transactions in less-liquid security-based swaps.
---------------------------------------------------------------------------

    We understand that financial group affiliates (whether affiliated
with U.S.-based financial groups or not) that are established in
foreign jurisdictions may use any of these structures to engage in
dealing activity in the United States, and that they may seek to engage
in dealing activity in the United States to transact with both U.S.-
person and non-U.S.-person counterparties. In transactions with non-
U.S.-person counterparties, these foreign affiliates may affirmatively
seek to engage in dealing activity in the United States because the
sales personnel of the non-U.S.-person dealer (or of its agent) in the
United States have existing relationships with counterparties in other
locations (such as Canada or Latin America) or because the trading
personnel of the non-U.S.-person dealer (or of its agent) in the United
States have the expertise to manage the trading books for security-
based swaps on U.S. reference securities or entities. We understand
that some of these foreign affiliates engage in dealing activity in the
United States through their personnel (or personnel of their
affiliates) in part to ensure that they are able to provide their own
counterparties, or those of financial group affiliates in other
jurisdictions, with access to liquidity (often in non-U.S. reference
entities) during U.S. business hours, permitting them to meet

client demand even when the home markets are closed. In some cases,
such as when seeking to transact with other dealers through an
interdealer broker, these foreign affiliates may act, in a dealing
capacity, in the United States through an unaffiliated, third-party
agent.
e. Current Estimates of Number of SBS Dealers and Major SBS
Participants
    As discussed above, security-based swap activity is concentrated in
a relatively small number of dealers, which already represent a small
percentage of all market participants active in the security-based swap
market. Based on analysis of 2014 data, our earlier estimates of the
number of entities likely to register as security-based swap dealers
remain largely unchanged.\1632\ Of the approximately 50 entities that
we estimate may potentially register as security-based swap dealers, we
believe it is reasonable to expect 22 to be non-U.S. persons.\1633\
Under the rules as they currently exist, we identified approximately
170 entities engaged in single-name CDS activity, with all
counterparties, of $2 billion or more. Of those entities, 155 would be
expected to incur assessment costs to determine whether they meet the
``security-based swap dealer'' definition. Approximately 57 of these
entities are non-U.S. persons.
---------------------------------------------------------------------------

    \1632\ See Registration Adopting Release, 80 FR 49000, supra
note 989.
    \1633\ These estimates are based on the number of accounts in
TIW data with total notional volume in excess of de minimis
thresholds, increased by a factor of two, to account for any
potential growth in the security-based swap market, to account for
the fact that we are limited in observing transaction records for
activity between non-U.S. persons to those that reference U.S.
underliers, and to account for the fact that we do not observe
security-based swap transactions other than in single-name CDS. See
U.S. Activity Proposing Release, 80 FR 27452, supra note 9. See also
Definitions Adopting Release, 77 FR 30725, n.1457, supra note 115.
---------------------------------------------------------------------------

    Many of these dealers are already subject to other regulatory
frameworks under U.S. law based on their role as intermediaries or on
the volume of their positions in other products, such as swaps.
Available data supports our prior estimates, based on our experience
and understanding of the swap and security-based swap market that of
the 55 firms that might register as SBS Dealers or Major SBS
Participants, approximately 35 would also be registered with the CFTC
as Swap Dealers or Major Swap Participants.\1634\ Based on our analysis
of TIW data and filings with the Commission, we estimate that 16 market
participants expected to register as SBS Dealers have already
registered with the Commission as broker-dealers and are thus subject
to Exchange Act and FINRA requirements applicable to such entities.
Finally, as we discuss below, some dealers may be subject to similar
requirements in one or more foreign jurisdictions.
---------------------------------------------------------------------------

    \1634\ Based on our analysis of 2014 TIW data and the list of
swap dealers provisionally registered with the CFTC, and applying
the methodology used in the Definitions Adopting Release, we
estimate that substantially all registered security-based swap
dealers would also be registered as swap dealers with the CFTC. See
U.S. Activity Proposing Release, 80 FR 27458, supra note 9;
Registration Adopting Release, 80 FR 49000, supra note 989. See also
CFTC list of provisionally registered swap dealers, available at:
http://www.cftc.gov/LawRegulation/DoddFrankAct/registerswapdealer.
---------------------------------------------------------------------------

3. Security-Based Swap Market: Levels of Security-Based Swap Trading
Activity
    As already noted, firms that act as dealers play a central role in
the security-based swap market. Based on an analysis of 2014 single
name CDS data in TIW, accounts of those firms that are likely to exceed
the SBS Dealer de minimis thresholds and trigger registration
requirements intermediated transactions with a gross notional amount of
approximately $8.5 trillion, over 60 percent of which was intermediated
by top 5 dealer accounts.\1635\
---------------------------------------------------------------------------

    \1635\ Commission staff analysis of TIW transaction records
indicates that approximately 99 percent of single name CDS price-
forming transactions in 2014 involved an ISDA-recognized dealer.
---------------------------------------------------------------------------

    These dealers transact with hundreds or thousands of
counterparties. Approximately 35 percent of accounts of firms expected
to register as SBS Dealers and observable in TIW have entered into
security-based swaps with over 1,000 unique counterparty accounts as of
year-end 2014. \1636\ Approximately 9 percent of these accounts
transacted with 500-1,000 unique counterparty accounts; another 35
percent transacted with 100-500 unique accounts, and only 22 percent of
these accounts intermediated swaps with fewer than 100 unique
counterparties in 2014. The median dealer account transacted with 453
unique accounts (with an average of approximately 759 unique accounts).
Non-dealer counterparties transact almost exclusively with these
dealers. The median non-dealer counterparty transacted with 3 dealer
accounts (with an average of approximately 4 dealer accounts) in 2014.
---------------------------------------------------------------------------

    \1636\ Many dealer entities and financial groups transact
through numerous accounts. Given that individual accounts may
transact with hundreds of counterparties, we may infer that entities
and financial groups, which may have multiple accounts, transact
with at least as many counterparties as the largest of their
accounts in terms of number of counterparties.
---------------------------------------------------------------------------

    Figure 2 below describes the percentage of global, notional
transaction volume in North American corporate single-name CDS reported
to the TIW between January 2008 and December 2014, separated by whether
transactions are between two ISDA-recognized dealers (interdealer
transactions) or whether a transaction has at least one non-dealer
counterparty.
    Figure 2 also shows that the portion of the notional volume of
North American corporate single-name CDS represented by interdealer
transactions has remained fairly constant and that interdealer
transactions continue to represent a significant majority of trading
activity even as notional volume has declined over the past six
years,\1637\ from more than $6 trillion in 2008 to less than $3
trillion in 2014.\1638\ The high level of interdealer trading activity
reflects the central position of a small number of dealers, each of
which intermediates trades with many hundreds of counterparties. While
we are unable to quantify the current level of trading costs for
single-name CDS, those dealers appear to enjoy market power as a result
of their small number and the large proportion of order flow they
privately observe.
---------------------------------------------------------------------------

    \1637\ The start of this decline predates the enactment of the
Dodd-Frank Act and the proposal of rules thereunder, which is
important to note for the purpose of understanding the economic
baseline for this rulemaking.
    \1638\ This estimate is lower than the gross notional amount of
$8.5 trillion noted above as it includes only the subset of single-
name CDS referencing North American corporate documentation, as
discussed above.
---------------------------------------------------------------------------

    Figure 2: Global, notional trading volume in North American
corporate single-name CDS by calendar year and the fraction of volume
that is interdealer.

[GRAPHIC] [TIFF OMITTED] TR13MY16.001

    Against this backdrop \1639\ of declining North American corporate
single-name CDS activity, about half of the trading activity in North
American corporate single-name CDS reflected in the set of data we
analyzed was between counterparties domiciled in the United States and
counterparties domiciled abroad, as shown in Figure 3 below. Using the
self-reported registered office location of the TIW accounts as a proxy
for domicile, we estimate that only 12 percent of the global
transaction volume by notional volume between 2008 and 2014 was between
two U.S.-domiciled counterparties, compared to 48 percent entered into
between one U.S.-domiciled counterparty and a foreign-domiciled
counterparty and 40 percent entered into between two foreign-domiciled
counterparties.\1640\
---------------------------------------------------------------------------

    \1639\ Adjustments to these statistics from the proposal reflect
additional analysis of TIW data. Cf. Registration Adopting Release,
80 FR 49001, supra note 989 (showing slightly different values for
2012 through 2014). For the purposes of this analysis, we assume
that same-day cleared transactions reflect inter-dealer activity.
    \1640\ For purposes of this discussion, we have assumed that the
registered office location reflects the place of domicile for the
fund or account, but we note that this domicile does not necessarily
correspond to the location of an entity's sales or trading desk. See
U.S. Activity Adopting Release, 81 FR 8607.
---------------------------------------------------------------------------

    If we consider the number of cross-border transactions instead from
the perspective of the domicile of the corporate group (e.g., by
classifying a foreign bank branch or foreign subsidiary of a U.S.
entity as domiciled in the United States), the percentages shift
significantly. Under this approach, the fraction of transactions
entered into between two U.S.-domiciled counterparties increases to 32
percent, and to 51 percent for transactions entered into between a
U.S.-domiciled counterparty and a foreign-domiciled counterparty.
    By contrast, the proportion of activity between two foreign-
domiciled counterparties drops from 40 percent to 17 percent. This
change in respective shares based on different classifications suggests
that the activity of foreign subsidiaries of U.S. firms and foreign
branches of U.S. banks accounts for a higher percentage of security-
based swap activity than U.S. subsidiaries of foreign firms and U.S.
branches of foreign banks. It also demonstrates that financial groups
based in the United States are involved in an overwhelming majority
(approximately 83 percent) of all reported transactions in North
American corporate single-name CDS.
    Financial groups based in the United States are also involved in a
majority of interdealer transactions in North American corporate
single-name CDS. Of transactions on North American corporate single-
name CDS between two ISDA-recognized dealers and their branches or
affiliates, 65 percent of transaction notional volume involved at least
one account of an entity with a U.S. parent.
    In addition, we note that a significant majority of North American
corporate single-name CDS transactions occur in the interdealer market
or between dealers and non-U.S.-person non-dealers, with the remaining
(and much smaller) portion of the market consisting of transactions
between dealers and U.S.-person non-dealers. Specifically, 79.5 percent
of North American corporate single-name CDS transactions involved
either two ISDA-recognized dealers or an ISDA-recognized dealer and a
non-U.S.-person non-dealer. Approximately 20 percent of such

transactions involved an ISDA-recognized dealer and a U.S.-person non-
dealer.
[GRAPHIC] [TIFF OMITTED] TR13MY16.002

4. Global Regulatory Efforts
    In 2009, leaders of the G20--whose membership includes the United
States, 18 other countries, and the European Union (``EU'')--addressed
global improvements in the OTC derivatives markets. They expressed
their view on a variety of issues relating to OTC derivatives
contracts. In subsequent summits, the G20 leaders have returned to OTC
derivatives regulatory reform and encouraged international consultation
in developing standards for these markets.\1641\
---------------------------------------------------------------------------

    \1641\ See, e.g., G20 Leaders' Final Declaration, November 2011,
para. 24 available at: https://g20.org/wp-content/uploads/2014/12/Declaration_eng_Cannes.pdf.
---------------------------------------------------------------------------

    Many SBS Dealers likely will be subject to foreign regulation of
their security-based swap activities that are similar to regulations
that may apply to them pursuant to Title VII, even if the relevant
foreign jurisdictions do not classify certain market participants as
``dealers'' for regulatory purposes. Some of these regulations may
duplicate, and in some cases conflict with, certain elements of the
Title VII regulatory framework.
    Foreign legislative and regulatory efforts have focused on five
general areas: Moving OTC derivatives onto organized trading platforms,
requiring central clearing of OTC derivatives, requiring post-trade
reporting of transaction data for regulatory purposes and public
dissemination of anonymized versions of such data, establishing or
enhancing capital requirements for non-centrally cleared OTC
derivatives transactions, and establishing or enhancing margin and
other risk mitigation requirements for non-centrally cleared OTC
derivatives transactions. Foreign jurisdictions have been actively
implementing regulations in connection with each of these categories of
requirements. Regulatory transaction reporting requirements are in
force in a number of jurisdictions including the EU, Hong Kong SAR,
Japan, Australia, Brazil, Canada, China, India, Indonesia, South Korea,
Mexico, Russia, Saudi Arabia, and Singapore; other jurisdictions are in
the process of proposing legislation and rules to implement these
requirements.\1642\ In addition, a number of major foreign
jurisdictions have initiated the process of implementing margin and
other risk mitigation requirements for non-centrally cleared OTC
derivatives transactions.\1643\ Several jurisdictions have also taken
steps to implement the Basel III recommendations governing capital
requirements for financial entities, which include enhanced capital
charges for non-centrally cleared OTC derivatives transactions.\1644\
---------------------------------------------------------------------------

    \1642\ Information regarding ongoing regulatory developments
described in this section was primarily obtained from progress
reports on implementation of OTC derivatives market reforms
published by the Financial Stability Board. These are available at:
http://www.financialstabilityboard.org/publications/progress-reports/?policy_area[]=17.
    \1643\ In November 2015, the Financial Stability Board reported
that 12 member jurisdictions participating in its tenth progress
report on OTC derivatives market reforms had in force a legislative
framework or other authority to require exchange of margin for non-
centrally cleared transactions and had published implementing
standards or requirements for consultation or proposal. A further 11
member jurisdictions had a legislative framework or other authority
in force or published for consultation or proposal. See Financial
Stability Board, OTC Derivatives Market Reforms Tenth Progress
Report on Implementation (November 2015), available at http://www.financialstabilityboard.org/wp-content/uploads/OTC-Derivatives-10th-Progress-Report.pdf.
    \1644\ In November 2015, the Financial Stability Board reported
that 18 member jurisdictions participating in its tenth progress
report on OTC derivatives market reforms had in force standards or
requirements covering more than 90% of transactions that require
enhanced capital charges for non-centrally cleared transactions. A
further three member jurisdictions had a legislative framework or
other authority in force and had adopted implementing standards or
requirements that were not yet in force. An additional three member
jurisdictions had a legislative framework or other authority in
force or published for consultation or proposal. See Financial
Stability Board, OTC Derivatives Market Reforms Tenth Progress
Report on Implementation (November 2015), available at http://www.financialstabilityboard.org/wp-content/uploads/OTC-Derivatives-10th-Progress-Report.pdf.

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

5. Dually Registered Entities
    We expect the magnitude of the above economic costs, benefits, and
effects on efficiency, competition and capital formation to depend on
the extent to which SBS Entities are already complying with similar
business conduct rules. As discussed extensively in the baseline and in
the sections that follow, most entities expected to register with the
Commission and become subject to these final business conduct standards
have registered with the CFTC as Swap Entities or with the Commission
as broker-dealers. Therefore, they have already become subject to
CFTC's adopted external business conduct rules and/or FINRA rules
related to, among others, suitability, communications with the public,
supervision, and compliance. The Commission has sought to harmonize the
regulatory regimes in recognition of swap and security-based swap
market integration and extensive cross-market participation. As a
result, some SBS Entities may have already restructured their
activities to comply with many of the substantive business conduct
standards being adopted. Dually registered SBS Entities that have
already restructured their systems and activities to comply with
parallel CFTC and FINRA rules may incur lower costs relative to non-
dually registered SBS Entities. The specific economic costs, benefits,
and effects on efficiency, competition, and capital formation of
various business conduct rules and requirements are discussed in
further detail in the sections that follow. Wherever practicable, we
also evaluate the economic effects of the various rules being adopted
against these parallel rules, and other reasonable alternatives.
6. Cross-Market Participation
    As noted above, persons registered as SBS Dealers and Major SBS
Participants are likely also to engage in swap activity, which is
subject to regulation by the CFTC.\1645\ This overlap reflects the
relationship between single-name CDS contracts, which are security-
based swaps, and index CDS contracts, which may be swaps or security-
based swaps. A single-name CDS contract covers default events for a
single reference entity or reference security. Index CDS contracts and
related products make payouts that are contingent on the default of
index components and allow participants in these instruments to gain
exposure to the credit risk of the basket of reference entities that
comprise the index, which is a function of the credit risk of the index
components. A default event for a reference entity that is an index
component will result in payoffs on both single-name CDS written on the
reference entity and index CDS written on indices that contain the
reference entity. Because of this relationship between the payoffs of
single-name CDS and index CDS products, prices of these products depend
upon one another,\1646\ creating hedging opportunities across these
markets.
---------------------------------------------------------------------------

    \1645\ See U.S. Activity Adopting Release, 81 FR 8609;
Registration Adopting Release, 80 FR 49000, supra note 989.
    \1646\ ``Correlation'' typically refers to linear relationships
between variables; ``dependence'' captures a broader set of
relationships that may be more appropriate for certain swaps and
security-based swaps. See, e.g., Casella, George and Roger L.
Berger, ``Statistical Inference'' (2002), at 171.
---------------------------------------------------------------------------

    These hedging opportunities mean that participants that are active
in one market are likely to be active in the other. Commission staff
analysis of approximately 4,500 TIW accounts that participated in the
market for single-name CDS in 2014 revealed that approximately 3,000 of
those accounts, or 67 percent, also participated in the market for
index CDS. Of the accounts that participated in both markets, data
regarding transactions in 2014 suggest that, conditional on an account
transacting in notional volume of index CDS in the top third of
accounts, the probability of the same account landing in the top third
of accounts in terms of single-name CDS notional volume is
approximately 64 percent; by contrast, the probability of the same
account landing in the bottom third of accounts in terms of single-name
CDS notional volume is only 10 percent.\1647\
---------------------------------------------------------------------------

    \1647\ The Commission recently revised its methodology for
estimating cross-market participation of TIW accounts. This has
resulted in an increase in the reported number of accounts that
participated in both markets relative to previous Commission
releases.
---------------------------------------------------------------------------

    Similarly, since the payoffs of security-based swaps are dependent
upon the value of underlying securities, activity in the security-based
swap market can be correlated with activity in underlying securities
markets. Security-based swaps may be used in order to hedge or
speculate on price movements of reference securities or the credit risk
of reference securities. For instance, prices of both CDS and corporate
bonds are sensitive to the credit risk of underlying reference
securities. As a result, trading across markets may sometimes result in
information and risk spillovers between these markets, with
informational efficiency, pricing and liquidity in the security-based
swap market affecting informational efficiency, pricing, and liquidity
in markets for related assets, such as equities and corporate
bonds.\1648\
---------------------------------------------------------------------------

    \1648\ See the Registration Adopting Release, 80 FR 49003, supra
note 989. Empirical evidence on the direction and significance of
the CDS-bond market spillover is mixed. See also Massa and Zhang
(2012) Massa & L. Zhang, CDS and the Liquidity Provision in the Bond
Market (INSEAD Working Paper No. 2012/114/FIN, 2012), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2164675
(considering whether the presence of CDS improves pricing and
liquidity of investment grade bonds in 2001-2009); S. Das, M.
Kalimipalli & S. Nayak, Did CDS Trading Improve the Market for
Corporate Bonds?, 111 J. Fin. Econ. 495 (2014) (considering the
effects of CDS trading on the efficiency, pricing error and
liquidity of corporate bond markets); M. Oehmke & A. Zawadowski, The
Anatomy of the CDS Market, Rev. of Fin. Studies (forthcoming),
available at https://www0.gsb.columbia.edu/faculty/moehmke/papers/OehmkeZawadowski_CDS.pdf (suggesting a standardization and liquidity
role of CDS markets and documenting cross-market arbitrage links
between the CDS market and the bond market); and Boehmer, S. Chava,
& H. Tookes, Related Securities and Equity Market Quality: The Cases
of CDS, 50(3) J. Fin. & Quant. Analysis (2015), pp 509-541
(providing evidence that firms with traded CDS contracts on their
debt experience significantly lower liquidity and price efficiency
in equity markets when these firms are closer to default and in
times of high market volatility).
---------------------------------------------------------------------------

7. Pay to Play Prohibitions
    The baseline against which we are assessing the potential effects
of the pay to play prohibitions in these final business conduct rules
reflects MSRB Rules G-37 and G-38, SEC Rule 206(4)-5 under the Advisers
Act, as well as CFTC Regulation 23.451. First, we note that MSRB rules
G-37 and G-38 are currently effective and are part of the economic
baseline. Second, Rule 206(4)-5 prohibits an adviser and its covered
associates from providing or agreeing to provide, directly or
indirectly, payment to any third party for solicitation of advisory
business from any government entity on such adviser's behalf unless
such third party is a ``regulated person,'' defined in Rule 206(4)-5 as
(i) an SEC-registered investment adviser, (ii) a registered broker or
dealer subject to pay-to-play rules adopted by a registered national
securities association, or (iii) a registered municipal advisor that is
subject to pay-to-play rules adopted by the MSRB (``third-party
solicitor ban''). Although the compliance date for the third-party
solicitor ban was July 31, 2015, the Division of Investment Management
stated that it will not

recommend enforcement action to the Commission with respect to the
third-party solicitor ban until the later of (1) the effective date of
a FINRA pay-to-play rule or (2) the effective date of an MSRB pay-to-
play rule for registered municipal advisors.\1649\ Therefore, certain
parts of Rule 206(4)-5--the prohibition from receiving compensation for
advising government entities for two years after certain contributions
are made, and the prohibition from coordinating and soliciting
contributions to government officials and parties--enter into our
economic baseline.
---------------------------------------------------------------------------

    \1649\ See ``Staff Responses to Questions About the Pay to Play
Rule,'' Question I.4, updated as of Jun. 25, 2015. Available at:
http://www.sec.gov/divsions/investment/pay-to-play-faq.htm, last
accessed 4/6/2016.
---------------------------------------------------------------------------

    Third, Commodity Exchange Act Rule 23.451 prohibits Swap Dealers
from offering to enter or entering into a swap with governmental
special entities within two years of any contribution to an official of
such entity by the Swap Dealer or any covered associate. The CFTC has
similarly stated that the rule is intended to deter fraud and undue
influence that harms the public, and to promote consistency in the
business conduct standards that apply to financial market professionals
dealing with municipal entities. However, CFTC Letter No. 12-33
provided no-action relief from Regulation 23.451 to Swap Dealers and
their covered associates with respect to ``governmental plans'' defined
in Section 3 of ERISA, to the extent that such plans are not otherwise
covered by SEC and/or MSRB rules. The CFTC has also clarified that the
two year ``look-back'' period does not include any time period that
precedes the date on which an entity is required to register as a Swap
Dealer.\1650\
---------------------------------------------------------------------------

    \1650\ See CFTC 77 FR at 9827. See also: CFTC No-Action Letter
No. 12-33 Amended, available at<EMAIL_ADDRESS>last accessed 8/
27/2015.
---------------------------------------------------------------------------

    As indicated above, we estimate that up to 35 of 55 entities
seeking to register as SBS Entities may be registered with the CFTC as
Swap Entities. Additionally, based on an analysis of 2014 TIW data on
accounts likely to trigger SBS Dealer registration requirements, we
have identified 18 entities belonging to a corporate group with at
least one MSRB registered broker-dealer or bank-dealer.\1651\ Finally,
as discussed in section V, the Commission continues to estimate that
the overwhelming majority of independent representatives of special
entities subject to these final rules are likely already registered as
municipal advisors.\1652\ As a result of the pay to play rules
currently in effect, some SBS Entities and third-party independent
advisers of special entities may have restructured their business
practices in various markets to comply with certain restrictions
imposed by pay to play rules on investment advisers, municipal
advisors, and SBS Entities discussed above.
---------------------------------------------------------------------------

    \1651\ See ``Broker-Dealers and Bank Dealers Registered with the
MSRB'', available at http://www.msrb.org/BDRegistrants.aspx, last
accessed 2/8/2016.
    \1652\ As of January 1, 2016 there were 665 municipal advisors
registered with the Commission (http://www.sec.gov/help/foia-docs-muniadvisorshtm.html). Of those, 381 indicated that they expect to
provide advice concerning the use of municipal derivatives or advice
or recommendations concerning the selection of other municipal
advisors or underwriters with respect to municipal financial
products or the issuance of municipal securities. We expect that
many of these municipal advisors will also act as independent
representatives for other special entities. As discussed in Section
V, the Commission estimates that approximately 385 municipal
advisors will act as independent representatives to special entities
with respect to security-based swaps.
---------------------------------------------------------------------------

C. Costs and Benefits of Business Conduct Rules

1. Verification of Status and Know Your Counterparty Rules
    Rule 15Fh-3(a)(1) requires an SBS Entity to verify that a
counterparty meets the standards for an eligible contract participant
before entering into a security-based swap with the counterparty,
except for transactions executed on a registered national securities
exchange. Rule 15Fh-3(a)(2) requires SBS Entities to verify whether a
known counterparty is a special entity before entering into a security-
based swap with that counterparty, except for transactions executed on
a registered or exempt SEF or registered national securities exchange,
where the SBS Entity does not know the identity of the counterparty at
a reasonably sufficient time prior to execution of the transaction to
permit compliance with obligations of the rule. Rule 15Fh-3(a)(3)
requires SBS Entities to verify whether a counterparty is eligible to
elect not to be a special entity under Rule 15Fh-2(d)(4) and, if so,
notify such counterparty of its right to make such an election.\1653\
Finally, Rule 15Fh-3(e) requires that SBS Dealers establish, maintain
and enforce written policies and procedures reasonably designed to
obtain and retain records of the essential facts concerning each known
counterparty necessary for conducting business with such
counterparties. The scope of such essential facts includes facts
required to comply with applicable laws, regulations and rules; facts
required to implement the SBS Dealer's credit and operational risk
management policies; and information regarding the authority of persons
acting for such counterparties.\1654\
---------------------------------------------------------------------------

    \1653\ See Section II.H supra.
    \1654\ The ability of SBS Entities to rely on representations to
comply with these and other business conduct rules is discussed in
detail in the section VI.C.4 below.
---------------------------------------------------------------------------

    We recognize that many SBS Entities, in the course of business,
already may be conducting due diligence and fact gathering concerning
their security-based swap counterparties, which may reduce the economic
effects of this rule.
    The scope of the ``know your counterparty'' rule reflects
differences in the roles of entities likely to register as SBS Dealers
and entities that may register as Major SBS Participants. The
Commission believes that entities that will register as SBS Dealers
will intermediate a large volume of security-based swap transactions as
both principal risk holders and agents transacting on behalf of
principal risk holders, such as special entities. As discussed in the
economic baseline, we understand that entities currently operating as
dealers in security-based swap markets play a central intermediation
role, transacting with hundreds and thousands of non-dealer
counterparties and accounting for large activity volumes. At the same
time, the Commission expects that Major SBS Participants will hold
large positions in security-based swaps, but have low volumes of
security-based swap activity. Hence, we expect Major SBS Participants
may not play the central intermediation role fulfilled by SBS Dealers.
    These rules limit the scope of application of the ``know your
counterparty'' requirement to SBS Dealers, and exclude Major SBS
Participants. As a result, entities that may register as Major SBS
Participants will not bear the costs of compliance with this rule. At
the same time, SBS Dealers will be required to comply and bear related
compliance costs. We note that this approach is substantially similar
to the CFTC's final external business conduct rules, which limit the
scope of ``know your counterparty'' requirements to Swap Dealers. This
results in a consistent treatment of entities that may trigger both
Major Swap Participant and Major SBS Participant registration
requirements, and will enable Major Swap Participants to enter into
security-based swap positions without bearing additional compliance
costs to comply with our ``know your counterparty'' requirement.

    To the extent that SBS Dealers do not already collect and retain
essential facts about their counterparties as a part of their normal
course of business, this requirement will increase the cost to SBS
Dealers of entering into security-based swaps. Specifically, SBS
dealers will incur costs of complying with the verification
requirements and costs of establishing, maintaining, and enforcing
policies and procedures reasonably designed to obtain and retain
essential facts about each known counterparty that are necessary for
conducting business with such counterparty. We note that the ability to
rely on counterparty representations to fulfill the SBS Dealer
diligence requirement partly lowers compliance burdens, as reflected in
our estimates. Further, to the extent that the majority of SBS Entities
have already cross-registered with the CFTC as Swap Entities and have
become subject to substantially similar verification and ``know your
counterparty'' requirements, and to the extent the majority of their
counterparties transact across swap and security-based swap markets and
have already benefited from existing CFTC rules, the economic effects
of these final rules may be partly mitigated.
    Direct costs of compliance with verification of status requirements
related to adherence to standardized protocols by SBS Entities that are
not dually registered as Swap Entities are estimated at, approximately,
$17,600.\1655\ As discussed in Section V, these estimates include costs
related to verification of counterparty's eligibility to elect not to
be a special entity and notification of counterparties of their right
to make such an election. In addition, SBS Dealers will also be
required to comply with ``know your counterparty'' obligations, which
will require a review of existing policies and procedures and related
documentation, involving an estimated initial cost of $95,000 for all
SBS Dealers.\1656\ Further, direct ongoing costs of ``know your
counterparty'' obligations are estimated at approximately $4,370,000
per year for all SBS Dealers.\1657\
---------------------------------------------------------------------------

    \1655\ Initial outside counsel cost: $500 * (20 non-CFTC
registered SBS Entities) = $10,000. Initial adherence letter burden:
(In-house attorney at $380 per hour) x 20 hours = $7,600.
    \1656\ Initial cost: (In-house attorney at $380 per hour) x 250
hours = $95,000.
    \1657\ (In-house attorney at $380 per hour) x 11,500 hours =
$4,370,000.
---------------------------------------------------------------------------

    Increases in SBS Entity costs due to these obligations may be
reflected in the terms offered to counterparties, and increases in
counterparty costs may affect their willingness to transact in
security-based swaps. Further, counterparties of SBS Entities that are
not also participating in swap markets and relying on the above
protocols may incur costs associated with the verification of status
requirement and related adherence letters, estimated at approximately
$3,051,840.\1658\ As estimated in Section V, counterparties or their
agents will also be required to collect and provide essential facts to
the SBS Dealer to comply with the ``know your counterparty''
obligations for an initial total cost estimate of approximately
$41,420,000.\1659\
---------------------------------------------------------------------------

    \1658\ Initial costs of disclosure of essential facts: $500 x
(3,468 counterparties) = $1,734,000. Initial costs of adherence
letters: (In-house attorney at $380 per hour) x 3,468 counterparties
= $1,317,840. Total initial costs: $1,734,000 + $1,317,840 =
$3,051,840.
    \1659\ Initial cost: (In-house attorney at $380 per hour) x
109,000 hours = $41,420,000.
---------------------------------------------------------------------------

    We note that the eligible contract participant status verification
requirement does not apply to transactions executed on a registered
national securities exchange. In addition, the special entity status
verification requirement does not apply to transactions where the SBS
Entity does not know the identity of the counterparty at a reasonably
sufficient time prior to execution of the transaction to permit
compliance. This limits the scope of the transactions covered by final
rules, therefore potentially reducing the expected benefits. However,
since anonymous transactions will not be subject to these requirements,
the rule imposes lower costs, delays and implementation challenges with
respect to anonymous trades. This approach to anonymous transactions
executed on registered exchanges or SEFs may incentivize SBS Entities
to trade through these venues, to avoid imposition of these obligations
under final business conduct rules. The compliance costs imposed on SBS
Entities by these and other business conduct requirements (excluding
anonymous transactions executed on a registered exchange or SEF) may
lead to a decrease in the volume of OTC bilateral security-based swap
trades, and an increase in the volume of transactions executed on
exchanges or SEFs. This may facilitate liquidity, price discovery and
risk mitigation in these transparent venues, which may attract greater
market participation. The overall effects will depend on the value of
disclosure and suitability requirements, customization and bilateral
relationships in OTC transactions, compared with the standardization,
liquidity and execution quality of contracts in SEFs and exchanges,
among others.
    As an alternative to the approach taken in the final rules, the
Commission has considered imposing specific requirements as to the form
and manner of documentation. Specific documentation requirements could
result in greater information gathering and documentation by SBS
Entities fulfilling their status verification and ``know your
counterparty'' obligations, which may further strengthen counterparty
protections and reduce evasion. However, we recognize commenter
concerns regarding costs and loss of flexibility from imposing specific
documentation requirements, and the importance of private contractual
negotiation, as well as the need to impose effective verification and
documentation requirements to facilitate enforcement.\1660\ We
therefore declined to adopt this approach.
---------------------------------------------------------------------------

    \1660\ See FIA/ISDA/SIFMA, supra note 5; CFA, supra note 5.
---------------------------------------------------------------------------

    The Commission is adopting a ``know your counterparty'' requirement
based on a policies and procedures approach. However, the final rules
explicitly delineate certain items that the Commission believes are
essential facts concerning the counterparty that are necessary for
conducting business with such counterparty. The CFTC has adopted a
substantially similar requirement for swap dealers to implement
policies and procedures reasonably designed to obtain and retain a
record of the essential facts about each known counterparty that are
necessary for conducting business with such counterparty. As noted
earlier, in light of extensive cross-market participation between swap
and security-based swap markets, and expected cross-registration of SBS
Entities already complying with CFTC's business conduct rules,
harmonization with the CFTC regime may facilitate continued integration
between these markets and may potentially reduce duplicative compliance
costs for some dual registrants.
2. Disclosures and Communications
    The Commission is adopting rules concerning SBS Entity disclosures
of material risks, characteristics, incentives, conflicts of interest
and daily mark of security-based swaps to their counterparties. The
final rules also require SBS Entities to make a written record of the
non-written disclosures and provide a written version of these
disclosures to counterparties no later than the delivery of the trade
acknowledgement for a particular transaction. We note that the scope of
the final disclosure requirements is

limited to counterparties that are not themselves SBS or Swap Entities,
the economic effects of which are discussed below.
    Broadly, these disclosure rules may mitigate information
asymmetries between more informed SBS Entities and less informed
counterparties, and may allow them to make more informed decisions
about capital allocation and counterparty selection. At the same time,
SBS Entities profit from information rents \1661\ and, to the extent
that disclosures will inform their counterparties, SBS Entities may
forgo profits on security-based swaps with counterparties as a result
of these requirements. In addition, SBS Entities will incur direct
compliance costs. As discussed in Section V and consistent with our
analysis in the Proposing Release, compliance with disclosure rules
will involve an initial cost burden of which has been estimated at
approximately $25,080,000, with the ongoing burden estimated at
$2,508,000 for all SBS Entities.\1662\ Similarly, the Commission
estimates that information technology infrastructure required to comply
with final disclosure rules will require will cost approximately
$124,520,000 initially, and an additional $62,260,000 per year for all
SBS Entities.\1663\ In addition, the Commission estimates that SBS
Entities will incur costs of evaluating whether more particularized
disclosures are necessary for each transaction and of developing the
additional disclosures for an ongoing aggregate estimated cost of
$121,124,000.\1664\ These and other costs less amenable to
quantification and discussed below may be passed on to counterparties.
---------------------------------------------------------------------------

    \1661\ Rents refer to profits that SBS Entities earn by trading
with counterparties who are less informed. In a market with
competitive access to information, there is no informational
premium; SBS Entities only earn a liquidity premium. The difference
between the competitive liquidity premium and the actual profits
that SBS Entities earn is the economic rent. See Cross-Border
Adopting Release, 79 FR 47283.
    As the Commission articulated in other releases, transparency
stemming from the SDR Rules and Regulation SBSR should reduce the
informational advantage of SBS dealers and promote competition among
SBS dealers and other market participants. See SDR Registration
Release 80 FR at 14528, supra note 1202; Regulation SBSR Adopting
Release, supra note 1602.
    \1662\ Initial cost: (In-house attorney at $380 per hour) x
66,000 hours = $25,080,000. Ongoing cost: (In-house attorney at $380
per hour) x 6,600 hours = $2,508,000.
    \1663\ Initial cost: (Compliance manager at $283 per hour) x
440,000 hours = $124,520,000. Ongoing cost: (Compliance manager at
$283 per hour) x 220,000 hours = $62,260,000.
    \1664\ Ongoing cost: (Compliance manager at $283 per hour) x
428,000 hours = $121,124,000.
---------------------------------------------------------------------------

    These rules may enhance transparency and protect counterparties,
but may also adversely affect the willingness of SBS Entities to
intermediate OTC security-based swaps with non-SBS or Swap Entity
counterparties, and the costs of entering OTC security-based swaps for
non-SBS or Swap Entity counterparties may increase. This fundamental
tradeoff is discussed in more detail in the sections below with respect
to individual disclosure requirements, their scope and implementation.
The overall economic effects of the final disclosure requirements will
depend on the severity of informational asymmetries and conflicts of
interest in security-based swap markets, the ability of some
counterparties of SBS Entities to obtain similar information
independently without the required disclosures and the costs of doing
so,\1665\ and the information content of the required disclosures, and
the extent to which market participants have already learned from
similar disclosures pertaining to swap transactions.
---------------------------------------------------------------------------

    \1665\ See Table 2 of the economic baseline, which shows the
overwhelming majority of most groups of non-dealer market
participants are represented by investment advisers in security-
based swap transactions. See also, e.g., MFA, supra note 5.
---------------------------------------------------------------------------

    We note that the SBS Entities will not be required to comply with
pre-transaction disclosure requirements if the identity of the
counterparty is not known to the SBS Entity at a reasonably sufficient
time prior to execution of the transaction to permit the SBS Entity to
comply with these obligations.
a. Risks, Characteristics, and Conflicts of Interest
    Rule 15Fh-3(b) requires SBS Entities to make disclosures concerning
a security based swap's material risks and characteristics, and the SBS
Entity's material incentives or conflicts of interest before entering
into a security-based swap. In addition to implementing the statutory
requirements, the rule also requires SBS Entities to make a written
record of the non-written disclosures and provide a written version of
these disclosures to counterparties in a timely manner, but no later
than the delivery of the trade acknowledgement for a particular
transaction.
    In evaluating the economic effects of this rule, we note that
security-based swaps are complex products, and security-based swap
markets are more opaque than markets for regular equity or fixed income
products. Security-based swap markets are characterized by a high
degree of informational asymmetry among various groups of
counterparties. As described in the economic baseline, dealers
intermediate large volumes of security-based swaps, observe quote
solicitations and order flow. In addition, SBS Dealers may serve in a
variety of capacities such as placement agents, underwriters,
structurers, securitizers, and lenders in relation to security-based
swaps and the securities underlying them. Further, as outlined above,
SBS Dealers generally have business incentives that may be competing
with those of their counterparties as a result of taking on the
opposite side of the transactions, and may have specific conflicts of
interest due to their advisory, market making, trader and other roles.
As discussed in Section VI.A, Major SBS Participants may also be better
informed about the risks and valuations of security-based swaps due to
their large positions in security-based swaps, compared with their non-
SBS Entity counterparties.
    At the same time, counterparties that are not SBS or Swap Entities
do not observe quote solicitations or order flow, and are less likely
to arrange or structure security-based swaps and their underlying
securities. Such counterparties may also be generally less informed
about the nature and risks of security-based swaps due to their low
volume of activity, as indicated by the low transaction share of non-
dealers in Table 1 of the economic baseline. Many non-dealer
counterparties transact in security-based swaps through investment
advisers; however approximately 7% transact in security-based swaps
directly. If the required disclosures are informative to non-SBS
Entities, these final rules may help less informed market participants
make more informed counterparty and capital allocation choices. The
records requirement may facilitate the implementation of the disclosure
requirement, enabling counterparties to reference the non-written
disclosures made prior to entering into the swap during the life of the
security-based swap.
    As we have recognized,\1666\ informational asymmetry can negatively
affect market participation and decrease the amount of trading--a
problem commonly known as adverse selection.\1667\ When information
about security-based swap risks, liquidity, pricing and counterparty
incentives is scarce, market participants may be less willing to enter
into transactions and the overall level of trading may fall. To

the extent that adverse selection costs are currently present in
security-based swap markets, if market participants become better
informed as a result of these final rules, they may increase their
activity in security-based swaps, which may facilitate greater
informational efficiency and liquidity in security-based swap markets.
Disclosures may inform counterparties of SBS Entities about security-
based swap markets, and counterparties may learn from repeatedly
accessing these markets. Hence, most of the benefits are expected to be
incurred by existing participants when the first disclosures are made,
and by new market participants when they first enter the market.
However, to the extent that disclosures will contain transaction-
specific information concerning risks, incentives, pricing and clearing
of individual security-based swaps, the informational benefits
described above may persist.
---------------------------------------------------------------------------

    \1666\ See, e.g., Registration Adopting Release 80 FR at 49004,
supra note 989.
    \1667\ See George A. Akerlof, The Market For ``Lemons'': Quality
Uncertainty and the Market Mechanism, 84 Q.J. Econ. 488 (1970).
---------------------------------------------------------------------------

    At the same time, disclosures required under these proposed rules
will involve costs to SBS Entities and their counterparties. As
discussed in Section V, SBS Entities will bear direct compliance
burdens related to the disclosures, which are reflected in our
compliance cost estimates above. In addition, since SBS Entities are
more informed about security-based swaps, they are able to extract
information rents in the form of higher markups and fees charged to
non-dealer counterparties. If SBS Entity disclosures better inform
counterparties concerning characteristics and risks of security-based
swaps, these rules may reduce the informational advantage of SBS
Entities relative to their counterparties and decrease profitability of
transactions with non-SBS Entity counterparties, which may reduce
incentives for dealers to provide liquidity to these
counterparties.\1668\
---------------------------------------------------------------------------

    \1668\ For instance, Grossman and Stiglitz (1980) showed that
because information is costly, prices cannot perfectly reflect the
information which is available, since if it did, those who spent
resources to obtain it would receive no compensation. In other
words, informational efficiency reduces incentives of economic
agents to expend resources to acquire information, and there is an
equilibrium amount of ``disequilibrium''. See Sanford J. Grossman
and Joseph E. Stiglitz, On the Impossibility of Informationally
Efficient Markets, 70 American Economic Review 393-408 (1980).
---------------------------------------------------------------------------

    We recognize that the above costs may be passed on to
counterparties through more adverse price and non-price terms of
security-based swaps. To the extent that SBS Entities may be unable to
recover these costs, they may become less likely to intermediate
transactions with non-SBS or Swap Entity counterparties and decrease
participation in U.S. security-based swap markets. Further, since final
business conduct rules require these disclosures to be made prior to
entering into the security-based swap, the disclosure requirements may
involve some delays in execution and may affect liquidity in security-
based swaps, to the extent that these disclosures are not already being
made in master agreements or post trade acknowledgements. We have
considered how the timing, manner and content of disclosures may affect
these competing considerations. First, we recognize that the ability to
rely on master agreements, standardized disclosures and ex post trade
acknowledgements of oral disclosures may significantly reduce ongoing
transaction specific costs and potential execution delays, as
recognized by a commenter,\1669\ but may reduce the specificity and
information content of disclosures. As the Commission discussed in the
Proposing Release,\1670\ security-based swaps are executed under master
agreements and SBS Entities may elect to make required disclosures in a
master agreement or accompanying standardized document. However, as
stated in the Proposing Release and discussed in Section II, supra,
standardized disclosures will not be sufficient in all circumstances
and certain provisions may need to be tailored to the particular
transaction, most notably pricing and other transaction-specific
commercial terms.
---------------------------------------------------------------------------

    \1669\ See FIA/ISDA/SIFMA, supra note 5.
    \1670\ See Proposing Release, 76 FR at 42406, supra note 3.
---------------------------------------------------------------------------

    We have considered commenter concerns that oral disclosures may not
satisfy the goal of pre-trade transparency, may make enforcement more
difficult, and may allow SBS Entities to obscure conflicts of interest
and misrepresent risks until after trade confirmation.\1671\ However,
we are sensitive to the fact that alternative requirements to provide
extensive written disclosures of risks, characteristics, incentives and
conflicts of interest before an SBS Entity enters into a transaction
with a counterparty may increase transaction costs or impose execution
delays, which may be particularly significant in periods of high market
volatility. We have received comments that a requirement to provide
these disclosures ``at a reasonably sufficient time'' prior to entering
the security-based swap transaction, in writing may better inform
unsophisticated counterparties,\1672\ however it may further raise the
risks discussed above. These could result in potentially significant
execution delays, decreases in liquidity and SBS Entity willingness to
intermediate transactions with non-SBS or Swap Entity counterparties.
We also note that, as proposed, under the final rules, standardized
disclosure will not be sufficient in all circumstances: Some forms of
disclosure may be highly standardized, but certain provisions will need
to be tailored to reflect material characteristics of individual
transactions, most notably pricing and other transaction-specific
commercial terms. The CFTC's approach to manner and form of disclosures
is substantially similar to the proposed requirements and to the rule
being adopted. In the Proposing Release, the Commission interpreted the
statutory requirement to disclose material risks and characteristics of
the security-based swap itself, and not of the underlying reference
security or index.\1673\ As an alternative, the Commission could
include underliers in the scope of required disclosures. Compared to
the approach being adopted, the alternative may help better inform less
sophisticated investors and enable them to make better tailored
investment decisions. However, it may increase transactional costs and
execution delays, which are particularly costly during times of high
market volatility. Further, information about many underliers, such as
corporate, municipal and sovereign bonds, is more likely to be publicly
available.
---------------------------------------------------------------------------

    \1671\ See CFA, supra note 5.
    \1672\ See Better Markets (August 2011), supra note 5 and CFA,
supra note 5.
    \1673\ See Proposing Release, 76 FR at 42407, supra note 3.
---------------------------------------------------------------------------

    We have received mixed comments on the relative balance of these
competing considerations with respect to underlier disclosures.\1674\
Under the CFTC's approach, disclosures regarding underlying assets are
not generally required, but to the extent that payments or cash-flows
of the swap are materially affected by the performance of an underlying
asset for which publicly available information is not available, the
Swap Entity is required to provide disclosure about the material risks
and characteristics of the underlying asset to enable the counterparty
to assess the material risks of the swap. As described in Section II,
our final rules require disclosure regarding the referenced security,
index, asset or issuer if it would be considered material to investors
in evaluating the

security-based swap, including any related payments.
---------------------------------------------------------------------------

    \1674\ See, e.g., Better Markets (2011) Letter; SIFMA (2011)
Letter; FIA/ISDA/SIFMA supra note 5; Levin, supra note 5; Markit,
supra note 5; Barnard, supra note 5; CFA, supra note 5. Also see
Section II.G.2 supra.
---------------------------------------------------------------------------

    Finally, we have considered the alternatives of adopting more
prescriptive requirements of characteristics to be disclosed, an
explicit risk taxonomy, requirements concerning volatility and
liquidity metrics, and scenario analysis regarding political, economic
events and underlying market factors. These approaches also present a
tradeoff between informing investors and protecting counterparties, and
costs and willingness of SBS Entities to intermediate trades with non-
SBS or Swap Entity counterparties, similar to the effects described
above.
    For instance, disclosure of a scenario analysis may inform
counterparties, but may be particularly costly since such analysis may
depend on the specific terms of the agreement. To the extent that the
provision of scenario analysis will impose costs on SBS Entities, a
requirement to include scenario analysis as part of mandated
disclosures may result in bundling research and advice, with SBS
intermediation functions for all affected transactions. This would
increase costs to SBS Entities, and these costs are likely to be passed
on to counterparties. Further, one commenter suggested that the
requirement to produce and disclose scenario analysis for each
transaction may delay execution and expose counterparties to market
risk in times of market volatility.\1675\
---------------------------------------------------------------------------

    \1675\ See SIFMA (August 2011), supra note 5.
---------------------------------------------------------------------------

    As an alternative, the CFTC's approach allows counterparties to opt
in to receive the scenario analysis for swaps that are not available
for trading on a SEF, and requires Swap Dealers to disclose to
counterparties their right to receive the scenario analysis. The CFTC's
external business conduct rules do not prescribe whether and how swap
dealers may be able to charge for such analysis and we do not have data
regarding whether any counterparties are taking advantage of the rule
provision. We understand that counterparties already privately
negotiate terms of over-the-counter derivatives with SBS Dealers, which
may also serve in advisory and other capacities. As discussed in the
economic baseline, non-dealer market participants are typically
institutional investors, the overwhelming majority of which rely on
investment advisers in their security-based swap activities. It is
unclear that a requirement to disclose the right to receive a scenario
analysis would affect the demand for such analyses or inform
counterparties.
    The Commission has also considered an alternative of adopting
prescriptive risk taxonomies, and requiring disclosure of volatility
and liquidity metrics. While these requirements may reveal additional
information to counterparties, they may be less informative for
customized over-the counter security-based swaps, may fail to capture
risks of new products, and would increase costs. To the extent that
these requirements would increase SBS Entity costs of transacting with
non-SBS or Swap Entity counterparties, these costs would also adversely
affect terms of security-based swaps for non-SBS or Swap Entity
counterparties. Rule 15Fh-3(b)(2) also requires SBS Entities to
disclose any material incentives or conflicts of interest that an SBS
Entity may have in connection with the security swap, including any
compensation or other incentives from any source other than the
counterparty. As articulated in Section II, this rule will not require
SBS Entities to report all profits or expected returns from the swap or
related hedging or trading activities, but will require reporting of
incentives, such as revenue sharing arrangements, from any source other
than the counterparty in connection with the swap. To the extent that
disclosure informs counterparties regarding SBS Entity conflicts of
interest, counterparties of SBS Entities may become better able to make
informed decisions about security-based swaps and the SBS Entities they
transact with. When SBS Entity conflicts of interest are severe,
disclosure of such conflicts may lead counterparties to renegotiate the
terms of a transaction or select another counterparty with fewer
conflicts of interest, contributing to more efficient capital
allocation by non-dealer counterparties. Importantly, this requirement
does not prohibit material conflicts of interest. Instead, the rule
focuses on disclosure of material incentives and conflicts of interest,
which may help counterparties better evaluate the terms and risks of
transacting with an SBS Entity. The severity of these conflicts of
interest in security-based swaps, the awareness of non-SBS or Swap
Entity counterparties about these conflicts, the similarity between
disclosures of conflicts already made by SBS Entities cross-registered
as Swap Entities under CFTC rules with disclosures that will be made
under these final rules, and the informativeness of the newly required
disclosures will influence the magnitude of the benefits described
above.
    We recognize that final external business conduct rules for Swap
Entities are already in place and include a similar set of conflict of
interest disclosure rules. Swap Entities are already disclosing
incentives and conflicts of interest in swap transactions, which enters
into our economic baseline and is reflected in current market activity.
Non-SBS or Swap Entity counterparties that are transacting with the
same dealers in both swap and security-based swap markets have
benefited from such disclosures in swap markets, and may have already
become familiar with standardized disclosures by Swap Dealer
counterparties. To the extent that disclosures by the same dealers
related to, for instance, index CDS and single name CDS may be similar,
such counterparties may enjoy fewer benefits of these final rules.
However, we note that the rules being adopted require disclosures
specific to security-based swap transactions, and certain disclosures
will need to be tailored to a particular security-based swap.
    In addition to direct costs of compliance born by SBS Entities, to
the extent that disclosures will provide new and relevant information
about SBS Entity conflicts of interest, SBS Entities with significant
conflicts of interest may lose business to SBS Entities that do not
have such conflicts. While this requirement may impose costs on those
SBS Entities with the most acute conflicts, such disclosures may
benefit less conflicted SBS Entities, enhance protections of
counterparties, and improve the ability of market participants to make
informed counterparty decisions.
    We have considered the costs and benefits of an alternative
requiring a disclosure of the difference in compensation between
selling a security-based swap versus another product with similar
economic terms, or expected profit of the SBS Entity from the
transaction, as suggested by some commenters.\1676\ We do not believe
that disclosure of SBS Entity profits to counterparties would protect
counterparties or improve their ability to make suitable investment
decisions, relative to the approach being adopted, and are not adopting
this alternative. SBS Entities compete for business on price, execution
quality, underlier and counterparty risks, among others. We understand
that counterparties need information about price, non-price terms and
risks of the security-based swap and conflicts of interest of the SBS
Entity to be able to assess the relative

merits of a particular transaction. The final business conduct rules
being adopted will require SBS Entities to disclose to their non SBS
Entity counterparties material characteristics and risks of the
transaction, as well as any compensation or incentives from any source
other than the counterparty in connection with the security-based swap.
Rules 15Fh-3(c) and 15Fh-3(d), the economic effects of which are
discussed below, will also require disclosure of the daily mark and
clearing rights. We also note that SDR Rules and Regulation SBSR
adopted by the Commission will introduce post-trade transparency to
security-based markets, and counterparties will have access to more
extensive and more accurate information upon which to make trading and
valuation determinations when compliance with these rules is required.
---------------------------------------------------------------------------

    \1676\ See CFA, supra note 5; Levin, supra note 5.
---------------------------------------------------------------------------

    SBS Entities are for-profit entities, buying security-based swaps
from counterparties seeking to sell them; and selling swaps to
counterparties seeking to purchase them. When SBS Entities carry
balance sheet risk, they profit from directional price moves that
result in losses for their counterparties and so, they may have an
incentive to offload security-based swaps in their inventory on less
informed non-dealer counterparties, even where such security-based
swaps are unsuitable. When SBS Entities hedge their inventory risk and
do not carry balance sheet exposure, they benefit from charging higher
costs and fees to their counterparties. SBS Entity business incentives
may, therefore, be generally competing with the interests or positions
of their counterparties. However, SBS Entities have reputational
incentives and benefit from intermediating a greater volume of trade
which, all else given, mitigates this conflict. Further, it is unclear
that market participants are generally unaware of these competing
incentives.
    SBS Entities act as principal risk holders and transacting agents
effecting security-based swaps on behalf of their customers. An SBS
Entity's expected return on a security-based swap depends on, among
others, price terms of the swap, cost of funds, shorting constraints,
balance sheet exposures, costs of underlying elements of the security-
based swap, and costs of structuring the security-based swap. It is
unclear that disclosure of expected profits of an SBS Entity has any
bearing on a counterparty's expected cost of the transaction, quality
of execution or assessment of the risks of a security-based swap given
the counterparty's investment objectives, horizons, hedging needs,
financial condition etc.\1677\ As a practical consideration, the SBS
Entity's expected profit would depend on potentially proprietary data
and valuation models, and numerous assumptions about future market
factors. At the same time, such a requirement would impose direct costs
of producing disclosures and potential reputational costs on SBS
Entities; if the costs become significant, some SBS Entities may reduce
security-based swap market activity with non-SBS or Swap Entity
counterparties. We note that the rules being adopted not only require
disclosure of material characteristics, risks, conflicts of interest or
incentives, daily mark and clearing rights, but also include fair and
balanced communications, antifraud, supervision, compliance, and
conduct requirements.
---------------------------------------------------------------------------

    \1677\ For instance, one commenter asserted that the best
protection for a counterparty is reviewing and selecting the best
available pricing. See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------

b. Daily Mark
    Rule 15Fh-3(c) requires SBS Entities to disclose the daily mark to
counterparties other than SBS or Swap Entities upon request. For
cleared security-based swaps, the rules require an SBS Entity to
disclose, upon request of the counterparty, the daily mark that the SBS
Entity receives from the appropriate clearing agency. For uncleared
swaps, Rule 15Fh-3(c) implements the statutory provision and requires
the SBS Entity make this disclosure on a daily basis for any uncleared
security-based swap by providing the midpoint between the bid and
offer, or the calculated equivalent thereof, as of the close of
business unless the parties agree in writing otherwise. The method for
computing the daily mark is not provided in the statute. For uncleared
swaps, the SBS Entity would also be able to use market quotations for
comparable security-based swaps and model implied valuations. The SBS
Entity is also required to disclose data sources, methodologies and
assumptions used to prepare the daily mark, and promptly disclose any
material changes to the above during the term of the security-based
swap.
    Similar to the economic effects of disclosures concerning material
risks and characteristics of security-based swaps, the overall impact
of the daily mark disclosure depends on the severity of the
informational asymmetries between SBS Entities and counterparties
regarding market prices of security-based swaps; the amount of
disclosure unsophisticated counterparties require to become better
informed; the informativeness of the disclosures; and the direct and
indirect costs of producing such disclosures by SBS Entities. For
cleared security-based swaps, the requirement to disclose the daily
mark from clearing agencies is an explicit statutory requirement, and
provides a standardized and comparable reference point for
counterparties.\1678\ As described above, based on the current model
for clearing security-based swaps, the security-based swap between the
SBS Entity and counterparty is terminated upon novation by the clearing
agency. The SBS Entity would no longer have any obligation to provide a
daily mark to the original counterparty because a security-based swap
no longer exists between them. Therefore, there would not be any
ongoing burden on the SBS Entity.
---------------------------------------------------------------------------

    \1678\ We have received comment that SBS Entities may have
direct or indirect affiliations or relationships with clearing
agencies and market data providers, which may pose conflicts of
interest. See Levin, supra note 5. Should such conflicts exist, they
may be partly mitigated by other substantive business conduct
requirements being adopted, such as the antifraud provision,
requirement to engage in fair and balanced communications, and other
statutory obligations. Further, counterparties will be able to
select the venue in which security-based swaps will be cleared and
will benefit from SBS Entities' disclosures of incentives and
conflicts of interest under these final rules.
---------------------------------------------------------------------------

    The ability of SBS Entities to rely on quotes, model imputed prices
or prices of comparable security-based swaps to calculate the daily
mark for uncleared swaps may produce valuations that are potentially
superior to stale market prices on illiquid contracts. However, we
continue to recognize that SBS Entities may influence the daily mark
disclosed to their less sophisticated counterparties by varying
modeling assumptions, data sources and methodology which produce the
daily mark, as supported by some commenters.\1679\ This tradeoff is
partially mitigated by the requirement to disclose data sources and a
description of the methodology and assumptions used to prepare the
daily mark, and promptly disclose any material changes during the term
of the swap.
---------------------------------------------------------------------------

    \1679\ See, e.g., Levin, supra note 5; IDC, supra note 5.
---------------------------------------------------------------------------

    As we recognized in the Proposing Release,\1680\ we anticipate
significant variability in the models and data sources, methodology and
assumptions used by different SBS Entities, leading to different daily
marks being established for similar security-based swaps. As a result,
security-based swap

market participants that consider the daily mark as an indicator in the
reporting of their positions may report different valuations of similar
security-based swap positions. However, we continue to believe that
since, as quantified in the economic baseline, non-dealer
counterparties typically transact with multiple dealers, counterparties
may be able to observe and analyze differences in security-based swap
valuations across SBS Entities. We recognize that the daily mark may
not be a reliable reference point for estimating fair values, potential
net asset values or prices at which the security-based swap could be
executed as suggested by a commenter,\1681\ however, we continue to
believe that it may inform counterparty understanding of their
financial relationship with SBS Entities.\1682\
---------------------------------------------------------------------------

    \1680\ See Proposing Release, 76 FR at 42449, supra note 3. Also
see, e.g., FIA/ISDA/SIFMA, supra note 5.
    \1681\ See MFA, supra note 5.
    \1682\ See Proposing Release, 76 FR at 42449, supra note 3.
---------------------------------------------------------------------------

    We are sensitive to cost considerations, and recognize that costs
borne by SBS Entities as a result of the final business conduct rules
may be passed on to counterparties in the form of higher transaction
costs. Further, if these costs are significant, SBS Entities may reduce
their security-based swap activity or become less willing to
intermediate swaps with certain groups of counterparties. As a result,
liquidity, price discovery and market access of certain groups of
counterparties may be adversely affected. As articulated in the
Proposing Release, we understand that SBS Entities routinely assess
end-of-day values in the course of their business as an integral
component of risk management. We continue to believe that SBS Entities
may already be estimating values that may be used to fulfil the daily
mark disclosure requirement, and, therefore, to the extent this is the
case, direct compliance costs of this requirement to costs of producing
disclosures may be less than estimated above.
    One commenter indicated that requiring Major SBS Participants to
comply with the daily mark requirement for uncleared swaps would result
in ``significant, unnecessary increased costs without any meaningful
benefit.'' \1683\ We recognize that the broader scope of this
requirement will impose costs on Major SBS Participants, as reflected
in our compliance cost estimates. To the extent that Major SBS
Participants may be better informed about the risks and valuations of
security-based swaps and more sensitive to market risk due to their
significant positions, disclosures of the daily mark may help their non
SBS Entity counterparties make more informed counterparty and valuation
determinations. We note that the rules being adopted provide all SBS
Entities significant flexibility with respect to how they may estimate
the daily mark for uncleared swaps. Specifically, similar to SBS
Dealers, Major SBS Participants will be able to rely on market quotes
for similar swaps, model based prices or some combination thereof under
Rule 15Fh-3(c). The Commission continues to believe that informing
counterparties' understanding of their financial relationship with SBS
Entities is an important benefit of these final rules.
---------------------------------------------------------------------------

    \1683\ See MFA, supra note 5.
---------------------------------------------------------------------------

    As discussed in Section II, supra, SBS Entities will not
necessarily be able to use the same mark for collateral purposes and
for meeting the disclosure requirement. We recognize commenter concern
that this approach may impose additional costs of estimating and
disclosing a daily mark valuation on SBS Entities with respect to
transactions where both counterparties have agreed on a basis for
margining uncleared swaps.\1684\ As discussed above, the Commission
continues to believe that the daily mark disclosure, as being adopted
for the purposes of this rule, would provide a useful and meaningful
reference point for counterparties holding positions in uncleared
security-based swaps.
---------------------------------------------------------------------------

    \1684\ See FIA/ISDA/SIFMA, supra note 5.
---------------------------------------------------------------------------

    Currently, entities that are likely to trigger SBS Entity
registration requirements due to their volume of dealing activity are
not required to disclose daily marks of security-based swaps, or data
sources, assumptions and methodologies used to calculate them. While
this requirement is currently effective in swap markets and some SBS
Entities may be making such security-based swap specific disclosures
voluntarily, these final rules impose mandatory disclosure requirements
on all SBS Entities in their security-based swap transactions with
counterparties that are not themselves SBS Entities or Swap Entities.
The requirement to disclose data sources, assumptions and methodology
used to calculate the value of security-based swaps may reduce the
informational advantage SBS Entities enjoy as a result of developing
superior valuation models or information, as supported by public
comments.\1685\ However, these costs are partly mitigated by the
ability to rely on standardized disclosures and a description of the
models, as opposed to disclosures of the models themselves.
---------------------------------------------------------------------------

    \1685\ See, e.g., MFA, supra note 5; IDC, supra note 5.
---------------------------------------------------------------------------

c. Clearing Rights
    Finally, Rule 15Fh-3(d) requires SBS Entities to make disclosures
regarding clearing rights to counterparties that are not SBS Entities
or Swap Entities before entering into the security-based swap. For
security-based swaps not subject to mandatory clearing, the SBS Entity
would be required to determine whether the security-based swap is
accepted for clearing by one or more clearing agencies, to disclose the
names of clearing agencies that accept the security-based swap for
clearing, and to notify the counterparty of their right to elect
clearing and the agency used to clear the transaction. For security-
based swaps subject to mandatory clearing, the final rules require SBS
Entities to disclose clearing agency names to the counterparty, and to
notify the counterparty of their right to select the clearing agency
subject to Section 3C(g)(5) of the Act. The rule also requires SBS
Entities to make a written record of the non-written disclosures and
provide counterparties with a written version of these disclosures no
later than the delivery of the trade acknowledgement of the
transaction.
    The required disclosure of clearing rights may increase how
informed a counterparty is concerning the availability of clearing in
general, the ability to require clearing of security-based swaps, as
well as the names of clearing agencies that may accept a given
security-based swap for clearing. The reliance on standardized
disclosures may lead to more general and less transaction specific
information being communicated, reflecting information that has already
been absorbed by market participants and potentially reducing these
benefits. To the extent that the rule results in greater transparency
concerning clearing rights, the volume of cleared security-based swaps
may increase.
    We note that clearing is currently voluntary and available for CDS
only.\1686\ Disclosure of the clearing

agencies that accept a security-based swap for clearing may inform
counterparties of the right to clear and of various clearing agencies
that are able to clear a given security-based swap, particularly
clearing agencies that have just started accepting a given security-
based swap or group of security-based swaps for clearing. This may
enhance potential competition among clearing agencies in the future,
which may lower clearing costs or improve quality of clearing services.
The above effect may be more significant if more clearing agencies
register to clear security-based swaps and clearing becomes available
for security-based swaps other than CDS, which are currently being
cleared voluntarily.
---------------------------------------------------------------------------

    \1686\ Mandatory clearing is not currently in effect and we
currently do not have sufficient information to estimate the number
and volume of security-based swap transactions executed across
different trading venues and using these various execution
practices. However, the Commission staff has performed an analysis
of voluntary clearing activity in single name CDS markets, which
generally informs our analysis. See SEC Division of Economic and
Risk Analysis, Single-Name Corporate Credit Default Swaps:
Background Data Analysis on Voluntary Clearing Activity, 15 (Apr.
2015), available at http://www.sec.gov/dera/staff-papers/white-papers/voluntary-clearing-activity.pdf.
---------------------------------------------------------------------------

    Currently, SBS Entities are not yet required to register and are
not subject to substantive Title VII requirements, including business
conduct rules. Therefore, SBS Entities currently are not required to
produce disclosures concerning clearing rights and a list of clearing
agencies accepting a security-based swap for clearing. Entities that
are currently registered with the CFTC as Swap Entities are required to
make clearing rights disclosures for swap transactions. Under these
final rules, all SBS Entities will bear costs of producing the clearing
rights disclosures pertaining to security-based swap transactions, and
communicating them to their counterparties other than SBS Entities and
Swap Entities, as estimated in Sections V and VI.C above. However, we
recognize that these costs may be lower for dually registered SBS
Entities that may have already adjusted their systems and practices to
comply with parallel CFTC rules. We also recognize that if, as a result
of the disclosure, some counterparties begin choosing to clear as well
as choosing the agency used to clear the transaction, SBS Entities may
lose potentially beneficial flexibility related to clearing, which may
affect the price of security-based swaps. In addition, if clearing
rights disclosures lead to a greater volume of transactions cleared
through registered clearing agencies, increases in clearing costs borne
by SBS Entities may be passed on to counterparties.
3. Suitability
    SBS Dealers intermediate large volumes of security-based swaps,
buying products from counterparties seeking to sell them; and selling
swaps to counterparties seeking to purchase them. When SBS Dealer
exposure is not hedged by offsetting transactions with other dealers,
SBS Dealers act as principal risk holders, benefiting from directional
price moves that result in losses for their counterparties, and vice
versa. SBS Dealers carrying inventory may have an incentive to
recommend security-based swaps from their inventory that may be
unsuitable to their counterparties, but help to manage dealer inventory
risk. When SBS Dealers hedge the underlying risk of a transaction,
dealer profits stem from commissions and fees charged to their
counterparties in relation to the security-based swap. As a result, SBS
Dealer incentives may be generally inconsistent with, or may be
contrary to the economic interests of their counterparties.
    As discussed in earlier sections, SBS Dealers are more informed
than their non-dealer counterparties as they can directly observe pre-
trade requests for quotes and order flow. Where SBS Dealers have
previously acted in other capacities, such as in the capacity of an
underwriter, arranger or structurer of a security-based swap, they may
have superior information about the quality and risk of a specific
security-based swap and its underlying assets. As a result, SBS Dealers
may have superior information about the inherent value and risk of
security-based swaps, including information concerning whether a given
security-based swap is unsuitable for a particular non-dealer
counterparty given the counterparty's horizon and ability to absorb
losses, among other things.
    When SBS Dealers advise their counterparties regarding security-
based swaps, the above conflicts of interest may result in
recommendations of security-based swaps that may be unsuitable for a
given counterparty. For instance, more complex security-based swaps are
more opaque and difficult to price for less informed counterparties;
they may also be unsuitable for a greater number of non-dealer
counterparties.\1687\ At the same time, such transactions may be
profitable for the dealer. To the extent that SBS Dealers may be
recommending unsuitable security-based swaps, and to the extent
counterparties may be relying on such advice and are unable to observe
and decouple bias from the information component of the recommendation,
counterparties may be entering into security-based transactions
inconsistent with their investment objectives and risk tolerance. The
central role and high market share of a small number of SBS Dealers
described in the economic baseline may reduce the effectiveness of
reputational considerations in mitigating these effects.
---------------------------------------------------------------------------

    \1687\ The Commission recognizes that complex over-the-counter
security-based swaps may benefit some market participants due to the
ability to tailor economic terms to counterparties' hedging needs or
market views.
---------------------------------------------------------------------------

    Under Rule 15Fh-3(f)(1), SBS Dealers recommending security-based
swaps or trading strategies involving a security-based swap to
counterparties other than an SBS Entity or a Swap Entity are required
to (i) undertake reasonable diligence to understand potential risks and
rewards associated with the recommendation; and, (ii) have a reasonable
basis to believe that the recommended swap or strategy is suitable for
the counterparty, taking into account, among other things, the
counterparty's investment profile, trading objectives and ability to
absorb potential losses. Rule 15Fh-3(f)(2) includes an alternative for
institutional counterparties (defined as a counterparty that is an
eligible contract participant as defined in clauses (A)(i), (ii),
(iii), (iv), (viii), (ix) or (x), or clause (B)(ii) of Section 1a(18)
of the Commodity Exchange Act and the rules and regulations thereunder,
or any person (whether a natural person, corporation, partnership,
trust or otherwise) with total assets of at least $50 million) that
allows an SBS Dealer to satisfy its customer-specific suitability
obligations in Rule 15Fh-3(f)(1)(ii) if (i) the SBS Dealer reasonably
determines that the counterparty or agent with delegated authority is
capable of independently evaluating investment risks with respect to a
given security-based swap or strategy; (ii) the counterparty or agent
represents in writing that they are exercising independent judgment in
evaluating the dealer's recommendations; and (iii) the SBS Dealer
discloses that it is acting as a counterparty and not assessing
suitability. Under Rule 15Fh-3(f)(3), an SBS Dealer will be deemed to
have satisfied the requirements of the first prong of the institutional
suitability alternative in Rule 15Fh-3(f)(2)(i) if it receives written
representations that: (i) In the case of a counterparty that is not a
special entity, the counterparty has complied in good faith with
written policies and procedures that are reasonably designed to ensure
that the persons responsible for evaluating the recommendation and
making trading decisions on behalf of the counterparty are capable of
doing so; and (ii) in the case of a counterparty that is a special
entity, satisfy the terms of the safe harbor in Rule 15Fh-5(b).
a. Costs and Benefits
    Rule 15Fh-3(f)(1) may benefit counterparties by requiring that SBS
Dealers undertake reasonable diligence to understand the potential risk
and

rewards associated with recommended security-based swaps or trading
strategies involving security-based swaps and that these
recommendations are suitable for the counterparty given the
counterparty's investment profile, trading objectives, and ability to
absorb potential losses. As a result, counterparties of SBS Dealers may
become more likely to allocate capital to suitable security-based
swaps, potentially enhancing counterparty protections and allocative
efficiency.\1688\ These benefits are expected to accrue only to the
extent that some SBS Dealers otherwise may be making unsuitable
recommendations, and to the extent that non-SBS or Swap Entity
counterparties rely on such SBS Dealer recommendations in their capital
allocation decisions. If incentive conflicts or governance failures
within counterparties, or other factors unrelated to SBS Dealer
recommendations, for instance, reaching for yield in low interest rate
environments, contribute to potentially unsuitable security-based swap
choices, the benefits of these rules may be muted. The suitability
standard does not require dealers to disclose whether another suitable
security-based swap or underlier has superior material characteristics.
Therefore, some of the above counterparty protection and allocative
efficiency benefits of the suitability standard may be less. Further,
this benefit is likely to be highest for those counterparties of SBS
Dealers which do not already rely on professional asset managers or
independent advisers in security-based swap transactions.
---------------------------------------------------------------------------

    \1688\ See, e.g., CFA, supra note 5; Levin, supra note 5.
---------------------------------------------------------------------------

    The suitability requirement will impose costs on SBS Dealers.
First, the rule requires SBS Dealers to undertake reasonable diligence
to understand the potential risks and rewards of the security-based
swaps or trading strategy involving a security-based swap they
recommend. Second, the rule will involve direct costs required to make
an assessment of suitability of a security-based swap or asset class
for each counterparty.\1689\ As estimated in Section V, we expect that
SBS Dealers may seek to obtain representations at an estimated cost of
up to $11,393,160.\1690\ Further, the Commission recognizes that
suitability assessments under these final rules may give rise to
potential liability and litigation costs of SBS Dealers.
---------------------------------------------------------------------------

    \1689\ See, e.g., FIA/ISDA/SIFMA, supra note 5.
    \1690\ Initial cost: (In-house attorney at $380 per hour) x
(6,271 x 2 hours for participants active in both swaps and SBS
markets + 3,488 x 5 hours for participants active in SBS markets
only) = 380 x 29,982 = $11,393,160.
---------------------------------------------------------------------------

    In considering the economic effects of this final rule, we note
that the suitability requirement does not apply to recommendations made
to SBS Dealers, Major SBS Participants, Swap Dealers, or Major Swap
Participants. Therefore, the rule may result in higher costs to SBS
Dealers in transacting with non-SBS or Swap Entity counterparties.
Additionally, costs of suitability assessments may be higher for
counterparties with which an SBS Dealer has had no prior transactions.
    The rule may adversely affect counterparties of SBS Dealers that
are not themselves SBS Dealers, Major SBS Participants, Swap Dealers,
or Major Swap Participants. In addition, SBS Dealer cost increases due
to suitability assessments discussed above may be passed on to
counterparties, and, if a significant percentage of the costs cannot be
recovered, the willingness of SBS Dealers to make recommendations to
non-dealer counterparties may decrease. Further, SBS Dealers may have
superior information about the quality of security-based swaps they
intermediate, but have significantly less information about their
counterparty. This informational asymmetry may result in SBS Dealers
not recommending security-based swaps that may be potentially suitable
to the counterparty. Moreover, to the extent that customer suitability
evaluations take time and require additional due diligence, the rule
may result in execution delays, particularly during times of high
market volatility when the value of risk mitigation may be higher. We
note, however, that suitability requirements apply only with respect to
swaps being recommended by SBS Dealers, and counterparties may continue
to have access to security-based swaps intermediated without bundled
SBS Dealer advice, as well as swaps executed on SEFs or registered
exchanges.
    The above benefits and costs of the suitability rule are likely to
be limited by the scope of these final rules and the institutional
suitability alternative. The suitability requirement is limited to
transactions between SBS Dealers and counterparties that are not
themselves SBS or Swap Entities. We believe that SBS Entities are
likely to be able to independently evaluate material risks, pricing,
and overall suitability of a security-based swap given, among others,
their investment objectives and risk tolerance. As shown in Figure 3,
the majority of trades and trade notional involved trades among
dealers, which substantially reduces the scope of application of the
suitability requirement. Further, as discussed below, the scope of
application of the suitability rule may be reduced if SBS Dealers are
able to take advantage of the institutional suitability alternative for
customer-specific suitability with respect to a significant fraction of
transactions.
    As noted in the proposing release,\1691\ many SBS Dealers may
already have an obligation to make suitable recommendations in other
contexts. FINRA imposes a suitability requirement on recommendations by
broker-dealers and we have elsewhere estimated that up to 16 entities
registering with the Commission as SBS Entities may be already
operating as registered broker-dealers subject to Commission and FINRA
oversight.\1692\ As discussed in Section II, Swap Dealers registered
with the CFTC are also subject to reasonable basis and customer-
specific suitability requirements with respect to swap transactions
under Rule 23.434, and we have elsewhere estimated that up to 35 SBS
Entities may be cross-registered with the CFTC as Swap Entities. Some
of these cross-registered entities may have adjusted their compliance
infrastructure and recommendation practices. These considerations may
mitigate both the costs and the benefits of these final rules.
---------------------------------------------------------------------------

    \1691\ See Proposing Release, 76 FR at 42450, supra note 3.
    \1692\ See Registration Adopting Release, 80 FR at 49000, supra
note 989.
---------------------------------------------------------------------------

b. Institutional Suitability Alternative
    Rule 15Fh-3(f)(2) includes an institutional suitability alternative
for customer-specific suitability assessments. SBS Dealers will be
deemed to have fulfilled their customer-specific suitability
obligations if they reasonably determine that the counterparty or its
agent is capable of independently evaluating the investment risks; the
counterparty or agent affirmatively represents in writing that they are
evaluating the investment independently; and the SBS Dealer discloses
that it is not undertaking to assess suitability for the counterparty.
The institutional suitability alternative for customer-specific
suitability requirements will not be available with respect to
counterparties that are not institutional counterparties (defined as a
counterparty that is an eligible contract participant as defined in
clauses (A)(i), (ii), (iii), (iv), (viii), (ix) or (x), or clause
(B)(ii) of Section 1a(18) of the Commodity Exchange Act and the rules
and regulations thereunder, or any

person (whether a natural person, corporation, partnership, trust or
otherwise) with total assets of at least $50 million. Recommendations
of any potentially unsuitable products could involve losses and lead to
inefficient capital allocation by non-dealer counterparties when such
counterparties lack the ability to independently assess suitability of
security-based swap transactions they enter into. Sophisticated
institutions or entities that rely on independent advisors in their
decision making may be better able to independently assess the merits
and suitability of a given security-based swap. Therefore, more
sophisticated counterparties and counterparties that rely on
independent advisers to assess disclosures and analyze the relative
merits of individual swaps are less likely to benefit from the
suitability rule. The institutional suitability alternative reflects
these considerations.
    As a result of the institutional suitability alternative, SBS
Dealers will not be required to undertake customer-specific suitability
evaluations for counterparties that the rule presumes are capable of
independently evaluating investment risks with regard to the relevant
security-based swap or trading strategy involving a security-based
swap. As shown in Table 2 of the economic baseline, between November
2006 and December 2014, 99% of private funds, 100% of registered
investment companies, 72% of insurance companies, 75% of non-financial
firms and 98% of special entities were represented by investment
advisers. Hence, non-dealer counterparties generally have third-party
representation and may be able to evaluate security-based swaps
independently of SBS Dealers. Many SBS Dealers may be able to rely on
the institutional suitability alternative to fulfill their customer-
specific suitability obligations. Therefore, a large fraction of
transactions may qualify for the institutional suitability alternative,
and the economic effects of the suitability requirement above may
accrue to a small share of security-based swap market activity.
    In addition, the institutional suitability alternative for
customer-specific suitability will not be available for SBS Dealers
making recommendations to counterparties that are not institutional
counterparties. The $50 million asset threshold in the institutional
counterparty definition narrows the scope of the alternative and
increases the potential counterparty protection and allocative
efficiency benefits of the final suitability rule. Our data do not
allow us to estimate how many counterparties that would not meet the
institutional counterparty definition are currently transacting in
security-based swap markets and relying on recommendations by SBS
Dealers, asset size thresholds for counterparties at which the intended
information and counterparty protection benefits of these final rules
become significant, or the extent to which asset size and counterparty
sophistication may be correlated in security-based swap markets. We
also recognize that the $50 million asset size threshold may increase
costs and diverges from the suitability safe harbor adopted by the CFTC
as part of business conduct standards for Swap Entities. As a result,
all SBS Dealers that are dually registered with the CFTC as Swap
Dealers will face a bifurcated suitability standard in swaps and
security-based swaps, such as index CDS and single name CDS, with
respect to counterparties that do not meet the institutional
counterparty definition. In response to these final rules, dually
registered SBS Dealers may choose not to rely on the institutional
suitability alternative when making recommendations to counterparties
that do not meet the institutional counterparty definition in both swap
and security-based swap markets.
    Direct burdens and costs of suitability assessments have been
estimated above. The Commission also recognizes that this aspect of the
institutional suitability alternative may increase system complexity,
liability and other costs less amenable to quantification that SBS
Dealers will incur as a result of advising and transacting with small
counterparties in security-based swaps. These costs may be passed on to
counterparties of SBS Dealers, which may experience an increase in
transaction costs, decreased access to SBS Dealer advice, or decreased
willingness of SBS Dealers to intermediate over-the-counter security-
based swaps.
    However, affected counterparties may continue to retain access to
anonymous SEF or exchange executed security-based swaps, which are not
subject to the suitability requirements of these final rules. Further,
while the asset threshold in the institutional suitability alternative
diverges from the CFTC's approach to suitability for Swap Dealers, it
aligns with FINRA's asset threshold for the institutional account
definition. SBS Dealers cross-registered as broker-dealers are
currently unable to rely on institutional suitability when recommending
less complex products, such as vanilla equity or fixed income
instruments, to the same group of counterparties, and may be less
affected by the institutional counterparty asset threshold for the
suitability alternative. We note that SBS Dealers will be able to avail
themselves of the institutional suitability alternative when making
recommendations to certain financial institutions, insurance companies,
registered investment companies, commodity pools with at least $5
million in assets, broker-dealers, futures commission merchants, floor
brokers, investment advisers and commodity trading advisors with less
than $50 million in assets. As discussed above, the Commission believes
that the $50 million asset threshold may enhance counterparty
protection and allocative efficiency benefits of the final suitability
rule relative to the alternative of not including an asset threshold as
part of institutional suitability.
    We note that the institutional suitability alternative is not
applicable to the suitability requirement to undertake reasonable
diligence to understand the potential risks and rewards associated with
the recommended security-based swap or trading strategy involving a
security-based swap. However, when SBS Dealers rely on the alternative,
they will not be required to make customer-specific suitability
assessments with respect to individual counterparties' investment
profile, trading objectives and ability to absorb losses.
    As clarified in Section II, the Commission believes that parties
should be able to make the disclosures and representations required by
Rules 15Fh-3(f)(2) and (3) on a transaction-by-transaction basis, on an
asset-class-by-asset-class basis, or in terms of all potential
transactions between the parties. As a result, SBS Dealers will not be
required to assess customer-specific suitability of whole asset classes
or all security-based swaps, if the counterparty makes appropriate
representations and other institutional suitability requirements are
met.
    To the extent that security-based swaps are heterogeneous in their
risk and expected return characteristics, and since the degree of
counterparty sophistication and familiarity with various types of
security-based swaps may vary over time, such an approach to
institutional suitability may lower the benefits of the rule. However,
the ability to take advantage of the institutional suitability
alternative for groups of security-based swaps, asset classes or
counterparties as a whole mitigates the burdens imposed on SBS
Dealers,\1693\

particularly when such dealers intermediate multiple homogeneous
transactions with the same counterparty over a limited time period. For
instance, as we have noted in the economic baseline, based on an
analysis of DTCC-TIW data, an average unique dealer-nondealer pair
entered into approximately 32 transactions in 2014. The ability of
dealers to rely on the institutional suitability alternative for some
or all of the trades with a given counterparty would be less costly,
and may also limit execution delays facilitating market access to
security-based swaps.
---------------------------------------------------------------------------

    \1693\ See, e.g., Barnard, supra note 5.
---------------------------------------------------------------------------

    In addition to the above considerations concerning institutional
suitability, we note that the final suitability requirements will not
apply if an SBS Dealer does not recommend a security-based swap or
trading strategy involving a security-based swap to counterparties. As
estimated above, the suitability requirement imposes costs on SBS
Dealers, and may decrease their willingness to recommend security-based
swaps to non-SBS or Swap Entity counterparties. However, as discussed
throughout the release, we believe that the overwhelming majority of
market participants already have access to third party advice
concerning security-based swaps.
    Finally, suitability obligations will also apply to transactions
with special entities, and the institutional suitability alternative
described above will be available for special entity counterparties
that meet the institutional counterparty definition (i.e., have total
assets of at least $50 million).
4. Special Entities
    The business conduct rules being adopted include a number of
requirements for SBS Entities specific to their dealings with special
entities governing, among other things: (a) The scope of entities that
will be subject to the substantive special entity standards; (b) the
duty to verify and inform entities when they are eligible to elect not
to be considered a special entity for the purposes of these rules; (c)
the definition of qualified independent representative for such
purposes; (d) the conduct of SBS Entities when they act as
counterparties to special entities; (e) the conduct of SBS Dealers when
they act as advisors to special entities.
a. Scope and Verification
    First, as part of verification of status requirement under Rule
15Fh-3(a)(2), SBS Entities will be required to verify whether a
counterparty is a special entity before entering into a security-based
swap, unless the transaction is executed on a registered or exempt SEF
or registered national securities exchange, and the SBS Entity does not
know the identity of the counterparty at a reasonably sufficient time
prior to execution of the transaction to permit the SBS Entity to
comply with the rule. Under Rule 15Fh-3(a)(3), an SBS Entity shall also
verify whether a counterparty is eligible to elect not to be a special
entity, and, if so, notify such counterparty of its right to make such
an election. Rule 15Fh-2(e) defines the scope of special entities to
include, among other things, federal and state agencies, States,
cities, counties, municipalities, and other political subdivisions of a
State, instrumentalities, departments or corporations of or established
by a State or political subdivision of a State, employee benefit plans
subject to Title I of ERISA, governmental plans as defined in Section
3(32) of ERISA, and endowments. Rule 15Fh-2(e) also provides that
employee benefit plans defined in Section 3 of ERISA, that are not
otherwise defined as special entities, may elect not to be treated as
special entities by notifying an SBS Entity prior to entering into a
security-based swap.
    These final rules define the set of special entities that will be
able to avail themselves of the protections in these final rules. The
inclusion of entities defined in, but not subject to, ERISA into the
special entity category, subject to an opt out provision, increases the
set of market participants afforded the counterparty protections under
the final business conduct standards, relative to the exclusive
application of these rules to entities subject to ERISA.\1694\ At the
same time, as discussed below, compliance with these final rules
concerning special entities will entail direct and indirect costs for
SBS Entities. Increased costs to SBS Entities may be passed on to
special entity counterparties in the form of more adverse terms of
available security-based swaps or a decreased willingness of SBS
Entities to intermediate such swaps with special entities, which may
reduce special entities' access to such security-based swaps.\1695\ The
ability of special entities defined in, but not subject to, ERISA to
opt out of the special entity status may give such entities greater
flexibility in structuring their relationships with SBS Entities, and
allow them to trade off the benefits of counterparty protections in
these final rules against potentially greater costs and lower liquidity
in SBS Entity intermediated OTC security-based swaps.
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    \1694\ See Church Alliance (August 2011), supra note 5 and
Church Alliance (October 2011), supra note 5, suggesting that church
plans may benefit from enhanced conduct by SBS Entities in their
advisory or intermediation roles, and requesting clarification of
status of church plans for purposes of regulations under Dodd Frank.
    \1695\ As we discuss in Section VI.C.4.f, special entity rules
will not apply to security-based swaps executed on registered or
exempt SEFs or registered national security exchanges, where SBS
Entities do not know the identity of the counterparty at a
reasonably sufficient time prior to execution of the transaction to
permit the SBS Entity to comply with these final obligations.
Therefore, special entities and entities defined in, but not subject
to ERISA, regardless of their opt out decision, will continue to
have access to anonymous SEF or exchange executed security-based
swaps.
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    We note that the opt out approach for special entities defined in,
but not subject to, ERISA differs from parallel CFTC business conduct
rules, which allow such entities to opt into the special entity status
instead. As discussed in the economic baseline, the Commission expects
extensive cross-registration of SBS Entities as Swap Entities, and
understands most market participants transact in both swap and
security-based swap markets. To the extent that SBS Entities have
significant bargaining power in transactions with special entities,
special entities that have selected not to opt into the special entity
status in swap markets are likely to opt out of similar protections
under these final rules. Therefore, it is unclear whether the ability
of special entities defined in, but not subject to ERISA to opt out of
special entity protections would lead to a greater number of special
entities benefiting from counterparty protections in these final rules,
relative to the opt in approach. We also recognize that under the final
rules, if a special entity chooses to opt out of the special entity
status, it would be required to provide a written notice to the SBS
Entity and would bear related costs. The overall economic effects of
this rule will, therefore, depend on the number of entities defined in,
but not subject to, ERISA that will choose to opt out of the special
entity status, the costs of producing notices, and magnitude of the
transaction cost increases in OTC security-based swaps resulting from
compliance with these final special entity rules.
    Estimates of special entity market participants in our economic
baseline are based on manual account classifications, and our data is
not sufficiently granular to estimate the number of special entities
defined in but not subject to ERISA currently active in security-based
swap markets that may be scoped in by these rules. Special

entities represent approximately 8% of market participants in swap
markets.\1696\ Out of 3,635 special entities subscribed to the ISDA
August 2012 DF Protocol, 1,453 market participants (approximately 40%)
elected to be a special entity under the protocol. This may indicate
that a substantial number of market participants in swap markets may
have opted into the special entity treatment. However, we note that
using hand classifications of accounts in TIW data on 2006-2014, we
estimate that special entities represent approximately 10.5% of single
name CDS market participants by count (see Table 2 above). This
estimate is comparable to the 8% of all special entities adhering to
the ISDA August 2012 DF Protocol, and our hand classifications of
accounts do not distinguish between special entities subject to ERISA,
and those defined in but not subject to ERISA. Therefore, our analysis
of special entity transaction activity throughout the release likely
includes both special entities subject to ERISA, and entities defined
in but not subject to ERISA that may opt out of the special entity
protections of these final rules.
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    \1696\ This estimate is based upon data provided by ISDA as of
December 31, 2015 on the number and type of market participants
adhering to the ISDA August 2012 DF Protocol. See Memorandum from
Lindsay Kidwell to File (Feb. 18, 2016) available on the
Commission's Web site at http://www.sec.gov/comments/s7-25-11/s72511.shtml under ``Meetings with SEC Officials.'' See also Section
VI.B.
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    Special entity requirements and related costs will not apply to
security-based swaps transacted on registered national securities
exchanges and registered or exempt SEFs, if the SBS Entity does not
know the identity of the counterparty at a reasonably sufficient time
prior to execution of the transaction to permit the SBS Entity to
comply with the obligations of the rules. We recognize that some
security-based swaps executed on a SEF or exchange may be bilaterally
negotiated, which may point to potential counterparty and information
benefits of applying the business conduct rules to SEF and exchange
traded security-based swaps. However, bilateral negotiations are likely
to require an SBS Entity to know the identity of the counterparty at a
reasonably sufficient time prior to execution to permit compliance. We
also recognize that conflicts of interest may affect SBS Dealer
recommendations of security-based swaps regardless of the venue in
which these transactions are executed. It is not clear whether an SBS
Dealer would be able to make a recommendation to a counterparty whose
identity is not known at a reasonably sufficient time prior to
execution. Finally, as we discuss throughout the release, while
business conduct rules, including rules concerning special entities,
may result in significant benefits, they will impose direct and
indirect costs on SBS Entities. In the context of SEF transactions, the
application of these rules may increase transaction costs, add
complexity and delays, or require negotiation with counterparties. To
the extent that security-based swaps executed through SEFs may
represent exclusively arms-length transactions, the terms of which are
not negotiated, the imposition of the final business conduct rules on
such trades could increase costs without corresponding benefits
anticipated by these final rules. For instance, if clearing reduces
credit risk of counterparties, SBS Entities may compete on transaction
costs and quality of execution, as opposed to credit risks of the
transaction, as suggested by commenters.\1697\ These final rules
recognize these competing considerations and provide explicit relief
for transactions executed on a registered or exempt SEF or registered
national exchange, if the SBS Entity does not know the identity of the
special entity counterparty at a reasonably sufficient time prior to
execution of the transaction to permit compliance with the obligations
of the rule. Finally, the Commission continues to recognize that the
benefits of these final special entity rules are expected to primarily
accrue to entities that are less informed about security-based swap
markets. While special entities will not be able to opt out of the
protections of these final rules as discussed in section VI.C.8, SBS
Entities will be able to rely on an independent representative safe
harbor, the economic effects of which are considered in detail in the
sections that follow.
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    \1697\ See SIFMA (August 2011), supra note 5 and BlackRock,
supra note 5.
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    As discussed in Section II, the special entity definition does not
include collective investment vehicles, and the final rules do not
require SBS Dealers to determine whether any of the investors in the
collective investment vehicle counterparty qualify as special entities.
Such an approach limits the scope of application of these final rules,
reducing potential counterparty protection and allocative efficiency
benefits, but also potential costs and risks of loss of access by
special entities and entities defined in, but not subject to ERISA, to
security-based swaps.
b. SBS Entities as Counterparties to Special Entities
    Under final Rule 15Fh-5(a) an SBS Entity that offers to enter or
enters into a security-based swap with a special entity must have a
reasonable basis to believe that the special entity has a qualified
independent representative. Under Rule 15Fh-5(c), before initiating a
swap, an SBS Dealer will also be required to disclose in writing the
capacity in which the dealer is acting in connection with the security-
based swap. Additionally, if the SBS Dealer or its associated persons
engage or have engaged in business with the special entity in more than
one capacity, the dealer would be required to disclose the material
differences between such capacities and any other financial
transactions or service involving the special entity. As discussed in
section II.H.7 supra, the SBS Dealer may use generalized disclosures
regarding the capacities in which the SBS Dealer and its associated
persons have acted or may act with respect to the special entity, along
with a statement distinguishing those capacities from the capacity in
which the SBS Dealer is acting with respect to the present security-
based swap. The requirements in Rule 15Fh-5 do not apply to a security-
based swap if the transaction is being executed on a registered or
exempt SEF or registered national securities exchange, and the SBS
Entity does not know the identity of the counterparty at a reasonably
sufficient time prior to execution of the transaction to permit
compliance with these obligations.
    Qualified independent representatives must have sufficient
knowledge to evaluate the transaction and risks; may not be subject to
statutory disqualification; undertake a duty to act in the best
interests of the special entity; appropriately and timely disclose
material information concerning the security-based swap to the special
entity; evaluate, consistent with any guidelines provided by the
special entity, the fairness of pricing and appropriateness of the
security-based swap; and for certain types of special entities the
representative must be subject to rules for the Commission, the CFTC,
or a SRO prohibiting it from engaging in specified activities if
certain political contributions have been made, unless the
representative is an employee of the special entity. Independence
requires that a representative does not have a relationship with the
SBS Entity, whether compensatory or otherwise, that reasonably could
affect the independent judgment or decision-making of the
representative. A

representative will be deemed to be independent of an SBS Entity if,
within one year of representing the special entity in connection with
the security-based swap, the representative was not an associated
person of an SBS Entity; provides timely disclosures to the special
entity of all material conflicts of interest that could reasonably
affect the judgment or decision making of the representative with
respect to its obligations to the special entity; complies with
policies and procedures reasonably designed to manage and mitigate such
material conflicts of interest; and the SBS Entity did not refer,
recommend, or introduce it to the special entity within one year of the
representative's representation of the special entity in connection
with the security-based swap. As proposed by some commenters, ERISA
plans will be able to comply with these requirements by relying on an
ERISA fiduciary.\1698\ Further, as we discuss in more detail below, the
independence requirement refers to the representative's independence of
the SBS Entity and not of the special entity and so, qualified
investment representatives that are employees or associates of the
special entity may qualify as independent representatives for the
purposes of these rules.
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    \1698\ See ABC, supra note 5 and SIFMA (August 2011), supra note
5.
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    In contrast with the final rule, the proposed rule defined
independence based on a two-prong test of (1) associated person status
within the preceding year; and (2) ten percent or greater revenue
reliance on a given SBS Entity. We are sensitive to commenter concerns
that this definition may impose undue restrictions and cost burdens on
SBS Entities, and may be difficult to implement.\1699\ Further, the
CFTC's independence formulation applicable to Swap Entities does not
include a ten percent revenue prong in the independent test with
special entities. In light of active cross-market participation and
expected SBS Entity cross-registration, adopting a substantively
different independence requirement from that required by Swap Entities
may impose costs of compliance with two different independent
representation standards. At the same time, it is unclear that such an
approach would be more beneficial to counterparty protections,
Commission oversight or enforcement in security-based swaps relative to
the approach being adopted.
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