Defining “Swap Execution Facilities”

The SEC to define “swap execution facilities”With the enactment of the Dodd-Frank Act, a new type of regulated marketplace was created known as “swap execution facilities” (“SEFs”) for which the Act established a comprehensive regulatory framework that would require swaps to be executed either on an exchange or on a SEF. The SEFs are defined under Dodd-Frank as a “trading system or platform in which multiple participants have the ability to execute or trade security-based swaps by accepting bids and offers made by multiple participants in the facility or system.” SEFs are a new category of markets, regulated by the Commission, where security-based swaps can be traded.

The SEC, recently, voted unanimously to propose rules defining SEFs and establishing their registration requirements. In a statement by SEC Chairman, Mary L. Schapiro, she explained that the four-part proposal would: 1. Provide a definition for a security-based swap execution facility – outlining what types of markets would meet the definition; 2. Address what it means for a security-based swap to be “made available to trade” on a SEF or an exchange; 3. Implement the 14 core principles detailed in Dodd-Frank (listed below); and 4. Establish a registration process for SEFs that would provide comprehensive information for the Commission to evaluate applications for registration.

The SEFs would be required to:

  1. Comply with the core principles and any requirement the Commission may impose.
  2. Establish and enforce rules governing, among other things, the terms and conditions of security-based swaps traded on their markets; any limitation on access to the facility; trading, trade processing and participation; and the operation of the facility.
  3. Permit trading only in security-based swaps that are not readily susceptible to manipulation.
  4. Establish rules for entering, executing and processing trades and to monitor trading to prevent manipulation, price distortion, and disruptions through surveillance, including real-time trade monitoring and trade reconstructions.
  5. Have systems to capture information necessary to carry out its regulatory responsibilities and share the collected information with the Commission upon request.
  6. Have rules and procedures to ensure the financial integrity of security-based swaps entered on or through the facility, including the clearance and settlement of security-based swaps.
  7. Have rules allowing it to exercise emergency authority, in consultation with the Commission, including the authority to suspend or curtail trading or liquidate or transfer open positions in any security-based swap.
  8. Make public post-trade information (including price, trading volume, and other trading data) in a timely manner to the extent prescribed by the Commission.
  9. Maintain records of activity relating to the facility’s business, including a complete audit, for a period of five years and to report such information to the Commission, upon request.
  10.  Not take any action that imposes any material anticompetitive burden on trading or clearing.
  11. Have rules designed to minimize and resolve conflicts of interest.
  12. Have sufficient financial, operational, and managerial resources to conduct its operations and fulfill its regulatory responsibilities.
  13. Establish a risk analysis and oversight program to identify and minimize sources of operational risk and to establish emergency procedures, backup facilities, and a disaster recovery plan, and to maintain such efforts, including through periodic tests of such resources.
  14. Have a chief compliance officer that performs certain duties relating to the oversight and compliance monitoring of the security-based SEF and that submits annual compliance and financial reports to the Commission.

The SEC has already engaged in several rulemakings related to the derivatives market which include: defining security-based swap terms, establishing reporting rules, rules on data repositories, fraud prevention, swap conflict, and reporting of pre-enactment security-based swaps. Public comments on this recent proposal should be sent to the Commission by April 4, 2011.