting the rule
as proposed on this issue. Unlike section 15D of the Securities
Exchange Act of 1934, which mandated that conflict-of-interest rules be
adopted either by the SEC, or by a registered securities association or
national securities exchange, sections 4s(j)(5) and 4d(c) of the CEA as
added by sections 731 and 732 of the Dodd-Frank Act, respectively,
direct the CFTC to promulgate such rules. The Commission will continue
to collaborate with SROs on conflict-of-interest policies and
procedures, particularly with respect to their effectiveness.
2. Exemptive Relief
The Commission's proposal in the FCM/IB NPRM did not expressly
address issues surrounding the Commission's exemptive authority.
Nonetheless, the Committee on Futures and Derivatives Regulation of the
New York City Bar Association argued that, due to the unprecedented
scope and breadth of the Commission's rulemakings, the Commission will
encounter situations it had not previously considered, rules that do
not operate in the manner intended, or unintended consequences when the
rules are applied in a specific context. In such situations, exemptive
relief would be appropriate and the Commission should prepare for such
situations by providing Commission staff with the authority to grant
exemptive relief in each rule. Having considered the comment, the
Commission does not believe it appropriate to address exemptive relief
in this rule. Rather, any person may submit a request for an exemptive,
no-action or interpretive letter, in accordance with the procedures set
forth in Commission Regulation 140.99.\21\ Further, should any person,
in the future, believe that an amendment to a Commission regulation is
warranted, such person may petition the Commission for an amendment in
accordance with the procedures set forth in Commission Regulation
13.2.\22\
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\21\ 17 CFR 140.99.
\22\ 17 CFR 13.2.
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3. Consistent Conflicts-of-Interest Treatment Between FCMs/IBs and SDs/
MSPs
Pierpont Securities Holdings LLC expressed agreement with the
Commission's proposal to apply Sec. 23.605 and Sec. 1.71 in a manner
that is consistent with one another. The consistency is particularly
important in situations where a FCM is an affiliate of, or dually
registered as, an SD or MSP. The Commission acknowledges the comment
and notes its belief that such consistent treatment is reasonable and
reflects the statutory directives and policy goals underlying sections
4d(c) and 4s(j)(5) of the CEA, as amended by sections 732 and 731 of
the Dodd-Frank Act, respectively.
4. Definitions--Sec. 23.605(a), Sec. 1.71(a)
a. Business Trading Unit--Sec. 23.605(a)(2), Sec. 1.71(a)(2)
The proposed rules defined the term ``business trading unit'' as
``any department, division, group, or personnel of a [SD, MSP, FCM, or
IB] or any of its affiliates, whether or not identified as such, that
performs or is involved in any pricing, trading, sales, marketing,
advertising, solicitation, structuring, or brokerage activities on
behalf of a [SD, MSP, FCM, or IB].''
The Commission received a comment from the FHLBs, and a joint
comment from FIA, ISDA, and SIFMA, arguing that the Commission should
clarify that Sec. 23.605(a)(2) and Sec. 1.71(a)(2) apply to
traditional ``front office'' functions and not to those functions that
support the
[[Page 20146]]
front office, such as legal, compliance, operations, credit, and human
resources functions. FIA/ISDA/SIFMA noted that in order to fulfill
legal, compliance, and risk management functions, firms are integrated
such that the exclusion of such control and/or support functions should
be excluded from the definitions of business trading unit and clearing
unit. In a separate comment, JP Morgan expressed a general agreement
with the points raised in the FIA/ISDA/SIFMA letter.
In the preambles of the SD/MSP and FCM/IB NPRMs, the Commission
noted that the proposed rules are not intended to hinder the execution
of sound risk management programs by SDs, MSPs, FCMs, IBs, or by any
affiliate of an SD, MSP, FCM, or IB. The Commission's proposals largely
addressed the issue raised by the commenters in the proposed
definitions of ``non-research personnel'' at Sec. 23.605(a)(5) and
Sec. 1.71(a)(5), which carved out legal and compliance personnel from
those definitions. In addition, the final rule modified the definition
of non-research personnel to those employees who are not directly
responsible for, or otherwise not directly involved in, research or
analysis intended for inclusion in a research report. The Commission
believes its prior statements and these changes should clarify the
scope of the definitions.
Nonetheless, upon reviewing the comments, the Commission has
determined it appropriate to modify the definitions. The rule language,
as originally proposed, is amended in the final rules to: (1) Clarify
that the term includes those persons who directly perform or exercise
supervisory authority over the performance of the tasks listed in the
rule, and not those who merely are ``involved in'' such activities,
such as the legal, compliance, human resources, risk management,
operations, and other support functions; and (2) exclude price
verification for risk management purposes from the types of pricing
activities covered by the definitions. The Commission believes that
these changes will address the issues raised by the commenters while
ensuring that the rule text properly reflects the intent of the
Commission.
b. Clearing Unit--Sec. 23.605(a)(3), Sec. 1.71(a)(3)
The proposed rules defined the term ``clearing unit'' as ``any
department, division, group, or personnel of a [SD, MSP, FCM, or IB] or
any of its affiliates, whether or not identified as such, that performs
or is involved in any proprietary or customer clearing activities on
behalf of a [SD, MSP, FCM, or IB].''
Similar to the concerns raised in comments on the proposed
definition of ``business trading unit,'' FIA, ISDA, and SIFMA, in a
joint comment, argued that the Commission should clarify that Sec.
23.605 and Sec. 1.71 applies to traditional ``front office'' functions
and not to functions that support the front office, such as legal,
compliance, operations, credit, and human resources functions. In a
separate comment, JP Morgan expressed a general agreement with the
points raised in the FIA/ISDA/SIFMA letter.
As stated above with respect to the comments received on the
proposed definition of ``business trading unit,'' the Commission noted
in the preambles to the SD/MSP and FCM/IB Conflicts NPRMs that the
proposed rules are not intended to hinder the execution of sound risk
management programs by SDs, MSPs, FCMs, IBs, or by any affiliate of an
SD, MSP, FCM, or IB. The NPRMs largely addressed the issue raised by
the commenters in the proposed definitions of ``non-research
personnel'' at Sec. 23.605(a)(5) and Sec. 1.71(a)(5), which carved
out legal and compliance personnel from that definition. The Commission
reiterates its prior statements on this issue, which should make clear
the scope of the definitions.
Nonetheless, upon reviewing the comments, the Commission has
determined it appropriate to modify the definitions. The rule language,
as originally proposed, is amended in the final rules to clarify that
the term includes those persons or groups who perform or exercise
supervisory authority over the performance of the tasks listed in the
rules, and not those who merely are ``involved in'' such activities.
The Commission believes that these changes will address the issues
raised by the commenters while ensuring that the rule text properly
reflects the intent of the Commission.
c. Non-Research Personnel--Sec. 23.605(a)(5)
The proposed rule defined the term ``non-research personnel'' as
``any employee of the business trading unit or clearing unit, or any
other employee of the [SD] or [MSP] who is not directly responsible
for, or otherwise involved with, research concerning a derivative,
other than legal or compliance personnel.''
EEI argued that the Commission should limit the definition of non-
research personnel to include only those persons involved with trading,
pricing, or clearing activities, and not to other areas.
Upon reviewing the comment, the Commission is adopting the language
as originally proposed. The Commission believes that changing the
language in the manner suggested by the commenter would increase the
risk that SDs or MSPs might attempt to evade the restrictions set forth
in the rule.
d. Public Appearance--Sec. 23.605(a)(6), Sec. 1.71(a)(6)
The proposed rules defined the term ``public appearance'' as ``any
participation in a conference call, seminar, forum (including an
interactive electronic forum) or other public speaking activity before
15 or more persons, or interview or appearance before one or more
representatives of the media, radio, television or print media, or the
writing of a print media article, in which a research analyst makes a
recommendation or offers an opinion concerning a derivatives
transaction.\23\ This term does not include a password-protected
webcast, conference call, or similar event with 15 or more existing
customers, provided that all of the event participants previously
received the most current research report or other documentation that
contains the required applicable disclosures, and that the research
analyst appearing at the event corrects and updates during the public
appearance any disclosures in the research report that are inaccurate,
misleading, or no longer applicable.''
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\23\ The Commission notes that SD and MSP communications with
counterparties and potential counterparties also are addressed in
the Commission's external business conduct standards rules. 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 (Feb. 17, 2012).
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FIA, ISDA, and SIFMA, in a joint comment, argued that the
definition of public appearance (speaking before 15 or more
``persons'') should articulate that the term ``person'' includes both a
customer that is a natural person and one that is an entity. For
example, if a single institutional customer sends 16 employees to a
forum held by an SD, MSP, FCM, or IB, each of those employees should
not be counted as a ``person;'' rather, employees from a single
institutional customer should be deemed to be one ``person'' at that
forum, for purposes of the rule. In a separate comment, JP Morgan
expressed a general agreement with the points raised in the FIA/ISDA/
SIFMA letter.
Upon reflection, the Commission agrees with the commenters, and is
altering the rules to incorporate the
[[Page 20147]]
recommendation offered by the commenter. Specifically, the Commission
is modifying the rule to clarify that the term ``persons'' in this
context refers to either natural persons or entities. Thus, for
example, if a single entity sends multiple natural persons as
representatives to a public speaking activity that may be subject to
the rule, such natural persons would be counted as a single ``person''
for purposes of determining whether the public speaking activity meets
the definition of ``public appearance.''
e. Research Department--Sec. 23.605(a)(8), Sec. 1.71(a)(8)
The proposed rules defined the term ``research department'' as
``any department or division that is principally responsible for
preparing the substance of a research report relating to any derivative
on behalf of a [SD, MSP, FCM, or IB], including a department or
division contained in an affiliate of a [SD, MSP, FCM, or IB].''
FIA, ISDA, and SIFMA, in a joint comment, argued that the scope of
``research department,'' and the restrictions imposed by the proposed
rules concerning research departments, should not apply to the global
affiliates of an SD, MSP, FCM, or IB. FIA/ISDA/SIFMA posited that the
imposition of such restrictions on global affiliates would create
significant logistical hurdles and expenses for multinational firms,
especially in situations where an affiliate has no significant
interaction with the SD, MSP, FCM, or IB. Further, FIA/ISDA/SIFMA
suggested that local regulations governing non-US affiliates may not
permit such non-US affiliates to comply with the rules. As an
alternative, FIA/ISDA/SIFMA suggested that the Commission limit the
rules to requiring disclosure ``on third party research reports,'' and
focus the Commission's enforcement resources on SDs, MSPs, FCMs, and
IBs that attempt to evade the rule by moving research analysts to
affiliates. In a separate comment, JP Morgan expressed a general
agreement with the points raised in the FIA/ISDA/SIFMA letter.
Upon reviewing the comments, the Commission has determined it
appropriate to adopt the rules as originally proposed. The Commission
believes that the alternatives suggested by FIA/ISDA/SIFMA would
increase the risk of evasion by multinational registrants. Such risk of
evasion outweighs any benefit to be derived from the proffered
alternative. However, to clarify any ambiguity that may exist in the
rules adopted herein, the Commission confirms that a holding company
need not examine the research functions of all of its affiliates under
these rules; rather, a holding company needs only to look at those
research groups doing research on behalf of an SD, MSP, FCM, or IB. In
light of its stated intent, the Commission believes that the cost-
effectiveness of the rules will be promoted.
f. Research Report--Sec. 23.605(a)(9), Sec. 1.71(a)(9)
The proposed rules defined the term ``research report'' as: ``[A]ny
written communication (including electronic) that includes an analysis
of the price or market for any derivative, and that provides
information reasonably sufficient upon which to base a decision to
enter into a derivatives transaction.'' However, the proposals
expressly excluded four categories of communications from coverage by
the definitions.
FIA, ISDA, and SIFMA, in a joint comment, argued that the
exclusions from the definition of ``research report'' should be
expanded to include general market discussions and other communications
that are not ``research reports'' in other regulatory contexts. The
definitions should be limited to those research reports analyzing a
specific derivative or futures transaction. Exclusions set forth in
other regulatory contexts--specifically NASD Rule 2711(a)(9)(A) and SEC
Regulation AC--should be included in the Commission's definitions of
``research report.'' FIA/ISDA/SIFMA further argued that communications
produced by a business trading unit labeled as a ``trading/sales desk
product'' and as ``non-research'' should be excluded from the
definitions of research report. In a separate comment, JP Morgan
expressed a general agreement with the points raised in the FIA/ISDA/
SIFMA letter.
EEI argued that the Commission should exclude from the definition
any communication between an SD or MSP, and its regulator, concerning
hedging activity. The commenter posited that firms with small trading
operations should be permitted to publish occasional research reports
to justify trading decisions, without being subject to the rules set
forth in the SD/MSP Conflicts NPRM.
The National Futures Association (NFA) argued that the definition
in proposed Sec. 1.71(a)(9) was too broad and suggested that the
definition be limited to reports containing material information at a
level of detail that amounts to ``a call to action to the customer,''
or that could have a price impact on the market for a particular
product. NFA also argued that the definition should include an
exception for general market commentary, similar to NASD Rule 2711.
Newedge USA LLC (Newedge) also argued that the definition in proposed
Sec. 1.71(a)(9) was too broad, because any discussion of a derivative
that references the underlying physical commodity or financial
instrument could be deemed to provide ``information reasonably
sufficient upon which to base a decision to enter into a derivatives
transaction.'' Newedge contended that the definition of research report
should be restricted to ``any written communication * * * including an
analysis of the price/market for any specific derivative contract, and
that provides information reasonably sufficient upon which to base a
decision to enter into a transaction involving such specific derivative
contract.''
ADM Investor Services Inc. commented on the differences between
daily research reports and weekly and monthly research reports, arguing
that proposed Sec. 1.71(a)(9) unnecessarily threatened existing
industry practices, particularly with respect to opening and closing
comments or intraday market comments by IBs, which do not consist of
detailed research but could be covered by the proposed definition of
``research report.''
Having considered the comments, the Commission has determined it
appropriate to modify the exclusions to the definitions of ``research
report,'' as that term was proposed in the SD/MSP and FCM/IB Conflicts
NPRMs. Specifically, the Commission agrees with FIA/ISDA/SIFMA's
recommendation that ``commentaries on economic, political, or market
conditions'' and ``statistical summaries of multiple companies'
financial data, including listings of current ratings'' should be
excluded from the definitions of research report. With regard to the
exclusion for commentaries on economic or market conditions, the
Commission believes that there are distinguishing characteristics
between research reports setting forth factual statements about the
market for specific derivatives and commentaries that provide opinion
on general economic, political, or market conditions. Accordingly, the
Commission has modified the rules to incorporate those two exclusions
into the definitions of ``research report.''
However, the Commission does not believe that other types of
communications should be excluded from the definitions, because they
could represent the core focus of a research department doing research
on behalf of an SD, MSP, FCM, or IB, e.g., asset
[[Page 20148]]
classes, economic variables commonly referenced in derivatives, and on-
the-run swap rates. Adopting the NASD 2711 exclusion for analysis
concerning economic variables (e.g. rates, inflation) that are commonly
referenced in derivatives, would create an exception that would swallow
the rule. For example, research conducted on trends in the interest
rate, gold, or oil markets are inextricably linked to the swap markets
that reference those underlying assets or rate.
The Commission believes that the changes adopted herein will
increase consistency with NASD Rule 2711, which was promulgated
pursuant to section 15D of the Securities Exchange Act. The Commission
believes that the rules, in final form, provide SDs, MSPs, FCMs, and
IBs with sufficient flexibility concerning solicitation materials
generated by the trading unit, given the exclusion from coverage of
``[a]ny communication generated by an employee of the business trading
unit that is conveyed as a solicitation for entering into a derivatives
transaction, and is conspicuously identified as such.'' \24\
---------------------------------------------------------------------------
\24\ The Commission notes that SD and MSP communications with
counterparties and potential counterparties are addressed in the
Commission's external business conduct standards rules. 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 (Feb. 17, 2012).
---------------------------------------------------------------------------
5. Policies and Procedures--Sec. 23.605(b)
As proposed, Sec. 23.605(b) required each SD and MSP to ``adopt
and implement written policies and procedures reasonably designed to
ensure that the [SD] or [MSP] and its employees comply with the
provisions of this rule.'' Chris Barnard commented that the prevention
of SDs and MSPs from engaging in activities with actual, perceived, or
potential conflicts of interest will improve transparency and
confidence in the markets, and will reduce risk. The Commission
acknowledges the comment and is adopting Sec. 23.605(b) without
revision.
6. Research Analysts and Research Reports--Sec. 23.605(c), Sec.
1.71(c)
a. Separation of Research Analysts From Business Trading Unit and
Clearing Unit--Sec. 23.605(c)(1)
Proposed Sec. Sec. 23.605 and 1.71 prescribed certain restrictions
on the relationship between the research department and all non-
research personnel. Such restrictions included limitations on
influencing the content of research reports, the supervision of
research analysts, and the review or approval of research reports.
With regard to this proposed rule, MFA suggested that the
Commission provide additional clarity on the proposed rule by further
describing the bright lines of separation between the research
department and non-research personnel. For example, the commenter
queried whether an SD may house its research department and trading
department in the same building or on the same floor, and whether
different key cards for entry into each department are required by the
rule. Additionally, BlackRock commented that the Commission ``should
explicitly exempt entities whose research personnel produce reports for
internal use only.''
After reviewing the comments, the Commission believes that the
comments raised by the commenters may best be addressed through
clarification of the underlying intent of the rule. Accordingly, the
Commission has determined it appropriate to adopt the rule as it was
originally proposed. First, with respect to MFA's comments, the rule
does not expressly require physical separation of the research
department and all non-research personnel; however, such separation
will be considered by the Commission to be a good practice by
registrants in order to minimize the risk of violating the rule.
Second, with respect to BlackRock's comments, the Commission believes
that the issue of internal research reports is adequately addressed by
proposed Sec. 23.605(a)(9)(iv), which excluded from the definition of
``research report'' any ``internal communications that are not given to
current or prospective customers.'' \25\
---------------------------------------------------------------------------
\25\ This language is being adopted by the Commission as
proposed; however, the provision has been renumbered as Sec.
23.605(a)(9)(vi).
---------------------------------------------------------------------------
b. Conflicts of Interest Adequately Addressed by Existing Commission
and NFA Rules
Proposed Sec. 1.71 did not discuss the issue of whether existing
Commission and NFA rules adequately address the directives set forth in
section 4d(c) of the CEA as amended by section 732 of the Dodd-Frank
Act. Nonetheless, the Commission received comments that raised the
issue.
NFA commented that certain of its existing rules address issues
raised in the Commission's rule proposal, and that the specific
requirements related to research reports that may not be directly
applicable to derivatives could have unintended consequences. K&L Gates
LLP (on behalf of Peregrine Financial Group Inc.), ADM Investor
Services Inc., John Stewart & Associates Inc., and Stewart-Peterson
Group Inc. each argued that the issues addressed by the proposed rule
are already addressed through existing rules.
Swaps and Derivatives Market Association commented that the
proposed rules should be adopted as they were originally proposed.
After considering the comments, the Commission has determined it
appropriate to adopt the rule, as it was originally proposed, on this
issue. Although certain Commission and NFA rules tangentially address
the issues set forth in the proposed rule, section 732 of the Dodd-
Frank Act directed the Commission to take certain actions beyond the
requirements previously promulgated in the rules of the Commission and
NFA. Further, given the similarities between section 4d(c) of the CEA
as amended by section 732 of the Dodd-Frank Act, and section 15D of the
Securities Exchange Act of 1934, the Commission believes that it is
important to provide a measure of specificity with respect to the
conflict-of-interest policies and procedures mandated under section
4d(c) and Sec. 1.71. Such specificity will promote consistency in the
marketplace. Further, by maintaining consistency--to the extent
warranted--with NASD Rule 2711, the Commission believes that the
proposed rule will minimize disruption to the marketplace, given that
such standards are well-established in the financial industry.
c. Treatment of Small IBs
As proposed, Sec. 1.71 did not establish a separate standard for
small IBs. However, in the preamble of the proposed rule, the
Commission expressly invited comment on how these rules should apply to
FCMs and IBs, considering the varying size and scope of the operations
of such firms. The preamble noted, as an example of how the rule could
be adjusted to account for firms of different sizes, that NASD Rule
2711(k) provides an exception from certain requirements for `small
firms,' defined to include those firms that over the past three years
have participated in ten or fewer investment banking services
transactions and generated $5 million or less in gross investment
banking services revenues from those transactions. The Commission
solicited comment on whether a similar approach should be adopted for
small FCMs and IBs. Moreover, the exceptions to the definition of
research report were designed to address issues typically found in
smaller firms where individuals in the trading unit perform
[[Page 20149]]
their own research to advise their clients or potential clients.
Several commenters suggested that small IBs should be excepted from
the proposed rule. NFA argued that the proposed rule effectively could
prohibit the business model of a number of firms that provide an
important service to the industry, particularly with respect to
agriculture. The commenter suggested that, in adopting an exception for
small IBs, the Commission could consider the following factors: A
firm's gross annual revenue, number of associated persons, number of
annual futures transactions, and nature of the customer base. National
Introducing Brokers Association, ADM Investor Services Inc., John
Stewart & Associates Inc., and Stewart-Peterson Group Inc. each argued
that implementing the proposed rules would be prohibitively costly,
burdensome, and unnecessary for small IBs, particularly for IBs dealing
with agricultural commodities, and would force small IBs out of
business. Chris Barnard noted that small IBs lack the capacity to carry
the proportionately heavier regulatory burden set forth in the proposed
rule, and as such, some regulatory mitigation would be beneficial,
based on number of staff or revenues. Multiple commenters also
commented on the limited market price impact of research reports
created or distributed by small IBs, as well as the potential that the
normal duties of associated persons may be deemed to be research
activities for purposes of the rule.
The Commission recognizes and agrees with certain concerns raised
by the commenters. Thus, upon review of the comments, the Commission is
adopting a separate regulatory standard for small IBs, reflecting the
alternative set forth in the preamble of the proposed rule. Section
4d(c) of the CEA mandates the establishment of ``appropriate
informational partitions'' within FCMs and IBs, and all such firms are
bound by that statutory requirement. However, the Commission recognizes
that the size of an IB plays a significant role in determining the
appropriateness of such partitions. Accordingly, the rule, in its final
form, establishes a separate standard for any IB that has generated,
over the preceding 3 years, $5 million or less in aggregate gross
revenues from its activities as an IB. This standard is similar to
language in NASD Rule 2711 that was raised expressly as a possible
alternative in the preamble of the proposed rule.
For any IB meeting those financial requirements, Sec. 1.71(c) of
the rule would not apply. Further, Sec. 1.71(b) has been changed to
set forth a separate policies and procedures requirement for small IBs.
The recommended language of new Sec. 1.71(b)(2) largely mirrors the
statutory requirement of section 4d(c). However, the Commission
believes that small IBs should be subject to Sec. 1.71(e) (policies
and procedures mandating disclosure of material incentives and
conflicts of interest) and Sec. 1.71(f) (recordkeeping and
reporting).\26\ The Commission believes that these changes to the rule,
as originally proposed, will address the concerns raised by the
commenters and limit the cost burden imposed on small IBs.
---------------------------------------------------------------------------
\26\ The provisions of Sec. 1.71(d) are applicable only to
FCMs.
---------------------------------------------------------------------------
Finally, the Commission notes that commentaries on market
conditions have been excluded from the definition of ``research
report,'' as discussed above.
d. Insider Trading and Futures Markets
Proposed Sec. 1.71 did not address insider trading in the futures
markets, or how that issue impacts the implementation of section 732 of
the Dodd-Frank Act. Nonetheless, the Commission received comments on
the issue. Specifically, K&L Gates LLP (on behalf of Peregrine
Financial Group Inc.), John Stewart & Associates Inc., ADM Investor
Services Inc., and Stewart-Peterson Group Inc. each argued that the
proposed rules inappropriately relied upon established rules in the
securities industry, claiming that no ban on insider trading exists in
the futures industry. Further, ADM Investor Services Inc. and Stewart-
Peterson Group Inc. each contended that only the publication of a U.S.
Department of Agriculture market report could have a dramatic effect on
the futures market.
Having considered the comments, the Commission has determined not
to modify the rule on this issue. Section 732 of the Dodd-Frank Act
directed the Commission to take actions concerning conflict-of-interest
policies and procedures, and in that provision, Congress included
language previously included in section 15D of the Securities Exchange
Act of 1934. Section 15D directed that regulatory language be
promulgated to implement that statute, and those regulatory standards
are now well-established in the financial industry. Given the
similarities in statutory language, coupled with the well-established
principles set forth in NASD Rule 2711, the Commission believes that it
is important to provide a measure of specificity with respect to the
conflict-of-interest policies and procedures mandated under section
4d(c) and the proposed rule. Such specificity will promote consistency
and certainty in the marketplace. Further, by maintaining consistency--
to the extent warranted--the Commission believes that the final rule
will minimize disruption to the marketplace.
e. Exception for FCMs If Engaged in Only a de minimis Amount of
Proprietary Trading
Proposed Sec. 1.71 did not set forth a de minimis exception for
FCMs. Nonetheless, the Commission received a comment from Newedge,
which argued that FCMs engaging in minimal proprietary trading should
not be subject to the provisions relating to research analysts. The
commenter stated that the proposed rule would impose unnecessary
burdens, and that a firm that engages in only limited proprietary
trading does not present a risk of conflicts of interest.
Having considered the comment, the Commission does not believe it
appropriate to modify the proposed rule on this issue. The imposition
of a de minimus exception to the conflicts rule is inconsistent with
the statutory directive that Congress set forth in section 732 of the
Dodd-Frank Act, which does not distinguish between proprietary trading
and trading for the accounts of customers. Moreover, the limited nature
of a firm's proprietary trading does not serve to negate the issues
intended to be addressed through the statutory mandate.
f. Lack of Examples of Research-Related Conflicts of Interest in the
Futures Industry
Proposed Sec. 1.71 did not cite specific examples of conflicts of
interest in the futures industry, nor did it discuss the prevalence of
conflicts in the industry. Nonetheless, the Commission received
comments relating to those issues. K&L Gates LLP (on behalf of
Peregrine Financial Group Inc.) commented that the Commission failed to
cite any evidence of conflicts of interest arising from the publication
of research reports. NFA commented that it had issued guidance
prohibiting a FCM or IB from trading in a security futures product in
anticipation of the issuance of a related research report, but that the
commenter was unaware of any instances of conflicts of interest in
research reports of security futures products. Further, Senator Carl
Levin commented that the Commission should encourage compliance by
developing examples of potential or actual conflicts of interest that
should be disclosed to investors.
After considering the comments, the Commission has decided not to
modify
[[Page 20150]]
the proposed rule on this issue. Section 732 of the Dodd-Frank Act
directed the Commission to take certain actions concerning conflict-of-
interest policies and procedures. Specifically, as noted in the
preamble of proposed Sec. 1.71, section 732 ``requires, in relevant
part, that FCMs and IBs implement conflicts of interest systems and
procedures that `establish structural and institutional safeguards to
ensure that the activities of any person within the firm relating to
research or analysis of the price or market for any commodity are
separated by appropriate informational partitions within the firm from
the review, pressure, or oversight of persons whose involvement in
trading or clearing activities might potentially bias the judgment or
supervision of the persons.''' This statutory language draws heavily
from section 15D of the Securities Exchange Act, which was established
through the Sarbanes-Oxley Act of 2002. The Commission believes that
the provisions of the proposed rule relating to conflicts of interest
represent a prudent implementation of the statutory directive.
As noted above, the regulatory requirements promulgated pursuant to
section 15D--which are similar to the requirements contained in the
rule--are now well-established in the financial industry. Given the
similarities in statutory language, coupled with the well-established
principles set forth in NASD Rule 2711, the Commission believes that
the proposed rule will promote consistency and certainty, while
minimizing disruption, in the marketplace. With respect to Senator
Levin's recommendation that the Commission should develop examples of
potential or actual conflicts of interest, the Commission notes the
many examples cited in Senator Levin's comment letter,\27\ but declines
to provide additional examples so as not to pre-judge the scope of
possible future enforcement actions.
---------------------------------------------------------------------------
\27\ See, e.g., SEC Fact Sheet on Global Analyst Research
Settlements, SEC (Apr. 28, 2003), available at http://www.sec.gov/news/speech/factsheet.htm; Hans G. Heidle and Xi Li, Is There
Evidence of Front-Running Before Analyst Recommendations? An
Analysis of the Quoting Behavior of Nasdaq Market Makers, Nov. 10,
2003, available at http://www.afajof.org; Joint Report by NASD and
the NYSE On the Operation and Effectiveness of the Research Analyst
Conflict of Interest Rules (Dec. 2005), available at http://www.finra.org/Industry/Issues/ResearchAnalystRules/.
---------------------------------------------------------------------------
g. Restriction on Non-Research Personnel From ``Influencing the
Content'' of Research Reports--Sec. 23.605(c)(1)(i), Sec.
1.71(c)(1)(i)
The proposed rule provided that ``[n]onresearch personnel shall not
influence the content of a research report of the [SD, MSP, FCM, or
IB].''
NFA commented that non-research personnel should be allowed to
influence the content of a research report under certain circumstances
and, further, that paragraph (i) should be eliminated from proposed
Sec. 1.71(c)(1). FIA, ISDA, and SIFMA, in a joint comment, argued that
the proposed prohibition on ``influencing the content'' should be
eliminated because it would impair ordinary communications between
research and non-research personnel. As an alternative, FIA/ISDA/SIFMA
suggested that non-research personnel should be prohibited only from
``directing the views and opinions expressed in research reports.'' In
a separate comment, JP Morgan expressed a general agreement with the
points raised in the FIA/ISDA/SIFMA letter.
Better Markets commented that the Commission should clarify and
further restrict the communications covered by the provisions.
Specifically, Better Markets argued that Sec. 23.605 and Sec. 1.71
should be expanded not only to prohibit non-research personnel from
influencing the content of a research report or any decision to publish
a research report, but also any decision not to publish a report or to
refrain from including relevant information.
Upon consideration of the comments, the Commission agrees with the
suggestions raised by both FIA/ISDA/SIFMA and Better Markets and is
incorporating the suggestions into the final rules. Specifically, the
Commission is modifying both proposed rules to remove the phrase
``shall not influence the content of a research report'' and replacing
it with the phrase ``shall not direct a research analyst's decision to
publish a research report of the [SD, MSP, FCM, or IB], and non-
research personnel shall not direct the views and opinions expressed in
a research report'' The Commission believes that the changes
accommodate the concerns raised by the commenters while still
reflecting the intent of the proposed rules.
h. Restriction on Research Analyst Supervision by Business Trading Unit
or Clearing Unit--Sec. 23.605(c)(1)(ii), Sec. 1.71(c)(1)(ii)
The proposed rules provided that ``[n]o research analyst may be
subject to the supervision or control of any employee of the [SD's,
MSP's, FCM's, or IB's] business trading unit or clearing unit, and no
personnel engaged in pricing, trading or clearing activities may have
any influence or control over the evaluation or compensation of a
research analyst.''
FIA, ISDA, and SIFMA, in a joint comment, suggested that the
Commission limit the scope of the rules, whereby employees of business
trading and clearing units would be prohibited only from acting as
direct supervisors of research analysts. In a separate comment, JP
Morgan expressed a general agreement with the points raised in the FIA/
ISDA/SIFMA letter.
Upon reviewing the comment, the Commission has decided not to
change the language of the proposed rules in the manner suggested by
the commenter. Any influence on research analysts by non-research
senior management responsible for pricing, trading, or clearing
activities would undermine the conflict-of-interest requirements
mandated by new sections 4d(c) and 4s(j)(5) of the CEA and set forth in
the rules. However, the Commission has determined it appropriate to
clarify the language of the rules, as they had been originally
proposed, by using the defined terms ``business trading unit'' and
``clearing unit'' to designate those personnel who may not have
influence or control over the evaluation or compensation of a research
analyst.
i. Trading Ahead of Research Report Publication
Proposed Sec. 1.71 did not expressly impose restrictions against
trading ahead of the publication of a research report. Senator Carl
Levin commented that the Commission should add provisions akin to FINRA
Rule 5280 (Trading Ahead of Research Reports) in order to improve the
quality of research reports and the integrity of the marketplace. The
Commission observes that it did not propose a trading ahead prohibition
in its original proposals. However, the Commission believes that the
restrictions on communications already included in the rules will
minimize the opportunities for such activities to take place.\28\
Moreover, the Commission will continue to monitor
[[Page 20151]]
this issue and may incorporate such a restriction in a future
rulemaking.
---------------------------------------------------------------------------
\28\ The Commission also notes that depending on the facts and
circumstances, improperly trading ahead or front running
counterparty orders may constitute fraudulent, deceptive or
manipulative conduct under sections 4b and 6(c)(1) of the CEA, and
Sec. 180.1 of Commission regulations, among other fraudulent,
deceptive, and manipulative practices protections under the CEA and
Commission regulations.
---------------------------------------------------------------------------
j. Requirement That Legal/Compliance Personnel Supervise Communication
Between Research and Non-Research Personnel--Sec. 23.605(c)(1)(iv)
The proposed rule permitted non-research personnel to review a
research report before its publication ``as necessary only to verify
the factual accuracy of information in the research report, to provide
for non-substantive editing, to format the layout or style of the
research report, or to identify any potential conflicts of interest.''
However, such review (1) may only be conducted through authorized legal
or compliance personnel, and (2) must be properly documented.
EEI commented that the Commission should exempt communications that
are factual in nature from oversight by legal and compliance personnel,
positing that coverage of such communications would hinder
unnecessarily the development of research reports and unnecessarily
burden legal/compliance personnel.
After considering the comment, the Commission has decided to
promulgate the rule as it was originally proposed. The Commission
believes that involvement by legal or compliance personnel in such
communications will reduce significantly the risk that non-research
personnel will act in an unlawful manner, inadvertently or otherwise.
k. Restrictions on Research Analyst Communications--Sec. 23.605(c)(2),
Sec. 1.71(c)(2)
The proposed rules provided that ``[a]ny written or oral
communication by a research analyst to a current or prospective
counterparty, or to any employee of the [SD, MSP, FCM, or IB], relating
to any derivative must not omit any material fact or qualification that
would cause the communication to be misleading to a reasonable
person.''
FIA, ISDA, and SIFMA, in a joint comment, argued that the proposed
rule would burden an affected firm's operations--especially firms with
foreign offices--and suggested that internal communications within a
firm should be exempt from the material facts or qualifications
required to be communicated to prospective and current customers. FIA/
ISDA/SIFMA further noted that neither NASD Rule 2210 nor similar SRO
rules contain equivalent restrictions, and that firms should be
permitted to consider the nature of the audience when assessing whether
a particular communication is misleading. FIA/ISDA/SIFMA also argued
that the phrase ``or to any employee'' should be struck from proposed
Sec. Sec. 23.605(c)(2) and 1.71(c)(2). In a separate comment, JP
Morgan expressed general agreement with the points raised in the FIA/
ISDA/SIFMA letter.
Upon review of the comments, the Commission has determined it
appropriate to change the rules to eliminate restrictions on
communications to employees of an SD, MSP, FCM, or IB. The Commission
believes that by deleting the phrase ``or to any employee of the [SD,
MSP, FCM, or IB],'' the cost concerns implicated by requiring
registrants to monitor internal communications will be addressed
without producing a materially adverse impact on the effectiveness of
the rules. To the extent that commenters stated that firms should be
permitted to consider the nature of the audience when assessing whether
a particular communication is misleading, the Commission notes that
such matters will be governed by the Commission's existing anti-fraud
standards.
l. Restriction on Influence of Business Trading Unit and Clearing Unit
on Research Analyst Compensation--Sec. 23.605(c)(3), Sec. 1.71(c)(3)
Proposed Sec. Sec. 23.605(c)(3) and 1.71(c)(3) provided that an
SD, MSP, FCM, or IB ``may not consider as a factor in reviewing or
approving a research analyst's compensation his or her contributions to
the [SD's, MSP's, FCM's, or IB's] trading or clearing business'' and
that ``[n]o employee of the business trading unit or clearing unit of
the [SD, MSP, FCM, or IB] may influence the review or approval of a
research analyst's compensation.''
FIA, ISDA, and SIFMA, in a joint comment, contended that research
management should be able to solicit input from business trading and
clearing unit personnel, particularly as non-research personnel may be
in a better position to receive feedback from clients concerning the
performance of research personnel. FIA/ISDA/SIFMA suggested that the
Commission exempt from Sec. Sec. 23.605(c)(1)(ii) and 1.71(c)(1)(ii)
any personnel who occupy non-trading or non-clearing positions, and who
are not employed in the business trading or clearing units. FIA/ISDA/
SIFMA, as well as Newedge, further argued that research management
decisions concerning the performance evaluation of research analysts
should be subject to firm-wide compensation guidelines, as long as they
are non-discriminatory and non-prejudicial. In a separate comment, JP
Morgan expressed a general agreement with the points raised in the FIA/
ISDA/SIFMA letter. Newedge complained of a lack of clarity as to which
personnel of a firm engaged exclusively or substantially in clearing
activities, and not proprietary trading, would be available to
supervise and evaluate research analysts. Newedge also argues that
senior officers and employees of departments other than business
trading and clearing units should be allowed to have input on
compensation decisions.
Michael Greenberger argued that research management should be
prohibited from soliciting any input of business trading and clearing
units concerning a research analyst's compensation or performance
evaluation, even if the influence is indirect or if research management
maintains the ability to make all final decisions on such
determinations. Better Markets commented that the provision should be
broadened. For example, Better Markets argued that a research analyst's
contribution to the trading business of an affiliate should be
prohibited from being considered when determining compensation. The
commenter further noted that, in addition to prohibiting a research
analyst's contributions to the trading business from being considered
in respect of an analyst's compensation, ``consideration of adverse
effects on such trading business'' must be also prohibited from being
considered.
After considering the comments, the Commission has determined it
appropriate to change the language as set forth in the original
proposal. As revised, the rules permit personnel of a business trading
unit or clearing unit to forward communications by a client or customer
to research department management, to the extent that such
communications relate to feedback, ratings, and other indicators of a
research analyst's performance provided by the client or customer. The
Commission believes that the change will address certain concerns
raised by FIA/ISDA/SIFMA and Newedge while not detracting from the
policy goals underlying the provision. Beyond that change, the
Commission has decided not to modify further the language that was
originally proposed. Maintaining a firewall around research analyst
compensation decisions is crucial to implementing effective conflict-
of-interest policies and procedures. Nonetheless, to address an issue
raised by FIA/ISDA/SIFMA, the Commission wishes to clarify the intent
of the rule. Specifically, the rule is not intended to prohibit
management decisions concerning the performance evaluation of research
analysts from being subject
[[Page 20152]]
to firm-wide compensation guidelines, as long as they are non-
discriminatory and non-prejudicial.
m. Relevance of a Promise of Favorable Research to Futures Market--
Sec. 1.71(c)(4)
As proposed, Sec. 1.71(c)(4) prohibits an FCM or IB from
``directly or indirectly offer[ing] favorable research, or
threaten[ing] to change research, to an existing or prospective
customer as consideration or inducement for the receipt of business or
compensation.'' K&L Gates LLP (on behalf of Peregrine Financial Group
Inc.) commented that the provision may be relevant in the context of
research on a particular company, but it has no relevance in terms of a
report on soybeans or the Euro.
After reviewing the comment, the Commission has decided not to
modify the proposed rule on this issue. The Commission believes that
the provision appropriately addresses the statutory directive and is an
important component of firewall protection. Moreover, inclusion of this
provision will maintain consistency with the conflict-of-interest
provisions proposed for SDs and MSPs.
n. Disclosure of Conflicts by Research Analysts in Research Reports and
Public Appearances--Sec. 23.605(c)(5), Sec. 1.71(c)(5)
Proposed Sec. Sec. 23.605(c)(5)(i) and 1.71(c)(5)(i) required that
an SD, MSP, FCM, or IB ``disclose in research reports and a research
analyst must disclose in public appearances: (1) Whether the research
analyst maintains, from time to time, a financial interest in any
derivative of a type that the research analyst follows, and the general
nature of the financial interest; and (2) any other actual, material
conflicts of interest of the research analyst or [SD, MSP, FCM, or IB]
of which the research analyst has knowledge at the time of publication
of the research report or at the time of the public appearance.''
FIA, ISDA, and SIFMA, in a joint comment, argued that Sec. Sec.
23.605(c)(5)(i) and 1.71(c)(5)(i) should be limited to disclosing
whether a research analyst maintains a relevant financial interest ``at
the time of publication of the report/time of public appearance,''
rather than the phrase ``from time to time.'' FIA/ISDA/SIFMA also
contended that the phrase ``any other actual, material conflict of
interest of the research analyst'' is vague and would be burdensome to
implement, requiring coordination among various business units and the
creation of special databases in order to comply with the rule. In a
separate comment, JP Morgan expressed a general agreement with the
points raised in the FIA/ISDA/SIFMA letter. NFA also commented on the
difficulty for FCMs to remain current on an analyst's financial
interests, and that the Commission should clarify that the term ``of a
type that the research analyst follows'' (Sec. 1.71(c)(5)(i)) refers
to interest rate swaps, credit swaps, equity swaps, and other commodity
swaps, consistent with the characterization of swaps set forth in the
Commission's proposed product definitions.
Senator Carl Levin commented that the Commission should use this
rule not only to ensure the integrity of research reports, but also to
impose a broader duty on FCMs and IBs to more completely disclose any
adverse interest. The commenter suggested that the rule should prohibit
firms from betting on the failure of instruments they designed and sold
to customers.
EEI suggested that the Commission modify the proposed rule to
provide a de minimis exception from the research analyst financial
interest disclosure requirements, and that a research analyst should be
required only to identify relevant financial interests.
Upon review of the comments, the Commission is modifying the
language of Sec. Sec. 23.605(c)(5) and 1.71(c)(5) to remove the phrase
``from time to time.'' The Commission believes that this change will
address the issue raised by FIA/ISDA/SIFMA. However, the Commission has
determined that a de minimus exception would be inappropriate given the
difficulty of deciding when a financial interest is de minimis in this
context. Further, the Commission believes that the cost concerns of
FIA/ISDA/SIFMA are misplaced. The rules require disclosure of ``any
other actual, material conflicts of interest of the research analyst or
[SD or MSP] of which the research analyst has knowledge at the time of
publication of the research report or at the time of the public
appearance'' (emphasis added).\29\ Thus, the disclosure requirement is
limited to conflicts of which the research analyst has knowledge, and
the SD, MSP, FCM, or IB need not construct the databases suggested by
FIA/ISDA/SIFMA in order to comply with the rule.
---------------------------------------------------------------------------
\29\ The Commission notes that in an action brought for failure
to disclose a material conflict of interest of an SD or MSP in a
research report or public appearance, the onus will be on the SD or
MSP to show that they had policies and procedures reasonably
designed to ensure that the research analyst had no knowledge of the
material conflict of interest of the SD or MSP.
---------------------------------------------------------------------------
o. Disclosure of Conflicts in Third-Party Research Reports--Sec.
23.605(c)(5)(iv), Sec. 1.71(c)(5)(iv)
As proposed, Sec. Sec. 23.605(c)(5)(iv) and 1.71(c)(5)(iv)
required that if an SD, MSP, FCM, or IB distributes or makes available
third-party research reports, each report must be accompanied by
certain disclosures or an internet link to the appropriate disclosures,
subject to certain conditions and qualifications.
EEI argued that the required disclosures are unnecessary because
third-parties are, by definition, independent of an SD or MSP. FIA,
ISDA, and SIFMA, in a joint comment, stated that it was unclear what
disclosures must be made in connection with the distribution of
independent third-party research reports, given that, by definition,
the SD, MSP, FCM, or IB has no role in the content or creation of an
``independent third-party research report.'' In a separate comment, JP
Morgan expressed a general agreement with the points raised in the FIA/
ISDA/SIFMA letter.
Upon review of the comments, the Commission is adopting the rule as
proposed. Third-party research reports provided by a registrant may be
interpreted by recipients as carrying the endorsement of the registrant
and may present conflicts-of-interest issues in the same way as
research reports originating with the registrant's own research
analysts. The Commission believes that the disclosures will afford
recipients with a clear understanding of conflicts posed by a
particular report.
p. Application of Proposed Research Conflicts Rules to Research Reports
Covering Derivatives and Securities
The proposed rules and accompanying preambles did not address how
the proposed requirements would apply to research reports that contain
information that is subject to the rule and information that is
securities-related.
FIA, ISDA, and SIFMA, in a joint comment, questioned how Sec.
23.605 and Sec. 1.71 would apply to a research report that addresses
multiple products (i.e., both derivatives and securities), or to a
report discussing a product that may be a derivative, security, or
both. FIA/ISDA/SIFMA suggested that only the derivatives section of a
report discussing securities and derivatives should be subject to the
proposed regulations. In a separate comment, JP Morgan expressed a
general agreement with the points raised in the FIA/ISDA/SIFMA letter.
Upon review of the comments, the Commission has decided not to
change
[[Page 20153]]
the language that was originally proposed. To the extent that
securities underlie the derivatives discussed in the report, or to the
extent that securities are otherwise intertwined with the discussion of
derivatives, the Commission believes that any such discussion of
securities should be subject to the Commission's rules. SDs, MSPs,
FCMs, and IBs will be registered with the Commission, and the swaps and
futures in which they transact will be within the Commission's
jurisdiction. Because the value of each swap and future intrinsically
may be based on the value of one or more underlying instruments,
research reports by SDs, MSPs, FCMs, or IBs that analyze such
underlying instruments should be addressed by the conflict-of-interest
policies and procedures mandated under sections 4d(c) and 4s(j)(5) of
the CEA.
q. Application of Proposed Research Conflicts Rules to Research
Analysts Covering Derivatives and Securities
The proposed rules and accompanying preambles did not address how
the proposed requirements would apply to research analysts that work
with derivatives subject to the Commission's rules and securities
subject to rules promulgated by the SEC or FINRA.
FIA, ISDA, and SIFMA, in a joint comment, queried how the rule
would apply to research analysts registered with both futures and
securities regulators. FIA/ISDA/SIFMA suggested that the Commission
confirm that individuals subject to both Sec. 23.605 or Sec. 1.71 and
securities regulations must only comply with Sec. 23.605 or Sec. 1.71
when acting in the capacity as a ``research analyst,'' as defined by
Sec. 23.605 or Sec. 1.71. FIA/ISDA/SIFMA also raised concerns with
respect to inconsistencies between Sec. Sec. 23.605 and 1.71 and other
rules promulgated in the securities or futures context. In a separate
comment, JP Morgan expressed a general agreement with the points raised
in the FIA/ISDA/SIFMA letter.
Having considered the comments, the Commission confirms that
individuals subject to both Sec. 23.605 or Sec. 1.71 and securities
regulations must only comply with Sec. 23.605 or Sec. 1.71 when
acting in the capacity of a ``research analyst,'' as defined by Sec.
23.605 or Sec. 1.71. SDs, MSPs, FCMs, and IBs will be registered with
the Commission, and the swaps and futures in which they transact will
be within the Commission's jurisdiction. Because the value of each swap
and future intrinsically may be based on the value of one or more
underlying instruments, research reports by SDs, MSPs, FCMs, and IBs
analyzing such underlying instruments should be addressed by the
conflict-of-interest policies and procedures mandated by new sections
4d(c) and 4s(j)(5) of the CEA.
7. Clearing Activities--Sec. 23.605(d), Sec. 1.71(d)
a. Separation of Clearing Unit From Business Trading Unit--Sec.
23.605(d)(1) and (2); Separation of Business Trading Unit and Clearing
Unit--Sec. 1.71(d)(1) and (2)
As proposed, Sec. 23.605(d)(1) provided that ``[n]o [SD] or [MSP]
shall directly or indirectly interfere with or attempt to influence the
decision of any affiliated clearing member of a [DCO] with regard to
the provision of clearing services and activities,'' while proposed
Sec. 1.71(d)(1) congruently provided that ``[n]o [FCM] shall permit
any affiliated [SD] or [MSP] to directly or indirectly interfere with,
or attempt to influence, the decision of the clearing unit personnel of
the [FCM] with regard to the provision of clearing services and
activities. * * *''
Likewise, proposed Sec. 23.605(d)(2) provided that ``[e]ach [SD
and MSP] shall create and maintain an appropriate informational
partition, as specified in section 4s(j)(5)(A) of the Act, between
business trading units of the [SD or MSP] and clearing member personnel
of any affiliated clearing member of a [DCO],'' while proposed Sec.
1.71(d)(2) congruently provided that ``[e]ach [FCM] shall create and
maintain an appropriate informational partition between business
trading units of an affiliated [SD] or [MSP] and clearing unit
personnel of the [FCM].''
MFA commented that it supports the prohibition of SDs and MSPs from
directly or indirectly interfering with, or attempting to influence,
the decision of any affiliated clearing member of a DCO with regard to
clearing services and activities, as well as the informational
partitions between business trading personnel and personnel of an
affiliated clearing member. Pierpont Securities Holdings LLC also
supported the Commission's proposals, contending that the informational
partitions between a business trading unit and a clearing unit within a
large financial institution must be established and maintained as to
all personnel, not just supervisory personnel, and the penalties for
violating those restrictions must be meaningful.
Swaps and Derivatives Market Association filed two comments on
these rules, both of which were supportive of the proposals. In the
first comment, the commenter argued that the proposed separation of
trading and clearing units in Sec. 23.605(d) should be expanded so as
to require ``distant physical separation'' of the two. The commenter
also expressed support for requiring the use of objective criteria in
determining whether to accept clearing customers. In the second letter,
the commenter contended that the restrictions set forth in Sec.
23.605(d), as proposed, correctly address key areas where conflicts
arise, and that the independence of clearing members is essential to
accomplish several policy goals of the Dodd-Frank Act. In the second
comment, the commenter stated its belief that the firewalls mandated by
the proposed rules ``are critical to reducing potential conflicts
between the trading unit of an FCM, IB, SD, or MSP and their clearing
unit.''
Michael Greenberger also expressed support for Sec. 23.605(d), as
proposed, noting that attempts to tie clearing decisions to trade
execution decisions would raise potential conflicts of interest, which
could serve to block access to clearing and prevent competition among
execution venues. The commenter also noted that mandatory public
disclosure of client acceptance criteria by SDs and MSPs is consistent
with legislative intent. Likewise, Pierpont Securities Holdings LLC
also expressed support for the Commission's proposal, in particular the
requirements that no direct or indirect interference or influence be
permitted by the business trading unit on the clearing unit as to (i)
whether clearing services will be provided and (ii) how clearing fees
will be set.
The Principal Traders Group supported a rule preventing
interference by the business trading unit of an SD or MSP, with respect
to the decision of an affiliated FCM to accept a client for clearing
services, but preferred that the rule be presented in the form
recommended by FIA/ISDA/SIFMA below.
In contrast, FIA, ISDA, and SIFMA, in a joint comment, commented
that the proposed rules would alter the business operations of
integrated financial services firms to the detriment of clients and in
a manner disproportionate to achieving the regulatory goals the
Commission has identified, including the promotion of effective risk
management. The commenters also argued that the Commission's proposed
application of the conflicts rules to FCM clearing activities is not
contemplated by section 732 of the Dodd-Frank Act. FIA/ISDA/SIFMA
argued that the proposed rules would impair an SD's/MSP's ability to
follow risk management best practices. FIA/ISDA/SIFMA
[[Page 20154]]
recommended that the Commission not adopt the proposed rules, but
instead adopt a rule that prohibits an affiliated SD or MSP from
obtaining information from an affiliated FCM's clearing personnel
concerning transactions conducted by FCM clients with either their own
clients or with independent SDs or MSPs. FIA/ISDA/SIFMA also expressed
support for a rule that would require each FCM's clearing unit to have
independent management that makes its own final decisions regarding
clients to which it will offer clearing services as well as the terms
for those services. FIA/ISDA/SIFMA also suggested that the Commission
clarify that the rule does not mandate that firms publicize client
sales and on-boarding decisions.
UBS Securities LLC echoed certain points made in the FIA/ISDA/SIFMA
comment, particularly with respect to the ability of a financial
services firm to operate its swap clearing business as a partnership
with its trading business in order to serve clients, while JP Morgan
agreed with the FIA/ISDA/SIFMA comment discussed above. JP Morgan also
posited that while ``it would be appropriate for the CFTC to issue
rules prohibiting any activity intended to restrict open access to
clearing, * * * we believe a SD/MSP should be permitted to work and
share information with its clearing member affiliate to promote and
facilitate a client's access to clearing services or to define the
parameters pursuant to which clearing services will be offered.''
The FHLBs argued that the proposed rule goes beyond the standards
set forth in the Dodd-Frank Act and that the proposed rule ``overly
restricts the ability of [SDs and MSPs] to run their trading and
clearing operations and effectively service the needs of their end-user
counterparties.'' The proposed rule also could inhibit SDs and MSPs
``from taking prudent, well-informed and timely actions in situations
with respect to the closing out of transactions, in a default scenario
or otherwise.''
NFA commented that Sec. 1.71(d) is too broad and may negatively
impact a firm's ability to share information about customers to make
credit and risk determinations. UBS Securities LLC echoed certain of
the points made in the FIA/ISDA/SIFMA comment, particularly with
respect to the ability of a financial services firm to operate its swap
clearing business as a partnership with its trading business in order
to serve clients. Newedge commented that the proposed rule would limit
firms' ability to coordinate, credit, risk, and other policies, and
suggested that rather than prohibiting an affiliated SD or MSP from
interfering with a FCM's decision to provide clearing services, Sec.
1.71(d) should prohibit a FCM from permitting business trading unit
personnel of an affiliated SD or MSP from interfering with the FCM's
decision to provide clearing services.
Commenters have expressed divergent views on this issue, with some
commenters strongly favoring the Commission's proposed rules (and, to a
certain extent, requesting that the rule be expanded), while others
have advocated that the provision not be adopted. Upon consideration of
all the comments, the Commission has determined it appropriate to
promulgate the rules largely as they were originally proposed. The
separation of the FCM clearing unit from the interference or influence
of an affiliated SD or MSP is crucial to promoting open access to
clearing. Open access to clearing will be essential for the expansion
of client clearing needed for market participants to comply with the
mandatory clearing of swaps as determined by the Commission under
section 723 of the Dodd-Frank Act. The Commission believes that the
promulgation of the language as proposed would be ``appropriate,'' as
that term is used in section 4d(c) as amended by section 732 of the
Dodd-Frank Act. Moreover, the Commission does not believe the rule will
hamper risk management. The Commission notes that it has proposed
straight-through processing rules,\30\ counterparty clearing
documentation rules,\31\ and clearing member risk management rules \32\
that would, if adopted, minimize the counterparty risk to an SD or MSP
with respect to transactions required or intended to be cleared.
---------------------------------------------------------------------------
\30\ See Requirements for Processing, Clearing, and Transfer of
Customer Positions, 76 FR 13101, 13109 (Mar. 10, 2011).
\31\ See Customer Clearing Documentation and Timing of
Acceptance for Clearing, 76 FR 45730, 45737 (Aug. 1, 2011).
\32\ See Clearing Member Risk Management, 76 FR 45724, 45729
(Aug. 1, 2011).
---------------------------------------------------------------------------
In response to commenters' concerns about an FCM's ability to
manage a default scenario without the benefit of the trading expertise
in the business trading unit, the Commission is modifying proposed
Sec. 1.71(d)(2)(i) to permit the business trading unit of an
affiliated SD or MSP to participate in the activities of an FCM during
an event of default. Specifically, the business trading unit personnel
would be permitted to participate in the activities of the FCM, as
necessary, during any default management undertaken by a derivatives
clearing organization that results from an event of default and for the
purposes of transferring, liquidating, or hedging any proprietary or
customer positions as a result of an event of default.
In addition, the Commission is including the term ``clearing
unit,'' as defined in Sec. 23.605(a), in the relevant provisions of
Sec. 23.605(d). This change will serve to clarify the scope of the
informational partition between the SD or MSP and the personnel or
division of a clearing member responsible for the provision of clearing
services.
To clarify an issue raised by FIA/ISDA/SIFMA, the Commission notes
that SDs and MSPs are not required to publicize their client sales and
on-boarding decisions; rather, the criteria used in making those
decisions should be publicly available and objective. In other words,
``all such decisions regarding the acceptance of customers for clearing
should be made in accordance with publicly disclosed, objective,
written criteria,'' as stated in the preamble of the proposed rule.
b. Division of Clearing Unit Into Self-Clearing Unit and Customer
Clearing Unit
The proposed rules did not distinguish between a self-clearing unit
(clearing for an SD's or MSP's own trades) and a customer clearing unit
(clearing for customers and competitors). However, Swaps and
Derivatives Market Association commented that the proposed rules should
differentiate between the two units. Having considered that comment,
the Commission has decided not to modify the language in the manner
suggested by the commenter. The Commission believes that subdividing
the clearing unit into two separate sub-units would create an
unnecessary complication that could erode the firewall mandated by the
statute.
c. Prohibition on Business Unit Personnel of an SD or MSP From
Supervising Personnel of an Affiliated DCO-Clearing Member--Sec.
23.605(d)(2); Restrictions on SD and MSP Business Trading Unit
Supervision of Clearing Unit of Affiliated FCM--Sec. 1.71(d)(2)(ii)
As proposed, Sec. 23.605(d)(2) provided that, at a minimum, the
Sec. 23.605(d)(2) informational partitions ``shall require that no
employee of a business trading unit of a [SD] or [MSP] shall supervise,
control, or influence any employee of a clearing member of a
derivatives clearing organization,'' while proposed, Sec.
1.71(d)(2)(ii) congruently provided that ``[n]o employee of a business
trading unit of an affiliated [SD] or [MSP] shall supervise, control,
or
[[Page 20155]]
influence any employee of a clearing unit of the [FCM].''
FIA, ISDA, and SIFMA, in a joint comment, posited that because
employees of a business trading unit and a clearing unit may be
supervised by the same manager, Sec. Sec. 23.605(d)(2) and
1.71(d)(2)(ii) should be amended to prohibit an employee of an SD or
MSP from acting as a direct supervisor of any non-management personnel
of an affiliated FCM's clearing unit. The commenter also suggested that
salespeople be permitted to associate with an SD or MSP and with an
affiliated FCM, and be permitted to act for clients at both entities.
Further, the commenter argued that a carve-out should be added to
Sec. Sec. 23.605(d) and 1.71(d) enabling an SD parent to exercise risk
management over its affiliated FCM (e.g., approving credit and risk
parameters for common and distinct customers) in a manner that is non-
discriminatory, non-prejudicial, and for the sole purpose of complying
with group risk and credit policies and parameters. In a separate
comment, JP Morgan expressed a general agreement with the points raised
in the FIA/ISDA/SIFMA letter.
After reviewing the comment, the Commission has decided to adopt
the rule with certain modifications. Any influence on clearing unit
personnel by upper-level supervisors involved in business trading unit
activities would undermine the conflict-of-interest requirements
mandated by new sections 4d(c) and 4s(j)(5) of the CEA, as amended by
sections 731 and 732 of the Dodd-Frank Act, respectively, and set forth
in the rule. Moreover, the Commission does not believe that the rule
language should be changed to permit sales personnel to act for both
the trading unit and the clearing unit. The risks associated with this
approach, in terms of potential undue influence and interference with
clearing decisions has been well-supported by commenters, as discussed
above.
With regard to proposed Sec. 1.71(d), the Commission is making
certain changes to clarify the intent of the rule. In particular, Sec.
1.71(d)(1)(vi) is modified to prohibit an affiliated SD or MSP from
interfering with or influencing decisions related to setting a
particular customer's fees for clearing services based upon criteria
that are not generally available and applicable to other customers of
the FCM. Additionally, as proposed Sec. 1.71(d)(2)(i) required that
the informational partitions between the business trading unit of the
affiliated SD or MSP and the clearing unit personnel of the FCM include
a prohibition on any business trading unit personnel participating in
any way with the provision of clearing services. As modified, the rule
clarifies that business trading unit personnel may not condition or tie
the provision of trading services to the provision of clearing services
or otherwise participate in clearing services by improperly
incentivizing or encouraging the use of the affiliated FCM.\33\ In
addition, as discussed above, business trading unit personnel would be
permitted to participate in the activities of the FCM in the event of a
default.
---------------------------------------------------------------------------
\33\ The Commission generally would not view as ``improper''
making available discounted clearing services in connection with
trading activities, provided that the business trading unit
personnel comply with applicable prohibitions and restrictions on
their interactions with the clearing unit. The Commission emphasizes
in this regard that in Sec. 1.71(d)(2), the term ``improperly''
modifies both the term ``incentivizing'' and the term
``encouraging'' and that the term ``otherwise'' is intended to
clarify that other ``improper'' activities, similar to conditioning
or tying, could be subject to Sec. 1.71(d)(2). Such ``improper''
activities are limited to those that wrongfully interfere with, or
attempt to influence, a decision of the affiliated FCM's clearing
unit personnel specified in Sec. 1.71(d)(1).
---------------------------------------------------------------------------
8. Undue Influence on Customers--Sec. 1.71(e)
As proposed, Sec. 1.71(e) mandated that FCMs and IBs ``adopt and
implement written policies and procedures that mandate the disclosure
to its customers of any material incentives and any material conflicts
of interest regarding the decision of a customer as to the trade
execution and/or clearing of the derivatives transaction.''
K&L Gates LLP (on behalf of Peregrine Financial Group Inc.)
commented that existing Commission regulations already impose risk
disclosure requirements on FCMs and IBs, and that the proposed rule
inappropriately imports a concept from the securities industry into the
futures industry.
Better Markets submitted two comment letters in support of the
proposal. In the first comment, the commenter suggested that the rule
should extend to the affiliates of an FCM or IB, and that the
disclosure should include the nature and amounts of the relevant
interests. In the second comment, the commenter suggested that the rule
be expanded so that any incentives received by FCMs or SDs in exchange
for use of various market infrastructures must be fully disclosed.
Swaps and Derivatives Market Association submitted a comment supporting
Sec. 1.71(e), as proposed.
Having considered the comments, the Commission has determined it
appropriate to adopt the rule as it was originally proposed. The
Commission believes that in order to ensure that counterparties are
adequately informed of any material incentives or conflicts prior to
the execution of a transaction, it is essential that FCMs and IBs be
required to adopt and implement written policies and procedures that
require the advance disclosure of such conflicts. In addition to
addressing issues of customer protection, the policies and procedures
will promote consistency with proposed Sec. 23.605(e). Further, to the
extent that Better Markets commented that the rule should be expanded
to include disclosures of certain incentives received by FCMs and IBs,
the Commission believes that the recommendation is beyond the scope of
this rule.
9. Undue Influence on Customers--Sec. 23.605(e)
As proposed, Sec. 23.605(e) mandated that SDs and MSPs ``adopt and
implement written policies and procedures that mandate the disclosure
to its counterparties of any material incentives and any material
conflicts of interest regarding the decision of a counterparty: (1)
Whether to execute a derivative on a swap execution facility or
designated contract market; or (2) Whether to clear a derivative
through a derivatives clearing organization.''
FIA, ISDA, and SIFMA, in a joint comment, noted that the proposed
rule overlaps with disclosures proposed by the Commission in a separate
notice of proposed rulemaking.\34\ The commenter argued that the
provision should be narrowed and, alternatively, that the Commission
could require SDs and MSPs to provide customers with an annual
disclosure document describing potential conflicts that may exist among
the firm, its affiliates, clients, and employees. In a separate
comment, JP Morgan expressed a general agreement with the points raised
in the FIA/ISDA/SIFMA letter.
---------------------------------------------------------------------------
\34\ See Business Conduct Standards for SDs and MSPs with
Counterparties, 75 FR 80638, 80659 (Dec. 22, 2010).
---------------------------------------------------------------------------
Better Markets submitted two comment letters addressing the
provision at issue. In the first comment, the commenter suggested that
the Commission extend the disclosure requirements in several respects.
In the second comment, the commenter reiterated its belief that
incentives of SDs and MSPs received in exchange for use of various
market infrastructures should be fully disclosed. Michael Greenberger,
UNITE HERE, and Swaps and Derivatives Market Association each submitted
comments supporting Sec. 23.605(e), as proposed.
[[Page 20156]]
After considering the comments, the Commission has determined it
appropriate to adopt the rule as it was originally proposed. The
Commission believes that in order to ensure that counterparties are
adequately informed of any material incentives or conflicts prior to
the execution of a transaction, it is essential that SDs and MSPs be
required to adopt and implement written policies and procedures that
require the advance disclosure of such conflicts. In addition to
addressing issues of customer protection, the policies and procedures
will promote the efficient use of trading facilities and DCOs for swap
transactions, by ensuring that counterparties are adequately informed
of any material incentives or conflicts of an SD or MSP that could
impact the execution and clearing decisions of the counterparty.
N. Designation of a Chief Compliance Officer; Required Compliance
Policies; and Annual Report of an FCM, SD, or MSP
Section 4d(d) of the CEA, as added by section 732 of the Dodd-Frank
Act, requires that each FCM designate an individual to serve as its
chief compliance officer (CCO). Likewise, section 4s(k) of the CEA as
added by section 731 of the Dodd-Frank Act requires that each SD and
MSP designate an individual to serve as its CCO. The CCO NPRM proposed
Sec. 3.3(a) to codify these requirements for FCMs, SDs, and MSPs, and
prescribed certain qualifications for the position.
Section 4s(k)(2) of the CEA sets forth certain duties to be
performed by a CCO of an SD and MSP, and section 4d(d) of the CEA
requires the Commission to promulgate rules concerning the duties of a
CCO of an FCM. The CCO NPRM proposed Sec. 3.3(d) to codify the duties
set forth in section 4s(k)(2) and applied them uniformly to FCMs, SDs,
and MSPs.
Section 4s(k)(3) of the CEA requires that the CCO of an SD or MSP
annually prepare and sign a report containing a description of the
registrant's compliance with the CEA and regulations promulgated under
the CEA, and a description of each policy and procedure of the CCO,
including the code of ethics and conflicts of interest policies.
Proposed Sec. 3.3([e]) \35\ codified this requirement and applied
these requirements to CCOs of FCMs as well.
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\35\ The proposed regulations misnumbered the subsections of
Sec. 3.3 such that two subsections were designated as ``(d).'' To
avoid confusion, this release re-designates such sections correctly
in brackets.
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The Commission received 25 comment letters and Commission staff
participated in one meeting in response to the CCO NPRM and considered
each in formulating the final rules.
1. Identical Rules Applicable to SDs, MSPs, and FCMs
The Commission proposed uniform rules applicable to SDs, MSPs, and
FCMs.
Rosenthal Collins Group, LLC (Rosenthal) and Newedge commented that
Congress did not intend for CCOs of FCMs to be subject to the same
requirements as CCOs for SDs and MSPs, and it is ``overkill'' for CCOs
of ``pure'' FCMs to be subject to the same requirements as CCOs of SDs
and MSPs. However, Rosenthal conceded that an FCM that is also an SD or
MSP should comply with the more stringent requirements.
NFA questioned why there was no explanation of the decision to
extend identical requirements to CCOs of FCMs. NFA argued that it is
more important to harmonize with FINRA Rule 3010 and FINRA Interpretive
Material 3010-1, Rule 3012, and Rule 3130 because 55% of FCMs are also
broker-dealers (BDs) registered with the SEC.
The FHLBs commented that they are already subject to Federal
Housing Finance Agency (FHFA) regulation, such as internal control
systems under 12 CFR 917.6, and requested that the Commission defer to
this regime because duplicative regulations will not increase
transparency and may cause some limited SDs to leave the business.
Better Markets supported extension of the same duties to FCMs
because of their critical role in the market that will expand
dramatically with the increased use of clearing. The National Society
of Compliance Professionals (NSCP) also supported application of
identical CCO requirements to all registrants, provided the NSCP's
suggested modifications to the rule were made. The Council of
Institutional Investors (CII) commented that extending the same duties
to CCOs of FCMs would be comprehensive and consistent, and may help
mitigate regulatory uncertainties.
FIA and SIFMA agreed with NSCP that the CCO requirements for SDs,
MSPs, and FCMs can be harmonized in an identical regime, provided the
suggested changes to the rule are made to bring the rule into harmony
with the traditional financial services compliance model. FIA and SIFMA
also noted that the more traditional compliance model would be
consistent with the approach the Commission took with regard to retail
foreign exchange dealers (RFEDs).\36\
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\36\ RFEDs are required to designate a CCO and prepare an annual
compliance certification under current Commission regulations. See
17 CFR 5.18(j).
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With regard to comments that CCOs of FCMs should be subject to
different or lesser standards than SDs or MSPs, the Commission notes
that FCMs are subject to fiduciary duty standards,\37\ and agrees with
Better Markets that the role of FCMs likely will grow in importance as
client clearing of swaps increases. The Commission also agrees with CII
that the Commission has an interest in consistent regulation of its
registrants. As discussed below, after considering the comments of
NSCP, FIA, SIFMA, and others, the Commission is making a number of
changes to the final rule to harmonize the rule to the extent possible
with the traditional financial services compliance model. Therefore,
the Commission is not promulgating different rules for FCMs. The
Commission further notes that whereas the Dodd-Frank Act required that
FCMs designate CCOs, the Act did not establish a similar requirement
that BDs must designate CCOs under the securities laws. Accordingly,
the distinction between treatment of FCMs and BDs has a statutory
basis.
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\37\ See Joint Report of the SEC and the CFTC on Harmonization
of Regulation at 68 (Oct. 16, 2009), available at www.cftc.gov/PressRoom/PressReleases/pr5735-09 (discussing relevant case law
establishing a fiduciary duty standard for FCMs).
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In response to comments regarding consistency with RFED and FINRA
rules, the Commission believes that the changes to the rule discussed
below will broadly harmonize the rule with the standard currently
applicable to CCOs of RFEDs and the standards applicable to the CCOs of
BDs.
The Commission recognizes that there may be some overlap with FHFA
rules for the FHLBs. However, the Commission believes that the two
approaches are broadly compatible. For example, the FHFA requires
senior management to establish and implement an effective system to
track internal control weaknesses and the actions taken to correct
them, and to monitor and report to the bank's board on the
effectiveness of the internal control system, whereas the Commission's
rule requires the CCO to establish, in consultation with the board or
the senior officer, procedures for the handling, management response,
remediation, retesting, and closing of noncompliance issues, and to
have a meeting with the board or senior officer at least once a year.
These provisions are compatible if the CCO works in
[[Page 20157]]
consultation with the senior officer (as permitted under Sec. 3.3 as
adopted) to establish a monitoring system. The board would receive the
benefit of two views on effectiveness of compliance policies--one from
managers who implement the policies, and one from a monitor of the
managers, who is the CCO.
2. Harmonization With CCO Rule of the Financial Industry Regulatory
Authority (FINRA)
Although the Commission reviewed and considered the existing FINRA
rules for BDs' CCOs, the duties and requirements of a CCO under section
4s(k) of the CEA are far more specific than the general policies,
procedures, and testing requirements of the FINRA rule. Thus, the
proposed rule necessarily differed in both form and substance from the
FINRA rule, which was not mandated by statute.
FIA and SIFMA argued that the proposal should be harmonized with
existing precedent for compliance models in the financial services
industry (such as those applicable to BDs), and that NFA, of which SDs
and MSPs will be required to be members, should have primary
responsibility for setting compliance standards.
Newedge argued that jointly registered BD-FCMs should be able to
apply the requirements of FINRA Rule 3130, which Newedge considers to
be better designed, and only comply with the Commission's rules if no
comparable provision exists in Rule 3130. Newedge also argued that NFA
has extensive experience dealing with FCM CCOs and is best positioned
to determine their proper role.
Rosenthal commented that the substantial experience of FINRA and
NFA in dealing with conduct and compliance should be relied upon, with
FINRA Rule 3130 as a guide.
Market participants \38\ in a May 17, 2011 meeting (May Meeting)
with Commission staff stated that the Commission's rules differed from
FINRA's rules in three main ways: resolution vs. mitigation of
conflicts, the term ``ensure compliance'' in the Commission's rules,
and whether the CEO or the CCO certifies the annual report. The
participants also stated that, without revisions to the proposed rule,
they would be required to prepare two annual reports: one for FINRA and
one for the Commission.
---------------------------------------------------------------------------
\38\ Representatives from the SEC and Commission staff met with
industry participants including representatives of FIA, SIFMA, UBS
Financial Services, Inc., MF Global, Morgan Stanley, JPMorgan Chase
& Co., Pershing, Alliance Bernstein, and Newedge USA on May 17,
2011. See http://comments.cftc.gov/PublicComments/.
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Having considered these comments, the Commission has determined it
is unable to conform the rule fully to match the FINRA standard for
CCOs of BDs and still meet the statutory requirements of section 4s(k).
However, the Commission believes the purpose of the rule is
supplemental to--not contradictory with--the relevant provisions of
FINRA Rules 3010, 3012, and 3130.
As explained by commenters, the CCO customarily has acted as an
advisor, and has not had the ability to enforce compliance policies by
directing staff or making hiring and firing decisions. By way of
contrast, new section 4s(k) of the CEA requires that the CCO resolve
conflicts of interest, be responsible for administering certain
policies and procedures, and ensure compliance with the CEA. While the
Commission has attempted to be responsive to the traditional role of
compliance officers in the financial services industry, the Commission
does not believe that FINRA's rules provide a model that would
encompass all of the statutory provisions in section 4s(k). The
Commission believes, however, that the changes to the rule discussed
below will broadly harmonize the final rule with FINRA standards and
allow a CCO of a dual registrant to fulfill the duties required by both
rules without undue duplication or contradiction.
Notably, as explained above, the Dodd-Frank Act required that FCMs
designate CCOs, whereas the Act did not establish a similar requirement
that BDs must designate CCOs under the securities laws. Accordingly,
the distinction between treatment of FCMs and BDs has a statutory
basis.
3. Regulatory Structure
In the CCO NPRM, the Commission requested comment on whether the
structure of the proposed rules allows for sufficient flexibility.
EEI urged the Commission to follow the Federal Energy Regulatory
Commission's approach by setting forth principles or attributes of an
effective compliance program while leaving the details to the
registrant.
Rosenthal argued that the rule should allow for flexibility because
the role of a CCO varies, and should not be a ``one size fits all,''
while NSCP commented that the proposed rules ``strike an appropriate
balance'' between aspirational standards and forcing all entities to
conform to one standard. Cargill commented that if the scope of the
rules is limited to a registrant's swap dealing division, the
provisions in the proposed rule are ``in general reasonable and provide
flexibility so that each swap dealer can apply the general requirements
to its own business structure.''
Commodity Markets Council (CMC) requested that the Commission
clarify whether registration as an SD due to activities in one
commodity would require compliance obligations for all activities of an
integrated firm, require compliance obligations on the activities of an
involved affiliate, or require compliance obligations for just those
activities in the underlying commodity.
NFA and the FHLBs commented that the rules should explicitly permit
the CCO to share any other executive role, such as CEO, to provide
flexibility for smaller firms. NFA also argued that the rules should
recognize that compliance expertise may reside with more than one
individual, and thus the Commission should consider allowing an entity
to designate multiple CCOs, so that each CCO's primary area of
responsibility is defined, and each CCO should be required to perform
duties and responsibilities with respect to their defined area. NFA
also recommended that CCOs explicitly be permitted to consult with
other employees, outside consultants, lawyers, and accountants.
Newedge, Hess Corporation (Hess), and The Working Group argued that
affiliated FCM/SD/MSPs that are separate legal entities should be
permitted to share the same CCO to increase compliance efficiency. The
Working Group also argued that the CCO of affiliated registrants should
be allowed to report to a board of an affiliated entity that controls
both entities. Better Markets, on the other hand, commented that a
senior CCO should have overall responsibility of each affiliated and
controlled entity, even if individual entities within the group have
CCOs. Better Markets also recommended that the rule require the CCO
office to be located remotely from the trading floor.
In response to EEI's recommendation that the Commission set forth
general principles akin to those required by FERC, the Commission
observes that the statutory regime established by Congress would not
permit such an approach.
The Commission agrees with commenters that CCOs should be permitted
to ``wear multiple hats.'' In other words, the Commission confirms that
a CCO may share additional executive responsibilities and/or be an
existing officer within the entity. This is particularly appropriate in
smaller firms, which may lack sufficient scale to employ a stand-alone
CCO. However, employing a stand-alone CCO may be
[[Page 20158]]
appropriate in a larger firm, depending on the scale of its operations
and degree of the CCO's responsibilities. Additionally, the Commission
confirms that nothing in the rules would prohibit multiple legal
entities from designating the same individual as CCO, but the rule as
adopted will require the CCO to report to each entity's board or senior
officer, rather than to the board or senior officer of a consolidated
corporate parent.
The Commission has determined not to permit designation of multiple
CCOs with delineated areas of responsibility because this arrangement
would not comply with sections 4d(d) and 4s(k) of the CEA, which
require FCMs, SDs, and MSPs to ``designate an individual to serve as
chief compliance officer.'' In response to NFA's concern about CCOs
being able to rely on the expertise of others, the annual report
certification language in the rule as adopted containing the qualifier
``to the best of his or her knowledge and reasonable belief'' would
permit the CCO to rely on other experts for statements made in the
annual report.
As previously noted, the Commission is clarifying in the final
rules that the CCO's duties extend only to the activities of the
registrant that are regulated by the Commission, namely, swaps
activities of SDs and MSPs and the derivatives activities included in
the definition of FCM under section 1(a)(28) of the CEA.
4. Public Availability of the Annual Report
The Working Group commented that it is likely that the annual
report will not be considered confidential information protected from
Freedom of Information Act requests, and could expose registrants to
legal and reputational risk if made public. The Working Group also
argued that the report may force firms to make disclosures prior to
having remedial actions agreed with the Commission and put into effect,
and could grant valuable insight to competitors. The Working Group
recommended that the Commission take steps to ensure that the
information remains confidential and should make explicit that there is
no private right of action for misstatements and inaccurate content in
the report. EEI also expressed concern about disclosure of confidential
or proprietary information if the report would be made public. FIA and
SIFMA recommended that the Commission make the report nonpublic by
including it in the list of exempted items in Commission regulation
Sec. 145.5.
In response to these comments, the Commission notes that a
registrant may request confidential treatment under Sec. 145.9 for
information submitted to the Commission under these regulations.
Accordingly, an FCM, SD, or MSP must petition for confidential
treatment of its annual report under Sec. 145.9 if it wants the
Commission to determine that a particular annual report should be
subject to confidentiality.
5. Definitions--Sec. 3.1
Proposed amendments to Part 3 of the Commissions regulations in the
CCO NPRM added chief compliance officers to the definition of
``principal'' in Sec. 3.1(a)(1), and added definitions of ``compliance
policies'' and ``board of directors'' at Sec. 3.1(g) and (h),
respectively.
a. Definition of ``Principal''--Sec. 3.1(a)(1)
The proposed regulations modified the definition of ``principal''
in Part 3 to include a CCO as an example of a person ``having the
power, directly or indirectly, through agreement or otherwise, to
exercise a controlling influence over the entity's activities that are
subject to regulation by the Commission.''
Rosenthal argued that declaring the CCO to be a principal adds no
incentive for qualified individuals to become a CCO because he or she
could be liable outside his/her area of competence or control.
Rosenthal also argued that it should be the firm's responsibility to
comply, with ultimate responsibility for compliance placed with the
firm's senior management. EEI argued that the proposal is overly
prescriptive, that requiring the CCO to be a principal would require
significant changes to current practice, and that the reporting
structure should be left to each individual firm. On the other hand,
Cargill commented that the requirement to be listed as a principal
applies statutory disqualification standards that are clear and
objective.
NFA recommended that the proposed change to the definition of
``principal'' be modified to mention the CCO earlier in the definition
rather than listing the position as an example of a person with
supervisory authority over business personnel (i.e., a position with
power to exercise a controlling influence). NFA stated that the rule
should clarify that the CCO is not a line supervisor, nor does the CCO
have supervisory authority over personnel.
FIA and SIFMA argued that, although the FINRA CCO rules require the
CCO to register as a ``general securities principal,'' FINRA has
explicitly stated that this ``does not create the presumption that a
chief compliance officer has supervisory responsibilities or is
otherwise a control person.'' FIA and SIFMA recommended that the
Commission make a similar qualifying statement when promulgating the
final rules.
Considering these comments, the Commission is modifying the
proposed rule to list the position of CCO within the definition of
principal separately for each type of entity as recommended by NFA,
rather than as an example of someone in a position to exercise a
controlling influence. The Commission believes that this modification
addresses the issue sufficiently, without the need to incorporate the
qualifying statement recommended by FIA and SIFMA. However, this change
should not be interpreted to undermine the CCO's ability to fulfill the
CCO's duties as provided for under the CEA and by Commission
regulation.
b. Definition of Compliance Policies--Sec. 3.1(g)
The proposed regulations defined ``compliance policies'' broadly to
include all policies required to be adopted or established by the
registrant pursuant to the CEA and regulations, including a code of
ethics.
The Working Group requested that the Commission clarify that the
proposed rules do not require that a firm must adopt a code of ethics,
but only that in its annual report the firm provide a description of a
code of ethics to the extent that it has one.
The National Whistleblowers Center (NWC) recommended that the
Commission establish a rule that provides contact with internal
compliance departments with the same whistleblower protection as
contacts with the Commission. NWC also recommended that the Commission
require registrants to adopt a code of ethics and conduct that contain
rigorous whistleblower protections. Finally, NWC recommended that the
Commission require an effective compliance program with the following
components: Consistent enforcement of the company's code of conduct;
professional management of the help line; vigorous enforcement of non-
retaliation policies; effective compliance and ethics risk-assessment;
integration of clear, measurable compliance and ethics goals into the
registrant's annual plan; direct access and reporting by the CCO to a
compliance-savvy board; strong compliance and ethics infrastructure;
compliance audits to uncover law-breaking; CEO action to promote
compliance; and shared learning within the registrant.
[[Page 20159]]
In order to achieve maximum consistency across the CCO provisions
for SDs, MSPs, FCMs, DCOs, SDRs, and SEFs, the Commission has deleted
the definition of ``compliance policies'' from the rule. The Commission
believes this definition is unnecessary given the overall changes to
the scope of the review required by the annual report, discussed below.
The changes to the scope of the review of the annual report track the
language of the statute in that the annual report will require a
description of the written policies and procedures, including a code of
ethics and conflicts of interest policies. The annual report separately
will require a description of material compliance with the CEA and
Commission regulations.
In response to The Working Group's comment, the Commission notes
that the statute requires that the CCO prepare and sign an annual
report that contains a description of each policy and procedure,
including the code of ethics and conflicts of interest policies.
Whether a firm decides to adopt a separate code of ethics in
furtherance of this requirement is left to its discretion.
In response to NWC's comments, the Commission takes note of NWC's
points related to whistleblowers as sound practices. However, these
additional requirements, such as requiring specific whistleblower
provisions in codes of ethics or conduct are outside the scope of this
rulemaking.
6. Designation of Chief Compliance Officer--Sec. 3.3(a)
Proposed Sec. 3.3(a) required each SD, MSP, and FCM to designate
an individual as a CCO and provide the CCO with the full responsibility
and authority to develop and enforce, in consultation with the board or
senior officer, appropriate policies and procedures to fulfill the
duties set forth in the CEA and regulations.
EEI argued that a CCO should work in concert with business and
control functions to assure appropriate policies are in place, but that
the proposed rules go beyond what is required by the CEA by
inappropriately imposing upon the CCO full responsibility to develop
and enforce all policies. Newedge also commented that CCOs generally do
not have full responsibility to develop and enforce compliance
policies, and cites a Security Industry Association White Paper that
states: ``* * * there is a huge difference between the role of the
Compliance Department and its personnel, and the overall broad firm
responsibility `to comply' with applicable rules and regulations. The
Compliance Department plays an integral support function for firm
compliance programs, but only senior management and business line
supervisors ultimately are responsible for ensuring firm compliance
with laws and regulations.''
Rosenthal commented that the Commission's rules should be revised
in a manner that reflects the view that the CCO is only an advisor to
management and should not be viewed as an enforcer of policies within
the FCM, as that would represent a ten-year step backward in
governance.
In an attempt to balance the traditional role of compliance
officers in the financial service industry with the statutory
requirements and policy objectives of promoting a strong culture of
compliance, the Commission is revising proposed Sec. 3.3(a) to (i)
remove the requirement that a CCO be provided with ``full''
responsibility and authority; (ii) remove the requirement that a CCO
``enforce'' policies and procedures; (iii) limit the responsibilities
of the CCO to the ``swaps activities'' of SDs and MSPs, and the FCMs'
derivatives activities included in the definition of FCM under section
1(a)(28) of the CEA; and (iv) clarify that a CCO need only develop
policies and procedures to fulfill the duties set forth in, and ensure
compliance with, the CEA and Commission regulations. The Commission is
making the changes to Sec. 3.3(a) to alleviate commenters' concerns
about the use of the term ``enforce'' and about the scope of the CCO's
duty to develop policies and procedures.
7. Reporting Line--Sec. 3.3(a)(1) & (2)
Proposed Sec. 3.3(a)(1) required that the CCO report to the board
of directors or the senior officer of a registrant, that the board or
senior officer approve the compensation of the CCO, and that the board
or senior officer meet with the CCO at least once a year to discuss the
effectiveness of compliance policies and their administration by the
CCO. Proposed Sec. 3.3(a)(2) also prohibited the board or senior
officer of a registrant from delegating its authority over the CCO,
including the authority to remove the CCO.
The CCO NPRM requested comment on the degree of flexibility in the
reporting structure, including whether it would be more appropriate for
a CCO to report to the board or the senior officer; whether the board
or the senior officer is a stronger advocate on compliance matters;
whether the proposed reporting structure should address issues related
to affiliates; and whether the rule should include a provision
requiring a majority of the board to remove the CCO. The proposal also
requested comment regarding whether it is necessary to adopt rules for
the CCO regarding conflicts of interest between compliance interests,
commercial interests, and ownership interests of a registrant.
Cargill recommended that the definition of board of directors be
expanded to include a governing body of a division, such as a
management committee, if the SD registration applies to activities
within a division of a larger company, rather than the company as a
whole. Cargill also recommended that the Commission add a definition of
``senior officer'' and that it include a senior officer of a division,
because a division might be more familiar with the swaps activities of
an SD. Cargill and The Working Group each argued that a requirement
that a CCO can be removed only by a majority of the members of a
governing body would be inflexible, and should not be added to the
rules.
The Working Group argued that the CCO should be allowed to report
to a board of an affiliated entity that controls both the affiliate and
the registrant. The Working Group also argued that the CCO should be
permitted to operate under the direction of other corporate officers,
even middle level officers, so that the CCO is not an independent
inspector general that operates outside the traditional reporting
structure within a corporate entity. EEI also argued that the proposal
is overly prescriptive and recommends that the reporting structure be
left to each individual firm. Similarly, FIA and SIFMA commented that
although the board is the ultimate supervisory authority, the CCO
should not be required to directly report to it. Instead, firms should
be free to determine the reporting structure as long as independence
and authority as a control function is maintained. FIA and SIFMA
recommended, for example, that the CCO be allowed to report to the
chief legal officer or the chief risk officer.
On the other hand, Rosenthal commented that the CCO should report
to the board or, if the registrant is not a corporation, to the senior
officer. Rosenthal also commented that the CCO should be prohibited
from receiving any transaction or customer-based compensation to
insulate the CCO from potential conflicts. NSCP also agreed that CCOs
should report to senior management and have compensation set by
managers that are not influenced by the profitability of particular
business units. NSCP noted that new Organizational Sentencing
Guidelines consider whether individuals with operational responsibility
for compliance and ethics have direct
[[Page 20160]]
reporting obligations to the governing authority or an appropriate
subgroup thereof (like an audit committee of a board), which the
proposed rules would require. NSCP recommended that a provision be
added to the proposed rules to make it illegal for a registrant to
coerce a CCO improperly, similar to the one for CCOs of investment
companies and independent public accountants.
Better Markets and Chris Barnard recommended that decisions to
designate or terminate a CCO, as well as compensation decisions, be
prescribed as the sole responsibility of independent members of the
board of directors, or audit committee, acting by majority vote, and
not the responsibility of the executive officer. Better Markets also
recommended that both the board and the senior officer be required to
meet with the CCO to discuss the effectiveness of compliance policies,
and that such meetings be held at least quarterly. Better Markets
further recommended that the CCO's duties be performed in consultation
with both the board and the senior officer.
National Whistleblowers Center (NWC) recommended that the term
``senior officer'' be defined as the CEO or chairman of the board, and
should not be the general counsel or a subordinate employee to the CEO.
NWC believes that the rule should permit the CCO to report to the full
board at any time with no interference from a board committee or a CEO.
NWC also argued that the rule should prohibit termination of the CCO
unless the CCO is presented the opportunity to address the board.
MetLife requested that the definition of board of directors include
``(or committee of such board or governing body)'' to permit it to
continue its current practice of delegating particular responsibilities
to expert committees of the whole board (i.e., audit, finance,
investments, risk, and compensation). NFA also sought additional
flexibility in the reporting structure for CCOs, provided that the
firm's business unit is not permitted to impose undue pressure on a CCO
regarding compliance.
Newedge recommended that the CCO be required to meet at least
quarterly with the board or senior officer to discuss the effectiveness
of compliance policies.
The Working Group believes it is not necessary to address conflicts
of interest between compliance interests and commercial interests in
the rule because the independent audit requirements imposed by the
Sarbanes Oxley Act already address such conflicts.
Having considered these comments, the Commission will not permit
CCOs to report to committees of a board of directors. Section 4s(k) of
the CEA requires the CCO to ``report directly'' to the board or the
senior officer of the SD or MSP. In other contexts (for example the
risk management duties rules for SDs and MSPs discussed above),
reporting to committees of the board is permitted. However, in this
context, the Commission believes that the statutory requirement that
the CCO report directly to the board or senior officer does not afford
such discretion. The Commission is guided by the policy objectives of
section 4s(k) in reaching the same conclusion with regard to FCMs, and
observes that no currently registered FCM requested that the CCO report
to a committee of the board. Indeed, Rosenthal, and FCM, agreed with
the requirement that CCOs for FCMs report to a board of directors if
the entity has one, or the senior officer, if the entity does not have
a board.
In response to Cargill's comments, the Commission notes that under
the CEA and under the rules as adopted, a registrant may elect to have
the CCO report to the senior officer of the registrant. Because,
``senior officer'' is not defined, if a division of a larger company is
a registered SD, then the CCO of such registrant could report to the
senior officer of that division.
In order to preserve CCO independence, the Commission is not
changing the requirement that only the board or the senior officer can
hire, set compensation for, and remove the CCO. However, in order to
promote consistency among the CCO rules for registrants and registered
entities, the Commission is modifying proposed Sec. 3.3(a)(1) and (2)
to (i) require only that the CCO and board or senior officer meet once
a year and at the election of the CCO, but not mandate the content of
such meeting; and (ii) to clarify that only the board or senior officer
may remove the CCO.
The Commission believes that additional requirements, such as
providing the CCO an opportunity to address the board prior to removal,
requiring more frequent meetings between the CCO and the board or
senior officer, restricting the composition of CCO compensation, or
mandating independent director approval, would be overly prescriptive
and unnecessary to achieve the purposes of the rule. Similarly, the
Commission believes that a provision prohibiting improper coercion is
unnecessary because the rule adequately ensures CCO independence
through a direct reporting line to the board or senior officer and by
requiring compensation decisions to be made by the board or a senior
officer.
8. Qualifications--Sec. 3.3(b)
As proposed, Sec. 3.3(b) required the CCO to have the background
and skills appropriate for fulfilling the responsibilities of the
position, and prohibited an individual who is statutorily disqualified
under sections 8a(2) or 8a(3) of the CEA from serving.\39\ The proposal
requested comments regarding whether additional limitations should be
placed on CCOs, such as a prohibition on designating a registrant's
counsel as CCO.
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\39\ These CEA sections contain an extensive list of matters
that constitute grounds pursuant to which the Commission may refuse
to register a person, including, without limitation, felony
convictions, commodities or securities law violations, and bars or
other adverse actions taken by financial regulators.
---------------------------------------------------------------------------
NFA argued that the statement that no individual disqualified from
registration under section 8a(2)-(3) of the CEA may serve as a CCO is
redundant because an SD, MSP, or FCM's registration could be denied or
revoked under section 8a(2)-(3) of the CEA if any principal of the
registrant is subject to a statutory disqualification. NFA argues that
inclusion of this qualification in the proposed rule could appear to
convey a different standard for CCOs than for other principals.
Cargill commented that the requirement for a CCO to have ``the
background and skills appropriate'' is a commendable aspirational goal
but is too vague a standard for Federal law, and is best reserved as a
business decision. Cargill agreed that the requirement to be listed as
a principal applies statutory disqualification standards that are clear
and objective.
Newedge recommended that CCOs be required to pass a specific
compliance examination and obtain a specific compliance license, as is
the case in the securities world. On the other hand, NSCP does not
believe that CCOs should have to pass a qualification exam or otherwise
have a certain number of years in the industry, given the diversity of
the registrant community. The Working Group also commented that wide
latitude for qualifications of a CCO is necessary.
EEI argues that the general counsel and other attorneys should be
allowed to be the CCO because they are subject to ethics considerations
and a prohibition on conflicts in their representation. NFA also
recommended that the CCO be permitted to be an attorney who represents
the registrant or its board as long as the conflict can be
[[Page 20161]]
managed and duties discharged. Rosenthal and Hess felt that persons
with legal training may be well-suited as CCOs, and that the rule
requirement to demonstrate compliance proficiency is reasonable. To the
contrary, Better Markets argued that a CCO should not be permitted to
be an attorney that represents the SD, MSP, or FCM, or its board
because the potential conflict would disqualify such an attorney.
Having considered these comments, the Commission is adopting the
rule substantially as proposed, with only a technical change to clarify
the references to sections 8a(2) and 8a(3) of the CEA. The Commission
believes it is important for the ``Qualifications'' section of the rule
to put registrants on notice of the possible disqualification of CCO
candidates pursuant to the CEA. The benefit of such notice outweighs
the concern of creating an appearance of a different standard for CCOs
than for other principals. The Commission is retaining the ``background
and skills'' qualification in the final rule because the standard
effectively will prohibit appointment of unqualified persons as CCO.
However, the Commission does not believe that it is necessary to
require a proficiency exam for CCOs at this time.
The Commission also agrees with Better Markets that there may be a
potential conflict if a member of the legal department or the general
counsel of a registrant also served as the registrant's CCO. The
Commission notes that the final rules for SDRs prohibited members of
the legal department or the entity's general counsel from serving as
CCO.\40\ On the other hand, the final rules for derivative clearing
organizations did not include the same prohibition.\41\ Given the
diversity of FCMs and probable diversity of SDs and MSPs and cost
considerations, the Commission is taking a flexible approach in these
final rules and is not prohibiting a member of the legal department or
general counsel from serving as CCO for an SD, MSP, or FCM. However,
should a CCO be a member of the registrant's legal department, the
Commission expects the CCO and registrant to articulate clearly the
segregation of that individual's CCO and non-CCO responsibilities. All
reports required under sections 4d(d) and 4s(k) of the CEA, as well as
the rules promulgated pursuant thereto, are meant to be made available
to the Commission, and as such, they should not be subject to the
attorney-client privilege, the work-product doctrine, or other similar
protections.
---------------------------------------------------------------------------
\40\ See Swap Data Repositories: Registration Standards, Duties
and Core Principles, 76 FR 54538, 54584 (Sept. 1, 2011).
\41\ See 17 CFR 39.10; Derivatives Clearing Organization General
Provisions and Core Principals, 76 FR 69334, 69434 (Nov. 8, 2011).
---------------------------------------------------------------------------
9. Duty To Establish Compliance Policies--Sec. 3.3(d)(1)
Proposed Sec. 3.3(d)(1) required the CCO to establish the
registrant's compliance policies in consultation with the board of
directors or senior officer.
Hess and Newedge each argued that the proposal concentrates too
much of the compliance function on a single individual to the exclusion
of other members of senior management and day-to-day business line
supervisors. Hess argued that overemphasis on the independent role of
the CCO and concentrating responsibility is less effective than
integration. Instead, Hess recommended that the CCO should remain the
monitor of the compliance monitors, which they could not be if they are
responsible for compliance.
The Commission believes that section 4s(k) of the CEA requires that
the CCO administer the compliance policies, but that it does not
require the CCO to establish all of a registrant's compliance policies.
To alleviate some of the commenters' concerns regarding concentration
of the compliance function, the Commission is revising the proposed
rule to track more closely the statutory language of section 4s(k).
10. Duty To Resolve Conflicts of Interest--Sec. 3.3(d)(2)
Following section 4s(k)(2)(C) of the CEA, proposed Sec. 3.3(d)(2)
required the CCO, in consultation with the board or senior officer, to
resolve any conflicts of interest that may arise.
NFA commented that resolution of conflicts of interest should rest
with the board or the senior officer, in consultation with the CCO. FIA
and SIFMA also commented that the CCO should not be deemed to be a
business line supervisor and the rule should not fundamentally change
the role of the CCO, which has customarily been an independent advisor
to the business line supervisors that are ultimately responsible for
compliance. FIA and SIFMA argued that when Congress used the term
``resolve any conflicts of interest that may arise,'' Congress did not
mean resolve in the executive or managerial sense, requiring a CCO to
examine the facts and determine the course of action. Instead, FIA and
SIFMA recommended that the rule be revised to provide a definition of
``resolving conflicts of interest'' that reads: ``designing a system of
conflict identification, assessment and resolution, advising on
conflict avoidance or mitigation alternatives, and escalating
inadequate management responses to conflicts to senior management. * *
*'' Newedge commented that the CEO and business line supervisors are in
a better position than the CCO to resolve conflicts. Newedge believes
that any transfer of regulatory responsibility currently held by
executive officers to the CCO could have the unintended effect of
reducing the amount of time and level of concern such officers will
spend on compliance matters.
Participants in the May Meeting with Commission staff stated that
the phrase ``resolve any conflicts of interest'' would traditionally be
interpreted as eliminating a conflict of interest, but that elimination
is not always preferable. The participants commented that further
interpretation is needed to permit conflicts of interest to be
addressed, mitigated, or conditioned as well. Participants argued that
the role of a compliance officer is to advise the business line of
acceptable and unacceptable alternatives, and if the business line
chooses an unacceptable alternative, then the compliance officer must
escalate the problem until an acceptable alternative is selected.
However, participants strongly believed that the compliance officer
should not be the actual decision maker in the resolution.
Having considered these comments, the Commission is not removing
the requirement that the CCO ``resolve'' conflicts of interest from the
rule because the requirement is provided for in section 4s(k)(2)(C) of
the CEA. However, the Commission confirms, as suggested by commenters,
that the term ``resolve'' encompasses both elimination of the conflict
of interest as well as mitigation of the conflict of interest, and that
the CCO's role in ``resolving'' conflicts of interest may involve
actions other than making the final decision. The Commission notes that
the SEC has taken a similar approach in the preamble of its equivalent
CCO proposal.\42\
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\42\ See Business Conduct Standards for Security-Based Swap
Dealers and Major Swap Participants, 76 FR 42396, 42436 (July 18,
2011) (stating ``we would anticipate that the CCO's role with
respect to such resolution and mitigation of conflicts of interest
would include the recommendation of one or more actions, as well as
the appropriate escalation and reporting with respect to any issues
related to the proposed resolution of potential or actual conflicts
of interest, rather than decisions relating to the ultimate final
resolution of such conflicts'').
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[[Page 20162]]
11. Duty To Review and Ensure Compliance--Sec. 3.3(d)(3)
Following the statutory text of section 4s(k)(2)(E) of the CEA,
proposed Sec. 3.3(d)(3) required the CCO to review and ``ensure
compliance'' by the registrant with the registrant's compliance
policies and all applicable laws and regulations.
FIA and SIFMA argued that the term ``ensure compliance'' needs to
be clarified, because the common usage of the word (i.e., to guarantee)
goes well beyond any existing compliance model and creates a standard
that is impossible to satisfy. FIA and SIFMA further argued that the
requirement to remediate non-compliance issues, and the discussion of
management's response to remediation, acknowledges that instances of
noncompliance are not wholly preventable by any person, and that it is
management's responsibility for implementing compliance policies.
Instead, FIA and SIFMA recommended that the phrase should mean taking
reasonable steps to adopt, review, test, and modify compliance
policies, and pointed to the Commission's RFED rule, which requires
each RFED to designate a CCO that must certify that the RFED has in
place policies and procedures ``reasonably designed to achieve
compliance with the Act, rules, regulations and orders thereunder.''
FIA and SIFMA also recommended that the Commission add a provision in
the definition of compliance policies and procedures to include
``procedures for escalating inadequate management responses to apparent
material violations of compliance policies and procedures to the
appropriate level of senior management * * * depending on the facts and
circumstances of the issues being addressed.''
The Working Group argued that the requirement to ``ensure
compliance'' should not be adopted literally from the statute, because
it is an impossible task. The Working Group recommended that the rules
be revised to avoid suggestions that an incident of noncompliance by a
firm might constitute or evidence a failure by a CCO to meet its
statutory or regulatory responsibilities.
NSCP argued that ``ensure compliance'' imposes a level of
responsibility on a CCO that cannot be discharged and is inconsistent
with the customary role of a compliance officer. Instead, NSCP
recommended that the CCO ``administer the system of compliance that is
designed to ensure compliance with compliance policies and applicable
law.'' NSCP concedes that although the statutory language may be viewed
as constraining, it offers section 501 of the Gramm-Leach-Bliley Act as
an example of constraining language modified by regulation. NSCP stated
that section 501 of that act required financial institutions to adopt
safeguards to ``ensure the security and confidentiality of personal
information,'' but that banking regulators modified the standard to
require adoption of safeguards ``designed to ensure the security and
confidentiality of personal information.'' NSCP further argued that the
business units within registrants either obey the law or violate it,
and a CCO is limited to providing guidance, monitoring for compliance,
and reporting on the business activities.
NFA commented that it should not be the duty of the CCO to ensure
compliance by the FCM, SD, or MSP because it is an impracticable
standard and imposes a duty to supervise a firm's business activities.
NFA argued that the rules improperly redefine a CCO's duties, and
registrants will have difficulty retaining CCOs who are willing to
perform these duties. NFA believes that FINRA's Rule 3130 sets forth
the appropriate role of a CCO.
Participants in the May Meeting with Commission staff stated that
the CCO's responsibility to escalate (repeatedly if necessary) a
problem that has not been resolved could serve as a possible meaning of
the term ``ensure compliance'' when applied to the CCO position.
EEI believes that a basic tenet of modern compliance is that
compliance departments advise, monitor, assist, and escalate to a
governing body if necessary. EEI argued that the act of complying must
be borne and executed by the business, and imposing responsibility on
the CCO could abrogate responsibility of senior management and other
employees.
Newedge believes that the CCO should be required only to review
whether a registrant has established policies designed to achieve
compliance and that the responsibility to enforce compliance should lie
with the business line. Newedge believes the enormity of the
obligations assigned to the CCO would result in inadequate means of
ensuring compliance, defeating the plain purpose of the statute.
In response to the comments received regarding the role of the CCO
in ensuring compliance, the Commission is modifying the proposed rule
to provide that the CCO must take ``reasonable steps to ensure
compliance.'' The Commission believes that this approach is responsive
to commenters' concerns, is consistent with the final rules for SDRs
\43\ and DCOs,\44\ and is broadly consistent with the SEC's proposal
for the duties of a CCO of a security-based swap dealer or a major
security-based swap participant.\45\
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\43\ See Swap Data Repositories: Registration Standards, Duties
and Core Principles, 76 FR at 54584 (stating that the duties of an
SDR's CCO include ``[t]aking reasonable steps to ensure compliance
with the [CEA] and Commission regulations'').
\44\ See Derivatives Clearing Organization General Provisions
and Core Principals, 76 FR at 69434 (stating that the duties of a
DCO's CCO include ``[t]aking reasonable steps to ensure compliance
with the [CEA] and Commission regulations'').
\45\ See Business Conduct Standards for Security-Based Swap
Dealers and Major Security-Based Swap Participants, 76 FR 42396,
42458-59 (July 18, 2011) (requiring the CCO of a security-based swap
dealer or major security-based swap participant to ``[e]stablish,
maintain and review policies and procedures reasonably designed to
ensure compliance with the Act and the rules and regulations
thereunder'').
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In response to comments advocating a purely advisory role for the
CCO, the Commission observes that the role of the CCO required under
the CEA, as amended by the Dodd-Frank Act, goes beyond what has been
represented by commenters as the customary and traditional role of a
compliance officer. While the Commission does not believe, as some
commenters have suggested, that the CCO's duties under the CEA or Sec.
3.3 requires that the CCO be granted ultimate supervisory authority by
a registrant, it is the Commission's expectation that the CCO will, at
a minimum, be afforded supervisory authority over all staff acting at
the direction of the CCO. Recent events have demonstrated the
importance of the active compliance monitoring duties required of the
CCO under the Dodd-Frank Act, as implemented through these regulations.
12. Duty To Prepare, Sign, and Certify Compliance Annual Report--Sec.
3.3(d)(6)
Proposed Sec. 3.3(d)(6) required the CCO of an SD, MSP, or FCM to
prepare, sign, and certify, under penalty of law, the annual report
specified in section 4s(k)(3) of the CEA.
Rosenthal commented that FINRA's approach to certification is
preferable, i.e., that the CEO certifies that the firm has processes to
establish, maintain, review, test, and modify written compliance
policies and written supervisory procedures reasonably designed to
achieve compliance with securities laws, regulations, and FINRA rules,
based on a report by the CCO. FIA, SIFMA, and Newedge each argued that
section 4s(k)(3) of the CEA requires the CCO to sign the annual report,
but does not require the CCO to certify the report. FIA, SIFMA, MFA,
Newedge,
[[Page 20163]]
and NFA all recommended that the rule be revised to require the CEO to
certify the report. Participants in the May Meeting with Commission
staff stated that requiring the CEO, rather than the CCO, to make a
certification as to whether policies are in place that are reasonably
designed to ensure compliance appropriately shares responsibility
between compliance and business management. FIA and SIFMA recommended
that if the Commission requires the CCO to certify the annual report,
then with respect to any Commission registrant that is also a BD, the
Commission also should require the CEO to make the certification
Rosenthal argued that requiring the CCO to certify under penalty of
law will make the CCO liable for firm infractions and will give
disgruntled customers a roadmap for frivolous lawsuits. Newedge also
believes that the requirement to certify under penalty of law is not
fair or practicable because whoever certifies will have to rely on many
individuals to compile the report. On the other hand, Hess commented
that the certification language strikes an appropriate balance such
that strict liability is not imposed for inadvertent errors. NSCP
commented that the certification that the report is accurate and
complete should have a materiality qualifier added to it. Participants
in the May Meeting with Commission staff requested clarification as to
how the certification of the accuracy and completeness of the
information in the annual report might be kept separate from matters of
opinion expressed in the annual report. The participants urged the
Commission to adopt a standard for the annual report certification that
is reasonably attainable.
FIA and SIFMA requested that the Commission clarify that criminal
liability for the certification will not apply (absent a knowing and
willful materially false and misleading statement) because there is no
indication that Congress ever thought CCOs should be subject to
criminal liability. Similarly, NSCP requested that the Commission
clarify whether ``under penalty of law'' means liability under 18
U.S.C. 1001 for a false statement to a Federal officer. FIA and SIFMA
also felt that imposing criminal liability for annual report
certifications would make it hard to fill the position of CCO.
EEI argued that although section 4s(k)(3) of the CEA requires the
CCO to certify the report, any additional content requirements for the
annual report beyond what section 4s(k)(3) requires will make the
certification more difficult.
In response to these comments, with respect to certification by the
CCO, the Commission is modifying the proposed rule to permit either the
CCO or the CEO to make the required certification. Section 4s(k)(3)(A)
of the CEA requires the CCO to sign the annual report and section
4s(k)(3)(B)(ii) requires that the annual report contain a certification
that, under penalty of law, the compliance report is accurate and
complete. Given the statutory provisions and under these circumstances,
the Commission believes it is appropriate to afford SDs, MSPs, and FCMs
the discretion to choose whether the CCO or CEO will make the
certification.
The Commission disagrees with commenters that a mere certification
that policies are in place that are reasonably designed to achieve
compliance would satisfy the requirements of section 4s(k)(3) of the
CEA. The Commission believes that the statute also requires a CCO to
assess how compliance policies are implemented.
The Commission is of the view that limiting the certification with
the qualifier ``to the best of his or her knowledge and reasonable
belief'' addresses commenters' concerns of overbroad liability because
the rule would not impose liability for compliance matters that are
beyond the certifying officer's knowledge and reasonable belief at the
time of certification. If the certifying officer has complied in good
faith with policies and procedures reasonably designed to confirm the
accuracy and completeness of the information in the annual report, both
the registrant and certifying officer would have a basis for defending
accusations of false, incomplete, or misleading statements or
representations made in the annual report.
With respect to requests for clarification of the liability that
may attach to the certification ``under penalty of law,'' the
Commission notes that administrative, civil, and/or criminal liability
could be imposed on the registrant or the certifying officer or both,
either directly or vicariously. As explained in the NPRM, possible
violations could include a claim of failure to supervise or false
statements to the Commission, and the Commission could seek an
injunction against future violations, civil monetary penalties, and/or
any other appropriate relief. Additionally, criminal penalties may be
sought by criminal authorities for willful violations of the CEA or
Commission regulations, in appropriate cases.
The Commission is declining to add a materiality qualifier to the
certification, as suggested by commenters. This approach is consistent
with the statutory text, with the approach taken in final rules for
SDRs \46\ and DCOs,\47\ and with proposed CCO rules for SEFs.\48\
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\46\ See Swap Data Repositories: Registration Standards, Duties
and Core Principles, 76 FR at 54584.
\47\ See Derivatives Clearing Organization General Provisions
and Core Principals, 76 FR at 69435.
\48\ See Core Principles and Other Requirements for Swap
Execution Facilities, 76 FR 1214, 1252 (Jan. 7, 2011).
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13. Description and Review of Compliance in Annual Report--Sec.
3.3([e])(1) and (2)
The proposed regulation required the annual report to contain a
description of the compliance by the registrant with respect to the CEA
and regulations; a description of each of the registrant's compliance
policies; and a review of each applicable requirement under the CEA and
regulations, and, with respect to each, identification of the policies
that ensure compliance, an assessment as to the effectiveness of the
policies, discussion of areas of improvement, and recommendations of
potential or prospective changes or improvements to its compliance
program and resources devoted to compliance.
NSCP, The Working Group, EEI, and Hess each argued that the level
of detail contemplated by the rule would impose unnecessary burdens on
the CCO with little offsetting benefits. NSCP argued that a better
approach would be to follow the SEC requirements for annual reviews of
compliance by registered investment advisers. NSCP stated that such
reviews must reflect review of the adequacy of policies established and
the effectiveness of their implementation (SEC Rule 206(4)-7(b)). NSCP
believes the proposed rule is overbroad and discourages reporting of
compliance issues to the CCO because if every issue, no matter how
trivial, must be reported and recorded, there may be a chilling effect
on open communication. NSCP believes that the key issue should be
whether material issues were escalated and remedied. Newedge argued
that thousands of Federal, SRO, and internal rules apply, so the report
should contain a summation of compliance, with details only for areas
of material noncompliance.
FIA and SIFMA argued that a one-size-fits-all approach to the
annual report requirements is not appropriate because some registrants
are not public reporting companies, some have customers while others
only conduct
[[Page 20164]]
proprietary trading, some deal with retail customers while others only
deal with sophisticated counterparties, and some are small and local,
while others are large, integrated institutions with thousands of
employees worldwide.
FIA and SIFMA recommended that the Commission specify the material
issues that should be discussed, so that there is no second guessing
with respect to the adequacy of the report, and that the Commission
clarify that compliance policies only include those relating to the CEA
and Commission regulations. FIA, SIFMA, and NFA also argued that the
report should identify the policies that are reasonably designed to
result in compliance, not that ensure compliance. Hess recommended that
the annual report contain only a summary of the registrant's compliance
policies and procedures. CMC commented that the scope of activities
included in the annual report should be limited to those directly
triggering the requirement of a CCO. EEI argued that inclusion of
descriptions of violations in the report to the Commission should not
be decided by the CCO, but should be decided on a case-by-case basis by
the registrant's governing body. NFA requested that a materiality
qualifier be added to the requirement that registrants include a
description of non-compliance.
Better Markets recommended that the board approve the annual report
in its entirety or specify where and why it disagrees with any
provision, and then CCOs should provide the report to the Commission
either as approved or with statements of disagreement.
The Working Group recommended that the Commission develop a
standard form of report and guidance as to how such report needs to be
completed.
In response to the comments received, the Commission is modifying
the proposed requirements for the annual report in Sec. 3.3([e]) to
(i) require the annual report to contain a description of the
registrant's policies and procedures, rather than a description of the
compliance of the registrant; (ii) require the annual report to
identify the registrant's policies and procedures that ``are reasonably
designed'' to ensure compliance, rather than those that ensure
compliance; (iii) require a description of material non-compliance
issues. The Commission agrees with commenters that certain information
need be reported only if it is materially significant and that the
requirement to ``ensure compliance'' can be interpreted to mean
``safeguard'' rather than ``guarantee.''
14. Certification of Compliance With Sections 619 and 716 of the Dodd-
Frank Act in Annual Report--Sec. 3.3([e])(3)
The proposed regulation required registrants to include in the
annual report a certification of compliance with sections 619 and 716
of the Dodd-Frank Act (the Volcker Rule and Derivatives Push-Out), and
any rules adopted pursuant to these sections.
NFA recommended that the certification of compliance with sections
619 and 716 of Dodd-Frank be deleted, arguing that the Commission
should wait for the implementing rulemakings for such sections before
determining certification requirements.
FIA and SIFMA commented that the requirement to certify compliance
with the Volcker Rule and Derivatives Push-Out provisions should be
included as part of the rulemaking that will address the scope and
requirements of those provisions, but not be prematurely included in
the CCO rule.
In consideration of these comments, the Commission has determined
not to finalize this provision.
15. Description of Compliance Resources in Annual Report--Sec.
3.3([e])(6)
Proposed Sec. 3.3([e])(6) required the annual report to contain a
description of the registrant's financial, managerial, operational, and
staffing resources set aside for compliance with the CEA and
regulations, including any deficiencies in such resources.
FIA and SIFMA argued that the CCO is not in a position to describe
the financial, material, operational, and staffing resources set aside
for compliance. FIA and SIFMA recommended that the CCO only be required
to describe the resources of the compliance department and any
recommendations that the CCO has made to senior management with regard
to financial, managerial, operational, or staffing resources.
The Working Group argued that a description of deficiencies in
resources dedicated to compliance would require a CCO to identify
potential shortcomings and report them in a document likely to be
available to the public, which could materially hinder the CCO's
ability to function as an integral member of the management team.
Having considered these comments, the Commission is adopting the
rule as proposed, but with the addition of a materiality standard with
respect to the description of any deficiency. The Commission does not
believe that the required description of resources available for
compliance would hinder the CCO's ability to fulfill his or her duties
in coordination with others in the firm. The rule requires a
description of compliance resources, but does not prescribe the form or
manner of this description, which the Commission views as within the
reasonable discretion of the registrant.
16. Delineation of Roles of the Board and Senior Officer in Addressing
Conflicts of Interest in Annual Report--Sec. 3.3([e])(7)
The proposed regulations required the annual report to include a
delineation of the roles and responsibilities of a registrant's board
of directors or senior officer, relevant board committees, and staff in
addressing any conflicts of interest, including any necessary
coordination with, or notification of, other entities, including
regulators.
FIA and SIFMA argued that the Sarbanes-Oxley Act already requires
public companies to report the roles and responsibilities of its board,
senior officers, and committees in resolving conflicts of interest, so
the Commission should allow such reporting to satisfy this content
requirement for the annual report. NFA also recommended that the
reporting of any necessary coordination with, or notification of other
entities, including regulators, should be deleted.
In response to FIA, SIFMA, and NFA's comments, the Commission is
deleting Sec. 3.3([e])(7) from the final rule. This provision is not
essential to the Commission's evaluation of registrants' compliance
programs, and if it is relevant to a material compliance matter, it
will be provided to the Commission pursuant to Sec. 3.3([e])(6). The
Commission also notes that removing this provision will make the CCO
requirements for FCMs, SDs, and MSPs more consistent with the CCO
requirements for SDRs and DCOs, and those proposed for SEFs.
17. Recordkeeping--Sec. 3.3([g])
Proposed Sec. 3.3([g]) required FCMs, SDs, and MSPs to maintain
records of its compliance policies, materials provided to the board in
connection with its review of the annual compliance report, and work
papers that form the basis of the annual compliance report.
The Working Group argued that retaining all materials relating to
the preparation of the report will cause the CCO to retain all
materials for fear of an audit that second-guesses the CCO's
materiality judgments, or the CCO will limit his or her inquiries to
avoid making a determination of materiality. The Working Group
recommended that
[[Page 20165]]
materials to be retained should be only those germane to the content of
the compliance report.
Better Markets recommended adding a requirement that discussions
between a CCO and traders or executives with oversight of traders
involving compliance and trading practices and strategies be recorded
by the CCO and retained in the CCO's records. Better Markets believes
this requirement is necessary because the duties of the CCO could come
into conflict with the interests of traders and managers.
The Commission is adopting the rule as proposed. In response to The
Working Group's comment, the Commission believes the rule sufficiently
qualifies the materials that must be retained by stating that the
records must be ``relevant'' to the annual report. With regard to
Better Markets' recommendation that CCOs record discussions with
traders and executives regarding compliance and trading practices, the
Commission believes that this material will be covered by the rules to
the extent that the annual report requires the CCO to assess the
effectiveness of the registrant's policies and procedures and describe
any material non-compliance issues and the corresponding action taken.
Consequently, any conflicts that arise between the CCO and the trading
unit of an SD, MSP, or FCM in which the CCO believes that the
requirements of the CEA and Commission regulations, including risk
management obligations, are not being met, must be included in the
annual report. Additionally, under Sec. 3.3(g)(1)(iii), all records of
that conflict as described in the annual report must be maintained. The
Commission further notes that in such instances, it would be good
practice for the CCO to make and maintain records of all discussions
with traders and management.
III. Effective Dates and Compliance Dates
In the Duties NPRM, Recordkeeping NPRM, and CCO NPRM, the
Commission requested comment on the length of time necessary for
registrants to come into compliance with the proposed rules.
A. Comments Regarding Compliance Dates
The Working Group recommended that the Commission not require
compliance with proposed Sec. Sec. 23.600 through 23.607 for at least
two years, not require compliance with proposed Sec. Sec. 23.200
through 23.205 for six to twelve months to provide adequate time to
develop the necessary information technology systems and business
practices, and not require compliance with the CCO designation
requirement of proposed Sec. 3.3 for one year after registration. With
respect to Sec. 23.601, The Working Group also commented that if
complex requirements are included in position limit rules, such as the
requirement to convert customized bilateral transactions into futures-
equivalents, substantially more time will be required for firms to
design and implement procedures to monitor compliance with position
limits. With respect to proposed Sec. 3.3, The Working Group commented
that entities should be able first to hire a CCO and then be permitted
a reasonable period of time in which to write, test, and implement
policies and procedures. With respect to all of the proposed rules, The
Working Group recommended that the Commission provide an extended
transition period for firms that have not been prudentially regulated
by a financial regulator and might require substantial corporate
restructuring.
FIA, ISDA, SIFMA, and the Financial Services Forum argued that if
existing systems are not easily adaptable to Sec. Sec. 23.200 through
23.205, the Commission must provide sufficient time for registrants to
make the necessary changes in an orderly manner, but no specific time
period was provided. FIA, ISDA, SIFMA, and the Financial Services Forum
also recommended that compliance with proposed Sec. 3.3 should not be
required until after the regulatory requirements under section 4s of
the CEA for which the CCO is responsible are finalized and become
effective.
Cargill recommended that the Commission provide SDs with at least
one year to come into compliance with proposed Sec. Sec. 23.600
through 23.607 following the effective date of the rules. Cargill also
stated that one year was a reasonable period to comply with proposed
Sec. 3.3.
MetLife recommended that the Commission allow one year from
registration as an MSP to comply with the proposed Sec. Sec. 23.600
through 23.607, because such compliance will require hiring required
human capital resources, build out of necessary information technology,
development of policies and procedures and internal vetting of a
mandated risk management program. MetLife also stated that it would it
would require one year after registration to recruit a CCO and develop
a compliance program in compliance with proposed Sec. 3.3.
NSCP stated that 18 months was necessary for registrants that do
not currently have a CCO to comply with proposed Sec. 3.3.
The Bank of Tokyo-Mitsubishi UFJ, Ltd., Mizuho Corporate Bank,
Ltd., and Sumitomo Mitsui Banking Corporation recommended that the
effective date of the rules be deferred until December 31, 2012.
The Commission received no comments related to the length of time
necessary for registrants to come into compliance with the rules
proposed in the SD/MSP Conflicts NPRM and FCM/IB Conflicts NPRM.
B. Compliance Dates
Having considered the comments received, the Commission is adopting
the effective and compliance dates as set forth below.
1. Reporting, Recordkeeping and Daily Trading Records of SDs and MSPs--
Sec. Sec. 23.200-23.205
The effective date of Sec. Sec. 23.200 through 23.205 will be the
date that is 60 days after publication of the final rules in the
Federal Register.
SDs and MSPs that are currently regulated by a U.S. prudential
regulator or are registrants of the SEC must comply with Sec. Sec.
23.200, 23.201, 23.202, 23.203, 23.204, and 23.205 by the date that is
the later of 90 days after publication of these final rules in the
Federal Register or the date on which SDs and MSPs are required to
apply for registration pursuant to Sec. 3.10. SDs and MSPs that are
not currently regulated by a U.S. prudential regulator and are not
registrants of the SEC must comply with Sec. Sec. 23.200, 23.201,
23.202, 23.203, 23.204, and 23.205 by the date that is the later of 180
days after publication of these final rules in the Federal Register or
the date on which SDs and MSPs are required to apply for registration
pursuant to Sec. 3.10.
2. Duties of SDs and MSPs--Sec. Sec. 23.600 Through 23.607
The effective date of Sec. Sec. 23.600 through 23.607 will be the
date that is 60 days after publication of the final rules in the
Federal Register.
With respect to Sec. 23.600 (Risk Management Program), SDs and
MSPs that are currently regulated by a U.S. prudential regulator or are
registrants of the SEC must comply with Sec. 23.600 by the date that
is the later of 90 days after publication of this final rule in the
Federal Register or the date on which SDs and MSPs are required to
apply for registration pursuant to Sec. 3.10. SDs and MSPs that are
not currently regulated by a U.S. prudential regulator and are not
registrants of the SEC must comply with Sec. 23.600 by the date that
is the later of 180 days after publication of this final rule in the
Federal Register or the date
[[Page 20166]]
on which SDs and MSPs are required to apply for registration pursuant
to Sec. 3.10.
With respect to Sec. 23.603 (Business Continuity and Disaster
Recovery), SDs and MSPs that are currently regulated by a U.S.
prudential regulator or are registrants of the SEC must comply with
Sec. 23.603 by the date that is the later of 180 days after
publication of this final rule in the Federal Register or the date on
which SDs and MSPs are required to apply for registration pursuant to
Sec. 3.10. SDs and MSPs that are not currently regulated by a U.S.
prudential regulator and are not registrants of the SEC must comply
with Sec. 23.603 by the date that is the later of 270 days after
publication of this final rule in the Federal Register or the date on
which SDs and MSPs are required to apply for registration pursuant to
Sec. 3.10.
With respect to Sec. 23.601 (Monitoring of Position Limits), Sec.
23.602 (Diligent Supervision), Sec. 23.605 (Conflicts of Interest
Policies and Procedures), Sec. 23.606 (General Information:
Availability for Disclosure and Inspection), and Sec. 23.607
(Antitrust Considerations), SDs and MSPs must comply with Sec. Sec.
23.601, 23.602, 23.605, 23.606, and 23.607 by the later of the
effective date of these rules or the date on which SDs and MSPs are
required to apply for registration pursuant to Sec. 3.10.
3. Conflicts of Interest Policies and Procedures by FCMs and IBs--Sec.
1.71
The effective date of Sec. 1.71 will be the date that is 60 days
after publication of the final rule in the Federal Register.
FCMs and IBs that are registered with the Commission as of the
effective date of this rule must comply with Sec. 1.71 by such
effective date except that such FCMs need not comply with Sec. 1.71(d)
until the later of the effective date or the date on which SDs and MSPs
are required to apply for registration pursuant to Sec. 3.10. FCMs and
IBs that are not registered with the Commission as of the effective
date of this rule must comply with Sec. 1.71 upon registration with
the Commission, except that such FCMs need not comply with Sec.
1.71(d) until the later of their registration or the date on which SDs
and MSPs are required to apply for registration pursuant to Sec. 3.10.
4. Chief Compliance Officer of FCMs, SDs, and MSPs--Sec. 3.3
The effective date of Sec. 3.3 and the amendments to Sec. 3.1
will be the date that is 60 days after publication of the final rule in
the Federal Register.
With respect to Sec. 3.3 (Chief Compliance Officer), SDs and MSPs
that are currently regulated by a U.S. prudential regulator or are
registrants of the SEC, must comply with Sec. 3.3 by the date that is
the later of 180 days after publication of this final rule in the
Federal Register or the date on which SDs and MSPs are required to
apply for registration pursuant to Sec. 3.10. SDs and MSPs that are
not currently regulated by a U.S. prudential regulator and are not
registrants of the SEC must comply with Sec. 3.3 by the date that is
the later of 360 days after publication of this final rule in the
Federal Register or the date on which SDs and MSPs are required to
apply for registration pursuant to Sec. 3.10. FCMs that are (1)
registered with the Commission as of the effective date of the rule,
and (2) currently regulated by a U.S. prudential regulator or are
registrants of the SEC, must comply with Sec. 3.3 by the date that is
180 days after publication of this final rule in the Federal Register.
FCMs that are (1) registered with the Commission as of the effective
date of the rule, and (2) not currently regulated by a U.S. prudential
regulator and are not registrants of the SEC must comply with Sec. 3.3
by the date that is 360 days after publication of this final rule in
the Federal Register. FCMs that are not registered with the Commission
as of the effective date of this rule must comply with Sec. 3.3 upon
registration with the Commission.
IV. Cost Benefit Considerations
A. Introduction
The swaps markets, which have grown exponentially in recent years,
are now an integral part of the nation's financial system. As the
financial crisis of 2008 demonstrated, inadequate understanding,
oversight, and management of swaps can contribute to systemic risk.\49\
The internal business conduct standards that the Commission is
promulgating for SDs and MSPs in this rulemaking are an important
element of the ``improve[d] financial architecture'' that Congress
intended in enacting the Dodd-Frank Act.\50\ For, as entities that,
respectively, engage in swap dealing activities \51\ and ``whose
outstanding swaps create substantive counterparty exposure that could
have serious adverse effects on the financial stability of the United
States banking system or financial markets,'' \52\ the standards that
SDs and MSPs follow (or fail to follow) in transacting their swaps may
have repercussions for financial system stability more broadly.
Effective systemic risk management for swaps begins with effective
internal risk management protocols of individual SDs and MSPs.
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\49\ As the U.S. Senate Committee on Banking, Housing, and Urban
Affairs explained in reporting what became the Dodd-Frank Act, while
a ``downturn in the national housing market'' was the 2008 financial
crisis' ``first trigger:''
* * * the use of unregulated derivatives products based on
[faulty mortgage loans was among the elements that] only served to
spread and magnify the risk. The system operated on the wholesale
misunderstanding of, or complete disregard for the risks inherent in
the underlying assets and the complex instruments they were backing
* * *' Technology, plus globalization, plus finance has created
something quite new, often called ``financial technology.'' Its
emergence is a bit like the discovery of fire--productive and
transforming when used with care, but enormously destructive when
mishandled' * * * Gaps in the regulatory structure allowed these
risks and products to flourish outside the view of those responsible
for overseeing the financial system.
S. Rep. No. 111-176, at 43 (2010) (quoting former Comptroller of
the Currency, Eugene Ludwig; citations omitted).
\50\ Id. at 228. Stated another way, they are an aspect of that
legislation's ``comprehensive regulation and rules'' to achieve a
``strengthened infrastructure for the financial system * * *
intended to make the system more resilient and resistant to the
adverse effects of financial instability.'' Id. at 228-29.
\51\ CEA section 1(a)(49)(A).
\52\ CEA section 1(a)(33)(A)(ii).
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Title VII of the Dodd-Frank Act mandates the Commission to
establish risk management requirements for SDs and MSPs. Specifically,
Section 731 adds new section 4s of the CEA that, among other things:
Establishes reporting, recordkeeping, and daily trading
records requirements for SDs and MSPs.\53\
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\53\ CEA section 4s(f)&(g).
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Defines and imposes duties on SDs and MSPs with regard to:
(1) Risk management procedures,\54\ (2) monitoring of trading to
prevent violations of applicable position limits,\55\ (3) diligent
supervision,\56\ (4) disclosure and the ability of regulators to obtain
general information,\57\ and (5) antitrust considerations.\58\
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\54\ CEA section 4s(j)(2).
\55\ CEA section 4s(j)(1).
\56\ CEA section 4s(h)(1).
\57\ CEA section 4s(j)(3).
\58\ CEA section 4s(j)(6).
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Establishes conflicts-of-interest requirements for SDs and
MSPs to establish information partitions between research and trading
and between trading and clearing.\59\
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\59\ CEA section 4s(j)(5).
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Requires each SD and MSP to designate a chief compliance
officer, set out qualifications and duties of the chief compliance
officer, and require that the chief compliance officer prepare, sign,
and furnish to the Commission an annual report containing an assessment
of the registrant's compliance activities.\60\
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\60\ CEA section 4s(k).
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Additionally, Dodd-Frank Act section 732 amends section 4d of the
CEA to add conflict of interest requirements for
[[Page 20167]]
FCMs and IBs,\61\ and a chief compliance officer requirement for
FCMs.\62\ This rulemaking implements these provisions of sections 4s
and 4d of the CEA.
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\61\ CEA section 4d(c).
\62\ CEA section 4d(d).
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Section 15(a) \63\ of the CEA requires the Commission to consider
the costs and benefits of its actions before promulgating a regulation
under the CEA or issuing an order. Section 15(a) further specifies that
the costs and benefits shall be evaluated in light of the following
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; (3) price discovery; (4) sound
risk management practices; and (5) other public interest
considerations. To the extent that these new regulations reflect the
statutory requirements of the Dodd-Frank Act, they will not create
costs and benefits beyond those resulting from Congress's statutory
mandates in the Dodd-Frank Act.\64\ However, to the extent that the new
regulations reflect the Commission's own determinations regarding
implementation of the Dodd-Frank Act's provisions, such Commission
determinations may result in other costs and benefits. It is these
other costs and benefits resulting from the Commission's own
determinations pursuant to and in accordance with the Dodd-Frank Act
that the Commission considers with respect to the section 15(a)
factors.
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\63\ 7 U.S.C. 19(a).
\64\ Certain commenters, such as The Working Group and the
FHLBs, posit that there is no benefit to be derived from internal
business conduct standards as mandated by Congress and that the
mandated provisions do not generate sufficient benefits relative to
costs or contribute to the purposes (e.g., mitigating systemic risk
and enhancing transparency) of the Dodd-Frank Act. As such, these
commenters' concerns fall outside the Commission's regulatory
discretion to implement sections 4s and 4d of the CEA and fail to
raise issues subject to consider under section 15(a).
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The Commission is obligated to estimate the burden of and provide
supporting statements for any collections of information it seeks to
establish under considerations contained in the PRA, 44 U.S.C. 3501 et
seq., and to seek approval of those requirements from the OMB. To the
extent costs of the rulemaking are associated with collections of
information, the estimated burden and support for such collections of
information, as well as the consideration of comments thereto, are
discussed in the PRA section of this rulemaking and the information
collection requests filed with OMB as required by that statute. The
Commission has also considered these costs, which it incorporates
herein by reference, in its CEA section 15(a) analysis.
In each of the NPRMs encompassed within this final rulemaking, the
Commission asked for public comment on the costs and benefits of the
proposed regulations, and specifically invited commenters to submit
``any data or other information * * * quantifying or qualifying'' the
costs and benefits of the proposal.\65\ The Commission also separately
requested comments on the overall costs and benefits of the proposed
rules implementing the Dodd-Frank Act.\66\ The Commission received
approximately 51 comments addressing the cost and benefit
considerations of the proposed rules, but few commenters presented to
the Commission quantitative data pertinent to any of the proposed
rulemakings, and no commenter stated whether such data is ascertainable
with a degree of certainty that could inform Commission deliberations.
After conducting a review of applicable academic literature, the
Commission is not aware of any research reports or studies that are
directly relevant to its considerations of costs and benefits of these
final rules.
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\65\ See SD/MSP Conflicts NPRM, 75 FR at 71395; FCM/IB Conflicts
NPRM, 75 FR at 70157; Duties NPRM, 75 FR at 71404; Recordkeeping
NPRM, 75 FR at 76673; and CCO NPRM, 75 FR at 70886.
\66\ Id.
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The Commission considered the comments on the costs and benefits of
the proposed rules and, in particular, reasonable alternatives
suggested by commenters. As detailed in the discussions of each
rulemaking above, the Commission is adopting alternatives or
modifications to the proposed rules where, in the Commission's
judgment, the alternative or modification accomplishes the same
regulatory objective in a less burdensome manner. Indeed, the
Commission has sought to reduce the burden on market participants to
the extent doing so satisfies the statute's requirements and does not
undermine important benefits that the Commission believes the statute
was intended to promote. In addition to benefits, the costs of the
regulations and the steps the Commission has taken to mitigate them are
discussed below.
Notwithstanding the paucity of available quantitative information,
the Commission has endeavored to estimate quantifiable costs and
benefits of the final rules when possible. Where estimation or
quantification is not feasible, the Commission provides a qualitative
assessment of the relevant costs and benefits. In the following
discussion, the Commission: (i) Addresses comments regarding the
effects of these final rules in terms of their material costs and
benefits; (ii) considers the material cost and benefit implications of
these final rules in comparison to baseline costs imposed by the
statutory requirements and discusses cost mitigation undertaken in
modifying the rules as proposed; and (iii) considers the material costs
and benefits of the final rules in light of the five broad areas of
market and public concern pursuant to section 15(a) of the CEA. After
discussing some general considerations applicable to all rulemaking
areas covered by this release and comments regarding rule scope, the
cost-benefit considerations are divided among the following rulemaking
areas: recordkeeping; duties and risk management; conflicts-of-interest
policies and procedures; and designation of a CCO.
B. General Considerations
This rulemaking generated an extensive record, which is discussed
at length throughout this notice as it relates to the substantive
provisions in the final rules. A number of commenters stated that they
would incur significant, though largely unquantified, costs because of
the proposed rules. Others identified benefits attributable to the
proposed rules or more stringent requirements. The Commission carefully
considered these comments and the alternatives proposed in them.\67\
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\67\ These comments also have been addressed in other sections
of this release. This section's consideration of costs and benefits
reviews and assesses them to the more narrow extent that they raise
relative cost/benefit issues. A complete policy analysis of, and
response to, these comments can be found in section II of this
release.
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In response to the Commission's invitation for comments on the
overall costs and benefits of the proposed rules,\68\ Better Markets
stated that the Commission's cost-benefit analyses in the notices of
proposed rulemaking may have understated the benefits of the proposed
rules.\69\ Better Markets argued
[[Page 20168]]
that adequate assessment of the costs and benefits of any single
proposed rule or element of such a rule would be difficult or
impossible without considering the integrated regulatory system of the
Dodd-Frank Act as a whole. According to Better Markets:
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\68\ See SD/MSP Conflicts NPRM, 75 FR at 71395; FCM/IB Conflicts
NPRM, 75 FR at 70157; Duties NPRM, 75 FR at 71404; Recordkeeping
NPRM, 75 FR at 76673; and CCO NPRM, 75 FR at 70886.
\69\ See Letter from Better Markets dated June 3, 2011(comment
file for 75 FR 71397 (Regulations Establishing and Governing the
Duties of Swap Dealers and Major Swap Participants)). On the other
hand, certain commenters, such as The Working Group and the FHLBs,
posit that there is no benefit to be derived from internal business
conduct standards as mandated by Congress and that the mandated
provisions do not generate sufficient benefits relative to costs or
contribute to the purposes (e.g., mitigating systemic risk and
enhancing transparency) of the Dodd-Frank Act.
It is undeniable that the Proposed Rules are intended and
designed to work as a system. Costing-out individual components of
the Proposed Rules inevitably double counts costs which are
applicable to multiple individual rules. It also prevents the
consideration of the full range of benefits that arise from the
system as a whole that provides for greater stability, reduces
systemic risk and protects taxpayers and the public treasury from
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future bailouts.
Better Markets also stated that an accurate cost benefit assessment
must include the avoided risk of a new financial crisis and opined that
one measure of this is the still accumulating cost of the 2008
financial crisis.\70\ The Commission agrees with Better Markets that
the proposed rules should operate in a coordinated manner to improve
and protect financial markets; notwithstanding this, the Commission
must (and has) conducted a cost-benefit analysis with respect to this
specific rulemaking.
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\70\ The comment letter cited Andrew G. Haldane, Executive
Director for Financial Stability of the Bank of England, who
estimated the worldwide cost of the crisis in terms of lost output
at between $60 trillion and $200 trillion, depending primarily on
the long term persistence of the effects.
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Recognizing that there will be costs incurred to comply with the
regulations, the Commission believes there are significant benefits to
be gained from these requirements, including but not limited to,
increased risk management and enhanced transparency. While the
Commission notes that the costs and benefits stemming from these
regulations, in large part, are attributable to the baseline statutory
mandate, each subsection herein further details the costs and benefits
of the numerous discrete provisions of the rules in order to inform
market participants more fully of the costs and benefits anticipated by
the Commission.
As a general matter across these rules, the Commission sought to
ease the burden for market participants through tailored phasing in of
compliance requirements. In each of the Duties NPRM, Recordkeeping
NPRM, and CCO NPRM, the Commission requested comment on the length of
time necessary for registrants to come into compliance with the
proposed rules. These comments are enumerated in section III.A., and
the Commission considered those comments in adopting compliance dates
for each rule as set forth in section III.B. above. The approach
recommended by commenters and accepted by the Commission recognizes and
generally differentiates between registrants that have been previously
regulated by the SEC or a prudential regulator and those that have not
been previously regulated. The Commission has elected to provide
additional time for compliance, where appropriate, for those that have
not been previously regulated. In many instances, the Commission is
providing more time for all market participants beyond the statutorily
prescribed minimum of 60 days.
C. Comments Regarding the Scope of the Proposed Rules
Several commenters questioned the scope of the proposed rules and
implicitly, if not expressly, whether the breadth as proposed was
appropriate in light of the costs that would result to certain
registrants. Comments illustrative of the concerns are discussed below.
The FHLBs articulated several reasons \71\ for exempting them from
the proposed internal business conduct standard rules. First, they
maintain that subjecting FHLBs to internal business conduct standards
could cause them to cease offering swaps transactions to their risk-
hedging members, depriving their members of a competitive swap
transaction counterparty and potentially increasing members' hedging
costs. Second, they maintain that many of the requirements duplicate
those imposed by their prudential regulator, the Federal Housing
Finance Agency (FHFA), thus there is no incremental benefit
attributable to the additional costs of complying with the proposed
rules.\72\
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\71\ In addition to the two reasons discussed, the FHLBs also
expressed that, unlike external business conduct standards, the
internal business conduct standards as mandated by Congress in the
Dodd-Frank Act do not generate benefits to justify their costs. As
noted above, this concern falls beyond the Commission's
implementation discretion.
\72\ SIFMA made a similar argument with respect to all SDs and
MSPs that are subject to regulation by a prudential regulator.
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The Commission finds the FHLB's position unpersuasive. First, the
concern that FHLBs would cease transacting swaps is undermined by the
FHLB's position that the proposed rules in large part duplicate the
requirements of its prudential regulator; if internal business conduct
standards would likely curb the FHLBs' swaps activity, presumably that
would have occurred already. Second, the Commission construes the
FHLB's position to be inconsistent with the statutory intent of
sections 4s(f), (g), (j), and (k)--i.e., consistent Commission
oversight of SDs and MSPs, regardless of whether they are also subject
to regulation by a prudential regulator. For, in the one area that
Congress intended the Commission to defer to prudential regulation with
respect to SDs and MSPs--capital and margin requirements--it provided
so expressly.\73\ There is no such express language requiring
prudential regulation deference in sections 4s(f), (g), (j), and (k).
This gives rise to a negative inference that, with respect to them,
Congress intended the Commission to establish uniform requirements for
SDs and MSPs, notwithstanding any overlapping prudential regulation. In
addition, to the extent that, as the FHLBs assert, FHFA rules are
substantively similar with the proposed rules, compliance with the
proposed rules should not present substantial additional compliance
costs.
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\73\ See CEA section 4s(e).
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The Working Group suggested that the proposed rules would impose
substantial costs with no corresponding increase in risk management and
compliance effectiveness. The Commission disagrees. It believes that
its final internal business conduct standards will enhance risk
management by requiring, among other things: (1) SDs and MSPs to have a
complete understanding of the various risks that the entity faces; and
(2) entities to monitor their traders for compliance with trading
policies established by the SD or MSP. These final rules also require
that SDs and MSPs have sound recordkeeping policies in place, which
will ensure that swap transactions are fully memorialized. Sound risk
management and internal controls on an individual firm level is the
basis of systemic risk mitigation.
Other commenters (MetLife, MFA, BlackRock, and AMG) argued that the
Dodd-Frank Act does not require the Commission to apply the same rules
to MSPs as those applied to SDs, and that MSPs should not be subject to
the same regulations as SDs because MSPs do not engage in market-making
activities. These commenters contend that the costs of compliance would
be too high for MSPs. The Commission believes that the statutory
baseline under sections 4s(f), (g), (j), and (k) of the CEA is
identical treatment of SDs and MSPs. The statutory provisions of
sections 4s(f), (g), (j), and (k) of the CEA do not distinguish between
the requirements applied to SDs and those applied to MSPs.
Additionally, in response to claims that the costs will be too high for
MSPs, the Commission notes that if an
[[Page 20169]]
MSP does not engage in certain activities, the regulations pertaining
to those activities are not applicable. Therefore, in these cases, the
Commission believes MSPs would be relieved of any burden such
regulations present.
Finally, Cargill recommended that the Commission make clear that
the Commission's regulations only apply to the swap dealing business of
an SD that is a division of a larger company, and not to the other,
non-swaps-related business activities of the company.\74\ The
Commission has accepted the alternative proposed by Cargill by
including a new definition of ``swaps activities'' in the final
regulations and by limiting the scope of several requirements to fit
this definition. Adopting this alternative approach should allow
entities to understand their duties and requirements under the final
regulations more clearly and reduce costs by limiting the scope of the
rules' applicability.
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\74\ Presumably, Cargill believes that limiting application of
Commission regulations to a specific division, rather than the
entirety of a larger company, will result in cost savings, although
it does not directly advance this argument.
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D. Recordkeeping, Reporting, and Daily Trading Records Requirements for
Swap Dealers and Major Swap Participants
As added by section 731 of the Dodd-Frank Act, sections 4s(f) and
4s(g) of the CEA establish reporting and recordkeeping requirements and
daily trading records requirements for SDs and MSPs. Section 4s(f)(1)
requires SDs and MSPs to ``make such reports as are required by the
Commission by rule or regulation regarding the transactions and
positions and financial condition of the registered swap dealer or
major swap participant.'' In the Recordkeeping NPRM, the Commission
proposed regulations, pursuant to sections 4s(f)(1)(B)(i) and (ii) of
the CEA, prescribing the books and records requirements for ``all
activities related to the business of swap dealers or major swap
participants,'' regardless of whether or not the entity has a
prudential regulator, as required by statute. In addition, the
Commission proposed regulations in the Recordkeeping NPRM pursuant to
section 4s(g)(1) of the CEA, requiring that SDs and MSPs ``maintain
daily trading records of the swaps of the registered swap dealer and
major swap participant and all related records (including related cash
and forward transactions) and recorded communications, including
electronic mail, instant messages, and recordings of telephone calls.''
The Commission notes that section 4s(g)(3) requires that daily trading
records for each swap transaction be identifiable by counterparty, and
section 4s(g)(4) specifies that SDs and MSPs maintain a ``complete
audit trail for conducting comprehensive and accurate trade
reconstructions.''
The Commission received 14 comment letters on the Recordkeeping
NPRM. The Commission considered each in formulating the final rules,
including any alternatives proposed and cost or benefit concerns
expressed. Of the 14 comments received, five addressed issues relevant
to the costs and benefits of the proposed rules, but no letters
provided any quantitative data to support their claims. The comment
letters focused on 9 areas of the rule that are most relevant to the
Commission's consideration of costs and benefits. Each of these areas
is discussed below. A more detailed discussion can be found in section
II.B-E. above.
1. Additional Types of Records
In the Recordkeeping NPRM, the Commission requested comments
regarding whether additional types of records other than those
specified in the proposed rules under Sec. 23.201 should be required
to be kept by SDs and MSPs. The Commission also requested comment
regarding whether drafts of documents should be kept. Having considered
the comments received,\75\ the Commission is not requiring any
additional types of records in the final rule. Although the Commission
agrees that drafts may provide information regarding the development of
transactions, the Commission does not believe that the marginal
incremental value of such information is sufficient to require draft
retention. The Commission also notes that pertinent pre-execution trade
information that may appear in drafts is already subject to retention
under the daily trading records rule.
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\75\ The Working Group commented that the current proposal is
sufficient. Chris Barnard, however, recommended that drafts of
documents should also be kept, arguing that the decision process
leading up to a final document can be very informative.
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2. Reliance on SDRs for Recordkeeping Requirements
The proposed regulations did not address whether an SD or MSP could
fulfill the recordkeeping requirements by reporting a swap to a swap
data repository (SDR), but ISDA & SIFMA requested that the Commission
consider the extent to which SDs and MSPs may rely upon SDRs to retain
records beyond the time periods that registrants currently retain such
records. ISDA & SIFMA did not elaborate on the current retention
periods for swaps records, nor did they explain how this approach would
work in the absence of established SDRs for all types of swaps. The
Commission considered this alternative to its recordkeeping rules, but
determined that it is premature at this time to permit SDs and MSPs to
rely solely on SDRs to meet their recordkeeping obligations under the
rules. Additionally, the Commission believes that SDs and MSPs must
maintain complete records of their swaps for the purposes of risk
management. The data that is required to be reported to an SDR may not
be sufficient for these purposes. At present, SDRs are new entities
under the Dodd-Frank Act with no track record of operation; and, for
particular swaps asset classes, SDRs have yet to be established. As
SDRs evolve, the proposed alternative may prove appropriate, but the
Commission believes that putative cost-savings benefits attributable to
SDR record retention in lieu of individual firm record retention are
too speculative presently to justify modification of the proposed
rules.
3. Records in a Single Electronic File, Searchable by Transaction and
Counterparty
Proposed Sec. 23.201(a)(1) required SDs and MSPs to keep
transaction records in a form identifiable and searchable by
transaction and by counterparty. Proposed Sec. Sec. 23.202(a) and
23.202(b) also required SDs and MSPs to keep daily trading records for
each swap and any related cash or forward transaction as a separate
electronic file identifiable and searchable by transaction and
counterparty. Commenters had several concerns with the costs of
complying with this requirement.\76\ In particular, commenters objected
to the burden of maintaining the records required for each transaction
in a separate electronic file and with maintaining the records in a
manner searchable by transaction and counterparty. No commenter
quantified the exact cost of these requirements, but the Commission
recognizes that SDs and MSPs would incur costs to comply with both
requirements. The Commission retained the requirement that trading
records be searchable by transaction and
[[Page 20170]]
counterparty because it interprets this to be the statutory minimum
imposed by section 4s(g)(3) of the CEA, i.e., that registrants
``maintain daily trading records for each counterparty in a manner and
form that is identifiable with each swap transaction.'' However, the
Commission is modifying the proposed rules to remove the provision in
Sec. 23.202(a) and Sec. 23.202(b) that requires each transaction
record to be maintained as a separate electronic file. The Commission
believes that this modification trims the rule's requirements to the
baseline required by statute, reducing the burden to the maximum extent
possible.
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\76\ ISDA & SIFMA argued that SDs and MSPs routinely store data
across a number of systems, and that aggregating transaction data
from all systems into a single electronic file would require a large
investment across market participants and would require a
substantial implementation period. The Working Group also argued
that tying relevant records to each individual transaction in a
manner that is identifiable and searchable by transaction would
create a heavy technical burden.
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4. Form of Maintaining Business Records
As proposed, Sec. 23.201(b) required SDs and MSPs to keep full,
complete, and systematic business records, including records related to
corporate governance, financial records, complaints, and marketing and
sales materials. The Working Group recommended that, to minimize
burden, the Commission permit these records to be retained as they
currently are in the normal course of business. Responding to this
concern, the Commission confirms that the rule does not require SDs and
MSPs to keep the required business records in a single comprehensive
file so long as such records can be readily accessed and provided to
the Commission upon request. This confirmation as requested by The
Working Group will minimize the burden on SDs and MSPs with regard to
establishing new recordkeeping policies.
5. Records of Complaints Received by MSPs
Proposed Sec. 23.201(b) required SDs and MSPs to retain a record
of complaints received, certain identifying information about the
complainant, and a record of the disposition of the complaint. Without
quantifying any cost, MFA commented that, because MSPs do not have
customers nor make markets in swaps, it is unwarranted to subject them
to the burden of retaining a complaint record. The Commission finds
MFA's position unpersuasive and is adopting the rule as proposed. The
Commission has no basis to find that the burden of maintaining a
complaint record will impose significant cost on MSPs. Moreover, the
Commission believes that the relevant consideration is not whether MSPs
have customers or whether they make markets, but the fact that they
have substantial swaps positions and the potential significance of
their swaps activities that defines them as MSPs. Given this, the
Commission believes a record of complaints, particularly if it
establishes a pattern, could be of important regulatory value.
6. Recording of Pre-Execution Trade Information, Including Voice
Recordings
Proposed Sec. 23.202(a)(1) required SDs and MSPs to make and keep
records of pre-execution trade information, including records of all
oral and written communications concerning quotes, solicitations, bids,
offers, instructions, trading, and prices that lead to the execution of
a swap, however communicated. As explained above, the Commission has
eliminated the requirement that pre-execution trade information be
maintained in a separate electronic file for each transaction.
Otherwise the Commission is adopting the rule as proposed despite
commenters concerns as to the cost of the required recording \77\
because it believes the information specified in the rule is the
minimum necessary to maintain an audit trail as statutorily required by
section 4s(g)(4) of the CEA.
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\77\ ATA commented that the current telephone recording systems
in use by SDs and MSPs may not meet all of the proposed rule's
requirements, and that implementing telephone recording systems that
are compliant with the requirements would impose a significant
additional cost. Notably, ATA did not propose any alternative ways
that the Commission might achieve the statutory requirement of the
CEA in a less burdensome manner.
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7. Timestamp for Quotations Using Universal Coordinated Time (UTC)
Proposed Sec. 23.202 required SDs and MSPs to use Universal
Coordinated Time to record the time of each quotation provided to, or
received from, a counterparty prior to execution; the time of swap and
related cash and forward transaction execution; and the time of swap
confirmation. The rule's use of UTC reflects an approach consistent
with the Commission's final rules for real-time public reporting,\78\
and the swap data reporting rule.\79\ By requiring the use of UTC in
Sec. 23.202, the Commission is ensuring that the requirements of Part
23, Part 43, and Part 45 remain consistent to the extent possible. The
Commission sees important benefits deriving from required UTC
consistency in reporting and recordkeeping: avoiding the need to
convert timestamps created in many different time zones is essential
for timely and efficient automated processing of large amounts of
market and pricing data by the Commission and others. Based on its
belief that rapid automated processing is critical to the success of
its regulatory mission, the Commission disagrees with the comments of
ISDA & SIFMA in their joint letter that the value of this benefit is
``minimal'' relative to the cost of moving to UTC, which cost they did
not quantify. Moreover, the Commission believes that UTC works in
complimentary tandem with Part 43 and Part 45 measures that promote
straight-through-processing.\80\
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\78\ See Real-Time Public Reporting of Swap Transaction Data, 77
FR 1182, 1251 (Jan. 9, 2012).
\79\ See Swap Data Recordkeeping and Reporting Requirements, 77
FR 2136, 2212 (Jan. 13, 2012).
\80\ Straight-through processing was considered a ``critical
risk mitigate'' in a 2005 report released by an industry group
chaired by the then-chairman of Goldman Sachs and composed of
representatives from Citigroup, JP Morgan Chase, and Morgan Stanley,
among other prominent financial institutions. See Counterparty Risk
Management Policy Group II, Toward Greater Financial Stability: A
Private Sector Perspective, July 27, 2005, p. 84. Publicly available
at http://fcic-static.law.stanford.edu/cdn_media/fcic-docs/2005-07-25%20Counterparty%20Risk%20Management%20Policy%20Group-%20Toward%20Greater%20Financial%20Stability.pdf.
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8. Daily Trading Records for Cash and Forward Transactions Related to a
Swap
Proposed Sec. 23.202(b) required SDs and MSPs to keep daily
trading records, similar to those SDs and MSPs are required to keep for
swaps, for related cash and forward transactions.\81\ The Commission is
adopting the rule as proposed because section 4s(g)(1) of the CEA
requires registrants to ``maintain daily trading records of their swaps
* * * and related records (including related cash and forward
transactions) . * * *'' No commenter objected to the proposed
definition of ``related cash and forward transactions,'' although
commenters argued that hedging and risk mitigation activities referred
to in the proposed daily trading records rule typically are not
executed with respect to specific trades and that it would not be
possible to link cash and forward transactions to a specific swap.\82\
The Working Group also argued that compliance with proposed Sec.
23.202(b) would impose expensive and burdensome requirements on
millions of physical transactions that are undertaken by commercial
energy firms that are also parties to swap transactions. No commenter
proposed, and the Commission has not identified, an alternative to
achieve the statutory requirement in a less burdensome manner, however.
Thus, the
[[Page 20171]]
Commission is adopting the rule as proposed.
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\81\ See definition under proposed Sec. 23.200, ``a purchase or
sale for immediate or deferred physical shipment or delivery of an
asset related to a swap where the swap and the related cash or
forward transaction are used to hedge, mitigate the risk of, or
offset one another.''
\82\ ISDA & SIFMA and The Working Group made this point.
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9. Record Retention Period
Proposed Sec. 23.203(b)(2) required SDs and MSPs to retain records
of any swap or related cash or forward transaction until the
termination or maturity of the transaction and for a period of five
years after such date. The Commission notes that proposed revisions to
Commission regulation Sec. 1.31 require retention of swap transaction
records for a period of five years following the termination,
expiration, or maturity of a swap,\83\ and that Sec. 23.203 is
consistent with retention requirements under the final swap data
reporting rule.\84\ However, to mitigate costs in response to
commenters' concerns \85\ regarding retention of pre-execution trade
information, the Commission is revising the rule to reduce the voice
recording retention period to one year. The Commission considered a
six-month retention period for voice recordings, as recommended by ISDA
& SIFMA, but determined that for swaps, particularly long tenor swaps,
a longer period is necessary in order to give trade discrepancies an
opportunity to surface. In addition, the Commission believes that a
one-year retention period is necessary to make the audit trail most
useful for the Commission's enforcement purposes. The Commission
believes the benefit of available voice recordings to clear up latent
trade discrepancies and aide in enforcement actions justifies the
incremental cost of an additional six-month retention period.
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\83\ See Adaptation of Commission Regulations to Accommodate
Swaps, 76 FR 33066, 33088 (June 7, 2011).
\84\ See Swap Data Recordkeeping and Reporting Requirements, 77
FR 2136, 2212 (Jan. 13, 2012).
\85\ See MFA (stating that the vast majority of its members do
not keep records of transactions for five years and compliance with
rule as proposed would be burdensome and costly); The Working Group
(long-term electronic storage of significant amounts of pre-
execution communication will prove costly over five-year period);
ISDA (supporting a voice recording obligation aligned to the six-
month minimum required by the UK Financial Services Authority);
SIFMA (same). Chris Barnard, conversely, recommended that records
should be required to be kept indefinitely rather than the general
five years under the proposal. Mr. Barnard argued that documents can
be scanned after five years, so there is no practical reason for
limiting the retention period and the information would be useful
for future analytical purposes.
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Costs
Sections 4s(f) and (g) of the CEA require SDs and MSPs to adopt and
implement certain reporting and recordkeeping requirements. The costs
and benefits that necessarily result from these basic statutory
requirements are considered to be the ``baseline'' against which the
costs and benefits of the Commission's final rules are compared or
measured. The ``baseline'' level of costs includes the costs that
result from the following activities required by the statute:
Keeping books and records of all activities related to the
business of the SD or MSP in such form and manner and for such period
as may be prescribed by the Commission;
Maintaining daily trading records of swaps and related
cash or forward transactions and recorded communications, including
electronic mail, instant messages, and recordings of telephone calls,
and including such information as the Commission shall require;
Maintaining daily trading records for each counterparty in
a manner and form that is identifiable with each swap;
Maintaining a complete audit trail for conducting
comprehensive and accurate trade reconstructions.
Compliance with the statutory baseline alone would result in costs
for SDs and MSPs. For example, the requirement to maintain recorded
communications would include the cost of a telephonic recording system.
Similarly, compliance with the statutory provisions would require data
storage and retrieval systems.
Congress mandated that the Commission adopt rules to implement each
of the statutory provisions. With regard to its implementation
decisions, the Commission has determined the following to be costs to
SDs and MSPs to comply with the final regulations regarding
recordkeeping obligations under Part 23:
Compiling transaction, position, and business records;
Compiling records of data reported to an SDR;
Compiling records of real-time reporting data;
Compiling daily trading records for swaps of pre-trade
information, including all oral and written communications concerning
quotes, solicitations, bids, offers, instructions, trading, and prices
that lead to the execution of a swap, however communicated; execution
trade information, including the name of the counterparty, the terms of
each swap, the date and time of execution; and post-execution trade
information;
Compiling daily trading records for related cash and
forward transactions of pre-trade information, including all oral and
written communications concerning quotes, solicitations, bids, offers,
instructions, trading, and prices that lead to the execution of a
related cash or forward transaction, however communicated; execution
trade information, including the name of the counterparty, the terms of
each swap, the date and time of execution; and post-execution trade
information;
Data storage, in physical and/or digital format, in most
cases for the term of a swap plus five years;
Telephonic recording system (to record voice calls related
to transactions); and
Software and/or hardware updates to existing systems to
capture and maintain the required records and to convert to Coordinated
Universal Time.
With regard to the reporting requirements, the Commission has
determined that compliance with the requirements relating to reporting
swap data to an SDR and the real-time public reporting of swap
transaction data will constitute compliance with such reporting
requirements in section 4s(f). The reporting rules set forth in this
release consist of cross-references to the reporting requirements in
the rules relating to the reporting of swaps to an SDR and the real-
time public reporting of swap transaction data. Accordingly, the
Commission has considered the costs and benefits of reporting swap data
to an SDR and real-time public reporting in those final rulemakings;
therefore, those costs and benefits are not addressed in this
rulemaking.\86\
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\86\ See Swap Data Recordkeeping and Reporting Requirements, 77
FR 2136 (Jan. 13, 2012); and Real-Time Public Reporting of Swap
Transaction Data, 77 FR 1182 (Jan. 9, 2012).
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As discussed, in adhering to its mandate from Congress, where
possible the Commission also has attempted to alleviate the burdens on
affected entities. In this regard, the Commission sought to minimize
recordkeeping costs by eliminating the requirement that daily trading
records of swaps and related cash and forward transactions be
maintained as a separate electronic file.
Based on the available data, the Commission has been unable to
reliably quantify the cost of compliance with the recordkeeping
rules.\87\ Although the rules were adapted from existing recordkeeping
regulations from a variety of sources including the Commission's
regulations and those of the SEC, such regulations have evolved over
time and reliable quantitative data is generally not available
regarding the costs of compliance with such requirements. A 1998
adopting release for the SEC's rules for OTC derivatives dealers
[[Page 20172]]
(including recordkeeping rules) cited commenters estimates in a range
from $75,000 to $500,000 per year. Although dated, these SEC estimates
provide a measure from which to very roughly attempt to gauge
compliance costs.\88\ Moreover, because financial entities that will
likely be required to register as SDs are currently subject to
prudential regulation or other form of regulatory oversight, the
Commission believes they will already have some form of recordkeeping
policies and procedures in place.
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\87\ To better inform this assessment, the Commission has
conducted a review of applicable academic literature, but found no
research reports or studies that are directly relevant to its
considerations of costs and benefits of these final rules.
\88\ See OTC Derivatives Dealers, 63 FR 59362, 59391 (Nov. 3,
1998).
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In contrast, the Commission anticipates that entities that are not
subject to prudential regulation may incur greater costs to develop the
infrastructure to comply with these recordkeeping requirements. In this
respect, one commenter presented a report prepared by National Economic
Research Associates, Inc. (NERA) stating that (1) compliance by certain
entities with the proposed requirement that SDs and MSPs retain instant
messages and tie them to transaction identifiers would entail average
initial retention costs of $464,000 and average incremental ongoing
annual costs of $228,000; (2) that the retention of phone calls would
entail an average initial investment of $649,000 with additional annual
costs of $382,000; and (3) that the requirement to time stamp
transactions and use unique identifiers for transactions would entail
average initial setup costs of $2,800,000 and average annual costs of
$302,000.\89\ The Commission notes that the required use of unique
identifiers is the subject of another rulemaking not adopted in this
release.
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\89\ 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 this late-filed comment
supplement, NERA concludes that cost-benefit considerations compel
excluding 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--from regulation as SDs, including these
recordkeeping and reporting rules.
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Certain of the costs associated with these recordkeeping rules
result from collections of information subject to the Paperwork
Reduction Act. Costs attributable to collections of information subject
to the PRA are discussed further in section V.B.1. below. The
Commission has also considered these costs, which it incorporates by
reference herein, in its section 15(a) analysis.
Benefits
The Commission believes these recordkeeping requirements will
contribute to important, though unquantifiable, benefits intended by
the Dodd-Frank Act. More specifically, complete, rigorous transactional
recordkeeping promotes both external and internal risk management by
providing an audit trail of past transactions. A strong audit trail, in
turn generates a number of benefits, including the following:
It facilitates a firm's ability to recognize and manage
its risk, thereby enhancing the risk management of the market as a
whole.
It acts as a disincentive to engage in unduly risky or
injurious conduct in that the conduct will be traceable.
In the event such conduct does occur, it provides a
mechanism for policing such conduct, both internally as part of a
firm's compliance efforts and externally by regulators.
It provides a basis for efficiently resolving
transactional disputes.
And, it supports SDR reporting in that it provides a
backstop to confirm the accuracy of reported information.
Section 15(a) Determination
1. Protection of Market Participants and the Public
The Commission believes that, by generating the benefits identified
above, these rules provide important protections to swap market
participants and the public. The recordkeeping requirements: (1)
Promote the ability of SDs and MSPs to manage their risks through
accurate and timely recordkeeping; (2) create disincentives for
conduct, such as rogue trading, that could be injurious to the firm (as
well as the market generally) by requiring a comprehensive audit trail;
(3) support internal compliance efforts by requiring that complaints
and other pertinent documents be retained; and (4) facilitate
resolution of trade disputes. Public protection also is enhanced in
that effective comprehensive, internal risk management improves risk
management for the market as a whole. Moreover, the rules serve as an
important link in the risk reduction chain envisioned by Congress in
enacting the Dodd-Frank Act. Working in concert with other Dodd-Frank
Act requirements, these rules further the goal of avoiding market
disruptions and the resulting financial losses to market participants
and the general public.
The Commission believes that any incremental costs of the final
rules over those necessitated by the statutory baseline of sections
4s(f) and (g) of the CEA do not hinder the goal of effective protection
of market participants and the public. Because some basic level of
recordkeeping is fundamental to any financial undertaking, the
Commission assumes that all likely SDs and MSPs currently keep records
of some sort for their own internal control purposes. Therefore, the
incremental costs of complying with the specific requirements of the
Commission's final rules are unlikely to lead SDs or MSPs to withdraw
from the market or cause SDs and MSPs to make investments in updating
recordkeeping systems that would otherwise be directed to activities
that increase protection of market participants or the public.
2. Efficiency, Competitiveness, and Financial Integrity of Markets \90\
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\90\ Although by its terms CEA section 15(a)(2)(B) applies to
futures markets only, the Commission finds this factor useful in
analyzing regulations pertaining to swaps markets as well.
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Accurate recordkeeping is foundational to sound risk management and
the financial integrity of SDs and MSPs, which impacts the financial
integrity of markets. As illustrated by the collapse of firms during
the 2008 financial crisis, poor recordkeeping can substantially impair
resolution of customer claims.\91\ Additionally, the recordkeeping
rules will enhance the financial integrity of the markets by ensuring
that swap transactions, especially those that are bilaterally executed
and require the exchange of margin, are documented and recorded in a
prompt and accurate manner. Market efficiency and competitiveness is
benefited by accurate and timely recordkeeping and the creation of a
complete audit trail to the extent that those requirements facilitate
Commission's enforcement actions against market manipulation and other
market abuses.
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\91\ 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 Lehman Derivatives Records a
``Mess,'' Barclays Executive Says, 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).
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On the other hand, compliance with the rules is likely to require
investment in recordkeeping, storage, and other back office systems;
investment costs that otherwise could be used to enhance the efficiency
and competitiveness of front office trading operations. For example,
the telephonic recording systems that are required for recording oral
communications may introduce new costs for SDs and MSPs that those
[[Page 20173]]
entities would prefer to avoid in favor of enhancing trading
operations.
3. Price Discovery
The Commission has identified no likely material impact on price
discovery from the costs and benefits of these recordkeeping rules.
4. Sound Risk Management
The Commission believes that proper recordkeeping--though likely to
require initial investment in recordkeeping and other back office
systems--is essential to risk management because it facilitates an
entity's awareness of its transactions, positions, trading activity,
internal operations, and any complaints made against it, among other
things. Such awareness supports sound internal risk management policies
and procedures by ensuring that decision-makers within SDs and MSPs are
fully informed about the entity's activities and can take steps to
mitigate and address significant risks faced by the firm. When
individual market participants engage in sound risk management
practices, the entire market benefits. Accordingly, the Commission
believes that these final rules, notwithstanding potential costs
identified above, will promote the public interest in sound risk
management.
5. Other Public Interest Considerations
The Commission has not identified any other public interest
considerations that could be impacted by these recordkeeping and
reporting obligations for SDs and MSPs.
E. Duties and Risk Management Requirements of Swap Dealers and Major
Swap Participants
As part of an overall business conduct regime for SDs and MSPs,
section 4s(j) of the CEA, as added by section 731 of the Dodd-Frank
Act, sets forth certain duties for SDs and MSPs. In its Duties NPRM,
the Commission proposed six regulations to implement section 4s(j),
specifically addressing risk management, monitoring of positions
limits, diligent supervision, business continuity and disaster
recovery, the availability of general information, and antitrust
considerations. The Commission's proposed conflicts-of-interest
policies and procedures were the subject of the separate SD/MSP
Conflicts NPRM.
As described in detail in the preamble, the Commission in preparing
these final rules sought and incorporated comment from the public. The
Commission received 20 comment letters on the Duties NPRM, and
considered each in formulating the final rules. Of the 20, eight
comments addressed issues relevant to the costs and benefits of the
proposed rules, but only two provided any quantitative data to support
their claims. The comments focused on seven areas of the rules that are
most relevant to the Commission's consideration of costs and benefits.
Each of these areas is discussed below. A more detailed discussion of
the Commission's policy decisions can be found in sections II.F-L.
above.
1. Scope of Risk Management Program
The proposed regulations required SDs and MSPs to establish,
document, maintain, and enforce a system of risk management policies
and procedures designed to monitor and manage the risks associated with
the business of the SD or MSP. The Working Group, MetLife, and the
Office of the Comptroller of the Currency, argued in favor of limiting
Sec. 23.600 to the risks associated with swaps activities, and not
other business lines in which an entity may engage.\92\ The Commission
agrees with the commenters that its regulatory purpose is the
management of the risk associated with SDs' and MSPs' swaps activities,
not risks from their non-swaps activities, and is modifying the rule as
they proposed. That is, the Commission is including a new definition of
``swaps activities'' in the final regulations and thus limiting the
scope of several requirements. Clearly delimiting the activities of
registrants subject to the rule in this way reduces the compliance
burden of Sec. 23.600.
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\92\ Although not expressly stated by these commenters, the
Commission presumes that burden concerns motivate their limitation
requests, at least in part.
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The Commission, however, declines to adopt The Working Group's
recommendation that the rule be limited further with respect to
affiliates and consolidated entity risk management.\93\ The Commission
believes that considering the risks posed by affiliates is part of
``robust and professional'' risk management as required by section
4s(j), and provides a benefit to the registrant, its counterparties,
and the swap market in the form of increased security and stability of
the registrant. In the Commission's view, it is not unreasonably
burdensome to require management of risk posed by affiliates--whether
in the form of inter-affiliate transactions or otherwise--given their
potential to be of the same kind and magnitude as risks posed by other
swap counterparties. Likewise, the benefit of increased security and
stability results from integrating the registrant's risk management
program with risk management at the consolidated entity level, if
applicable, where a top level company may be in the best position to
evaluate risk due to its organization-wide view. Again, in light of
this benefit, the Commission does not believe integration of an SD's or
MSP's Risk Management Program into overall risk management at the
consolidated entity level would be unduly burdensome.
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\93\ More specifically, The Working Group recommended that the
rule be revised to require the risk management program to take into
account only swaps-related risks posed by affiliates and take an
integrated approach to risk management at the consolidated entity
level only to the extent the SD or MSP deems necessary to enable
effective risk and compliance oversight. Presumably, The Working
Group recommended these alternatives out of an unexpressed concern
for increased costs necessitated by monitoring and managing other
risks posed by affiliates or being required to take an integrated
approach to risk management; it did not quantify these however.
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2. Risks Covered by the Risk Management Program
The proposed regulation required a registrant's risk management
program to include certain enumerated elements: Identification of risks
and risk tolerance limits; periodic risk exposure reports; a new
product policy; policies and procedures to monitor and manage market
risk, credit risk, liquidity risk, foreign currency risk, legal risk,
and operational risk; use of central counterparties; compliance with
margin and capital requirements; monitoring of compliance with risk
management program; and approval of trading policies and monitoring of
traders.
In response to comments received, the Commission is modifying the
rule in several respects as discussed specifically below. The
Commission believes that each of these changes will reduce the
compliance burden on SDs and MSPs. More generally, the Commission
believes the rules allow registrants to manage their costs by relying
upon existing compliance or risk management capabilities to a large
extent.\94\ In this respect, the rules generally only require
``policies and procedures'' to monitor and manage the enumerated risks,
but do not prescribe the content of such policies and procedures or
require any specific control systems.
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\94\ Comments of The Working Group, SIFMA, EEI, and MetLife,
each of whom suggested that proposed Sec. 23.600 be flexible enough
to allow firms to adapt their existing compliance and risk
management measures, and not cause firms to add entirely new
compliance or risk management infrastructure.
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Risk Tolerance Limits: With respect to risk tolerance limit
exceptions, the
[[Page 20174]]
Commission agrees with commenters \95\ that requiring approval by risk
management personnel would be more costly without materially enhancing
benefits than allowing SDs and MSPs the flexibility to structure their
approval process in accordance with written policies and procedures.
Accordingly, the Commission has modified the rule to reflect this
approach.
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\95\ With respect to exceptions to risk tolerance limits, SIFMA
recommended that trading supervisors, rather than risk management
personnel, should have the authority to approve risk tolerance limit
exceptions because the quarterly risk exposure reports provided to a
registrant's senior management and governing body are an adequate
check on decision-making by trading supervisors. Presumably, SIFMA
believes trading supervisor approval presents less costs than risk
management unit approval.
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New Product Policy Requirement: Concerning the new product policy
requirement, the Commission notes that the rule was adapted from
existing regulatory guidance in this area,\96\ and thus believes some
SDs and MSPs already have such a policy in place; for them, the
requirement would not impose any new burden. The Commission rejects the
more limited alternative approach recommended by the Working Group--
i.e., that before offering a new product an SD or MSP need only conduct
due diligence that is commensurate with the risks associated with a new
product, and receive approval from appropriate risk management and
business unit personnel within the firm. While The Working Group's
recommended approach may be less costly for some unspecified number of
registrants that to date have not implemented a new product policy in
line with the proposed rule and existing regulatory guidance, the
Commission believes that the benefits to SDs, MSPs, and financial
markets of greater scrutiny for new products, which may entail degrees
of risk that are not initially evident, are sufficient to adopt the
rule substantially as proposed. However, the Commission believes that
SIFMA's recommended alternative--allowing approval of new products on a
contingent or preliminary limited-time basis at a non-material risk
level for the registrant to gain product experience and develop
appropriate risk management processes for the product--better addresses
the unforeseen risk potential. Accordingly, the Commission considers
SIFMA's proposed alternative preferable on cost/benefit grounds to the
rule as proposed and has modified the rule in line with it.
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\96\ See OCC's Comptroller's Handbook, Risk Management of
Financial Derivatives at 7 (Jan. 1997); Federal Reserve Board's
Trading and Capital-Markets Activities Manual.
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Reconciliation of Profits and Losses to the General Ledger: The
Commission has responded to commenters that objected to the burden of
daily reconciliation by modifying the rule to require periodic, rather
than daily, reconciliation. The Commission believes this modification,
increases the flexibility available to registrants to design cost-
effective procedures best suited to their own circumstances.
Assessing Liquidity of Non-Cash Collateral: With respect to
assessing liquidity of non-cash collateral, the Commission agrees with
commenters that testing by simulated disposition presented an
unnecessary cost to SDs and MSPs \97\ and has adjusted the final rule
to provide flexibility for registrants to design procedures to fit
their own circumstances.
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\97\ SIFMA recommended that the Commission not require testing
of liquidation procedures by simulated disposition, but only require
policies and procedures for identifying acceptable collateral and
establishing appropriate haircuts, taking into account reasonably
anticipatable adverse price movements, arguing that simulated
disposition could be costly during periods of market stress.
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Foreign Currency Risk: With respect to foreign currency risk,
rather than mandating daily measurement, The Working Group recommended
relaxing the rule to allow firms discretion with respect to how
frequently capital exposed to fluctuations in the value of foreign
currency needs to be measured. The Commission is rejecting The Working
Group's recommendation because daily measurement is necessary for
effective prudent risk management because the foreign currency markets
are fluid, quick moving, and potentially volatile. Given the wide
availability of foreign currency pricing information at a low cost, the
Commission does not believe that the cost of daily measurement is
unduly burdensome in light of the benefit of consistent management of
foreign currency risk.
Monitoring of Trading Requirements: Concerning the monitoring of
trading requirements, the Commission agrees with commenters that the
proposed rule's requirement that traders be monitored to prevent the
incurrence of ``undue risk'' is vague and thus potentially burdensome
to implement. To add clarity, the Commission is revising the rule to
require monitoring of trading to prevent the incurrence of
``unauthorized risk.'' \98\
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\98\ The Working Group and SIFMA requested that the Commission
remove the requirement that firms monitor traders to prevent traders
from ``incurring undue risk'' because the meaning of the phrase is
ambiguous and presumably more costly to monitor under such standard.
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The Commission also agrees with The Working Group's recommendation
that the proposed rule be modified to add a materiality standard for
reporting of trade discrepancies to management. Accordingly, the
Commission is modifying the rule to require that only trade
discrepancies that are not immaterial, clerical errors be brought to
the immediate attention of management of the business trading unit.
Use of Brokers: The Commission agrees with commenters recommending
against tasking the risk management unit with reviewing brokers'
statements, monitoring commissions or initiating broker payments;
allowing these functions to be handled by operations or other control
units, and presumably lowering the cost of compliance. The Commission
has narrowed the rule to require risk management units to periodically
audit brokers' statements and payments only. The Commission believes
that this modification retains the benefits of the rule (independent
oversight of the use of brokers), while lowering the cost of compliance
by not requiring modifications to current operations.
3. Risk Exposure Reports
Proposed Sec. 23.600(c)(2)(ii) required SDs and MSPs to provide
their senior management and governing body with quarterly Risk Exposure
Reports detailing the registrant's risk exposure and any
recommendations for changes to the risk management program. Copies of
these reports were required to be furnished to the Commission within
five business days of providing them to senior management. The Working
Group and Cargill suggested as an alternative that SDs' and MSPs'
periodic Risk Exposure Reports be required only annually and submitted
to the Commission only upon request. They argued that quarterly reports
will be costly, distract risk management personnel from their primary
responsibilities, and tax Commission resources to review reports that
frequently. The Commission is declining to modify the rule as suggested
because, as recent events have shown, it is important that financial
firm management have frequent information about the risk exposures
faced. This affords prompt corrective action important to maintain
financial stability. The potential costs of instability in the
financial markets have been exhibited in a number of recent failures of
major financial institutions, such as Long Term Capital Management,
Bear Stearns, Lehman Brothers, and others. The Commission believes that
any incremental additional burden of providing Risk Exposure Reports on
a quarterly rather than annual basis is not
[[Page 20175]]
significant and is warranted by the benefit of Commission oversight and
early risk detection capability.
4. Frequency of Risk Management Program Testing
Proposed Sec. 23.600(e) required SDs and MSPs to review and test
their risk management programs quarterly using internal or external
auditors independent of the business trading unit. As explained in more
detail below, commenters objected to the costs of quarterly risk
management program testing required by the rule. The Commission is
modifying proposed Sec. 23.600(e) to require only annual testing and
audit of an SD's or MSP's risk management program, having been
persuaded by the comments of The Working Group, Cargill, and MetLife,
each of which recommended that both the frequency and the scope of
audits of the risk management program be left to the discretion of the
registrant so long as such audits are effective and are conducted at
least annually. The Working Group and Cargill argued that this regime
would provide the desired results without the unnecessary cost and
administrative burden imposed by the proposed rules. The Commission
agrees that the regulatory purpose of periodic testing will be met by
annual testing. In order to further lessen the burden on SDs and MSPs,
the Commission has determined not to specify testing procedures at this
time, but to leave the design and implementation of testing procedures
to the reasonable judgment of each registrant based on their own
circumstances.
5. Monitoring of Position Limits
Proposed Sec. 23.601 required SDs and MSPs to establish policies
and procedures to monitor, detect, and prevent violations of applicable
position limits established by the Commission, a designated contract
market (DCM), or a swap execution facility (SEF), and to monitor for
and prevent improper reliance upon any exemptions or exclusions from
such position limits.
One commenter presented a report prepared by NERA stating that
compliance with proposed Sec. 23.601 for certain entities would entail
average incremental start-up costs of $245,000 and average incremental
ongoing annual costs of $228,000.\99\ The Commission observes that the
incremental average costs provided by NERA do not differentiate between
the costs of compliance with proposed Sec. 23.601 and the costs of
compliance with section 4s(j)(1) of the CEA, which requires each SD and
MSP to ``monitor its trading in swaps to prevent violations of
applicable position limits.'' Accordingly, the Commission believes that
the cost estimates presented by NERA exceed the incremental costs
attributable to Commission rulemaking. The NERA report, however,
provides insufficient information to allow the Commission to assess the
magnitude of the excess.
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\99\ NERA Economic Consulting, Cost-Benefit Analysis of the
CFTC's Proposed Swap Dealer Definition Prepared for the Working
Group of Commercial Energy Firms, December 20, 2011. In this late-
filed comment supplement, NERA argues that cost-benefit
considerations compel excluding 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--from regulation as
swap dealers, including Sec. 23.601.
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As discussed in more detail below, the Commission has also
quantified certain costs of a monitoring regime based on the assumption
that a firm could choose to implement a particular monitoring regime
from a wide range of compliance systems, based on the specific,
individual needs of the firm. Several other commenters requested that
the rule be modified to lessen the cost burden on registrants.\100\ The
Commission is reducing the burden on SDs and MSPs by modifying the rule
as follows: (1) Require policies and procedures reasonably designed to
monitor for and prevent violations of applicable position limits; (2)
require only notification to relevant personnel of changes to
applicable position limits (rather than training); (3) except on-
exchange violations of position limits from the Commission reporting
requirement; (4) require testing of position limit procedures only if
the registrant has transactions in instruments for which position
limits have been established; and (5) require testing of position limit
procedures quarterly (rather than monthly).
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\100\ SIFMA recommended that testing of Position Limit
Procedures be required only annually and not be required to be done
all at the same time, The Working Group recommended that testing
only be required on a semi-annual basis, and MetLife requested that
the Commission permit the frequency of testing to be determined by
an MSP based on the extent of its swap activities. MetLife also
recommended that there be a clear exemption from testing
requirements for MSPs that do not trade in swaps for which position
limits have been established. BGA recommended that the Commission
clarify that as long as an SD or MSP provides training on the
position limits and establishes and enforces policies for
monitoring, detecting, and curing violations, they will have met the
obligation to ``prevent violations.'' SIFMA recommended that the
Commission revise Sec. 23.601(c) to provide that a change in
position limit levels will not trigger ``training,'' but only
require effective notification. The Working Group and MetLife
recommended that the Commission require alerting the governing body
only when a violation is material. The Working Group argued that the
reporting of on-exchange violations of position limits to the
Commission is already done by DCMs and will likely be the
responsibility of SEFs as well, so SDs and MSPs should not be
required to report on-exchange violations.
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With respect to quarterly reporting of compliance with position
limits to the chief compliance officer, senior management, and
governing body under proposed Sec. 23.601(g), The Working Group
recommended that the proposed rule should be revised to require only
annual reports to the entity's senior management and governing body,
but did not quantify the cost burden of quarterly reporting. The
Commission recognizes that generating such reports will entail costs in
the form of preparing and transmitting the reports as required by the
rule, but is unable to quantify the cost because the reports will vary
greatly depending on the trading volume of individual SDs and MSPs in
products for which position limits have been established. As discussed
above with respect to Risk Exposure Reports, the Commission believes
that the benefit of such reporting will be timely notification to
decision makers within the SD and MSP of the entity's record of
compliance with applicable position limits, thus providing a timely
opportunity to adjust or revise Position Limit Procedures to prevent
future violations, if necessary, and avoiding the costs to the public
of excessive speculation.
6. Diligent Supervision
Proposed Sec. 23.602 required SDs and MSPs to: (1) Establish a
system to supervise all activities relating to its business performed
by its partners, members, officers, employees, and agents; (2) have
that system be reasonably designed to achieve compliance with the CEA
and Commission regulations; (3) have that system designate a person
with authority to carry out the supervisory responsibilities of the SD
or MSP; and (4) have all such supervisors meet qualification standards
that the Commission finds necessary or appropriate.
The benefits of diligent supervision result from increased
compliance with the regulatory standards of the CEA and the rules of
the Commission. The standards that SDs and MSPs follow (or fail to
follow) in transacting their swaps may have repercussions for financial
system stability more broadly. Effective systemic risk management for
swaps depends upon effective internal risk management protocols of
individual SDs and MSPs and effective internal risk management in turn
depends not
[[Page 20176]]
just on appropriate policies and procedures, but on diligent
supervision by the registrant to ensure that such policies and
procedures are actually followed.
No commenters provided quantitative data on the cost of complying
with the diligent supervision rule, but several commenters requested
changes to the rule to lessen the compliance costs of SDs and MSPs.
The Working Group recommended that the Commission not require
designation of a single individual with responsibility for supervision.
The Commission considered whether permitting SDs and MSPs to designate
more than a single individual for supervisory responsibilities would
lessen the benefits of the rule and determined that it would not.
Accordingly, the Commission is modifying the rule to require SDs and
MSPs to designate ``at least one person'' (rather than ``a person'')
with authority to carry out supervisory responsibilities.
The Working Group also recommended that SDs and MSPs be given
discretion to determine supervisor qualifications, presumably because
such a standard would entail fewer compliance costs then the standard
proposed (i.e., ``training, experience, competence, and such other
qualification standards as the Commission finds necessary or
appropriate''). The Commission considered whether the benefits of the
rule could be maintained with this change, and determined they could
not. Accordingly, the Commission is declining to modify the rule on
this point because it believes that full accountability for compliance
with the CEA and Commission regulations is best served by requiring
designation of individuals with objective qualifications.
7. Business Continuity and Disaster Recovery
Proposed Sec. 23.603 required SDs and MSPs to establish a business
continuity and disaster recovery plan that includes procedures for and
the maintenance of back-up facilities, systems, infrastructure,
personnel, and other resources to achieve the timely recovery of data
and documentation and to resume operations generally within the next
business day. The proposed regulations also required SDs and MSPs to
have their business continuity and disaster recovery plan tested
annually by qualified, independent internal audit personnel or a
qualified third party audit service. The Commission believes that all
SDs and MSPs may be critically important to the proper functioning of
the swaps market. SDs are critical participants in the swaps market and
MSPs may have counterparty exposures that could have serious adverse
effects on the financial stability of the United States. Therefore, the
Commission believes the benefit of the rule is that it ensures, to the
extent practicable, that system failures or natural disaster will not
stop the proper functioning of the swaps market for more the one
business day.
With respect to costs, the Commission again believes that it is not
possible to reasonably quantify the industry-wide costs of a business
continuity and disaster recovery program for SDs and MSPs because such
costs necessarily flow from the size of the SD or MSP and the scope of
activities in which it engages. One commenter stated that most SDs have
the technology and network infrastructure in place to achieve a next
day recovery time objective, reducing the incremental costs of
compliance for these registrants. But the commenter also believes that
some MSPs may have to develop and implement a plan from scratch. The
commenter estimates that it would take up to 200 personnel days for
MSPs to comply with this requirement. Thus, at eight hours a day and
$100 per hour,\101\ the upper end of personnel costs related to
implementation for an MSP would be $160,000. In response, the
Commission is lengthening the time for compliance to one year from the
publication date of the final rule in the Federal Register for
registrants that have not been previously regulated by a U.S.
prudential regulator and are not SEC registrants. No other commenter
provided cost estimates of compliance with the rule. Nevertheless,
several commenters requested changes to the rule to reduce the cost of
compliance.\102\
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\101\ See section V.B. below for a discussion of the
Commission's use of this hourly wage rate.
\102\ The Working Group argued that the Commission should not
require next business day recovery for non-systemically important
SDs or MSPs, but should only require recovery ``reasonably
promptly.'' The Working Group also argued that the Commission should
not require staffing of back-up facilities to avoid the burden of
requiring two persons for the same job, and recommended that the
Commission should not require annual testing of the business
continuity and disaster recovery plan by independent auditors
because independent audits would be too costly.
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To further reduce the compliance burden, the Commission is
additionally modifying the rule as follows: (1) Requiring procedures
for alternative staffing (rather than back-up personnel); (2) requiring
annual testing (rather than auditing); and (3) requiring auditing only
once every three years. The Commission believes that these changes will
lower compliance costs without reducing benefits.
Finally, SIFMA recommended that the Commission clarify that an SD's
or MSP's business continuity and disaster recovery plan may be part of
a consolidated plan established for the various entities in a holding
company group. The Commission confirmed this could be the case.
Costs
Section 4s(j) of the CEA imposes certain duties and risk management
requirements on SDs and MSPs. The costs and benefits that necessarily
result from these basic statutory requirements are considered to be the
``baseline'' against which the costs and benefits of the Commission's
final rules are compared or measured. The ``baseline'' level of costs
includes the costs that result from the following activities required
by the statute:
Monitoring of trading in swaps to prevent violations of
applicable position limits;
Establishing robust and professional risk management
systems;
Disclosing to the Commission and applicable prudential
regulators general information related to swaps and establishing
internal systems and procedures to provide such information;
Foregoing any process or action that results in any
unreasonable restraint of trade, or impose any material anticompetitive
burden on trading and clearing.
Compliance with the statutory baseline alone would result in costs
for SDs and MSPs. For example, the requirement to monitor trading in
swaps to prevent violations of applicable position limits would include
the cost of designing and implementing monitoring procedures.
Similarly, compliance with the statutory provisions would require
establishment of robust and professional risk management policies and
procedures.
Congress mandated that the Commission adopt rules to implement each
of the statutory provisions. With regard to its implementation
decisions, the Commission has determined the following to be costs to
SDs and MSPs to comply with the final regulations regarding duties and
risk management:
Compiling and reporting certain risk assessment reports;
Establishing, implementing, testing, and reviewing risk
management policies and procedures;
Auditing of policies and procedures;
Ensuring the monitoring of traders and of applicable
position limits;
[[Page 20177]]
Implementing diligent supervision policies and procedures;
and
Implementing, testing, and reviewing business continuity
and disaster recovery policies and procedures.
In adhering to its mandate from Congress, where possible the
Commission has attempted to alleviate the burdens on affected entities.
The Commission has modified the definition of ``governing body'' to
provide additional flexibility and potentially eliminate the need for
some registrants to change their current internal governance
structures, thereby reducing compliance costs. The Commission has
clarified that the requirements for a risk management program are
confined to ``swaps activities'' of registrants, rather than the ``day-
to-day business'' of the registrant, thereby avoiding the potential
burden associated with an SD's or MSP's need to extend the program to
any non-swaps business lines. In addition, risk management policies and
procedures are required to be provided to the Commission only upon
request, rather than upon any material change, reducing the reporting
burden on registrants.
Risk management unit personnel are permitted to fulfill other
duties. This should provide cost-lowering flexibility and potentially
eliminate the need for some registrants to change current practices
dramatically. The Commission also will permit limited preliminary
approval for new products for testing purposes, reducing the necessary
time and burden of new product analysis. Pricing models may be
validated by internal personnel, eliminating the burden of hiring an
external auditor to validate potentially valuable proprietary
information. The requirement to reconcile profits and losses to the
general ledger on a daily basis has been removed. Entities may perform
an assessment of collateral liquidation procedures, instead of
performing a potentially time-intensive and expensive test.
The proposed quarterly testing of risk management programs and
position limit procedures has been reduced to annual testing to reduce
costs. The proposed monthly testing of position limit procedures has
been reduced to quarterly testing. To reduce the burden on senior
management, only material trade discrepancies are required to be
brought to senior management. The proposed employee training on
position limits change has been modified to a notice requirement.
Position limit violations that occur ``on-exchange'' are no longer
required to be reported to the Commission by registrants, as the
exchange will notify the Commission. Finally, business continuity and
disaster recovery plans are required to be audited triennially (not
annually, as proposed).
With respect to quantifying the cost of compliance with the final
rules, one commenter stated that the cost of implementing a
comprehensive risk management program will be substantial. The
commenter analogizes the cost to the cost of implementing a compliance
program and cites FERC administrative proceedings that required
implementation of compliance programs at a cost of $1,000,000 to
$2,000,000. The same commenter also estimates that a required audit of
the risk management program would cost $24,000 per audit ($96,000
annually). Another commenter stated that implementation of a business
continuity and disaster recovery program could take up to 200 personnel
days. At eight hours a day and $100 per hour,\103\ implementation
personnel costs alone could thus cost a registrant $160,000. The
Commission believes these estimates may be on the high end of the range
of potential costs, given that some likely SDs are subject to
prudential regulation or other form of regulatory oversight currently
and will already have some form of risk management and business
continuity program in place.\104\ By contrast, costs are expected to be
higher for those entities not currently regulated or not currently
implementing risk management policies and procedures. In this respect,
one commenter 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 $224,000.\105\
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\103\ See section V.B. below for a discussion of the
Commission's use of this wage rate.
\104\ The Commission notes that in 2006 the UK FSA conducted a
cost benefit analysis when promulgating requirements related to
ensuring effective risk controls, including requirements for
implementing effective policies and procedures to identify, manage,
monitor, and report current and possible risks. The UK FSA was
adopting rules that replaced existing guidance and concluded from
survey results that the incremental aggregate cost of compliance for
approximately 2000-2500 firms was [pound]10.5 to 14 million in one-
off costs ($16.4 to 21.9 million at the current exchange rate, or
$8,200 to $10,950 per firm) and [pound]7 to 9.2 million in ongoing
costs ($10.9 to 14.4 million at the current exchange rate, or $5,450
to $7,200 per firm). See FSA Consultation Paper 06/9, Organisational
Systems and Controls: Common Platform for Firms, Annex 2 (May 2006).
\105\ 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 last of which
is required under a separate rulemaking proposal not being adopted
in this release.
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The Commission also has estimated potential costs to implement a
tracking and monitoring system for position limits; the Commission
anticipates that a firm could choose to implement a monitoring regime
from a wide range of potential compliance systems, based on the
specific, individual needs of the firm.\106\ For example, a firm may
elect to use an automatic software system, which may include high
initial costs but lower long-term operational and labor costs.
Conversely, a firm may decide to use a less capital-intensive system
that requires more human labor to monitor positions. Thus, taking this
range into account, the Commission anticipates, on average, labor costs
per entity ranging from 40 to 1,000 annual labor hours, $5,000 to
$100,000 in total annualized capital/start-up costs, and $1,000 to
$20,000 in annual operating and maintenance costs.\107\ The Commission
contrasts this estimate with that provided by one commenter stating
that compliance with proposed Sec. 23.601 by non-financial energy
companies would entail average incremental start-up costs of $245,000
and average incremental ongoing annual costs of $228,000.\108\
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\106\ See Position Limits for Futures and Swaps, 76 FR 71626,
71667 (Nov. 18, 2011).
\107\ These costs would likely be lower for firms with positions
far below the speculative limit, as those firms may not need
comprehensive, real-time analysis of their swaps positions for
position limit compliance to observe whether they are at or near the
limit. Costs may be higher for firms with very large or very complex
positions, as those firms may need comprehensive, real-time analysis
for compliance purposes. Due to the variation in both number of
positions held and degree of sophistication in existing risk
management systems, it is not feasible for the Commission to provide
a greater degree of specificity as to the particularized costs for
SDs and MSPs.
\108\ NERA, Cost-Benefit Analysis of the CFTC's Proposed Swap
Dealer Definition Prepared for the Working Group of Commercial
Energy Firms, December 20, 2011. See also text accompanying note 103
for a discussion of these figures.
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Other than as indicated with respect to monitoring for position
limits, the limited cost data provided by commenters discussed above,
and costs resulting from collections of information subject to the
Paperwork Reduction Act (incorporated by reference herein), the
Commission has little or no reliable quantitative data from which to
reasonably estimate the costs of compliance with the duties and risk-
management rules.\109\ The
[[Page 20178]]
Commission's review of applicable academic literature yielded no
research reports or studies directly relevant to its considerations of
costs of the final rules. Moreover, because it largely refrained from
establishing prescriptive requirements under Sec. 23.600--requiring
certain policies and procedures while leaving their design and
formulation to the discretion of each individual registrant--the
Commission believes that many of the costs associated with the rules
will be highly specific to each entity, and thus difficult to quantify
for an individual firm or on an aggregated basis. Certain of the costs
associated with these rules addressing duties and risk management
requirements of SDs and MSPs result from collections of information
subject to the Paperwork Reduction Act. Costs attributable to
collections of information subject to the PRA are discussed further in
section V.B.2. below. The Commission has also considered these costs,
which it incorporates by reference herein, in its section 15(a)
analysis.
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\109\ Although the rules were adapted from existing risk
management guidance from a variety of sources including the Federal
Reserve and the OCC, such guidance has been built up incrementally
over a period of time and the overall costs of compliance with such
guidance has not been quantified.
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Benefits
The Commission believes that the central, driving role of SDs and
MSPs in swaps markets--markets that can be systemically critical as
recent events have shown--requires that SDs and MSPs give due regard
to, and properly manage, the risks they incur as part of their day-to-
day businesses. The impact of an SD or MSP default may be greater than
the impact to the entity alone, and of potentially profound
significance to the financial system broadly. Given this, the
Commission believes these regulations prescribing internal risk
management requirements better assure the protection of market
participants and the public.
In promulgating the regulations governing the duties of SDs and
MSPs, the Commission has created a framework that requires proper
internal oversight but also ensures that these participants retain the
flexibility to comply in the manner best suited for their individual
needs. While the Commission recognizes that the costs incurred by
participants to comply with these regulations may be significant, the
Commission also believes that the strength of critical market
participants like SDs and MSPs is a vital component in the strength of
the financial system as a whole. By requiring entities to monitor the
risks arising from their operations actively and rigorously, the
Commission believes that an entity's default risk will decrease
substantially. Should an emergency situation--such as a natural
disaster--occur, the largest derivatives market participants will have
systems in place to resume full operation within one business day,
mitigating the effects of a major crisis for the financial system as a
whole. The Commission also recognizes that, given the systemic
importance of these entities, ensuring proper risk management within
SDs and MSPs helps to protect the public against major market
disruptions and financial losses.
In addition, the registrants will benefit from the required
oversight of their internal operations. The required monitoring is
designed to protect an entity from ``rogue'' or unauthorized trading.
Further, the required monitoring of applicable position limits protects
the entity from an unforeseen violation that could lead to, among other
things, an enforcement action from an exchange or the Commission.
Moreover, the regulations require identification and monitoring of
several different kinds of risk, allowing entities to realize and
correct potential issues before problems (and associated costs)
escalate. Finally, the stability of any entity rests on its ability to
manage the risks inherent in its business; by requiring stringent
internal oversight, the Commission believes these regulations will aid
in the growth and competitiveness of SDs and MSPs by ensuring the
stability that flows from the most basic forms of risk management.
Section 15(a) Determination
1. Protection of Market Participants and the Public
The Commission believes that requiring prudent risk management
policies and procedures lessens the risk of market disruptions and
financial losses that could greatly impact not only a particular SD or
MSP, but also other market participants and the public at large. The
Commission also believes that requiring entities to assess and monitor
their level of risk, as well as the adequacy of their own risk
management policies and procedures, helps to: (i) Protect the entity
from undue impacts from unanticipated market events, (ii) ensure swift
recovery after a disaster or other emergency, and (iii) promotes the
stability of the entity. The business practices of SDs and MSPs are of
critical importance to the integrity and stability of the derivatives
markets; this makes proper oversight and risk mitigation essential to
the well-being of the financial system.
The Commission does not believe that the costs associated with
these rules will have a detrimental effect on the protection of market
participants or the public. It is possible that the costs associated
with these rules will require that SDs and MSPs modify their business
decisions in order to allocate more resources to risk management,
monitoring traders, business continuity, and diligent supervision of
personnel.
2. Efficiency, Competitiveness, and Financial Integrity of Markets
\110\
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\110\ 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 swaps markets as well.
The Commission has identified no impact to futures markets.
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The Commission believes that effective internal risk management and
oversight helps protect the financial integrity of individual SDs and
MSPs. Their financial integrity, in turn, promotes the financial
integrity of derivatives markets by helping to foster confidence in the
stability of the financial system. Further, the regulations are
designed to ensure that SDs and MSPs can sustain their market
operations and meet their financial obligations to market participants,
further protecting the financial integrity of derivatives markets.
Additionally, the Commission believes that these regulations, as
carefully tailored to minimize costs beyond those required by the
statute, will enhance the efficiency and competitiveness of markets to
the extent that SDs and MSPs have sound risk management programs and
proper monitoring of traders. Monitoring traders to ensure that they do
not engage in manipulative or other disruptive market behaviors is
crucial to the efficiency of markets.
3. Price Discovery
The Commission has identified no likely material impact on price
discovery from the costs and benefits of these duties and risk
management rules.
4. Sound Risk Management
The regulations go to the heart of sound risk management for key
market participants and for the swaps market generally. The rules
require SDs and MSPs to establish policies and procedures for: (i)
Monitoring and managing traders and all risks associated with their
swaps activities, including market, credit, liquidity, foreign
currency, legal, and operational risk; (ii) business continuity
planning, and (iii) diligent supervision. Such policies and procedures
will ensure that the largest derivatives market
[[Page 20179]]
participants understand the risks associated with their swaps
activities, take steps to mitigate those risks when appropriate, and
are prepared for managing crisis situations. In essence, these rules
create risk management benefits by working to prevent SDs and MSPs from
having to default on their financial obligations, potentially
threatening overall financial stability in the process.
The costs associated with these rules will likely require that SDs
and MSPs allocate more resources to risk management, monitoring
traders, business continuity, and diligent supervision of personnel.
The Commission does not foresee that the allocation of these additional
resources will have a detrimental effect on sound risk management.
5. Other Public Interest Considerations
The Commission has not identified any other public interest
considerations that could be impacted by these duties and risk
management requirements for SDs and MSPs.
F. Conflicts-of-Interest Policies and Procedures for SDs, MSPs, FCMs,
and IBs
Section 4s(j) of the CEA, as added by section 731 of the Dodd-Frank
Act, sets forth certain duties for SDs and MSPs, including the duty to
implement conflict-of-interest systems and procedures. Specifically,
section 4s(j)(5) mandates that SDs and MSPs implement conflict-of-
interest systems and procedures that establish safeguards to ensure
that research activities and the provision of clearing services are
separated by appropriate informational partitions from the review,
pressure, or oversight of persons whose involvement in pricing,
trading, or clearing activities might potentially bias their judgment
or supervision. Section 4s(j)(5) further requires that such systems and
procedures ``address such other issues as the Commission determines to
be appropriate.'' The proposed regulations, as set forth in the SD/MSP
Conflicts NPRM, addressed the statutory mandate of section 4s(j)(5).
Similarly, section 732 of the Dodd-Frank Act amended section 4d of
the CEA by creating a new subsection (c), which mandates that the
Commission ``require that futures commission merchants and introducing
brokers implement conflict-of-interest systems and procedures.'' New
section 4d(c) mandates that such systems and procedures establish
firewalls between research and trading or clearing. New section 4d(c)
further requires that such systems and procedures ``address such other
issues as the Commission determines to be appropriate.'' The proposed
regulations, as set forth in the FCM/IB Conflicts NPRM, addressed the
statutory mandate of section 4d(c).
As described in detail in the preamble, the Commission, in
preparing these final rules, sought and incorporated comment from the
public. In the SD/MSP Conflicts NPRM and the FCM/IB Conflicts NPRM, the
Commission requested comment on the Commission's consideration of costs
and benefits and invited commenters to provide data quantifying the
costs and benefits of the proposed regulations.\111\ The Commission
received 29 comment letters to the SD/MSP Conflicts NPRM and 26 comment
letters to the FCM/IB Conflicts NPRM. Many commenters provided comments
addressing identical provisions or issues in both proposed rules. The
Commission considered each in formulating the final rules, including
any alternatives and cost concerns. Of the comment letters received, 21
letters addressed issues relevant to the costs and benefits of the
proposed rules, but no letters provided any quantitative data to
support their claims.
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\111\ See SD/MSP Conflicts NPRM, 75 FR at 71395 and FCM/IB
Conflicts NPRM, 75 FR at 70157.
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With regard to the conflicts provisions, the comment letters
focused on 16 areas of the rule that are most relevant to the
Commission's consideration of costs and benefits. Each of these areas
is discussed below. A more detailed discussion can be found in section
II.M. above.
1. Compliance Oversight by SROs
The Commission declines the recommendation of commenters \112\ to
delegate conflicts of interest oversight to an SRO because sections
4d(c) and 4s(j)(5) of the CEA direct the Commission exclusively to
promulgate such rules. In this regard, the CEA differs from section 15D
of the Securities Exchange Act of 1934, which mandates that conflict-
of-interest rules be adopted either by the SEC or by an SRO. Therefore,
the cost savings that the commenters asserted would result from the
delegation of oversight and rulemaking authority to an SRO are in fact
not an option that the Commission may consider under the statutory
framework provided by the Congress.
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\112\ FIA, ISDA, SIFMA, and JP Morgan suggested that the
Commission instruct an appropriate SRO to write detailed compliance
requirements within a framework set forth by the Commission because
SROs would be in a better position than the Commission to address
the likely need for future amendments to the rule. The Commission
presumes that the commenters believe that this alternative
arrangement would streamline compliance requirements resulting in
cost savings. The Commission notes, however, that the comments of
Michael Greenberger and UNITE HERE supported monitoring and
enforcement of the implementation of conflict-of-interest policies
and procedures by the Commission, as opposed to SROs.
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2. Non-Research Personnel
EEI argued that the Commission should limit the definition of non-
research personnel \113\ to only those persons involved with trading,
pricing, or clearing activities because implementing the restrictions
on communications between research analysts and all non-research
personnel as the proposed rule more broadly defined the term will be
burdensome. Sections 4d(c) and 4s(j)(5) of the CEA require
informational partitions between research analysts and persons involved
in pricing, trading, or clearing activities. The Commission recognizes
that extending the requirement for informational partitions above the
statutory minimum to all non-research personnel may cause registrants
to experience some incremental cost increase, though EEI did not
provide any quantification. Notwithstanding this, however, the
Commission is adopting the definition as proposed because it believes
doing so closes a significant window that could be exploited to evade
the statutory purpose--i.e., to ensure that research reports published
by registrants are free from bias. The Commission believes that
informational partitions only between research analysts and persons
involved in pricing, trading, or clearing activities are unlikely to
ensure that research reports are free from bias because other personnel
may have similar motives for influencing the content of research
reports, or may be subject to the influence of pricing, trading, or
clearing personnel and thus present an avenue of indirect influence on
research personnel. The Commission observes that the definition and use
of the term ``non-research personnel'' was adapted from NASD rule 2711,
which also prohibits all non-research personnel from reviewing or
approving a securities research report prior to publication.\114\ Thus,
despite some potential
[[Page 20180]]
incremental cost to registrants, the Commission believes that ensuring
unbiased registrant research reports accords with statutory intent and
justifies the increased burden.
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\113\ The proposed rule defined the term ``non-research
personnel'' as ``any employee of the business trading unit or
clearing unit, or any other employee of the [SD] or [MSP] who is not
directly responsible for, or otherwise involved with, research
concerning a derivative, other than legal or compliance personnel.''
\114\ See NASD rule 2711(b)(2) (stating ``no employee of the
investment banking department or any other employee of the member
who is not directly responsible for investment research (`non-
research personnel'), other than legal or compliance personnel, may
review or approve a research report of the member before its
publication'').
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3. Public appearances by research personnel
The proposed rules defined the term ``public appearance'' as ``any
participation in a conference call, seminar, forum (including an
interactive electronic forum) or other public speaking activity before
15 or more persons * * *.'' FIA, ISDA, and SIFMA argued that the
definition of public appearance should articulate that the term
``person'' includes both a customer that is a natural person and one
that is an entity. The Commission presumes these commenters to be
concerned that requiring public-appearance disclosures when the 15-
person threshold is crossed due to attendance by multiple
representatives of one entity increases the disclosure burden with no
attendant increase in benefit. The Commission agrees and is modifying
the rule accordingly.
4. Research department
FIA, ISDA, and SIFMA, in a joint comment, objected that the
imposition of the rule's restrictions to research departments \115\ of
global affiliates would create logistical difficulties and expense for
multinational firms; this impact was not quantified by the commenters.
FIA, ISDA, and SIFMA suggested that the Commission limit the rules to
requiring disclosure ``on third party research reports.'' The
Commission believes that the rule helps ensure that the research
reports produced by or on behalf of an SD, MSP, FCM, or IB, on which
consumers may rely in making investment or risk management decisions,
are not biased in favor of the financial interest of the SD, MSP, FCM,
or IB--a benefit. This, in turn, promotes consumer confidence in such
reports--another benefit. Therefore, because it believes that the
alternative suggested by FIA, ISDA, and SIFMA would be unacceptably
porous and invite evasion by registrants that move their research
function to an affiliate, the Commission is adopting the rule as
proposed. The Commission believes that ensuring that the intended
benefits of the rule are not depleted through evasion justifies any
incremental cost of extending the rule to affiliates of registrants. In
addition, the Commission believes that the increased costs are not as
significant as posited by the commenters. A registrant need not examine
the research functions of all of its affiliates under these rules;
rather, the rules only require that a registrant apply the
informational partitions of the rules to those research groups doing
research on behalf of an SD, MSP, FCM, or IB.
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\115\ The proposed rules defined the term ``research
department'' as ``any department or division that is principally
responsible for preparing the substance of a research report
relating to any derivative * * * including a department or division
contained in an affiliate * * *.''
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5. Research Report
As proposed, the definition of the term ``research report''
expressly excluded four categories of communications from coverage.
After considering the comments received, the Commission is expanding
the list of exclusions as recommended to include ``commentaries on
economic, political or market conditions'' and ``statistical summaries
of multiple companies' financial data, including listings of current
ratings.'' As modified, the Commission believes the rule strikes a
reasonable balance between the need to identify research reports on
which an investor or risk manager may rely in making a decision to
enter into a swap or other derivative that may also be subject to
potential bias in favor of the financial interest of an SD, MSP, FCM,
or IB, and those research reports on which an investor or risk manager
may rely, but that are not likely to be subject to such bias. The
benefits of the rule as modified are that the rules foster less biased
research reports without burdening registrants with unnecessary
restrictions on those research reports that, by their nature, are not
likely to be subject to bias. To maintain these benefits, the
Commission declines to broaden the definitional exclusion as suggested
by commenters \116\ to communications the Commission believes could
represent the core focus of a research department--e.g., asset classes,
economic variables commonly referenced in derivatives, and on-the-run
swap rates--and thus be susceptible to bias.
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\116\ FIA, ISDA, and SIFMA argued for the expansion of the
exclusions that the Commission has accepted. FIA/ISDA/SIFMA further
argued that communications produced by a business trading unit
labeled as a ``trading/sales desk product'' and as ``non-research''
should be excluded from the definitions of research report. In a
separate comment, JP Morgan expressed a general agreement with the
points raised in the FIA/ISDA/SIFMA letter. EEI argued that the
Commission should exclude from the definition any communication
between an SD or MSP, and its regulator, concerning hedging activity
because firms with small trading operations should be permitted to
publish occasional research reports to justify trading decisions,
without being subject the proposed rules. NFA also argued that the
definition in proposed Sec. 1.71(a)(9) was too broad and suggested
that the definition be limited in a number of ways similar to NASD
Rule 2711. Newedge also argued that the definition was too broad and
suggested a more narrow definition of research report.
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6. Conflicts of Interest Adequately Addressed by Existing Commission
and NFA Rules; FCM de minimis Exception
NFA commented that existing NFA rules address issues raised in
proposed Sec. 1.71, and that the rule could have unintended
consequences. K&L Gates LLP (on behalf of Peregrine Financial Group
Inc.), ADM Investor Services Inc., John Stewart & Associates Inc., and
Stewart-Peterson Group Inc. each agreed with NFA that existing rules of
NFA and the Commission are sufficient, and thus the additional
compliance costs imposed by the rules are not justified.
The Commission believes that sections 4d(c) and 4s(j)(5) of the CEA
require registrants to institute safeguards beyond what has been
previously required in the rules of the Commission and NFA, and,
accordingly, is adopting the rule substantially as proposed. For
example, the statutory provisions require ``structural and
institutional safeguards'' to ensure that research and trading
functions are ``separated by appropriate informational partitions,'' a
requirement not imposed by existing NFA or Commission rules. Thus, to
the extent institution of these additional safeguards incur added
costs, these are attributable to the statutory requirements imposed by
Congress. Moreover, by providing specificity under the rules with
respect to the conflict-of-interest requirement and by maintaining
consistency with NASD Rule 2711, the Commission believes that the rule
will minimize disruption to the market and minimize the additional
compliance costs required by the CEA because the rules rely on well-
established standards.
7. FCM de minimis Exception
Newedge commented that FCMs engaging in minimal proprietary trading
should not be subject to the burdens of the rule relating to research
analysts because such a firm does not present a risk of conflicts of
interest. Again, the Commission notes that sections 4d(c) and 4s(j)(5)
of the CEA require registrants to institute ``structural and
institutional safeguards'' to ensure that research and trading
functions are ``separated by appropriate informational partitions,''
and that neither of these sections makes an allowance for a de minimis
amount of trading or research. Thus, the Commission cannot adopt the
alternative approach suggested by Newedge because the imposition of a
de minimis exception to the conflicts rule
[[Page 20181]]
is inconsistent with the statutory directive that Congress set forth.
Moreover, the Commission does not believe that the limited nature of a
firm's proprietary trading negates the issues intended to be addressed
through the statutory mandate because a firm engaged in trading solely
on behalf of customers can increase its commissions by encouraging an
increase in trading activity through research reports.
8. Small IB Exception
In the FCM/IB Conflicts NPRM, the Commission invited comment on how
the proposed rules should apply to FCMs and IBs, considering the
varying size and scope of the operations of such firms. A number of
commenters requested relief for small IBs on grounds that the burden to
them would be high and could discourage them from providing research to
the detriment of customers seeking to hedge commercial risk.\117\ Given
the mandate of section 4d(c) of the CEA to establish ``appropriate
informational partitions'' within all FCMs and IBs, the Commission is
not able to exempt small firms from the statutory requirements.
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\117\ NFA, National Introducing Brokers Association, ADM
Investor Services Inc., John Stewart & Associates Inc., and Stewart-
Peterson Group Inc. each argued that implementing the proposed rules
would be prohibitively costly, burdensome, and unnecessary for small
IBs, particularly for IBs dealing with agricultural commodities
where the IB may have only a few employees engaged in both research
and trading for customers, and would force an unspecified number of
small IBs out of business. Chris Barnard noted that small IBs lack
the capacity to carry the proportionately heavier regulatory burden
set forth in the proposed rule, and as such, some regulatory
mitigation would be beneficial based on number of staff or revenues.
Multiple commenters also commented on the limited market price
impact of research reports created or distributed by small IBs.
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The Commission, however, recognizes that an IB's size is a
significant factor in determining the ``appropriateness'' of the
informational partitions required by section 4d(c). Thus, in light of
the burden to small IBs and the attendant loss of research benefits for
consumers that could result, the Commission has modified Sec. 1.71(b)
to set forth a separate policies and procedures requirement for small
IBs designed to provide them greater flexibility in determining the
appropriate informational partitions required under their own
circumstances.\118\
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\118\ The threshold to qualify for this small IB alternative is
$5 million or less in aggregate gross revenues generated over the
preceding 3 years from activities as an IB. This approach is similar
to that taken in NASD Rule 2711 and was raised as a possible
alternative in the preamble of the proposed rule.
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9. Restriction on Non-Research Personnel From ``Influencing the
Content'' of Research Reports
The proposed rules provided that non-research personnel shall not
influence the content of a research report. In response to commenters'
concerns that the proposed standard was unnecessarily broad and would
tend to chill all communications, including those beneficial to
research integrity, between research and non-research personnel, the
Commission is modifying the rules in line with suggested alternatives
to provide instead that non-research personnel shall not direct the
views and opinions expressed in a research report.\119\ The Commission
believes that accepting this change will reduce the compliance burden
of registrants because it directs compliance efforts toward ensuring
that the views and opinions expressed in research reports are those of
the research analyst, rather than attempting to prohibit all
influence.\120\
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\119\ FIA, ISDA, SIFMA, and JP Morgan argued that the proposed
prohibition on ``influencing the content'' should be eliminated
because it would impair ordinary communications between research and
non-research personnel. As an alternative, FIA/ISDA/SIFMA suggested
that non-research personnel should be prohibited only from
``directing the views and opinions expressed in research reports.''
Better Markets argued that the rules should be expanded to include
any decision not to publish a report or to refrain from including
relevant information.
\120\ The Commission further modified the rules in response to
commenters to provide that non-research personnel shall not direct a
research analyst's decision to publish a research report. The
Commission believes this is a burden-neutral modification to provide
clarification, however.
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10. Restriction on Research Analyst Supervision by Business Trading
Unit or Clearing Unit
The proposed rules prohibited (1) supervision or control of a
research analyst by any employee of the registrant's business trading
unit or clearing unit, and (2) influence or control over the evaluation
or compensation of a research analyst by personnel engaged in pricing,
trading, or clearing activities. The intent of the rules is to foster
research free of bias that may result from research analysts'
expectation of increased compensation for producing research reports
favorable to the financial interests of personnel in the business
trading unit or clearing unit--a benefit.
FIA, ISDA, and SIFMA recommended--presumably on the basis that
requiring a separate reporting line adds to the compliance burden--that
the restriction only apply to direct supervision of research analysts,
and not to others further up the management chain. No commenter
provided quantitative information with respect to the costs of such
burden. The Commission believes that it has resolved the concerns of
commenters through (1) changes to the definitions of ``business trading
unit'' and ``clearing unit'' discussed in section II.M above, and (2)
using those definitions to designate personnel who may not have
influence or control over the evaluation or compensation of a research
analyst. As modified, the definitions reach only those performing
certain functions in the unit and those supervising the performance of
those functions. The Commission believes the threat to research analyst
independence that would result from permitting supervision by any
member of the business trading unit or clearing unit, as defined in the
final rules, justifies adopting the rule as proposed.
11. Requirement That Legal/Compliance Personnel Supervise Communication
Between Research and Non-Research Personnel
The proposed rules permitted non-research personnel to review a
research report before its publication for limited purposes, such as
verifying factual accuracy. Such review: (1) May only be conducted
through authorized legal or compliance personnel, and (2) must be
properly documented. In this respect, the rules maintain consistency
with NASD Rule 2711 and the Commission believes that such consistency
will minimize compliance costs because the rules rely on well-
established standards. In addition, the Commission notes that the
benefit of this provision is that it maintains the independence of the
views and opinions expressed in research reports while improving the
accuracy of such reports. The rules accomplish these benefits by
balancing the need for some review of research reports by non-research
personnel, while ensuring the review is limited in scope by requiring
the presence of legal or compliance personnel.
EEI recommended that the Commission exempt communications that are
factual in nature from oversight by legal and compliance personnel,
arguing that such oversight unnecessarily burdens legal/compliance
personnel. EEI did not further qualify or quantify the costs implicated
by the proposed exemption. Upon consideration of the alternative's
cost/benefit ramifications, the Commission determined to adopt the rule
as proposed. The Commission finds the suggested alternative
unacceptable for several reasons. First, the Commission does not
believe that registrants will be able to distinguish easily
[[Page 20182]]
communications that are ``factual in nature'' from those that are not,
likely resulting in more uncertainty and needed review by legal and
compliance personnel, not less. In addition, the Commission believes
that allowing for communications that are merely ``factual in nature''
opens an avenue for evasion that could undermine the rules' intended
benefits.
12. Restrictions on Research Analyst Communications
The proposed rules provided that a research analysts' written or
oral communication relating to any derivative must not omit any
material fact or qualification that would cause the communication to be
misleading to a reasonable person. The requirement, as proposed,
applied to external communications to a current or prospective
counterparty as well as internal communications to any employee of the
registrant. The Commission intends the rules to promote research report
integrity--i.e., help ensure that reports are both unbiased in favor of
a registrant's financial interests and factually accurate in material
respects. The Commission anticipates that the cost attendant to achieve
the accuracy component of this intended benefit is any increased time a
registrant spends ensuring that research analysts' reports are free of
material misleading inaccuracies.
FIA, ISDA, SIFMA, and JP Morgan commented that the proposed rule
would materially burden an affected firm's operations because it
applies to internal communications as well as external communications.
Upon consideration of the potentially significant cost of including
internal communications relative to the limited gain in intended
benefits, the Commission is modifying the rules to exclude
communications with employees of the registrant from the requirement.
13. Restriction on Influence of Business Trading Unit and Clearing Unit
on Research Analyst Compensation
Proposed Sec. Sec. 23.605(c)(3) and 1.71(c)(3) precludes (1) a
registrant from considering a research analyst's contribution to the
trading or clearing business as a factor in his or her compensation
review or approval, and (2) a review or approval role for business
trading or clearing unit personnel with respect to a research analyst's
compensation. As articulated above, the Commission believes that the
benefit of unbiased research flows directly from a research analyst's
independence, which is compromised if the analyst's compensation is
subject to business trading or clearing unit influence.
The Commission recognizes that the rule, to some incremental
extent, may add to compliance costs, although no commenter specifically
articulated or quantified this impact. After considering the comments
received,\121\ the Commission has determined to revise the proposed
rule to relieve the compliance burden by permitting communications to
research department management relating to client or customer feedback,
ratings, and other indicators of a research analyst's performance. The
Commission does not believe that this relaxation will negatively impact
research independence. The Commission declines to further modify the
rule, however, based on its belief that maintaining a firewall around
research analyst compensation decisions is crucial to implementing
effective conflict-of-interest policies and procedures and ensuring the
benefits of unbiased research reports. The Commission also confirms
that the rule does not prohibit compensation decisions from being
subject to non-discriminatory and non-prejudicial firm-wide
compensation guidelines.
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\121\ FIA, ISDA, SIFMA, and JP Morgan contended that research
management should be able to solicit input from business trading and
clearing unit personnel concerning the performance of research
personnel. FIA/ISDA/SIFMA, as well as Newedge, further argued that
research management decisions should be subject to firm-wide
compensation guidelines. By contrast, Michael Greenberger argued
that research management should be prohibited from soliciting any
input of business trading and clearing units concerning a research
analyst's compensation or performance evaluation, even if the
influence is indirect or if research management maintains the
ability to make all final decisions on such determinations. Better
Markets commented that the provision should be broadened.
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14. Disclosure of Conflicts by Research Analysts in Research Reports
and Public Appearances; Disclosure of Conflicts in Third-Party Research
Reports
Proposed Sec. Sec. 23.605(c)(5)(i) and 1.71(c)(5)(i) required
certain disclosures in registrants' research reports and at research
analysts' public appearances. Specifically, it required disclosure of
whether the analyst that prepared the report or makes the appearance
maintains, from time to time, a financial interest in the types of
derivatives that the analyst follows, the general nature of such
interest, and any other material conflicts of interest of which the
research analyst has knowledge. Additionally, as proposed, Sec. Sec.
23.605(c)(5)(iv) and 1.71(c)(5)(iv) required that, if a registrant
distributes or makes available third-party research reports, each
report be accompanied by certain disclosures pertinent to conflicts of
interest. The required disclosures benefit consumers of research
reports produced by SDs, MSPs, FCMs, and IBs because they alert the
consumers of such reports to interests that may influence the content
of such reports, allowing the consumer to make an independent judgment
as to their value.
Several commenters recommended changes that could lessen the
incremental (though unquantified) compliance costs of the rule by
curtailing the required disclosures.\122\ The Commission has considered
these comments and has determined that the benefits of the rule will be
maintained without subjecting registrants to the burden of determining
and disclosing financial interests that are maintained ``from time to
time.'' Thus, the Commission is modifying the language of Sec. Sec.
23.605(c)(5) and 1.71(c)(5) to remove the phrase ``from time to time,''
such that a research analyst need only disclose whether she maintains a
relevant financial interest at the time of publication of the report or
the time of a public appearance. However, the Commission is not
adopting a de minimis exception, due to the difficulty of deciding when
a financial interest is de minimis in this context. A de minimis
exception would require a registrant to determine the threshold point
at which a financial interest poses a threat of conflicts of interest--
a nebulous standard; such determination is likely to increase the costs
of compliance of the rule over the cost that would be incurred to
simply disclose all financial interests.
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\122\ FIA, ISDA, and SIFMA argued that Sec. Sec.
23.605(c)(5)(i) and 1.71(c)(5)(i) should be limited to disclosing
whether a research analyst maintains a relevant financial interest
at the time of publication of the report/time of public appearance,
rather than ``from time to time'' as provided in the rule. EEI
suggested that the Commission modify the proposed rule to provide a
de minimis exception to the disclosure requirements, such that a
research analyst should be required only to identify relevant
financial interests.
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Commenters also raised concerns regarding the burden of required
disclosures when distributing research reports produced by a third-
party.\123\ The Commission considered the burden of disclosure in this
context in light of maintaining the benefit of disclosure of
information necessary for consumers to judge the content of research
reports. The Commission has determined not to modify the rule in regard
to third-party research disclosures. It believes that
[[Page 20183]]
third-party research reports distributed by a registrant may be
interpreted as carrying the endorsement of the registrant and thus may
present conflicts-of-interest issues in the same way as research
reports originating with the registrant's own research analysts;
accordingly, the same level of disclosure is appropriate.
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\123\ FIA, ISDA, SIFMA, JP Morgan, and EEI argued that the
required disclosures with respect to third-party research reports
are unnecessary because third-parties are, by definition,
independent.
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Finally, commenters also contended that the phrase ``any other
actual, material conflict of interest of the research analyst'' is
vague and would be burdensome to implement, requiring coordination
among various business units and the creation of special databases in
order to comply with the rule. The Commission believes that the cost
concerns of commenters are misplaced in this regard. The rules require
disclosure of ``any other actual, material conflicts of interest of the
research analyst or [SD, MSP, FCM, or IB] of which the research analyst
has knowledge at the time of publication of the research report or at
the time of the public appearance'' (emphasis added). Thus, the
disclosure requirement is limited to conflicts of which the research
analyst has knowledge, and the SD, MSP, FCM, or IB need not construct
the databases suggested by commenters in order to comply with the rule.
15. Separation of Clearing Unit From Business Trading Unit
As proposed, Sec. 23.605(d) and Sec. 1.71(d) prohibited
interference by an SD or MSP with the decisions of clearing members,
including FCMs, regarding the provision of clearing services and
activities. The proposed rules also required informational partitions
between business trading units and clearing member personnel. In
addition, the proposals prohibited any employee of a business trading
unit from supervising or controlling any employee of a clearing member.
The Commission believes the benefits of the rules are that, to the
extent practicable, the rules protect fair and open access to clearing
by ensuring that decisions to accept clearing customers are not
motivated solely by considerations of trading profits.
Commenters raised a number of cost concerns related to operation of
the rule, as follows:
Sales personnel should be able to act for both the trading
unit and the clearing unit to offer a full range of services to
customers efficiently; \124\
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\124\ FIA/ISDA/SIFMA and JP Morgan argue that sales personnel
should be permitted to act for both units. UBS Securities LLC also
argued that the rule inhibits the ability of a financial services
firm to operate its swap clearing business as a partnership with its
trading business in order to serve clients. Similarly, the FHLBs
argued that the proposed rule overly restricts the ability of SDs
and MSPs to run their trading and clearing operations and
effectively serve the needs of their end-user counterparties.
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The rules will impair a registrant's ability to follow
risk management best practices by requiring independent risk
assessments in the trading unit and clearing unit for the same
counterparty, rather than a consolidated risk assessment; \125\
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\125\ FIA/ISDA/SIFMA and the FHLBs argued that the proposed
rules would impair an SD's/MSP's ability to follow risk management
best practices. NFA commented that Sec. 1.71(d) is too broad and
may negatively impact a firm's ability to share information about
customers to make credit and risk determinations.
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The rule should be limited to prohibiting a trading unit
from obtaining information about the transactions or positions of
customers of the clearing unit; \126\
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\126\ FIA/ISDA/SIFMA recommended that the Commission not adopt
the proposed rules, but instead adopt a rule that prohibits an
affiliated SD or MSP from obtaining information from an affiliated
FCM's clearing personnel concerning transactions conducted by FCM
clients with either their own clients or with independent SDs or
MSPs.
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No commenter provided any quantitative information regarding the
expected costs of complying with the rules.
Having considered the costs of compliance as presented by
commenters in light of the benefits of open access to clearing, the
Commission has determined it appropriate to promulgate the rules
largely as they were originally proposed. Despite the varying
incremental costs of any needed corporate structure reorganization and
instituting informational partitions, the Commission believes the
separation of the FCM clearing unit from the interference or influence
of an affiliated SD or MSP is crucial to promoting open access to
clearing and securing the benefits to market participants and the
stability of the financial system itself expected to follow from
increased central clearing.\127\ Open access to clearing will be
essential for the expansion of client clearing needed for market
participants to comply with the mandatory clearing of swaps as
determined by the Commission under section 723 of the Dodd-Frank Act.
Specifically, the Commission does not believe that the rule language
should be changed to permit sales personnel to act for both the trading
unit and the clearing unit. The risks associated with this approach, in
terms of potential undue influence and interference with clearing
decisions, has been well-supported by commenters.\128\
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\127\ In September 2009, the G-20 Leaders agreed in Pittsburgh
that ``all standardised OTC derivative contracts should be traded on
exchanges or electronic trading platforms, where appropriate, and
cleared through central counterparties by end-2012 at the latest.''
\128\ MFA and Pierpont Securities Holdings LLC commented that
they support the Commission's proposals. Swaps and Derivatives
Market Association contended that that the restrictions correctly
address key areas where conflicts arise, and that the independence
of clearing members is essential to accomplish several policy goals
of the Dodd-Frank Act. Michael Greenberger also expressed support
for Sec. 23.605(d), noting that attempts to tie clearing decisions
to trade execution decisions would raise potential conflicts of
interest, which could serve to block access to clearing and prevent
competition among execution venues.
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However, in response to commenters' concerns about an FCM's ability
to manage a default scenario without the benefit of the trading
expertise in the business trading unit, the Commission is modifying
proposed Sec. 1.71(d)(2)(i) to permit the business trading unit of an
affiliated SD or MSP to participate in the activities of an FCM during
an event of default. Specifically, the business trading unit personnel
would be permitted to participate in the activities of the FCM, as
necessary, during any default management undertaken by a derivatives
clearing organization and for the purposes of transferring,
liquidating, or hedging any proprietary or customer positions as a
result of an event of default.
16. Undue Influence on Customers
As proposed, Sec. 1.71(e) required that FCMs and IBs adopt and
implement written policies and procedures that mandate the disclosure
of any material incentives and any material conflicts of interest
regarding the decision of a customer as to trade execution and/or
clearing of a derivatives transaction. Proposed Sec. 23.605(e)
mandated that SDs and MSPs adopt policies and procedures requiring
disclosure to counterparties of any material incentives and conflicts
of interest regarding the decision of a counterparty: (1) Whether to
execute a derivative on a swap execution facility or designated
contract market; or (2) whether to clear a derivative through a
derivatives clearing organization. The Commission believes that the
rules benefit counterparties by ensuring that they are adequately
informed of any material incentives or conflicts prior to the execution
of a transaction, and benefit the market by promoting the efficient use
of trading facilities and clearing for swap transactions.
Some commenters objected to the rule on the grounds that existing
Commission regulations already impose risk disclosure requirements on
FCMs and IBs. FIA, ISDA, SIFMA, and JP Morgan argued that the
Commission could reduce the burden of the rules by
[[Page 20184]]
requiring SDs and MSPs to provide customers with an annual disclosure
document describing potential conflicts that may exist among the firm,
its affiliates, clients, and employees.
After considering costs of compliance with the rule in light of the
benefits outlined above, and the underlying statutory requirements, the
Commission has determined it appropriate to adopt the rules as
originally proposed. The Commission believes that the disclosure of
conflicts of interest in this context are materially different from the
risk disclosures required of FCMs and IBs under existing Commission
regulations and, therefore, existing regulations are inadequate to
secure the benefits of the rule outlined above. In addition, the
Commission notes that the rule does not prohibit an SD or MSP from
providing its customers with an annual disclosure document, and the
Commission confirms that such would be permitted assuming that such
document is sufficient to meet the requirements of the rule.
Costs
Sections 4d(c) and 4s(j)(5) of the CEA require FCMs, IBs, SDs, and
MSPs, to adopt and implement certain conflict of interest systems,
procedures and safeguards, including research firewalls. The costs and
benefits that necessarily result from these basic statutory
requirements are considered to be the ``baseline'' against which the
costs and benefits of the Commission's final rules are compared or
measured. The ``baseline'' level of costs includes the costs that
result from the following activities required by the statute:
FCMs and IBs must establish structural and institutional
safeguards to ensure that the activities of any person within the firm
relating to research or analysis of the price or market for any
commodity are separated by appropriate informational partitions within
the firm from the review, pressure, or oversight of persons whose
involvement in trading or clearing activities might potentially bias
the judgment or supervision of the persons.
SDs and MSPs must establish structural and institutional
safeguards to ensure that the activities of any person within the firm
relating to research or analysis of the price or market for any
commodity or swap are separated by appropriate informational partitions
within the firm from the review, pressure, or oversight of persons
whose involvement in pricing, trading, or clearing activities might
potentially bias their judgment or supervision and contravene the core
principles of open access and the business conduct standards described
in the CEA.
SDs and MSPs must establish structural and institutional
safeguards to ensure that the activities of any person within the firm
acting in a role of providing clearing activities or making
determinations as to accepting clearing customers are separated by
appropriate informational partitions within the firm from the review,
pressure, or oversight of persons whose involvement in pricing,
trading, or clearing activities might potentially bias their judgment
or supervision and contravene the core principles of open access and
the business conduct standards described in the CEA.
Compliance with the statutory baseline alone would result in costs
for FCMs, IBs, SDs, and MSPs. For example, the requirement to establish
informational partitions would include the cost of identifying
personnel involved in research or analysis of the price or market for
any commodity or swap, identifying personnel involved in pricing,
trading, or clearing activities, and designing and implementing
communication policies and procedures.
Congress mandated that the Commission adopt rules to implement each
of the statutory provisions. With regard to its implementation
decisions, the Commission has determined the following to be potential
costs to FCMs, IBs, SDs, and MSPs to comply with the final regulations
regarding conflicts-of-interest policies and procedures:
Identifying reports that qualify as research reports;
Maintaining records of public appearances by research
analysts; and
Designing and implementing policies and procedures
regarding:
Legal or compliance participation in communications
between research analysts and non-research personnel regarding the
content of research reports;
Oversight of research analyst communications regarding
omissions of material facts or qualifications that would cause the
communication to be misleading to a reasonable person;
Communication of any client or customer feedback on
research analyst performance from the business trading unit or clearing
unit to research department management;
Implementing the prohibition on promises of favorable
research by research analysts;
Discovering, monitoring, and disclosing financial
interests maintained by research analysts;
Implementing the prohibition on retaliation against
research analysts;
Implementing the prohibition of interference with or
influence on decisions with regard to the provision of clearing
services or activities; and
Disclosing material incentives and conflicts-of-interest
regarding exchange trading or clearing decisions by counterparties.
In adhering to its mandate from Congress, where possible the
Commission has attempted to alleviate the burdens on affected entities.
The Commission has narrowed the definitions of ``business trading
unit'' and ``clearing unit'' to include fewer registrant personnel
affected by the rules. The Commission has narrowed the definition of
``public appearance'' to include fewer appearances by research analysts
that would require the disclosures mandated by the rules. The
Commission has broadened the number of exclusions from the definition
of ``research report'' such that there are fewer subject areas that
would be covered by the rules. The Commission has provided a separate
regulatory standard for small IBs that will lessen the compliance
burden on such firms. The Commission also has narrowed the prohibition
on non-research personnel involvement in producing content of research
reports, and removed the need to police internal communications from
research analysts for omissions of material facts or qualifications.
The Commission has permitted trading and clearing units to provide
client and customer feedback on research analyst performance to
research department management and removed the need to determine and
document financial interests of research analysts maintained ``from
time to time'' for disclosure purposes. Finally, the Commission has
permitted business trading unit personnel to participate in the
activities of an FCM, as necessary, during any default management
undertaken by a derivatives clearing organization and for the purposes
of transferring, liquidating, or hedging any proprietary or customer
positions as a result of an event of default.
Other than costs resulting from collections of information subject
to the Paperwork Reduction Act, incorporated by reference herein, the
Commission has no reliable quantitative data from which to reasonably
estimate the costs of compliance with these conflict of interest
rules.\129\ No commenter provided any quantitative data on the costs of
compliance with the rules as
[[Page 20185]]
proposed. The Commission's review of applicable academic literature
yielded no research reports or studies directly relevant to its
considerations of costs of the final rules.
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\129\ Although the rules were adapted from NASD rule 2711, that
rule was promulgated by an SRO (now FINRA), which was not required
to conduct a cost-benefit analysis of the rule prior to
promulgation.
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The Commission anticipates that many entities may currently have,
pursuant to other regulation, the informational partitions required by
the rules in place. The Commission notes that dually registered FCMs
and BDs are more likely to have implemented such informational
partitions under other regulatory regimes \130\ than entities that are
subject to such requirements for the first time. Costs, therefore, are
expected to be higher for those entities not currently dually
registered or not currently implementing conflicts of interest policies
and procedures. Certain of the costs associated with these conflict of
interest rules result from collections of information subject to the
Paperwork Reduction Act. Costs attributable to collections of
information subject to the PRA are discussed further in section V.B.3.
below. The Commission has also considered these costs, which it
incorporates by reference herein, in its section 15(a) analysis.
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\130\ In this respect, the Commission observes that 55% of
current FCMs are also registered as BDs with the SEC, and thus may
already have informational partitions between research and trading
as required under the rules of FINRA. See letter from NFA, dated
Jan. 18, 2011 (comment file for 75 FR 70881 (Designation of a Chief
Compliance Officer; Required Compliance Polices; and Annual Report
of a FCM, SD, or MSP)). The Commission also notes that in 2003 the
UK FSA conducted a cost benefit analysis when promulgating conflicts
of interest rules and guidance with respect to investment research
and issues of securities. The UK FSA concluded that because UK firms
were required to comply with their existing statutory obligations
including management of conflicts of interest when carrying out
regulated activity, the ``total compliance costs relating to [the
FSA's] new proposed rule and supporting guidance on objective
investment research will be of no more than minimal significance.''
See FSA Consultation Paper 205, Conflicts of Interest: Investment
Research and Issues of Securities, Annex 1 (October 2003); FSA
Consultation Paper 171, Conflicts of Interest: Investment Research
and Issues of Securities, Annex 5 (February 2003).
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Benefits
The Commission believes that the proper informational partitions
between research and trading and between clearing and trading,
including restrictions on communications, supervision, and compensation
oversight, help to ensure that research being released by SDs, MSPs,
FCMs, and IBs and decisions related to trade execution and clearing are
not tainted by inappropriate incentives. Because this research may be
relied upon by a public that views such entities as experts in
derivatives markets by virtue of their intimate knowledge of the
products and markets, it is imperative that the information released
therein is as accurate and free of conflicts of interest as possible.
Similarly, because the importance of central clearing in derivatives
markets necessitates free and open access to clearing, unrestrained by
any potential conflicts of interest, it is imperative that access to
clearing is not impeded by any inappropriate motivation. The rules
adopted in this release require entities to establish appropriate
policies and procedures to accomplish these benefits.
In addition, by ensuring that decisions on clearing activities
remain separate from decisions relating to trade execution and other
proprietary activities, the final regulations promote competitiveness
in futures and swaps markets by ensuring open access to clearing.
Central clearing is a pillar of derivatives reform initiatives,
contributing heavily to the efficiency and safety of derivatives
markets; barriers to clearing access may have an adverse effect on that
efficiency and safety.
To the extent that a research report informs the financial
investment in derivatives markets, protecting the integrity of that
report aids in the protection of the financial integrity of markets.
Moreover, requiring registrants to disclose any potential conflicts
of interest further affords the public the opportunity to make
judgments regarding the information provided to them in the written
reports and public appearances of research analysts. The Commission's
mission to ensure fair and orderly markets relies in part on the
transparency of certain market information, in order to provide
potential investors the accurate information necessary to make informed
decisions.
Section 15(a) Determination
1. Protection of Market Participants and the Public
The Commission believes that, as a result of these rules, market
participants and the public are better protected from the potential
harm that may occur when financial research reports are not insulated
from the bias of registrants' own financial interests. This bias holds
strong potential to operate as an incentive for registrants to produce
and distribute research reports tainted by misleading, unbalanced, and/
or inaccurate information. Such tainted reports, in turn, may induce
market participants to engage in a financial transaction that they
otherwise would not. Thus, the Commission believes that these
regulations perform an important consumer protection function in the
markets it regulates. While, in theory regulation could discourage some
SDs, MSPs, FCMs, or IBs from making research reports public, the
Commission believes the rules are carefully tailored to minimize costs
beyond those required by the statute. The Commission also believes that
SDs, MSPs, FCMs, and IBs likely will use research reports as a tool to
differentiate themselves from competitors. In addition, the Commission
believes that by insulating clearing services from pricing and trading
bias, the regulations foster fair and open access to central clearing.
2. Efficiency, Competitiveness, and Financial Integrity of Markets
\131\
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\131\ Although by its terms CEA section 15(a)(2)(B) applies to
futures markets only, the Commission finds this factor useful in
analyzing regulations pertaining to swaps markets as well.
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The final rules promote the efficiency, competitiveness, and
financial integrity of futures and swaps markets \132\ by prohibiting
an entity's trading personnel from manipulating research reports or
otherwise biasing the information contained in research reports to
their own financial advantage. To the extent the research produced by
registrants is used to inform financial strategies, the integrity of
that research is beneficial to the financial integrity of derivatives
markets. The final rules strive to ensure the integrity of research
performed by Commission registrants. Sound research also promotes
market efficiency insofar as the increased dissemination of reliable,
unbiased market information is acted upon by market participants in
their decision-making. As discussed above, the Commission does not
believe that the costs of these regulations, as carefully tailored to
minimize costs beyond those required by the statute, will materially
decrease market efficiency by leading to less sharing of relevant
market information, particularly in light of the competitive incentives
to do so.
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\132\ Although by its terms CEA section 15(a)(2)(B) applies to
futures markets only, the Commission finds this factor useful in
analyzing regulations pertaining to swaps markets as well.
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Because the final rules promote fair and open access to central
clearing, they also promote the financial integrity of derivatives
markets--both futures and swaps markets. Greater access to central
clearing ensures that more market participants will have the option to
mitigate the counterparty credit risk that they face when entering into
derivatives transactions. Protecting market participants from
discrimination in the provision of clearing services will foster
[[Page 20186]]
a competitive environment for the provision of clearing services and
afford market participants greater choice in clearing members. While
the Commission recognizes that some costs are attendant to the required
firewall between trading and clearing, the Commission does not believe
that these costs, as carefully tailored to minimize costs beyond those
required by the statute, are sufficient to materially inhibit the
provision of clearing services.
3. Price Discovery
To the extent that insulating research reports from registrant
financial bias results in hedgers and investors making more accurately
informed investment decisions, reported trade and transaction prices
should better reflect the intrinsic value. This promotes the price
discovery function of derivative markets. In contrast, where there is
no check on the integrity of registrant research materials and market
actors transact on the basis of misleading or inaccurate information,
resulting prices may be distorted. Because the rules are carefully
tailored to minimize costs, the Commission does not believe these rules
will reduce liquidity to hinder price discovery.
4. Sound Risk Management
The final rules regarding informational partitions between clearing
and trading will contribute to sound risk management because the
separation of the FCM clearing unit from the interference or influence
of an affiliated SD or MSP promotes open access to clearing. Open
access to clearing will be essential for the expansion of client
clearing needed for market participants to comply with the mandatory
clearing of swaps as determined by the Commission under section 723 of
the Dodd-Frank Act. The mandatory central clearing of swaps is one of
the primary responses to the 2008 financial crisis, as central clearing
is believed to promote sound risk management in the swap markets. While
the Commission recognizes that some costs are attendant to the required
firewall between trading and clearing, the Commission does not believe
that these costs, as carefully tailored to minimize costs beyond those
required by the statute, are sufficient to materially inhibit the
provision of clearing services and the risk management benefit these
services afford.
5. Other Public Interest Considerations
The Commission has not identified any other public interest
considerations impacted by these conflicts-of-interest rules.
G. Designation of a Chief Compliance Officer, Required Compliance
Policies, and Annual Report of an FCM, SD, or MSP
The CCO NPRM proposed several rules addressing chief compliance
officer (CCO) designation and certain CCO requirements:
Proposed Sec. 3.3(a) codified the statutory requirements
that each FCM, SD, and MSP designate a CCO and prescribed certain
qualifications for the position.\133\
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\133\ Section 4d(d) of the CEA requires that each FCM designate
an individual to serve as its chief compliance officer (CCO).
Likewise, section 4s(k) of the CEA requires that each SD and MSP
designate an individual to serve as its CCO.
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Proposed Sec. 3.3(d) codified the CCO duties defined in
section 4s(k)(2) for SDs and MSPs, and extended their application to
FCMs.\134\
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\134\ Section 4d(d) of the CEA authorizes the Commission to
promulgate rules concerning the duties of a CCO of an FCM.
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Proposed Sec. 3.3([e]) \135\ codified the requirements of
section 4s(k)(3) of the CEA for SDs and MSPs--i.e., that the CCO
annually prepare and sign a report containing descriptions of: (i) The
registrant's compliance with the CEA and regulations promulgated under
the CEA, and (ii) each policy and procedure of the CCO, including the
code of ethics and conflicts-of-interest policies--and extended their
application to FCMs pursuant section 4d(d) of the CEA.
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\135\ The proposed regulations mis-numbered the subsections of
Sec. 3.3 such that two subsections were designated as ``(d).'' To
avoid confusion, this release re-designates such sections correctly
in brackets.
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Of the 25 comment letters the Commission received on the CCO NPRM,
17 raised issues relevant to the consideration of the proposed rules'
material costs and benefits; two of these provided some quantitative
data relevant to costs and benefits.
The comments relevant to costs and benefits can be classified with
respect to the following 10 aspects, each of which is discussed
below.\136\
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\136\ A more detailed discussion of the comments can be found in
section II.N. above.
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1. Decision To Extend Same Requirements to FCMs as SDs and MSPs
The Commission proposed uniform rules applicable to SDs, MSPs, and
FCMs. After reviewing the comments received,\137\ the Commission is
adopting the same requirements for SDs, MSPs, and FCMs. The Commission
recognizes commenters' concerns (though not substantiated with
quantitative data) that subjecting FCMs to the same CCO requirements as
applied to SDs and MSPs by section 4s(k) of the CEA (as codified in
these rules) may increase costs for FCMs as compared to a less
prescriptive approach. The Commission believes these costs may vary
widely among FCMs, depending on the activities in which an FCM engages
and the size and complexity of an FCM's operations.\138\ Lacking
quantitative information requested of commenters, the Commission has
looked to public sources to estimate the boundaries of this range. In
this regard, it finds the estimates contained in the SEC's 2003
published final compliance program rules for investment companies and
investment advisers informative and, in lieu of FCM-specific
information, a reasonable proxy for estimating an FCM compliance cost
range.\139\ The SEC estimated costs for developing a compliance
program, depending on the manner chosen, ranging from $1,000 to
$200,000.\140\
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\137\ Comments from Rosenthal, Newedge, and NFA advocated
separate treatment for FCMs, given the Commission's separate
statutory authority over them. A number of other commenters,
including Better Markets, NSCP, and CII generally supported
extension of the same duties to FCMs (provided that certain
modifications were made to the proposed rules).
\138\ In this respect, the Commission observes that 55% of
current FCMs are also registered as BDs with the SEC, and thus will
already have a CCO and significant compliance regimes as required
under the rules of FINRA. See letter from NFA, dated Jan. 18, 2011
(comment file for 75 FR 70881 (Designation of a Chief Compliance
Officer; Required Compliance Polices; and Annual Report of a FCM,
SD, or MSP)). FCMs that do not currently have a CCO or a compliance
program may choose to develop a program in-house if their activities
are limited and the regulatory requirements well-understood. Other
FCMs may choose to purchase an off-the-shelf compliance manual and
adjust it to correspond to their regulatory requirements. Still
others may hire a third-party compliance firm, a law firm, or an
accounting firm to draft a firm-specific manual. As of 2003, when
the SEC published final compliance program rules for investment
companies and investment advisers, the costs for these options
ranged from $1,000 to $200,000. See Compliance Programs of
Investment Companies and Investment Advisers, 68 FR 74714 (Dec. 24,
2003).
\139\ See Compliance Programs of Investment Companies and
Investment Advisers, 68 FR 74714 (Dec. 24, 2003).
\140\ The SEC considered the same three alternative compliance
avenues as noted above for FCMs. See id.
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Notwithstanding these costs, the Commission believes the same
considerations and benefits, discussed further below, that warrant
these regulations for SDs and MSPs, warrant them for FCMs as well. As
recent Congressional hearings in the wake of the MF Global bankruptcy
have highlighted, an FCM's conduct holds potential to cause severe
negative impact to market participants and the public.\141\ In that the
statutory
[[Page 20187]]
requirements of the CEA and Commission regulations under it seek to
prevent harm to market participants and the public by FCMs, the
Commission believes that requiring a robust CCO function within FCMs is
an important benefit of these regulations. A CCO will serve as a focal
point to better monitor and assure FCM legal compliance. Moreover, the
Commission believes the role of FCMs likely will grow in importance as
client clearing of swaps increases, fostering commensurate growth in
the benefits of active compliance monitoring by CCOs of FCMs to the
security and stability of swaps markets. The Commission also expects
that consistent regulation of its registrants is likely to benefit the
Commission's regulatory mission by increasing the efficiency of
registrant oversight.
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\141\ See Press Release, Senate Committee on Agriculture,
Nutrition & Forestry, Senator Pat Roberts: We Need Answers on MF
Global * * * Futures Still Critical to Risk Management (Dec. 1,
2011), available at http://www.ag.senate.gov/hearings/continuing-oversight-of-the-wall-street-reform-and-consumer-protection-act
(prepared remarks of Sen. Pat Roberts, ranking subcommittee member,
at December 1, 2011 Senate Committee on Agriculture, Nutrition &
Forestry).
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2. Harmonization With Other Regulatory Regimes
After reviewing comments,\142\ the Commission is modifying its
proposal to reduce the cost burden by harmonizing the CCO requirements
for SDs, MSPs, and FCMs with the traditional compliance model as
reflected in other regulatory regimes--including regimes established by
FINRA for broker-dealers (BDs), the FHFA, and by the Commission for
RFEDs--to the extent consistent with section 4s(k) of the CEA.\143\
Specifically, the Commission has modified the rule to (1) require that
the CCO ``administer'' the compliance policies of the registrant
(rather than establish compliance polices); (2) confirm, as suggested
by commenters, that the CCO's role in ``resolving'' conflicts of
interest may involve actions other than making the final decision; (3)
provide that the CCO must take ``reasonable steps to ensure
compliance'' (rather than simply ``ensure compliance''); and (4) permit
either the CCO or the CEO to make the required certification of the
annual report.
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\142\ See e.g., NFA's comment letter and representatives of
market participants in a May meeting with SEC and Commission staff
(see http://comments.cftc.gov/PublicComments/) were concerned with
differences between the Commission's proposed rules and FINRA's
rules and recommended harmonization. The FHLBs commented that they
are subject to FHFA regulation and requested that the Commission not
impose duplicative regulations for them. Edison Electric Institute
(EEI) urged the Commission to follow the Federal Energy Regulatory
Commission's approach by setting forth principles of an effective
compliance program while leaving the details to the registrant. FIA
and SIFMA noted that the more traditional compliance model-- RFEDs
are required to designate a CCO and prepare an annual compliance
certification under current Commission regulations (see 17 CFR
5.18(j).)--would be consistent with the approach the Commission took
with regard to RFEDs. FIA and SIFMA, along with Newedge and
Rosenthal, argued that the Commission should harmonize its rules
with those of FINRA and defer to NFA's experience in determining the
proper role for the CCO.
\143\ To the extent the other regulatory regimes prescribe CCO
rules more general than those specifically required by section
4s(k), they do not conform to statutory requirements and are not
implemented in the final rules. However, the Commission believes the
more specific requirements of section 4s(k) are supplemental--not
contradictory--to the more general ``policies, procedures, and
testing'' requirements of the rules of the other regulatory regimes.
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3. Flexibility in Rule's Structure
In the CCO NPRM, the Commission requested comment on whether the
structure of the proposed rules allows for sufficient flexibility,
thereby permitting FCMs, SDs, and MSPs to control costs by tailoring
their compliance programs to their individual circumstances. The
comments received raised the following issues with cost-benefit
implications:
Allowing a CCO to perform other duties in addition to
compliance duties; \144\
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\144\ NFA and the FHLBs commented that the rules explicitly
should permit the CCO to share any other executive role, such as
CEO, to provide flexibility for smaller firms.
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Designation of multiple CCOs with defined areas of
responsibility; \145\
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\145\ NFA also argued that the rules should recognize that
compliance expertise may reside with more than one individual, and
thus the Commission should consider allowing an entity to designate
multiple CCOs, so that each CCO's primary area of responsibility is
defined, and each CCO should be required to perform duties and
responsibilities with respect to their defined area.
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Allowing a single officer to be CCO for multiple
affiliated entities; \146\
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\146\ Newedge, Hess, and The Working Group argued that
affiliated FCMs, SDs, and MSPs that are separate legal entities
should be permitted to share the same CCO to increase compliance
efficiency.
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Allowing CCOs of multiple affiliated entities to report to
the board of a holding company that controls all affiliated entities;
\147\
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\147\ The Working Group also argued and that the CCO of
affiliated registrants should be allowed to report to a board of an
affiliated entity that controls both entities.
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Allowing CCOs to consult with other employees, outside
consultants, lawyers, and accountants in fulfilling their duties; \148\
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\148\ NFA also recommended that CCOs explicitly be permitted to
consult with other employees, outside consultants, lawyers, and
accountants.
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Requiring a senior CCO to have responsibility for multiple
affiliated entities, even if each has its own CCO; and \149\
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\149\ Better Markets commented that a senior CCO should have
overall responsibility of each affiliated and controlled entity,
even if individual entities within the group have CCOs.
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Requiring the CCO to be located remotely from the business
trading unit.\150\
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\150\ Better Markets recommended that the rule require the CCO
office to be located remotely from the trading floor.
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Having considered these comments, the Commission has taken steps to
reduce the cost burden on registrants by expanding the flexibility
allowed under the proposed rule. Specifically, the Commission agrees
that firms, especially small firms, could reduce costs if a CCO were
permitted to perform additional duties and therefore confirms that a
CCO may share additional executive responsibilities and/or be an
existing officer within the entity. In addition, the final rule would
allow registrants to recognize cost savings by not prohibiting multiple
legal entities from designating the same individual as CCO. The
Commission also is not requiring the CCO to be remotely located from
the business trading unit. Moreover, the Commission is modifying the
rule to permit either the CCO or the CEO to make the certification
required in the annual report, as requested by commenters. This change
will reduce the compliance costs insofar as it may make it easier to
recruit and retain qualified candidates for CCO. In response to NFA's
concern about CCOs being able to rely on the expertise of others,
presumably in part to reduce the cost of personally developing the
requisite expertise, the Commission confirms that the qualifying
language ``to the best of his or her knowledge and reasonable belief''
in the annual report certification required by the rule permits the CCO
or CEO to rely on other experts for statements made in the annual
report.
With respect to two of the above-noted issues, however, the
statutory language does not afford the Commission flexibility to relax
requirements. Specifically, section 4s(k) of the CEA requires the CCO
to report to each registrant's board or senior officer, rather than to
the board or senior officer of a consolidated corporate parent, so the
Commission is unable to adjust the rule to permit the CCOs of multiple
affiliated entities to report to the board of a holding company.
Similarly, the statutory language of sections 4d(d) and 4s(k) of the
CEA--requiring FCMs, SDs, and MSPs to ``designate an individual to
serve as chief compliance officer''--provides the
[[Page 20188]]
Commission no latitude to permit designation of multiple CCOs with
delineated areas of responsibility. The Commission notes that any costs
of these requirements are directly attributable to the statutory
requirements of Congress, and not to Commission action.
4. Limited Scope of the Rule
Proposed Sec. 3.3(a) required each SD, MSP, and FCM to designate
an individual as a CCO and provide the CCO with the full responsibility
and authority to develop and enforce, in consultation with the board or
senior officer, appropriate policies and procedures to fulfill the
duties set forth in the CEA and regulations. The proposed rule also
required the CCO to establish policies and procedures required to be
established by a registrant pursuant to the CEA and Commission
regulations. The Commission believes that the benefits of the rule
consist of consolidating oversight of compliance by FCMs, SDs, and MSPs
in a single individual, thereby reducing the risk that compliance
matters will be subject to inconsistent policies and procedures or that
compliance matters will not receive the attention necessary to be
effective.
Commenters \151\ criticized the proposed rule for two reasons, each
presumably based in part on the cost of expanding the traditional role
of a CCO:
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\151\ Rosenthal commented that the Commission's rules should be
revised in a manner that reflects the view that the CCO is only an
advisor to management and should not be viewed as an enforcer of
policies within the FCM. EEI and Newedge argued that the proposed
rules go beyond what is required by the CEA by inappropriately
imposing upon the CCO full responsibility to develop and enforce all
policies.
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A CCO should not be viewed as an enforcer of compliance
polices; and
A CCO should not be required to develop all compliance
policies.
The Commission agrees with commenters that the rule could be
modified to maintain the benefits identified above while imposing less
burden on registrants. The Commission is therefore narrowing proposed
Sec. 3.3(a) by (i) removing the requirement that a CCO be provided
with ``full'' responsibility and authority; (ii) removing the
requirement that a CCO ``enforce'' policies and procedures; (iii)
limiting the responsibilities of the CCO to (a) the ``swaps
activities'' of SDs and MSPs and (b) FCMs' derivatives activities
included in the definition of FCM under section 1(a)(28) of the CEA;
and (iv) clarifying that a CCO need only develop policies and
procedures to fulfill the duties set forth in, and ensure compliance
with, the CEA and Commission regulations. The Commission believes that
the rule as modified will achieve the benefits of consolidated
compliance oversight without imposing costs on registrants that are
unnecessary to achieve this goal.
5. CCO Reporting Line
Proposed Sec. 3.3(a)(1) required that the CCO report to the board
of directors or the senior officer of a registrant, that the board or
senior officer approve the compensation of the CCO, and that the board
or senior officer meet with the CCO at least once a year to discuss the
effectiveness of compliance policies and their administration by the
CCO. Proposed Sec. 3.3(a)(2) also prohibited the board or senior
officer of a registrant from delegating its authority over the CCO,
including the authority to remove the CCO. The Commission believes that
these aspects of the rule will ensure CCO independence from influence,
interference, or retaliation from business trading unit personnel and
freedom from conflicts of interest in performance of the CCO's duties.
The Commission believes CCO independence is crucial to achieving the
benefits of the CCO role as envisioned under the statutory provisions
of the CEA because an independent CCO is more likely to: (i) Question
business line decisions, (ii) speak out on non-compliance issues and
raise them with senior management and the board, and (iii) have stature
within the firm to successfully institute a culture of compliance.
Commenters raised the following issues with respect to the above-
described aspects of the proposed rule:
The CCO should be permitted to report to the governing
body or senior officer of a division, rather than to the board; \152\
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\152\ Cargill recommended that the definition of board of
directors be expanded to include a governing body of a division,
such as a management committee, and that the Commission add a
definition of ``senior officer'' to include a senior officer of a
division, because a division might be more familiar with the swaps
activities of an SD.
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The CCO should be permitted to report to a board
committee, rather than to the whole board; \153\
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\153\ MetLife requested that the definition of board of
directors include expert committees of the whole board.
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The CCO should be permitted to report to the board of a
holding company; \154\
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\154\ The Working Group argued that the CCO should be allowed to
report to a board of an affiliated entity.
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The CCO should be permitted to report to an officer other
than the senior officer; \155\
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\155\ EEI, FIA, SIFMA, NFA, and The Working Group argued that
the CCO should be permitted to operate under the direction of
corporate officers other than the senior officer, as long as
independence and authority as a control function is maintained.
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CCO compensation and termination decisions should be
reserved to the independent members of the board; \156\
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\156\ Better Markets and Chris Barnard recommended that
decisions to designate or terminate a CCO, as well as compensation
decisions, be prescribed solely by independent members of the board,
acting by majority vote.
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The CCO should be permitted to report to the full board at
any time, without interference; \157\ and
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\157\ NWC recommended that (1) the term ``senior officer'' be
defined as the CEO or chairman of the board, (2) the rule should
permit the CCO to report to the full board at any time with no
interference from a board committee or a CEO, and (3) that the rule
should prohibit termination of the CCO unless the CCO is presented
the opportunity to address the board.
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The CCO should have the right to address the board prior
to termination.\158\
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\158\ Id.
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Having considered the costs and benefits implications of these
issues, the Commission is adopting the rule as proposed. Section 4s(k)
of the CEA requires the CCO to ``report directly'' to the board or the
senior officer of the SD or MSP. The Commission believes, therefore,
that despite the costs imposed the statutory requirement that the CCO
report directly to the board or senior officer does not permit a firm
to have its CCO report to a board committee, the independent members of
the board, the board of a holding company, or any officer other than
the senior officer.
The Commission recognizes that adopting some commenters'
recommendations would increase the independence of the CCO. The
Commission has declined to modify the rule to include such
recommendations because it believes the benefits outlined above will be
sufficiently assured by the rule as adopted herein and thus the
additional burden of more stringent independence requirements is
unnecessary at this time.
6. Qualifications of the CCO
As proposed, Sec. 3.3(b) required the CCO to have the background
and skills appropriate for fulfilling the responsibilities of the
position, and prohibited an individual who is statutorily disqualified
under sections 8a(2) or 8a(3) of the CEA from serving. The Commission
rationale for this is that a well-qualified CCO, without a history of
disqualifying attributes, is
[[Page 20189]]
more likely to fulfill the duties of the position successfully and have
the stature and experience to demand the respect necessary to instill a
culture of compliance. The Commission believes that an effective CCO
serves an important role in guarding against registrant failures and
misfeasance, and the resulting losses to customers and other market
participants.
Commenters criticized the above-described aspects of the proposed
rule as follows, but no commenter provided any quantitative data to
justify their arguments:
It is unnecessary to include statutory disqualification as
a qualification for the CCO; \159\
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\159\ NFA argued that the prohibition on individuals who are
disqualified by statute is unnecessary because an SD, MSP, or FCM's
registration could be denied or revoked under section 8a(2)-(3) of
the CEA if any principal of the registrant is subject to a statutory
disqualification.
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``Background and skills appropriate for fulfilling the
responsibilities of the position'' is too vague a standard--
qualifications should be left to the discretion of the firm; \160\
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\160\ Cargill commented that the requirement for a CCO to have
``the background and skills appropriate'' is a commendable
aspirational goal but is too vague a standard for Federal law, and
is best reserved as a business decision. The Working Group also
commented that wide latitude for qualifications of a CCO is
necessary.
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The Commission should require CCOs to pass a specific
compliance examination and be licensed; \161\ and
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\161\ Newedge recommended that CCOs be required to pass a
specific compliance examination and obtain a specific compliance
license, as is the case in the securities world.
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The Commission should prohibit members of a firm's legal
department from acting as CCO due to potential conflicts of
interest.\162\
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\162\ Better Markets argued that a CCO should not be permitted
to be an attorney that represents the SD, MSP, or FCM, or its board
because the potential conflict would disqualify such an attorney.
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Based on the issues raised by commenters, the Commission presumes
that commenters are concerned about the cost of locating, recruiting,
and compensating a CCO that meets the necessary qualifications, or
about the costs to the market if CCOs are not well-qualified and fail
to fulfill their duties under the CEA and rule. The Commission
estimates that a well-qualified CCO for an FCM, SD, or MSP is likely to
be compensated at approximately $216,000 per year.\163\
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\163\ The Commission staff estimates concerning the wage rates
are based on salary information for the securities industry compiled
by SIFMA. The salary estimate was taken from SIFMA Report on
Management & Professional Earnings in the Securities Industry 2010.
Staff took an average of the last two years of salary estimates for
Chief Compliance Officers, modified to account for inflation as well
as overhead and other benefits, then adjusted upward based on the
additional responsibility demanded from SD, MSP, and FCM CCOs as
required by the CEA (as noted by commenters).
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Having considered the costs and benefits implications of these
issues, the Commission is adopting the rule as proposed. Given the
duties and responsibilities of the CCO as set forth in the CEA and the
rule, the Commission believes that the cost to FCMs, SDs, and MSPs to
hire a well-qualified person to act as CCO are appropriate given the
critical role the CCO will play in ensuring registrants comply with the
CEA and Commission regulations. Moreover, the Commission believes the
qualifications required by the rule as proposed are sufficient to
ensure the necessary level of CCO qualification without need to adopt
the more restrictive CCO qualifications (e.g., an examination and
licensing requirement and/or legal counsel bar) recommended by some
commenters. To maintain flexibility in the rule for the wide variety of
registrants that will be affected, the Commission also is not defining
what the ``background and skills appropriate for fulfilling the
responsibilities of the position'' would be, leaving this determination
to the discretion of the registrant as appropriate to their unique
circumstances.
7. Role of the CCO
As proposed, Sec. 3.3 established a number of duties for the CCO.
Proposed Sec. 3.3(d)(1) required the CCO to establish the registrant's
compliance policies in consultation with the board of directors or
senior officer. Proposed Sec. 3.3(d)(2) required the CCO, in
consultation with the board or senior officer, to resolve any conflicts
of interest that may arise. Proposed Sec. 3.3(d)(3) required the CCO
to review and ``ensure compliance'' by the registrant with the
registrant's compliance policies and all applicable laws and
regulations.
Commenters criticized the above-described aspects of the proposed
rule as follows:
Responsibility for resolving conflicts of interest belongs
more appropriately to the board or senior officer, not a CCO; \164\
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\164\ NFA commented that resolution of conflicts of interest
should rest with the board or the senior officer, in consultation
with the CCO. FIA and SIFMA argued that when Congress used the term
``resolve any conflicts of interest that may arise,'' Congress did
not mean resolve in the executive or managerial sense. Newedge
commented that the CEO and business line supervisors are in a better
position than the CCO to resolve conflicts. Participants in the May
Meeting with Commission staff stated that resolving a conflict would
traditionally be interpreted as eliminating the conflict, but that
elimination is not always preferable and the compliance officer
should not be the actual decision maker in the resolution.
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Responsibility for ensuring compliance belongs more
appropriately to the board or senior officer, not a CCO; \165\
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\165\ NSCP argued that ``ensure compliance'' imposes a level of
responsibility on a CCO that cannot be discharged and is
inconsistent with the customary role of a compliance officer. Hess
argued that the proposal concentrates too much of the compliance
function on a single individual and recommended that the CCO should
remain the monitor of the compliance monitors. FIA, SIFMA, The
Working Group, Newedge, and NFA each argued that requiring the CCO
to ensure compliance goes beyond existing compliance models and
creates a standard that is impossible to satisfy. FIA and SIFMA
further argued that the requirement to remediate non-compliance
issues acknowledges that instances of noncompliance are not wholly
preventable by any person. FIA and SIFMA recommended that ``ensure
compliance'' should mean taking reasonable steps to adopt, review,
test, and modify compliance policies. EEI and participants in the
May Meeting with Commission staff stated that ensuring compliance
could mean that the CCO escalates a problem that has not been
resolved.
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The transfer of regulatory responsibility from executive
officers to the CCO may result in executive officers spending less time
and attention to compliance matters; \166\
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\166\ Newedge believes that any transfer of regulatory
responsibility currently held by executive officers to the CCO could
have the unintended effect of reducing the amount of time such
officers spend on compliance matters.
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Firms will have difficulty retaining a CCO who is willing
to perform the duties set forth in the rule.\167\
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\167\ NFA also argued that the rules improperly redefine a CCO's
duties, and registrants will have difficulty retaining CCOs who are
willing to perform these duties.
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Having considered the cost and benefit implications of these
issues, the Commission presumes that commenters are concerned in part
about the cost of expanding their compliance departments to fulfill
duties currently or traditionally handled by other executive officers
or departments. In response to this concern, the Commission is adopting
the final rule as follows: (1) The Commission is revising proposed
Sec. 3.3(d)(1) to track more closely the statutory language of section
4s(k) and require that the CCO ``administer'' the compliance policies
of the registrant; (2) the Commission is not removing the requirement
that the CCO ``resolve'' conflicts of interest from the rule because
the requirement is provided for in section 4s(k)(2)(C) of the CEA, but
confirms, as suggested by commenters, that the CCO's role in
``resolving'' conflicts of interest may involve actions other than
making the final decision; and (3) the Commission is modifying proposed
Sec. 3.3(d)(3) to provide that the CCO must take ``reasonable steps to
ensure compliance.''
[[Page 20190]]
The foregoing changes align the rule to the duties of the CCO for
SDs and MSPs as set forth in the CEA, and, thus, the costs of these
requirements are directly attributable to the statutory requirements of
Congress, and not to Commission action. The Commission's decision to
extend the same requirements to CCOs for FCMs is explained in detail
above.
8. Certification of the Annual Report by the CCO ``Under Penalty of
Law''
Proposed Sec. 3.3(d)(6) required the CCO of an SD, MSP, or FCM to
prepare, sign, and certify, under penalty of law, the annual report
specified in section 4s(k)(3) of the CEA.
Commenters criticized the above-described aspects of the proposed
rule as follows:
The CEO, not the CCO, should certify the annual report;
\168\
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\168\ Rosenthal commented that FINRA's approach to certification
is preferable, i.e., the CEO certifies that the firm has processes
to establish, maintain, review, test, and modify written compliance
policies and written supervisory procedures reasonably designed to
achieve compliance with securities laws, regulations, and FINRA
rules. FIA, SIFMA, and Newedge each argued that section 4s(k)(3) of
the CEA requires the CCO to sign the annual report, but does not
require the CCO to certify the report. FIA, SIFMA, MFA, Newedge, and
NFA all recommended that the rule be revised to require the CEO to
certify the report. Participants in the May Meeting with Commission
staff stated that requiring the CEO to make the certification
appropriately shares responsibility between compliance and business
management. FIA and SIFMA recommended that, with respect to any
Commission registrant that is also a BD, the Commission should
require the CEO to make the certification.
---------------------------------------------------------------------------
Requiring the CCO to certify the annual report under
penalty of law will make it difficult for registrants to retain a CCO
and, thus, should not be required; \169\ and
---------------------------------------------------------------------------
\169\ FIA and SIFMA felt that imposing criminal liability for
annual report certifications would hinder the ability to fill the
position of CCO. FIA and SIFMA requested that the Commission clarify
that criminal liability for the certification will not apply (absent
a knowing and willful materially false and misleading statement)
because there is no indication that Congress ever thought CCOs
should be subject to criminal liability. Similarly, NSCP requested
that the Commission clarify whether ``under penalty of law'' means
liability under 18 U.S.C. 1001 for a false statement to a Federal
officer. Rosenthal argued that requiring the CCO to certify under
penalty of law will make the CCO liable for firm infractions and
will give disgruntled customers a roadmap for frivolous lawsuits.
Newedge also believes that the requirement to certify under penalty
of law is not fair or practicable because whoever certifies will
have to rely on many individuals to compile the report. On the other
hand, Hess commented that the certification language strikes an
appropriate balance such that strict liability is not imposed for
inadvertent errors.
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The required certification should be subject to a
materiality qualifier.\170\
---------------------------------------------------------------------------
\170\ NSCP commented that the certification that the report is
accurate and complete should have a materiality qualifier added to
it. Participants in the May Meeting with Commission staff urged the
Commission to adopt a standard for the annual report certification
that is reasonably attainable.
---------------------------------------------------------------------------
Having considered the cost-benefit implications of these issues and
the arguments raised by commenters, the Commission is modifying the
requirement that the CCO make the required certification of the annual
report to allow the registrant the discretion to choose whether the CCO
or the CEO makes the certification. As explained by commenters, this
change will make it easier and less costly for registrants to recruit
and retain candidates for the position of CCO.
However, consistent with the statutory text in section
4s(k)(3)(B)(ii) of the CEA, the Commission is also declining to add a
materiality qualifier to the certification, as suggested by commenters.
Moreover, not qualifying certification on materiality is consistent
with the approach taken in final rules for SDRs \171\ and DCOs,\172\
and with proposed CCO rules for SEFs; \173\ the Commission expects
consistent regulation of its registrants and registered entities to
benefit the Commission's regulatory mission by increasing the
efficiency of oversight. The Commission believes that limiting the
CCO's certification requirement with the qualifier ``to the best of his
or her knowledge and reasonable belief'' sufficiently mitigates
commenters' liability costs concerns because the rule would not impose
liability for compliance matters that are beyond the certifying
officer's knowledge and reasonable belief at the time of certification.
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\171\ See Swap Data Repositories: Registration Standards, Duties
and Core Principles, 76 FR at 54584.
\172\ See Derivatives Clearing Organization General Provisions
and Core Principals, 76 FR at 69435.
\173\ See Core Principles and Other Requirements for Swap
Execution Facilities, 76 FR 1214, 1252 (Jan. 7, 2011).
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Having modified the rule as described above, and otherwise confined
the rule to the requirements of the CEA, the Commission believes that
the costs of these requirements are directly attributable to the
statutory requirements of Congress, and not to Commission action. The
Commission's decision to extend the same requirements to CCOs for FCMs
is explained in detail above.
9. Content of the Annual Report
The proposed regulation required the annual report to contain (1) a
description of the compliance by the registrant with respect to the CEA
and regulations; (2) a description of each of the registrant's
compliance policies; (3) a review of each applicable requirement under
the CEA and regulations, and, with respect to each, identification of
the policies that ensure compliance, an assessment as to the
effectiveness of the policies, discussion of areas of improvement, and
recommendations of potential or prospective changes or improvements to
its compliance program and resources devoted to compliance; (4) a
description of the registrant's financial, managerial, operational, and
staffing resources set aside for compliance with the CEA and
regulations, including any deficiencies in such resources; (5) a
delineation of the roles and responsibilities of a registrant's board
of directors or senior officer, relevant board committees, and staff in
addressing any conflicts of interest, including any necessary
coordination with, or notification of, other entities, including
regulators; and (6) a certification of compliance with sections 619 and
716 of the Dodd-Frank Act (the Volcker Rule and Derivatives Push-Out),
and any rules adopted pursuant to these sections. The proposed rule
also required FCMs, SDs, and MSPs to maintain records of its compliance
policies, materials provided to the board in connection with its review
of the annual compliance report, and work papers that form the basis of
the annual compliance report.
The Commission believes the benefits of the annual report result
from the focus on compliance with the CEA and Commission regulations.
The annual requirement to compile in a single document the results of a
registrant's compliance policies and procedures should serve as an
efficient means to focus the registrant's board and senior management
on areas requiring additional compliance resources or changes to
business practices; it also will provide the Commission with a detailed
overview of the state of compliance of the industry as a whole. This
annual and ongoing compliance focus will result in increased industry
compliance, thereby increasing market security and stability. A secure
and stable market fosters increased market confidence and increased
activity by investors and hedgers managing risk.
Commenters raised the following issues with respect to the above-
described aspects of the proposed rule:
Overbreadth concerns with the requirements for the content
of the annual report; \174\
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\174\ NSCP, The Working Group, EEI, and Hess each argued that
the level of detail contemplated by the rule would impose
unnecessary burdens on the CCO with little offsetting benefits. NSCP
argued that a better approach would be to follow the SEC
requirements for annual reviews of compliance by registered
investment advisers. NSCP believes the proposed rule is overbroad
and discourages reporting of compliance issues to the CCO. Newedge
argued that thousands of Federal, SRO, and internal rules apply, so
the report should contain a summation of compliance, with details
only for areas of material noncompliance. FIA and SIFMA argued that
a one-size-fits-all approach to the annual report requirements is
not appropriate because registrants vary in size and focus. FIA,
SIFMA, and The Working Group recommended that the Commission specify
the material issues that should be discussed, or provide a standard
form. FIA, SIFMA, and NFA also argued that the report should
identify the policies that are reasonably designed to result in
compliance, not that ensure compliance. Hess recommended that the
annual report contain only a summary of the registrant's compliance
policies and procedures. CMC commented that the scope of activities
included in the annual report should be limited to those directly
triggering the requirement of a CCO. EEI argued that inclusion of
descriptions of violations in the report should be decided on a
case-by-case basis by the registrant's governing body. NFA requested
that a materiality qualifier be added to the requirement that
registrants include a description of non-compliance. FIA and SIFMA
argued that the CCO is not in a position to describe the financial,
material, operational, and staffing resources set aside for
compliance, rather the CCO only should be required to describe the
resources of the compliance department and any recommendations that
the CCO has made to senior management with regard to the same. FIA
and SIFMA argued that the Sarbanes-Oxley Act already requires public
companies to report the roles and responsibilities of its board,
senior officers, and committees in resolving conflicts of interest,
so the Commission should allow such reporting to satisfy this
content requirement for the annual report. NFA also recommended that
the reporting of any necessary coordination with, or notification of
other entities, including regulators, should be deleted. NFA, FIA,
and SIFMA recommended that the certification of compliance with
sections 619 and 716 of the Dodd-Frank Act be deleted, arguing that
the Commission should wait for the implementing rulemakings for such
sections before determining certification requirements.
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[[Page 20191]]
Concern that the annual report is not subject to board
approval or a board addendum noting any disagreement with the report;
\175\
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\175\ Better Markets recommended that the board approve the
annual report in its entirety or specify where and why it disagrees
with any provision, and then CCOs should provide the report to the
Commission either as approved or with statements of disagreement.
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Concern that some requirements for the content of the
annual report are inappropriate for a document that may be publicly
available; \176\ and
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\176\ The Working Group argued that a description of
deficiencies in resources dedicated to compliance would require a
CCO to identify potential shortcomings and report them in a document
likely to be available to the public, which could materially hinder
the CCO's ability to function as an integral member of the
management team.
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Concern that, absent a materiality qualifier, the
recordkeeping obligations will be unduly burdensome.\177\
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\177\ The Working Group argued that retaining all materials
relating to the preparation of the report will cause the CCO to
retain all materials for fear of an audit that second-guesses the
CCO's materiality judgments, or the CCO will limit his or her
inquiries to avoid making a determination of materiality. The
Working Group recommended that materials to be retained should be
only those germane to the content of the compliance report.
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In response to comments, the Commission has reduced the cost burden
of the annual report by modifying the rule as follows: (1) Requiring a
description of the registrant's policies and procedures, rather than a
description of the compliance of the registrant; (2) requiring
identification of the registrant's policies and procedures that ``are
reasonably designed'' to ensure compliance, rather than those that
ensure compliance; (3) including a required description of material
non-compliance issues; (4) including a materiality standard with
respect to the description of any deficiency in compliance resources;
(5) deleting the proposed delineation of the roles and responsibilities
of a registrant's board of directors or senior officer, relevant board
committees, and staff in addressing any conflicts of interest; and (6)
removing the requirement to certify compliance with sections 619 and
716. The Commission has not modified the recordkeeping requirement
because it believes the rule sufficiently qualifies the materials that
must be retained by stating that the records must be ``relevant'' to
the annual report.
The Commission observes that section 4s(k) of the CEA requires the
annual report and specifies that it contain a description of the
compliance of the SD or MSP with respect to the CEA, and a description
of each policy and procedure of the SD or MSP of the CCO (including the
code of ethics and conflict-of-interest policies). To the extent that
the rule also requires these descriptions, the Commission believes that
the costs of these requirements are attributable to statutory
requirements not subject to Commission discretion. The Commission's
decision to extend the same requirements to CCOs for FCMs is explained
in detail above. Therefore, the Commission believes the modified rule
would impose modest costs, attributable to the narrow requirements of:
(i) Listing any material changes to compliance policies and procedures;
and (ii) describing the financial, managerial, operational, and
staffing resources set aside for compliance, including any material
deficiencies. The Commission believes the benefits of these
requirements warrant the limited incremental costs to comply.
Costs
Section 4s(k) requires SDs and MSPs to designate a CCO and
undertake certain other compliance measures. The costs and benefits
that necessarily result from these basic statutory requirements are
considered to be the ``baseline'' against which the costs and benefits
of the Commission's final rules are compared or measured. The
``baseline'' level of costs includes the costs that result from the
following activities required by the statute:
Designating a CCO;
Corporate governance changes to require the CCO to report
directly to the board or senior officer;
Reviewing the compliance of the SD and MSP with section 4s
of the CEA;
Requiring the CCO, in consultation with the board or the
senior officer, to resolve any conflicts of interest;
Administration of each policy and procedure required to be
established under section 4s;
Ensuring compliance with the CEA and Commission
regulations relating to swaps;
Establishing procedures for the handling, management
response, remediation, retesting, and closing of non-compliance issues;
Preparing and signing a compliance report containing a
description of compliance and a description of each policy and
procedure of the SD or MSP; and
Furnishing the annual report to the Commission along with
each appropriate financial report.
Similarly Section 4d(d) defines a statutory ``baseline'' against
which the costs and benefits of the Commission's final rules are to be
measures with respect to FCMs. That ``baseline'' cost level is defined
by those costs that result from an FCM's CCO designation.
Compliance with the statutory baselines alone will result in costs
for FCMs, SDs and MSPs. For example, designating a CCO that reports to
the board or senior officer could include the cost of board action and
the salary of the CCO. Similarly, preparing and signing a compliance
report containing a description of compliance and each compliance
policy and procedure entails the cost of the CCO's time.
Congress mandated that the Commission adopt rules to implement each
of the statutory provisions. The following implementation decisions may
cause affected entities to incur costs to comply with the final
regulations regarding designation of a CCO, the duties of the CCO, and
the annual report:
Extending the statutory and rule requirements applicable
to SDs and MSPs to FCMs;
Providing the CCO with authority to develop, in
consultation with the board
[[Page 20192]]
or senior officer, appropriate policies and procedures;
Requiring the board or senior officer to appoint the CCO,
approve the CCO's compensation, and meet with the CCO once a year;
Requiring designation of a CCO with the background and
skills appropriate for fulfilling the responsibilities of the position
and that is not statutorily disqualified;
Submission of a Form 8-R to the Commission for the CCO as
a principal of the firm;
Listing any material changes to compliance policies and
procedures in the annual report; and
Describing the financial, managerial, operational, and
staffing resources set aside for compliance, including any material
deficiencies, in the annual report.
As discussed, the Commission has attempted, wherever possible, to
alleviate burdens for registrants while remaining consistent with the
CEA. The Commission has taken steps to reduce the responsibilities of
the CCO and lower staffing and corporate governance costs for the
entity by permitting the CCO to perform other duties and act as the CCO
for more than one entity. The Commission has removed the requirement
that the CCO be provided with the authority to enforce compliance
policies and procedures, limited the CCO's duties to those directly
required by the CEA and Commission regulations relating only to the
swaps activities of SDs and MSPs and the derivatives activities
included in the definition of FCM under section 1(a)(28) of the CEA,
and required the CCO be responsible for administering, not
establishing, compliance policies. The Commission also is permitting
either the CCO or the CEO to certify the annual report.
The Commission estimates a base salary for a Chief Compliance
Officer in the financial services industry at approximately $216,000
per year, as explained above. Because entities may designate a current
employee as the CCO, some SDs, MSPs, or FCMs may not need to hire an
additional member of staff. For example, entities currently regulated
by prudential authorities already may have a CCO or another employee
who could serve as a CCO; other entities may determine it is more cost-
effective based on their current business models to designate a current
employee as CCO, perhaps adjusting that individual's salary
accordingly. Because of the wide variety of possibilities in
determining the compensation of a CCO, the Commission finds it is
impossible to estimate a cost burden for the industry of the statutory
requirement to designate a CCO.
One commenter presented a report prepared by NERA stating that
designation of a CCO and preparation of an annual compliance report by
certain entities would entail average incremental start-up costs of
$445,000 and average incremental ongoing annual costs of $760,000.\178\
The Commission observes that the incremental average costs provided by
NERA do not differentiate between the costs of compliance with proposed
Sec. 3.3 and the costs of compliance with sections 4d(d) and 4s(k) of
the CEA absent Commission rulemaking. Accordingly, the Commission
believes that the cost estimates presented by NERA exceed the
incremental costs attributable to Commission rulemaking. The NERA
report, however, provides insufficient information to allow the
Commission to assess the magnitude of the excess.
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\178\ 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 this late-filed comment
supplement, NERA concludes that cost-benefit considerations compel
excluding 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--from regulation as swap dealers,
including Sec. 3.3.
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Other than as indicated below with respect to CCO compensation and
costs resulting from collections of information subject to the
Paperwork Reduction Act, incorporated by reference herein, the
Commission has no reliable quantitative data from which to reasonably
estimate the costs of compliance associated with the CCO's duties and
the annual report required by the rules in this release. After
conducting a review of applicable academic literature, the Commission
is not aware of any research reports or studies that are directly
relevant to its considerations of costs and benefits of the final
rules. The Commission anticipates that many entities may currently have
a CCO pursuant to other regulations. The Commission notes that dually
registered FCMs and BDs are more likely to have a CCO \179\ than
entities that are subject to such requirement for the first time.\180\
Costs, therefore, are expected to be higher for those entities not
currently dually registered. Registrants that do not currently have a
CCO or a compliance program may choose to develop a program in-house if
their activities are limited and the regulatory requirements well-
understood. Other registrants may choose to purchase an off-the-shelf
compliance manual and adjust it to correspond to their regulatory
requirements. Still others may hire a third-party compliance firm, a
law firm, or an accounting firm to draft a firm-specific manual. As of
2003, when the SEC published final compliance program rules for
investment companies and investment advisers, the costs for these
options ranged from $1,000 to $200,000.\181\
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\179\ In this respect, the Commission observes that 55% of
current FCMs are also registered as BDs with the SEC, and thus may
already have a CCO as required under the rules of FINRA. See letter
from NFA, dated Jan. 18, 2011 (comment file for 75 FR 70881
(Designation of a Chief Compliance Officer; Required Compliance
Polices; and Annual Report of a FCM, SD, or MSP)).
\180\ The Commission notes that in 2006 the UK FSA conducted a
cost benefit analysis when promulgating requirements related to
ensuring effective compliance with the applicable regulatory
framework, including a requirement that a compliance officer be
appointed that reports to the governing body and has the necessary
authority and responsibility for the compliance oversight function.
The UK FSA was adopting rules that replaced existing guidance and
concluded from survey results that the incremental aggregate cost of
compliance for approximately 2000-2500 firms was [pound]4.5 to 5.5
million in one-off costs ($7.1 to 8.6 million at the current
exchange rate, or $3,550 to $4,300 per firm) and [pound]6.5 to 8.5
million in ongoing costs ($10.1 to 13.3 million at the current
exchange rate, or $5,050 to $6,650 per firm). See FSA Consultation
Paper 06/9, Organisational Systems and Controls: Common Platform for
Firms, Annex 2 (May 2006).
\181\ See Compliance Programs of Investment Companies and
Investment Advisers, 68 FR 74714 (Dec. 24, 2003). The Commission
notes that significant differences in the activities and structures
of investment advisors and SDs/MSPs/FCMs may create significant
differences in the costs incurred by the respective entities; these
SEC estimates provide at best an imperfect measure from which to
very roughly attempt to gauge compliance costs for affected
entities.
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Certain of the costs associated with these CCO, compliance policy,
and annual report rules result from collections of information subject
to the Paperwork Reduction Act. Costs attributable to collections of
information subject to the PRA are discussed further in section V.B.3.
below. The Commission has also considered these costs, which it
incorporates by reference herein, in its section 15(a) analysis.
Benefits
The Commission believes that the CCO rules will protect market
participants and the public by promoting compliance with the CEA and
Commission regulations through (1) the designation and effective
functioning of the CCO, and (2) the establishment of a framework for
preparation of a meaningful annual review of an FCM's, SD's, and MSP's
compliance program. As a qualified, impartial, accountable focal point,
the CCO is an effective vehicle to ensure that vital market actors--
SDs, MSPs, and FCMs--comply with the law and
[[Page 20193]]
regulations, including those designed to contain systemic risk through
appropriate risk management efforts. In this way, these rules foster
financial integrity and responsible risk management practices to
protect the public from the adverse consequences of FCM, SD, or MSP
failure or misfeasance that an effective compliance program may help to
prevent.
The annual compliance report will help FCMs, SDs, MSPs, and the
Commission to assess whether the registrant has mechanisms in place to
address adequately compliance problems that could lead to a failure of
the registrant. It also will assist the Commission in determining
whether the registrant remains in compliance with the CEA and the
Commission's regulations, including the customer protection regime for
segregation of customer funds, supervision of trading activities, and
risk management. Such compliance will protect market participants and
the public from market disruptions and financial losses resulting from
the failure or misfeasance of a registrant.
Section 15(a) Determination
1. Protection of Market Participants and the Public
The Commission believes that the compliance measures specified in
these rules reinforce the CEA's protections for swap market
participants, futures markets participants, and the public. Just as the
CEA's regulation of futures and swaps transactions promotes the
``national public interest by providing a means for managing and
assuming price risks, discovering prices, or disseminating pricing
information through trading in liquid, fair, and financially secure
trading facilities'' \182\ so do these rules by ensuring, through a
CCO, that entities are in compliance with CEA regulations.
Concentrating compliance responsibility in one individual with
independent authority, rather than dispersing it throughout an
organization (and thus potentially diminishing accountability), is one
example of this. Compliance evaluation and preparation of an annual
report are other examples. Thus, taken together, these requirements set
out a compliance regime that endeavors to ensure protection for market
participants and public that the CEA is intended to provide. Moreover,
to the extent that provisions of the CEA diminish the potential for
harmful market disruptions and attendant financial losses to market
participants and the general public as Congress intended in enacting
the Dodd-Frank Act, these rules enhance that protection.
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\182\ Section 3(a) of the CEA.
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While the Commission recognizes there are costs associated with
this rulemaking and the mandate from Congress it represents, the
Commission believes that, as discussed above, it has included measures
to afford firms flexibility in the designation of a CCO, as well as
other made other burden-reducing changes to the proposed rules. It
believes these measures minimize the costs attributable to
implementation decisions within its statutory authority. The Commission
does not believe that any such incremental costs undermine effective
protection of market participants and the public, but rather will be a
worthwhile investment toward enhancing that protection.
2. Efficiency, Competitiveness, and Financial Integrity of Markets
183
Secure and stable SDs, MSPs, and FCMs are critical components of
the efficient, competitive, and financially sound functioning of
derivatives markets--futures and swaps. The financial integrity of
these markets, in particular, is achieved through layers of protection.
Requirements for an effective FCM, SD, and MSP compliance program will
add a new layer of protection to ensure that registrants remain
compliant with the CEA and Commission regulations, and in particular
those relating to risk management, diligent supervision, and system
safeguards.
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\183\ Although by its terms CEA section 15(a)(2)(B) applies to
futures markets only, the Commission finds this factor useful in
analyzing regulations pertaining to swaps markets as well.
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An effective CCO will provide benefits to FCMs, SDs, and MSPs and
the markets they serve by implementing and overseeing compliance
measures that enhance the safety and efficiency of registrants and
reduce systemic risk. Reliable and financially sound FCMs, SDs, and
MSPs are essential for the stability of the derivatives markets they
serve, and for the greater public, which benefits from a sound
financial system.
The Commission believes that to the extent there are any
incremental costs associated with these rules attributable to the
implementation decisions within its statutory authority, they are
competitively neutral. They do not favor or disfavor any class of
market participant over others. In other words, no entity should have a
greater advantage over another based on these rules alone.
3. Price Discovery
The Commission has identified no likely material impact on price
discovery from the costs and benefits of these rules pertaining to CCO
designation and related compliance requirements.
4. Sound Risk Management
The Commission believes these rules promote sound risk management.
The regulatory provisions that interpret or implement the statutory
requirements for the CCO and annual report serve to reinforce and
ensure the effectiveness of FCM, SD, and MSP compliance programs,
including their risk management components. Compliance with Sec.
23.600 (risk management program) and related regulations encompasses,
among other things, policies and procedures for monitoring and managing
of credit exposures to counterparties, market risk, liquidity risk,
settlement risk, and other applicable risk exposures. Compliance with
Sec. 1.14 (risk assessment recordkeeping requirements for FCMs) and
related regulations encompasses, among other things, policies and
procedures for monitoring and managing of credit risk, market risk, and
other applicable risk exposures. The CCO has responsibility to ensure
that the FCM, SD, or MSP is compliant with these regulations. Costs
attendant to satisfying CCO and annual report requirements in these
rules represent an investment towards improved risk management, not a
diminution from them.
5. Other Public Interest Considerations
The Commission does not believe that the rule will have a material
effect on public interest considerations other than those identified
above.
H. Conclusion
Having considered the costs and benefits of the final rules in
light of the factors enumerated in section 15(a)(2) of the CEA, the
Commission is adopting the rules as set forth in this release.
V. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA) \184\ 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
[[Page 20194]]
be used in evaluating the impact of its rules on such small entities in
accordance with the RFA.\185\ 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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\184\ 5 U.S.C. 601 et seq.
\185\ 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
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.
The final rules will also impact FCMs and IBs, each of which is
addressed separately in the following paragraphs.
In its proposals, the Commission explained that it had previously
established certain definitions of ``small entities'' to be used in
evaluating the impact of the Commission's rules on such small entities
in accordance with the RFA. In the Commission's ``Policy Statement and
Establishment of Definitions of `Small Entities' for Purposes of the
Regulatory Flexibility Act,'' \186\ the Commission concluded that
registered FCMs should not be considered to be small entities for
purposes of the RFA. The Commission's determination in this regard was
based, in part, upon the obligation of registered FCMs to meet the
capital requirements established by the Commission. Likewise, the
Commission determined ``that, for the basic purpose of protection of
the financial integrity of futures trading, Commission regulations can
make no size distinction among registered FCMs.'' \187\ Thus, with
respect to registered FCMs, the Commission believes that the proposed
regulations will not have a significant economic impact on a
substantial number of small entities.
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\186\ 47 FR 18618, Apr. 30, 1982.
\187\ Id. at 18619.
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The Commission previously has determined that, for purposes of the
RFA, the Commission should ``evaluate within the context of a
particular rule proposal whether all or some [IBs] should be considered
to be small entities and, if so, to analyze the economic impact on
[IBs] of any such rule at that time. Specifically, the Commission
recognizes that the [IB] definition, even as narrowed to exclude
certain persons, undoubtedly encompasses many business enterprises of
variable size.'' \188\ At present, IBs are subject to various existing
rules that govern and impose minimum requirements on their internal
compliance operations, based on the nature of their business. The
Commission believes that the amendments will merely augment the
existing compliance requirements of such persons to address potential
conflicts of interest within such firms. To the extent that certain IBs
may be considered to be small entities, the Commission believes that
the final rules will not have a significant economic impact.
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\188\ 48 FR 35248, 35276, Aug. 3, 1983.
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The Commission did not receive any comments on its analysis of the
application of the RFA to FCMs and IBs.
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 and rule amendments will not have a significant economic impact
on a substantial number of small entities.
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. 23.200 through 23.205
(Reporting, Recordkeeping, and Daily Trading Records), 23.600 (Risk
Management Program), 23.601 (Monitoring of Position Limits), 23.602
(Diligent Supervision), 23.603 (Business Continuity and Disaster
Recovery), 23.605 (Conflicts of Interest Policies and Procedures for
SDs and MSPs), 23.606 (General Information: Availability for Disclosure
and Inspection), 23.607 (Antitrust Considerations), 3.3 (Chief
Compliance Officer), and 1.71 (Conflicts of Interest Policies and
Procedures for FCMs and IBs) impose new information collection
requirements on registrants within the meaning of the Paperwork
Reduction Act.\189\
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\189\ 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
``Reporting, Recordkeeping, and Daily Trading Records Requirements for
Swap Dealers and Major Swap Participants, OMB control number 3038-
0087,'' ``Regulations Establishing and Governing the Duties of Swap
Dealers and Major Swap Participants, OMB control number 3038-0084,''
``Conflicts of Interest Policies and Procedures by Swap Dealers and
Major Swap
[[Page 20195]]
Participants, OMB control number 3038-0079,'' ``Annual Report for Chief
Compliance Officer of Registrants, OMB control number 3038-0080,'' and
``Conflicts of Interest Policies and Procedures by Futures Commission
Merchants and Introducing Brokers, OMB control number 3038-0078.''
\190\ Many of the responses to this new collection of information are
mandatory.
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\190\ 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.\191\ The
Commission invited the public and other Federal agencies to comment on
any aspect of the information collection requirements discussed in the
Recordkeeping NPRM, the Duties NPRM, the CCO NPRM, the SD/MSP Conflicts
NPRM, and the FCM/IB Conflicts 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.
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\191\ See 75 FR at 76674 (maintain transaction and position
records of swaps, including daily trading records of swaps and
related cash and forward transactions; business records; records of
data and information reported to SDRs and for real time public
reporting purposes).
See 75 FR at 71404 (establish a risk management program,
including specific policies for compliance with position limits and
to ensure business continuity and disaster recovery; policies to
prevent unreasonable restraints of trade and anticompetitive
burdens; establish systems to diligently supervise the activities
relating to its business; and make certain information available for
disclosure and inspection by the Commission).
See 75 FR at 71395 (adopt conflicts of interest policies and
procedures; recordkeeping obligations related to implementation of
policies and procedures designed to ensure compliance with
Commission regulations; document certain communications between non-
research and research personnel; record of the basis for
determination of research personnel compensation; provision of
certain disclosures to recipients of research reports).
See 76 FR at 70887 (prepare a Form 8-R designating a CCO; draft
and maintain certain compliance policies and procedures; annually
prepare and furnish to the Commission an annual report describing
the registrant's compliance policies and resources and compliance
with the CEA and Commission regulations; amend previously furnished
annual reports, if necessary; and maintain records related to
compliance policies and annual reports).
See 75 FR at 70157 (adopt conflicts of interest policies and
procedures; recordkeeping obligations related to implementation of
policies and procedures designed to ensure compliance with
Commission regulations; document certain communications between non-
research and research personnel; record of the basis for
determination of research personnel compensation; provision of
certain disclosures to recipients of research reports).
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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.\192\ Since
publication of the proposals in late 2010, 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.\193\ After recently receiving additional specific
information from NFA on the regulatory program it is developing for SDs
and MSPs,\194\ 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 that there will be a combined number of 125 SDs and MSPs
that will be subject to new information collection requirements under
these rules.\195\
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\192\ 75 FR at 76671, 75 FR at 71402, 75 FR at 71394, and 75 FR
70885.
\193\ 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.
\194\ 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).
\195\ 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.''
In each of the NPRMs the Commission estimated the cost burden of
the proposed regulations based upon an average salary of $100 per hour.
In response to this estimate, 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 estimate of $100 per hour was 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.\196\ Taking these data, the Commission then increased its
hourly wage estimate 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
[[Page 20196]]
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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\196\ 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
remains a reasonable estimate 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 DCO final rules.\197\
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\197\ See Derivatives Clearing Organization General Provisions
and Core Principals, 76 FR at 69428.
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The Commission received comments related to the PRA for three of
its notices of proposed rulemaking: Recordkeeping, Duties, and CCO. No
comments were received with regard to the two Conflicts proposals.
1. Recordkeeping NPRM
With respect to the voice recording requirements of the
Recordkeeping NPRM, as explained in more detail above, ATA commented
that telephone recording systems that are compliant with all of these
requirements would impose a significant additional cost to dealers. The
Working Group commented that the long-term electronic storage of
significant amounts of pre-execution communications will prove costly
over the proposed five-year period. The Working Group also commented
that requiring records of physical positions linked with related swap
transactions would impose very expensive and burdensome requirements on
millions of physical transactions that are undertaken by commercial
energy firms that are also parties to swap transactions.
With respect to the record retention requirements in the
Recordkeeping NPRM, MFA commented that maintaining records of
transactions for 5 years following the termination, expiration, or
maturity of the transactions would constitute an additional
administrative burden and entail substantial additional cost. ISDA &
SIFMA also believe that recordkeeping of all oral and written
communications that may lead to execution of a swap for the life of a
swap plus five years could impose a heavy cost burden to implement and
maintain, for only a small incremental benefit and would be more
supportive of a voice recording obligation to retain recordings for a
minimum period of six months. The Commission notes that it is modifying
the retention period for voice recordings to one year, which should
minimize the burden on SDs and MSPs.
Notably, none of these commenters suggested specific revised
calculations with regard to the Commission's burden estimate.
Accordingly, the only change that the Commission is making to its
estimation of burdens associated with its Recordkeeping rules is the
change to reflect the new estimate of the number of SDs and MSPs. The
Commission now estimates the burden to be 2096 hours, at an annual cost
of $209,600 [2096 x $100 per hour] for each SD and MSP, and the
aggregate hour burden cost for all registrants is 262,000 burden hours
and $26,200,000 [262,000 x $100 per hour].
In addition to the per hour burden discussed above, the Commission
anticipated 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 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. Based on
comments received regarding system installation or upgrades that may be
needed to meet the requirements of the rules, the Commission is
doubling its estimate of programming burden hours associated with
technology improvements to be 320 hours, rather than 160 hours.
The Commission received no comments with respect to its programming
wage estimate of $60 per hour. Accordingly, the Commission has revised
only the estimate of the start-up burden associated with the required
technological improvements with respect to the number of burden hours.
The Commission estimates that the start-up burden would be $19,200 [$60
x 320 hours] per affected registrant or $2,400,000 in the aggregate for
all registrants.
2. Duties NPRM
The burden associated with regulations proposed in the Duties NPRM
will result from the development of the required policies and
procedures, satisfaction of various reporting obligations, and the
documentation of required testing.
The Working Group commented that the Commission's average personnel
cost estimate of $20,450 per effected entity significantly understates
the cost of compliance with the proposed rules for commercial firms
that are deemed SDs or MSPs. Specifically, the Working Group stated
that a commercial energy firm will require at least five new fulltime
employees at 1,800 hours per year, not the 204.5 hours per year
estimated by the Commission; and the Commission's analysis does not
consider any necessary information technology expenditures or third-
party costs.
The Working Group also commented that quarterly documentation of
risk management testing should be 200 personnel-hours per quarter at a
cost of $96,000 per year for each registrant, rather than 1 personnel-
hour per quarter at a cost of $400 per year as estimated by the
Commission.
With respect to the reporting requirements proposed in the Duties
NPRM, The Working Group argued that Risk Exposure Reports should be
provided to senior management and governing body annually, not
quarterly because quarterly reporting would be too costly and
burdensome.
With respect to the documentation of testing requirements proposed
in the Duties NPRM, The Working Group recommended that both the
frequency and the scope of audits of the risk management program be
left to the discretion of registrants in order to lessen the cost and
administrative burden imposed by the proposed rules. Cargill
recommended that testing of the risk management program be required
annually rather than quarterly. Cargill stated that a quarterly
requirement is excessive and unduly expensive. MetLife stated that
monthly testing of position limit monitoring procedures and quarterly
testing of the risk management program may be excessive, costly, and
overly burdensome for some MSPs and that the frequency of testing
should be determined by the MSP based on the extent of its swap
activities.
In the Duties NPRM, the burden per registrant was estimated to be
204.5
[[Page 20197]]
hours per year, at an annual cost of $20,450. Based on comments
received, as discussed above, the Commission is changing the required
risk management testing from quarterly to annually. The Commission also
is accepting The Working Group's contention that it will take more than
160 hours annually to draft, file, and update the Risk Management
Program materials, including the entity's position limit procedures and
its business continuity and disaster recovery plan. While the
Commission does not agree with the estimate that the new rules will
require at least five new fulltime employees at 1,800 hours per year,
the Commission accepts that on average it will take 900 hours to comply
with the information collection required by these provisions. The
Commission also agrees with The Working Group's revised estimation of
200 hours for documentation of risk management testing and is
increasing its estimate from four hours. Finally, the Commission is
increasing its estimate of the burden hours associated with quarterly
documentation of position limit compliance from two hours to 10 hours
to account for the required testing. Accordingly, the Commission has
revised its overall burden estimate to be 1148.5 hours per year per
registrant, at an annual cost of $114,850. The aggregate cost for all
registrants (with a revised estimate of 125 SDs and MSPs) is 143,562.5
burden hours and $14,356,250 [143,562.5 x $100 per hour].
3. SD/MSP Conflicts NPRM and FCM/IB Conflicts NPRM
The Commission received no comments related to its estimates of the
information collection burden with respect to either the SD/MSP
Conflicts NPRM or the FCM/IB Conflicts NPRM. Accordingly, the only
change that the Commission is making to its estimation of burdens
associated with its Conflicts rules is the change to reflect the new
estimate of the number of SDs and MSPs. The Commission estimates the
overall burden to be 44.5 hours per year per SD and MSP, at an annual
cost of $4,450 [44.5 x $100 per hour], and the aggregate cost for all
SDs and MSPs (with a revised estimate of 125 SDs and MSPs) is 5562.5
burden hours and $556,250 [5562.5 x $100 per hour]. There are currently
159 registered FCMs and 1,645 registered IBs that will be required to
comply with the proposed conflicts of interest provisions (or a total
of 1,804 registrants). The Commission estimates the burden to be 44.5
hours, at an annual cost of $4,450 for each FCM and IB, and the
aggregate cost for all FCMs and IBs is 80,278 burden hours and
$8,027,800 [80,278 burden hours x $100 per hour].
4. CCO NPRM
With respect to the annual compliance report requirement in the CCO
NPRM, NSCP commented the level of detail required by the annual report
would impose unnecessary burdens on the CCO with little offsetting
benefits. NSCP argues that a better approach would be to require a
review of the adequacy of policies and the effectiveness of their
implementation. EEI commented that the annual report requirements would
be so lengthy and detailed that the usefulness of the annual report
would be greatly diminished. The Working Group recommended that the
Commission provide a standardized form for the annual report because
such would mutually benefit the Commission and registrants. The Working
Group also believes the annual report as proposed would be
unnecessarily exhaustive, and without a materiality limitation, the
report would be of limited use to the Commission and costly for firms
to produce. The Working Group also objected to the requirement that
firms preserve all materials relating to the preparation of an annual
report because such would not promote any compliance policy other than
facilitating regulatory enforcement actions. The Working Group believes
that the scope of provisions means that a firm will spend considerable
resources to meet its obligations under the compliance report, and
preparation of the report will be quite expensive because the scope of
policies and procedures will be very broad. The Working Group estimates
that the burden of preparing a report is, at a minimum, 160 hours, 4
times the Commission's estimate.
FIA and SIFMA provided the following revised cost assessment: Form
8-R and related matters are 10 hours, not 1 hour; preparing, updating
and maintaining policies and procedures is 1000 hours, not 80 hours;
preparing the annual report is 500 hours not 40 hours; annually
amending the annual report is 50 hours and not 5 hours; and
recordkeeping is closer to 500 hours, not 10 hours. Therefore, FIA and
SIFMA estimate that the total cost per registrant is closer to $800,000
and the total to the industry is $350 million.
Despite the fact that FIA and SIFMA did not provide an explanation
for any of their revised burden estimates, the Commission is accepting
their arguments, in part, and is revising its burden estimate to
reflect some of their comments.
The Commission is not modifying the amount of time required to
prepare and file a Form 8-R designating the chief compliance officer.
This form requests only the information necessary about the individual
designated as CCO that is necessary for the Commission to appropriately
exercise its statutory registration and compliance oversight functions.
This information generally includes the name, addresses, location of
records, regulatory and disciplinary histories, and other similarly
straightforward matters--all of which should be in the possession of
the applicant and readily available for the applicant to provide. Most
notably, the PRA estimates provided for these forms are averages that
do not necessarily reflect the actual time expended by each and every
individual to complete the forms.
The Commission is modifying its burden estimate for the amount of
time it will take to draft and update compliance policies from 80 hours
annually to 900 hours, which reflects half of a full-time employee's
time. Additionally, the Commission is revising the burden estimate
associated with preparing and furnishing to the Commission an annual
report that describes the respondent's compliance policies and
resources and the respondent's compliance with the CEA and Commission
regulations. The Commission had estimated that it would take 40 hours
per year. The revised estimate would double that number to 80 hours per
year, which is in line with estimates made by the DCO final rulemaking.
The Commission is maintaining its original estimate for the time
required to amend a previously furnished annual report when material
errors or omissions are identified at 5 hours annually, but the
Commission is doubling the time estimate required to maintain records
related to respondent's compliance policies and annual reports from 10
hours to 20 hours. With regard to recordkeeping required under the CCO
rules, the Commission notes that much of the burden associated with
this requirement has been included in the overall recordkeeping
estimates for SDs and MSPs, and in existing regulations for FCMs, all
of which require general business records to be kept.
There are 159 FCMs currently registered with the Commission and it
is anticipated that there will be approximately 125 SDs and MSPs that
will register with the Commission. Thus, the total number of
respondents is expected to be 284. Based on comments received and the
changes to the rules discussed above, the Commission has revised its
estimate of the burden
[[Page 20198]]
associated with the regulations to be 1,006 hours, at a cost of
$100,600 annually for each respondent. Based upon the above, the
aggregate cost for all respondents is 285,704 burden hours [1,006 hours
x 284 respondents] and $28,570,400 [285,704 burden hours x $100 per
hour].
List of Subjects
17 CFR Part 1
Brokers, Commodity futures, Conflicts of interest, Reporting and
recordkeeping requirements.
17 CFR Part 3
Administrative practice and procedure, Brokers, Commodity futures,
Major swap participants, Reporting and recordkeeping requirements, Swap
dealers.
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 the preamble, the CFTC amends 17 CFR
parts 1, 3, and 23 as follows:
PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
0
1. The authority citation for part 1 is revised to read as follows:
Authority: 7 U.S.C. 1a, 2, 2a, 5, 6, 6a, 6b, 6b-1, 6c, 6d, 6e,
6f, 6g, 6h, 6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 6r, 6s, 7, 7a-1, 7a-2,
7b, 7b-3, 8, 9, 9a, 10a, 12, 12a, 12c, 13a, 13a-1, 16, 16a, 18, 19,
21, 23 and 24, as amended by Title VII of the Dodd-Frank Wall Street
Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376
(July 21, 2010).
0
2. Section 1.71 is added to read as follows:
Sec. 1.71 Conflicts of interest policies and procedures by futures
commission merchants and introducing brokers.
(a) Definitions. For purposes of this section, the following terms
shall be defined as provided.
(1) Affiliate. This term means, with respect to any person, a
person controlling, controlled by, or under common control with, such
person.
(2) Business trading unit. This term means any department,
division, group, or personnel of a futures commission merchant or
introducing broker or any of its affiliates, whether or not identified
as such, that performs, or personnel exercising direct supervisory
authority over the performance of, any pricing (excluding price
verification for risk management purposes), trading, sales, marketing,
advertising, solicitation, structuring, or brokerage activities on
behalf of a futures commission merchant or introducing broker or any of
its affiliates.
(3) Clearing unit. This term means any department, division, group,
or personnel of a futures commission merchant or any of its affiliates,
whether or not identified as such, that performs, or personnel
exercising direct supervisory authority over the performance of, any
proprietary or customer clearing activities on behalf of a futures
commission merchant or any of its affiliates.
(4) Derivative. This term means:
(i) A contract for the purchase or sale of a commodity for future
delivery;
(ii) A security futures product;
(iii) A swap;
(iv) Any agreement, contract, or transaction described in section
2(c)(2)(C)(i) or section 2(c)(2)(D)(i) of the Act; and
(v) Any commodity option authorized under section 4c of the Act;
and (vi) any leverage transaction authorized under section 19 of the
Act.
(5) Non-research personnel. This term means any employee of the
business trading unit or clearing unit, or any other employee of the
futures commission merchant or introducing broker, other than an
employee performing a legal or compliance function, who is not directly
responsible for, or otherwise not directly involved in, research or
analysis intended for inclusion in a research report.
(6) Public appearance. This term means any participation in a
conference call, seminar, forum (including an interactive electronic
forum) or other public speaking activity before 15 or more persons
(individuals or entities), or interview or appearance before one or
more representatives of the media, radio, television or print media, or
the writing of a print media article, in which a research analyst makes
a recommendation or offers an opinion concerning a derivatives
transaction. This term does not include a password-protected Webcast,
conference call or similar event with 15 or more existing customers,
provided that all of the event participants previously received the
most current research report or other documentation that contains the
required applicable disclosures, and that the research analyst
appearing at the event corrects and updates during the public
appearance any disclosures in the research report that are inaccurate,
misleading, or no longer applicable.
(7) Research analyst. This term means the employee of a futures
commission merchant or introducing broker who is primarily responsible
for, and any employee who reports directly or indirectly to such
research analyst in connection with, preparation of the substance of a
research report relating to any derivative, whether or not any such
person has the job title of ``research analyst.''
(8) Research department. This term means any department or division
that is principally responsible for preparing the substance of a
research report relating to any derivative on behalf of a futures
commission merchant or introducing broker, including a department or
division contained in an affiliate of a futures commission merchant or
introducing broker.
(9) Research report. This term means any written communication
(including electronic) that includes an analysis of the price or market
for any derivative, and that provides information reasonably sufficient
upon which to base a decision to enter into a derivatives transaction.
This term does not include:
(i) Communications distributed to fewer than 15 persons;
(ii) Commentaries on economic, political or market conditions;
(iii) Statistical summaries of multiple companies' financial data,
including listings of current ratings;
(iv) Periodic reports or other communications prepared for
investment company shareholders or commodity pool participants that
discuss individual derivatives positions in the context of a fund's
past performance or the basis for previously-made discretionary
decisions;
(v) Any communications generated by an employee of the business
trading unit that is conveyed as a solicitation for entering into a
derivatives transaction, and is conspicuously identified as such; and
(vi) Internal communications that are not given to current or
prospective customers.
(b) Policies and procedures. (1) Except as provided in paragraph
(b)(2) of this section, each futures commission merchant and
introducing broker subject to this rule must adopt and implement
written policies and procedures reasonably designed to ensure that the
futures commission merchant or introducing broker and its employees
comply with the provisions of this rule.
(2) Small Introducing Brokers. An introducing broker that has
generated, over the preceding 3 years, $5 million or less in aggregate
gross revenues from its activities as an introducing broker must
establish structural and institutional safeguards reasonably
[[Page 20199]]
designed to ensure that the activities of any person within the firm
relating to research or analysis of the price or market for any
commodity or derivative are separated by appropriate informational
partitions within the firm from the review, pressure, or oversight of
persons whose involvement in trading or clearing activities might
potentially bias the judgment or supervision of the persons.
(c) Research analysts and research reports. (1) Restrictions on
relationship with research department. (i) Non-research personnel shall
not direct a research analyst's decision to publish a research report
of the futures commission merchant or introducing broker, and non-
research personnel shall not direct the views and opinions expressed in
a research report of the futures commission merchant or introducing
broker.
(ii) No research analyst may be subject to the supervision or
control of any employee of the futures commission merchant's or
introducing broker's business trading unit or clearing unit, and no
employee of the business trading unit or clearing unit may have any
influence or control over the evaluation or compensation of a research
analyst.
(iii) Except as provided in paragraph (c)(1)(iv) of this section,
non-research personnel, other than the board of directors and any
committee thereof, shall not review or approve a research report of the
futures commission merchant or introducing broker before its
publication.
(iv) Non-research personnel may review a research report before its
publication as necessary only to verify the factual accuracy of
information in the research report, to provide for non-substantive
editing, to format the layout or style of the research report, or to
identify any potential conflicts of interest, provided that:
(A) Any written communication between non-research personnel and
research department personnel concerning the content of a research
report must be made either through authorized legal or compliance
personnel of the futures commission merchant or introducing broker or
in a transmission copied to such personnel; and
(B) Any oral communication between non-research personnel and
research department personnel concerning the content of a research
report must be documented and made either through authorized legal or
compliance personnel acting as an intermediary or in a conversation
conducted in the presence of such personnel.
(2) Restrictions on communications. Any written or oral
communication by a research analyst to a current or prospective
customer relating to any derivative must not omit any material fact or
qualification that would cause the communication to be misleading to a
reasonable person.
(3) Restrictions on research analyst compensation. A futures
commission merchant or introducing broker may not consider as a factor
in reviewing or approving a research analyst's compensation his or her
contributions to the futures commission merchant's or introducing
broker's trading or clearing business. Except for communicating client
or customer feedback, ratings and other indicators of research analyst
performance to research department management, no employee of the
business trading unit or clearing unit of the futures commission
merchant or introducing broker may influence the review or approval of
a research analyst's compensation.
(4) Prohibition of promise of favorable research. No futures
commission merchant or introducing broker may directly or indirectly
offer favorable research, or threaten to change research, to an
existing or prospective customer as consideration or inducement for the
receipt of business or compensation.
(5) Disclosure requirements. (i) Ownership and material conflicts
of interest. A futures commission merchant or introducing broker must
disclose in research reports and a research analyst must disclose in
public appearances whether the research analyst maintains a financial
interest in any derivative of a type, class, or category that the
research analyst follows, and the general nature of the financial
interest.
(ii) Prominence of disclosure. Disclosures and references to
disclosures must be clear, comprehensive, and prominent. With respect
to public appearances by research analysts, the disclosures required by
paragraph (c)(5) of this section must be conspicuous.
(iii) Records of public appearances. Each futures commission
merchant and introducing broker must maintain records of public
appearances by research analysts sufficient to demonstrate compliance
by those research analysts with the applicable disclosure requirements
under paragraph (c)(5) of this section.
(iv) Third-party research reports. (A) For the purposes of
paragraph (c)(5)(iv) of this section, ``independent third-party
research report'' shall mean a research report, in respect of which the
person or entity producing the report:
(1) Has no affiliation or business or contractual relationship with
the distributing futures commission merchant or introducing broker, or
that futures commission merchant's or introducing broker's affiliates,
that is reasonably likely to inform the content of its research
reports; and
(2) Makes content determinations without any input from the
distributing futures commission merchant or introducing broker or from
the futures commission merchant's or introducing broker's affiliates.
(B) Subject to paragraph (c)(5)(iv)(C) of this section, if a
futures commission merchant or introducing broker distributes or makes
available any independent third-party research report, the futures
commission merchant or introducing broker must accompany the research
report with, or provide a web address that directs the recipient to,
the current applicable disclosures, as they pertain to the futures
commission merchant or introducing broker, required by this section.
Each futures commission merchant and introducing broker must establish
written policies and procedures reasonably designed to ensure the
completeness and accuracy of all applicable disclosures.
(C) The requirements of paragraph (c)(5)(iv)(B) of this section
shall not apply to independent third-party research reports made
available by a futures commission merchant or introducing broker to its
customers:
(1) Upon request; or
(2) Through a Web site maintained by the futures commission
merchant or introducing broker.
(6) Prohibition of retaliation against research analysts. No
futures commission merchant or introducing broker, and no employee of a
futures commission merchant or introducing broker who is involved with
the futures commission merchant's or introducing broker's trading or
clearing activities, may, directly or indirectly, retaliate against or
threaten to retaliate against any research analyst employed by the
futures commission merchant or introducing broker or its affiliates as
a result of an adverse, negative, or otherwise unfavorable research
report or public appearance written or made, in good faith, by the
research analyst that may adversely affect the futures commission
merchant's or introducing broker's present or prospective trading or
clearing activities.
(7) Small Introducing Brokers. An introducing broker that has
generated, over the preceding 3 years, $5 million or less in aggregate
gross revenues from its activities as an introducing broker is
[[Page 20200]]
exempt from the requirements set forth in this paragraph (c).
(d) Clearing activities. (1) No futures commission merchant shall
permit any affiliated swap dealer or major swap participant to directly
or indirectly interfere with, or attempt to influence, the decision of
the clearing unit personnel of the futures commission merchant to
provide clearing services and activities to a particular customer,
including but not limited to a decision relating to the following:
(i) Whether to offer clearing services and activities to a
particular customer;
(ii) Whether to accept a particular customer for the purposes of
clearing derivatives;
(iii) Whether to submit a customer's transaction to a particular
derivatives clearing organization;
(iv) Whether to set or adjust risk tolerance levels for a
particular customer;
(v) Whether to accept certain forms of collateral from a particular
customer; or
(vi) Whether to set a particular customer's fees for clearing
services based upon criteria that are not generally available and
applicable to other customers of the futures commission merchant.
(2) Each futures commission merchant shall create and maintain an
appropriate informational partition between business trading units of
an affiliated swap dealer or major swap participant and clearing unit
personnel of the futures commission merchant to reasonably ensure
compliance with the Act and the prohibitions specified in paragraph
(d)(1) of this section. At a minimum, such informational partitions
shall require that:
(i) No employee of a business trading unit of an affiliated swap
dealer or major swap participant may review or approve the provision of
clearing services and activities by clearing unit personnel of the
futures commission merchant, make any determination regarding whether
the futures commission merchant accepts clearing customers, or in any
way condition or tie the provision of trading services upon or to the
provision of clearing services or otherwise participate in the
provision of clearing services by improperly incentivizing or
encouraging the use of the affiliated futures commission merchant. Any
employee of a business trading unit of an affiliated swap dealer or
major swap participant may participate in the activities of the futures
commission merchant as necessary for (A) participating in default
management undertaken by a derivatives clearing organization during an
event of default; and (B) transferring, liquidating, or hedging any
proprietary or customer positions during an event of default;
(ii) No employee of a business trading unit of an affiliated swap
dealer or major swap participant shall supervise, control, or influence
any employee of a clearing unit of the futures commission merchant; and
(iii) No employee of the business trading unit of an affiliated
swap dealer or major swap participant shall influence or control
compensation or evaluation of any employee of the clearing unit of the
futures commission merchant.
(e) Undue influence on customers. Each futures commission merchant
and introducing broker must adopt and implement written policies and
procedures that mandate the disclosure to its customers of any material
incentives and any material conflicts of interest regarding the
decision of a customer as to the trade execution and/or clearing of the
derivatives transaction.
(f) Records. All records that a futures commission merchant or
introducing broker is required to maintain pursuant to this regulation
shall be maintained in accordance with Commission Regulation Sec. 1.31
and shall be made available promptly upon request to representatives of
the Commission.
PART 3--REGISTRATION
0
3. The authority citation for part 3 is revised to read as follows:
Authority: 5 U.S.C. 552, 552b; 7 U.S.C. 1a, 2, 6a, 6b, 6b-1,
6c, 6d, 6e, 6f, 6g, 6h, 6i, 6k, 6m, 6n, 6o, 6p, 6s, 8, 9, 9a, 12,
12a, 13b, 13c, 16a, 18, 19, 21, and 23, as amended by Title VII of
the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub.
L. 111-203, 124 Stat. 1376 (Jul. 21, 2010).
0
4. Amend Sec. 3.1 by revising paragraph (a)(1) and by adding
paragraphs (h) and (i) to read as follows:
Sec. 3.1 Definitions.
(a) * * *
(1) If the entity is organized as a sole proprietorship, the
proprietor and chief compliance officer; if a partnership, any general
partner and chief compliance officer; if a corporation, any director,
the president, chief executive officer, chief operating officer, chief
financial officer, chief compliance officer, and any person in charge
of a principal business unit, division or function subject to
regulation by the Commission; if a limited liability company or limited
liability partnership, any director, the president, chief executive
officer, chief operating officer, chief financial officer, chief
compliance officer, the manager, managing member or those members
vested with the management authority for the entity, and any person in
charge of a principal business unit, division or function subject to
regulation by the Commission; and, in addition, any person occupying a
similar status or performing similar functions, having the power,
directly or indirectly, through agreement or otherwise, to exercise a
controlling influence over the entity's activities that are subject to
regulation by the Commission;
* * * * *
(h) Swaps activities. Swaps activities means, with respect to a
registrant, such registrant's activities related to swaps and any
product used to hedge such swaps, including, but not limited to,
futures, options, other swaps or security-based swaps, debt or equity
securities, foreign currency, physical commodities, and other
derivatives.
(i) Board of directors. Board of directors means the board of
directors, board of governors, or equivalent governing body of a
registrant.
0
5. Add Sec. 3.3 to read as follows:
Sec. 3.3 Chief compliance officer.
(a) Designation. Each futures commission merchant, swap dealer, and
major swap participant shall designate an individual to serve as its
chief compliance officer, and provide the chief compliance officer with
the responsibility and authority to develop, in consultation with the
board of directors or the senior officer, appropriate policies and
procedures to fulfill the duties set forth in the Act and Commission
regulations relating to the swap dealer's or major swap participant's
swaps activities, or to the futures commission merchant's business as a
futures commission merchant and to ensure compliance with the Act and
Commission regulations relating to the swap dealer's or major swap
participant's swaps activities, or to the futures commission merchant's
business as a futures commission merchant.
(1) The chief compliance officer shall report to the board of
directors or the senior officer of the futures commission merchant,
swap dealer, or major swap participant. The board of directors or the
senior officer shall appoint the chief compliance officer, shall
approve the compensation of the chief compliance officer, and shall
meet with the chief compliance officer at least once a year and at the
election of the chief compliance officer.
(2) Only the board of directors or the senior officer of the
futures commission merchant, swap dealer, or major swap participant may
remove the chief compliance officer.
[[Page 20201]]
(b) Qualifications. The individual designated to serve as chief
compliance officer shall have the background and skills appropriate for
fulfilling the responsibilities of the position. No individual
disqualified, or subject to disqualification, from registration under
section 8a(2) or 8a(3) of the Act may serve as a chief compliance
officer.
(c) Submission with registration. Each application for registration
as a futures commission merchant under Sec. 3.10, a swap dealer under
Sec. 23.21, or a major swap participant under Sec. 23.21, must
include a designation of a chief compliance officer by submitting a
Form 8-R for the chief compliance officer as a principal of the
applicant pursuant to Sec. 3.10(a)(2).
(d) Chief compliance officer duties. The chief compliance officer's
duties shall include, but are not limited to:
(1) Administering the registrant's policies and procedures
reasonably designed to ensure compliance with the Act and Commission
regulations;
(2) In consultation with the board of directors or the senior
officer, resolving any conflicts of interest that may arise;
(3) Taking reasonable steps to ensure compliance with the Act and
Commission regulations relating to the swap dealer's or major swap
participant's swaps activities, or to the futures commission merchant's
business as a futures commission merchant;
(4) Establishing procedures, in consultation with the board of
directors or the senior officer, for the remediation of noncompliance
issues identified by the chief compliance officer through a compliance
office review, look-back, internal or external audit finding, self-
reported error, or validated complaint;
(5) Establishing procedures, in consultation with the board of
directors or the senior officer, for the handling, management response,
remediation, retesting, and closing of noncompliance issues; and
(6) Preparing and signing the annual report required under
paragraphs (e) and (f) of this section.
(e) Annual report. The chief compliance officer annually shall
prepare a written report that covers the most recently completed fiscal
year of the futures commission merchant, swap dealer, or major swap
participant, and provide the annual report to the board of directors or
the senior officer. The annual report shall, at a minimum:
(1) Contain a description of the written policies and procedures,
including the code of ethics and conflicts of interest policies, of the
futures commission merchant, swap dealer, or major swap participant;
(2) Review each applicable requirement under the Act and Commission
regulations, and with respect to each:
(i) Identify the policies and procedures that are reasonably
designed to ensure compliance with the requirement under the Act and
Commission regulations;
(ii) Provide an assessment as to the effectiveness of these
policies and procedures; and
(iii) Discuss areas for improvement, and recommend potential or
prospective changes or improvements to its compliance program and
resources devoted to compliance;
(3) List any material changes to compliance policies and procedures
during the coverage period for the report;
(4) Describe the financial, managerial, operational, and staffing
resources set aside for compliance with respect to the Act and
Commission regulations, including any material deficiencies in such
resources; and
(5) Describe any material non-compliance issues identified, and the
corresponding action taken.
(f) Furnishing the annual report to the Commission. (1) Prior to
furnishing the annual report to the Commission, the chief compliance
officer shall provide the annual report to the board of directors or
the senior officer of the futures commission merchant, swap dealer, or
major swap participant for its review. Furnishing the annual report to
the board of directors or the senior officer shall be recorded in the
board minutes or otherwise, as evidence of compliance with this
requirement.
(2) The annual report shall be furnished electronically to the
Commission not more than 90 days after the end of the fiscal year of
the futures commission merchant, swap dealer, or major swap
participant, simultaneously with the submission of Form 1-FR-FCM, as
required under Sec. 1.10(b)(2)(ii), simultaneously with the Financial
and Operational Combined Uniform Single Report, as required under Sec.
1.10(h), or simultaneously with the financial condition report, as
required under section 4s(f) of the Act, as applicable.
(3) The report shall include a certification by the chief
compliance officer or chief executive officer of the registrant that,
to the best of his or her knowledge and reasonable belief, and under
penalty of law, the information contained in the annual report is
accurate and complete.
(4) The futures commission merchant, swap dealer, or major swap
participant shall promptly furnish an amended annual report if material
errors or omissions in the report are identified. An amendment must
contain the certification required under paragraph (f)(3) of this
section.
(5) A futures commission merchant, swap dealer, or major swap
participant may request from the Commission an extension of time to
furnish its annual report, provided the registrant's failure to timely
furnish the report could not be eliminated by the registrant without
unreasonable effort or expense. Extensions of the deadline will be
granted at the discretion of the Commission.
(6) A futures commission merchant, swap dealer, or major swap
participant may incorporate by reference sections of an annual report
that has been furnished within the current or immediately preceding
reporting period to the Commission. If the futures commission merchant,
swap dealer, or major swap participant is registered in more than one
capacity with the Commission, and must submit more than one annual
report, an annual report submitted as one registrant may incorporate by
reference sections in the annual report furnished within the current or
immediately preceding reporting period as the other registrant.
(g) Recordkeeping. (1) The futures commission merchant, swap
dealer, or major swap participant shall maintain:
(i) A copy of the registrant's policies and procedures reasonably
designed to ensure compliance with the Act and Commission regulations;
(ii) Copies of materials, including written reports provided to the
board of directors or the senior officer in connection with the review
of the annual report under paragraph (e) of this section; and
(iii) Any records relevant to the annual report, including, but not
limited to, work papers and other documents that form the basis of the
report, and memoranda, correspondence, other documents, and records
that are created, sent or received in connection with the annual report
and contain conclusions, opinions, analyses, or financial data related
to the annual report.
(2) All records or reports that a futures commission merchant, swap
dealer, or major swap participant are required to maintain pursuant to
this section shall be maintained in accordance with Sec. 1.31 and
shall be made available promptly upon request to representatives of the
Commission and to representatives of the applicable prudential
regulator, as defined in 1a(39) of the Act.
[[Page 20202]]
PART 23--SWAP DEALERS AND MAJOR SWAP PARTICIPANTS
0
6. The authority citation for part 23 is revised 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, and 21 as amended by the
Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L.
111-203, 124 Stat. 1376 (Jul. 21, 2010).
0
7. Add Subpart F, Sec. Sec. 23.200, 23.201, 23.202, 23.203, 23.204,
23.205, and 23.206 to read as follows:
Subpart F--Reporting, Recordkeeping, and Daily Trading Records
Requirements for Swap Dealers and Major Swap Participants
Sec.
23.200 Definitions.
23.201 Required records.
23.202 Daily trading records.
23.203 Records; retention and inspection.
23.204 Reporting to swap data repositories.
23.205 Real-time public reporting.
23.206 Delegation of authority to the Director of the Division of
Swap Dealer and Intermediary Oversight to establish an alternative
compliance schedule to comply with daily trading records.
Subpart F--Reporting, Recordkeeping, and Daily Trading Records
Requirements for Swap Dealers and Major Swap Participants
Sec. 23.200 Definitions.
For purposes of subpart F, the following terms shall be defined as
provided.
(a) Business trading unit means any department, division, group, or
personnel of a swap dealer or major swap participant or any of its
affiliates, whether or not identified as such, that performs, or
exercises supervisory authority over the performance of, any pricing
(excluding price verification for risk management purposes), trading,
sales, purchasing, marketing, advertising, solicitation, structuring,
or brokerage activities on behalf of a registrant.
(b) Clearing unit means any department, division, group, or
personnel of a registrant or any of its affiliates, whether or not
identified as such, that performs any proprietary or customer clearing
activities on behalf of a registrant.
(c) Complaint means any formal or informal complaint, grievance,
criticism, or concern communicated to the swap dealer or major swap
participant in any format relating to, arising from, or in connection
with, any trading conduct or behavior or with the swap dealer or major
swap participant's performance (or failure to perform) any of its
regulatory obligations, and includes any and all observations,
comments, remarks, interpretations, clarifications, notes, and
examinations as to such conduct or behavior communicated or documented
by the complainant, swap dealer, or major swap participant.
(d) Executed means the completion of the execution process.
(e) Execution means, with respect to a swap, an agreement by the
parties (whether orally, in writing, electronically, or otherwise) to
the terms of a swap that legally binds the parties to such swap terms
under applicable law.
(f) Governing body. This term means:
(1) A board of directors;
(2) A body performing a function similar to a board of directors;
(3) Any committee of a board or body; or
(4) The chief executive officer of a registrant, or any such board,
body, committee, or officer of a division of a registrant, provided
that the registrant's swaps activities for which registration with the
Commission is required are wholly contained in a separately
identifiable division.
(g) Prudential regulator has the meaning given to such 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.
(h) Registered entity has the meaning given to such term in section
1a(40) of the Commodity Exchange Act, and includes boards of trade
designated as contract markets, derivatives clearing organizations,
swap execution facilities, and swap data repositories.
(i) Related cash or forward transaction means a purchase or sale
for immediate or deferred physical shipment or delivery of an asset
related to a swap where the swap and the related cash or forward
transaction are used to hedge, mitigate the risk of, or offset one
another.
(j) Swaps activities means, with respect to a registrant, such
registrant's activities related to swaps and any product used to hedge
such swaps, including, but not limited to, futures, options, other
swaps or security-based swaps, debt or equity securities, foreign
currency, physical commodities, and other derivatives.
(k) Swap confirmation means 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).
Sec. 23.201 Required records.
(a) Transaction and position records. Each swap dealer and major
swap participant shall keep full, complete, and systematic records,
together with all pertinent data and memoranda, of all its swaps
activities. Such records shall include:
(1) Transaction records. Records of each transaction, including all
documents on which transaction information is originally recorded. Such
records shall be kept in a form and manner identifiable and searchable
by transaction and by counterparty, and shall include:
(i) All documents customarily generated in accordance with market
practice that demonstrate the existence and nature of an order or
transaction, including, but not limited to, records of all orders
(filled, unfilled, or cancelled); correspondence; journals; memoranda;
ledgers; confirmations; risk disclosure documents; statements of
purchase and sale; contracts; invoices; warehouse receipts; documents
of title; and
(ii) The daily trading records required to be kept in accordance
with Sec. 23.202.
(2) Position records. Records of each position held by each swap
dealer and major swap participant, identified by product and
counterparty, including records reflecting whether each position is
``long'' or ``short'' and whether the position is cleared. Position
records shall be linked to transaction records in a manner that permits
identification of the transactions that established the position.
(3) Records of transactions executed on a swap execution facility
or designated contract market or cleared by a derivatives clearing
organization. Records of each transaction executed on a swap execution
facility or designated contract market or cleared by a derivatives
clearing organization maintained in compliance with the Act and
Commission regulations.
(b) Business records. Each swap dealer and major swap participant
shall keep full, complete, and systematic records of all activities
related to its business as a swap dealer or major swap participant,
including but not limited to:
(1) Governance. (i) Minutes of meetings of the governing body and
relevant committee minutes, including handouts and presentation
materials;
(ii) Organizational charts for its governing body and relevant
[[Page 20203]]
committees, business trading unit, clearing unit, risk management unit,
and all other relevant units or divisions;
(iii) Biographies or resumes of managers, senior supervisors,
officers, and directors;
(iv) Job descriptions for manager, senior supervisor, officer, and
director positions, including job responsibilities and scope of
authority;
(v) Internal and external audit, risk management, compliance, and
consultant reports (including management responses); and
(vi) Business and strategic plans for the business trading unit.
(2) Financial records. (i) Records reflecting all assets and
liabilities, income and expenses, and capital accounts as required by
the Act and Commission regulations; and
(ii) All other financial records required to be kept under the Act
and Commission regulations.
(3) Complaints. (i) A record of each complaint received by the swap
dealer or major swap participant concerning any partner, member,
officer, employee, or agent. The record shall include the complainant's
name, address, and account number; the date the complaint was received;
the name of all persons identified in the complaint; a description of
the nature of the complaint; the disposition of the complaint, and the
date the complaint was resolved.
(ii) A record indicating that each counterparty of the swap dealer
or major swap participant has been provided with a notice containing
the physical address, email or other widely available electronic
address, and telephone number of the department of the swap dealer or
major swap participant to which any complaints may be directed.
(4) Marketing and sales materials. All marketing and sales
presentations, advertisements, literature, and communications, and a
record documenting that the swap dealer or major swap participant has
complied with, or adopted policies and procedures reasonably designed
to establish compliance with, all applicable Federal requirements,
Commission regulations, and the rules of any self-regulatory
organization of which the swap dealer or major swap participant is a
member.
(c) Records of data reported to a swap data repository. With
respect to each swap, each swap dealer and major swap participant shall
identify, retain, and produce for inspection all information and data
required to be reported in accordance with part 45 of this chapter,
along with a record of the date and time the swap dealer or major swap
participant made the report.
(d) Records of real-time reporting data. Each swap dealer and major
swap participant shall identify, retain, and produce for inspection all
information and data required to be reported in accordance with part 43
of this chapter, along with a record of the date and time the swap
dealer or major swap participant made the report.
Sec. 23.202 Daily trading records.
(a) Daily trading records for swaps. Each swap dealer and major
swap participant shall make and keep daily trading records of all swaps
it executes, including all documents on which transaction information
is originally recorded. Each swap dealer and major swap participant
shall ensure that its records include all information necessary to
conduct a comprehensive and accurate trade reconstruction for each
swap. Each swap dealer and major swap participant shall maintain each
transaction record in a manner identifiable and searchable by
transaction and counterparty.
(1) Pre-execution trade information. Each swap dealer and major
swap participant shall make and keep pre-execution trade information,
including, at a minimum, records of all oral and written communications
provided or received concerning quotes, solicitations, bids, offers,
instructions, trading, and prices, that lead to the execution of a
swap, whether communicated by telephone, voicemail, facsimile, instant
messaging, chat rooms, electronic mail, mobile device, or other digital
or electronic media. Such records shall include, but are not limited
to:
(i) Reliable timing data for the initiation of the trade that would
permit complete and accurate trade reconstruction; and
(ii) A record of the date and time, to the nearest minute, using
Coordinated Universal Time (UTC), by timestamp or other timing device,
for each quotation provided to, or received from, the counterparty
prior to execution.
(2) Execution trade information. Each swap dealer and major swap
participant shall make and keep trade execution records, including:
(i) All terms of each swap, including all terms regarding payment
or settlement instructions, initial and variation margin requirements,
option premiums, payment dates, and any other cash flows;
(ii) The trade ticket for each swap (which, together with the time
of execution of each swap, shall be immediately recorded electronically
for further processing);
(iii) The unique swap identifier, as required by Sec. 45.4(a), for
each swap;
(iv) A record of the date and time of execution of each swap, to
the nearest minute, using Coordinated Universal Time (UTC), by
timestamp or other timing device;
(v) The name of the counterparty with which each such swap was
executed, including its unique counterparty identifier, as required by
Sec. 45.4(b);
(vi) The date and title of the agreement to which each swap is
subject, including but not limited to, any swap trading relationship
documentation and credit support arrangements;
(vii) The product name of each swap, including its unique product
identifier, as required by Sec. 45.4(c);
(viii) The price at which the swap was executed;
(ix) Fees or commissions and other expenses, identified by
transaction; and
(x) Any other information relevant to the swap.
(3) Post-execution trade information. Each swap dealer and major
swap participant shall make and keep records of post-execution trade
information containing an itemized record of all relevant post-trade
processing and events.
(i) Records of post-trade processing and events shall include all
of the following, as applicable:
(A) Confirmation;
(B) Termination;
(C) Novation;
(D) Amendment;
(E) Assignment;
(F) Netting;
(G) Compression;
(H) Reconciliation;
(I) Valuation;
(J) Margining;
(K) Collateralization; and
(L) Central clearing.
(ii) Each swap dealer and major swap participant shall make and
keep a record of all swap confirmations, along with the date and time,
to the nearest minute, using Coordinated Universal Time (UTC), by
timestamp or other timing device; and
(iii) Each swap dealer and major swap participant shall make and
keep a record of each swap 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);
(iv) Each swap dealer and major swap participant shall make and
keep a
[[Page 20204]]
record of each swap portfolio compression exercise in which it
participates, including the dates of the compression, the swaps
included in the compression, the identity of the counterparties
participating in the exercise, the results of the compression, and the
name of the third-party entity performing the compression, if any; and
(v) Each swap dealer and major swap participant shall make and keep
a record of each swap that it centrally clears, categorized by
transaction and counterparty.
(4) Ledgers. Each swap dealer and major swap participant shall make
and keep ledgers (or other records) reflecting the following:
(i) Payments and interest received;
(ii) Moneys borrowed and moneys loaned;
(iii) The daily calculation of the value of each outstanding swap;
(iv) The daily calculation of current and potential future exposure
for each counterparty;
(v) The daily calculation of initial margin to be posted by the
swap dealer or major swap participant for each counterparty and the
daily calculation of initial margin to be posted by each counterparty;
(vi) The daily calculation of variation margin payable to or
receivable from each counterparty;
(vii) The daily calculation of the value of all collateral, before
and after haircuts, held by or posted by the swap dealer or major swap
participant;
(viii) All transfers of collateral, including any substitutions of
collateral, identifying in sufficient detail the amounts and types of
collateral transferred; and
(ix) All charges against and credits to each counterparty's
account, including funds deposited, withdrawn, or transferred, and
charges or credits resulting from losses or gains on transactions.
(b) Daily trading records for related cash and forward
transactions. Each swap dealer and major swap participant shall make
and keep daily trading records of all related cash or forward
transactions it executes, including all documents on which the related
cash or forward transaction information is originally recorded. Each
swap dealer and major swap participant shall ensure that its records
include all information necessary to conduct a comprehensive and
accurate trade reconstruction for each related cash or forward
transaction. Each swap dealer and major swap participant shall maintain
each transaction record in a manner identifiable and searchable by
transaction and by counterparty. Such records shall include, but are
not limited to:
(1) A record of all oral and written communications provided or
received concerning quotes, solicitations, bids, offers, instructions,
trading, and prices, that lead to the conclusion of a related cash or
forward transaction, whether communicated by telephone, voicemail,
facsimile, instant messaging, chat rooms, electronic mail, mobile
device, or other digital or electronic media;
(2) Reliable timing data for the initiation of the transaction that
would permit complete and accurate trade reconstruction;
(3) A record of the date and time, to the nearest minute, using
Coordinated Universal Time (UTC), by timestamp or other timing device,
for each quotation provided to, or received from, the counterparty
prior to execution;
(4) A record of the date and time of execution of each related cash
or forward transaction, to the nearest minute, using Coordinated
Universal Time (UTC), by timestamp or other timing device;
(5) All terms of each related cash or forward transaction;
(6) The price at which the related cash or forward transaction was
executed; and
(7) A record of the daily calculation of the value of the related
cash or forward transaction and any other relevant financial
information.
Sec. 23.203 Records; retention and inspection.
(a) Location of records. (1) Records. All records required to be
kept by a swap dealer or major swap participant by the Act and by
Commission regulations shall be kept at the principal place of business
of the swap dealer or major swap participant or such other principal
office as shall be designated by the swap dealer or major swap
participant. If the principal place of business is outside of the
United States, its territories or possessions, then upon the request of
a Commission representative, the swap dealer or major swap participant
must provide such records as requested at the place in the United
States, its territories, or possessions designated by the
representative within 72 hours after receiving the request.
(2) Contact information. Each swap dealer and major swap
participant shall maintain for each of its offices a listing, by name
or title, of each person at that office who, without delay, can explain
the types of records the swap dealer or major swap participant
maintains at that office and the information contained in those
records.
(b) Record retention. (1) The records required to be maintained by
this chapter shall be maintained in accordance with the provisions of
Sec. 1.31, except as provided in paragraphs (b)(2) and (3) of this
section. All records required to be kept by the Act and by Commission
regulations shall be kept for a period of five years from the date the
record was made and shall be readily accessible during the first two
(2) years of the five-year period. All such records shall be open to
inspection by any representative of the Commission, the United States
Department of Justice, or any applicable prudential regulator. Records
relating to swaps defined in section 1a(47)(A)(v) shall be open to
inspection by any representative of the Commission, the United States
Department of Justice, the Securities and Exchange Commission, or any
applicable prudential regulator.
(2) Records of any swap or related cash or forward transaction
shall be kept until the termination, maturity, expiration, transfer,
assignment, or novation date of the transaction, and for a period of
five years after such date. Such records shall be readily accessible
until the termination, maturity, expiration, transfer, assignment, or
novation date of the transaction and during the first two years of the
5-year period following such date. Provided, however, that records of
oral communications communicated by telephone, voicemail, mobile
device, or other digital or electronic media pursuant to Sec.
23.202(a)(1) and (b)(1) shall be kept for a period of one year. All
such records shall be open to inspection by any representative of the
Commission, the United States Department of Justice, or any applicable
prudential regulator. Records relating to swaps defined in section
1a(47)(A)(v) shall be open to inspection by any representative of the
Commission, the United States Department of Justice, the Securities and
Exchange Commission, or any applicable prudential regulator.
(3) Records of any swap data reported in accordance with part 45 of
this chapter shall be maintained in accordance with the requirements of
Sec. 45.2 of this chapter.
Sec. 23.204 Reports to swap data repositories.
(a) Reporting of swap transaction data to swap data repositories.
Each swap dealer and major swap participant shall report all
information and data in accordance with part 45 of this chapter.
(b) Electronic reporting of swap transaction data. Each swap dealer
and major swap participant shall have the electronic systems and
procedures
[[Page 20205]]
necessary to transmit electronically all information and data required
to be reported in accordance with part 45 of this chapter.
Sec. 23.205 Real-time public reporting.
(a) Real-time public reporting of swap transaction and pricing
data. Each swap dealer and major swap participant shall report all
information and swap transaction and pricing data required to be
reported in accordance with the real-time public recording requirements
in part 43 of this chapter.
(b) Electronic reporting of swap transaction data. Each swap dealer
and major swap participant shall have the electronic systems and
procedures necessary to transmit electronically all information and
data required to be reported in accordance with part 43 of this
chapter.
Sec. 23.206 Delegation of authority to the Director of the Division
of Swap Dealer and Intermediary Oversight to establish an alternative
compliance schedule to comply with daily trading records.
(a) The Commission hereby delegates to the Director of the Division
of Swap Dealer and Intermediary Oversight or such other employee or
employees as the Director may designate from time to time, the
authority to establish an alternative compliance schedule for
requirements of Sec. 23.202 that are found to be technologically or
economically impracticable for an affected swap dealer or major swap
participant that seeks, in good faith, to comply with the requirements
of Sec. 23.202 within a reasonable time period beyond the date on
which compliance by such swap dealer or major swap participant is
otherwise required.
(b) A request for an alternative compliance schedule under this
section shall be acted upon by the Director of the Division of Swap
Dealer and Intermediary Oversight within 30 days from the time such a
request is received, or it shall be deemed approved.
(c) Relief granted under this section shall not cause a registrant
to be out of compliance or deemed in violation of any registration
requirements.
(d) Notwithstanding any other provision of this section, in any
case in which a Commission employee delegated authority under this
section believes it appropriate, he or she may submit to the Commission
for its consideration the question of whether an alternative compliance
schedule should be established. Nothing in this section shall be deemed
to prohibit the Commission, at its election, from exercising the
authority delegated in this section.
0
8. Add Subpart J, consisting of Sec. Sec. 23.600 through 23.607, to
read as follows:
Subpart J--Duties of Swap Dealers and Major Swap Participants
Sec.
23.600 Risk Management Program for swap dealers and major swap
participants.
23.601 Monitoring of position limits.
23.602 Diligent supervision.
23.603 Business continuity and disaster recovery.
23.604 [Reserved]
23.605 Conflicts of interest policies and procedures.
23.606 General information: availability for disclosure and
inspection.
23.607 Antitrust considerations.
Subpart J--Duties of Swap Dealers and Major Swap Participants
Sec. 23.600 Risk Management Program for swap dealers and major swap
participants.
(a) Definitions. For purposes of subpart J, the following terms
shall be defined as provided.
(1) Affiliate. This term means, with respect to any person, a
person controlling, controlled by, or under common control with, such
person.
(2) Business trading unit. This term means any department,
division, group, or personnel of a swap dealer or major swap
participant or any of its affiliates, whether or not identified as
such, that performs, or personnel exercising direct supervisory
authority over the performance of any pricing (excluding price
verification for risk management purposes), trading, sales, marketing,
advertising, solicitation, structuring, or brokerage activities on
behalf of a registrant.
(3) Clearing unit. This term means any department, division, group,
or personnel of a registrant or any of its affiliates, whether or not
identified as such, that performs, or personnel exercising direct
supervisory authority over the performance of any proprietary or
customer clearing activities on behalf of a registrant.
(4) Governing body. This term means:
(1) A board of directors;
(2) A body performing a function similar to a board of directors;
(3) Any committee of a board or body; or
(4) The chief executive officer of a registrant, or any such board,
body, committee, or officer of a division of a registrant, provided
that the registrant's swaps activities for which registration with the
Commission is required are wholly contained in a separately
identifiable division.
(5) Prudential regulator. This term has the same meaning as 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.
(6) Senior management. This term means, with respect to a
registrant, any officer or officers specifically granted the authority
and responsibility to fulfill the requirements of senior management by
the registrant's governing body.
(7) Swaps activities. This term means, with respect to a
registrant, such registrant's activities related to swaps and any
product used to hedge such swaps, including, but not limited to,
futures, options, other swaps or security-based swaps, debt or equity
securities, foreign currency, physical commodities, and other
derivatives.
(b) Risk management program. (1) Purpose. Each swap dealer and
major swap participant shall establish, document, maintain, and enforce
a system of risk management policies and procedures designed to monitor
and manage the risks associated with the swaps activities of the swap
dealer or major swap participant. For purposes of this regulation, such
policies and procedures shall be referred to collectively as a ``Risk
Management Program.''
(2) Written policies and procedures. Each swap dealer and major
swap participant shall maintain written policies and procedures that
describe the Risk Management Program of the swap dealer or major swap
participant.
(3) Approval by governing body. The Risk Management Program and the
written risk management policies and procedures shall be approved, in
writing, by the governing body of the swap dealer or major swap
participant.
(4) Furnishing to the Commission. Each swap dealer and major swap
participant shall furnish a copy of its written risk management
policies and procedures to the Commission, or to a futures association
registered under section 17 of the Act, if directed by the Commission,
upon application for registration and thereafter upon request.
(5) Risk management unit. As part of its Risk Management Program,
each swap dealer and major swap participant shall establish and
maintain a risk management unit with sufficient authority; qualified
personnel; and financial, operational, and other resources to carry out
the risk management program established pursuant to this regulation.
The risk management unit shall report directly to senior management and
shall be
[[Page 20206]]
independent from the business trading unit.
(c) Elements of the Risk Management Program. The Risk Management
Program of each swap dealer and major swap participant shall include,
at a minimum, the following elements:
(1) Identification of risks and risk tolerance limits. (i) The Risk
Management Program should take into account market, credit, liquidity,
foreign currency, legal, operational, settlement, and any other
applicable risks together with a description of the risk tolerance
limits set by the swap dealer or major swap participant and the
underlying methodology in written policies and procedures. The risk
tolerance limits shall be reviewed and approved quarterly by senior
management and annually by the governing body. Exceptions to risk
tolerance limits shall be subject to written policies and procedures.
(ii) The Risk Management Program shall take into account risks
posed by affiliates and the Risk Management Program shall be integrated
into risk management at the consolidated entity level.
(iii) The Risk Management Program shall include policies and
procedures for detecting breaches of risk tolerance limits set by the
swap dealer or major swap participant, and alerting supervisors within
the risk management unit and senior management, as appropriate.
(2) Periodic Risk Exposure Reports. (i) The risk management unit of
each swap dealer and major swap participant shall provide to senior
management and to its governing body quarterly written reports setting
forth the market, credit, liquidity, foreign currency, legal,
operational, settlement, and any other applicable risk exposures of the
swap dealer or major swap participant; any recommended or completed
changes to the Risk Management Program; the recommended time frame for
implementing recommended changes; and the status of any incomplete
implementation of previously recommended changes to the Risk Management
Program. For purposes of this regulation, such reports shall be
referred to as ``Risk Exposure Reports.'' The Risk Exposure Reports
also shall be provided to the senior management and the governing body
immediately upon detection of any material change in the risk exposure
of the swap dealer or major swap participant.
(ii) Furnishing to the Commission. Each swap dealer and major swap
participant shall furnish copies of its Risk Exposure Reports to the
Commission within five (5) business days of providing such reports to
its senior management.
(3) New product policy. The Risk Management Program of each swap
dealer and major swap participant shall include a new product policy
that is designed to identify and take into account the risks of any new
product prior to engaging in transactions involving the new product.
The new product policy should include the following elements:
(i) Consideration of the type of counterparty with which the new
product will be transacted; the product's characteristics and economic
function; and whether the product requires a novel pricing methodology
or presents novel legal and regulatory issues.
(ii) Identification and analysis of all relevant risks associated
with the new product and how they will be managed. The risk analysis
should include an assessment, if relevant, of any product, market,
credit, liquidity, foreign currency, legal, operational, settlement,
and any other risks associated with the new product. Product risk
characteristics may include, if relevant, volatility, non-linear price
characteristics, jump-to-default risk, and any correlation between the
value of the product and the counterparty's creditworthiness.
(iii) An assessment, signed by a supervisor in the risk management
unit, as to whether the new product would materially alter the overall
entity-wide risk profile of the swap dealer or major swap participant.
If the new product would materially alter the overall risk profile of
the swap dealer or major swap participant, the new product must be pre-
approved by the governing body before any transactions are effectuated.
(iv) A requirement that the risk management unit review the risk
analysis to identify any necessary modifications to the Risk Management
Program and implement such modifications prior to engaging in
transactions involving the new product.
(v) Notwithstanding the foregoing, a swap dealer's or major swap
participant's new product policy may include provisions permitting
limited preliminary approval of new products--
(A) At a risk level that would not be material to the swap dealer
or major swap participant; and
(B) Solely in order to provide the swap dealer or major swap
participant with the opportunity to facilitate development of
appropriate operational and risk management processes for such product.
(4) Specific risk management considerations. The Risk Management
Program of each swap dealer and major swap participant shall include,
but not be limited to, policies and procedures necessary to monitor and
manage the following risks:
(i) Market risk. Market risk policies and procedures shall take
into account, among other things:
(A) Daily measurement of market exposure, including exposure due to
unique product characteristics, volatility of prices, basis and
correlation risks, leverage, sensitivity of option positions, and
position concentration, to comply with market risk tolerance limits;
(B) Timely and reliable valuation data derived from, or verified
by, sources that are independent of the business trading unit, and if
derived from pricing models, that the models have been independently
validated by qualified, independent external or internal persons; and
(C) Periodic reconciliation of profits and losses resulting from
valuations with the general ledger.
(ii) Credit risk. Credit risk policies and procedures shall take
into account, among other things:
(A) Daily measurement of overall credit exposure to comply with
counterparty credit limits;
(B) Monitoring and reporting of violations of counterparty credit
limits performed by personnel that are independent of the business
trading unit; and
(C) Regular valuation of collateral used to cover credit exposures
and safeguarding of collateral to prevent loss, disposal,
rehypothecation, or use unless appropriately authorized.
(iii) Liquidity risk. Liquidity risk policies and procedures shall
take into account, among other things:
(A) Daily measurement of liquidity needs;
(B) Assessing procedures to liquidate all non-cash collateral in a
timely manner and without significant effect on price; and
(C) Application of appropriate collateral haircuts that accurately
reflect market and credit risk.
(iv) Foreign currency risk. Foreign currency risk policies and
procedures shall take into account, among other things:
(A) Daily measurement of the amount of capital exposed to
fluctuations in the value of foreign currency to comply with applicable
limits; and
(B) Establishment of safeguards against adverse currency
fluctuations.
(v) Legal risk. Legal risk policies and procedures shall take into
account, among other things:
(A) Determinations that transactions and netting arrangements
entered into have a sound legal basis; and
[[Page 20207]]
(B) Establishment of documentation tracking procedures designed to
ensure the completeness of relevant documentation and to resolve any
documentation exceptions on a timely basis.
(vi) Operational risk. Operational risk policies and procedures
shall take into account, among other things:
(A) Secure and reliable operating and information systems with
adequate, scalable capacity, and independence from the business trading
unit;
(B) Safeguards to detect, identify, and promptly correct
deficiencies in operating and information systems; and
(C) Reconciliation of all data and information in operating and
information systems.
(vii) Settlement risk. Settlement risk policies and procedures
shall take into account, among other things:
(A) Establishment of standard settlement instructions with each
counterparty;
(B) Procedures to track outstanding settlement items and aging
information in all accounts, including nostro and suspense accounts;
and
(C) Procedures to ensure timely payments to counterparties and to
resolve any late payments.
(5) Use of central counterparties. Each swap dealer and major swap
participant shall establish policies and procedures relating to its use
of central counterparties. Such policies and procedures shall:
(i) Require the use of central counterparties where clearing is
required pursuant to Commission regulation or order, unless the
counterparty has properly invoked a clearing exemption under Commission
regulations;
(ii) Set forth the conditions for the voluntary use of central
counterparties for clearing when available as a means of mitigating
counterparty credit risk; and
(iii) Require diligent investigation into the adequacy of the
financial resources and risk management procedures of any central
counterparty through which the swap dealer or major swap participant
clears.
(6) Compliance with margin and capital requirements. Each swap
dealer and major swap participant shall satisfy all capital and margin
requirements established by the Commission or prudential regulator, as
applicable.
(7) Monitoring of compliance with Risk Management Program. Each
swap dealer and major swap participant shall establish policies and
procedures to detect violations of the Risk Management Program; to
encourage employees to report such violations to senior management,
without fear of retaliation; and to take specified disciplinary action
against employees who violate the Risk Management Program.
(d) Business trading unit. Each swap dealer and major swap
participant shall establish policies and procedures that, at a minimum:
(1) Require all trading policies be approved by the governing body
of the swap dealer or major swap participant;
(2) Require that traders execute transactions only with
counterparties for whom credit limits have been established;
(3) Provide specific quantitative or qualitative limits for traders
and personnel able to commit the capital of the swap dealer or major
swap participant;
(4) Monitor each trader throughout the trading day to prevent the
trader from exceeding any limit to which the trader is subject, or from
otherwise incurring unauthorized risk;
(5) Require each trader to follow established policies and
procedures for executing and confirming all transactions;
(6) Establish means to detect unauthorized trading activities or
any other violation of policies and procedures;
(7) Ensure that all trade discrepancies are documented and, other
than immaterial, clerical errors, are brought to the immediate
attention of management of the business trading unit;
(8) Ensure that broker statements and payments to brokers are
periodically audited by persons independent of the business trading
unit;
(9) Ensure that use of trading programs is subject to policies and
procedures governing the use, supervision, maintenance, testing, and
inspection of the program; and
(10) Require the separation of personnel in the business trading
unit from personnel in the risk management unit.
(e) Review and testing. (1) Risk Management Programs shall be
reviewed and tested on at least an annual basis, or upon any material
change in the business of the swap dealer or major swap participant
that is reasonably likely to alter the risk profile of the swap dealer
or major swap participant.
(2) The annual reviews of the Risk Management Program shall include
an analysis of adherence to, and the effectiveness of, the risk
management policies and procedures, and any recommendations for
modifications to the Risk Management Program. The annual testing shall
be performed by qualified internal audit staff that are independent of
the business trading unit being audited or by a qualified third party
audit service reporting to staff that are independent of the business
trading unit. The results of the quarterly reviews of the Risk
Management Program shall be promptly reported to and reviewed by, the
chief compliance officer, senior management, and governing body of the
swap dealer or major swap participant.
(3) Each swap dealer and major swap participant shall document all
internal and external reviews and testing of its Risk Management
Program and written risk management policies and procedures including
the date of the review or test; the results; any deficiencies
identified; the corrective action taken; and the date that corrective
action was taken. Such documentation shall be provided to Commission
staff, upon request.
(f) Distribution of risk management policies and procedures. The
Risk Management Program shall include procedures for the timely
distribution of its written risk management policies and procedures to
relevant supervisory personnel. Each swap dealer and major swap
participant shall maintain records of the persons to whom the risk
management policies and procedures were distributed and when they were
distributed.
(g) Recordkeeping. (1) Each swap dealer and major swap participant
shall maintain copies of all written approvals required by this
section.
(2) All records or reports that a swap dealer or major swap
participant is required to maintain pursuant to this regulation shall
be maintained in accordance with Commission Regulation Sec. 1.31 and
shall be made available promptly upon request to representatives of the
Commission and to representatives of applicable prudential regulators.
Sec. 23.601 Monitoring of position limits.
(a) Each swap dealer and major swap participant shall establish and
enforce written policies and procedures that are reasonably designed to
monitor for and prevent violations of applicable position limits
established by the Commission, a designated contract market, or a swap
execution facility, and to monitor for and prevent improper reliance
upon any exemptions or exclusions from such position limits. For
purposes of this regulation, such policies and procedures shall be
referred to as ``Position Limit Procedures.'' The Position Limit
Procedures shall be incorporated into
[[Page 20208]]
the Risk Management Program of the swap dealer or major swap
participant.
(b) For purposes of the Position Limit Procedures, each swap dealer
and major swap participant shall convert all swap positions into
equivalent futures positions using the methodology set forth in
Commission regulations.
(c) Each swap dealer and major swap participant shall provide
training to all relevant personnel on applicable position limits on an
annual basis and shall promptly notify personnel upon any change to
applicable position limits. Each swap dealer and major swap participant
shall maintain records of such training and notifications including the
substance of the training, the identity of those receiving training,
and the identity of those notified of changes to applicable position
limits.
(d) Each swap dealer and major swap participant shall diligently
monitor its trading activities and diligently supervise the actions of
its partners, officers, employees, and agents to ensure compliance with
the Position Limit Procedures of the swap dealer or major swap
participant.
(e) The Position Limit Procedures of each swap dealer and major
swap participant shall implement an early warning system designed to
detect and alert its senior management when position limits are in
danger of being breached (such as when trading has reached a percentage
threshold of the applicable position limit, and when position limits
have been exceeded). Any detected violation of applicable position
limits shall be reported promptly to the firm's governing body. Any
detected violation of applicable position limits, other than on-
exchange violations reported to the Commission by a designated contract
market or a swap execution facility, shall be reported promptly to the
Commission. Each swap dealer and major swap participant shall maintain
a record of any early warning received, any position limit violation
detected, any action taken as a result of either, and the date action
was taken.
(f) Each swap dealer and major swap participant that transacts in
instruments for which position limits have been established by the
Commission, a designated contract market, or a swap execution facility
shall test its Position Limit Procedures for adequacy and effectiveness
at least once each calendar quarter and maintain records of such tests;
the results thereof; any action that is taken as a result thereof
including, without limitation, any recommendations for modifications to
the firm's Position Limit Procedures; and the date action was taken.
(g) Each swap dealer and major swap participant shall document its
compliance with applicable position limits established by the
Commission, a designated contract market, or a swap execution facility
in a written report on a quarterly basis. Such report shall be promptly
reported to and reviewed by the chief compliance officer, senior
management, and governing body of the swap dealer or major swap
participant, and shall include, without limitation, a list of all early
warnings received, all position limit violations, the action taken in
response, the results of the quarterly position limit testing required
by this regulation, any deficiencies in the Position Limit Procedures,
the status of any pending amendments to the Position Limit Procedures,
and any action taken to amend the Position Limit Procedures to ensure
compliance with all applicable position limits. Each swap dealer and
major swap participant shall retain a copy of this report.
(h) On an annual basis, each swap dealer and major swap participant
shall audit its Position Limit Procedures as part of the audit of its
Risk Management Program required by Commission regulations.
(i) All records required to be maintained pursuant to these
regulations shall be maintained in accordance with Commission
Regulation Sec. 1.31 and shall be made available promptly upon request
to representatives of the Commission and to representatives of
applicable prudential regulators.
Sec. 23.602 Diligent supervision.
(a) Supervision. Each swap dealer and major swap participant shall
establish and maintain a system to supervise, and shall diligently
supervise, all activities relating to its business performed by its
partners, members, officers, employees, and agents (or persons
occupying a similar status or performing a similar function). Such
system shall be reasonably designed to achieve compliance with the
requirements of the Commodity Exchange Act and Commission regulations.
(b) Supervisory System. Such supervisory system shall provide, at a
minimum, for the following:
(1) The designation, where applicable, of at least one person with
authority to carry out the supervisory responsibilities of the swap
dealer or major swap participant for all activities relating to its
business as a swap dealer or major swap participant.
(2) The use of reasonable efforts to determine that all supervisors
are qualified and meet such standards of training, experience,
competence, and such other qualification standards as the Commission
finds necessary or appropriate.
Sec. 23.603 Business continuity and disaster recovery.
(a) Business continuity and disaster recovery plan required. Each
swap dealer and major swap participant shall establish and maintain a
written business continuity and disaster recovery plan that outlines
the procedures to be followed in the event of an emergency or other
disruption of its normal business activities. The business continuity
and disaster recovery plan shall be designed to enable the swap dealer
or major swap participant to continue or to resume any operations by
the next business day with minimal disturbance to its counterparties
and the market, and to recover all documentation and data required to
be maintained by applicable law and regulation.
(b) Essential components. The business continuity and disaster
recovery plan of a swap dealer or major swap participant shall include
the following components:
(1) Identification of the documents, data, facilities,
infrastructure, personnel and competencies essential to the continued
operations of the swap dealer or major swap participant and to fulfill
the obligations of the swap dealer or major swap participant.
(2) Identification of the supervisory personnel responsible for
implementing each aspect of the business continuity and disaster
recovery plan and the emergency contacts required to be provided
pursuant to this regulation.
(3) A plan to communicate with the following persons in the event
of an emergency or other disruption, to the extent applicable to the
operations of the swap dealer or major swap participant: employees;
counterparties; swap data repositories; execution facilities; trading
facilities; clearing facilities; regulatory authorities; data,
communications and infrastructure providers and other vendors; disaster
recovery specialists and other persons essential to the recovery of
documentation and data, the resumption of operations, and compliance
with the Commodity Exchange Act and Commission regulations.
(4) Procedures for, and the maintenance of, back-up facilities,
systems, infrastructure, alternative staffing and other resources to
achieve the timely recovery of data and documentation and to resume
operations as soon as reasonably
[[Page 20209]]
possible and generally within the next business day.
(5) Maintenance of back-up facilities, systems, infrastructure and
alternative staffing arrangements in one or more areas that are
geographically separate from the swap dealer's or major swap
participant's primary facilities, systems, infrastructure and personnel
(which may include contractual arrangements for the use of facilities,
systems and infrastructure provided by third parties).
(6) Back-up or copying, with sufficient frequency, of documents and
data essential to the operations of the swap dealer or major swap
participant or to fulfill the regulatory obligations of the swap dealer
or major swap participant and storing the information off-site in
either hard-copy or electronic format.
(7) Identification of potential business interruptions encountered
by third parties that are necessary to the continued operations of the
swap dealer or major swap participant and a plan to minimize the impact
of such disruptions.
(c) Distribution to employees. Each swap dealer and major swap
participant shall distribute a copy of its business continuity and
disaster recovery plan to relevant employees and promptly provide any
significant revision thereto. Each swap dealer and major swap
participant shall maintain copies of the business continuity and
disaster recovery plan at one or more accessible off-site locations.
Each swap dealer and major swap participant shall train relevant
employees on applicable components of the business continuity and
disaster recovery plan.
(d) Commission notification. Each swap dealer and major swap
participant shall promptly notify the Commission of any emergency or
other disruption that may affect the ability of the swap dealer or
major swap participant to fulfill its regulatory obligations or would
have a significant adverse effect on the swap dealer or major swap
participant, its counterparties, or the market.
(e) Emergency contacts. Each swap dealer and major swap participant
shall provide to the Commission the name and contact information of two
employees who the Commission can contact in the event of an emergency
or other disruption. The individuals identified shall be authorized to
make key decisions on behalf of the swap dealer or major swap
participant and have knowledge of the firm's business continuity and
disaster recovery plan. The swap dealer or major swap participant shall
provide the Commission with any updates to this information promptly.
(f) Review and modification. A member of the senior management of
each swap dealer and major swap participant shall review the business
continuity and disaster recovery plan annually or upon any material
change to the business. Any deficiencies found or corrective action
taken shall be documented.
(g) Testing and audit. Each business continuity and disaster
recovery plan shall be tested annually by qualified, independent
internal personnel or a qualified third party service. The date the
testing was performed shall be documented, together with the nature and
scope of the testing, any deficiencies found, any corrective action
taken, and the date that corrective action was taken. Each business
continuity and disaster recovery plan shall be audited at least once
every three years by a qualified third party service. The date the
audit was performed shall be documented, together with the nature and
scope of the audit, any deficiencies found, any corrective action
taken, and the date that corrective action was taken.
(h) Business continuity and disaster recovery plans required by
other regulatory authorities. A swap dealer or major swap participant
shall comply with the requirements of this regulation in addition to
any business continuity and disaster recovery requirements that are
imposed upon the swap dealer or major swap participant by its
prudential regulator or any other regulatory or self-regulatory
authority.
(i) Recordkeeping. The business continuity and disaster recovery
plan of the swap dealer and major swap participant and all other
records required to be maintained pursuant to this section shall be
maintained in accordance with Commission Regulation Sec. 1.31 and
shall be made available promptly upon request to representatives of the
Commission and to representatives of applicable prudential regulators.
Sec. 23.604 [Reserved]
Sec. 23.605 Conflicts of interest policies and procedures.
(a) Definitions. For purposes of this section, the following terms
shall be defined as provided.
(1) Affiliate. This term means, with respect to any person, a
person controlling, controlled by, or under common control with, such
person.
(2) Business trading unit. This term means any department,
division, group, or personnel of a swap dealer or major swap
participant or any of its affiliates, whether or not identified as
such, that performs, or personnel exercising direct supervisory
authority over the performance of, any pricing (excluding price
verification for risk management purposes), trading, sales, marketing,
advertising, solicitation, structuring, or brokerage activities on
behalf of a swap dealer or major swap participant or any of its
affiliates.
(3) Clearing unit. This term means any department, division, group,
or personnel of a swap dealer or major swap participant or any of its
affiliates, whether or not identified as such, that performs, or
personnel exercising direct supervisory authority over the performance
of, any proprietary or customer clearing activities on behalf of a swap
dealer or major swap participant or any of its affiliates.
(4) Derivative. This term means:
(i) A contract for the purchase or sale of a commodity for future
delivery;
(ii) A security futures product;
(iii) A swap;
(iv) Any agreement, contract, or transaction described in section
2(c)(2)(C)(i) or section 2(c)(2)(D)(i) of the Act;
(v) Any commodity option authorized under section 4c of the Act;
and
(vi) Any leverage transaction authorized under section 19 of the
Act.
(5) Non-research personnel. This term means any employee of the
business trading unit or clearing unit, or any other employee of the
swap dealer or major swap participant, other than an employee
performing a legal or compliance function, who is not directly
responsible for, or otherwise not involved in, research or analysis
intended for inclusion in a research report.
(6) Public appearance. This term means any participation in a
conference call, seminar, forum (including an interactive electronic
forum) or other public speaking activity before 15 or more persons
(individuals or entities), or interview or appearance before one or
more representatives of the media, radio, television or print media, or
the writing of a print media article, in which a research analyst makes
a recommendation or offers an opinion concerning a derivatives
transaction. This term does not include a password-protected Webcast,
conference call or similar event with 15 or more existing customers,
provided that all of the event participants previously received the
most current research report or other documentation that contains the
required applicable disclosures, and that the research analyst
appearing at the event corrects and updates during the public
appearance any disclosures in the research report that are
[[Page 20210]]
inaccurate, misleading, or no longer applicable.
(7) Research analyst. This term means the employee of a swap dealer
or major swap participant who is primarily responsible for, and any
employee who reports directly or indirectly to such research analyst in
connection with, preparation of the substance of a research report
relating to any derivative, whether or not any such person has the job
title of ``research analyst.''
(8) Research department. This term means any department or division
that is principally responsible for preparing the substance of a
research report relating to any derivative on behalf of a swap dealer
or major swap participant, including a department or division contained
in an affiliate of a swap dealer or major swap participant.
(9) Research report. This term means any written communication
(including electronic) that includes an analysis of the price or market
for any derivative, and that provides information reasonably sufficient
upon which to base a decision to enter into a derivatives transaction.
This term does not include:
(i) Communications distributed to fewer than 15 persons;
(ii) Commentaries on economic, political, or market conditions;
(iii) Statistical summaries of multiple companies' financial data,
including listings of current ratings;
(iv) Periodic reports or other communications prepared for
investment company shareholders or commodity pool participants that
discuss individual derivatives positions in the context of a fund's
past performance or the basis for previously-made discretionary
decisions;
(v) Any communications generated by an employee of the business
trading unit that is conveyed as a solicitation for entering into a
derivatives transaction, and is conspicuously identified as such; and
(vi) Internal communications that are not given to current or
prospective customers.
(b) Policies and procedures. Each swap dealer and major swap
participant subject to this rule must adopt and implement written
policies and procedures reasonably designed to ensure that the swap
dealer or major swap participant and its employees comply with the
provisions of this rule.
(c) Research analysts and research reports. (1) Restrictions on
relationship with research department. (i) Non-research personnel shall
not direct a research analyst's decision to publish a research report
of the swap dealer or major swap participant, and non-research
personnel shall not direct the views and opinions expressed in a
research report of the swap dealer or major swap participant.
(ii) No research analyst may be subject to the supervision or
control of any employee of the swap dealer's or major swap
participant's business trading unit or clearing unit, and no employee
of the business trading unit or clearing unit may have any influence or
control over the evaluation or compensation of a research analyst.
(iii) Except as provided in paragraph (c)(1)(iv) of this section,
non-research personnel, other than the board of directors and any
committee thereof, shall not review or approve a research report of the
swap dealer or major swap participant before its publication.
(iv) Non-research personnel may review a research report before its
publication as necessary only to verify the factual accuracy of
information in the research report, to provide for non-substantive
editing, to format the layout or style of the research report, or to
identify any potential conflicts of interest, provided that:
(A) Any written communication between non-research personnel and
research department personnel concerning the content of a research
report must be made either through authorized legal or compliance
personnel of the swap dealer or major swap participant or in a
transmission copied to such personnel; and
(B) Any oral communication between non-research personnel and
research department personnel concerning the content of a research
report must be documented and made either through authorized legal or
compliance personnel acting as an intermediary or in a conversation
conducted in the presence of such personnel.
(2) Restrictions on communications. Any written or oral
communication by a research analyst to a current or prospective
counterparty relating to any derivative must not omit any material fact
or qualification that would cause the communication to be misleading to
a reasonable person.
(3) Restrictions on research analyst compensation. A swap dealer or
major swap participant may not consider as a factor in reviewing or
approving a research analyst's compensation his or her contributions to
the swap dealer's or major swap participant's trading or clearing
business. Except for communicating client or customer feedback,
ratings, and other indicators of research analyst performance to
research department management, no employee of the business trading
unit or clearing unit of the swap dealer or major swap participant may
influence the review or approval of a research analyst's compensation.
(4) Prohibition of promise of favorable research. No swap dealer or
major swap participant may directly or indirectly offer favorable
research, or threaten to change research, to an existing or prospective
counterparty as consideration or inducement for the receipt of business
or compensation.
(5) Disclosure requirements. (i) Ownership and material conflicts
of interest. A swap dealer or major swap participant must disclose in
research reports and a research analyst must disclose in public
appearances:
(A) Whether the research analyst maintains a financial interest in
any derivative of a type, class, or, category that the research analyst
follows, and the general nature of the financial interest; and
(B) Any other actual, material conflicts of interest of the
research analyst or swap dealer or major swap participant of which the
research analyst has knowledge at the time of publication of the
research report or at the time of the public appearance.
(ii) Prominence of disclosure. Disclosures and references to
disclosures must be clear, comprehensive, and prominent. With respect
to public appearances by research analysts, the disclosures required by
this paragraph (c)(5) must be conspicuous.
(iii) Records of public appearances. Each swap dealer and major
swap participant must maintain records of public appearances by
research analysts sufficient to demonstrate compliance by those
research analysts with the applicable disclosure requirements under
this paragraph (c)(5).
(iv) Third-party research reports. (A) For the purposes of this
paragraph (c)(5)(iv), ``independent third-party research report'' shall
mean a research report, in respect of which the person or entity
producing the report:
(1) Has no affiliation or business or contractual relationship with
the distributing swap dealer or major swap participant, or that swap
dealer's or major swap participant's affiliates, that is reasonably
likely to inform the content of its research reports; and
(2) Makes content determinations without any input from the
distributing swap dealer or major swap participant or that swap
dealer's or major swap participant's affiliates.
(B) Subject to paragraph (c)(5)(iv)(C) of this section, if a swap
dealer or major swap participant distributes or makes available any
independent third-party
[[Page 20211]]
research report, the swap dealer or major swap participant must
accompany the research report with, or provide a Web address that
directs the recipient to, the current applicable disclosures, as they
pertain to the swap dealer or major swap participant, required by this
section. Each swap dealer and major swap participant must establish
written policies and procedures reasonably designed to ensure the
completeness and accuracy of all applicable disclosures.
(C) The requirements of paragraph (c)(5)(iv)(B) of this section
shall not apply to independent third-party research reports made
available by a swap dealer or major swap participant to its customers:
(1) Upon request; or
(2) Through a Web site maintained by the swap dealer or major swap
participant.
(6) Prohibition of retaliation against research analysts. No swap
dealer or major swap participant, and no employee of a swap dealer or
major swap participant who is involved with the swap dealer's or major
swap participant's pricing, trading, or clearing activities, may,
directly or indirectly, retaliate against or threaten to retaliate
against any research analyst employed by the swap dealer or major swap
participant or its affiliates as a result of an adverse, negative, or
otherwise unfavorable research report or public appearance written or
made, in good faith, by the research analyst that may adversely affect
the swap dealer's or major swap participant's present or prospective
pricing, trading, or clearing activities.
(d) Clearing activities. (1) No swap dealer or major swap
participant shall directly or indirectly interfere with or attempt to
influence the decision of the clearing unit of any affiliated clearing
member of a derivatives clearing organization to provide clearing
services and activities to a particular customer, including but not
limited to a decision relating to the following:
(i) Whether to offer clearing services and activities to a
particular customer;
(ii) Whether to accept a particular customer for the purposes of
clearing derivatives;
(iii) Whether to submit a customer's transaction to a particular
derivatives clearing organization;
(iv) Whether to set or adjust risk tolerance levels for a
particular customer;
(v) Whether to accept certain forms of collateral from a particular
customer; or
(vi) Whether to set a particular customer's fees for clearing
services based upon criteria that are not generally available and
applicable to other customers of the swap dealer or major swap
participant.
(2) Each swap dealer and major swap participant shall create and
maintain an appropriate informational partition, as specified in
section 4s(j)(5)(A) of the Act, between business trading units of the
swap dealer or major swap participant and clearing units of any
affiliated clearing member of a derivatives clearing organization to
reasonably ensure compliance with the Act and the prohibitions
specified in paragraph (d)(1) of this section. At a minimum, such
informational partitions shall require that no employee of a business
trading unit of a swap dealer or major swap participant shall
supervise, control, or influence any employee of the clearing unit of
any affiliated clearing member of a derivatives clearing organization.
(e) Undue influence on counterparties. Each swap dealer and major
swap participant must adopt and implement written policies and
procedures that mandate the disclosure to its counterparties of any
material incentives and any material conflicts of interest regarding
the decision of a counterparty:
(1) Whether to execute a derivative on a swap execution facility or
designated contract market; or
(2) Whether to clear a derivative through a derivatives clearing
organization.
(f) All records that a swap dealer or major swap participant is
required to maintain pursuant to this regulation shall be maintained in
accordance with Commission Regulation Sec. 1.31 and shall be made
available promptly upon request to representatives of the Commission
and to representatives of the applicable prudential regulator, as
defined in 7 U.S.C. 1a(39).
Sec. 23.606 General information: availability for disclosure and
inspection.
(a) Disclosure of information. (1) Each swap dealer and major swap
participant shall make available for disclosure to and inspection by
the Commission and its prudential regulator, as applicable, all
information required by, or related to, the Commodity Exchange Act and
Commission regulations, including:
(i) The terms and condition of its swaps;
(ii) Its swaps trading operations, mechanisms, and practices;
(iii) Financial integrity and risk management protections relating
to swaps; and
(iv) Any other information relevant to its trading in swaps.
(2) Such information shall be made available promptly, upon
request, to Commission staff and the staff of the applicable prudential
regulator, at such frequency and in such manner as is set forth in the
Commodity Exchange Act, Commission regulations, or the regulations of
the applicable prudential regulator.
(b) Ability to provide information. (1) Each swap dealer and major
swap participant shall establish and maintain reliable internal data
capture, processing, storage, and other operational systems sufficient
to capture, process, record, store, and produce all information
necessary to satisfy its duties under the Commodity Exchange Act and
Commission regulations. Such systems shall be designed to produce the
information within the time frames set forth in the Commodity Exchange
Act and Commission regulations or upon request, as applicable.
(2) Each swap dealer and major swap participant shall establish,
implement, maintain, and enforce written procedures for the capture,
processing, recording, storage, and production of all information
necessary to satisfy its duties under the Commodity Exchange Act and
Commission regulations.
(c) Record retention. All records or reports that a swap dealer or
major swap participant is required to maintain pursuant to this
regulation shall be maintained in accordance with Commission Regulation
Sec. 1.31 and shall be made available promptly upon request to
representatives of the Commission and to representatives of applicable
prudential regulators.
Sec. 23.607 Antitrust considerations.
(a) No swap dealer or major swap participant shall adopt any
process or take any action that results in any unreasonable restraint
of trade, or impose any material anticompetitive burden on trading or
clearing, unless necessary or appropriate to achieve the purposes of
the Commodity Exchange Act.
(b) Consistent with its obligations under paragraph (a) of this
section, each swap dealer and major swap participant shall adopt
policies and procedures to prevent actions that result in unreasonable
restraint of trade, or impose any material anticompetitive burden on
trading or clearing.
Issued in Washington, DC, on February 23, 2012, by the
Commission.
David A. Stawick,
Secretary of the Commission.
Note: The following appendices will not appear in the Code of
Federal Regulations:
[[Page 20212]]
Appendices to Swap Dealer and Major Swap Participant Recordkeeping and
Reporting, Duties, and Conflicts of Interest Policies and Procedures;
Futures Commission Merchant and Introducing Broker Conflicts of
Interest Policies and Procedures; Swap Dealer, Major Swap Participant,
and Futures Commission Merchant Chief Compliance Officer--Commission
Voting Summary and Statements of Commissioners
Appendix 1--Commission Voting Summary
On this matter, Chairman Gensler and Commissioners Chilton and
Wetjen voted in the affirmative; Commissioners Sommers and O'Malia
voted in the negative.
Appendix 2--Statement of Chairman Gary Gensler
I support the internal business conduct rule, which will lower
the risk that swap dealers pose to the rest of the economy. These
rules are the result of a critical reform in the Dodd-Frank Wall
Street reform and Consumer Protection Act (Dodd-Frank Act) where
Congress gave the Commodity Futures Trading Commission (CFTC)
authority to write rules overseeing swap dealer business conduct.
This rule is a collection of five CFTC proposals in four key areas.
First, the final rule establishes a number of duties for swap
dealers (SDs) and major swap participants (MSPs), including a risk
management program with policies and procedures to monitor and
manage the risks associated with their swap activities. Among the
requirements are: (a) Ensuring the risk management program takes
into account market risk, credit risk, liquidity risk, foreign
currency risk, legal risk, operational risk, settlement risk, and
risk posed by traders; (b) establishing a system of diligent
supervision by qualified personnel over the SD and MSP activities;
and (c) ensuring risk management issues are elevated within
management.
Second, the final rule establishes firewalls to protect against
conflicts of interest that can arise between trading and research
units of SDs, MSPs, futures commission merchants (FCMs), and
introducing brokers. In addition, the rules establish a firewall
between clearing and trading that will protect against conflicts of
interest relating to a firm's clearing activities. A 2009 Commission
study on harmonization between the Securities and Exchange
Commission and the CFTC recommended that the Commission establish
these firewalls, which are based upon similar protections in the
securities markets.
Third, the final rule establishes the reporting, recordkeeping
and daily trading requirements for SDs and MSPs. Importantly, this
section creates an audit trail detailing the full history of trades
so the SD or MSP can better ensure compliance internally, and, when
appropriate, the CFTC can be a more effective cop on the beat.
Fourth, the final rule establishes requirements for the
designation of a chief compliance officer of SDs, MSPs and FCMs.
This compliance officer will ensure that the firm's policies and
procedures comply with the CEA and Commission regulations. The
officer will prepare an annual report describing the registrant's
compliance with its own policies, as well as CEA and Commission
regulations.
Appendix 3--Statement of Commissioner Scott O'Malia
The latest issue of The Economist features an article titled
``Over-regulated America'' \198\ that features as its archetype for
excessive and badly-written regulation our own Dodd-Frank Act. The
problem, the article points out, is that rules that sound reasonable
on their own may impose a huge collective burden due, in part, to
their complexity. Part of the problem is that we, as The Economist
points out, are under the impression that we can anticipate and
regulate for every eventuality. In our hubris, The Economist warns,
our overreaching tends to defeat our good intentions and creates
loopholes and perhaps unintentional safe-harbors, leaving our rules
ineffectual and subject to abuse. The solution The Economist offers
isn't so unfamiliar, at least to this Commissioner. It is rather
simple. It is just that: Rules need to be simple. Echoing President
Obama's 2011 Executive Order 13563 ``Improving Regulation and
Regulatory Review'' \199\ (which applies equally to independent
Federal agencies such as the Commodity Futures Trading Commission
(the ``Commission'' or ``CFTC'') per a subsequent Executive Order
\200\), The Economist advises that we ought to cut out the verbiage
and focus on writing rules that articulate broad goals and prescribe
only what is strictly necessary to achieve them.
---------------------------------------------------------------------------
\198\ Over-regulated America, Economist, Feb. 18, 2012, at 9.
\199\ Exec. Order No. 13,563, 76 FR 3821 (Jan. 21, 2011).
\200\ Exec. Order No. 13,579, 76 FR 41,587 (July 14, 2011).
---------------------------------------------------------------------------
In my own words, in several prior statements, I have argued that
we must ensure that regulations are accessible, consistent, written
in plain language, guided by empirical data, and are easily
understood. I cautioned that, with each piecemeal rulemaking, we
risk creating redundancies and inconsistencies that result in
costs--both opportunity costs and economic costs--without
corresponding benefits. Consistent with Executive Order 13563, which
reaffirms prior guidance on the subject of regulatory review issued
in the 1993 Executive Order 12866 \201\ as well as Office of
Management and Budget (``OMB'') guidance to Federal agencies with
respect to said Executive Order,\202\ agencies like the CFTC must go
out of their way to ensure responsible rulemaking by, among other
things, undertaking thorough cost-benefit analyses, both
qualitatively and quantitatively, to ensure that new rules do not
impose unreasonable costs.
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\201\ Exec. Order No. 12,866, 58 FR 51,735 (Oct. 4, 1993).
\202\ OMB Circular A-4, available at http://www.whitehouse.gov/sites/default/files/omb/assets/regulatory_matters_pdf/a-4.pdf.
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I accepted wholeheartedly the mission put upon this
administration by the President to ``[T]o root out regulations that
conflict, that are not worth the cost, or that are just plain
dumb.'' \203\ Today, in furtherance of that mission, I will not
support the final rules governing various internal business conduct
standards for futures commission merchants, introducing brokers,
swap dealers and major swaps participants (the ``Internal Business
Conduct Rules''). These rules fail to articulate necessary and clear
performance objectives, are needlessly complex, and create a
collective burden without the benefit of even an appropriate
baseline cost-benefit analysis. The fact that OMB's Office of
Information and Regulatory Affairs \204\ has concurred \205\ with
our determination that this set of rules qualifies as a ``Major
Rule'' under the Congressional Review Act with an annual effect on
the economy of more than $100 million without a fulsome discussion
of anticipated costs, let alone an analysis based on reasoned
assumptions or evaluation of the impacts of this rulemaking against
the pre-statutory baseline, is regulatory malpractice in my book.
While we set the bar low here at the Commission for our cost-benefit
analyses, and accept what is ``reasonably feasible,'' this
rulemaking is nothing but unreasonably feeble.
---------------------------------------------------------------------------
\203\ Barack Obama, Toward a 21st-Century Regulatory System,
Wall St. J., Jan. 18, 2011, at A17.
\204\ The Office of Information and Regulatory Affairs
(``OIRA''), among other things, reviews draft regulations under
Executive Order 12866. See Office of Information and Regulatory
Affairs (``OIRA'') Q & As, available at: http://www.whitehouse.gov/omb/OIRA_QsandAs.
\205\ I use this term loosely since the only verification we
received at the Commission was a perfunctory email from an OMB
employee stating, ``OMB concurs that the rule is major.'' It is
unclear as to what data OMB could have relied upon in reaching its
conclusion.
---------------------------------------------------------------------------
After reviewing the Internal Business Conduct Rules, I have
reached a tipping point and can no longer tolerate the application
of such weak standards to analyzing the costs and benefits of our
rulemakings. Our inability to develop a quantitative analysis, or to
develop a reasonable comparative analysis of legitimate options,
hurts the credibility of this Commission and undermines the quality
of our rules. I believe it is time for professional help, and I will
be following up this statement with a letter to the Director of the
OMB seeking an independent review of the Internal Business Conduct
Rules to determine whether or not this rulemaking fully complies
with the President's Executive Orders and the OMB guidance found in
OMB Circular A-4. To the extent that OMB finds any concerns with the
Commission's economic analysis, I hope that it will provide specific
recommendations as to how the Commission can improve its cost-
benefit analysis and analytical capabilities.
Lest anyone think that I am inadvertently waiving a work-product
or other privilege, the Commission's May 13, 2011 internal Staff
Guidance on Cost-Benefit Considerations for Final Rulemakings under
the Dodd-Frank Act (``Staff Guidance'') was made public as Exhibit 2
to the CFTC's Office of Inspector General's June 13, 2011 Review of
Cost-Benefit Analyses Performed by the CFTC in
[[Page 20213]]
Connection with Rulemakings Undertaken Pursuant to the Dodd-Frank
Act, which is available on the CFTC's Web site.\206\ While it is not
my intent to walk you through the Staff Guidance (or the Inspector
General's report for that matter), I do think it warrants attention
for the inattention it gives to both the principles of Executive
Orders 13563 and 12866 and OMB guidance found in Circular A-4 (``OMB
Circular A-4''). More specifically, and among other things, the
Staff Guidance provides that each rulemaking team should,
``incorporate the principles of Executive Order 13563 to the extent
they are consistent with section 15(a) [of the Commodity Exchange
Act] and it is reasonably feasible to do so.'' Keep in mind that
while Section 15(a) of the Commodity Exchange Act requires the CFTC
to consider the costs and benefits of its proposed regulations, the
Commission has interpreted the language of section 15(a) to neither
require quantification of such costs and benefits, nor to require
the agency to determine whether the benefits exceed costs or whether
the proposed rules are the most cost-effective means of reaching
goals.\207\ ``Rather, section 15 simply requires the Commission to
`consider the costs and benefits' of its action.'' \208\ That was a
direct quote from the Federal Register.
---------------------------------------------------------------------------
\206\ Office of the Inspector General of the Commodity Futures
Trading Commission, A Review of Cost-Benefit Analyses performed by
the Commodity Futures Trading Commission in Connection with
Rulemakings Undertaken Pursuant to the Dodd-Frank Act, June 13,
2011, available at: www.cftc.gov/ucm/groups/public/@aboutcftc/documents/file/oig_investigation_061311.pdf.
\207\ A New Regulatory Framework for Trading Facilities,
Intermediaries and Clearing Organizations, 66 FR 14,262, 14,267
(March 9, 2001).
\208\ Id.
---------------------------------------------------------------------------
Further, under the Staff Guidance--and clearly consistent with
the Commission's interpretation of section 15--rulemaking teams need
only quantify costs and benefits ``to the extent it is reasonably
feasible and appropriate to address comments received.'' As
additional guidance, staff is advised that ``reasonably feasible and
appropriate'' means ``the extent to which (i) certain analyses,
quantitative or qualitative, is [sic] needed to address comments
received (``appropriate'') and (ii) whether such an analysis may be
performed with available resources (``reasonably feasible'').
Accordingly, our interpretation of our duties pursuant to section
15(a) and Staff Guidance provides that we need not quantify the
costs or benefits of our rules unless we need to do so in order to
respond to comments, and that we can do so with whatever resources
are immediately at our fingertips. As for the Executive Orders, it
appears that we will incorporate their principles only when they
neatly align with our own interpretation of section 15(a), and only
when we can do so without utilizing the resources immediately within
our coffers.
Setting the bar this low is pretty remarkable. Indeed, former
Commissioner and Acting Chairman William P. Albrecht recently
remarked that expecting any detailed cost-benefit analysis of the
proposed Dodd-Frank rules is impossible in part because, ``[T]he
CFTC has never had to develop CBA expertise.'' \209\ Commissioner
Albrecht advised that, ``A good starting point might be to require
more detailed analysis of the costs of alternative means of
accomplishing a particular goal. This would help the agency develop
CBA expertise and should, over time, lead to a deeper understanding
of the costs of regulation.'' \210\
---------------------------------------------------------------------------
\209\ William P. Albrecht, Cost Benefit Analysis and the
Commodity Futures Trading Commission (``CFTC''), Discussion Paper,
May 2011, available at http://www.rff.org/RFF/Documents/RFF-DP-11-24.pdf.
\210\ Id. at 9.
---------------------------------------------------------------------------
I believe that Commissioner Albrecht's advice is already well-
articulated in both Executive Orders and OMB Circular A-4 as
incorporated directly into the Staff Guidance. However, the
Commission skirts these requirements and apparently refuses to
develop expertise. Instead, the Commission limits itself to
responding to comments, but only when it doesn't require any
analysis beyond that which it did for the proposal.
Additionally, as in today's final rulemaking, the Commission has
determined, in contradiction of OMB guidance directly on point, that
in setting the baseline for comparison of the costs and benefits of
regulatory alternatives, it may set the ``baseline'' to incorporate
the costs of statutorily mandated rulemakings, regardless of how the
CFTC has interpreted the statutory goals and regardless of the
existence of alternative means to comply with such goals. Thereby,
the Commission is relying on an arbitrary presumption that, ``To the
extent that * * * new regulations reflect the statutory requirements
of the Dodd-Frank Act, they will not create costs and benefits
beyond those resulting from Congress's statutory mandates in the
Dodd-Frank Act.'' \211\ What does this mean? Well, according to the
Commission in this rulemaking, it means that for commenters who
``posit that there is no benefit to be derived from internal
business conduct standards as mandated by Congress and that the
mandated provisions do not generate sufficient benefits relative to
costs or contribute to the purposes (e.g. mitigating systemic risk
and enhancing transparency) of the Dodd-Frank Act. * * * these
commenters' concerns fall outside the Commission's regulatory
discretion to implement sections 4s and 4d of the CEA and fail to
raise issues subject to consider[ation] under section 15(a).'' \212\
That is, the Commission will ignore comments related to required
rulemaking provisions that mirror statutory language in spite of the
fact that the Commission always has some level of discretion in
determining the means to achieve such mandates. Rather the
Commission will consider comments on new regulations ``that reflect
the Commission's own determinations regarding implementation of the
Dodd-Frank Act's provisions. * * * It is these other costs and
benefits * * * that the Commission considers with respect to the
section 15(a) factors.'' \213\ It is unacceptable that the
Commission ignores pre-Dodd-Frank reality and establishes its own
economic baseline for its rulemakings. This practice defies not only
common sense, but rigorous and competent economic analysis as well.
---------------------------------------------------------------------------
\211\ See Swap Dealer and Major Swap Participant Recordkeeping
and Reporting, Duties, and Conflicts of Interest Policies and
Procedures; Futures Commission Merchant and Introducing Broker
Conflicts of Interest Policies and Procedures; Swap Dealer, Major
Swap Participant, and Futures Commission Merchant Chief Compliance
Officer, Final Rule, at Section IV of the Preamble.
\212\ Id. at Section IV of the Cost Benefit Considerations, note
64.
\213\ Id. at Section IV of the Preamble.
---------------------------------------------------------------------------
I will briefly highlight how these rules not only fail to
include a rational, rigorous, and sustainable cost-benefit analysis,
but fail to articulate necessary and clear performance objectives,
are complex, and create an unjustifiable cumulative burden within
this rule and when considered with other CFTC regulations and those
of prudential regulators.
I believe the Commission has failed to carefully and precisely
identify a clear baseline against which the Commission measured
costs and benefits and the range of alternatives under consideration
in this rule. Specifically, the Commission's cost-benefit analysis
with regard to this rule fails to comply with the basic direction in
OMB Circular A-4 to establish an appropriate baseline that includes
an evaluation of the pre-statutory baseline in light of the range of
Commission discretion as to the manner in which the rules implement
the statutory goals of section 4s.\214\ The circular also directs
the Commission to consider alternatives available ``for the key
attributes or provisions of the rule.'' \215\ The Circular goes on
to recommend that, ``It is not adequate simply to report a
comparison of the agency's preferred option to the chosen baseline.
Whenever you report the benefits and the costs of alternative
options, you should present both total and incremental benefits and
costs.'' \216\ It is at this most basic level of analysis where the
Commission has failed to provide alternative options for
consideration or has failed to justify its choice of regulation with
a specific cost-benefit analysis.
---------------------------------------------------------------------------
\214\ OMB Circular A-4 at 15-16.
\215\ Id. at 16.
\216\ Id.
---------------------------------------------------------------------------
In two examples articulated by the Commission, the Internal
Business Conduct Rules dismisses out of hand, and without specific
justification the concerns raised by two commenters: (1) The Federal
Home Loan Banks who raised concerns regarding compliance burdens and
duplicative nature of regulations for comparably regulated entities;
and (2) The Working Group of Commercial Energy Firms, which raised
concerns that the rules failed to provide benefits with regard to
risk management and compliance that matched, much less exceeded, the
cost of compliance. Both concerns were dismissed without
consideration of alternatives and without any attempt to quantify
the cited costs.
With regard to recordkeeping requirements, the Internal Business
Conduct Rules impose a substantial burden on Swap
[[Page 20214]]
Dealers (``SDs'') and Major Swap Participants (``MSPs'') to maintain
extensive audio recordings including the requirement to tag each
taped conversation and make it searchable by transaction and
counterparty. Understandably, section 4s(g) does require the
maintenance of such daily trading records for each counterparty and
that they be identifiable with each swap transaction. However, in
spite of enormous technological challenges it is unclear as to
whether or not the Commission undertook any independent effort to
determine the technical challenges of implementing such a system,
including, whether such technology currently exists, the costs of
acquiring and installing such technology, and whether such a system
could be developed and/or installed within the timetable set by the
Commission. The Commission has failed the fundamental test in
Circular A-4 to establish an appropriate baseline and consider a
range of alternatives with associated costs and benefits. Although
the Commission modified its original proposal to not require each
telephone record to be kept as a single file, it fails to quantify
the specific cost of complying with a costly and technically
challenging mandate. Moreover, in determining that such audio
recordings are to be maintained for a one-year period, the
Commission provides no analytical support for this retention period
over a more reasonable six-month period other than to say that such
period will be ``most useful for the Commission's enforcement
purposes.'' \217\
---------------------------------------------------------------------------
\217\ See Swap Dealer and Major Swap Participant Recordkeeping
and Reporting, Duties, and Conflicts of Interest Policies and
Procedures; Futures Commission Merchant and Introducing Broker
Conflicts of Interest Policies and Procedures; Swap Dealer, Major
Swap Participant, and Futures Commission Merchant Chief Compliance
Officer, Final Rule, at Section IV of the Preamble.
---------------------------------------------------------------------------
Further, the Commission also ignored commenters' requests to
allow firms to rely on swap data repositories (``SDRs'') for
recordkeeping requirements. The analysis states:
The Commission considered this alternative to its recordkeeping
rules, but determined that it is premature at this time to permit
SDs and MSPs to rely solely on SDRs to meet their recordkeeping
obligations under the rules. * * * At present, SDRs are new entities
under the Dodd-Frank Act with no track record of operations; and,
for particular swap asset classes, SDRs have yet to be
established.\218\
---------------------------------------------------------------------------
\218\ Id.
---------------------------------------------------------------------------
In addition to finalizing rules governing registration
standards, duties and core principles for SDRs,\219\ the Commission
has already voted on the final rules that establish and compel the
reporting of swap transaction information to SDRs for purposes of
real-time public reporting (the ``Real-Time Reporting Rule'') and to
ensure that complete data concerning swaps is available to
regulators throughout the existence of each swap and for fifteen
years following termination.\220\ In addition, the track record of
entities that will likely be our first registered SDRs is considered
proven as data from these repositories in both rates and credit have
been used to establish the foundation for today's re-proposal of
Procedures to Establish Appropriate Minimum Block Sizes For Large
Notional Off-Facility Swaps and Block Trades; Further Measures to
Protect the Identities of Parties to Swap Transactions (the ``Block
Proposal'').
---------------------------------------------------------------------------
\219\ Swap Data Repositories: Registration Standards, Duties and
Core Principles, 76 FR 54,538 (Sept. 1, 2011) (to be codified at 17
CFR partart 49).
\220\ Real-Time Public Reporting of Swap Transaction Data, 76 FR
1,182 (Jan. 9, 2012) (to be codified at 17 CFR part 43); Swap Data
Recordkeeping and Reporting Requirements, 76 FR 2,136 (Jan. 13,
2012) (to be codified at 17 CFR partpart 45).
---------------------------------------------------------------------------
If the Commission truly has doubts as to the fidelity and
reliability SDR data, then it ought not to have relied upon it in a
proposed rulemaking. That being said, although the analysis seems to
indicate that the Commission considered alternatives, it is curious
as to how the Commission came to the conclusion that the Internal
Business Conduct Rules are cost-effective, given that they require
firms to keep duplicative and redundant trade records when all
trades must be reported to an SDR and stored by the SDR for the life
of the swap, plus an additional fifteen years--which is ten years
more than our rules require that such records be kept by
registrants.
I would also point out that the Real-Time Reporting Rule
provides that a party to a publicly-reportable swap transaction
satisfies its real-time reporting requirements by executing the swap
on or pursuant to the rules of an exchange or swap execution
facility.\221\ That is, SDs and MSPs, among others, may rely on
exchanges and swap execution facilities to report all on-exchange
trades; there is no mandated separate reporting requirement.
However, the Internal Business Conduct Rules undermine this relief
by requiring redundant recordkeeping and by mandating that SDs and
MSPs save all transaction records and by failing to trust our own
regulatory-creation to actually serve as a repository for all trade
data as envisioned by Dodd-Frank Act. I have serious concerns about
the Commission's ability to monitor and reconcile two sets of
records, which is the rationale put forth in this final rule.
---------------------------------------------------------------------------
\221\ Real-Time Public Reporting of Swap Transaction Data, 76 FR
1,182, 1,244 (Jan. 9, 2012) (to be codified at 17 CFR part 43).
---------------------------------------------------------------------------
Ironically, the SDRs were created in the Dodd-Frank Act to
facilitate market transparency and reporting. The Commission could
provide greater transparency into its own cost-benefit analysis by
disclosing its assumptions and data to support its conclusions. OMB
Circular A-4 outlines standards for transparency with the following
direction, ``A good analysis should be transparent and your results
must be reproducible. You should clearly set out the basic
assumptions, methods and data underlying the analysis and discuss
the uncertainties associated with your estimates.'' \222\ It goes on
to recommend that, ``To provide greater access to your analysis, you
should generally post it, with all the supporting documents, on the
internet so the public can review the findings.'' \223\ I presume
the Commission feels that this level of compliance is not
appropriate, given that the commenters failed to demand it, and is
simply not reasonably feasible.
---------------------------------------------------------------------------
\222\ OMB Circular A-4 at 17.
\223\ Id.
---------------------------------------------------------------------------
One of my major criticisms is that the Internal Business Conduct
Rules, and, in particular, section 23.600--Risk Management Program
for Swap Dealers and Major Swap Participants, attempt to cover every
possible contingency instead of articulating goals and performance
objectives. Section 4s(j)(2) simply requires that the SD or MSP
``establish robust and professional risk management systems adequate
for managing the day-to-day business of the swap dealer or major
swap participant.'' Could anyone truly argue that that provision
could not stand largely on its own as a performance objective? Did
the Commission need to specify to the nth degree the behavior and
manner of compliance that SDs and MSPs must adopt in order to meet
that objective? And in doing so, has the Commission created
loopholes and unintentional safe harbors for those who meet the
regulatory requirements, but still manage to violate other
provisions of the Commodity Exchange Act and regulations?
Another concern is that the Internal Business Conduct Rules do
not provide for substituted compliance with any of these
requirements for SDs and MSPs for which the CFTC is not their
prudential regulator. While one distinct part of the preamble
regarding rules pertaining to business continuity and disaster
recovery suggest that if an SD or MSP is subject to other rules that
meet the requirements of the Commission's rule, then such SD or MSP
would be in compliance with the Commission's rule, the rules
themselves do not evidence any attempts to coordinate our regulatory
requirements with those of our fellow prudential regulators through
the explicit provision for substituted compliance. More egregiously,
section 23.603(h)--Business Continuity and Disaster Recovery Plans
Required by Other Regulatory Authorities, specifically requires SDs
and MSPs to comply with the business continuity and disaster
recovery requirements of this regulation ``in addition to any
business continuity and disaster recovery requirements that are
imposed on the swap dealer or major swap participant by its
prudential regulator or any other regulatory or self-regulatory
authority.'' \224\ There is no quantification or qualification of
costs and benefits of this regulatory decision, and I am not
surprised.
---------------------------------------------------------------------------
\224\ Swap Dealer and Major Swap Participant Recordkeeping and
Reporting, Duties, and Conflicts of Interest Policies and
Procedures; Futures Commission Merchant and Introducing Broker
Conflicts of Interest Policies and Procedures; Swap Dealer, Major
Swap Participant, and Futures Commission Merchant Chief Compliance
Officer, Final Rule, at Sec. 23.603(h).
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I believe our reasonably ``feasible standard'' as articulated in
our own Staff Guidance has caused us to miss any marker for
identifying and using the best, most innovative and least burdensome
tools to meet the regulatory ends laid out in section 4s of the
Commodity Exchange Act. We
[[Page 20215]]
should be held accountable for not only failing to even attempt to
meet the goals set by the President, but for deliberately eschewing
them. I agree with Chairman Albrecht that the CFTC ought to be
required to undertake more rigorous cost-benefit analyses. I believe
all of our analyses should be more rigorous. While it may not solve
all of our problems with putting out complex and inefficient
regulations, as noted by Chairman Albrecht, it should help.\225\ I
will be sending a letter to Acting OMB Director Jeffrey Zients
requesting his assistance in determining just how far off the
baseline the Commission has fallen. If OMB Circular A-4 means
anything at all, then OMB should take action and hold the Commission
to the Circular's standards.
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\225\ Albrecht, supra, at 10.
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Appendix 4--Statement of Chairman Gensler and Commissioners Chilton and
Wetjen
The Commission fully considered all comments and the costs and
benefits of its actions in this rulemaking. The preamble of this
Federal Register release specifically addresses issues concerning
compliance burdens and recordkeeping requirements. Indeed, the
preamble addresses the comments received in response to, and
proffers the Commission's rationale for, each of the final rules
promulgated herein. The final rules also contain numerous examples
in which the recommendations of commenters have been adopted and
incorporated into the final rule text. Further, all comments
relevant to the Commission's consideration of costs and benefits
were expressly addressed in the Commission's discussion of its cost-
benefit considerations.
With respect to comments received in response to the
recordkeeping rules, for example, the Commission is aware that the
technology exists to implement a recording system as required under
section 4s(g) of the Commodity Exchange Act (CEA). Indeed, other
regulatory regimes across the globe already require such recording.
As explained in the preamble to the proposed recordkeeping rules, in
2008, the United Kingdom's Financial Services Authority (FSA)
implemented rules relating to the recording and retention of voice
conversations and electronic communications, including a recent
determination that all financial service firms will be required to
record any relevant communication by employees on their work cell
phones.\226\ The FSA implemented this requirement based on
significant technological advancements in recent years, particularly
with respect to the cost of capturing and retaining copies of
electronic material, including telephone communications, which have
made recordkeeping requirements for digital and electronic
communications more economically feasible and systemically prudent.
Similar rules mandating the recording of certain voice and/or
telephone conversations have been promulgated by the Hong Kong
Securities and Futures Commission and by the Autorit[eacute] des
March[eacute]s Financiers in France, and have been recommended by
the International Organization of Securities Commissions
(IOSCO).\227\ Moreover, as noted on the Commission's Web site,
Commission staff met with two firms that provide elements of the
technology needed for compliance with the recording rules under
section 4s(g). These meetings, as well as the international
requirements, informed the Commission's response to comments
received.
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\226\ 75 FR 76666, 76668-69 (Dec. 9, 2010) (Reporting,
Recordkeeping, and Daily Trading Records Requirements for Swap
Dealers and Major Swap Participants) (citing Financial Services
Authority, ``Policy Statement: Telephone Recording: Recording of
voice conversations and electronic communications,'' (March 2008)).
\227\ Id. at 76669 (citing Code of Conduct for Persons Licensed
by or Registered with the Securities and Futures Commission para.
3.9 (2010) (H.K.); General Regulation of the Autorit[eacute] des
March[eacute]s Financiers art. 313-51 (2010) (Fr.); and Press
Release, International Organization of Securities Commissions,
``IOSCO Publishes Recommendations to Enhance Commodity Futures
Markets Oversight,'' (Mar. 5, 2009), http://www.iosco.org/news/pdf/IOSCONEWS137.pdf).
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In addition, one commenter asked that swap dealers (SDs) and
major swap participants (MSPs) be permitted to rely upon swap data
repositories (SDRs) to retain records beyond the time periods that
registrants currently retain such records. In concluding that SDs
and MSPs must retain their own records as well as submit a certain
subset of data to SDRs, the Commission did not call into question
the integrity of its final swap data reporting rules or SDRs
themselves; rather, the Commission determined that the retention of
such records by SDs and MSPs is necessary for purposes of risk
management and monitoring the entity's trading activities for
unlawful conduct, among other things. Certain trade execution
information that is critical for risk management and monitoring
purposes, such as reconciliations to the general ledger, will not be
retained at SDRs.
With regard to cost-benefit considerations of these elements of
the recordkeeping rules, as well as for all of the final rules, the
Commission strove to limit the burden on SDs and MSPs to the extent
reasonably possible. For instance, as originally proposed, the
recording requirement (discussed above) included a provision that
would have required each transaction record to be maintained as a
separate electronic file. The Commission dropped this requirement
and clarified that the rule permits the data to be stored in
databases that do not need to be tagged with transaction and
counterparty identifiers so long as the SD or MSP can readily access
and identify records by running a search on the data. By making this
change, the Commission responded to comments and limited the rule's
requirements to those dictated by statute,\228\ reducing the burden
to the extent reasonably possible.
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\228\ See, e.g., CEA Sec. 4s(g)(3) (``Each registered swap
dealer and major swap participant shall maintain daily trading
records for each counterparty in a manner and form that is
identifiable with each swap transaction.'').
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Additionally, during the February 23, 2011 public meeting at
which the Commission adopted these final rules, there was discussion
of a concern relating to the technological and economic feasibility
of the recordkeeping requirements. Responding to the concern, the
Commission adopted 5 CFR 23.206, which delegates to the Director of
the Division of Swap Dealer and Intermediary Oversight ``the
authority to establish an alternative compliance schedule for
requirements of Sec. 23.202 that are found to be technologically or
economically impracticable for an affected swap dealer or major swap
participant that seeks, in good faith, to comply with the
requirements of Sec. 23.202 within a reasonable time period beyond
the date on which compliance by such swap dealer or major swap
participant is otherwise required.''
In sum, in this rulemaking the Commission has adequately
addressed comments and considered the costs and benefits of its
actions as required by section 15(a) of the CEA.
[FR Doc. 2012-5317 Filed 4-2-12; 8:45 am]
BILLING CODE 6351-01-P
Last Updated: April 3, 2012