[Federal Register: October 26, 2010 (Volume 75, Number 206)]
[Proposed Rules]
[Page 65881-65932]
[DOCID:fr26oc10-25]

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Part IV

Securities and Exchange Commission

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17 CFR Part 242

Ownership Limitations and Governance Requirements for Security-Based
Swap Clearing Agencies, Security-Based Swap Execution Facilities, and
NationalSecurities Exchanges With Respect to Security-Based Swaps Under
Regulation MC; Proposed Rule

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 242

[Release No. 34-63107; File No. S7-27-10]
RIN 3235-AK74

Ownership Limitations and Governance Requirements for Security-
Based Swap Clearing Agencies, Security-Based Swap Execution Facilities,
and National Securities Exchanges With Respect to Security-Based Swaps
Under Regulation MC

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: In accordance with Section 765 (``Section 765'') of Title VII
(``Title VII'') of the Dodd-Frank Wall Street Reform and Consumer
Protection Act of 2010 (``Dodd-Frank Act''), the Securities and
Exchange Commission (``SEC'' or ``Commission'') is proposing Regulation
MC under the Securities Exchange Act of 1934 (``Exchange Act'') for
clearing agencies that clear security-based swaps (``security-based
swap clearing agencies'') and for security-based swap execution
facilities (``SB SEFs'') and national securities exchanges that post or
make available for trading security-based swaps (``SBS exchanges'').
Regulation MC is designed to mitigate potential conflicts of interest
that could exist at these entities. Specifically, the Commission seeks
to mitigate the potential conflicts of interest through conditions and
structures relating to ownership, voting, and governance of security-
based swap clearing agencies, SB SEFs, and SBS exchanges.

DATES: Comments should be submitted on or before November 26, 2010.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://
www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to<EMAIL_ADDRESS>Please include
File Number S7-27-10 on the subject line; or
     Use the Federal eRulemaking Portal (http://
www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy,
Secretary, Securities and Exchange Commission, 100 F St., NE.,
Washington, DC 20549-1090.

All submissions should refer to File Number S7-27-10. This file number
should be included on the subject line if e-mail is used. To help us
process and review your comments more efficiently, please use only one
method. The Commission will post all comments on the Commission's
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments
are also available for Web site viewing and printing in the
Commission's Public Reference Room, 100 F St., NE., Washington, DC
20549 on official business days between the hours of 10 a.m. and 3 p.m.
All comments received will be posted without change; the Commission
does not edit personal identifying information from submissions. You
should submit only information that you wish to make available
publicly.

FOR FURTHER INFORMATION CONTACT: Proposals relating to security-based
swap clearing agencies: Catherine Moore, Senior Special Counsel, at
(202) 551-5710; and Joseph P. Kamnik, Special Counsel, at (202) 551-
5710; Office of Clearance and Settlement, Division of Trading and
Markets, Securities and Exchange Commission, 100 F Street, NE.,
Washington, DC 20549-7010; proposals relating to security-based swap
execution facilities and national securities exchanges that post or
make available for trading security-based swaps: Nancy Burke-Sanow,
Assistant Director, at<PHONE_NUMBER>; Molly Kim, Special Counsel, at
(202) 551-5644; Steven Varholik, Special Counsel, at<PHONE_NUMBER>;
Sarah Schandler, Attorney, at<PHONE_NUMBER>; and Iliana Lundblad,
Attorney, at<PHONE_NUMBER>; Office of Market Supervision, Division of
Trading and Markets, Securities and Exchange Commission, 100 F Street,
NE., Washington, DC 20549-7010.

SUPPLEMENTARY INFORMATION: The Commission is proposing new Regulation
MC under the Exchange Act relating to conflicts of interest with
respect to security-based swap clearing agencies, SB SEFs, and SBS
exchanges.

I. Introduction

    On July 21, 2010, the President signed the Dodd-Frank Act into
law.\1\ The Dodd-Frank Act was enacted to, among other purposes,
promote the financial stability of the United States by improving
accountability and transparency in the financial system.\2\ Title VII
of the Dodd-Frank Act provides the Commission and the Commodity Futures
Trading Commission (``CFTC'') with the authority to regulate over-the-
counter (``OTC'') derivatives in light of the recent financial crisis,
which demonstrated the need for enhanced regulation in the OTC
derivatives market. The Dodd-Frank Act is intended to close loopholes
in the existing regulatory structure and to provide the Commission and
the CFTC with effective regulatory tools to oversee the OTC swaps
market, which has grown exponentially in recent years and is capable of
affecting significant sectors of the U.S. economy.
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    \1\ The Dodd-Frank Wall Street Reform and Consumer Protection
Act (Pub. L. 111-203, H.R. 4173).
    \2\ See Public Law 111-203, Preamble.
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    The Dodd-Frank Act provides that the CFTC will regulate ``swaps,''
the Commission will regulate ``security-based swaps,'' and the CFTC and
the Commission will jointly regulate ``mixed swaps.'' \3\ The Dodd-
Frank Act amends the Exchange Act to require, among other things, the
following: (1) Transactions in security-based swaps must be cleared
through a clearing agency if they are of a type that the Commission
determines must be cleared, unless an exemption from mandatory clearing
applies; (2) transactions in security-based swaps must be reported to a
registered security-based swap data repository or

the Commission; and (3) if a security-based swap is subject to a
clearing requirement, it must be traded on a registered trading
platform, i.e., a SB SEF or SBS exchange, unless no facility makes such
security-based swap available for trading.\4\
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    \3\ Section 712(d) of the Dodd-Frank Act provides that the
Commission and the CFTC, in consultation with the Board of Governors
of the Federal Reserve System (``Federal Reserve''), shall jointly
further define the terms ``swap,'' ``security-based swap,'' ``swap
dealer,'' ``security-based swap dealer,'' ``major swap
participant,'' ``major security-based swap participant,'' ``eligible
contract participant,'' and ``security-based swap agreement.'' These
terms are defined in Sections 721 and 761 of the Dodd-Frank Act and,
with respect to the term ``eligible contract participant,'' in
Section 1a(18) of the Commodity Exchange Act (``CEA''), 7 U.S.C.
1a(18), as re-designated and amended by Section 721 of the Dodd-
Frank Act. Further, Section 721(c) of the Dodd-Frank Act requires
the CFTC to adopt a rule to further define the terms ``swap,''
``swap dealer,'' ``major swap participant,'' and ``eligible contract
participant,'' and Section 761(b) of the Dodd-Frank Act permits the
Commission to adopt a rule to further define the terms ``security-
based swap,'' ``security-based swap dealer,'' ``major security-based
swap participant,'' and ``eligible contract participant,'' with
regard to security-based swaps, for the purpose of including
transactions and entities that have been structured to evade Title
VII of the Dodd-Frank Act. Finally, Section 712(a) of the Dodd-Frank
Act provides that the Commission and CFTC, after consultation with
the Federal Reserve, shall jointly prescribe regulations regarding
``mixed swaps'' as may be necessary to carry out the purposes of
Title VII. To assist the Commission and CFTC in further defining the
terms specified above, and to prescribe regulations regarding
``mixed swaps'' as may be necessary to carry out the purposes of
Title VII, the Commission and the CFTC have requested comment from
interested parties. See Securities Exchange Act Release No. 62717
(August 13, 2010), 75 FR 51429 (August 20, 2010) (File No. S7-16-10)
(advance joint notice of proposed rulemaking regarding definitions
contained in Title VII of the Dodd-Frank Act) (``Definitions
Release'').
    \4\ See Section 761 of the Dodd-Frank Act, added as Section
3(a)(77) of the Exchange Act, 15 U.S.C. 78(c)(a), which defines the
term ``security-based swap execution facility'' to mean ``a trading
system or platform in which multiple participants have the ability
to execute or trade security-based swaps by accepting bids and
offers made by multiple participants in the facility or system,
through any means of interstate commerce, including any trading
facility that (A) facilitates the execution of security-based swaps
between persons; and (B) is not a national securities exchange.''
See Public Law 111-203, Section 761. The Dodd-Frank Act amends the
CEA to provide for a similar regulatory framework with respect to
transactions in swaps regulated by the CFTC.
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II. Mandated Rulemaking on Mitigating Conflicts of Interest

    Section 765 of the Dodd-Frank Act requires the Commission to adopt
rules to mitigate specified conflicts of interest.\5\ Section 765(a)
requires the Commission to adopt rules, which rules may include
numerical limits on the control of, or the voting rights with respect
to, any security-based swap clearing agency, or on the control of any
SB SEF or SBS exchange, by specified entities, such as a bank holding
company with total consolidated assets of $50 billion or more,\6\ a
nonbank financial company,\7\ an affiliate of such bank holding company
or nonbank financial company, a security-based swap dealer,\8\ or a
major security-based swap participant (collectively, ``Specified
Entities'').\9\
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    \5\ See Public Law 111-203, Section 765.
    \6\ The term ``bank holding company'' has the meaning set forth
in Section 2 of the Bank Holding Company Act of 1956 (12 U.S.C.
1841) (``Bank Holding Company Act''), and generally means any
company that has control over any bank or over any company that is
or becomes a bank holding company by virtue of the Bank Holding
Company Act.
    \7\ Under Section 765(a) of the Dodd-Frank Act, the term
``nonbank financial company'' has the meaning set forth in Section
102 of the Dodd-Frank Act, and generally means a company, other than
a bank holding company, national securities exchange, clearing
agency, SB SEF, registered security-based swap data repository,
board of trade designated as a contract market (``DCM''),
derivatives clearing organization, swap execution facility (``SEF'')
or registered swap data repository, that is predominantly engaged in
financial activities (including through a branch in the U.S., if
such company is incorporated or organized in a country other than
the U.S.). See Public Law 111-203, Section 102 for the complete
definition.
    \8\ Pursuant to Section 761 of the Dodd-Frank Act, the term
``security-based swap dealer'' is added as Section 3(a)(71) of the
Exchange Act, 15 U.S.C 78c(a), and generally means any person who
(A) holds themselves out as a dealer in security-based swaps; (B)
makes a market in security-based swaps; (C) regularly enters into
security-based swaps with counterparties as an ordinary course of
business for its own account; or (D) engages in any activity causing
it to be commonly known in the trade as a dealer or market maker in
security-based swaps. See Public Law 111-203, Section 761 for the
complete definition. See also Definitions Release, 75 FR 51429,
supra note 3.
    \9\ Pursuant to Section 761 of the Dodd-Frank Act, the term
``major security-based swap participant'' is added as Section
3(a)(67) of the Exchange Act, 15 U.S.C 78c(a), and generally means
any person (A) who is not a security-based swap dealer; and (B)(I)
who maintains a substantial position in security-based swaps for any
of the major security-based swap categories, as such categories are
determined by the Commission, excluding positions held for hedging
or mitigating commercial risk; (II) whose outstanding security-based
swaps create substantial counterparty exposure that could have
serious adverse effects on the financial stability of the U.S.
banking system or financial markets; or (III) that is a financial
entity that (a) is highly leveraged relative to the amount of
capital such entity holds and that is not subject to capital
requirements established by an appropriate Federal banking
regulator; and (b) maintains a substantial position in outstanding
security-based swaps in any major security-based swap category, as
such categories are determined by the Commission. See Public Law
111-203, Section 761 for the complete definition. See also
Definitions Release, 75 FR 51429, supra note 3.
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    Section 765(b)--captioned ``Purposes''--provides that the
Commission shall adopt such rules if it determines they are necessary
or appropriate to improve the governance of, or to mitigate systemic
risk, promote competition or mitigate conflicts of interest in
connection with a security-based swap dealer's or major security-based
swap participant's conduct of business with, a security-based swap
clearing agency, SB SEF, or SBS exchange and in which such security-
based swap dealer or major security-based swap participant has a
material debt or equity investment.\10\ Section 765(b) sets forth a
number of underlying policy objectives for the Commission's
rulemaking--improving governance, mitigating systemic risk, promoting
competition, and mitigating conflicts of interest with respect to
security-based swap clearing agencies, SB SEFs, and SBS exchanges. In
considering proposed rules to mitigate conflicts of interest, the
Commission is mindful that, in some instances, certain of these diverse
policy objectives may be in tension with others. For example, as
described in Section III.A.2.a below, with respect to security-based
swap clearing agencies, the statutory objective of promoting
competition, which may be furthered through enhanced access to cleared
products and clearing venues, may to some extent be in tension with the
objective of minimizing systemic risk through effective risk management
of the clearing agency.
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    \10\ See Public Law 111-203, Section 765(b).
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    Section 765(c) of the Dodd-Frank Act also provides that in adopting
rules under Section 765, the Commission shall consider any conflicts of
interest arising from the amount of equity ownership and voting by a
single investor; the ability of owners to vote, cause the vote of, or
withhold votes entitled to be cast on any matters by the holders of the
ownership interest; and the governance arrangements of any derivatives
clearing organization that clears swaps, or swap execution facility or
board of trade designated as a contract market that posts swaps or
makes swaps available for trading.\11\
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    \11\ See Public Law 111-203, Section 765(c). Although this
provision refers to swaps and to entities regulated by the CFTC, the
Commission believes that the Congress intended it to refer to
security-based swaps and to security-based swap clearing agencies,
SB SEFs, and SBS exchanges, because Section 765 pertains to
transactions in security-based swaps and persons and entities
related thereto.
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    The Commission is cognizant that the proposed rules discussed
herein, as well as other proposals that the Commission may consider in
the coming months to implement the Dodd-Frank Act, if adopted, could
significantly affect--and be significantly affected by--the nature and
scope of the security-based swaps market in a number of ways. For
example, the Commission recognizes that if the measures proposed in
this release are adopted and are too onerous for new entrants, they
could hinder the further development of a market for security-based
swaps by unduly discouraging competition and the formation of new
security-based swap clearing agencies and of new SB SEFs or SBS
exchanges. On the other hand, if the Commission adopts rules that are
too permissive, conflicts of interest may be inadequately mitigated and
such conflicts may incentivize restricting access to centralized
clearing and lack of transparency in the trading of security-based
swaps as described in detail in Section III below. The Commission is
also mindful that the further development of the security-based swaps
market may alter the calculus for future regulation of conflicts of
interest. As commenters review the instant proposals, they are urged to
consider generally the role that regulation may play in fostering or
limiting the development of the market for security-based swaps (or,
vice versa, the role that market developments may play in changing the
nature and implications of regulation) and specifically to focus on
this issue with respect to the proposals to mitigate conflicts of
interest for security-based swap clearing agencies, SB SEFs, and SBS
exchanges.

    The Commission must adopt the rules required by Section 765 of the
Dodd-Frank Act by January 17, 2011, which is 180 days after enactment
of the Dodd-Frank Act.\12\ The Commission therefore is proposing
Regulation MC under the Exchange Act to mitigate conflicts of interest
with respect to security-based swap clearing agencies, SB SEFs, and SBS
exchanges.
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    \12\ Section 726 of the Dodd-Frank Act similarly requires the
CFTC to adopt rules designed to mitigate conflicts of interest with
respect to entities under its jurisdiction that clear or trade
swaps. See Public Law 111-203, Section 726. The Commission
preliminarily believes that an entity that registers with the
Commission as either a security-based swap clearing agency or a SB
SEF is likely to register also with the CFTC as a derivatives
clearing organization or swap execution facility, respectively. As a
result, the Commission staff and the CFTC staff have consulted and
coordinated with one another regarding their respective agencies'
proposed rules to mitigate conflicts of interest.
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    This proposed rulemaking is among the first that the Commission has
considered in connection with its mandates under the Dodd-Frank Act,
and the Commission is mindful of the considerations raised by this
timing. In particular, under the prescribed timeframes of the Dodd-
Frank Act, the Commission must propose rules required by Section 765
before it has the opportunity to consider proposed rules that also are
likely to affect the development of security-based swap clearing
agencies, SB SEFs, and SBS exchanges, as well as the security-based
swaps market overall. The Commission also notes that the market for
security-based swaps is in a nascent stage of development compared to
the markets for equity securities and listed options and that the
market for security-based swaps could develop further as the Dodd-Frank
Act is fully implemented and these transactions continue to move to
central clearing and trading on organized markets.

III. Discussion of Potential Conflicts of Interest

A. Security-Based Swap Clearing Agencies

1. Current Regulatory Structure
    Credit market events from the last few years have demonstrated that
a security-based swaps market operating without meaningful regulation
\13\ and central counterparties \14\ can pose systemic risks. In
November 2008, under the auspices of the President's Working Group on
Financial Markets, the Secretary of the Department of the Treasury, the
Chairs of the Board of Governors of the Federal Reserve, the Office of
the Comptroller of the Currency, the CFTC, and the Commission
established as a policy objective for the OTC derivatives market that
regulators and prudential supervisors require participants in a central
counterparty (``CCP'') arrangement to clear all eligible contracts
through that CCP.\15\ In furtherance of this policy objective, the
Commission, the Federal Reserve, and the CFTC signed a Memorandum of
Understanding that established a framework for consultation and
information sharing on issues related to central counterparties for the
OTC derivatives market.\16\
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    \13\ See, generally, Policy Objectives for the OTC Derivatives
Market, The President's Working Group on Financial Markets (November
14, 2008) (available at http://www.ustreas.gov/press/releases/
reports/policyobjectives.pdf).
    \14\ See The Role of Credit Derivatives in the U.S. Economy
before the H. Agric. Comm., 110th Cong. (2008) (Statement of Erik
Sirri, Director of the Division of Trading and Markets, Commission)
(available at http://agriculture.house.gov/testimony/110/110-
49.pdf).
    \15\ See supra note 13. See also Policy Statement on Financial
Market Developments, The President's Working Group on Financial
Markets (March 13, 2008) (available at http://www.treas.gov/press/
releases/reports/pwgpolicystatemktturmoil_03122008.pdf) and
Progress Update on March Policy Statement on Financial Market
Developments, The President's Working Group on Financial Markets
(October 2008) (available at http://www.treas.gov/press/releases/
reports/q4progress%20update.pdf).
    \16\ See Memorandum of Understanding Between the Board of
Governors of the Federal Reserve System, the U.S. Commodity Futures
Trading Commission, and the U.S. Securities and Exchange Commission
Regarding Central Counterparties for Credit Default Swaps (November
14, 2008) (available at http://www.treas.gov/press/releases/reports/
finalmou.pdf).
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    The Commission has taken steps to help foster the prompt
development of CCPs. In particular, the Commission acted to authorize
the clearing of OTC security-based swaps by permitting certain clearing
agencies to clear credit default swaps (``CDS'') on a temporary
conditional basis.\17\ Today, a significant volume of CDS transactions
is cleared centrally and the Commission monitors the activities of
these clearing agencies.\18\
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    \17\ The Commission authorized five entities to clear credit
default swaps. See Securities Exchange Act Release Nos. 60372 (July
23, 2009), 74 FR 37748 (July 29, 2009) and 61973 (April 23, 2010),
75 FR 22656 (April 29, 2010) (CDS clearing by ICE Clear Europe
Limited); 60373 (July 23, 2009), 74 FR 37740 (July 29, 2009) and
61975 (April 23, 2010), 75 FR 22641 (April 29, 2010) (CDS clearing
by Eurex Clearing AG); 59578 (March 13, 2009), 74 FR 11781 (March
19, 2009), 61164 (December 14, 2009), 74 FR 67258 (December 18,
2009) and 61803 (March 30, 2010), 75 FR 17181 (April 5, 2010) (CDS
clearing by Chicago Mercantile Exchange Inc.); 59527 (March 6,
2009), 74 FR 10791 (March 12, 2009), 61119 (December 4, 2009), 74 FR
65554 (December 10, 2009) and 61662 (March 5, 2010), 75 FR 11589
(March 11, 2010) (CDS clearing by ICE Trust US LLC); 59164 (December
24, 2008), 74 FR 139 (January 2, 2009) (temporary CDS clearing by
LIFFE A&M and LCH.Clearnet Ltd.) (collectively, ``CDS Clearing
Exemption Orders''). LIFFE A&M and LCH.Clearnet Ltd. allowed their
order to lapse without seeking renewal.
    \18\ To date most cleared CDS transactions have cleared at ICE
Trust US LLC (``ICE Trust'') or ICE Clear Europe Limited (``ICE
Clear Europe''). As of October 8, 2010, ICE Trust had cleared
approximately $7.1 trillion notional amount of CDS contracts based
on indices of securities and approximately $490 billion notional
amount of CDS contracts based on individual reference entities or
securities. As of October 8, 2010, ICE Clear Europe had cleared
approximately [euro]3.09 trillion notional amount of CDS contracts
based on indices of securities and approximately [euro]560 billion
notional amount of CDS contracts based on individual reference
entities or securities. See https://www.theice.com/marketdata/
reports/ReportCenter.shtml.
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    The Exchange Act does not impose specific requirements regarding
the ownership structure of a clearing agency. As a result, clearing
agencies may operate under a variety of appropriate organizational
structures provided that they have the capacity to meet the standards
in Section 17A of the Exchange Act.\19\ Certain clearing agencies
registered with the Commission are owned either by participants or by
securities exchanges.\20\ Other clearing agencies, such as the
security-based swap clearing agencies that, once registered, would be
required to comply with proposed Regulation MC, are subsidiaries of or
partly-owned by publicly traded companies.\21\ These entities are not
wholly-owned by participants or exchanges and may have different
governance related issues than the securities clearing agencies
currently registered with the Commission.
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    \19\ See 78q-1(b)(3)(A).
    \20\ The Depository Trust and Clearing Corporation (``DTCC'') is
participant-owned and has three separate subsidiaries that are
registered clearing agencies which function as quasi-utilities. The
Options Clearing Corporation is owned by five unaffiliated options
exchanges.
    \21\ These clearing agencies include ICE Trust US LLC, ICE Clear
Europe Limited, Eurex Clearing AG, and Chicago Mercantile Exchange
Inc.
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    Upon the effective date of Title VII of the Dodd-Frank Act,
clearing agencies that clear and settle security-based swap
transactions will be subject to a number of regulatory obligations that
are intended to promote the policy objectives of the Dodd-Frank Act,
including increased clearing of security-based swaps and effective risk
management. Accordingly, security-based swap clearing agencies will be
required to be registered with, and regulated by, the Commission under
Section 17A.\22\ In addition, all registered

clearing agencies must comply with the standards in Section 17A, which
include, but are not limited to, maintaining rules for promoting the
prompt and accurate clearance and settlement of securities
transactions, assuring the safeguarding of securities and funds which
are in the custody or control of the clearing agency or for which it is
responsible, fostering cooperation and coordination with persons
engaged in the clearance and settlement of securities transactions,
removing impediments to and perfecting the mechanism of a national
system for the prompt and accurate clearance and settlement of
securities transactions, and, in general, protecting investors and the
public interest.\23\ A registered clearing agency is also required to
provide fair access to clearing and to have the capacity to facilitate
the prompt and accurate clearance and settlement of securities
transactions and derivative agreements, contracts, and transactions for
which it is responsible, as well as to safeguard securities and funds
in its custody or control or for which it is responsible.\24\
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    \22\ Section 763(b) of the Dodd-Frank Act adds new Section
17A(k) to the Exchange Act, which authorizes the Commission to
exempt, conditionally or unconditionally, a security-based swap
clearing agency from registration if the Commission determines it is
subject to comparable, comprehensive supervision and regulation by
the CFTC or appropriate government authorities in the home country
of the security-based swap clearing agency. See Public Law 111-203,
Section 763(b).
    \23\ See 15 U.S.C. 78q-1(b)(3)(F). Section 17A of the Exchange
Act also includes standards that help to mitigate conflicts of
interest. See infra Section IV.C. for a discussion of these
standards.
    \24\ 15 U.S.C. 78q-1(b)(3)(A), (B), and (F).
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    Pursuant to Section 765 of the Dodd-Frank Act, the Commission must
identify the nature and sources of any conflicts of interest relating
to the voting interests in and governance of a security-based swap
clearing agency that may interfere with achieving the policy objectives
described above or with the clearing agency complying with the
regulatory mandates of Section 17A of the Exchange Act described above,
including the obligation to adopt rules consistent with the protection
of investors and the public interest.
2. Sources of Conflicts of Interest
    The Commission's experience in monitoring the activities of the
clearing agencies engaged in clearing CDS has provided it with insight
into the potential sources of conflicts of interest that may exist at
security-based swap clearing agencies. Since shortly after the
enactment of the Dodd-Frank Act, the Commission staff and staff from
the CFTC have met with interested persons to learn more about potential
conflicts. Moreover, on August 20, 2010, the staff of the Commission
and CFTC held a joint public roundtable in part to gain further insight
into the sources of conflicts of interest at security-based swap
clearing agencies, SB SEFs, and SBS exchanges, as well as methods for
mitigating conflicts of interest (``Conflicts Roundtable'').\25\
Panelists from this roundtable included industry and non-industry
participants.\26\
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    \25\ See Securities Exchange Act Release No. 62725, 75 FR 51305
(August 19, 2010). The Commission solicited comments on the
Conflicts Roundtable (comments received by the Commission are
available at http://sec.gov/cgi-bin/ruling-comments?ruling=4-
609&rule_path=/comments/4-609&file_num=4-609&action=Show_
Form&title=SEC%2DCFTC Roundtable on Swaps and Security%2DBased
Swaps%3A Notice of roundtable discussion and request for comment).
    \26\ The transcript of the Conflicts Roundtable is available on
the CFTC's Web site at http://cftc.gov/ucm/groups/public/@newsroom/
documents/file/derivative9sub082010.pdf.
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    Drawing on these experiences, the Commission has reviewed the
potential for conflicts of interest at security-based swap clearing
agencies in accordance with Section 765 of the Dodd-Frank Act and has
identified those conflicts that could affect access to clearing agency
services, products eligible for clearing, and risk management practices
of the clearing agencies. Preliminarily, the Commission believes that
the most significant conflicts of interest that may have an adverse
effect on statutory goals in Section 765 of the Dodd-Frank Act are
those that arise when a small number of participants,\27\ including
participants that are Specified Entities and including related persons
of the participants,\28\ exercise undue control or influence over a
security-based swap clearing agency.
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    \27\ The term ``participant'' when used with respect to a
clearing agency has the meaning set forth in Section 3(a)(24) of the
Exchange Act, 15 U.S.C 78c(a), and shall include Specified Entities.
See proposed Rule 700(o) under Regulation MC.
    \28\ See infra Section IV.A.3. for a discussion of ``related
person'' in the context of a security-based swap clearing agency.
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    The Commission has identified three key areas where it believes a
conflict of interest of participants who exercise undue control or
influence over a security-based swap clearing agency could adversely
affect the central clearing of security-based swaps. First,
participants could limit access to the security-based swap clearing
agency, either by restricting direct participation in the security-
based swap clearing agency or restricting indirect access by
controlling the ability of non-participants to enter into correspondent
clearing arrangements.\29\ Second, participants could limit the scope
of products eligible for clearing at the security-based swap clearing
agency, particularly if there is a strong economic incentive to keep a
product traded in the OTC market for security-based swaps. Third,
participants could use their influence to lower the risk management
controls of a security-based swap clearing agency in order to reduce
the amount of collateral they would be required to contribute and
liquidity resources they would have to expend as margin or guaranty
fund to the security-based swap clearing agency.
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    \29\ See, generally, Matthew Leising and Shannon D. Harrington,
``Wall Street Dominance of Swaps Must End, Brokers Say (Update 1),''
Bloomberg (March 16, 2010).
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    Each of these potential conflicts of interest could limit the
benefits of a security-based swap clearing agency in the security-based
swaps market, and even potentially cause substantial harm to that
market and the broader financial markets, as described below. Conflicts
of interest in these areas could also potentially undermine the
mandatory clearing requirement in Section 763 of the Dodd-Frank Act,
thereby affecting transparency, investor protection, risk management,
efficiency, and competition in the security-based swaps market.\30\
---------------------------------------------------------------------------

    \30\ See Public Law 111-203, Section 763(a). Section 763(a) of
the Dodd-Frank Act adds new Section 3C to the Exchange Act, which
requires clearing for certain security-based swaps. Specifically,
Section 3C(a)(1) provides that ``It shall be unlawful for any person
to engage in a security-based swap unless that person submits such
security-based swap for clearing to a clearing agency that is
registered under the Exchange Act or a clearing agency that is
exempt from registration under the Exchange Act if the security-
based swap is required to be cleared.''
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a. Limitations on Open Access to Security-Based Swap Clearing Agencies
    The Commission believes that the increased use of central clearing
for security-based swaps should help to promote robust risk management,
foster greater efficiencies, improve investor protection, and promote
transparency in the market for security-based swaps. For these reasons,
the Commission has encouraged the use of central clearing for security-
based swaps.\31\ A consequence of increased use of central clearing
services, however, is that participants that control or influence a
security-based swap clearing agency may gain a competitive advantage in
the security-based swaps market by restricting access to the clearing
agency. If that occurred, financial institutions and marketplaces that
do not have access to central clearing would have limited ability to
trade in or list security-based swaps. This problem would continue to
exist after the mandatory clearing requirement under Section 763 of the
Dodd-Frank Act becomes effective, because financial institutions may be
required either to submit security-based swaps for central

clearing or face heightened capital or margin requirements associated
with bilateral agreements.
---------------------------------------------------------------------------

    \31\ See CDS Clearing Exemption Orders, supra note 17.
---------------------------------------------------------------------------

    Market participants generally obtain access to a clearing agency in
one of two ways: (1) Directly, by becoming a participant in a clearing
agency or (2) indirectly, by entering into a correspondent clearing
arrangement with a participant in a clearing agency.\32\ There are
several ways that both direct and indirect access to a security-based
swap clearing agency could be restricted if persons who make decisions
for or act on behalf of the clearing agency have a conflict of interest
because of their incentives to further their own business interests
outside of the security-based swap clearing agency. Participants may
seek to limit the number of other direct participants in a security-
based swap clearing agency in order to limit competition and increase
their ability to maintain higher profit margins. A security-based swap
clearing agency that is controlled by a limited number of participants
might also adopt policies and procedures that are designed to unduly
restrict access, or have the effect of unduly restricting access, to
the clearing agency by other participants in ways that are unrelated to
sound risk management practices.\33\ At the same time, affording
greater access to the clearing agency at some point may come at the
expense of sound risk management practices.
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    \32\ Correspondent clearing is an arrangement between a current
participant of a clearing agency and a non-participant that desires
to use the clearing agency for clearance and settlement services.
    \33\ An example of such restrictive policies and procedures
would be a clearing agency establishing prohibitively high
participation standards so that only the largest financial
institutions qualify as participants.
---------------------------------------------------------------------------

    The Commission recognizes that security-based swap clearing
agencies must establish reasonable participation standards in order to
ensure the participants in the clearing agency do not expose it to
unacceptable risk or otherwise adversely affect the performance of the
clearing agency, particularly during periods of market stress. However,
participant standards may have the effect of restricting access to the
clearing agency. On the one hand, panelists at the Conflicts Roundtable
and others have raised the concern that participation requirements
could be unnecessarily restrictive and primarily designed to limit the
number of entities that are permitted to become direct participants in
the clearing agency.\34\ While appropriate participation standards are
necessary for the sound operation of the security-based swap clearing
agency, unduly high standards may needlessly exclude persons who are
otherwise qualified to clear security-based swaps. On the other hand,
some panelists at the Conflicts Roundtable also suggested that
increasing access can come at the expense of sound risk management
practices.\35\
---------------------------------------------------------------------------

    \34\ See, generally, Swaps and Derivatives Market Association,
``Lessening Systemic Risk: Removing Final Hurdles to Clearing OTC
Derivatives'' (available at http://media.ft.com/cms/fe51a538-78d7-
11df-a312-00144feabdc0.pdf) (``SDMA Letter''). See also Public
Roundtable on Governance and Conflicts of Interest in the Clearing
and Listing of Swaps, comments of Darrell Duffie (``[W]e want to be
very careful that the members of a central clearing counterparty
that determine what gets cleared * * * are the members that have * *
* the right social incentives to create competition.'') (available
at http://cftc.gov/ucm/groups/public/@newsroom/documents/file/
derivative9sub082010.pdf at 62).
    \35\ See supra note 25.
---------------------------------------------------------------------------

    Access could also be restricted by the way that clearing members
determine executable end-of-day settlement prices. Since there is
currently no exchange or other venue that publishes security-based swap
prices, the Commission has required security-based swap clearing
agencies to publish end-of-day settlement prices and any other prices
with respect to cleared security-based swaps that the security-based
swap clearing agency may use to calculate mark-to-market
requirements.\36\ To ensure that end-of-day settlement prices are
reliable and consistent, a security-based swap clearing agency may
require that the price submission be executable.\37\ The security-based
swap clearing agency, however, might not permit an entity to rely on a
third party to provide an executable end-of-day settlement price. This
could potentially prevent all but the largest dealer firms from having
direct access to the clearing agency as they may be the only firms that
have the processes to determine executable end-of-day settlement
prices.\38\
---------------------------------------------------------------------------

    \36\ See, e.g., CDS Clearing Exemption Orders, supra note 17.
    \37\ As part of their internal processes, security-based swap
clearing agencies generally calculate end-of-day settlement prices
for each product in which they hold a cleared interest each business
day. See, e.g., Letter from Kevin McClear, ICE Trust, to Elizabeth
Murphy, Secretary, Commission, December 4, 2009, and letter from Ann
K. Shuman, Managing Director and Deputy General Counsel, CME, to
Elizabeth Murphy, Secretary, Commission, December 14, 2009. One
method for calculating an end-of-day settlement price for open
positions is based on prices submitted by participants. As part of
this mark-to-market process, the security-based swap clearing agency
may periodically require participants to execute certain security-
based swap trades at the applicable end-of-day settlement price.
This is designed to ensure that participants' submitted prices
reflect their best assessment of the value of their open positions
on a daily basis. Id.
    \38\ See SDMA Letter, supra note 34.
---------------------------------------------------------------------------

    In situations where direct access is limited by reasonable
participation standards, non-participant firms may be able to access
the security-based swap clearing agency through correspondent clearing
arrangements with direct participants. Correspondent clearing is common
in securities markets as well as in futures markets. However, the non-
participant firms ultimately would be required to enter into a
correspondent clearing arrangement with a participant in order to have
the transactions submitted to the security-based swap clearing agency.
Thus, the success of correspondent clearing arrangements depends on the
willingness of security-based swap participants to enter into such
arrangements with non-participant firms that may act as direct
competitors to the participants. Given that current participants may
have an incentive to restrict access to potential competitors,
correspondent clearing arrangements may not be readily established
while only the large dealer firms are direct participants in the
security-based swap clearing agency.
    In addition, procedural barriers may prohibit a firm from having
indirect access to a security-based swap clearing agency. For example,
although there are no overt restrictions on indirect access at the
currently exempted security-based swap clearing agencies, many of the
processing platforms by which participants submit transactions to the
security-based swap clearing agency do not have the functionality to
allow a non-participant firm to submit a trade with a customer to the
security-based swap clearing agency through a correspondent arrangement
with a direct member.
    Prohibitively burdensome or restrictive direct participation
standards and lack of availability of correspondent clearing
arrangements effectively deny non-participant firms access to the
security-based swap clearing agency's services and, accordingly, create
a substantial competitive advantage for those firms that are direct
participants in the security-based swap clearing agency. As previously
noted, this competitive advantage would become even more significant
after the mandatory clearing requirement for security-based swaps in
the Dodd-Frank Act becomes effective.
b. Limitations on the Scope of Products Eligible for Clearing
    As discussed above, Congress found and the Commission believes that
increased use of central clearing would provide significant benefits to
the security-based swaps market and mitigate systemic risk,
particularly

during times of financial crisis. Central clearing of security-based
swaps likely would result in lower spreads and lower transaction costs
for end-users. A participant in a security-based swap clearing agency
might, however, derive greater revenues from its activities in the OTC
market for security-based swaps than it would from sharing in the
profits of a security-based swap clearing agency in which it holds a
financial interest. As a result, the increased use of central clearing
may be contrary to the economic interests of some participants to a
security-based swap clearing agency. Such participants or their related
persons could therefore seek to have the security-based swap clearing
agency limit the types of security-based swaps that are eligible for
clearing at a security-based swap clearing agency over which they
exercise influence or control.\39\
---------------------------------------------------------------------------

    \39\ Representative Barney Frank, who chaired the conference
committee that reconciled the House Bill and the Senate Bill,
referred to this specific concern when discussing the amendment
adding Section 765 to the Dodd-Frank Act. Chairman Frank stated,
``The purpose of this in part is to get many more derivatives
cleared. But the clearing houses have the right to refuse them if
they say the transactions aren't suitable for clearing. We believe
that some banks have an interest in not having them cleared. So we
don't want entities that have an interest and [sic] there being no
clearing, owning the clearing houses. That's why this is an
important amendment to us, and it was passed after considerable
debate on the House floor.'' House-Senate Conf. Comm. Holds Markup
on HR 4173, Financial Regulatory Overhaul Bill, June 24, 2010,
reprinted in CQ Congressional Transcripts, 111th Cong. 182 (2010)
(statement of Barney Frank, Chairman, House Comm. on Fin. Serv.).
---------------------------------------------------------------------------

    A further incentive for a clearing agency controlled by
participants to restrict the products that are eligible for clearing at
the security-based swap clearing agency may be to control a security-
based swap's price transparency. Trading in the OTC derivatives market
is currently dominated by a small number of firms.\40\ Prior to the use
of clearing agencies to clear security-based swaps, end-users had to
transact directly with a small number of firms to trade in security-
based swaps without the benefit of publicly available pricing data.
Security-based swap clearing agencies provide greater price
transparency by making certain price data available to the public and
thereby helping to reduce the information asymmetry that benefits firms
in the OTC market.\41\ Publicly available pricing data may result in
reducing the spreads and reduce the profit per trade for firms that
have dominated the OTC market.
---------------------------------------------------------------------------

    \40\ See Office of the Comptroller of the Currency, Quarterly
Report on Bank Trading and Derivatives Activities, First Quarter
2010. (``Derivatives activity in the U.S. banking system continues
to be dominated by a small group of large financial institutions.
Five large commercial banks represent 97% of the total banking
industry notional amounts * * *.'')
    \41\ See Darrell Duffie, Ada Li, and Theo Lubke, ``Policy
Perspectives on OTC Derivatives Market Infrastructure,'' Federal
Reserve Bank of New York Staff Report No. 424, dated January 2010,
as revised March 2010 (``Even after an OTC derivatives product has
achieved relatively active trading * * * dealers have an incentive
to maintain the wide bid-ask spreads that they can obtain in the OTC
market * * *. Thus, from the viewpoint of profits, dealers may
prefer to reduce the migration of derivatives trading from the OTC
market to central exchanges.'').
---------------------------------------------------------------------------

    While certain security-based swaps may be suitable for central
clearing, the Commission recognizes the possibility that some security-
based swaps may not be suitable for clearing if their risks cannot be
adequately managed by the security-based swap clearing agency. Clearing
products whose risks cannot be adequately managed may increase the
potential of a default of a participant or even the failure of the
security-based swap clearing agency.\42\ This in turn could adversely
affect systemic risk, as participants and their customers would likely
have significant funds and securities tied to the clearing agency and
would be dependent on the continued operations of a security-based swap
clearing agency in order to enter into new transactions in security-
based swaps. This again highlights the potential tensions between sound
risk management and the increased use of central clearing services.
Expanding the number and scope of products cleared would in some cases
be in the best interests of the security-based swap clearing agency and
the security-based swaps market generally, because it provides
processing efficiencies and replaces bilateral counterparty risk.
However, allowing a greater number and scope of products to be
centrally cleared would in some cases be harmful to the security-based
swap clearing agency and the security-based swaps market, if sound risk
management standards are compromised in order to clear those products.
---------------------------------------------------------------------------

    \42\ Section 763(a) adds new Section 3C(d)(3)(A) to the Exchange
Act, which prohibits the Commission from requiring any clearing
agency to accept a security-based swap for central clearing. See
Public Law 111-203, Section 763(a).
---------------------------------------------------------------------------

    The Commission is mindful of the need to balance goals associated
with promoting the central clearing of security-based swaps and
assuring that proposed rules are designed to increase the number of
products eligible for central clearing with the goals associated with
effective risk management. The Commission is also aware that any rules
that it may ultimately adopt relating to conflicts of interest may
affect this balance. The Commission believes, however, that decisions
regarding the products that are eligible for clearing by a security-
based swap clearing agency should not be subject to undue influence by
parties that have a financial interest in keeping such products from
being centrally cleared, while also noting that non-participants may
have an interest in increasing access, which potentially could serve to
compromise effective risk management.
c. Reduced Risk Management Controls
    Security-based swap clearing agencies will perform a critical
function in mitigating financial risk for market participants. The
Commission believes that through uniform margining and other risk
controls, including controls over market-wide concentrations that
cannot be implemented effectively when counterparty risk management is
decentralized, security-based swap clearing agencies would help to
prevent a single market participant's failure from destabilizing other
market participants and, ultimately, the broader financial system.
    Although participants may seek to raise risk management controls in
order to restrict access to the clearing agency or protect their
financial stake in the clearing agency, they might also seek to lower
certain risk management controls such as margin requirements in order
to release collateral that they may wish to use for other purposes.
Furthermore, as security-based swap clearing agencies become more
established and the mandatory clearing requirement under Section 763 is
implemented, more security-based swaps will likely be centrally cleared
and clearing participants will be required to provide a substantially
larger amount of liquid collateral to security-based swap clearing
agencies in the form of margin. As a result, participants may be
willing to accept greater risk than is prudent for the security-based
swap clearing agency in order to reduce the amount of their margin
contributions. A reduction in risk management controls ultimately could
function to increase systemic risk by increasing the potential for a
financial loss that must be borne by the participants of the security-
based swap clearing agency.\43\
---------------------------------------------------------------------------

    \43\ Such a scenario would arise, for example, where a
defaulting participant has contributed insufficient margin to meet
its obligations to the security-based swap clearing agency.
---------------------------------------------------------------------------

    The Commission recognizes that participants generally have a
financial incentive to ensure that the security-based swap clearing
agency collects sufficient margin from each participant.

A clearing agency's rules and procedures typically provide that in the
event of a participant default, losses exceeding a participant's
individual margin contribution may be satisfied from a guaranty fund
composed of contributions from all participants. As a result,
participants have a unique financial incentive to ensure that the
security-based swap clearing agency has sufficient collateral from each
participant to withstand a participant default in almost all market
conditions. However, participant defaults occur infrequently and the
incentive for participants to protect their guaranty fund contributions
may have less weight than the incentive to reduce margin requirements
in order to release margin collateral for immediate use.
    A non-participant does not contribute to a guaranty fund and may
not have the same incentives as a participant with respect to
establishing and maintaining sufficiently robust participant margin
requirements. Non-participants' incentives may be to focus less on risk
management and focus more on allowing more participants to be admitted
to the clearing agency and more products to be made eligible for
central clearing.
d. Implications for Ownership and Governance
    As described above, conflicts of interest may arise if participants
exercise undue control or influence over a security-based swap clearing
agency. This influence, typically acquired through an ownership stake
in the clearing agency, generally may be exercised by participants
through either (i) voting interests in the security-based swap clearing
agency or (ii) participation in the governance of the security-based
swap clearing agency, such as by selecting (or influencing the
selection of) the directors of the security-based swap clearing
agency.\44\ In either case, undue control or influence may be
particularly acute if (i) the participants are part of the process for
nominating the directors, even if such participants are not themselves
directors, or (ii) the election of directors is subject to concentrated
voting power in a small number of participants, especially if such
participants also dominate much of the trading in security-based swaps
and could use their controlling position to maintain or extend their
dominant market position.
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    \44\ Section 765 of the Dodd-Frank Act authorizes the Commission
to adopt rules regarding conflicts of interest of Specified Entities
at security-based swap clearing agencies in general. However, the
Commission preliminarily believes that those entities that are
participants in a security-based swap clearing agency will have a
conflict of interest that could be acted upon to adversely affect
the development of the market for security-based swaps consistent
with the policy objectives of Section 765 of the Dodd-Frank Act.
---------------------------------------------------------------------------

    In addition, it is important to consider the likely incentives of
individual directors, once they are on the Board, when they are
governing the security-based swap clearing agency.\45\ Directors of a
security-based swap clearing agency owe a fiduciary duty to the
security-based swap clearing agency and all of its shareholders. In
addition, among other obligations, the Board as a whole is ultimately
responsible for overseeing the clearing agency's compliance with the
regulatory obligations of security-based swap clearing agencies under
the Dodd-Frank Act and the Exchange Act, including the open and fair
access requirements. At the same time, however, directors may be
subject to different perspectives when fulfilling these duties and
roles. Although the Commission recognizes that incentives and
motivations may vary among directors and over time for a range of
reasons--and therefore it is not possible to predict precisely how any
individual director will address a particular matter--directors who are
appointed by or related to participants (``participant-related
directors'') may on balance be more likely to reflect the views of
participants than would directors who are not appointed by or related
to participants (``non-participant-related directors'').\46\
---------------------------------------------------------------------------

    \45\ The Commission's discussion in this Release of the
motivations or incentives of directors of a clearing agency, SB SEF,
or SBS exchange comes in the context of requiring modes of
governance that permit consideration of a variety of perspectives.
As noted throughout this Release, a company's directors have a duty
to all the company's shareholders, and the Commission does not
regard any directors as simply surrogates for a particular group of
shareholders. The Commission's discussion is intended to forestall
possible conflicts and does not reflect findings that particular
conflicts are present.
    \46\ This distinction between participant-related and non-
participant-related directors may be most significant where the
clearing agency is (i) a publicly owned corporation, or part of a
publicly owned corporation, or (ii) otherwise owned by persons other
than participants. The Commission recognizes that ownership
structures for clearing agencies may take other forms, including
ownership solely by participants, in which case the incentives and
perspectives of the directors may be somewhat different.
---------------------------------------------------------------------------

    In light of these dynamics, as between the two categories of
directors, participant-related directors, like participants themselves,
may on balance be more likely to favor reducing or minimizing the risk
exposure of the clearing agency, potentially at the expense of more
open access. In addition, participant-related directors may also be
more likely to favor restricting access to the clearing agency, which
as discussed above would serve to preserve profits that participants
earn through trading security-based swaps in the OTC markets.
    In contrast, non-participant-related directors may, on balance, be
more likely to seek to maximize the value of the enterprise, which, in
addition to sound risk management, may involve increasing the revenues
of the security-based swap clearing agency, such as by expanding the
number and scope of products being cleared. Moreover, at a minimum it
would seem less likely that non-participant-related directors would
favor unduly restricting access to the clearing agency and its
services. Thus, non-participant-related directors may be inclined to
favor expanded access to products and services, which may increase the
amount of risk that the clearing agency must successfully manage. The
interest in expanded access to products and services may be especially
relevant in the early stages of a clearing agency's development, when
establishing a new entity as a viable clearing agency is especially
important.
    The Commission recognizes that other factors may also affect
director incentives and behavior. For example, it may be argued that
participant-related directors may in general have greater risk
management expertise and experience than non-participant-related
directors, and that non-participant-related directors may tend to defer
to the views or judgment of participants or participant-related
directors on risk matters, with the effect that open access may be
unduly compromised in favor of risk management. On the other hand, it
may be argued that qualified non-participant-related directors with
sufficient risk management expertise can be readily found, and in any
event these directors' independence of participants would justify their
heightened involvement on the Board.
    In addition, directors may face other conflicts of interest. For
example, there may be conflicts between the competing interests of
different shareholders--whether or not participants--which could have
implications for director behavior, as discussed more fully below.
There also may be a tension between the directors' incentives to
maximize profits and their duties to oversee the security-based swap
clearing agency's compliance with applicable legal restrictions which,
although not necessarily unique to clearing agencies, may nevertheless
affect how they decide any particular matter.
    As described more fully below, the proposed rules are intended to
strike a balance among these various

considerations by allowing participants to maintain a significant voice
within a security-based swap clearing agency while also imposing
ownership limitations and independent director requirements to mitigate
the potential influences of participant owners and participant-related
directors.
e. Request for Comments Regarding Identified Conflicts of Interest
    The Commission requests comment on the conflicts of interest it has
identified with respect to security-based swap clearing agencies,
including the conflicts related to participant standards, product
eligibility, and risk management. Do commenters agree with the
potential conflict concerns that the Commission has identified? Some
parties have questioned the benefits of central clearing generally in
terms of reducing systemic risk,\47\ potentially suggesting a different
analysis with respect to the identified conflicts of interest. What are
commenters views on the potential benefits and costs of central
clearing and the resulting effect on the conflicts of interest
analysis?
---------------------------------------------------------------------------

    \47\ See, e.g., Craig Pirrong, ``The Inefficiency of Clearing
Mandates,'' Cato Institute Policy Analysis No. 665, July 21, 2010.
---------------------------------------------------------------------------

    What effect would the identified conflicts of interest likely have?
Should the Commission focus on any of these conflicts more than others?
Are there other existing conflicts concerns that commenters believe
warrant scrutiny? If so, what are they and how are they likely to
affect security-based swap clearing agencies?
    The conflicts of interest discussed in part stem from the current
concentrated market structure for security-based swaps. How is the
current market structure likely to evolve over time? What effect will
that evolution have on the consideration of conflicts of interest? Are
there any other conflicts of interest that may result due to expected
changes in the security-based swaps market or the clearing of security-
based swaps that the Commission should consider? If so, what are they
and how are they likely to affect security-based swap clearing
agencies?
    The central clearing of security-based swaps is still developing
and may change significantly as the market for security-based swaps
develops. In particular, the new provisions in the Dodd-Frank Act
relating to the central clearing of security-based swaps are not yet
effective. Once they become effective, security-based swap clearing
agencies will be subject to substantially more regulation, which may
have an effect on conflicts of interest. How are conflicts of interest
likely to change as the central clearing of security-based swaps, and
security-based swap clearing agencies, become more established? What
potential new conflicts of interest could arise that the Commission
should consider? How will potential changes in the trading of security-
based swaps affect conflicts of interest at security-based swap
clearing agencies? In addition, competitive forces within the security-
based swaps market may help to mitigate conflicts of interest, for
example, by increasing the number of institutions that trade in
security-based swaps and creating a broader market in security-based
swaps. How might competition issues affect or change current conflicts
of interest? Will competition potentially create different or
additional conflicts of interest that the Commission should consider?
Will competition potentially mitigate conflicts of interest?
    What other parties may have conflicts of interest that would affect
whether they should control or participate in the governance of a
security-based swap clearing agency? In what circumstances do these
conflicts of interest arise? Under certain circumstances, there is the
potential that incentives of shareholders to maximize profits could
compromise prudent risk management by a security-based swap clearing
agency. For example, shareholders could seek to increase revenue from
clearing fees by increasing the number of products cleared by the
clearing agency beyond those that can be appropriately risk managed or
by having the clearing agency expand its services or engage in new
lines of business that would expose the security-based swap clearing
agency to increased risk. Shareholders that are not users of a
security-based swap clearing agency may also not have the same
incentives to keep the costs of clearing low. The Commission requests
comment on the conflicts of interest that non-participant shareholders
may have and the effect such conflicts could have on a security-based
swap clearing agency. What are the differences in conflicts of interest
between participants and non-participants? What are the different
effects these conflicts could have on a security-based swap clearing
agency? Which conflicts of interest could potentially cause the
greatest harm to the security-based swap clearing agency?
    Do persons who are selected to be directors of a security-based
swap clearing agency by participants have a conflict of interest based
on their status as directors that would affect their ability to act in
the best interest of the clearing agency, to act in conformity with the
Exchange Act, or to act to meet the policy objectives in Section 765 of
the Dodd-Frank Act? Would directors be less likely to act to meet the
policy objectives in Section 765 of the Dodd-Frank Act if they are
selected by shareholders seeking to maximize the profits of the
security-based swap clearing agency? What effect would they likely have
on security-based swap clearing agencies? How do participants'
conflicts of interest that affect risk management and open access
issues compare with non-participants' interests regarding these issues?
How do participants' incentives with respect to risk management compare
with the incentives of non-participant shareholders or directors? How
do the incentives of independent directors differ from the non-
independent directors in terms of considering the potential for
conflicts of interest?
    The Commission also requests comment on the interplay of the
identified conflicts of interest, and any additional conflicts of
interest identified by commenters, and how that may affect a security-
based swap clearing agency. For example, there may at times be a trade-
off between risk management standards and open access to the clearing
agency. What is the best way to balance these and other potential
conflicts of interest in order to assure that the clearing agency has
both robust risk management and fair and open access to clearing
services? Are there any other conflicts of interest that pose similar
trade-offs? What conflicts are these and how should the Commission
balance the related concerns?
    The Commission recognizes that other conflicts of interest may
arise in the governance of security-based swap clearing agencies--for
example, there may be a conflict between the interests of certain
shareholders. The rules the Commission is proposing today focus on the
conflicts of interest presented by the potential influence of
participants in the security-based swaps market because, as described
above, the Commission believes those conflicts may be most relevant to
the development of security-based swap clearing agencies. The
Commission recognizes that conflicts of interest may also arise with
respect to independent directors and has attempted to achieve a balance
between the different incentives of participant-related and non-
participant-related directors and the potential benefits each might
bring to the Board of a security-based swap clearing agency.

B. Security-Based Swap Execution Facilities and National Securities
Exchanges

    The Commission has also reviewed the potential for conflicts of
interest at SB SEFs and SBS exchanges in accordance with Section 765 of
the Dodd-Frank Act and has identified those conflicts that it believes
may be mitigated by rules designed to improve the governance of a SB
SEF or SBS exchange, promote competition, or mitigate conflicts of
interest in connection with the operation of a SB SEF or SBS exchange
by a security-based swap execution facility participant (``SB SEF
participant'') \48\ or a member of an SBS exchange (``SBS exchange
member'') \49\ that has an ownership interest in the SB SEF or SBS
exchange. As with security-based swap clearing agencies, the Commission
preliminarily believes that conflicts of interest that may have an
adverse affect on the statutory goals of Section 765 are those that
arise when a small number of market participants, including
participants that are Specified Entities and including related persons
of participants,\50\ exercise control or undue influence over a SB SEF
or SBS exchange. This influence may be exercised either through
ownership of voting interests \51\ or participation in the governance
of the SB SEF or SBS exchange.
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    \48\ The term ``security-based swap execution facility
participant'' means a person permitted to directly effect
transactions on the security-based swap execution facility. See
proposed Rule 700(z) under Regulation MC.
    \49\ A ``member'' when used with respect to a national
securities exchange means (i) any natural person permitted to effect
transactions on the floor of the exchange without the services of
another person acting as broker, (ii) any registered broker or
dealer with which such a natural person is associated, (iii) any
registered broker or dealer permitted to designate as a
representative such a natural person, and (iv) any other registered
broker or dealer which agrees to be regulated by such exchange and
with respect to which the exchange undertakes to enforce compliance
with the provisions of the Exchange Act, the rules and regulations
thereunder, and its own rules. See Section 3(a)(3)(A) of the
Exchange Act, 15 U.S.C. 78c(a)(3)(A).
    \50\ See infra Section V.A. for a discussion of ``related
person'' in the context of a SB SEF and SBS exchange or facility
thereof.
    \51\ See infra Section V.A. for a discussion of the ownership
and voting limits of proposed Rule 702 under Regulation MC.
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    The Commission believes that through ownership of voting interests
or ability to influence governance, market participants could exercise
influence with respect to the services provided by SB SEFs or SBS
exchanges, the rules and policies applicable to participants or members
of such entities, and, more generally, the security-based swaps market.
When a small group of those same market participants also dominate much
of the trading in security-based swaps, control of a SB SEF or SBS
exchange by these participants raises a heightened concern. If a SB SEF
or a SBS exchange is controlled by a small group of dealers who also
dominate trading in the market for security-based swaps, the dealers
may have competitive incentives to exert undue influence to control the
level of access to the SB SEF or SBS exchange and thus impede
competition by other market participants. In other words, participants
or members in a SB SEF or SBS exchange, as applicable, might seek to
limit the number of direct participants in the trading venue in order
to limit competition and increase their ability to maintain higher
profit margins. Given such incentives, a SB SEF or SBS exchange that is
controlled by a limited number of participants or members might adopt
policies and procedures that are designed to restrict access.
    Participants or members also might be motivated to restrict the
scope of security-based swaps that are eligible for trading at SB SEFs
or SBS exchanges if there is a strong economic incentive to keep such
swaps in the OTC market. On the other hand, this concern may be
mitigated by competitive forces if a greater number and variety of
facilities where security-based swaps can be traded are available. A
small number of firms currently dominate trading in the OTC derivatives
market.\52\ Centralized trading of security-based swaps likely would
result in lower spreads and lower transaction costs for end-users,
particularly as a result of increased pre-trade and post-trade
transparency of prices, assuming sufficient trading volume and
liquidity.\53\ As noted above, increased price transparency might help
to eliminate much of the basis for asymmetrical information, reduce
spreads, and reduce the profit per trade for firms that dominated the
OTC security-based swaps market. As a result, this might create an
incentive for participants or members in a SB SEF or SBS exchange, as
applicable, to seek to limit the number of security-based swaps that
are made available for trading by such venues. The Commission
recognizes, however, that there could in certain circumstances be
legitimate concerns regarding liquidity or other trading
characteristics of a security-based swap that reasonably might justify
the decision of participants in a SB SEF or members of a SBS exchange
not to make a particular product available for trading on a SB SEF or a
SBS exchange. However, decisions regarding the eligibility of security-
based swaps for trading on a SB SEF or SBS exchange should not be
subject to undue influence by parties that have a financial interest in
keeping such products from being centrally traded on a facility or
exchange.
---------------------------------------------------------------------------

    \52\ See supra note 40.
    \53\ The Commission will address the issue of transparency of
security-based swap pricing and transaction data in a separate
rulemaking.
---------------------------------------------------------------------------

    Finally, the Commission also believes that a SB SEF or SBS exchange
could have potential conflicts of interest between the commercial
interests of the SB SEF or SBS exchange or the SB SEF's or SBS
exchange's owners and the SB SEF's or SBS exchange's market oversight
responsibilities.\54\ With respect to these kinds of conflicts of
interest, the Commission's proposal is informed, in part, by its
experience overseeing national securities exchanges. The Commission
notes, however, that a SB SEF's regulatory obligations under Section
763(c) of the Dodd-Frank Act are not identical to those of a national
securities exchange's obligations under Section 6 of the Exchange Act.
---------------------------------------------------------------------------

    \54\ An entity that registers as a SB SEF will have oversight
responsibility over its market pursuant to the Exchange Act (as
amended by the Dodd-Frank Act) and rules adopted thereunder. See
Section 763(c) of the Dodd-Frank Act, Public Law 111-203, Section
763(c). Similarly, all national securities exchanges, including
those that may post or make available for trading security-based
swaps, have oversight responsibilities over their markets and their
members pursuant to the Exchange Act. See Section 6 of the Exchange
Act, 15 U.S.C. 78(f).
---------------------------------------------------------------------------

    National securities exchanges are self-regulatory organizations
(``SROs'') and are statutorily required to comply, and enforce
compliance by their members and their associated persons, with the
Federal securities laws, the rules and regulations thereunder, and
their own rules.\55\ Exchanges also generally operate for-profit
markets and, as a result, are concerned with preserving and enhancing
their competitive positions vis-[agrave]-vis other exchanges.\56\
Consequently, exchanges have potential conflicts of interest between
carrying out their regulatory obligations to vigorously oversee their
members and marketplace and promoting their and their shareholders'
economic interests. For example, an exchange could put its interest and
that of its members or

shareholders ahead of its regulatory responsibilities by failing to
take regulatory or enforcement actions or to adequately fund self-
regulation. Further, the commercial interests of the shareholders of an
exchange may conflict with the regulatory obligations of an exchange. A
shareholder may be incentivized to maximize profits through the
economic stake it has in the exchange or, if the shareholder is also a
member of the exchange, to more directly further its own commercial
interests.\57\ For example, a shareholder could promote the
distribution of the exchange's revenues in a manner that could result
in inadequate funding of the exchange's regulatory operations or, if
also an exchange member, could use the exchange's disciplinary process
potentially to harass or penalize a competitor.
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    \55\ See Sections 6(b)(1) of the Exchange Act, 15 U.S.C.
78f(b)(1).
    \56\ Historically, national securities exchanges were structured
as not-for-profit or similar organizations owned by their members.
Exchanges, however, have more recently evolved to become
shareholder-owned. See supra note 49 for the definition of
``member'' as applicable to national securities exchanges.
    \57\ See SRO Governance Proposing Release, 69 FR 71126, infra
note 59.
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    The Commission has considered the conflicts between an exchange's
regulatory responsibilities and its commercial interests in operating a
marketplace for the trading of securities. To address these types of
concerns, the Commission has developed, consistent with the
requirements of Section 6 of the Exchange Act,\58\ an approach to
mitigate conflicts of interest for national securities exchanges.\59\
Specifically, through its review of proposals filed by exchanges with
respect to changes to their ownership and governance structures
(generally from member-owned to shareholder-owned organizations)
pursuant to Section 19 of the Exchange Act \60\ or of applications
filed by entities to register as national securities exchanges pursuant
to Section 6 of the Exchange Act,\61\ the Commission examines the way
in which an exchange applies ownership and voting limits and addresses
certain governance principles.\62\ Namely, the Commission looks to
ensure that there are limits on the ability of persons to own and
control exchanges by, for example, requiring at a minimum that no
person, alone or together with its related persons,\63\ be permitted to
own more than 40%, and no member, alone or together with its related
persons, be permitted to own more than 20%, of the ownership interests
of the exchange or be entitled to vote shares in excess of 20%.\64\
Further, the Commission also looks to ensure that an exchange provide
fair representation of members in the selection of directors and the
administration of its affairs, consistent with the requirement in
Section 6(b)(3) of the Exchange Act,\65\ that an exchange is organized
in a manner that allows it to carry out the purposes of the Exchange
Act pursuant to Section 6(b)(1) of the Exchange Act,\66\ and that it
provides fair procedures for disciplining members, consistent with the
requirements in Sections 6(b)(6) and 6(b)(7) of the Exchange Act.\67\
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    \58\ See Section 6(b) of the Exchange Act, 15 U.S.C. 78f(b).
    \59\ See, e.g., Securities Exchange Act Release Nos. 61698
(March 12, 2010), 75 FR 13151 (March 18, 2010) (In the Matter of the
Applications of EDGX Exchange, Inc., and EGDA Exchange, Inc. for
Registration as National Securities Exchanges; Findings, Opinion,
and Order of the Commission) (``Exchange Act Release No. 61698'');
58375 (August 18, 2008), 73 FR 49498 (August 21, 2008) (In the
Matter of the Application of BATS Exchange, Inc. for Registration as
a National Securities Exchange; Findings, Opinion, and Order of the
Commission) (``Exchange Act Release No. 58375''). In 2004, the
Commission proposed rules relating to: the fair administration and
governance of SROs; disclosure and regulatory reporting by SROs;
recordkeeping requirements by SROs; ownership and voting limitations
for SROs; and listing and trading of affiliated securities by SROs.
The Commission has not taken action on these proposed rule changes.
See Securities Exchange Act Release No. 50699 (November 18, 2004),
69 FR 71126 (December 8, 2004) (``SRO Governance Proposing
Release'').
    \60\ 15 U.S.C. 78s.
    \61\ 15 U.S.C. 78f.
    \62\ See, e.g., Securities Exchange Act Release Nos. 62158 (May
24, 2010), 75 FR 30082 (May 28, 2010) (order approving the
demutualization of the Chicago Board Options Exchange, Incorporated
(``CBOE'')) and 53382 (February 27, 2006), 71 FR 11251 (March 6,
2006) (order approving the merger of New York Stock Exchange, Inc.
(``NYSE'') and Archipelago and NYSE's demutualization).
    \63\ Generally, a ``related person'' means, with respect to any
person, any other person, directly or indirectly, controlling,
controlled by, or under common control with such person or any
person acting in concert with such person.
    \64\ See, e.g., Exchange Act Release No. 61698, 75 FR at 13156,
supra note 59. The exchange's Board may waive the voting and
ownership limits if it makes certain findings, including a finding
that such a waiver would be consistent with the exchange's self-
regulatory obligations. The board, however, may not waive these
limits for any exchange members. Moreover, the exchange must file
such waiver with the Commission as a proposed rule change for
approval before it could be implemented.
    The ownership limits currently in place for exchanges generally
apply to any ownership interest. See, e.g., Exchange Act Release No.
61698, 75 FR 13151, supra note 59; Amended and Restated Certificate
of Incorporation of BATS Global Markets, Inc., Article FIFTH. In
contrast, proposed Rule 702 would apply ownership limits only with
respect to those shares or other interests entitled to vote. See
infra Section V.A. for a discussion of the differences between the
ownership and voting limits in proposed Rule 702 and those limits
currently in place for exchanges.
    \65\ 15 U.S.C. 78f(b)(3). Pursuant to Section 6(b)(3), the
Commission generally requires, at a minimum, that at least 20% of
the directors on the board be selected by exchange members. The
Commission also requires that exchange members be permitted to
participate in the nomination process of such representative
directors and that they have the right to petition for alternative
candidates. See, e.g., Securities Exchange Act Release No. 58375, 73
FR at 49500, supra note 59.
    \66\ 15 U.S.C. 78f(b)(1). Pursuant to Section 6(b)(1), the
Commission generally requires, at a minimum, that the number of non-
industry directors on the exchange's board equal or exceed the
number of industry directors. Generally, a ``non-industry director''
is someone who is not subject to regulation by the exchange, is not
a broker or dealer or an officer, director, or employee of a broker
or dealer, is not associated with an entity that is affiliated with
a broker or dealer, and has neither a material ownership interest
nor investment in a broker or dealer. See, e.g., CBOE By-Laws,
Article III, Section 3.1. Some exchanges also have ``independent
directors.'' Typically, an independent director has no material
relationship with the exchange or an exchange member. See, e.g.,
Amended and Restated By-Laws of BATS Exchange, Inc., Article I(m).
For example, an officer or director of a listed issuer generally is
considered a non-industry director rather than an independent
director. The definitions of ``non-industry'' and ``independent''
do, however, differ across exchanges.
    \67\ 15 U.S.C. 78f(b)(6) and (7). To find an exchange's
disciplinary rules to be consistent with the Exchange Act, the
Commission generally requires that disciplinary processes be
balanced and include industry member participation. See, e.g.,
Exchange Act Release No. 61698, 75 FR at 13160, n. 124, supra note
59.
---------------------------------------------------------------------------

    The Commission's recognition of potential conflicts of interest at
exchanges and its approach to date in reviewing and approving measures
designed to mitigate those conflicts of interest are a useful point of
reference as the Commission identifies, and develops proposals to
mitigate, the conflicts of interest potentially faced by SB SEFs and
SBS exchanges as the trading of security-based swaps moves to regulated
markets. However, as noted above, the Commission recognizes that a SB
SEF's regulatory obligations are not the same as a national securities
exchange's regulatory obligations.
    The Commission in 2004 proposed rules to promote the fair
administration and governance of, and to impose ownership and voting
limitations on, national securities exchanges and registered national
securities associations.\68\ Among other things, the proposal would
have required an exchange to: Have a Board composed of a majority of
independent directors; maintain fully independent nominating,
compensation, and audit committees; separate its regulatory obligations
and business functions by establishing a fully independent regulatory
oversight committee (``ROC'') or equivalent structure; and limit
ownership and voting control by members.\69\ This proposal was intended
to improve the governance of certain SROs by establishing independence
standards for the board of directors (``Board'') and key committees and
by minimizing conflicts of interest by instituting ownership and voting
limitations and the separation of the exchange's regulatory obligations
and commercial interests. Although the

Commission has not acted further on this proposal, a number of
exchanges have adopted some of the governance concepts on their own
initiative \70\ and all of the exchanges registered under Section 6 of
the Exchange Act have adopted ownership and/or voting limitations, with
the Commission's approval.\71\
---------------------------------------------------------------------------

    \68\ See SRO Governance Proposing Release, 69 FR 71126, supra
note 59.
    \69\ Id.
    \70\ See, e.g., CBOE By-Laws, Article III, Board of Directors
(``Board of Directors'' must have a majority of ``Non-Industry
Directors'') and Article IV, Committees (``Regulatory Oversight
Committee'' must consist of at least three directors, all of whom
shall be ``Non-Industry Directors''); By-Laws of the NASDAQ Stock
Market LLC (``Nasdaq''), Article III, Board of Directors, Section 2,
Qualifications (``Board of Directors'' must have a majority of
``Non-Industry Directors'') and Section 5, Committees Composed
Solely of Directors (Regulatory Oversight Committee must consist of
at least three members, each of whom shall be a ``Public Director''
and an ``independent director'' as defined in Nasdaq Rule 4200).
    \71\ See, e.g., Amended and Restated Certificate of
Incorporation of BATS Global Markets, Inc., Article FIFTH.
---------------------------------------------------------------------------

    Each potential conflict of interest identified in this Section
III.B. could limit the benefits of centralized trading in the security-
based swaps market and potentially undermine the mandatory trading
requirement in new Section 3C(h) of the Exchange Act, thereby
negatively affecting efficiency and competition in the security-based
swaps market.\72\ Further, while the Commission believes that its past
application of statutory requirements has been appropriate to improve
the governance of, and mitigate the conflicts of interest for,
exchanges, given the difference in the structure of the OTC derivatives
market and the markets for exchange-listed securities, it also believes
that potential conflicts of interest in SBS exchanges can and should be
further examined.\73\ Namely, unlike exchange-listed securities,
trading in the OTC derivatives market is currently dominated by a small
group of dealers.\74\ Although mechanisms in place to address conflicts
of interest among members, shareholders, and exchanges would help
mitigate some concerns about conflicts of interest that could result
from dealer control of the current security-based swaps market, the
Commission believes that additional measures may be necessary to
effectively mitigate conflict of interest concerns. For example,
applying standards approved for exchanges to SB SEFs and SBS exchanges,
as described above, may not alone adequately address the potential
concern that a small group of dealers could gain control over such
entities and limit security-based swaps from trading on, and
participant or member access to, a centralized market. Accordingly, the
Commission is proposing rules for SB SEFs and SBS exchanges that are
designed to mitigate the potential conflicts of interest that it has
identified in the context of the security-based swaps market, including
ownership limitations and governance requirements, as more fully
described below.\75\
---------------------------------------------------------------------------

    \72\ See Public Law 111-203, Section 763(a). Section 3C(h) of
the Exchange Act imposes a mandatory trading requirement, which
provides that counterparties shall execute a transaction in a
security-based swap subject to the clearing requirement of Section
3C(a)(1) on an exchange or a registered SB SEF or a SB SEF that is
exempt from registration pursuant to Section 3D(e) of the Exchange
Act.
    \73\ Within the past several years, the Commission has reviewed
and assessed comprehensively the governance structure of each
national securities exchange, either in connection with a
significant transaction by the exchange or as part of its
application for registration as a national securities exchange. See,
e.g., Securities Exchange Act Release Nos. 58324 (August 7, 2008),
73 FR 46936 (August 12, 2008) (order approving The NASDAQ OMX Group,
Inc.'s (``Nasdaq OMX'') acquisition of the Boston Stock Exchange,
Inc. (``BSE'')); 58179 (July 17, 2008), 73 FR 42874 (July 23, 2008)
(order approving Nasdaq OMX's acquisition of the Philadelphia Stock
Exchange, Inc. (``Phlx'')); 55293 (February 14, 2007), 72 FR 8033
(February 22, 2007) (order approving the business combination
between NYSE and Euronext N.V.); 56955 (December 13, 2007), 72 FR
71979 (December 19, 2007) (order approving acquisition of
International Securities Exchange, Inc. (``ISE'') by Eurex Frankfurt
AG); Exchange Act Release No. 58375, 73 FR at 49500, supra note 59;
61152 (December 10, 2009), 74 FR 66699 (December 16, 2009) (order
approving application of C2 Options Exchange, Incorporated to
register as a national securities exchange); Exchange Act Release
No. 61698, 75 FR at 13156, supra note 59; 53128 (January 13, 2006),
71 FR 3550 (January 23, 2006) (order approving Nasdaq's application
to register as a national securities exchange).
    \74\ See supra note 40.
    \75\ As of the date of this release, the Commission has not
proposed rules regarding the scope, registration requirements, and
operation of a SB SEF, including the types of entities that would
qualify for registration as a SB SEF.
---------------------------------------------------------------------------

    The Commission has considered the mechanisms in place to mitigate
conflicts of interest at national securities exchanges in developing
its proposals to mitigate conflicts of interest for SB SEFs and SBS
exchanges. The Commission notes that there are similarities and
differences between the exchange-listed markets and the market for
security-based swaps that merit consideration in crafting appropriate
proposals to mitigate conflicts of interest for SB SEFs and SBS
exchanges. National securities exchanges list and trade cash equity
securities and options pursuant to a well-developed body of their own
rules, as well as Commission rules, and compete actively with each
other and with other non-exchange trading venues for market share and
revenues associated with trading volume. The markets for cash equity
securities and listed options are generally liquid, trading is widely
dispersed, and there are numerous trading venues and market
participants. Unlike the well-established cash equity and options
markets, the security-based swaps market is at an earlier stage of
development and, as noted above, is currently dominated by a small
number of dealers. Further, the regulatory structure governing the
security-based swaps market will not be completely realized until all
provisions of the Dodd-Frank Act and any rules promulgated thereunder
are fully implemented. However, like exchanges, SB SEFs may have
shareholder-owners who also may be SB SEF participants and may compete
with any other SB SEF to the extent that they trade the same security-
based swaps. In addition, although SB SEFs would not be SROs and
therefore would not be subject to the same obligations under the
Exchange Act as SROs, they nonetheless will be subject to regulatory
responsibilities under Section 763(c) of the Dodd-Frank Act and, as a
result, will have to establish rules and enforce compliance with those
rules by their participants.\76\ Thus, the conflicts of interest that
the Commission has experienced with exchanges may be similar, although
not necessarily identical, to the conflicts of interest that SB SEFs
and SBS exchanges may face. The Commission nevertheless is mindful of
the need to mitigate conflicts of interest for SB SEFs and SBS
exchanges without unduly restricting the ability of trading facilities
to be formed or the emergence of a competitive market for the trading
of security-based swaps.
---------------------------------------------------------------------------

    \76\ See Section 763(c) of the Dodd-Frank Act, Public Law 111-
203, Section 763(c).
---------------------------------------------------------------------------

    The Commission requests comment on the types of conflicts of
interest it has identified with respect to SB SEFs and SBS exchanges,
including the listing and trading of security-based swaps on SB SEFs
and SBS exchanges. Has the Commission identified all of the significant
potential conflicts concerns? Do commenters disagree with any potential
conflicts concerns that the Commission has identified? What other
conflicts concerns may exist, if any?
    As discussed above, the Commission seeks to minimize the conflicts
of interest for national securities exchanges through ownership
limitations and governance requirements. Are the conflicts of interest
relating to exchanges, which could elect to trade swaps and thus become
SBS exchanges, different than the conflicts of interest relating to SB

SEFs, and, if so, how? To what extent, if any, should the Commission
draw on its experience with conflicts of interest that may arise in the
exchange context and with efforts to mitigate those conflicts and apply
that experience in assessing conflicts of interest that may arise in
the context of SB SEFs and SBS exchanges? What are the differences and
similarities between the conflicts of interest that the Commission has
encountered with respect to national securities exchanges and the
conflicts of interest that it has identified with respect to SB SEFs
and SBS exchanges?
    Further, are the conflicts of interest relating to SBS exchanges
different than the conflicts of interest relating to exchanges that do
not post or make available for trading security-based swaps? If there
are no differences, should the Commission propose to adopt rules to
mitigate conflicts of interest with respect to national securities
exchanges that are not SBS exchanges or are the existing approaches to
mitigating conflicts of interest for such exchanges sufficient?
    The Commission also requests comment on potential changes in these
conflicts of interest. The Commission recognizes that the conflicts of
interest that may exist today with respect to the trading of security-
based swaps by SB SEFs and SBS exchanges may evolve over time and that,
as this market evolves, the conflicts of interest that the Commission
has identified for SB SEFs and SBS exchanges may change. The
centralized trading of security-based swaps is still developing and may
change significantly as the market for security-based swaps develops.
In particular, the provisions in the Dodd-Frank Act relating to the
centralized trading of security-based swaps are not yet effective. Once
they become effective, market participants that trade security-based
swaps will be subject to substantially more regulation, which may have
an effect on the conflicts of interest at SB SEFs and SBS exchanges.
What are commenters' views on whether and how conflicts of interest for
SB SEFs and SBS exchanges may evolve over time and how the Commission
should respond to such changes? How are conflicts of interest likely to
change as the centralized trading of security-based swaps and SB SEFs
and SBS exchanges become more established? Are the conflicts of
interest identified by the Commission likely to change as the trading
of security-based swaps moves to regulated markets that must provide
for impartial access and, if so, how? What potential new conflicts of
interest could arise that the Commission should consider? How will
potential changes in the clearing of security-based swaps affect
conflicts of interest at SB SEFs and SBS exchanges? In addition,
competitive forces within the security-based swaps market may help to
mitigate conflicts of interest, for example, by increasing the number
of institutions that trade security-based swaps and creating a broader
market for security-based swaps. How will competition issues affect or
change current or identified conflicts of interest? Will competition
potentially create different or additional conflicts of interest that
the Commission should consider? Would the Commission's proposal to
apply to SB SEFs and SBS exchanges standards to mitigate conflicts of
interest that are similar to those approved for national securities
exchanges influence whether those conflicts of interest will increase,
diminish, or remain unchanged over time?
    Are there any other conflicts of interest that warrant examination?
What other parties may have conflicts of interest that would affect
whether they should control or participate in the governance of a SB
SEF or SBS exchange? In what circumstances would these conflicts of
interest arise? For example, might non-participant or non-member
shareholders have a conflict of interest? What would be the differences
in conflicts of interest between participants and non-participants or
members and non-members that would affect the SB SEF or SBS exchange?
    Would persons who are selected to be directors of a SB SEF or SBS
exchange by participants or members have conflicts of interest based on
their status as directors that would affect their ability to act in the
best interest of the entity or in conformity with the Exchange Act, or
to act to meet the policy objectives in Section 765 of the Dodd-Frank
Act? Would directors be less likely to act to meet the policy
objectives in Section 765 of the Dodd-Frank Act if they are selected by
shareholders seeking to maximize the profits of the SB SEF or SBS
exchange? How would participants' or members' potential conflicts of
interest concerning open access and products traded compare to non-
participants' or non-members' conflicts on such issues? How do the
incentives of independent directors differ from those of non-
independent directors with respect to increasing access or promoting
competition?

IV. Discussion of Proposed Regulation MC: Mitigation of Conflicts of
Interest of Security-Based Swap Clearing Agencies

    Section 765 directs the Commission to adopt rules to mitigate
conflicts of interest, which rules may include numerical limits on
control of, or voting rights with respect to, any security-based swap
clearing agency. The Commission preliminarily believes that
requirements applicable to both governance and voting interests can
play an essential role in mitigating conflicts of interests. However,
the Commission recognizes that the nature of the governance, ownership
and voting requirements to mitigate conflicts may differ depending on
the conflicts of interest of the persons making decisions on behalf of
the security-based swap clearing agency. In particular, the nature of
the ownership and voting power of stockholders of the security-based
swap clearing agency plays a role in determining the nature of the
conflicts of interest that directors of the security-based swap
clearing agency will face.
    As previously noted, the Commission preliminarily believes that
conflicts of interest may arise when a small number of participants
exercise control or undue influence over a security-based swap clearing
agency. Conflicts of interest may also arise, however, simply because
directors and other decision-makers at a security-based swap clearing
agency have multiple interests and goals, including maximizing profit
for the benefit of shareholders and imposing risk restraints that may
limit short-term profits, among others.
    In seeking to address conflicts of interests, the imposition of
governance restrictions may lessen the need to impose certain voting
limitations, while the imposition of certain voting limitations may
alleviate the need to impose certain governance restrictions.
Accordingly, the Commission is proposing two alternative approaches
with respect to voting limitations and governance that would place
differing levels of emphasis on each of these factors.\77\
---------------------------------------------------------------------------

    \77\ See proposed Rule 701(a) and (b) of Regulation MC.
---------------------------------------------------------------------------

    The proposed rule would allow the security-based swap clearing
agency to elect between the two alternatives. The first alternative
places an emphasis on voting limitations while also imposing certain
governance restrictions (``Voting Interest Focus Alternative'').\78\
The second alternative places an emphasis on governance restrictions
while also

imposing certain voting limitations (``Governance Focus
Alternative'').\79\ Although the Commission is proposing two separate
alternatives, the Commission may also consider adopting only one
alternative as the final rule or may combine aspects of each proposed
alternative and adopt it as a single rule.\80\
---------------------------------------------------------------------------

    \78\ See proposed Rule 701(a) under Regulation MC.
    \79\ See proposed Rule 701(b) under Regulation MC.
    \80\ See infra Section VIII requesting comment on whether
alternatives with or without modifications should be allowed and
whether certain requirements in each alternative should be combined
to form a single approach.
---------------------------------------------------------------------------

    In addition, the existing standards in Section 17A of the Exchange
Act also help to mitigate conflicts of interest at registered clearing
agencies and will be applied in addition to any standards adopted by
the Commission under the Dodd-Frank Act.\81\
---------------------------------------------------------------------------

    \81\ See discussion infra Section IV.C. Security-based swap
clearing agencies will be required to be registered with the
Commission under Section 17A of the Exchange Act upon the effective
date of Title VII and, as a result, must comply with the standards
in Section 17A that are applicable to all registered clearing
agencies.
---------------------------------------------------------------------------

A. Alternative I: Voting Interest Focus Alternative

    As more fully described below, under the Voting Interest Focus
Alternative, the Commission is proposing limitations on the voting
interests held by individual participants of a security-based swap
clearing agency and by participants acting collectively as a group. In
addition, the Commission is proposing certain requirements related to
governance that would give independent directors a strong role in
overseeing the security based-swap clearing agency.
1. Voting Interest Focus Alternative: Individual Voting Limitation
    The Voting Interest Focus Alternative would provide that a
security-based swap clearing agency may not permit a participant,
either alone or together with its related persons, to (1) beneficially
own, directly or indirectly, any interest in the security-based swap
clearing agency that exceeds 20% of any class of securities, or other
ownership interest, entitled to vote of such security-based swap
clearing agency or (2) directly or indirectly vote, cause the voting
of, or give any consent or proxy with respect to the voting of, any
interest in the security-based swap clearing agency that exceeds 20% of
the voting power of any class of securities or other ownership interest
of such security-based swap clearing agency.\82\ This proposed
limitation on individual participant voting interest is designed to
prevent any individual participant from owning, on a direct or indirect
basis, a voting interest that would allow it to act on conflicts of
interest in the security-based swap clearing agency to the detriment of
such security-based swap clearing agency and the security-based swaps
market.
---------------------------------------------------------------------------

    \82\ See proposed Rule 701(a)(1)(i) and (ii) under Regulation
MC.
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    The terms ``beneficial ownership,'' ``beneficially owns'' or any
derivatives thereof would be defined in reference to Rule 13d-3 under
the Exchange Act, Determination of Beneficial Ownership.\83\ The
concept of beneficial ownership in Rule 13d-3 is designed to encompass
any person or group of persons that may be able to act to influence or
control an issuer. The Commission proposes to use the same definition
of beneficial ownership in this rule because it also would describe
those persons or groups of persons that may be able to act to influence
or control a security-based swap clearing agency. However, to the
extent any participant beneficially owns any security or other
ownership interest solely because such participant is a member of a
group within the meaning of Section 13(d)(3) of the Exchange Act, such
participant would not be deemed to beneficially own such security or
other ownership interest for purposes of this section, unless such
person had the power to direct the vote of such security or other
ownership interest. The Commission proposes to exclude beneficial
ownership that results solely from being a member of a group to provide
more certainty to those that would be required to comply with the
limitations, in light of the effect of exceeding the ownership limit--
i.e., that the participant will be divested of the excess interest.
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    \83\ See proposed Rule 700(b) under Regulation MC, which
provides that the terms ``beneficial ownership,'' ``beneficially
owns,'' or any derivative thereof would be defined as having the
same meaning, with respect to any security or other ownership
interest, as set forth in Sec.  240.13d-3, as if (and whether or
not) such security or other ownership interest were a voting equity
security registered under Section 12 of the Exchange Act (15 U.S.C.
78l); provided that to the extent any person beneficially owns any
security or other ownership interest solely because such person is a
member of a group within the meaning of Section 13(d)(3) of the
Exchange Act (15 U.S.C. 78m(d)(3)), such person shall not be deemed
to beneficially own such security or other ownership interest,
unless such person has the power to direct the vote of such security
or other ownership interest.
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    While the Commission has not previously adopted voting interest
limitations for registered clearing agencies in the other securities
markets, the security-based swaps market presents a different potential
concern with respect to conflicts of interests. In the securities
markets for which clearing agencies currently registered with the
Commission provide clearance and settlement services,\84\ there are
significantly more dealers and participants. The incentives of
participant-owners of these registered clearing agencies are generally
aligned with those of the clearing agency: To accept for clearing as
many participants that can meet reasonable participation standards and
as many transactions that fit into the clearing agencies' risk
management structure. Furthermore, the OTC derivatives market has a
relatively high concentration of market activity among a limited number
of dealers \85\ that earn significant revenues from the currently
opaque OTC market.\86\ The existing cash equities and listed options
markets, on the other hand, are transparent and widely disbursed over a
range of market participants. As previously discussed, participants in
a security-based swap clearing agency may have incentives to limit
participation in the clearing agency and to limit the scope of products
cleared. Moreover, the Commission's experience regulating security-
based swap clearing agencies along with the views expressed by market
participants suggest that security-based swap clearing agencies may be
particularly susceptible to conflicts of interest.\87\ The Commission
preliminarily believes that prohibiting a participant and its
affiliates and related persons from having more than a 20% voting
interest in a security-based swap clearing agency, taking into account
the other requirements under the Voting Interest Focus Alternative as
described below, would establish a sufficiently high threshold to
preclude any one participant from exerting undue influence over the
security-based swap clearing agency. The 20% threshold proposed for
participant voting interests in a security-based swap clearing agency
is similar to the threshold that the Commission previously proposed for
national securities exchanges and national securities associations, is
the same as the threshold now being proposed for SBS exchanges and SB
SEFs, and is consistent with the limits

currently in place with respect to national securities exchanges.\88\
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    \84\ The four clearing agencies registered with the Commission
that have active business operations include: The Depository Trust
Company, The National Securities Clearing Corporation, The Fixed
Income Clearing Corporation, and The Options Clearing Corporation.
    \85\ See supra note 40.
    \86\ Id. (stating that U.S. commercial banks reported trading
revenues of $8.3 billion in the first quarter of 2010).
    \87\ See supra notes 26 and 34.
    \88\ As previously noted, national securities exchanges
generally prohibit exchange members, alone or together with their
related persons, from owning more than 20% of the exchange or being
entitled to vote shares in excess of 20%. See, e.g., Securities
Exchange Act Release No. 61698, 75 FR at 13156, supra note 59.
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2. Voting Interest Focus Alternative: Aggregate Voting Limitation
    The Voting Interest Focus Alternative would provide that a
security-based swap clearing agency may not permit a participant,
either alone or together with its related persons, to in the aggregate
with any other security-based swap clearing agency participants and
their related persons (1) beneficially own, directly or indirectly, any
interest in the security-based swap clearing agency that exceeds 40% of
any class of securities, or other ownership interest, entitled to vote
of such security-based swap clearing agency or (2) directly or
indirectly vote, cause the voting of, or give any consent or proxy with
respect to the voting of, any interest in the security-based swap
clearing agency that exceeds 40% of the voting power of any class of
securities or other ownership interest of such security-based swap
clearing agency.\89\ Under the individual participant voting limitation
and without this aggregate limitation on voting interest, five entities
that have voting interests of 20% could control the security-based swap
clearing agency. Since a small number of dealers currently control the
OTC derivatives market,\90\ the Commission preliminarily believes that
this aggregate limitation on voting interest is a necessary corollary
to the individual participant voting limitation. The 40% aggregate
limitation on voting interest, which is consistent with limits used in
similar contexts,\91\ would restrict participants' ability to
collectively acquire a majority voting interest, while maintaining the
integrity of the 20% individual participant limitation.
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    \89\ See proposed Rule 701(a)(1)(iii) and (iv) under Regulation
MC.
    \90\ See supra note 40.
    \91\ As previously noted, the Commission has generally
prohibited any person, alone or together with its related persons,
from owning more than 40% of a national securities exchange. See,
e.g., Securities Exchange Act Release No. 61698, 75 FR at 13156,
supra note 59.
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3. Voting Interest Focus Alternative: Indirect or Affiliate Ownership
and Ownership Through Related Persons
    The Voting Interest Focus Alternative would also address conflicts
of interest created by indirect voting interests of the security-based
swap clearing agency because a rule that limits only direct voting
interests could be circumvented by holding the interest through an
affiliated party or by holding an interest in a controlling entity. For
purposes of determining a security-based swap clearing agency
participant's voting interest, the proposed rule would, as indicated in
the description of the rules above, combine such person's interest with
those of its ``related persons.'' \92\
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    \92\ See proposed Rule 700(u) of Regulation MC.
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    The Commission proposes to define the term ``related person'' to
include persons whose relationship with respect to a participant would
likely cause them to have the same conflicts of interest with respect
to the security-based swap clearing agency (e.g., ``affiliate,''
``immediate family member,'' and ``person associated with a participant
in a security-based swap clearing agency''). Specifically, proposed
Rule 700(u) would define ``related person'' as that term relates to
security-based swap clearing agencies as: (i) Any affiliate \93\ of a
participant in a security-based swap clearing agency; (ii) any person
associated with a participant in a security-based swap clearing agency;
\94\ (iii) any immediate family member \95\ of a participant in the
security-based swap clearing agency that is a natural person, or any
immediate family member of the spouse of such person, who, in each
case, has the same home as the participant in the security-based swap
clearing agency, or who is a director or officer of the security-based
swap clearing agency or any of its parents or subsidiaries; and (iv)
any immediate family member of a person associated with a participant
in the security-based swap clearing agency that is a natural person, or
any immediate family member of the spouse of such person, who, in each
case, has the same home as the person associated with the participant
in the security-based swap clearing agency, or who is a director or
officer of the security-based swap clearing agency, or any of its
parents or subsidiaries.
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    \93\ The term ``affiliate'' would be defined as any person that,
directly or indirectly, controls, is controlled by, or is under
common control with, the person. See proposed Rule 700(a) under
Regulation MC. ``Control'' would be defined as the possession,
direct or indirect, of the power to direct or cause the direction of
the management and policies of a person, whether through the
ownership of voting securities, by contract, or otherwise. Any
person that (i) is a director, general partner, or officer
exercising executive responsibility (or having similar status or
function); (ii) directly or indirectly has the right to vote 25% or
more of a class of voting securities or has the power to sell or
direct the sale of 25% or more of a class of voting securities; or
(iii) in the case of a partnership, has the right to receive, upon
dissolution, or has contributed, 25% or more of the capital, is
presumed to control that person. See proposed Rule 700(e) under
Regulation MC.
    \94\ There is currently not a definition for a ``person
associated with a participant in a clearing agency'' in the Exchange
Act or in Commission rules. However, the Commission believes that
the definition for the term ``person associated with a member'' in
Section 3(a)(21) of the Exchange Act should be used as the basis for
the definition of the term ``person associated with a participant in
a security-based swap clearing agency,'' as the purposes of the two
defined terms are similar. Accordingly, the Commission proposes to
define the term ``person associated with a participant in a
security-based swap clearing agency'' as (1) any partner, officer,
director, or branch manager of such security-based swap dealer or
major security-based swap participant (or any person occupying a
similar status or performing similar functions); (2) any person
directly or indirectly controlling, controlled by, or under common
control with such security-based swap dealer or major security-based
swap participant; or (3) any employee of such security-based swap
dealer or major security-based swap participant. This term does not
include any person associated with a participant in a security-based
swap clearing agency whose functions are solely clerical or
ministerial. See proposed Rule 700(r) of Regulation MC.
    \95\ The term ``immediate family member'' would be defined in
the proposed rules as a person's spouse, parents, children, and
siblings, whether by blood, marriage, or adoption, or anyone
residing in such person's house. See proposed Rule 700(i) under
Regulation MC.
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    A voting interest limitation of 20% for an individual participant
of a security-based swap clearing agency and an aggregate voting
interest limitation of 40% for all participants of a security-based
swap clearing agency is intended to restrict the ability of security-
based swap clearing agency participants to exercise undue influence
over the governance of a security-based swap clearing agency for their
own self-interest. At the same time, these voting limitations would
still permit participants to hold significant economic interests in a
security-based swap clearing agency.
4. Voting Interest Focus Alternative: Divestiture and Voting
Restriction Requirement
    In order to assure that a security-based swap clearing agency
maintains the proposed voting interest limitations, the Commission is
proposing to require security-based swap clearing agencies to have
rules in place for the divestiture of voting interests that exceed the
prescribed limitations.\96\ The Commission preliminarily believes that
in order for the voting limitations to be effective, the rule must
require security-based swap clearing agencies to take action to reduce
participants' and participants' related persons' voting interests.
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    \96\ See proposed Rule 701(a)(2) under Regulation MC.
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    The Commission is proposing to provide security-based swap clearing
agencies flexibility in determining how

to implement this divesture requirement. Any rules adopted by a
security-based swap clearing agency must assure that the security-based
swap clearing agency has a viable, enforceable mechanism to divest a
participant and its related persons of any voting interest owned in
excess of the 20% limitation, and not to give effect to the portion of
any voting interest in excess of the 20% individual limitation or the
40% aggregate limitation. The Commission is also proposing to require a
security-based swap clearing agency's procedures to provide a mechanism
for the security-based swap clearing agency to obtain information
relating to the voting interests in the security-based swap clearing
agency held by its participants and their related persons.\97\ The
Commission believes that this requirement is essential to a security-
based swap clearing agency's ability to monitor the voting interest
held by its participants and their related persons in relation to the
proposed voting limitations.
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    \97\ Id.
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5. Voting Interest Focus Alternative: Independent Directors on Board
    The Commission's Voting Interest Focus Alternative would impose
substantive requirements on the governance of security-based swap
clearing agencies that are designed to address the concern that
participants' conflicts of interest may lead them to take actions that
would potentially limit fair and open access and product eligibility
for central clearing, as well as potentially weaken the risk management
of security-based swap clearing agencies. The proposed governance
provisions, as discussed below, are intended to help mitigate potential
conflicts of interest and assure the fair administration and governance
of a security-based swap clearing agency by limiting the control that
any one participant or group of participants may exercise over the
security-based swap clearing agency.
    The Commission proposes under the Voting Interest Focus Alternative
to require the Board \98\ of a security-based swap clearing agency to
be composed of at least 35% independent directors.\99\ The presence of
a significant number of independent directors on the Board of a
security-based swap clearing agency should provide the addition of
strong and independent oversight within the security-based swap
clearing agency to serve as a potential check against conflicts of
interest that could pose a detriment to the security-based swap
clearing agency, other firms, or the security-based swaps market
generally. The Commission preliminarily believes that a level below 35%
independent directors may not be sufficient to assure that independent
directors have a significant voice.\100\ A requirement lower than 35%
would potentially place independent directors in a small enough
minority that, relative to the remaining director slots that could