positions that the entity holds against its counterparties. The
Commission then calculates the aggregate gross notional amount of each
entity's open single-name CDS positions. For these 23 dealing entities,
the mean, median, maximum, and minimum aggregate gross notional amount
are respectively, $219 billion, $115 billion, $902 billion, and $3
billion. The standard deviation in aggregate gross notional amounts is
$242 billion.
    These entities also engage in dealing activity in the swap market.
The aggregate gross notional amounts of their open positions in the
swap market have a mean of $11,725 billion, a median of $10,244
billion, a minimum of $72 billion, a maximum of $45,264 billion, and a
standard deviation of $10,496 billion.\967\ To gauge the relative
significance of single-name CDS open positions, the Commission
expresses each entity's single-name CDS aggregate gross notional amount
as a percentage of its combined swaps and single-name CDS aggregate
gross notional amount. The mean, median, maximum, and minimum
percentages are respectively 1.34%, 1.23%, 0.03%, and 5.39%. The
standard deviation is 1.13%.
---------------------------------------------------------------------------

    \967\ The Commission obtained these entities' open positions in
interest rate swaps, currency swaps, and index CDS from the CFTC.
---------------------------------------------------------------------------

e. Cross-Market Participation
    The numerous financial markets are integrated, often attracting the
same market participants that trade across corporate bond, swap, and
security-based swap markets, among others. In a prior release, the
Commission discussed the hedging opportunities across the single-name
CDS and index CDS markets and how such hedging opportunities in turn
influence the extent to which participants that are active in the
single-name CDS market are likely to be active in the index CDS
market.\968\
---------------------------------------------------------------------------

    \968\ See Applications by Security-Based Swap Dealers or Major
Security-Based Swap Participants for Statutorily Disqualified
Associated Persons to Effect or Be Involved in Effecting Security-
Based Swaps, 84 FR at 4927.
---------------------------------------------------------------------------

2. Counterparty Credit Risk Mitigation
    In contrast to the securities markets, counterparty credit risk
represents a major source of risk to participants in the OTC security-
based swap market.\969\ For example, in a CDS transaction, the first
party, the protection buyer, agrees to pay the second party, the
protection seller, a periodic premium for a set time period in exchange
for the protection seller agreeing to pay some amount in the event of
the occurrence of a given credit event during the same period. The
ongoing reciprocal obligations of the parties in such transactions
expose each to ongoing reciprocal counterparty credit risk.
---------------------------------------------------------------------------

    \969\ See Robert R. Bliss and Robert S. Steigerwald, Derivatives
Clearing and Settlement: A Comparison of Central Counterparties and
Alternative Structures, Economic Perspectives 30, no. 4.
---------------------------------------------------------------------------

    Currently, security-based swap market participants mitigate
counterparty credit risk by: (1) Using a central counterparty (``CCP'')
such as a clearing agency or DCO to clear a trade; (2) using
standardized netting agreements between counterparties; (3) performing
portfolio compression to minimize counterparty exposure; and (4)
requiring margin (i.e., collateral). Below is a brief discussion of the
extent to which market participants make use of each of these practices
in the CDS market, which comprises the majority of security-based swap
transactions.
a. Clearing
    Central clearing through a CCP provides a method for dealing with
the counterparty credit risk inherent in security-based swap
transactions. Where a clearing agency provides CCP services, clearance
and settlement of security-based swap contracts replaces bilateral
counterparty exposures with exposures against the clearing agency
providing CCP services.\970\ Using a CCP to centrally manage credit
risk can reduce the monitoring costs and counterparty credit risk of
both parties to the original transaction. A centralized clearing
structure, when widely adopted, also maximizes the opportunities for
netting offsetting contracts thus reducing collateral requirements in
centrally-cleared transactions. It can also improve price discovery and
financial stability
---------------------------------------------------------------------------

    \970\ See Standards for Covered Clearing Agencies, 81 FR 70786.
---------------------------------------------------------------------------

    Although central clearing offers a number of advantages, it is not
without limitations. For example, ``bespoke'' or otherwise illiquid
contracts are not amenable to clearing. Widespread adoption of central
clearing in security-based swap markets would raise the systemic
importance of CCPs.
    The ratio of the aggregate notional amount of outstanding CDS
contracts cleared through CCPs to the aggregate notional amount of all
outstanding CDS contracts has been increasing steadily since 2010.\971\
In 2017, this ratio peaked at 27.5%, representing a significant
increase over 2016 (21.8%), 2015 (17.1%), 2014 (14.6%), 2013 (13.13%),
2012 (9.75%), 2011 (9.55%), and 2010 (7.36%).\972\ Limiting attention
to just single-name CDS contracts (i.e., excluding index CDS and multi-
name non-index CDS) provides a less consistent picture. While the
percentage of single-name CDS contracts that were cleared has increased
from 36% in 2010 to 40% in 2017, the upward trend has not been uniform,
with a local peak in 2011 (46%) followed by a decline in

2012 (45%) and 2013 (37%), an increase in 2014 (43.5%) and 2015 (48%),
and then another decline in 2016 (47%) and 2017 (40%).\973\
---------------------------------------------------------------------------

    \971\ 2010 is the first year the BIS' OTC derivatives market
surveys separate out CDS market activity by counterparty, including
CCPs. See BIS, OTC derivatives market activity in the second half of
2010 (May 2011).
    \972\ See BIS, OTC derivatives statistics at end-December 2017
(May 2018), BIS, OTC derivatives statistics at end-December 2016
(May 2017), BIS, OTC derivatives statistics at end-December 2015
(May 2016); BIS, OTC derivatives statistics at end-December 2014
(Apr. 2015); BIS, OTC derivatives statistics at end-December 2013
(May 2014); BIS, OTC derivatives statistics at end-December 2012
(May 2013); BIS, OTC derivatives statistics at end-December 2011
(May 2012); BIS, OTC derivatives market activity in the second half
of 2010 (May 2011). For each year, the original ratio is obtained
from Table 4 (replaced by Table D10.1 beginning with 2015) of the
statistical releases and is calculated by dividing the CCPs'
outstanding aggregate notional amount by the total outstanding
aggregate notional amount, with the result divided by two (a
contract submitted for clearing to a CCP is replaced, post-novation,
by two contracts (with the same notional value as the original
contract) between the CCP and each of the original counterparties).
    \973\ These percentages are obtained from Table 4 (replaced by
Table D10.1 beginning with 2015) of the statistical releases, by
dividing the CCPs' outstanding aggregate notional amount for single-
name CDS by the CCPs' outstanding aggregate notional amount for all
CDS contracts.
---------------------------------------------------------------------------

b. Netting Agreements
    Netting agreements between counterparties can mitigate counterparty
risk by allowing the positive exposure of counterparty A to
counterparty B in a transaction to offset the positive exposure of
counterparty B to counterparty A in another transaction. Such offsets
are made possible through master netting agreements (``MNAs'').\974\
---------------------------------------------------------------------------

    \974\ Under the ISDA Master Agreement, netting can take two
forms: (1) Settlement (or payment) netting, which is the process of
combining offsetting cash flow obligations between solvent
counterparties into a single net payment; and (2) close-out netting,
which is the process of terminating and netting the marked-to-market
values of all outstanding transactions when one of the
counterparties becomes insolvent. The former is optional, while the
latter is a contractual obligation under the ISDA Master Agreement.
---------------------------------------------------------------------------

    One way to measure the degree of netting in a set of positions is
with the ``net-to-gross ratio,'' the ratio of the absolute value of the
sum of the marked-to-market values of the positions after all product-
specific netting agreements (cross-product agreements are excluded) are
given effect, to the sum of the positions' absolute marked-to-market
values. The more the gains on some positions offset losses on others,
the lower the ratio. On an aggregate basis (i.e., across all market
participants), the net-to-gross ratio for security-based swaps
positions was 27% in 2015. This is a significant increase compared to
2014 (23%) and 2013 (21%), and a marginal increase compared to 2012
(24%) and 2011 (26%).\975\
---------------------------------------------------------------------------

    \975\ See BIS, OTC derivatives statistics at end-December 2015;
BIS, OTC derivatives statistics at end-December 2014; BIS, OTC
derivatives statistics at end-December 2013.
---------------------------------------------------------------------------

    On a disaggregated basis, there is substantial variation in the
degree of netting across different market participants. For instance,
in 2015, the ratio of net market value to gross market value was as low
as 18% and 20% for CCPs and dealers, respectively, and as high as 78%
for insurance companies.\976\ These differences in the net-to-gross
ratio across different types of market participants reflect differences
in their participation in the security-based swap market.
---------------------------------------------------------------------------

    \976\ See BIS, OTC derivatives statistics at end-December 2015;
BIS, OTC derivatives statistics at end-December 2014; BIS, OTC
derivatives statistics at end-December 2013.
---------------------------------------------------------------------------

c. Portfolio Compression
    Portfolio compression reduces counterparty risk through the
termination of early redundant derivatives trades without changing the
net exposure of any of the counterparties. The amount of redundant
notional amount eliminated through portfolio compression declined
steadily over the years, from more than $30 trillion in 2008 \977\ and
more than $15 trillion in 2009, to $9.8 trillion in 2010, $6.4 trillion
in 2011, and $4.1 trillion in 2012.\978\
---------------------------------------------------------------------------

    \977\ See TriOptima, triReduce Statistics, available at http://www.trioptima.com/resource-center/statistics/triReduce.html. The
amount of portfolio compression as reported by TriOptima, a provider
of third-party portfolio compression services.
    \978\ ISDA, OTC Derivatives Market Analysis Year-End 2012 (June
2013, rev. Aug. 9, 2013). 2012 is the last year when ISDA reported
aggregate compression statistics.
---------------------------------------------------------------------------

d. Margin
    Participants in the security-based swap market may mitigate
counterparty risk by collecting collateral through margin assessment
under an active collateral agreement.\979\ The Commission lacks
regulatory data on the use of collateral by participants in the
security-based swap and swap markets.\980\ Thus, the Commission's
quantitative understanding of margin practices in these markets is
largely based on the ISDA's annual margin surveys. These surveys
suggest that: (1) The use of collateral has generally increased over
the last decade; (2) collateral practices vary by type of market
participant and counterparty; (3) segregation of collateral is not
widespread; and (4) use of central clearing is increasing.\981\
---------------------------------------------------------------------------

    \979\ A collateral agreement specifies the terms for the use of
collateral to support a bilateral derivatives trade. According to
the ISDA, a collateral agreement is active when: (1) There is an
open exposure with active trades beneath it, regardless of whether
collateral has been collected or delivered for any of the trades;
and (2) collateral has actually been collected or delivered. See
ISDA Margin Survey 2015. In contrast, inactive collateral agreements
are those that have been executed and have no current outstanding
exposure, or those that show no current activity but may be used to
trade at some point in the future. Cleared OTC derivatives trades
are generally subject to collateral agreements specified by the CCP.
    \980\ In the proposing release, the Commission requested data
and information from commenters to assist it in analyzing the
economic consequences of the proposed rules; no additional data was
provided. See Capital, Margin, and Segregation Proposing Release, 77
FR at 70300. See also Capital, Margin, and Segregation Comment
Reopening, 83 FR at 53019-20.
    \981\ The discussion in this section of the release is based on
the ISDA Margin Survey 2009 (Apr. 15, 2009), ISDA Margin Survey 2010
(Aug. 15, 2010), ISDA Margin Survey 2011 (Apr. 14, 2011), ISDA
Margin Survey 2012, ISDA Margin Survey 2013 (June 21, 2013), ISDA
Margin Survey 2014 (Apr. 10, 2014), and ISDA Margin Survey 2015. The
format of these reports has not remained constant over time.
Consequently, certain statistics are only available in the earlier
surveys.
---------------------------------------------------------------------------

    The statistics in the margin surveys suggest that the use of
collateral in security-based swap and swap transactions generally
increased in the period from the end of 2002 through the end of
2012.\982\ At the end of 2002, 53% of fixed income derivatives
transactions and 30% of credit derivatives transactions were subject to
a credit support agreement (``CSA''); by 2009, the percentages were 63%
and 71%, respectively.\983\ By 2012, similar statistics indicated that
79% of fixed income derivative transactions and 83% of credit
derivative transactions were subject to CSAs.\984\ With respect to non-
cleared transactions, the 2012 percentages of fixed income derivative
trades and credit derivative trades subject to a CSA were 73% and 79%,
respectively.
---------------------------------------------------------------------------

    \982\ See ISDA Margin Survey 2009 at Table 4.2; ISDA Margin
Survey 2010 at Table 3.3; ISDA Margin Survey 2011 at Table 3.2; ISDA
Margin Survey 2012 at Table 3.2; ISDA, ISDA Margin Survey 2013 at
Table 3.4.
    \983\ See ISDA Margin Survey 2009 at Table 4.2. This table
reports the fraction of transactions (cleared and non-cleared)
subject to a CSA.
    \984\ See ISDA Margin Survey 2013 at Table 3.4. Due to
methodological changes, the 2002 through 2009 statistics and the
2012 statistics are not directly comparable. Comparable statistics
were not reported in more recent surveys.
---------------------------------------------------------------------------

    While the industry margin surveys suggest that the prevalence of
CSAs in derivative transactions increased over time, they provide less
recent information about collateralization levels and their cross-
sectional characteristics. The ISDA reports that, in 2010, an estimated
73% of aggregate OTC derivatives exposures were collateralized.\985\
According to the ISDA, collateralization levels in 2010 varied
considerably depending on the type of counterparty.\986\
Collateralization of exposures to sovereigns was very limited (18%).
Collateralization of exposures to hedge funds was much more extensive
(160%),\987\ reflecting a greater tendency to collect initial margin
from those participants. In between these extremes were
collateralization levels of current

exposures to mutual funds (100%), banks and broker-dealers (79%),
pension funds (71%), insurance companies (68%), energy and/or commodity
firms (37.2%), non-financial firms (37%), and special purpose vehicles
(19%). The statistics for 2009 reveal a similar pattern.\988\ These
collateralization level patterns are consistent with the following
stylized facts: (1) A counterparty's exposure to a special purpose
vehicle is generally not covered to any significant extent; (2)
counterparties do not generally require initial margin from dealers,
banks, pension funds, and insurance companies, but will collect
variation margin in certain cases or on an ad-hoc basis; (3)
counterparties require hedge funds to post variation margin and initial
margin; (4) counterparties require variation margin from mutual funds,
but generally do not require mutual funds to post initial margin; (5)
non-financial end-users are generally not required to post margin.\989\
---------------------------------------------------------------------------

    \985\ See ISDA Margin Survey 2011 at Table 3.3. Statistics based
on derivatives type (e.g., credit derivatives) were not provided.
More recent ISDA margin surveys do not report these statistics.
    \986\ In this discussion, collateralization level means the
ratio of collateral to current exposure.
    \987\ The 160% collateralization level for hedge funds indicates
that on average, current exposures to hedge funds were fully
collateralized and that some additional margin covering potential
future exposures (i.e., initial margin) was also collected.
    \988\ See ISDA Margin Survey 2010 at Table 3.3.
    \989\ See generally ISDA Margin Survey 2011; ISDA Margin Survey
2012. The results of the surveys, however, could be substantially
different if limited only to U.S. participants, because the data
contained in the surveys is global. See id. For example, 47% of the
institutions responding to the ISDA margin survey published in 2012
were based in Europe, the Middle East, or Africa, and 31% were based
in the Americas. See ISDA Margin Survey 2012 at Chart 1.1.
---------------------------------------------------------------------------

    An ISDA margin survey provides some evidence about the asset
composition of collateral. According to this survey, in 2014, of the
collateral received/(delivered) by survey respondents to cover initial
margin, 55.4%/(64.7%) was in cash, 24.2%/(11.1%) was in government
securities, and the rest was in other securities. In addition, of the
collateral received/(delivered) to cover variation margin, 77.2%/
(75.3%) was in cash, 16.3%/(21.4%) was in government securities, and
the rest was in other securities. Finally, of the collateral received/
(delivered) to cover commingled initial and variation margin, 71.7%/
(76.4%) was in cash, 12%/(20.9%) was in government securities, and the
rest was in other securities.\990\
---------------------------------------------------------------------------

    \990\ See ISDA Margin Survey 2015 at Table 7.
---------------------------------------------------------------------------

    The margin surveys also suggest that collateral for non-cleared
derivatives is generally not segregated. According to an ISDA margin
survey, where initial margin is collected, ISDA members reported that
most (72%) was commingled with variation margin and not segregated, and
only 5% of the amount received was segregated with a third-party
custodian.\991\
---------------------------------------------------------------------------

    \991\ See ISDA Margin Survey 2012. The survey also notes that
while the holding of the independent amount (initial margin) and
variation margin together continued to be the industry standard both
contractually and operationally, the ability to segregate had been
made increasingly available to counterparties over the previous
three years on a voluntary basis, and had led to 26% of the
independent amounts received and 27.8% of independent amounts
delivered being segregated in some respects. See id. at 10. See also
ISDA, Independent Amounts, Release 2.0 (Mar. 1, 2010).
---------------------------------------------------------------------------

    Finally, an ISDA margin survey also reports a significant increase
in the number of active collateral agreements for client's cleared
trades. Specifically, 2014 saw a 67.1% increase in collateral
agreements covering client's cleared trades over the previous
year.\992\ This significant increase is most likely due to the
introduction of the clearing mandates in 2013 under the Dodd-Frank Act
in the US.\993\
---------------------------------------------------------------------------

    \992\ See ISDA Margin Survey 2015. The ISDA also reported that
the number of active agreements for house cleared trades was 258 for
2014, which was a decline of 21.3% compared to 2013.
    \993\ The CFTC mandate regarding clearing of certain index CDS
came into effect on March 11, 2013. See Clearing Requirement
Determination Under Section 2(h) of the CEA, 77 FR 74284 (Dec. 13,
2012).
---------------------------------------------------------------------------

    In response to a commenter's suggestion,\994\ the Commission has
supplemented its analysis of the ISDA margin surveys with an analysis
of initial margins estimated for dealer CDS positions. For each dealing
entity that is expected to register as an SBSD, the Commission uses
DTCC-TIW data as of the end of September 2017 to identify the single-
name and index CDS positions that the entity holds against its
counterparties. For each dealing entity, the Commission then calculates
the initial margin amount \995\ from its single-name and index CDS
positions with each counterparty by using historical CDS price
movements \996\ from five one-year samples: 2008, 2011, 2012, 2017, and
2018. The Commission believes the 2008, 2011, and 2012 samples are
likely to capture stressed market conditions, while the 2017 and 2018
samples are likely to capture normal market conditions. For each sample
and each dealing entity, the Commission then calculates the risk margin
amount (i.e., initial margin amounts) of its cleared and non-cleared
CDS positions by summing up the initial margins calculated above across
all counterparties. Table 2 Panel A below reports a number of
statistics, such as minimum, maximum, mean, standard deviation, and the
quartiles of the distribution, that summarize the distribution of the
dealers' risk margin amounts for each sample.
---------------------------------------------------------------------------

    \994\ See SIFMA 11/19/2018 Letter (suggesting that the
Commission provide data or analysis to support its proposed 8%
margin factor, which depended, in part, on the total amount of
initial margin calculated by the nonbank SBSD with respect to
cleared and non-cleared security-based swaps).
    \995\ The Commission calculates initial margin using the
methodology described in Darrell Duffie, Martin Scheicher, and
Guillaume Vuillemey, Central Clearing and Collateral Demand, Journal
of Financial Economics 116, no. 2, 237-256 (May 2015).
    \996\ These price movements are derived from historical pricing
data on single-name CDS contracts. The data are purchased from ICE
Data Services.
---------------------------------------------------------------------------

    The Commission can make a number of observations from Table 2 Panel
A. The risk margin amounts vary across the five annual samples. Risk
margin amounts tend to be larger in 2008 and 2017, but smaller in 2011,
2012, and 2018. For example, the mean risk margin amount in 2008 and
2017 are $768 million and $507 million, respectively, while the mean
risk margin amount in 2011, 2012, and 2018 range between $260 and $329
million. The risk margin amounts also vary across dealing entities,
suggesting that these entities may hold single-name and index CDS
positions with different levels of risk. For example, in the 2008
sample, risk margin amounts range from a minimum of $9.89 million to a
maximum of $3,302.12 million. The variation in risk margin amounts
across dealing entities, as measured by the standard deviation, also
changes across the five annual samples. The standard deviation is
higher in 2008 and 2017 and lower in 2011, 2012, and 2018.
    The Commission repeats the preceding analysis using only
interdealer CDS positions (i.e., calculating risk margin amounts for
single-name and index CDS positions held by a dealing entity against
another dealing entity). Table 2 Panel B reports statistics summarizing
the distribution of these interdealer risk margin amounts for each
sample. A key result from Table 2 Panel B is that interdealer risk
margin amounts are significantly smaller than risk margin amounts based
on single-name and index CDS positions held by a dealer against all its
counterparties. For example, in Table 2 Panel A, the mean risk margin
amount ranges between $260 million and $768 million, while in Table 2
Panel B, the mean risk margin amount ranges between $8.4 million and
$23.1 million. Interdealer risk margin amounts tend to be larger in
2008 and 2017, but smaller in 2011, 2012, and 2018. Interdealer risk
margin amounts also vary across different pairs of dealing entities,
suggesting that these entities may hold single-name and index CDS
positions with different levels of risk. The variation in interdealer
risk margin amounts across different pairs of dealing entities, as
measured by the standard deviation, also changes across the five annual
samples.

    Table 2: Risk Margin Amounts. This table reports summary statistics
of risk margin amounts for the single-name and index CDS positions held
by dealers against all counterparties (Panel A) and risk margin amounts
for the single-name and index CDS positions held by dealers against
other dealers (Panel B) as of the end of September 2017. Risk margin
amounts are in millions of dollars. The summary statistics are Min
(minimum), P25 (first quartile/25th percentile), P50 (second quartile/
50th percentile), P75 (third quartile/75th percentile), Max (maximum),
Mean, and Std (standard deviation).

 Panel A: Risk Margin Amounts for Single-Name and Index CDS Positions Held by Dealers Against All Counterparties
----------------------------------------------------------------------------------------------------------------
                   Year                        Min       P25       P50       P75       Max      Mean       Std
----------------------------------------------------------------------------------------------------------------
2008......................................      9.89    255.73    488.50    673.46   3302.12    767.76    817.96
2011......................................      7.43     95.46    188.56    449.53   1377.82    329.30    381.85
2012......................................      6.67     80.60    154.86    321.10   1137.43    260.05    295.31
2017......................................      1.39    138.58    385.75    600.70   1487.74    507.48    472.19
2018......................................      2.82     95.99    204.94    376.68   1380.57    316.00    350.30
----------------------------------------------------------------------------------------------------------------

   Panel B: Risk Margin Amounts for Single-Name and Index CDS Positions Held by Dealers Against Other Dealers
----------------------------------------------------------------------------------------------------------------
                   Year                        Min       P25       P50       P75       Max      Mean       Std
----------------------------------------------------------------------------------------------------------------
2008......................................      0.01      3.35     10.00     29.98    170.89     21.81     28.39
2011......................................      0.00      1.27      3.28     10.56    100.38     10.32     16.56
2012......................................      0.00      0.92      3.34      8.97     64.82      8.45     12.43
2017......................................      0.00      0.50      3.08     17.23    528.61     23.07     60.24
2018......................................      0.00      0.75      3.83     11.84     67.07      9.46     14.07
----------------------------------------------------------------------------------------------------------------

3. Global Regulatory Efforts
    In 2009, the G20 leaders--whose membership includes the United
States, 18 other countries, and the European Union--addressed global
improvements in the OTC derivatives market. 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.\997\
---------------------------------------------------------------------------

    \997\ See, e.g., The G20 Toronto Summit Declaration (June 27,
2010) at paragraph 25; Cannes Summit Final Declaration--Building Our
Common Future: Renewed Collective Action for the Benefit of All
(Nov. 4, 2011) at paragraph 24.
---------------------------------------------------------------------------

    Many SBSDs likely will be subject to foreign regulation of their
security-based swap activities that is similar to regulations that may
apply to them pursuant to Title VII of the Dodd-Frank Act, 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 generally focused
on five areas: (1) Moving OTC derivatives onto organized trading
platforms; (2) requiring central clearing of OTC derivatives; (3)
requiring post-trade reporting of transaction data for regulatory
purposes and public dissemination of anonymized versions of such data;
(4) establishing or enhancing capital requirements for non-centrally
cleared OTC derivatives transactions; and (5) 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. 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.\998\
---------------------------------------------------------------------------

    \998\ In November 2018, the Financial Stability Board reported
that 16 member jurisdictions participating in its thirteenth
progress report on OTC derivatives market reforms had in force
margin requirements for non-centrally cleared derivatives. A further
4 jurisdictions made some progress leading to a change in reported
implementation status during the reporting period. See Financial
Stability Board, OTC Derivatives Market Reforms Thirteenth Progress
Report on Implementation (Nov. 19, 2018), available at http://www.fsb.org/wp-content/uploads/P191118-5.pdf.
---------------------------------------------------------------------------

    Notably, the European Parliament and the European Council have
adopted the European Market Infrastructure Regulation (``EMIR''), which
includes provisions aimed at increasing the safety and transparency of
the OTC derivatives market. EMIR mandates the European Supervisory
Authorities (``ESAs'') to develop regulatory technical standards
specifying margin requirements for non-centrally cleared OTC derivative
contracts.\999\ The ESAs have developed, and in October 2016 the
European Commission adopted, these regulatory technical
standards.\1000\
---------------------------------------------------------------------------

    \999\ The ESAs are the European Banking Authority, European
Insurance and Occupational Pensions Authority, and European
Securities and Markets Authority.
    \1000\ See ESAs, Final Draft Regulatory Technical Standards on
risk-mitigation techniques for OTC-derivative contracts not cleared
by a CCP under Article 11(15) of Regulation (EU) No 648/2012 (Mar.
8, 2016). See also Commission Delegated Regulation (EU) 2016/2251
supplementing Regulation (EU) No 648/2012 of the European Parliament
and of the Council on OTC derivatives, central counterparties and
trade repositories with regard to regulatory technical standards for
risk-mitigation techniques for OTC derivative contracts not cleared
by a central counterparty (Oct. 4, 2016).
---------------------------------------------------------------------------

    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.\1001\ Moreover, as discussed
above, subsequent to the publication of the proposing release, the BCBS
and IOSCO issued the BCBS/IOSCO Paper. The BCBS/IOSCO Paper recommended
(among other things): (1) That all financial entities and systemically
important non-financial

entities exchange variation and initial margin appropriate for the
counterparty risk posed by such transactions; (2) that initial margin
should be exchanged without provisions for ``netting'' and held in a
manner that protects both parties in the event of the other's default;
and (3) that the margin regimes of the various regulators should
interact so as to be sufficiently consistent and non-duplicative.\1002\
---------------------------------------------------------------------------

    \1001\ In November 2018, the Financial Stability Board reported
that 23 of the 24 member jurisdictions participating in its
thirteenth progress report on OTC derivatives market reforms had in
force interim standards for higher capital requirements for non-
centrally cleared transactions. See Financial Stability Board, OTC
Derivatives Market Reforms Thirteenth Progress Report on
Implementation (Nov. 19, 2018).
    \1002\ One commenter noted that since 2015, the prudential
Regulators, CFTC, and a number of foreign regulators have adopted
margin requirements that implement the framework in the BCBS/IOSCO
Paper. See SIFMA 11/19/2018 Letter.
---------------------------------------------------------------------------

4. Capital Regulation
    It is difficult to precisely delineate a baseline for capital
requirements and capital levels in the security-based swap market. As
discussed in prior sections, the entities that participate in this
market may be subject to several overlapping regulatory regimes,
including Federal Reserve capital standards at the bank holding company
level,\1003\ bank capital standards of the OCC and FDIC that apply to
bank security-based swap entities,\1004\ as well as the net capital
requirements applicable to stand-alone broker-dealers. In addition,
many entities in this space may be subject to the capital requirements
applicable to FCMs, as well to the regimes of foreign regulators.\1005\
Finally, certain entities may not be subject to any (direct) capital
requirements under the baseline. In the discussion that follows, the
relevant aspects of the capital regimes applicable to the various
entities operating in the security-based swap market are reviewed, and
their relation to the baseline is noted. The discussion focuses on the
capital treatment of market risk arising from an entity's proprietary
positions in security-based swap transactions specifically, and OTC
derivative transactions generally as well as the capital treatment of
credit risk arising from exposures to counterparties in OTC derivative
transactions.
---------------------------------------------------------------------------

    \1003\ These standards are based on the Basel II and Basel III
framework. See BCBS, Basel II: International Convergence of Capital
Measurement and Capital Standards: A Revised Framework--
Comprehensive Version (June 2006), available at http://www.bis.org/publ/bcbs128.htm; BCBS, Basel III: A global regulatory framework for
more resilient banks and banking systems (June 2011), available at
http://www.bis.org/publ/bcbs189.pdf.
    \1004\ See Prudential Regulator Margin and Capital Adopting
Release, 80 FR 74840.
    \1005\ The Commission expects that most entities that will
register with the Commission and become subject to these final
capital, margin, and segregation rules have registered with the CFTC
as swap entities or with the Commission as broker-dealers. The
Commission has previously estimated that, of the total 55 entities
expected to register with the Commission as an SBSD or MSBSP, 35
will be registered with the CFTC as swap dealers or major swap
participants. See Registration Process for Security-Based Swap
Dealers and Major Security-Based Swap Participants, 80 FR at 49000.
---------------------------------------------------------------------------

a. Commission-Registered Broker-Dealers
    As described in the prior section, security-based swap dealing
activity is concentrated in a small number of large financial
firms.\1006\ Historically, these firms have not undertaken their
security-based swap activities and OTC derivative transactions through
Commission-registered broker-dealers. Rather, the dealing activity of
these financial firms was housed either in its bank affiliates, its
unregistered nonbank affiliates, or in affiliated foreign entities.
These arrangements reflected the lack of a legal requirement to house
such activities in entities regulated by the Commission, the potential
disadvantage in the capital treatment of these activities under Rule
15c3-1,\1007\ as well as restrictions on the use of customers'
collateral under the Commission's customer protection rule.\1008\
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    \1006\ See section VI.A. of this release.
    \1007\ OTC derivatives dealers and ANC broker-dealers have been
permitted to use internal models to compute net capital since 1998
and 2004, respectively. See OTC Derivatives Dealers, 63 FR 59362;
Alternative Net Capital Requirements for Broker-Dealers That Are
Part of Consolidated Supervised Entities, 69 FR 34428. However, this
has not led to increased dealing in security-based swaps by broker-
dealers.
    \1008\ The existing possession or control and customer reserve
account requirements of Rule 15c3-3 as applied to initial margin
held for security-based swaps has made it disadvantageous for
broker-dealers to deal in security-based swaps as compared to
entities (such as unregulated dealers) that were not subject to
these requirements. The requirements of Rule 15c3-3 are designed to
protect customers by preventing broker-dealers from using customer
assets to finance any part of their business unrelated to servicing
customer securities activities. Unregulated entities would not be
subject to these restrictions and could freely use collateral
received from security-based swap transactions in their business,
including to finance proprietary activities.
---------------------------------------------------------------------------

    In 1998, the Commission established a program for broker-dealers
that operate as OTC derivatives dealers. The program, among other
things, permitted OTC derivatives dealers to use internal models to
compute capital charges for market and credit risk. In 2004, the
Commission extended the use of such models to broker-dealers subject to
consolidated supervision with the adoption of alternative net capital
requirements for ANC broker-dealers. Today, only a small fraction of
broker-dealers are ANC broker-dealers; however, these few ANC broker-
dealers are large and account for nearly all of the assets held by
Commission-supervised broker-dealers. The capital requirements being
adopted today for nonbank SBSDs, including permitting nonbank SBSDs to
elect to use models to compute net capital, are modeled on the
Commission's net capital rule currently applicable to broker-dealers.
    The existing broker-dealer net capital requirements are codified in
Rule 15c3-1 and seven appendices to Rule 15c3-1. Specifically, Rule
15c3-1 requires broker-dealers to maintain a minimum level of net
capital (meaning highly liquid capital) at all times. Paragraph (a) of
the rule requires that a broker-dealer perform two calculations: (1) A
computation of the minimum amount of net capital the broker-dealer must
maintain; and (2) a computation of the amount of net capital the
broker-dealer is maintaining. The minimum net capital requirement is
the greater of a fixed-dollar amount specified in the rule and an
amount determined by applying 1 of 2 financial ratios: The 15-to-1
ratio or the 2% debit item ratio. Large broker-dealers that dominate
the industry use the 2% debit item ratio.
    Requirements for computing net capital are set forth in paragraph
(c)(2) of Rule 15c3-1, which defines the term ``net capital.'' The
first step in a net capital calculation is to compute the broker-
dealer's net worth under GAAP. Next, the broker-dealer must make
certain adjustments to its net worth. These adjustments are designed to
leave the firm in a position in which each dollar of unsubordinated
liabilities is matched by more than a dollar of highly liquid assets.
There are fourteen categories of net worth adjustments required by the
rule, including the application of haircuts.\1009\ Broker-dealers use
either standardized haircuts or model-based haircuts that are comprised
of market and credit risk charges.
---------------------------------------------------------------------------

    \1009\ See paragraphs (c)(2)(i) through (xiv) of Rule 15c3-1.
---------------------------------------------------------------------------

Market Risk Charges
    The internal models used by ANC broker-dealers and OTC derivatives
dealers to compute market risk charges must meet certain qualitative
and quantitative requirements under Appendix E or F that parallel
requirements for U.S. banking agencies under Basel II.\1010\ The use of
internal

models to compute market risk charges can substantially reduce the
deductions to the market value of proprietary positions as compared to
standardized haircuts. Consequently, large broker-dealers that dominate
the industry rely on internal models rather than the standardized
haircuts to compute net capital. However, ANC broker-dealers and OTC
derivative dealers (i.e., dealers using internal models to compute net
capital) are subject to higher fixed-dollar minimum capital
requirements than broker-dealers using the standardized haircuts. Under
existing paragraph (a)(7) of Rule 15c3-1, ANC broker-dealers are
required to maintain tentative net capital of not less than $1 billion
and net capital of not less than $500,000,000. In addition, ANC broker-
dealers are required to provide notice to the Commission if their
tentative net capital falls below $5 billion. For OTC derivative
dealers, under existing paragraph (a)(5) of Rule 15c3-1, the
corresponding fixed-dollar minimums are $100 million in tentative net
capital and $20 million in net capital.
---------------------------------------------------------------------------

    \1010\ See generally OTC Derivatives Dealers, 63 FR 59362;
Alternative Net Capital Requirements for Broker-Dealers That Are
Part of Consolidated Supervised Entities, 69 FR 34428. The
requirements for banks were subsequently enhanced by the prudential
regulators with the implementation of capital requirements
consistent with the Basel III framework. See Regulatory Capital
Rules: Regulatory Capital, Implementation of Basel III, Capital
Adequacy, Transition Provisions, Prompt Corrective Action,
Standardized Approach for Risk-weighted Assets, Market Discipline
and Disclosure Requirements, Advanced Approaches Risk-Based Capital
Rule, and Market Risk Capital Rule, 78 FR 62018 (Oct. 11, 2013).
---------------------------------------------------------------------------

Credit Risk Charges
    For ANC broker-dealers, the credit risk charge is the sum of 3
calculated amounts: (1) A counterparty exposure charge; (2) a
concentration charge if the current exposure to a single counterparty
exceeds certain thresholds; and (3) a portfolio concentration charge if
aggregate current exposure to all counterparties exceeds 50% of the
firm's tentative net capital.\1011\ The OTCDD credit risk model is
similar to the ANC credit risk model except that the former does not
include a portfolio concentration charge.\1012\
---------------------------------------------------------------------------

    \1011\ See paragraph (c) of Rule 15c3-1e.
    \1012\ See paragraph (d) of Rule 15c3-1f.
---------------------------------------------------------------------------

b. Banking Entities
    As described in previous sections, the security-based swap market
is dominated by a small number of global financial firms. Of the firms
expected to register with the Commission as SBSDs, the Commission
believes that most will, in the near-term, be subsidiaries of a U.S.
bank holding company and therefore be subject to consolidated
supervision by the Federal Reserve. Nonbank SBSDs and MSBSPs will be
subject not only to the Commission's capital requirements but also
indirectly to the capital standards applicable at their parent bank
holding companies. For the purposes of satisfying the capital
requirements at the bank holding company level, the OTC derivatives
positions booked under any consolidated bank subsidiary are accounted
for in the capital computation of the holding company. The bank holding
companies' consolidated bank subsidiaries also are subject to direct
capital requirements of the prudential regulators and indirect capital
requirements applicable to their parent bank holding companies. Below
is a discussion of the relevant aspects of the capital regime for bank
holding companies as it relates to security-based swap positions (and
OTC derivative positions in general).
    In July 2013, the Federal Reserve and OCC adopted a final rule that
implements in the U.S. the Basel III regulatory capital reforms from
the BCBS and certain changes to the existing capital standards required
by the Dodd-Frank Act.\1013\ These rules generally strengthened the
capital regime for bank holding companies and banks (collectively,
``banks'') by increasing both the quality and the quantity of bank
regulatory capital.\1014\
---------------------------------------------------------------------------

    \1013\ See Regulatory Capital Rules: Regulatory Capital,
Implementation of Basel III, Capital Adequacy, Transition
Provisions, Prompt Corrective Action, Standardized Approach for
Risk-weighted Assets, Market Discipline and Disclosure Requirements,
Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital
Rule, 78 FR 62018.
    \1014\ See Regulatory Capital Rules: Regulatory Capital,
Implementation of Basel III, Capital Adequacy, Transition
Provisions, Prompt Corrective Action, Standardized Approach for
Risk-weighted Assets, Market Discipline and Disclosure Requirements,
Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital
Rule, 78 FR 62018. Among other things, the new rules implemented a
revised definition of regulatory capital, a new common equity tier 1
minimum capital requirement, a higher minimum tier 1 capital
requirement, and, for banking organizations subject to the advanced
approaches risk-based capital rules, a supplementary leverage ratio
The new rules also amended the methodologies for determining risk-
weighted assets (``RWAs'').
---------------------------------------------------------------------------

    The bank capital regime for OTC derivative transactions prescribes
the capital treatment of the transactions' market risk and credit risk
exposures. Banks with significant presence in the security-based swap
market tend to be large global firms that employ the internal models
methodology to compute charges for market risk. The quantitative
requirements for these models resemble in many respects those
applicable to the market risk models of ANC broker-dealers and OTC
derivative dealers.\1015\
---------------------------------------------------------------------------

    \1015\ See Prudential Regulator Margin and Capital Adopting
Release, 80 FR at 74876.
---------------------------------------------------------------------------

    Banks calculate market risk capital charges using a model with a
one-tailed 99% confidence interval.\1016\ These charges are subject to
specific risk add-ons and backtesting adjustments.\1017\ Following
adoption of the Basel III framework by the prudential regulators, these
capital requirements were strengthened; they now include an additional
``stressed VaR'' floor to the capital charge, as well as potentially
binding leverage ratios.\1018\
---------------------------------------------------------------------------

    \1016\ This discussion assumes that the bank is subject to
market risk capital charges. Banking organizations with aggregate
trading assets and liabilities that exceed $1 billion or 10% of
total assets are subject to the market risk rule. See Risk-Based
Capital Standards: Market Risk, 61 FR 47358 (Sept. 6, 1996).
    \1017\ See 12 CFR 3.122(i)(4)(iii); 12 CFR 3.131.
    \1018\ See Regulatory Capital Rules: Regulatory Capital,
Implementation of Basel III, Capital Adequacy, Transition
Provisions, Prompt Corrective Action, Standardized Approach for
Risk-Weighted Assets, Market Discipline and Disclosure Requirements,
Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital
Rule, 78 FR 62018.
---------------------------------------------------------------------------

    Capital charges for a bank's credit risk exposure to its OTC
derivative counterparties are based on the RWA framework. In general,
under the RWA framework, the capital requirement for a credit exposure
is 8% times the RWA-equivalent amount of the credit exposure. Under the
2013 capital rule, large banking organizations (i.e., the type of
organizations that dominate dealing in the security-based swap market)
are required to calculate capital requirements using the advanced
approaches.\1019\ In the advanced approaches, the RWA-equivalent of a
counterparty exposure is calculated according to the internal rating-
based (``IRB'') capital formula, where the bank's internal credit risk
model along with the bank's estimates of the probability of default and
the loss-given default is used to calculate the effective risk weight
on the exposure amount.
---------------------------------------------------------------------------

    \1019\ See id.
---------------------------------------------------------------------------

    Under the advanced approach, the exposure amount (exposure at
default (``EAD'')) for an OTC derivative transaction may be calculated
under either the current exposure method (``CEM'') or using the
internal models method (``IMM''), with the latter being subject to
regulatory approval.\1020\ Under the current exposure method, the
capital charge is the sum of the current exposure and potential future
exposure. The potential future exposure is calculated as the product of
the

derivative's notional amount and a conversion factor that depends on
the risk and maturity of the transaction. The conversion factors range
from 0% to 15% and are specified in the regulations.\1021\ For a group
of transactions within the same asset class that are covered by a
qualifying master netting agreement, the current exposure for the group
is calculated on a net basis. Potential future exposure for a group of
transactions subject to a qualifying master netting agreement is
calculated as the sum of gross potential future exposures (i.e., no
netting), multiplied by a factor that is a function of the net-to-gross
ratio (``NGR'') of current exposures.\1022\ For banks that engage in
off-setting transactions, the NGR is typically far lower than one,
permitting some netting benefits.\1023\
---------------------------------------------------------------------------

    \1020\ The OCC, Federal Reserve, and the FDIC have issued a
notice of proposed rulemaking to provide an updated framework for
measuring derivative counterparty credit exposure. The proposed rule
would replace the existing CEM with the Standardized Approach for
Counterparty Credit Risk (SA-CCR) for banks subject to the advanced
approaches, while permitting smaller banks to use CEM or SA-CCR. See
Standardized Approach for Calculating the Exposure Amount of
Derivative Contracts, 83 FR 64660 (Dec. 17, 2018). See also Proposed
Changes to Applicability Thresholds for Regulatory Capital and
Liquidity Requirements, 83 FR 66024 (Dec. 21, 2018).
    \1021\ See Regulatory Capital Rules: Regulatory Capital,
Implementation of Basel III, Capital Adequacy, Transition
Provisions, Prompt Corrective Action, Standardized Approach for
Risk-Weighted Assets, Market Discipline and Disclosure Requirements,
Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital
Rule, 78 FR 62018, at Table 19.
    \1022\ The potential future exposure for the group equals ((0.4
+ 0.6 x NGR) x AGross), where AGross is aggregate gross potential
future exposure for positions subject to a qualifying master netting
agreement, and NGR is the ratio of net current exposure to gross
current credit exposure for the group.
    \1023\ See Regulatory Capital Rules: Regulatory Capital,
Implementation of Basel III, Capital Adequacy, Transition
Provisions, Prompt Corrective Action, Standardized Approach for
Risk-weighted Assets, Market Discipline and Disclosure Requirements,
Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital
Rule, 78 FR 62018.
---------------------------------------------------------------------------

    Banks are allowed to recognize a broad set of collateral as credit
risk mitigants in calculating credit risk charges.\1024\ They may use
either the simple approach or the collateral haircut approach to reduce
credit risk capital charges. Under the simple approach, the risk weight
of a collateralized credit exposure to an OTC derivative counterparty
is replaced with the risk weight of the collateral posted by that
counterparty. Under this approach, subject to certain exceptions, the
risk weight assigned to the collateralized portion of the exposure must
be at least 20%.\1025\ Under the collateral haircut approach, the risk
weight of the counterparty exposure does not change, but the exposure
amount is adjusted by the haircut-adjusted value of the collateral
received. Banks using the advanced approach to calculate RWA may use
internal models to compute these haircuts, otherwise regulatory
haircuts are used.\1026\
---------------------------------------------------------------------------

    \1024\ Generally, the credit risk of the collateral must not be
positively correlated with the credit risk of the collateralized
exposure. The set of eligible collateral has been broadened to
include investment grade corporate debt securities and publicly
traded equity securities. 78 FR at 62107.
    \1025\ 78 FR 62018. One exception is when the collateral
consists of ``cash on deposit,'' in which case the risk weight is
0%. Another exception is when the collateral is a sovereign that
qualifies for a 0% risk weight under the general risk weight
provision and it is subject to certain haircuts or account
maintenance practices, in which case the risk weight can be either
0% or 10%.
    \1026\ See 78 FR at 62239.
---------------------------------------------------------------------------

    Accounting rules now generally require banks to take into account
the creditworthiness of an OTC derivative counterparty in determining
the fair value of an OTC derivative position. During the financial
crisis, approximately two-thirds of credit losses on OTC derivative
positions were the result of accounting adjustments rather than
outright counterparty defaults.\1027\ Subsequently, Basel III
requirements as implemented by the prudential regulators introduced
capital charges for potential accounting losses resulting from such
credit valuation adjustments (``CVA'') due to an increase in credit
risk of the counterparty. Banks that are subject to the advanced
approach have to calculate a CVA capital charge using either the
advanced CVA approach, if the bank is approved to use this method, or
the simple CVA approach. The former relies on a bank's internal credit
models while the latter uses a combination of supervisory risk weights,
external ratings, and the bank's credit-risk calculations.\1028\
---------------------------------------------------------------------------

    \1027\ See BCBS, Basel Committee finalizes capital treatment for
bilateral counterparty credit risk (June 2011), available at http://www.bis.org/press/p110601.pdf.
    \1028\ Regulatory Capital Rules: Regulatory Capital,
Implementation of Basel III, Capital Adequacy, Transition
Provisions, Prompt Corrective Action, Standardized Approach for
Risk-weighted Assets, Market Discipline and Disclosure Requirements,
Advanced Approaches Risk-Based Capital Rule, and Market Risk Capital
Rule, 78 FR at 62134.
---------------------------------------------------------------------------

c. CFTC-Registered Entities
    Starting in October 2012, swap dealers and major swap participants
were required to provisionally register with the CFTC. However, as of
now, neither swap dealers nor major swap participants are subject to
any capital requirements, unless they are also registered as
FCMs.\1029\
---------------------------------------------------------------------------

    \1029\ The CFTC re-proposed capital requirements for swap
dealers and major swap participants in 2016. See CFTC Capital
Proposing Release, 81 FR 91252. The current capital requirements for
FCMs make it particularly costly for FCMs to engage in OTC CDS. For
this reason, traditionally, OTC CDS have been conducted outside of
FCMs, in affiliated entities. See Capital Requirements of Swap
Dealers and Major Swap Participants, 76 FR 27802.
---------------------------------------------------------------------------

    CFTC Rule 1.17 requires FCMs to maintain adjusted net capital in
excess of a minimum adjusted net capital amount. The rule prescribes a
net liquid assets test similar to the broker-dealer net capital rule.
The CFTC defines adjusted net capital as liquid assets net of
liabilities, after taking into account certain capital deductions for
market and credit risk. The minimum net adjusted capital depends, among
other things, on the margin amount of the client-cleared OTC swap
positions.
    With respect to the treatment of OTC derivatives positions, an FCM
is required to account for an OTC derivatives position by first
marking-to-market the position and then deducting (adding) the full
amount of the loss (collateralized portion of the gain) from (to) its
adjusted net capital. In addition, an FCM also has to take a capital
charge for the market risk of its OTC derivatives position. Paragraph
(c) of CFTC Rule 1.17 allows FCMs registered with the Commission as an
ANC broker-dealer to compute this capital charge using models approved
by the Commission.
5. Margin Regulation
    The baseline regulatory regime for margin regulation of security-
based swaps is the phase-in of regulations adopted by U.S. prudential
regulators, foreign regulators, and the CFTC, as well as the broker-
dealer SRO margin rules.
a. Prudential Regulators, CFTC, and Foreign Regulators
Prudential Regulators
    In October 2015, the U.S. prudential regulators adopted new rules
to address minimum margin requirements for bank swap dealers, major
swap participants, SBSDs, and MSBSPs with respect to non-cleared
security-based swaps and swaps.\1030\ For these entities, the margin
rules became effective on April 1, 2016, with compliance phased-in over
4 years beginning in September 2016. The rules impose initial and
variation margin requirements on bank SBSDs, MSBSPs, swap dealers, and
major swap participants for non-cleared security-based swaps and swaps.
---------------------------------------------------------------------------

    \1030\ See Prudential Regulator Margin and Capital Adopting
Release, 80 FR 74840.
---------------------------------------------------------------------------

    Bank SBSDs, MSBSPs, swap dealers, and major swap participants are
required to collect and post variation and initial margin from (to)
certain counterparties. Initial margin must be collected in the form of
cash or other eligible collateral. Variation margin must be collected
on a daily basis and be in the form of cash for a transaction with an
SBSD, MSBSP, swap dealer, or major swap participant, or cash or other
eligible collateral for a transaction with a financial end user. These
bank entities are also required to both collect and post initial margin
for transactions with

SBSDs, MSBSPs, swap dealers, major swap participants, and with
financial end users that have material swaps exposure (i.e., gross
notional exposure in excess of $8 billion). Initial margin must be
computed using standardized haircuts or an approved model. The initial
margin is to be computed on a daily basis but its exchange is not
required if it falls below a consolidated $50 million threshold. The
rules further require that the initial margin collected or posted by
bank SBSDs, MSBSPs, swap dealers, and swap participants be segregated
with a third-party custodian and prohibit its re-hypothecation. The
rules provide an exception to the initial margin requirements in
transactions involving an affiliated entity: In such cases, initial
margin need not be posted to an affiliated financial end user with
material swaps exposure.
    In December 2015, the CFTC adopted new rules that address margin
requirements for nonbank swap dealers and major swap participants with
respect to non-cleared swaps.\1031\ Similar to the prudential
regulators' final rules, the rules became effective on April 1, 2016,
with compliance phased-in over 4 years beginning in September 2016. The
rules are similar to the final margin rules of the prudential
regulators. However, with respect to affiliates, swap dealers and major
swap participants need to collect or post initial margin under certain
conditions.
---------------------------------------------------------------------------

    \1031\ See CFTC Margin Adopting Release, 81 FR 636.
---------------------------------------------------------------------------

    Foreign entities, including foreign subsidiaries of U.S. entities
that transact in the security-based swap market fall under a variety of
foreign regulations, principally those of regulators in certain
European countries. European regulators have adopted or proposed a
series of regulations covering mandatory clearing of OTC derivatives as
well as margin requirements for those derivatives not subject to the
mandatory clearing requirement.\1032\
---------------------------------------------------------------------------

    \1032\ See Regulation (EU) No 648/2012 of the European
Parliament and of the Council on OTC derivatives, central
counterparties and trade repositories (July 4, 2012).
---------------------------------------------------------------------------

    Currently, the European regulations require central clearing of
certain security-based swap transactions involving parties that are not
covered by exemptions from the clearing requirement.\1033\ Exemptions
include certain inter-affiliate transactions, as well as transactions
involving non-financial counterparties with gross notional values of
OTC derivative transactions that fall below the regulatory clearing
thresholds. These clearing requirements are currently being phased in
and will take full effect by mid-2019.
---------------------------------------------------------------------------

    \1033\ Starting on February 9, 2017, certain iTraxx Europe Index
CDS became subject to the clearing obligation. See Commission
Delegated Regulation (EU) 2016/592 supplementing Regulation (EU) No
648/2012 of the European Parliament and of the Council with regard
to regulatory technical standards on the clearing obligation (Mar.
1, 2016).
---------------------------------------------------------------------------

    The European margin rules on non-cleared security-based swap
transactions will apply to entities with gross notional values for OTC
derivatives of more than [euro]8 billion. Such entities will generally
have an obligation to collect and post margin.\1034\
---------------------------------------------------------------------------

    \1034\ See Regulation (EU) No 648/2012 of the European
Parliament and of the Council on OTC derivatives, central
counterparties and trade repositories (July 4, 2012).
---------------------------------------------------------------------------

    Entities subject to the European rules will be required to collect
and post variation margin for non-cleared security-based transactions
with other covered entities, financial counterparties, as well as non-
financial counterparties that fall above the clearing thresholds.
Variation margin will have to be exchanged on a daily basis, subject to
certain de minimis exceptions.
    Entities subject to the European rules (i.e., those with gross
notional values for OTC derivatives of more than [euro]8 billion) will
also be required to exchange initial margin. The requirement to collect
initial margin will not apply if the initial margin amount is less than
[euro]50 million. Initial margin is limited to cash and other high
quality assets. The amount of initial margin may be computed using a
model that satisfies certain technical criteria. The initial margin
amount must be recomputed under conditions enumerated in the
regulations; in practice this will generally be on a daily basis. The
party collecting initial margin must ensure that the collateral
received is segregated either through a third-party custodian, or
through other legally binding arrangements. Re-hypothecation of initial
margin is not permitted. The rules further require that the collecting
party provide the posting party the option to segregate its initial
margin from the assets of other posting counterparties.
    While the minimum margin requirements adopted by the prudential
regulators, CFTC, and foreign regulators will not be completely phased
in until September 2020, there is already some evidence on how market
participants are reacting to these requirements. A June 2017 survey on
dealer financing terms noted that some of the survey respondents
indicated that their clients' transaction volume or their own
transaction volume in non-cleared swaps decreased somewhat over the
period of September 2016 to June 2017.\1035\ However, the respondents
reported no changes in the prices that they quote to their clients in
non-cleared swaps over this period. This evidence indicates that some
dealers responded to margin requirements by reducing the level of
intermediation services they provided to other market participants on
an non-cleared basis. One-fifth of the survey respondents also reported
that they would be less likely to exchange daily variation margin with
mutual funds, exchange-traded funds, pension plans, endowments, and
separately managed accounts established with investment advisers due
primarily to lack of operational readiness (e.g., the need to establish
or update the necessary credit support annexes to cover daily exchange
of variation margin) over this period. Two-fifths of the survey
respondents also reported that the volume of mark and collateral
disputes on variation margin has increased somewhat over this period.
Furthermore, the survey noted that there is variation among respondents
with respect to the number of days it takes to resolve a mark and
collateral dispute on variation margin, with \1/3\ reporting less than
two days, while \3/5\ reporting more than two days but less than a
week, on average.
---------------------------------------------------------------------------

    \1035\ See Yesol Huh, Division of Research and Statistics, Board
of Governors of the Federal Reserve System, The June 2017 Senior
Credit Officer Opinion Survey on Dealer Financing Terms, available
at https://www.federalreserve.gov/data/scoos/files/scoos_201706.pdf.
---------------------------------------------------------------------------

    In addition, the ISDA margin survey covering 2017 documents the
amount and type of collateral collected and posted by the 20 firms with
the largest non-cleared derivatives exposures (``phase-one'' firms),
that were subject to the first phase of the new margin regulations for
non-cleared derivatives in the US, Canada, and Japan from September
2016, and Europe from February 2017. The survey distinguishes between
initial margin collected or posted by the phase-one firms to comply
with the new margin requirements (``regulatory initial margin'') and
other initial margin collected or posted by these firms
(``discretionary initial margin''). At the end of 2017, phase-one firms
collected and posted regulatory initial margin in the amount of $73.7
billion and $75.2 billion, respectively. Relative to the end of the
first quarter of 2017, these amounts reflect a 58% and 59% increase,
respectively. The similarity in these two amounts may reflect the two-
way initial margin requirement applicable to phase-one

firms. In contrast, at the end of 2017, phase-one firms collected and
posted $56.9 billion and $6.4 billion, respectively, in discretionary
initial margin. These amounts reflect a decline in the level of initial
margin collected and posted by phase-one firms of 6% and 61%,
respectively, relative to the end of the first quarter of 2017. The
large discrepancy between these two rates is probably the result of
phase-one firms continuing to collect initial margin on a discretionary
basis for transactions that are not yet within the scope of the new
margin requirements as more counterparties to whom phase-one firms post
discretionary initial margin become subject to the new margin
requirements (e.g., phase two of the implementation started in
September 2017).
    The survey also reports the amount of variation margin collected
and posted by phase-one firms. At the end of the 2017, phase-one firms
collected and posted $893.7 billion and $631.7 billion, respectively,
in variation margin, including both regulatory and discretionary.
    Of the regulatory initial margin posted, 85.3% consisted of
government securities; while 14.7% consisted of other securities.
Similarly, of the discretionary initial margin posted, 39.8% was in
government securities, 37% in cash, and, 23.2% in other securities. In
contrast, of the variation margin posted, 85.8% was in cash, followed
by 12.1% in government securities, and, finally, 2.1% in other
securities.
    The ISDA margin survey covering 2018 applies the methodology of the
ISDA margin survey covering 2017 but also expands the set of surveyed
firms to include not just the 20 phase-one firms described above, but
also firms that were subject to the new margin regulations from
September 2017 (``phase-two firms'') and September 2018 (``phase-3
firms''), respectively.\1036\ At the end of 2018, phase-one firms
collected and posted regulatory initial margin in the amount of $83.8
billion and $83.2 billion, respectively. Relative to the end of 2017,
these amounts reflect a 14% and 11% increase, respectively. At the end
of 2018, phase-one firms collected and posted $74.1 billion and $10.1
billion, respectively, in discretionary initial margin. These amounts
have increased by 30% and 57%, respectively, relative to the end of
2017. The 4 phase-two and 3 phase-3 firms that participated in the
survey collected $4.8 billion of initial margin at the end of 2018, of
which $2.2 billion is regulatory initial margin and $2.6 billion is
discretionary initial margin.
---------------------------------------------------------------------------

    \1036\ ISDA received responses from four phase-two firms (out of
the six in scope) and three phase-three firms (out of the eight
firms in scope). See ISDA Margin Survey Year-End 2018 (Apr. 2019) at
p.5.
---------------------------------------------------------------------------

    At the end of 2018, phase-one firms collected and posted $858.6
billion and $583.9 billion, respectively, in variation margin,
including both regulatory and discretionary. Relative to the end of
2017, these amounts represent a 4% and 8% decrease for variation margin
collected and posted, respectively.
    At the end of 2018, of the regulatory initial margin posted, 88.4%
consisted of government securities while 11.6% consisted of other
securities. Of the discretionary initial margin posted, 42% was in
government securities, 44.4% in cash, and, 13.6% in other securities.
Of the variation margin posted, 86.5% was in cash, followed by 12% in
government securities, and, finally, 1.5% in other securities.
b. Broker-Dealer Margin Rules
    Broker-dealers are subject to margin requirements in Regulation T
promulgated by the Federal Reserve, in rules promulgated by the SROs,
and, with respect to security futures, in rules jointly promulgated by
the Commission and the CFTC.\1037\
---------------------------------------------------------------------------

    \1037\ See 12 CFR 220.1, et seq.; FINRA Rules 4210 through 4240;
CBOE Rules 12.1-12.12; 17 CFR 242.400 through 406. See also Capital,
Margin, and Segregation Proposing Release, 77 FR at 70259
(discussing broker-dealer margin rules and equity requirements).
---------------------------------------------------------------------------

    Although the Dodd-Frank Act expanded the definition of ``security''
to include security-based swaps and in so doing expanded the
applicability of the aforementioned rules and regulations to security-
based swap transactions, the Commission has issued a series of
exemptive orders exempting security-based swaps from, among other
things, the margin requirements of Regulation T.\1038\
---------------------------------------------------------------------------

    \1038\ See section III.C. of this release (discussing the
exemption orders).
---------------------------------------------------------------------------

6. Segregation
    Existing market practice under the baseline is for dealers
generally not to segregate initial margin related to OTC derivative
transactions. An ISDA margin survey reports that in 2010, 71% of
initial margin received was comingled with variation margin.\1039\ Of
the remaining 29%, 9% was segregated on the books of the dealer,\1040\
6% was segregated with a custodian, and 14% was subject to tri-party
arrangements.\1041\ For large dealers, on average 89% of collateral
received was eligible for re-hypothecation, while 74% of collateral
received was actually re-hypothecated.\1042\
---------------------------------------------------------------------------

    \1039\ See ISDA Margin Survey 2011 at Table 2.3
    \1040\ See id. The ISDA survey does not define what it means for
margin to be ``segregated on the books of the dealer.'' Therefore,
it is not certain that margin segregated in this manner would
substantially satisfy the omnibus segregation requirements of Rule
18a-4, as adopted.
    \1041\ See id. The ISDA survey does not define what it means for
margin to be ``segregated with custodian'' and ``tri-party.''
Therefore, it is not certain that margin segregated in this manner
would substantially satisfy the individual segregation requirements
of Section 3E(f) of the Exchange Act or the requirements in Rule
18a-4, as adopted, relating to third-party custodians.
    \1042\ ISDA Margin Survey 2011 at Table 2.4.
---------------------------------------------------------------------------

    The Dodd-Frank Act amended the Exchange Act to establish
segregation requirements for cleared and non-cleared security-based
swaps. Section 3E(b) of the Exchange Act provides that, for cleared
security-based swaps, the money, securities, and property of a
security-based swap customer shall be separately accounted for and
shall not be commingled with the funds of the broker, dealer, or SBSD
or used to margin, secure, or guarantee any trades or contracts of any
security-based swap customer or person other than the person for whom
the money, securities, or property are held. However, Section 3E(c)(1)
of the Exchange Act also provides that, for cleared security-based
swaps, customers' money, securities, and property may, for convenience,
be commingled and deposited in the same one or more accounts with any
bank, trust company, or clearing agency. Section 3E(c)(2) further
provides that, notwithstanding Section 3E(b), in accordance with such
terms and conditions as the Commission may prescribe by rule,
regulation, or order, any money, securities, or property of the
security-based swaps customer of a broker, dealer, or security-based
swap dealer described in Section 3E(b) may be commingled and deposited
as provided in Section 3E with any other money, securities, or property
received by the broker, dealer, or security-based swap dealer and
required by the Commission to be separately accounted for and treated
and dealt with as belonging to the security-based swaps customer of the
broker, dealer, or security-based swap dealer.
    Section 3E(f) of the Exchange Act establishes a program by which a
counterparty to non-cleared security-based swaps with an SBSD or MSBSP
can elect to have initial margin held at an independent third-party
custodian (individual segregation). Section 3E(f)(4) provides that if
the counterparty does not choose to require segregation of funds or
other property, the SBSD or MSBSP shall send a report to the
counterparty on a quarterly basis stating

that the firm's back office procedures relating to margin and
collateral requirements are in compliance with the agreement of the
counterparties. The Exchange Act also provides that the segregation
requirements for non-cleared security-based swaps do not apply to
variation margin payments, so that the right of an SBSD or MSBSP
counterparty to require individual segregation applies only to initial
and not variation margin.
    The statutory provisions of Sections 3E(b) and (f) of the Exchange
Act are self-executing. The baseline incorporates these self-executing
provisions in the Exchange Act.
7. Historical Pricing Data
    The profits and losses of a security-based swap position depend on
the fluctuations in risk factors, other than counterparty risks, that
are relevant to the position. The cumulative exposure of the position
to these risk factors is commonly referred to as the market risk of the
position. For entities subject to capital requirements, the market risk
of their trading books (and corresponding market risk charges the
trading book positions incur) may affect the amount of capital that
they have available to establish new trades. Stand-alone broker-dealers
must maintain capital to cover the market risk of their trading
portfolios. The use of standardized haircuts is a common method for
calculating the amount of capital necessary to cover the market risk of
a position.\1043\
---------------------------------------------------------------------------

    \1043\ See, e.g., Rule 15c3-1; Basel II: International
Convergence of Capital Measurement and Capital Standards: A Revised
Framework--Comprehensive Version (June 2006); Basel III: A global
regulatory framework for more resilient banks and banking systems
(June 2011); CFTC Capital Proposing Release, 81 FR 91252.
---------------------------------------------------------------------------

    One commenter suggested that the Commission conduct further
economic analysis to confirm that the standardized haircuts proposed
for security-based swaps are appropriately tailored to the risk the
relevant positions present. The commenter further suggested that the
analysis should be based on quantitative data regarding the security-
based swap and swap markets since the enactment of the Dodd-Frank
Act.\1044\ In response to these comments, the Commission is providing
additional support to the discussion in the proposal \1045\ by
analyzing historical pricing data for single-name and index CDS
contracts.\1046\ Specifically, the analysis uses historical pricing
data to estimate the losses stemming from historical price movements of
security-based swap and swap positions and compares those estimated
losses with the Commission's proposed standardized haircuts for CDS
that are security-based swaps or swaps. The Commission analyzes
historical prices in several one-year samples: 3 samples that are
likely to capture stressed market conditions (2008, 2011, and 2012),
and two samples that are likely to capture normal market conditions
(2017 and 2018).\1047\
---------------------------------------------------------------------------

    \1044\ See SIFMA 11/19/2018 Letter.
    \1045\ See Capital, Margin, and Segregation Proposing Release,
77 FR at 70311-12.
    \1046\ The pricing data were purchased from ICE Data Services.
    \1047\ With respect to including data from 2008, the Commission
acknowledges the commenter's suggestion that quantitative data since
the enactment of the Dodd-Frank Act should be used. However, the
Commission believes that the inclusion of 2008 data is justified
because the stressed market conditions in that year would help
ensure that the analysis does not underestimate the riskiness of
security-based swap positions. Therefore, the Commission has
retained 2008 data in the analysis. At the same time, most of the
data used in the analysis (i.e., 2011, 2012, 2017, and 2018) are
from the period since the enactment of the Dodd-Frank Act.
---------------------------------------------------------------------------

    For each day of each sample, the Commission assigns each single-
name CDS contract to the appropriate cell in the grid set forth in
paragraph (c)(2)(vi)(P)(1)(i) of Rule 15c3-1, as amended.\1048\ The
Commission then calculates the 10-day change in the value of the
contract based on the historical pricing data for that contract and
expresses the change as a percentage of the notional value of the
contract. The Commission repeats this process for each day of the
sample for all single-name CDS contracts with historical pricing data
to generate a distribution of 10-day value changes for each cell in the
grid set forth in paragraph (c)(2)(vi)(P)(1)(i) of Rule 15c3-1. The
Commission estimates the extreme, but plausible loss for each cell as
the loss that is only exceeded by 1% of the observations in that
cell.\1049\ The Commission summarizes the distribution of such extreme
but plausible losses for all cells in the grid by calculating the
minimum, maximum, mean, standard deviation, and the quartiles of the
distribution. The Commission reports the summary statistics for each
sample in Panel A of Table 3. In Panel B of Table 3, the Commission
reports the summary statistics of extreme but plausible losses on long
credit default swap positions.
---------------------------------------------------------------------------

    \1048\ The Commission assigns the single-name CDS contracts
based on the length of time to maturity and midpoint spread on the
CDS (i.e., the average of the basis point spread bid and offer on
the CDS).
    \1049\ In other words, only 1% of the observations experienced
losses that are larger than the extreme but plausible loss.
---------------------------------------------------------------------------

    To analyze extreme, but plausible losses experienced by CDS
referencing broad-based securities indices (``index CDS''), the
Commission repeats the analyses of Panels A and B but uses historical
pricing data on index CDS contracts and the maturity and spread
combinations set forth in (b)(2)(i)(A) of Rule 15c3-1b, as amended. The
Commission reports the summary statistics of extreme, but plausible
losses on short index CDS and long index CDS in Panels C and D of Table
3, respectively.
    The summary statistics for CDS provide a number of findings as
reflected in Table 3, Panels A and B. For both short and long
positions, the mean and median losses vary across the five annual
samples. The biggest mean and median losses occurred in 2008, possibly
a reflection of severe market stresses experienced in that year. Short
CDS positions tend to experience larger losses than long CDS positions.
For example, the mean losses on short positions are larger than those
on long positions for each of the five annual samples. Losses on short
CDS positions also tend to be more variable than losses on long CDS
positions. The standard deviation, which captures the extent to which
losses deviate from the mean, is higher for short positions than for
long positions in all five annual samples.
    The summary statistics for index CDS provide broadly similar
findings, although differences exist as reflected in Table 3, Panels C
and D. For both short and long index CDS positions, the mean and median
losses vary across the five annual samples. Short index CDS positions
have the highest mean and median losses in 2008. In contrast, long
index CDS positions have the highest mean and median losses in 2012.
Compared to long positions, short positions tend to experience larger
losses in 2008 and 2011, but smaller losses in 2012, 2017, and 2018.
For example, in 2008 the mean losses on short and long positions are
17.1% and 4.7%, respectively; in 2012 the mean losses on short and long
positions are 2.4% and 5.1%, respectively. For two of the five annual
samples (2008 and 2018), losses on short index CDS positions tend to be
more variable than losses on long index CDS positions based on the
standard deviation. For the other 3 annual samples, long index CDS
positions tend to have more variable losses than short index CDS
positions.
    Table 3: Extreme But Plausible Losses Based on Historical CDS
Pricing Data. This table reports summary statistics of the distribution
of extreme, but plausible losses stemming from historical price
movements that could have impacted credit default swap positions.
Losses are in percentages. The

summary statistics are Min (minimum), P25 (first quartile/25th
percentile), P50 (second quartile/50th percentile), P75 (third
quartile/75th percentile), Max (maximum), Mean, and Std (standard
deviation).

                                        Single-Name Credit Default Swaps
----------------------------------------------------------------------------------------------------------------
                   Year                        Min       P25       P50       P75       Max      Mean       Std
----------------------------------------------------------------------------------------------------------------
                                            Panel A: Short Positions
----------------------------------------------------------------------------------------------------------------
2008......................................      0.85      6.08     12.10     20.55     71.89     18.49     19.08
2011......................................      0.33      2.94      6.30     11.37     40.89     10.41     11.42
2012......................................      0.00      1.52      3.54      6.26     27.93      6.56      8.11
2017......................................      0.07      1.63      4.44      8.46     71.92     11.24     17.66
2018......................................      0.09      2.33      5.15      9.54     41.35      9.40     11.04
----------------------------------------------------------------------------------------------------------------
                                             Panel B: Long Positions
----------------------------------------------------------------------------------------------------------------
2008......................................      0.15      1.53      4.36      9.52     46.72      7.90      9.72
2011......................................      0.22      1.52      3.49      6.53     19.06      5.34      5.37
2012......................................      0.23      1.38      3.38      6.57     19.18      5.23      5.30
2017......................................      0.08      1.58      3.21      5.75     23.22      5.13      5.31
2018......................................      0.05      1.16      3.32      6.40     20.39      5.18      5.67
----------------------------------------------------------------------------------------------------------------

                                           Index Credit Default Swaps
----------------------------------------------------------------------------------------------------------------
                   Year                        Min       P25       P50       P75       Max      Mean       Std
----------------------------------------------------------------------------------------------------------------
                                            Panel C: Short Positions
----------------------------------------------------------------------------------------------------------------
2008......................................      1.51      2.98      8.02     24.09     87.24     17.06     20.48
2011......................................      0.26      1.61      3.31      5.88     12.46      4.01      3.09
2012......................................      0.19      0.98      1.78      3.15      6.91      2.38      1.92
2017......................................      0.00      0.39      0.76      1.54      3.83      1.12      1.07
2018......................................      0.00      0.34      1.01      2.18      4.50      1.46      1.30
----------------------------------------------------------------------------------------------------------------
                                             Panel D: Long Positions
----------------------------------------------------------------------------------------------------------------
2008......................................      0.00      0.34      1.90      3.59     36.85      4.74      9.24
2011......................................      0.12      1.04      2.08      4.04     30.37      3.83      5.80
2012......................................      0.07      1.33      3.51      4.65     44.16      5.07      8.65
2017......................................      0.10      0.52      1.80      4.74      9.33      2.81      2.60
2018......................................      0.00      0.21      0.66      1.53      3.16      0.91      0.85
----------------------------------------------------------------------------------------------------------------

B. Analysis of the Final Rules and Alternatives

    Prior to the passage of the Dodd-Frank Act, the non-cleared
security-based swap and swap markets were characterized by opaque and
complex bilateral exposure networks. As a result, it was not possible
for market participants to accurately ascertain counterparty exposures
to other market participants. Moreover, because counterparties did not
demand margin in support of transactions, nor were such margins
required by regulation, there was considerable potential for market
participants to develop large exposures to their counterparties. As a
result of these large exposures, the failure of a market participant
could undermine the financial condition of its counterparties, leading
to sequential counterparty failure. Moreover, the possibility of large
exposures when combined with uncertainty about where such potential
exposures lie could cause markets to quickly become illiquid when
doubts about the viability of even one of the major participants
surfaced. Specifically, counterparties might be unwilling to extend
credit or to trade with each other.
    Title VII of the Dodd-Frank Act established a new regulatory
framework for U.S. markets in security-based swaps and swaps. The Dodd-
Frank Act requires all sufficiently standardized swaps to be cleared
through a CCP. However, the Dodd-Frank Act does not subject all
transactions to the mandatory clearing requirement. Section 764 of the
Dodd-Frank Act requires the Commission to adopt rules imposing margin
and capital requirements on such ``non-cleared'' security-based swap
transactions when the transactions are undertaken by entities subject
to the Commission's oversight \1050\ and for which there is no
prudential regulator. These requirements are intended to offset the
greater risk to the entity and the financial system from such
transactions.
---------------------------------------------------------------------------

    \1050\ These entities include nonbank SBSDs and MSBSPs.
---------------------------------------------------------------------------

    In formulating the new rules and amendments to existing rules being
adopted today (collectively the ``final rules''), the Commission has
considered the potential benefits of reducing the risk that the failure
of one firm will cause financial distress to other firms and disrupt
financial markets and the U.S. financial system. It has also taken into
account the potential costs to firms, the financial markets, and the
U.S. financial system of complying with capital, margin, and
segregation requirements. The Commission also considered related
requirements that have been adopted or proposed by other U.S. and
foreign financial regulators.
    The current broker-dealer capital, margin, and segregation
requirements serve as the template for the final rules. However, the
Commission recognized that there may be other appropriate approaches to
establishing capital, margin, and segregation requirements--including,
for example, requirements

based on the proposed or adopted capital, margin, and segregation
standards of the prudential regulators or the CFTC. In determining the
appropriate capital, margin, and segregation requirements--whether
based on current broker-dealer rules or other alternative approaches--
the Commission has assessed and considered a number of different
approaches, and the Commission recognizes that determinations it has
made could have a variety of economic consequences for the relevant
firms, markets, and the financial system as a whole.
    The capital, margin, and segregation requirements being adopted
today by the Commission are broadly intended to work in tandem to
improve the resilience of the market for security-based swaps. The
margin requirements are designed to reduce a dealer's uncollateralized
counterparty exposures from non-cleared security-based swap positions
and the potential losses from such exposures in the event of
counterparty failure. In cases where a nonbank SBSD is not required to
collect margin (i.e., the counterparty or the security-based swap
transaction is subject to an exception in Rule 18a-3), capital
requirements are designed to complement the margin requirements to
reduce the nonbank SBSD's risk of failure due to potential losses from
uncollateralized exposures. Specifically, capital requirements are
designed to enhance the safety and soundness of nonbank SBSDs and
reduce the likelihood of sequential dealer failure by setting capital
standards that adjust dynamically with the risk of exposures in
security-based swaps. In addition, the capital and margin requirements
work together to reduce the incentives of market participants to engage
in excessive risk-taking strategies, restrict their implicit leverage
through non-cleared security-based swap transactions, and reduce the
potential cost advantage of non-cleared transactions relative to
cleared transactions, and thereby encourage clearing. Finally, the
segregation requirements are designed to complement the margin and
capital requirements by helping ensure that the collateral posted by a
counterparty is adequately protected and readily available to be
returned if the nonbank SBSD fails.
    The Commission acknowledges that the new requirements of the final
rules will impose direct costs on the individual firms. These direct
costs could lead to potentially significant collective costs for the
security-based swap market and the financial system. For example,
restrictive requirements that increase the cost of trading by
individual firms could reduce their willingness to engage in such
trading, adversely affecting liquidity in the security-based swap
market, increasing transaction costs, and harming price discovery.
These, in turn, can impose costs on those market participants who rely
on security-based swaps to manage or hedge the risks arising from their
business activities that may support capital formation.
    Several commenters discussed the absence of an economic analysis in
the 2018 comment reopening. A commenter stated that the Commission
``offered no economic analysis of the proposed changes or of the
original proposals despite the now very different regulatory context.''
\1051\ Another commenter noted significant changes to security-based
swap market since the original 2012 proposal, stating that ``the cost-
benefit analysis conducted by the Commission in 2012 is simply out of
date.'' \1052\ Other commenters voiced similar concerns.\1053\ In
addition, a number of commenters had specific concerns about the impact
of the adopted rules on individual firms, market participants, and
society in general, and requested that the economic analysis address
these concerns.\1054\
---------------------------------------------------------------------------

    \1051\ See Better Markets 11/19/2018 Letter.
    \1052\ See SIFMA 11/19/2018 Letter.
    \1053\ See Citadel 11/19/2018 Letter; Harrington 11/19/2018
Letter; ICI 11/19/2018 Letter; ISDA 11/19/2018 Letter; MFA/AIMA 11/
19/2018 Letter; SIFMA AMG 11/19/2018 Letter; SIFMA 11/19/2018
Letter.
    \1054\ See American Council of Life Insurers 11/19/2018 Letter;
Better Markets 11/19/2018 Letter; Citadel 11/29/2018 Letter; FIA 11/
18/2019 Letter; Harrington 11/19/2018 Letter; ICI 11/19/2018 Letter;
IIB 11/19/2018 Letter; ISDA 11/19/2018 Letter; MFA/AIMA 11/19/2018
Letter; Morgan Stanley 11/19/2018 Letter; SIFMA AMG 11/19/2018
Letter; SIFMA 11/19/2018 Letter.
---------------------------------------------------------------------------

    The Commission is sensitive to the issues raised by commenters. As
noted in the 2018 comment reopening, the 2012 proposals contained an
analysis of the potential economic consequences, and the Commission
sought further comment on that analysis, including changes to the
baseline. The economic analysis in this adopting release takes into
consideration the changes to the baseline since 2012 and, relative to
the economic analysis in the 2012 proposing release, provides a more
thorough and complete discussion of the issues involved because it has
been informed by commenters and addresses the issues they raised. In
particular, the analysis takes into consideration market trends and
changes to market practices, the regulatory environment, and regulatory
data to identify the appropriate baseline. The analysis also evaluates
the costs and the benefits of the final rules and their impact on the
efficiency, competition, and capital formation relative to this
baseline.
    In addition, as discussed in the 2018 comment reopening, the
Commission proposed the amendments in 2012, extended the comment period
once, reopened the comment period in connection with the cross-border
release and proposed an additional security-based swap nonbank capital
requirement in 2014. In the 2012 proposal, 2013 proposal and 2014
proposal, the Commission described the potential economic consequences,
including the baseline against which the proposed rules and amendments
may be evaluated, the potential costs and benefits, reasonable
alternatives, and the potential effects on efficiency, competition and
capital formation. The Commission also has issued other releases
related to Title VII rulemakings since 2014. The economic analysis from
2012 was brought forward and made more current by these later releases.
    With respect to the magnitude of the economic impact of the final
rules, it is generally difficult to quantify certain benefits and costs
that may result from them. For example, although the adverse spillover
effects of defaults on liquidity and valuations were evident during the
financial crisis, it is difficult to quantify the effects of measures
intended to reduce the default probability of the individual
intermediary, the ensuing prevention of contagion, and the adverse
effects on liquidity and valuation. More broadly, it is difficult to
quantify the costs and benefits that may be associated with steps to
mitigate or avoid future sequential counterparty failures. Similarly,
although capital, margin, or segregation requirements may, among other
things, affect liquidity and transaction costs in the security-based
swap market, and result in a different allocation of capital than may
otherwise occur, it is difficult to quantify the extent of these
effects, or the resulting effect on the financial system more
generally.
    These difficulties are compounded by the availability of limited
public and regulatory data related to the security-based swap market,
in general, and to security-based swap market participants in
particular, all of which could assist in quantifying certain benefits
and costs. In light of these challenges, much of the discussion of the
final rules in this economic analysis will remain qualitative in
nature, although where possible the economic analysis attempts to
quantify these benefits and costs. The

inability to quantify certain benefits and costs, however, does not
mean that the overall benefits and costs of the final rules are any
less significant.
    In addition, as noted above, the final rules include a number of
specific quantitative requirements, such as numerical thresholds,
limits, deductions, and ratios. These quantitative requirements have
not been derived directly from econometric or mathematical models, but
are based on the Commission's prior experience and understanding of the
markets, and by rules promulgated by the CFTC and SROs. Accordingly,
the discussion generally describes in a qualitative way the primary
costs, benefits, and other economic effects that the Commission has
identified and taken into account in developing these specific
quantitative requirements. Where possible, the Commission supplements
the qualitative discussion of these requirements with quantitative
analysis of historical data.
1. The Capital Rules for Nonbank SBSDs--Rules 15c3-1 and 18a-1
    As noted earlier, dealers and major participants in the non-cleared
security based swap market are generally not subject to capital
requirements. Given the central role played by these entities, the lack
of a capital standard may raise concerns about the continued safety and
soundness of these firms and the provision of liquidity in this market.
Such concerns can destabilize the market in the event of a dealer
failure, especially in times of economic stress. The new capital rules
are intended to alleviate such concerns by imposing capital standards
for nonbank SBSDs that are designed to adjust dynamically with the risk
of their security-based swap exposures. In this section, the Commission
first describes the mechanics of the new capital requirements, and then
discusses in detail the benefits and the costs associated with these
requirements.
a. Overview
    The key features of Rule 18a-1, as adopted and Rule 15c3-1, as
amended, are regulatory minimum levels of capital, capital charges for
posting margin, capital charges in lieu of collecting margin, methods
for computing haircuts for security-based swaps and swaps, and risk
management procedures. Each of these features is considered in turn.
i. Minimum Net Capital Requirements
    The minimum requirements consist of a fixed-dollar component and a
variable component. These components differ across different types of
nonbank SBSDs, and for nonbank SBSDs that are also registered as
broker-dealers.
    As described in detail in section II.A.2.a. of this release,
nonbank SBSDs authorized to use models are subject to minimum tentative
net capital and net capital requirements. Nonbank SBSDs not authorized
to use models are subject to minimum net capital requirements (but not
minimum tentative net capital requirements). The minimum tentative net
capital requirement for an ANC broker-dealer, including an ANC broker-
dealer SBSD, is $5 billion and the minimum net capital requirement is
the greater of $1 billion or the applicable existing financial ratio
amount (the 15-to-1 ratio or 2% debit item ratio) plus the 2% margin
factor. The tentative net capital requirement for a stand-alone SBSD
authorized to use models (including a firm registered as an OTC
derivatives dealer) is $100 million and the minimum net capital
requirements is the greater of $20 million or the 2% margin factor. The
minimum net capital requirement for a broker-dealer SBSD not authorized
to use models is the greater of $20 million or the applicable existing
financial ratio amount (the 15-to-1 ratio or 2% debit item ratio) plus
the 2% margin factor. The minimum net capital requirement for a stand-
alone SBSD not approved to use internal models is the greater of a $20
million or the 2% margin factor.
    The 2% margin factor will remain level for 3 years after the
compliance date of the rule. After 3 years, the multiplier could
increase to not more than 4% by Commission order, and after 5 years the
multiplier could increase to not more than 8% by Commission order if
the Commission had previously issued an order raising the multiplier to
4% or less. The final rules further provide that the Commission will
consider the capital and leverage levels of the firms subject to these
requirements as well as the risks of their security-based swap
positions and provide notice before issuing an order raising the
multiplier. This approach will enable the Commission to analyze the
impact of the new requirement.
ii. Capital Charge for Posting Initial Margin
    As described in detail in section II.A.2.b.i. of this release, if a
broker-dealer or nonbank SBSD delivers initial margin to another SBSD
or other counterparty, it must take a capital charge in the amount of
the posted collateral. The Commission is providing interpretive
guidance as to how a broker-dealer or nonbank SBSD can avoid taking
this capital charge. Under the guidance, initial margin provided by the
broker-dealer or nonbank SBSD to a counterparty need not be deducted
from net worth when computing net capital if:
     The initial margin requirement is funded by a fully
executed written loan agreement with an affiliate of the broker-dealer
or nonbank SBSD;
     The loan agreement provides that the lender waives re-
payment of the loan until the initial margin is returned to the broker-
dealer or nonbank SBSD; and
     The liability of the broker-dealer or the nonbank SBSD to
the lender can be fully satisfied by delivering the collateral serving
as initial margin to the lender.
    Nonbank SBSDs and broker-dealers may apply this guidance to
security-based swap and swap transactions.
iii. Capital Deductions in Lieu of Margin
    As described in detail in section II.A.2.b.ii. of this release,
broker-dealers and nonbank SBSDs will be required to take a deduction
for under-margined accounts because of a failure to collect margin
required under Commission, CFTC, clearing agency, DCO, or DEA) rules
(i.e., a failure to collect margin when there is no exception from
collecting margin). These firms also will be required to take
deductions when they elect not to collect margin pursuant to exceptions
in the margin rules of the Commission and the CFTC for non-cleared
security-based swaps and swaps, respectively. For firms that are not
approved to use models, these deductions for electing not to collect
margin must equal 100% of the amount of margin that would have been
required to be collected from the security-based swap or swap
counterparty in the absence of an exception. These deductions can be
reduced by the value of collateral held in the account.
    Regarding the capital charges for initial margin collected but
segregated with a third-party custodian, the final rule contains a
provision that allows a nonbank SBSD to avoid taking a capital
deduction or the alternative credit risk charge for the initial margin
collected but held with a third-party custodian as long as certain
conditions are satisfied.
iv. Standardized Haircuts for Security-Based Swaps
    As described in detail in section II.A.2.b.iii. of this release, a
nonbank SBSD will be required to apply standardized haircuts to its
proprietary positions (including security-based swap and swap
positions), unless the Commission has approved its use of

model-based haircuts. The standardized haircuts for positions--other
than security-based swaps and swaps--generally are the pre-existing
standardized haircuts required by Rule 15c3-1. With respect to
security-based swaps and swaps, the Commission is prescribing
standardized haircuts tailored to those instruments. In the case of a
cleared security-based swap and swap, the standardized haircut is the
applicable clearing agency or DCO margin requirement. For a non-cleared
CDS, the standardized haircut is set forth in two grids (one for
security-based swaps and one for swaps) in which the amount of the
deduction is based on two variables: The length of time to maturity of
the CDS contract and the amount of the current offered basis point
spread on the CDS. For other types of non-cleared security-based swaps
and swaps, the standardized haircut generally is the percentage
deduction of the standardized haircut that applies to the underlying or
referenced position multiplied by the notional amount of the security-
based swap or swap.
v. Credit Risk Charges
    As described in detail in section II.A.2.b.v. of this release, ANC
broker-dealers and stand-alone SBSDs authorized to use models may take
credit risk charges instead of the deductions in lieu of margin
discussed in section II.A.2.b.ii. of this release. More specifically,
an ANC broker-dealer (including a firm registered as an SBSD) and a
stand-alone SBSD approved to use models for capital purposes can apply
a credit risk charge with respect to uncollateralized exposures arising
from derivatives instruments, including exposures arising from not
collecting variation and/or initial margin pursuant to exceptions in
the non-cleared security-based swap and swap margin rules of the
Commission and CFTC, respectively. In applying the credit risk charges,
ANC broker-dealers (including firms registered as SBSDs) are subject to
a portfolio concentration charge that has a threshold equal to 10% of
the firm's tentative net capital. Under the portfolio concentration
charge, the application of the credit risk charges to uncollateralized
current exposure across all counterparties arising from derivatives
transactions is limited to an amount of the current exposure equal to
no more than 10% of the firm's tentative net capital. The firm must
take a charge equal to 100% of the amount of the firm's aggregate
current exposure in excess of 10% of its tentative net capital. Stand-
alone SBSDs, including SBSDs operating as OTC derivatives dealers, are
not subject to a portfolio concentration charge with respect to
uncollateralized current exposure.
vi. Risk Management Procedures
    As described in detail in section II.A.2.c. of this release,
nonbank SBSDs will be required to comply with the risk management
provisions of Rule 15c3-4 as if they were OTC derivatives dealers. The
risks of trading security-based swaps--including market, credit,
operational, and legal risks--are similar to the risks faced by OTC
derivatives dealers in trading other types of OTC derivatives.\1055\
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    \1055\ For example, individually negotiated OTC derivatives,
including security-based swaps, generally are not very liquid.
Market participants face risks associated with the financial and
legal ability of counterparties to perform under the terms of
specific transactions.
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b. Benefits and Costs of the Capital Rules for Nonbank SBSDs
    The OTC market for security-based swaps as it exists today is
characterized by complex networks of bilateral exposures. At the center
of these networks are the dealers, who are the main liquidity providers
to this market. The networks are fairly opaque; market participants
have little or no knowledge about a dealer's uncollateralized exposure
to any given counterparty or the dealer's ability to withstand
potential losses from such exposure. In times of market stress,
uncertainty about the safety and soundness of the dealers may hinder
the efficient allocation of capital between market participants. For
instance, in the event of a dealer or a major participant failure,
uncertainty about the uncollateralized exposures of the surviving
dealers to the failed entity and their ability to withstand potential
losses from such exposures may discourage some market participants from
seeking new transactions with the surviving dealers. This ``run'' by
the market participants on the surviving dealers may cause some of
these dealers to fail. Sequential dealer failure would have a
significant negative impact on the provision of liquidity in this
market, and may ultimately cause the security-based swap market to
break down.
    The safety and soundness of the dealer, including its ability to
withstand losses from its trading activity depends ultimately on the
dealer's capital. As noted earlier, there are no market-imposed capital
standards in the market for non-cleared security-based swaps.
    Some of the dealers in this market are affiliated with broker-
dealers, but are not subject to the capital requirements applicable to
broker-dealers. In addition, a majority of the dealers are organized as
subsidiaries of bank holding companies and, while they may not be
subject to direct capital requirements, they are indirectly subject to
capital requirements imposed on their bank holding company parent. Some
dealers are not affiliated with a broker-dealer or have a parent bank
holding company and, consequently, are not subject to direct or
indirect capital requirements.
    Given that most of the dealers in this market are affiliated with
institutions that are subject to capital regulation, it is likely that
these dealers are organized as dealing structures designed to
efficiently deploy capital. Such capital-efficient dealing structures
may not voluntarily maintain capital buffers that adjust with the risk
of their exposures, such as to minimize the risk of their own failure
and the cost of externalities caused by such failure. Dealers currently
not subject to direct capital regulation may choose capital levels and
capital assets that, while privately optimal, are too low and too
illiquid from a market stability perspective.
    The final capital rules in this adopting release impose a capital
standard on nonbank SBSDs. This capital standard requires that, among
other things, a nonbank SBSD maintain a minimum level of net capital
that adjusts dynamically with the risk of its exposure in security-
based swap market and that promotes the liquidity of the firm. This
capital standard is intended to enhance the safety and soundness of
nonbank SBSDs by reducing their incentives to engage in excessive risk-
taking, by increasing their ability to withstand losses from their
trading activity, and by reducing the risk of sequential counterparty
failure. The Commission acknowledges, however, that the new capital
requirements may impose direct costs on nonbank SBSDs, and indirect
costs on the rest of the market participants.
    Due to the opacity of the market for non-cleared security-based
swaps, dealers currently may have an incentive to engage in excessive
risk-taking behavior. As a result, aside from reputational concerns,
the market, as it exists today, lacks mechanisms that would force
dealers to internalize the cost of the negative externalities created
by their excessive risk-taking behavior.
    The final capital rules require nonbank SBSDs to allocate
additional liquid capital for any new security-based swap position,
cleared or non-cleared. Specifically, nonbank SBSDs will need to
maintain net capital (and, for firms authorized to use models,
tentative net capital) levels that are no less than their minimum
fixed-dollar

requirements. Further, once their ratio-based minimum net capital
requirements equal or exceed their fixed-dollar minimum net capital
requirements, nonbank SBSDs will have to increase their minimum net
capital to enter a new cleared or non-cleared security-based swap
position (i.e., because the amount required under the 2% margin factor
will increase). In addition, the nonbank SBSD will have to take a
capital charge against the market risk of the position (e.g., risk of
that a change in value or default of the reference entity will cause a
mark-to-market loss for the security-based swap position). Furthermore,
to the extent that the credit exposure is uncollateralized (e.g., the
counterparty is subject to a margin collection exception), the nonbank
SBSD will also have to take a capital deduction to act as a buffer
against potential losses from replacing or closing out the position in
the event of the counterparty's failure. These capital charges increase
with the risk of the position. In particular, these capital charges may
discourage risk-taking. A reduction in risk-taking by nonbank SBSDs
would arise because the firms will have to allocate capital to account
for the market and credit exposures created by their trading positions.
In some instances, reduced risk-taking may represent an intended
economic consequence of the final rules, for example, if it manifests
as a lower propensity to establish large directional positions in
security-based swaps that may impose negative externalities on other
market participants (e.g., such positions may not take into account the
cost of the SBSD's potential failure on its counterparties). In other
cases, however, reduced risk taking could impede market functioning by,
for example, increasing the compensation that nonbank SBSDs demand to
intermediate transactions between other market participants,
potentially impairing efficient risk sharing.
    The requirements of the final margin rule may further discourage
risk-taking behavior among nonbank SBSDs. For instance, the final
margin rule requires that nonbank SBSDs post variation margin to all
their counterparties that are not subject to a variation margin
exception. In particular, a nonbank SBSD will have to post more
variation margin to a counterparty as the counterparty's current
exposure to the dealer increases. Here too, reductions in nonbank SBSD
risk-taking may reflect margin requirements that cause nonbank SBSDs to
appropriately internalize more of the costs their activities impose on
other market participants, even as these margin requirements
potentially curtail efficient reallocation of risk by market
participants.
    In general, by requiring nonbank SBSDs to allocate capital in an
amount that scales up with the size of the security-based swap
positions, and by requiring nonbank SBSDs to post variation margin
whenever they create an exposure, the capital and margin requirements
of the final capital and margin rules and amendments are intended to
reduce a nonbank SBSD's incentive to engage in excessive risk-taking
behavior in the market for non-cleared security-based swaps.
    Similarly, due to the opacity of the market for security-based
swaps, currently, it is not always clear whether a dealer is
financially sound. In particular, it is not clear whether dealers are
adequately capitalized to withstand losses from their trading activity.
The final capital rules impose a capital standard on nonbank SBSDs. As
discussed above, this capital standard requires a nonbank SBSD to
allocate capital against the market and credit exposures created by a
security-based swap position, which would permit the nonbank SBSD to
cover potential losses stemming from these exposures. These capital
charges are designed to help a nonbank SBSD manage losses from its
trading activities in cases where the nonbank SBSD cannot rely entirely
on collateral.
    Moreover, by imposing a capital standard on nonbank SBSDs that
complements the requirements of the final margin rule, the capital and
margin requirements of the final capital and margin rules and
amendments are intended to increase a nonbank SBSD's viability,
including its ability to withstand potential losses from its trading
activity. In general, when a counterparty to a non-cleared security-
based swap transaction fails, the dealer may want to replace the
position. To this end, under the final capital and margin rules, a
nonbank SBSD will be able to rely on the collateral posted by the
counterparty prior to its default (e.g., variation and initial margin)
and the capital that the nonbank SBSD allocated at the outset and
throughout the life of the position (e.g., the capital charges against
the market and credit exposure created by the position). If in the
aftermath of the counterparty's failure the market exposure of the
position continues to deteriorate, the collateral that the dealer
collected from the counterparty prior to its default may not be enough
to offset the replacement cost of the position. In this case the
nonbank SBSD may incur losses on the position. However, the nonbank
SBSD's losses would be limited by the capital that the nonbank SBSD was
required to allocate by way of a capital charge to support the position
prior to the counterparty's default as well as the increase in the
minimum net capital amount that reflects the exposure of the position
and that the nonbank SBSD is required to maintain at all times (e.g.,
the incremental adjustment to the 2% margin factor resulting from the
position).
    Finally, due to the opacity of the market for security-based swaps,
dealers do not know other dealers' exposures outside the positions that
they have in common. In particular, losses from trading activity may
cause a dealer to fail, which in turn, may cause losses for surviving
counterparty dealers and precipitate their failure. In other words, the
market for security-based swaps as it exists today is subject to the
risk of sequential dealer failure.
    Because the final margin rule would require nonbank SBSDs to
collect variation margin but not initial margin from other nonbank
SBSDs and financial market intermediaries, nonbank SBSDs would have
credit exposures to each other that may not be fully collateralized
(i.e., no inter-dealer exchange of initial margin). However, the final
capital rules and amendments work in tandem with the final margin rules
to impose a capital standard on nonbank SBSDs that requires them to
allocate capital against the market and credit exposures created by the
inter-dealer positions, and further increase their minimum net capital
by an amount that is proportional to the exposure created by the
positions. This capital buffer is designed to help a nonbank SBSD
withstand potential losses from replacing inter-dealer positions that
expose the dealer to uncollateralized credit exposure, because of the
absence of inter-dealer collection of initial margin. In addition,
while nonbank SBSDs are not required to collect initial margin from
each other, they are not prohibited from doing so.
    Thus, by requiring nonbank SBSDs to allocate capital that scales up
with the risk of the inter-dealer credit exposures (whether or not
collateralized), the capital and margin requirements of the final
capital and margin rules and amendments are expected to reduce the
likelihood that the losses at one nonbank SBSD impact the other nonbank
SBSD. In turn, the final capital and margin rules, taken together,
should reduce the risk of sequential dealer failure.

    The final capital rules and amendments will impose direct
compliance costs on nonbank SBSDs. To be adequately capitalized, SBSDs
will have to ensure that their net capital is larger than the required
minimum net capital. An SBSD will have to calculate its net capital by
taking capital charges against their tentative net capital for the
uncollateralized exposures created by their trading activity. As noted
earlier, the minimum net capital, through the 2% margin factor, as well
as the capital charges (i.e., standardized or model-based haircuts)
scale up with a nonbank SBSD's trading activity in the security-based
swap market. Thus, the new capital requirements directly constrain a
nonbank SBSD's trading activity, and the profits that the nonbank SBSD
expects to generate from such activity. In turn, these capital
constraints may limit the provision of liquidity in the market for non-
cleared security-based swaps, and the resulting reduction in price
discovery may, in turn, impose a cost on market participants.
    The Commission has made two significant modifications to the final
capital rules for nonbank SBSDs. First, as discussed above in section
II.A.2.b.v. of this release, the Commission has modified Rule 18a-1 so
that it no longer contains a portfolio concentration charge that is
triggered when the aggregate current exposure of the stand-alone SBSD