08.31.2011
By Terry Flanagan

OTC Swaps Seek Dodd-Frank Clearing Exemption

SEC proposals to exempt security-based swaps from registration are examined.

Market participants are assessing proposed regulations under the Dodd-Frank Act pertaining to security-based swaps.

The Securities and Exchange Commission has proposed exemptions from registration requirements for security-based swaps issues by certain clearing agencies.

Security-based swaps (SBSs) are broadly defined as swaps based on a single security, a loan, a narrow-based group or index of securities or events relating to a single issuer or issuers of securities in a narrow-based security index.

The proposed rules would exempt transactions by clearing agencies in these security-based swaps from all provisions of the Securities Act, as well as exempt these security-based swaps from Exchange Act registration requirements and from the provisions of the Trust Indenture Act, provided certain conditions are met.

The Dodd-Frank Wall Street Reform and Consumer Protection Act, which established a comprehensive framework for regulating the over-the-counter swaps markets, envisioned that certain security-based swaps would be cleared through a clearing agency. The proposed exemptions would facilitate the clearing of such security-based swaps.

A clearing agency generally acts as a middleman between the parties to a transaction, and when providing central counterparty services, assumes the risk should there be a default. When structured and operated appropriately, such a clearing agency can provide benefits such as improving the management of counterparty risk and reducing outstanding exposures through multilateral netting of trades.

However, the exemptions would apply only to security-based swaps sold to a so-called eligible contract participant or ECP—typically banks, broker-dealers and futures commission merchants (FCMs).

Some market participants have called upon the SEC to extend the exemption to cover all SBS issued by eligible clearing agencies. At the same time, they acknowledge that will be difficult, given the express Dodd-Frank requirement that SBS transactions with investors that are not eligible contract participants be registered under the Securities Act.

As an alternative, they are urging the SEC to make the process of registering SBS issued by eligible clearing agencies as simple as possible by relying on investor protection provisions that are already in place for standardized options.

“We believe that the same factors that led the Commission to … exempt standardized exchange-traded options from Securities Act registration requirements are equally applicable to SBS that are cleared through an SBS clearing agency acting as CCP,” said Bruce Bolander, a partner at Gibson, Dunn & Crutcher LLP.

A disclosure scheme like that used for standardized options would be more appropriate for cleared SBS than traditional Securities Act registration, Bolander said.

For SBS, the SEC is being asked to follow as closely as possible the approach it has taken under the Securities Act with standardized options, which are exempt from registration if issued by a registered clearing agency. The exemption requires delivery to customers of an options disclosure document that’s filed with the SEC.

In cases where the exemption is not available for a standardized option (as when the clearing agency is not registered or the option does not trade on an exchange), then a relatively simplified Securities Act registration process is available through the use of Form S-20.

“The Commission should follow this model in connection with registration of any SBS that are registered because they are sold to non-ECPs,” said Bolander.

Similarly, the SEC proposed rule requires that transactions in SBS sold to no-ECPs be effected on a registered exchange, yet there is nothing in Dodd-Frank that suggests than the SEC could not exempt SBS from Exchange Act registration in the same manner it has done with standardized options, he said.

“We suggest that the Commission make the exemption comparable to the exemptions for standardized options, conditioned on the requirement that SBS disclosure statements be filed with the Commission and provided to all non-ECPs that invest in the SBS,” he said.

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