among the largest in terms of level of trading activity in the
security-based swap and swap markets.\1112\ If these dealing entities
are currently registered with the CFTC as swap dealers, major swap
participants or FCMs, their market and credit risk exposures from
certain legacy security-based swap and swap positions will have to be
collateralized per CFTC's margin rules. However, these margin rules
have exceptions such that not all exposures from legacy positions have
to be collateralized (e.g., security-based swaps and swaps with
counterparties that are not a ``covered swap entity'' or ``financial
end user,'' as defined by the CFTC's margin rules).\1113\ To the extent
that these dealing entities will register as ANC broker-dealers or ANC
broker-dealer SBSDs, the requirement to cap the use of the alternative
credit risk charge for capital charges in lieu of margin to 10% of an
ANC broker-dealer's tentative net capital as a portfolio concentration
charge could impose costs on these broker-dealers. More generally, the
10% cap requirement may impose additional costs on a dealer that has
uncollateralized market risk exposure from legacy and new security-
based swap and swap positions in excess of the 10% cap and that chooses
to register as ANC broker-dealer or both ANC broker-dealer and SBSD
rather than other forms of nonbank SBSD, including stand-alone SBSDs
approved to use models. ANC broker-dealers may pass on a portion of
these additional costs to their counterparties, and therefore, the
requirement may increase the costs of transacting in security-based
swaps and swaps for market participants that access these markets
through ANC broker-dealers. However, competitive pressure may limit the
extent to which ANC broker-dealers may be able to pass on these
additional costs to their counterparties. For instance, stand-alone
SBSDs that are not subject to this requirement may be able to offer
better prices compared to ANC broker-dealers that are subject to this
requirement. As a corollary, if a dealing entity expects the additional
costs to be large, the requirement may reduce the entity's incentives
to engage in security-based swap dealing activity that would trigger a
requirement to register as an ANC broker-dealer SBSD.
---------------------------------------------------------------------------

    \1112\ See section VI.A.1. of this release.
    \1113\ See CFTC Margin Adopting Release, 81 FR 636. In certain
cases, FCMs may have to take capital charges against
uncollateralized security-based swap and swap positions. See section
VI.A.4.c. of this release (discussing the capital requirements for
FCMs).
---------------------------------------------------------------------------

    As discussed above, the 10% cap requirement will limit the extent
to which an ANC broker-dealer, including an ANC broker-dealer SBSD, can
make use of the alternative credit risk charge in lieu of the 100%
capital deduction. As a result, the capital buffer that an ANC broker-
dealer will have to hold as a result of the 10% cap requirement is
larger than the capital buffer that the ANC broker-dealer would hold,
absent this requirement. Because a larger capital buffer allows ANC
broker-dealers to better withstand potential losses from
uncollateralized market risk exposures, the requirement is intended to
enhance the safety and soundness of ANC broker-dealers and therefore
benefit market participants.
vi. Risk Management Procedures
    Nonbank SBSDs will be required to comply with Rule 15c3-4, which
currently applies to OTC derivatives dealers and ANC broker-dealers.
Rule 15c3-4 requires firms to, among other things, establish, document,
and maintain a system of internal risk management controls to assist in
managing the risks associated with its business activities, including
market, credit, leverage, liquidity, legal, and operational risks.
These requirements may help nonbank SBSDs better monitor the risk of
their operations, and it may help reduce the risk of significant

losses from unmonitored positions.\1114\ Nonbank SBSDs may incur costs
in documenting their risk management procedures and updating their
information technology systems to meet these requirements. These costs
could vary significantly among nonbank SBSDs depending on their size,
the degree to which their risk management systems are already
documented, and the types of business they engage in.\1115\
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    \1114\ See Barnard Letter.
    \1115\ See section VI.C. of this release.
---------------------------------------------------------------------------

c. Alternatives Considered
    The 2012 proposal discussed the benefits and the costs of the
proposed net liquid assets test capital standard for nonbank SBSDs. A
number of commenters suggested several other alternatives to this
standard. In this section, the Commission discusses alternative capital
standards that were either proposed or suggested by commenters.
i. Bank Standard
    One commenter argued that the bank capital standard should be used
for nonbank SBSDs, and was concerned that the proposed capital
requirements for nonbank SBSDs were not comparable to those proposed by
other U.S. regulators and that modeling the capital standards on the
broker-dealer capital standard was not appropriate.\1116\ As discussed
above in section II.A.1. of this release, the Commission has made two
significant modifications to the final capital rules for nonbank SBSDs
that reduce some of the differences between the final capital rules for
nonbank SBSDs and the capital rules of the prudential regulators (and
the CFTC). First, as discussed above in section II.A.2.b.v. of this
release, the Commission has modified Rule 18a-1 so that it no longer
contains a portfolio concentration charge that is triggered when the
aggregate current exposure of a stand-alone SBSD to its derivatives
counterparties exceeds 50% of the firm's tentative net capital.\1117\
This means that stand-alone SBSDs that have been authorized to use
models will not be subject to this limit on applying the credit risk
charges to uncollateralized current exposures related to derivatives
transactions. This includes uncollateralized current exposures arising
from electing not to collect variation margin for non-cleared security-
based swap and swap transactions under exceptions in the margin rules
of the Commission and the CFTC (which is generally consistent with the
margin rules of the prudential regulators). The credit risk charges are
based on the creditworthiness of the counterparty and can result in
charges that are substantially lower than deducting 100% of the amount
of the uncollateralized current exposure.\1118\ This approach to
addressing credit risk arising from uncollateralized current exposures
related to derivatives transactions is generally consistent with the
treatment of such exposures under the capital rules for banking
institutions.\1119\
---------------------------------------------------------------------------

    \1116\ See Morgan Stanley 2/22/2013 Letter.
    \1117\ See paragraph (e)(2) of Rule 18a-1, as adopted. See also
Capital, Margin, and Segregation Proposing Release, 77 FR at 70244
(proposing a portfolio concentration charge in Rule 18a-1 for stand-
alone SBSDs).
    \1118\ See paragraph (e)(2) of Rule 18a-1, as adopted.
    \1119\ See OTC Derivatives Dealers, 63 FR at 59384-87.
---------------------------------------------------------------------------

    The second significant modification is the alternative compliance
mechanism. As discussed above in section II.D. of this release, the
alternative compliance mechanism will permit a stand-alone SBSD that is
registered as a swap dealer and that predominantly engages in a swaps
business to comply with the capital, margin, and segregation
requirements of the CEA and the CFTC's rules in lieu of complying with
the Commission's capital, margin, and segregation requirements.\1120\
The CFTC's proposed capital rules for swap dealers that are FCMs would
retain the existing capital framework for FCMs, which imposes a net
liquid assets test similar to the existing capital requirements for
broker-dealers.\1121\ However, under the CFTC's proposed capital rules,
swap dealers that are not FCMs would have the option of complying with:
(1) A capital standard based on the capital rules for banks; (2) a
capital standard based on the Commission's capital requirements in Rule
18a-1; or (3) if the swap dealer is predominantly engaged in non-
financial activities, a capital standard based on a tangible net worth
requirement.
---------------------------------------------------------------------------

    \1120\ See Rule 18a-10, as adopted.
    \1121\ See CFTC Capital Proposing Release, 81 FR 91252.
---------------------------------------------------------------------------

    Notwithstanding the modification to Rule 18a-1 described above, the
rule continues to be modeled in large part on the broker-dealer capital
rule. For example, as is the case with Rule 15c3-1, most unsecured
receivables (aside from uncollateralized current exposure relating to
derivatives transactions) will not count as allowable capital.
Moreover, fixed assets and other illiquid assets will not count as
allowable capital. Consequently, stand-alone SBSDs subject to Rule 18a-
1 (i.e., firms that do not operate under the alternative compliance
mechanism) will remain subject to certain requirements designed to
promote their liquidity. Additionally, broker-dealer SBSDs will be
subject to Rule 15c3-1 and the stricter (as compared to Rule 18a-1) net
liquid assets test it imposes.
    Several factors have influenced the Commission's decision not to
use a bank capital standard for nonbank SBSDs. First, a nonbank SBSD's
role of dealing in security-based swaps and performing market-making
activity is fundamentally different from a bank's central role of
making loans and taking deposits. Second, banks have access to sources
of liquidity and support that nonbank SBSDs do not have access to, such
as retail deposits and central bank support. Finally, like the bank
standard, the net liquid test capital standard is also risk-based, as
nonbank SBSDs will be required to take capital charges that are
proportionate to the risk exposures from their trading activity, and
the 2% margin factor for calculating the minimum net capital
requirement is tied directly to the credit risk of the nonbank SBSD's
exposures from trading activity.
    The adopted capital standard has a number of similarities and
differences compared to the bank capital standard. Under the current
bank capital standard, bank SBSDs would also have to allocate capital
for their exposures with other covered entities, including other
dealers. The capital that supports a bank SBSD's dealing activities in
the OTC markets is determined in accordance with the prudential
regulators' rules on banks' capital adequacy. These rules require that
bank SBSDs calculate a risk weight amount for each of their exposures,
including exposures to non-cleared security-based swaps. Furthermore,
the rules require that bank SBSDs calculate an additional risk weight
amount for the exposure created through the posting of initial margin
to collateralize a non-cleared security-based swap. However, both of
these risk weight amounts are likely to be small. The dealer's exposure
to a covered-entity counterparty is collateralized by the initial
margin that the counterparty has to post with a third-party custodian
(for the benefit of the dealer), and the risk weight of this exposure
reflects almost entirely the risk weight of the collateral--usually
minimal. Similarly, by posting initial margin, the dealer creates an
exposure to the third-party custodian holding the collateral. Exposures
to custodian banks usually have low risk weight.
    The capital that bank SBSDs have to allocate for their non-cleared
security-based swaps equals the sum of the two risk weight amounts
calculated above multiplied by a factor--usually 8%.

Thus, the capital that a bank SBSD has to allocate to support a non-
cleared security-based swap is relatively small, and likely of the same
order of magnitude as the capital that a nonbank SBSD would have to
allocate for a similar exposure. However, unlike the nonbank SBSD, the
bank SBSD still has to post away the initial margin. The posting of
collateral will ``consume'' the bank SBSD's capital, and gives nonbank
SBSD a comparative advantage in terms of capital efficiency, to the
extent their counterparty is not an entity that is required to collect
initial margin from them.
    While collateral posting makes dealing under a bank SBSD structure
costly, the cost of funding such collateral is likely smaller for these
dealers compared to nonbank SBSDs. Unlike nonbank SBSDs, bank SBSDs may
have access to less costly sources of collateral funding, including
deposits and central bank mechanisms.
ii. Harmonization with the CFTC
    As discussed above in section II.A.1. of this release, several
commenters argued that the Commission should harmonize its rules with
the CFTC and other regulatory bodies that have finalized their capital
and/or margin rules.\1122\ One commenter suggested that the Commission
coordinate with the CFTC and, as appropriate, the prudential regulators
to assure that each agency's respective capital rules are harmonized
and do not have the unintended effect of impairing the ability of
broker-dealers that are dually registered as FCMs to provide clearing
services for security-based swaps and swaps.\1123\ Differences between
these final capital rules and any final rules adopted by the CFTC could
mean that nonbank SBSDs that are also registered with the CFTC as swap
dealers would need to perform two different calculations to determine
whether they satisfy their respective capital standards. The
difficulties and inefficiencies associated with satisfying both
standards could cause some firms to separate nonbank SBSDs from nonbank
swap dealers. Thus, relative to the adopted rule, an approach that
prioritized greater regulatory harmonization might have mitigated the
costs borne by nonbank SBSDs.
---------------------------------------------------------------------------

    \1122\ See Citadel 11/19/18 Letter; Financial Services
Roundtable Letter; FIA 11/19/2018 Letter; Morgan Stanley 11/19/2018
Letter.
    \1123\ See FIA 11/19/2018 Letter.
---------------------------------------------------------------------------

    Although the Commission has declined to fully harmonize its rules
with the CFTC's proposed approach to capital for the reasons described
above, the final rules eliminate or modify many of the provisions in
the proposed rules that commenters identified as posing particular
challenges to firms registered as both SBSDs and swap dealers.
Moreover, the alternative compliance mechanism should achieve the same
benefits as full harmonization for a subset of firms that will register
as SBSDs by permitting those stand-alone SBSDs that are likely to be
most affected by differences between the Commission's rules and the
CFTC's rules to comply with the capital, margin, and segregation
requirements of the CEA and the CFTC's rules (if they meet certain
conditions).
iii. Tangible Net Worth Test
    Several commenters were concerned about the differences between the
risk-based capital standards used for banks, and the transaction volume
based broker-dealer capital standard.\1124\ One commenter suggested
that the Commission apply a tangible net worth test to nonbank SBSDs,
claiming that it is ``particularly appropriate for entities that have
not been prudentially regulated before and effectively protects against
any losses in the event of a potential liquidation.'' \1125\
---------------------------------------------------------------------------

    \1124\ See section II.A.1. of this release.
    \1125\ See Sutherland Letter.
---------------------------------------------------------------------------

    As mentioned in section II.A.1., the Commission believes that a
tangible net worth test would give incentives to nonbank SBSDs to hold
illiquid, higher yielding assets to meet the requirement, which would
undermine the Commission's goal of promoting liquidity for SBSDs. In
addition, a nonbank SBSD will not also have the support of retail
deposits or central bank support. Thus, the Commission is adopting the
broker-dealer capital standard for nonbank SBSDs.
iv. Standardized Haircuts for Cleared Security-Based Swap and Swap
Positions
    The Commission proposed that the standardized haircuts for cleared
and non-cleared security-based swaps be calculated the same way. The
proposed standardized haircut for a CDS was determined using one of two
maturity grids: one for a CDS that is a security-based swap and the
other for a CDS that is a swap.\1126\ For a security-based swap that is
not a CDS, the proposed standardized haircuts required multiplying the
notional amount of the security-based swap by the amount of the
standardized haircut that applied to the underlying position pursuant
to the pre-existing provisions of Rule 15c3-1.\1127\ In addition, under
the proposal, firms authorized to use internal models were allowed to
use model-based haircuts instead of the standardized haircuts.
---------------------------------------------------------------------------

    \1126\ See Capital, Margin, and Segregation Proposing Release,
77 FR at 70232-34, 70248-49.
    \1127\ See Capital, Margin, and Segregation Proposing Release,
77 FR at 70234-36.
---------------------------------------------------------------------------

    The final capital rules differ from the proposed rules in terms of
how broker-dealers and nonbank SBSDs must calculate standardized
haircuts for cleared security-based swaps and swaps. Namely, the
Commission is modifying the proposed standardized haircut requirements
for cleared security-based swaps and swaps to require that the amount
of the deduction will be the amount of margin required by the CCP where
the position is cleared.\1128\ However, an ANC broker-dealer and stand-
alone SBSD authorized to use a model can calculate model-based haircuts
instead of standardized haircuts for positions for which the firm has
been approved to use the model.
---------------------------------------------------------------------------

    \1128\ See paragraph (c)(2)(vi)(O) of Rule 15c3-1, as amended;
paragraph (b)(1) of Rule 15c3-1b, as amended; paragraph
(c)(1)(vi)(A) of Rule 18a-1, as adopted; paragraph (b)(1) of Rule
18a-1b, as adopted.
---------------------------------------------------------------------------

    As an alternative to the final capital rules, the Commission could
have taken the proposed approach with respect to standardized haircuts
for cleared security-based swaps and swaps. The Commission analyzes
below the economic impact of this alternative. Requiring SBSDs to take
the proposed standardized haircuts for cleared proprietary security-
based swap and swap positions could create a larger capital buffer
against the market risk of a cleared position if the proposed
standardized haircuts were more conservative than the margin
requirements of the CCPs. As a result, the proposed approach could
increase the safety and soundness of SBSDs, which would benefit the
market participants in the security-based swap and swap markets, all
things being equal. At the same time, however, to the extent the
proposed standardized haircuts were more conservative, generally, than
the margin requirements of the CCPs, the proposed approach would have
resulted in relatively higher capital requirements for cleared
security-based swap and swap positions. This could have discouraged
broker-dealers and nonbank SBSDs from engaging in cleared security-
based swap and swap transactions if the firms believed their capital
could be deployed more profitably. Alternatively, nonbank SBSDs would
likely have passed the costs associated higher capital requirements
under this alternative to

their customers, increasing the relative costs of cleared transactions.
    Adopting standardized haircuts based on clearing agency and DCO
margin requirements is consistent with the treatment of futures
products and potentially consistent with the standardized haircuts the
CFTC ultimately will adopt. Differences in the capital treatment of
these positions under the Commission's and the CFTC's rules could have
caused broker-dealers and nonbank SBSDs to be subject to overlapping
regulatory regimes if they were registered as FCMs or swap dealers in
terms of calculating standardized haircuts for cleared security-based
swaps and swaps. This could have imposed costs on broker-dealers and
SBSDs if the proposed standardized haircuts were larger than the margin
amount required by the CCP where the position is cleared. These costs
could have further reduced the incentives of broker-dealers and nonbank
SBSDs to clear security-based swap and swap positions.
    Finally, cleared security-based swaps and swaps differ from non-
cleared security-based swaps and swaps in ways that could have made the
capital charges using the proposed standardized haircuts for cleared
security-based swaps and swaps inappropriately high. In particular, as
counterparties to cleared OTC derivatives contracts, CCPs must meet
risk management standards that support the orderly liquidation of
portfolios in the event of clearing member default and mitigate the
risk of CCP default. In addition, regulatory standards as well as
private incentives encourage CCPs to offer to clear products that are
sufficiently liquid to enable CCPs to replace positions they hold
against defaulting members without substantial price impact.
v. 1% Minimum Standardized Haircut for Interest Rate Swaps
    Under the final rules being adopted today, the standardized
haircuts for non-cleared interest rate swaps are determined using the
maturity grid for U.S. government securities in paragraph (c)(2)(vi)(A)
of Rule 15c3-1.\1129\ Moreover, the standardized haircuts for non-
cleared security-based swaps and swaps (other than CDS) being adopted
today permit a broker-dealer and nonbank SBSD to reduce the deduction
by an amount equal to any reduction recognized for a comparable long or
short position in the reference security under the standardized
haircuts in Rule 15c3-1.\1130\ The standardized haircuts in paragraph
(c)(2)(vi)(A) of Rule 15c3-1 permit a broker-dealer to take a capital
charge on the net long or short position in U.S. government securities
that are in the same maturity categories in the rule. This treatment
will apply to interest rate swaps. The standardized haircut for non-
cleared interest rate swaps can be no less than \1/8\ of 1% of a long
position that is netted against a short position in the case of a non-
cleared swap with a maturity of 3 months or more.\1131\ The
standardized haircuts in paragraph (c)(2)(vi)(A) of Rule 15c3-1 require
a 0% haircut for the unhedged amount of U.S. government securities that
have a maturity of less than 3 months. Therefore, the standardized
haircuts for interest rate swaps will treat hedged and unhedged
positions with maturities of less than 3 months identically in that
there will be no haircut applied to the positions. The minimum
standardized haircut for hedged interest rate swaps with a maturity of
3 months or more will be \1/8\ of 1%.
---------------------------------------------------------------------------

    \1129\ See paragraph (b)(2)(ii)(A)(3) of Rule 15c3-1b, as
amended; paragraph (b)(2)(ii)(A)(3) of Rule 18a-1b, as adopted.
    \1130\ See paragraph (c)(2)(vi)(P)(2) of Rule 15c3-1, as
amended; paragraph (b)(2)(ii)(B) of Rule 15c3-1b, as amended;
paragraph (c)(1)(vi)(B)(2) of Rule 18a-1, as adopted; paragraph
(b)(2)(ii)(B) of Rule 18a-1b, as adopted.
    \1131\ See paragraph (b)(2)(ii)(A)(3) of Rule 15c3-1b, as
amended; paragraph (b)(2)(ii)(A)(3) of Rule 18a-1b, as adopted.
---------------------------------------------------------------------------

    The proposed haircut for interest rate swaps had a floor of 1%
(whereas U.S. government securities with a maturity of less than 9
months are subject to haircuts of \3/4\ of 1%, \1/2\ of 1%, or 0%
depending on the time to maturity). The proposed 1% floor is an
alternative to the minimum standardized haircut for non-cleared
interest rate swaps in the final rules. A commenter opposed the
proposed 1% minimum standardized haircut for interest rate swaps as
being too severe.\1132\ Based on an analysis of sample positions, this
commenter believed that the proposed 1% minimum standardized haircut
would result in market risk charges that are nearly 35 times higher
than charges without the 1% minimum.\1133\
---------------------------------------------------------------------------

    \1132\ See SIFMA 2/22/2013 Letter.
    \1133\ See SIFMA 11/19/2018 Letter.
---------------------------------------------------------------------------

    The Commission is persuaded that the 1% minimum haircut was too
conservative, particularly when applied to tightly hedged positions
such as those in the commenter's examples. A minimum standardized
haircut for non-cleared interest rate swaps that was too conservative
could have unduly increased the transaction costs of broker-dealers and
nonbank SBSDs that engage in these types of swaps. To the extent that
these entities passed on these increased costs to their customers in
the form of higher prices to liquidity provision, the ability of their
customers to use interest rate swaps for risk mitigation could have
been impaired. In addition, by raising their prices for liquidity
provision, broker-dealers and nonbank SBSDs could have become less
competitive than other liquidity providers that are not subject to the
Commission's capital rules.
    However, the Commission continues to believe that a minimum haircut
should be applied to non-cleared interest rate swaps. A minimum haircut
for non-cleared interest rate swaps will help enhance the safety and
soundness of broker-dealers and nonbank SBSDs by reducing their
incentives to engage in excessive risk-taking, by increasing their
ability to withstand losses from their trading activity, and by
reducing the risk of sequential counterparty failure. It also will
account for potential differences between the movement of interest
rates on U.S. government securities and interest rates upon which the
non-cleared interest rate swap payments are based. The Commission
believes the final rules for standardized haircuts for non-cleared
security-based swaps strike an appropriate balance in terms of
addressing commenters' concerns that the proposed minimum was too
conservative and the objective of enhancing the safety and soundness of
nonbank SBSDs. Thus, the Commission believes that the adopted approach
is preferable to the alternative.
vi. Same Control and Opinion of Counsel Conditions for Avoiding Capital
Charge When Collateral is Held by an Independent Third-Party Custodian
as Initial Margin
    The Commission asked in the 2018 comment reopening whether there
should be an exception to taking the deduction for initial margin
collateral held by an independent third-party custodian pursuant to
Section 3E(f) of the Act or Section 4s(l) of the CEA under conditions
that promote the SBSD's ability to promptly access the collateral if
needed.\1134\ Specifically, the Commission sought comment on whether
there should be such an exception under the following conditions: (1)
The custodian is a bank; (2) the nonbank SBSD enters into an agreement
with the custodian and the counterparty that provides the nonbank SBSD
with the same control over the collateral as would be the case if the
nonbank SBSD controlled the collateral

directly; and (3) an opinion of counsel deems the agreement
enforceable.
---------------------------------------------------------------------------

    \1134\ See Capital, Margin, and Segregation Comment Reopening,
83 FR at 53011-12.
---------------------------------------------------------------------------

    As discussed above in section II.A.2.b.ii. of this release, the
Commission agrees with commenters that the ``same control'' language
could create practical obstacles that would make it difficult to
execute an account control agreement that would be sufficient to avoid
the capital charge when initial margin is held by a third-party
custodian. Moreover, even if such an agreement could be executed,
existing agreements that are in place in accordance with the third-
party custodian and documentation requirements of the CFTC and the
prudential regulators likely would need to be re-drafted to meet the
requirements of the potential condition. Doing so would be a costly and
burdensome process. Some commenters opposed the condition requiring a
legal opinion of outside counsel on the basis of cost and
impracticability, arguing it is inconsistent with market practice and
operationally burdensome to implement. The Commission acknowledges that
requiring an opinion of counsel could have been a costly burden. To the
extent that the counterparties of nonbank SBSDs bore at least part of
the costs associated with the re-drafting of account control agreements
and the acquisition of an opinion of counsel, they would have incurred
higher costs in transacting in the security-based swap market, which
could have reduced their participation in this market. These effects
could have been strengthened if the nonbank SBSDs bore part of the
costs associated with the re-drafting of account control agreements and
the acquisition of an opinion of counsel, and passed on those costs to
their counterparties in the form of higher prices for liquidity
provision. In light of these concerns, the Commission believes that the
adopted approach is preferable to this alternative.
vii. Requiring a Nonbank SBSD To Take a Capital Deduction for the
Margin Difference
    The Commission proposed a deduction that applied if a nonbank SBSD
collects margin from a counterparty in an amount that is less than the
deduction that would apply to the security-based swap if it was a
proprietary position of the nonbank SBSD (i.e., the collected margin
was less than the amount of the standardized or model-based haircuts,
as applicable).\1135\ This proposed requirement was designed to account
for the risk of the counterparty defaulting by requiring the nonbank
SBSD to maintain capital in the place of collateral in an amount that
is no less than required for a proprietary position. It also was
designed to ensure that there is a standard minimum coverage for
exposure to cleared security-based swap counterparties apart from the
individual clearing agency margin requirements, which could vary among
clearing agencies and over time. In the 2018 comment reopening, the
Commission asked whether this proposed rule change should be modified
to include a risk-based threshold under which the deduction need not be
taken, and provided modified rule text to apply the deduction to
cleared swap transactions.\1136\
---------------------------------------------------------------------------

    \1135\ See Capital, Margin, and Segregation Proposing Release,
77 FR at 7045-47.
    \1136\ See Capital, Margin, and Segregation Comment Reopening,
83 FR at 53009. More specifically, the Commission requested comment
on whether the rule should provide that the deduction need not be
taken if the difference between the clearing agency margin amount
and the haircut is less than 1% (or some other amount) of the SBSD's
tentative net capital, and less than 10% (or some other amount) of
the counterparty's net worth, and the aggregate difference across
all counterparties is less than 25% (or some other amount) of the
counterparty's tentative net capital.
---------------------------------------------------------------------------

    In light of comments received and for reasons discussed further
below, the final rules will not require a nonbank SBSD to deduct the
margin difference for each account it carries that holds cleared
security-based swaps or swaps. Consequently, this approach is analyzed
below as an alternative.
    As discussed above in section II.A.2.b.ii. of this release,
commenters raised a number of concerns with the proposed capital
deduction for the difference between the haircuts and CCP margin
requirements for cleared security-based swaps and swaps and with
potential threshold discussed in the 2018 comment reopening. In light
of these concerns, the Commission has supplemented the analysis of the
capital deduction in the proposing release \1137\ by analyzing the
potential direct costs associated with the capital charge for the
margin difference for each account carried by the nonbank SBSD that
holds cleared security-based swaps or swaps. To estimate the capital
charge under this alternative, Commission staff examined initial margin
requirements \1138\ for customer accounts carried by 11 registered
broker-dealers \1139\ that hold cleared security-based swap and swap
positions. The Commission staff also reviewed initial margin
requirements for a range of hypothetical single-name and index CDS that
were calculated using clearing agency initial margin methodology \1140\
and ISDA's SIMMTM model. Assuming that the SIMMTM
model initial margin calculations reasonably approximate the initial
margin requirements that would apply if the hypothetical security-based
swap and swap positions were proprietary, the resulting margin
difference--expressed as a ratio of the SIMMTM initial
margin requirements to the clearing agency initial margin
requirements--ranges from a minimum of 0.57 to a maximum of 2,
depending on the direction of the hypothetical security-based swap and
swap positions.\1141\ Commission staff applied these ratios to the
initial margin requirements for customer accounts to estimate an upper
bound for the capital charge. At the maximum ratio of 2, the aggregate
capital charge would be $4,644.55 million \1142\ or 422.23 million
\1143\ per broker-dealer.
---------------------------------------------------------------------------

    \1137\ See Capital, Margin, and Segregation Proposing Release,
77 FR at 70312-13.
    \1138\ These initial margin requirements were calculated as of
October 2, 2017, based on clearing agency data.
    \1139\ These 11 registered broker-dealers are clearing members
of a CCP. These broker-dealers are entities that will likely
register as SBSDs or are affiliated with entities that will likely
register as SBSDs.
    \1140\ This is the initial margin methodology of the clearing
agency that provided the initial margin requirements examined by
Commission staff.
    \1141\ A ratio of 0.57 for a position means that the associated
SIMMTM initial margin requirement is 57% of the
associated clearing agency initial margin requirement. Conversely, a
ratio of 2 means that the SIMMTM initial margin
requirement is 200% of the clearing agency initial margin
requirement. When the ratio is greater than 1, there would be a
capital charge under this alternative.
    \1142\ The aggregate capital charge is calculated as $4,644.55
million (total initial margin requirements for customer accounts) x
(2-1) = $4,644.55 million.
    \1143\ The capital charge per registered broker-dealer is
calculated as $4,644.55 million / 11 registered broker-dealers =
$422.23 million.
---------------------------------------------------------------------------

    Under this alternative, nonbank SBSDs would likely have passed on
the costs associated with this capital charge to their clients, either
in the form of higher prices or by demanding that clients post
collateral in excess of the amounts set by the CCPs. As a result, the
proposed capital charge may have increased the cost of clearing
security-based swaps or swaps for market participants who wish to clear
such transactions through nonbank SBSDs. Instead of passing on costs
associated with the capital charge to clients, nonbank SBSDs may have
chosen to limit their client clearing services to those security-based
swap and swap products that are less likely to attract the capital
charge. These responses from nonbank SBSDs may have reduced the
incentive of market participants to engage in centrally cleared
security-

based swap or swap transactions.\1144\ Further, CCPs are generally
required to meet minimum margin standards under the rules of most
jurisdictions. These minimum standards--to the extent they prohibit a
``race to the bottom'' by a CCP in terms of the margin it requires from
clearing members--would limit the likelihood of a margin difference and
the associated capital deduction.
---------------------------------------------------------------------------

    \1144\ This reduction in the incentives to clear a security-
based swap or a swap transaction may have been limited by a number
of factors, including but not limited to: (1) Any mandatory clearing
determinations for security-based swaps by the Commission under
Section 763(a) of the Dodd-Frank Act; (2) any mandatory clearing
determinations for swaps by the CFTC under Section 723(a) of the
Dodd-Frank Act; (3) the margin requirements for non-cleared
security-based swaps and swaps; (4) the segregation regime of
initial margin posted by the customer to collateralize a non-cleared
security-based swap or swap; and (5) the presence of financial
market intermediaries that are clearing members and that are not
directly subject to the requirements of the proposed capital rule
and amendments (e.g., banks).
---------------------------------------------------------------------------

    While the proposed capital deduction would have imposed a cost on
nonbank SBSDs and ultimately, their clients, the Commission
acknowledges it could have enhanced the safety and soundness of nonbank
SBSDs, and in turn promoted financial stability. Indeed, absent this
proposed requirement, a nonbank SBSD may collect margin from the client
that is just enough to satisfy the CCP's margin requirements. This CCP-
bound margin may not always adequately capture the risk of the
position, relative to the margining standards of nonbank SBSDs. For
example, if CCPs weaken their margin standards as a way to compete
among themselves, and, if this competition turns into a ``race to the
bottom,'' the initial margin that a CCP would assess at the outset of a
trade would have to reflect, in part, this competitive pressure and, as
a result, may not adequately capture the risk of the cleared
position.\1145\ Because the nonbank SBSD would have to fulfil any CCP-
bound margin calls that the insolvent client was not able to fulfill,
resulting in an unexpected draw on the nonbank SBSD's capital, the
proposed requirement was intended to provide a capital buffer (in the
form of a capital deduction for the margin difference) against such
potential losses, potentially allowing the nonbank SBSD to better
withstand a client default. The main beneficiaries of the enhanced
safety and soundness of the nonbank SBSD as a result of the requirement
would have been market participants, in particular those market
participants that employ the services of the nonbank SBSD.
---------------------------------------------------------------------------

    \1145\ Market participants have often raised concerns about the
adverse effects of a race to the bottom in initial margin standards
among CCPs. See, e.g., Futures & Options World (FOW), OTC
Derivatives Clearing Roundtable. There is also some preliminary
evidence of the adverse effects of competition on margin standards
among CCPs in the futures markets. See Nicole Abbruzzo and Yang-Ho
Park, An Empirical Analysis of Futures Margin Changes: Determinants
and Policy Implications, Finance and Economics Discussion Series,
Divisions of Research & Statistics and Monetary Affairs, Federal
Reserve Board (2014-86), available at https://www.federalreserve.gov/econresdata/feds/2014/files/201486pap.pdf.
---------------------------------------------------------------------------

2. The Capital Rule for Nonbank MSBSPs--Rule 18a-2
    As discussed above in section II.A.3. of this release, Rule 18a-2
will prescribe capital requirements for nonbank MSBSPs that are not
also registered as broker-dealers and will require them to hold at all
times positive tangible net worth. Nonbank MSBSPs are also required to
comply with Rule 15c3-4 with respect to their security-based swap and
swap activities.
a. Benefits and Costs of the Capital Rule for Nonbank MSBSPs
    The entities that are expected to register as nonbank MSBSPs
typically engage in both security-based swap activities and other
business activities. These other business activities could be
commercial in nature (e.g., manufacturing, energy, transportation), and
require that firms pre-commit capital in advance (i.e., capital that is
generally not liquid). In contrast, security-based swap activities
(like other securities activities) are more opportunistic in nature and
require liquid capital.
    The requirement that nonbank MSBSPs maintain positive tangible net
worth will allows these entities to offset losses in their security-
based swap positions with capital that is tied to other business
activities. In particular, a nonbank MSBSP does not need to hold liquid
capital beyond what is necessary to support its security-based swap
activities. Since capital tied to other business activities counts
toward regulatory capital, the requirement should result in more
efficient use of capital, which would be a clear benefit for nonbank
MSBSPs.
    While the requirement may allow a nonbank MSBSP to engage in
security-based swap activities without having to reallocate its capital
inefficiently, it may also lead to situations where the nonbank MSBSP
may fail to be compliant with the final margin rule and, thereby,
create risk for counterparties that rule is designed to protect. Under
Rule 18a-3, as adopted, a nonbank MSBSP is required to post collateral
to cover current exposure of counterparties to the nonbank SBSD if the
transaction is not subject to an exception in the rule. Consider a
situation where a nonbank MSBSP has losses on its non-cleared security-
based swap positions (i.e., gains for the counterparty) that are in
excess of its liquid capital. If its productive capital cannot be
liquidated right away, then the nonbank MSBSP may not have collateral
available to post to the counterparty to cover the counterparty's
current exposure to the nonbank SBSD. In this case, the nonbank SBSD
would be in violation of Rule 18a-3, as adopted, and, as a consequence,
the counterparty with the gains would be at risk.
    However, as discussed above, Rule 18a-2, as adopted, has a
provision that requires nonbank MSBSPs to comply with Rule 15c3-4. To
the extent that a nonbank MSBSP has effective risk management controls
in place, it should be able limit the number of situations where
potential losses on its positions exceed its buffer of liquid capital.
b. Alternatives Considered
    An alternative to the positive tangible net worth standard is the
net liquid assets test standard. The main difference between these two
approaches is that under the former nonbank MSBSPs are allowed to count
capital tied to other business activities towards regulatory capital,
while under the latter they are not to the extent the capital is
illiquid. Thus, the net liquid assets test standard is substantially
more conservative as nonbank MSBSPs would now need to set aside more
liquid capital to support their non-cleared security-based swap trading
activities. To the extent that nonbank MSBSPs obtain their liquid
capital by scaling down their business activities, the alternative
leads to less efficient allocation of capital and imposes significant
costs on nonbank MSBSPs.
3. The Margin Rule--Rule 18a-3
a. Overview
    As discussed above in section II.B.1. of this release, Rule 18a-3,
as adopted, will establish margin requirements for nonbank SBSDs and
nonbank MSBSPs with respect to transactions with counterparties in non-
cleared security-based swaps.
i. Nonbank SBSDs
    Rule 18a-3 prescribes margin requirements for nonbank SBSDs with
respect to non-cleared security-based swaps. The rule requires a
nonbank SBSD to perform two calculations with respect to each account
of a counterparty as of the close of business each day: (1) The amount
of current exposure in the account of the

counterparty (also known as variation margin); and (2) the initial
margin amount for the account of the counterparty (also known as
potential future exposure or initial margin). Variation margin is
calculated by marking the position to market. Initial margin must be
calculated by applying the standardized haircuts prescribed in Rule
15c3-1 or Rule 18a-1 (as applicable). However, a nonbank SBSD may apply
to the Commission for authorization to use a model (including an
industry standard model) to calculate initial margin. Broker-dealer
SBSDs must use the standardized haircuts (which include the option to
use the more risk sensitive methodology in Appendix A to Rule 15c3-1)
to compute initial margin for non-cleared equity security-based swaps
(even if the firm is approved to use a model to calculate initial
margin). Stand-alone SBSDs may use a model to calculate initial margin
for non-cleared equity security-based swaps (and potentially equity
swaps if portfolio margining is implemented by the Commission and
CFTC), provided the account of the counterparty does not hold equity
security positions other than equity security-based swaps (and
potentially equity swaps).
    Rule 18a-3 requires a nonbank SBSD to collect collateral from a
counterparty to cover a variation and/or initial margin requirement.
The rule also requires the nonbank SBSD to deliver collateral to the
counterparty to cover a variation margin requirement. The collateral
must be collected or delivered by the close of business on the next
business day following the day of the calculation, except that the
collateral can be collected or delivered by the close of business on
the second business day following the day of the calculation if the
counterparty is located in another country and more than four time
zones away. Further, collateral to meet a margin requirement must
consist of cash, securities, money market instruments, a major foreign
currency, the settlement currency of the non-cleared security-based
swap, or gold. The fair market value of collateral used to meet a
margin requirement must be reduced by the standardized haircuts in Rule
15c3-1 or 18a-1 (as applicable), or the nonbank SBSD can elect to apply
the standardized haircuts prescribed in the CFTC's margin rules. The
value of the collateral must meet or exceed the margin requirement
after applying the standardized haircuts. In addition, collateral being
used to meet a margin requirement must meet conditions specified in the
rule, including, for example, that it must have a ready market, be
readily transferable, and not consist of securities issued by the
nonbank SBSD or the counterparty.
    There are exceptions in Rule 18a-3 to the requirements to collect
initial and/or variation margin and to deliver variation margin. A
nonbank SBSD need not collect variation or initial margin from (or
deliver variation margin to) a counterparty that is a commercial end
user, the BIS, the European Stability Mechanism, or a multilateral
development bank identified in the rule. Similarly, a nonbank SBSD need
not collect variation or initial margin (or deliver variation margin)
with respect to a legacy account (i.e., an account holding security-
based swaps entered into prior to the compliance date of the rule).
Further, a nonbank SBSD need not collect initial margin from a
counterparty that is a financial market intermediary (i.e., an SBSD, a
swap dealer, a broker-dealer, an FCM, a bank, a foreign broker-dealer,
or a foreign bank) or an affiliate. A nonbank SBSD also need not hold
initial margin directly if the counterparty delivers the initial margin
to an independent third-party custodian. Further, a nonbank SBSD need
not collect initial margin from a counterparty that is a sovereign
entity if the nonbank SBSD has determined that the counterparty has
only a minimal amount of credit risk.
    The rule also has a threshold exception to the initial margin
requirement. Under this exception, a nonbank SBSD need not collect
initial margin to the extent that the initial margin amount when
aggregated with other security-based swap and swap exposures of the
nonbank SBSD and its affiliates to the counterparty and its affiliates
does not exceed $50 million. The rule also would permit an SBSD to
defer collecting initial margin from a counterparty for two months
after the month in which the counterparty does not qualify for the $50
million threshold exception for the first time. Finally, the rule has a
minimum transfer amount exception of $500,000. Under this exception, if
the combined amount of margin required to be collected from or
delivered to a counterparty is equal to or less than $500,000, the
nonbank SBSD need not collect or deliver the margin. If the initial and
variation margin requirements collectively or individually exceed
$500,000, collateral equal to the full amount of the margin requirement
must be collected or delivered.
ii. Nonbank MSBSPs
    Rule 18a-3 also prescribes margin requirements for nonbank MSBSPs
with respect to non-cleared security-based swaps. The rule requires a
nonbank MSBSP to calculate variation margin for the account of each
counterparty as of the close of each business day. The rule requires
the nonbank MSBSP to collect collateral from (or deliver collateral to)
a counterparty to cover a variation margin requirement. The collateral
must be collected or delivered by the close of business on the next
business day following the day of the calculation, except that the
collateral can be collected or delivered by the close of business on
the second business day following the day of the calculation if the
counterparty is located in another country and more than four time
zones away. Further, the variation margin must consist of cash,
securities, money market instruments, a major foreign currency, the
security of settlement of the non-cleared security-based swap, or gold.
The rule has an exception pursuant to which the nonbank MSBSP need not
collect variation margin if the counterparty is a commercial end user,
the BIS, the European Stability Mechanism, or one of the multilateral
development banks identified in the rule (there is no exception from
delivering variation margin to these types of counterparties). The rule
also has an exception pursuant to which the nonbank MSBSP need not
collect or deliver variation margin with respect to a legacy account.
There also is a $500,000 minimum transfer amount exception to the
collection and delivery requirements for nonbank MSBSPs.
b. Benefits and Costs of the Margin Rule
    As noted earlier, the market for non-cleared security-based swaps
as it exists today is fairly opaque. Market participants have little or
no knowledge about a dealer's uncollateralized exposure to a failed
counterparty and the dealer's ability to withstand potential losses
from such exposure. When a dealer fails, uncertainty about the
uncollateralized exposures of the surviving dealers to the failed
dealer and their safety and soundness may discourage some market
participants from entering transactions with the surviving dealers. In
turn, this uncertainty may hinder the efficient allocation of capital
in this market.
    In the market for non-cleared security-based swaps and in the
market for OTC derivatives generally, collateral is the means for
mitigating counterparty credit risk.\1146\ Counterparties can
collateralize a transaction by exchanging variation and initial margin.
The regular exchange of variation margin between counterparties limits
the potential for

one party in an OTC derivative transaction to build up a large
``current exposure'' to the other. The current exposure of counterparty
A to counterparty B is the amount that counterparty B would be
obligated to pay counterparty A if all the OTC derivatives contracts
between the two parties were terminated (i.e., it is the net amount of
the current receivable from counterparty B). A positive current
exposure of counterparty A to counterparty B implies a zero current
exposure of counterparty B to counterparty A. The exchange of variation
margin between two parties represents the settlement of profits and
losses resulting from some subset of derivative transactions between
those parties.
---------------------------------------------------------------------------

    \1146\ See section VI.A.5. of this release.
---------------------------------------------------------------------------

    In the absence of significant market frictions and under suitable
conditions, requiring the exchange of variation margin at a suitably
high frequency can limit the probability that a counterparty exposure
grows beyond a set level.\1147\ However, in many instances, this may
not be the case. In particular, market frictions in the CDS market,
especially in times of stress, can result in liquidity shortages that
prevent timely replacement of defaulted CDS positions. Delays in the
replacement of such defaulted positions or closing out the positions
can lead to losses for the non-defaulting party. Moreover, the
occurrence of unexpected credit-related events at the reference entity
can precipitate a counterparty default. For example, a seller of credit
protection may itself enter financial distress as a result of a
downgrade of the reference entity. Under such conditions, the exchange
of variation margin may--by itself--be inadequate at limiting
counterparty credit risk as unexpected credit events at the reference
entity can contribute to both the development of current exposures to a
counterparty and its default.
---------------------------------------------------------------------------

    \1147\ This follows under the assumption of, among other things,
frictionless markets in which a defaulted position can be
immediately replaced. In other words, if frequent exchange of
variation margin guarantees that a market participant has collected
enough margin to replace an outstanding position, markets for
collateral assets are sufficiently liquid to permit sales with no
price impact, and derivatives markets are sufficiently liquid to
permit replacement of an outstanding position with no price impact,
the market participant would be indifferent to whether her
counterparty defaults or not, because she would be able to replace
her outstanding position with the counterparty instantly without
taking on any market risk.
---------------------------------------------------------------------------

    Such concerns provide the economic rationale for requiring initial
margin. The exchange of initial margin is intended to limit ``potential
future exposures'' (i.e., losses resulting from the costs of replacing
transactions with a failed counterparty). The potential future exposure
of counterparty A to counterparty B is an estimate of the amount that
the current exposure of counterparty A to counterparty B could increase
before the position can be liquidated in the event of B's default.
Generally, both parties in an OTC derivatives transaction will have
positive potential future exposures to each other. By collecting
initial margin amounts to cover these potential future exposures,
market participants can reduce the costs associated with re-
establishing their positions with a failed counterparty.
    However, initial margin may be less effective in circumstances
where the prevalent market practice is to not exchange initial margin
and where there is no regulatory requirement that market participants
do so. If only a limited number of inter-dealer exposures are
collateralized with initial margins, and absent a capital regime for
dealers that is sufficiently conservative to cover losses from
positions that are not collateralized with initial margin, the failure
of one dealer may still trigger the sequential failure of other
dealers. Uncertainty about the uncollateralized exposures of the
surviving dealers to the failed dealer and their ability to withstand
losses from such exposures may erode the confidence of market
participants in the safety and soundness of the surviving dealers. In
times of stress, this uncertainty may cause the market to break down;
market participants may suddenly ``run'' on the surviving firms due to
uncertainty about their uncollateralized exposure to the failed dealer.
    Thus, if the exchange of initial margin is not an adopted market
practice or is not mandated by regulation, or if capital requirements
for dealers are not sufficiently conservative to cover losses from
positions that are not collateralized with initial margin, market
participants may face additional uncertainty about the safety and
soundness of the surviving dealers, which, in times of stress, may lead
to a market shutdown.
    A number of commenters argue that an approach based on the exchange
of initial margin may prevent an inappropriate build-up of systemic
risk within the financial system, which they argue would be more
consistent with the intent of the Dodd-Frank Act.\1148\ A commenter
argued that it would be inappropriate to allow a nonbank SBSD to have
non-cleared security-based swap exposure to another SBSD without any
requirement to collect initial margin or to take a capital charge to
recognize the risk in the non-cleared security-based swap and in the
counterparty.\1149\ Other commenters noted that the prudential
regulators have explicitly required bank SBSDs to collect initial
margin from other SBSDs and argued that the Commission should do so as
well, and that the Commission should maximize harmonization with rules
already implemented by the CFTC and the prudential regulators.\1150\
Finally, one commenter criticized the Commission for making these
proposals despite the fact that insufficient margin and capital were
two of the triggers of the financial crisis.\1151\
---------------------------------------------------------------------------

    \1148\ See Americans for Financial Reform Education Letter;
Barnard Letter; Citadel 11/19/2018 Letter; Council for Institutional
Investors Letter.
    \1149\ See OneChicago 2/19/2013 Letter.
    \1150\ See Americans for Financial Reform Education Fund Letter;
Citadel 11/19/2018 Letter; Rutkowski 11/20/2018 Letter.
    \1151\ See Better Markets 11/19/2018 Letter.
---------------------------------------------------------------------------

    The Commission agrees with the commenters that allowing dealers to
enter non-cleared security-based swap exposures without having to
collect initial margin or take a capital deduction for the credit risk
of exposure may increase risk in the financial system, which may
increase the risk of sequential dealer failure. This is why the final
capital rules impose a capital deduction or credit risk charge when a
nonbank SBSD elects not to collect initial margin under an exception in
the Commission's final margin rule or the margin rules of the CFTC. In
addition, there is a trade-off in terms of the benefits of requiring a
nonbank SBSD to collect initial margin from another financial market
intermediary: Namely, the liquidity of the delivering firm is reduced
by the amount of initial margin posted to the nonbank SBSD. Thus, while
the initial margin collected by the nonbank SBSD enhances the firm's
safety and soundness, the delivery of liquid capital by the other
financial market intermediary diminishes that firm's safety and
soundness because it cannot use the delivered liquid capital to protect
itself from losses or to meet liquidity demands.
    Moreover, the final margin rule is intended to enhance the safety
and soundness of nonbank SBSDs in the market for non-cleared security-
based swaps by reducing the uncertainty about uncollateralized
exposures to a failed counterparty. The requirement to exchange
variation margin is intended to reduce a nonbank SBSD's potential
losses stemming from uncollateralized market risk exposures, and the
risk of nonbank SBSD failure as a result of

these potential losses. Further, the requirement that nonbank SBSDs
collect initial margin from their counterparties that are not subject
to an exception to the margin rule is intended to reduce a nonbank
SBSD's potential losses stemming from uncollateralized credit risk
exposures, and therefore reduce the risk of nonbank SBSD failure as a
result of these potential losses.
    However, the final margin rule includes a number of exceptions to
the requirement that nonbank SBSDs collect variation and/or initial
margin from counterparties, such as the exception from the requirement
to collect variation or initial margin in transactions with commercial
end users and the exception from the requirement to collect initial
margin in transactions with other financial market intermediaries. The
Commission acknowledges, however, as noted by a number of commenters,
that financing additional collateral can also impose certain costs on
parties in non-cleared security-based swap transactions, as well as
potentially reduce liquidity in that market. In cases where an
exception to the final margin rule applies and nonbank SBSDs have
uncollateralized exposures from security-based swap transactions, the
final capital rules and amendments require nonbank SBSDs to take
capital deductions or credit risk charges against such uncollateralized
exposures. While this approach may leave nonbank SBSDs with residual
uncollateralized exposures, because capital deductions and credit risk
charges against uncollateralized credit exposures can be much lower
than the initial margin appropriate for such exposures, this approach
may benefit nonbank SBSDs and market participants more generally, by
supporting nonbank SBSD liquidity provision and promoting the liquidity
and therefore the safety and soundness of nonbank SBSDs to the extent
it relieves them from having to post initial margin to other nonbank
SBSDs.
    As described in the baseline, reliable information about
counterparty exposures in the non-cleared security-based swap market is
not currently publicly observable. Because market participants
generally lack reliable information about their counterparty's exposure
to a failed dealer or major participant, the failure of a dealer or
major participant in these markets can lead to questions about the
continued viability of other firms. It is generally not possible for
market participants to reliably estimate the size of other
participants' exposures to a failing firm. Uncertainty can cause market
participants to cease trading with participants suspected of having had
large exposures to the failed entity. This can precipitate the demise
of suspect firms. By constraining uncollateralized counterparty
exposures, margin requirements reduce the likelihood of sequential
dealer failure.
    To reduce these exposures, the final rule requires nonbank SBSDs to
collect variation margin on a daily basis from other financial market
intermediaries, including other SBSDs. Under the baseline, non-cleared
security-based swap transactions are typically covered by agreements
outlining the rights of the parties to make margin calls; however, such
agreements may not require the contracting parties to exchange
variation margin on a daily basis.\1152\ Therefore, dealers may defer
making margin calls during relatively benign market conditions, and
make margin demands only when conditions deteriorate or when doubts
about specific counterparties surface. This can destabilize markets and
lead to contagion. By requiring daily collection or delivery of
variation margin in inter-dealer trades, the final rule will limit the
buildup of uncollateralized inter-dealer exposures. This will help
ensure that, at all times, the immediate losses of a nonbank SBSD
resulting from its non-cleared security-based swap exposures to a
failing financial market intermediary are limited to a one-day change
in the value of its positions with the failing firm.\1153\
---------------------------------------------------------------------------

    \1152\ See, e.g., ISDA, User's Guide to the ISDA 1994 Credit
Support Annex, 1994.
    \1153\ Although the immediate losses are limited to a one-day
net change in the value of the positions, eventual losses may be
more significant due to the surviving dealer's inability to replace
defaulted positions in a timely manner.
---------------------------------------------------------------------------

    While the inter-dealer exchange of variation margin may reduce the
immediate losses from exposure to a failed dealer, this form of
collateralization is usually not enough to isolate a dealer against
potential losses from re-establishing or closing out the positions with
a failed dealer. As noted earlier, such losses are usually covered by
initial margin. The final margin rule does not require nonbank SBSDs to
collect initial margin from other financial market intermediaries,
including other SBSDs. While the rule does not preclude nonbank SBSDs
from collecting initial margin from other financial market
intermediaries, in general, the Commission does not expect most inter-
dealer transactions to be collateralized with initial margin. However,
as discussed above in section II.A.2.b.ii. of this release, the final
capital rules will require nonbank SBSDs to take a capital deduction or
credit risk charge for these inter-dealer uncollateralized exposures.
In addition, the final capital rules require dealers to increase their
minimum net capital by a factor proportional to the initial margin that
would cover such exposures (when the margin factor amount equals or
exceeds its fixed-dollar requirement). The additional capital that a
surviving nonbank SBSD will have to allocate to support inter-dealer
transactions that are not collateralized with initial margin will act
as a buffer against potential losses from replacing or closing out the
positions with a failed firm, and reduce the surviving nonbank SBSD's
risk of default. To this end, while surviving nonbank SBSDs may still
incur losses from replacing or closing out positions with defaulting
counterparties that were not collateralized with initial margin, the
final capital rules are designed to reduce the likelihood that such
losses will lead to their failure. Thus, the final capital rules
complement the margin requirements to limit the risk of sequential
dealer failure in this market. By reducing the uncertainty about
uncollateralized exposures to a failed dealer, and by reducing the risk
of sequential dealer failure, the margin requirements together with the
capital requirements should enhance the safety and soundness of the
dealers in times of stress. Further, as discussed above, the exception
from collecting initial margin from other financial market
intermediaries involves a trade-off between the benefits that initial
margin provides the collecting firm and the costs (including the loss
of liquid capital) that such a requirement imposes on the delivering
firm.
    While the scale of the above benefits is difficult to quantify, it
can be broadly characterized as a function of the size of the affected
transactions and the degree to which a dealer's private incentives in
those transactions may create uncollateralized exposures that reduce
the stability of the market for security-based swaps. In the non-
cleared security-based swap market, inter-dealer transactions represent
a significant portion of transactions.\1154\ Industry surveys indicate
that on average, these transactions are partly collateralized (i.e.,
margin for current or potential future exposure is not always
collected).\1155\ This collateralization practice, while limited, is
consistent with major dealer defaults being rare and resulting from
certain aggregate shocks. Dealer failures resulting from aggregate
shocks could impose significant negative externalities on the financial
system. If dealers were to fully

margin their inter-dealer transactions, including collecting initial
margin from other dealers, the negative externalities associated with a
dealer failure would be significantly reduced, resulting in
improvements to financial stability. However, fully-margining inter-
dealer transactions would impose costs on dealers because delivering
margin collateral may reduce a dealer's available liquid capital and,
therefore, the extent to which the dealer can provide liquidity to the
market. Improvements to financial stability, on one hand, and higher
costs associated with liquidity provision on the other hand could have
offsetting effects on the overall economy. While dealers may pass on
some of these costs to other security-based swap market participants
through increased spreads or reduced liquidity provision, these costs
generally may reduce a dealer's incentives to fully-margin its
transactions with other dealers. Thus, private incentives alone may be
insufficient to result in margin arrangements that improve the
stability of the market for security-based swaps and the benefit of
regulations can be significant.
---------------------------------------------------------------------------

    \1154\ See section VI.A.1.d of this release.
    \1155\ See section VI.A.2.d of this release.
---------------------------------------------------------------------------

    The requirement to collect variation and initial margin from non-
excepted counterparties is likely to generate qualitatively similar but
quantitatively smaller benefits. The requirement should significantly
limit the extent to which a nonbank SBSD can build a large
uncollateralized exposure to a non-excepted counterparty, and
therefore, significantly reduce the likelihood of the SBSD's failure
due to potential losses from such exposure. However, although defaults
among certain non-excepted counterparties may be more common, their
defaults tend to be idiosyncratic and the negative externalities of
these failures are less significant compared to those that result from
a financial market intermediary's failure.
    Margin requirements--initial margin requirements in particular--can
also constrain risk-taking. As noted above, currently, nonbank dealers
may collateralize some portion of the exposures created by their
positions.\1156\ In general, depending on the margin arrangements with
the counterparties, a dealer may maintain a buffer of pledgeable assets
to satisfy expected margin calls from the counterparties over a given
period. In the absence of regulatory margin requirements, privately-
negotiated margin requirements may be limited, resulting in small
expected margin calls from the counterparties.\1157\ This may likely
result in a buffer of pledgeable assets that is small relative to the
size of the exposures created by the dealer's derivatives book.
Conversely, regulatory margin requirements, by imposing more extensive
margin requirements, increase expected margin calls; the increased
expected margin calls necessitate a larger buffer of pledgeable assets
to support the same derivatives book. As pledgeable collateral must be
funded, margin requirements link the expansion of a firm's derivatives
book, and therefore the amount of risk it takes, more closely to its
ability to obtain funding. In particular, regulatory margin
requirements may reduce a dealer's ability to create uncollateralized
exposures, and, therefore, limit its ability to take on risk.
---------------------------------------------------------------------------

    \1156\ See section VI.A.2.d. of this release.
    \1157\ Although private incentives may be sufficient to require
margin under certain circumstances, private incentives alone need
not result in margin exchange policies that are optimal from a
social perspective. In general, privately negotiated margin policies
do not take account of the systemic risk externalities of
uncollateralized counterparty exposures and are therefore expected
to result in margin policies that require too little margin. See,
e.g., Viral V. Acharya, Aaditya M. Iyer, and Rangarajan K. Sundaram,
Risk-Sharing and the Creation of Systemic Risk (New York University
Stern School of Business, Working Paper (2015), available at http://
pages.stern.nyu.edu/~sternfin/vacharya/public_html/pdfs/2015-01-
23_SystemicRiskCreation.pdf.
---------------------------------------------------------------------------

    The margin rule should further contribute to financial stability by
limiting effective leverage in the non-cleared security-based swap
market. By requiring nonbank SBSDs to exchange variation margin and to
collect initial margin from non-commercial counterparties when the
amount exceeds the initial margin threshold, the rule increases the
collateral required to support non-cleared security-based swap
transactions, limiting the effective leverage of such transactions. One
commenter noted that the economic analysis should consider the impact
of the final rules on market participants' ability to build up leverage
through non-cleared security-based swaps.\1158\ Absent the need to post
margin, financial entities such as dealers, hedge funds, insurance
companies, and banks are relatively unconstrained in the size of their
security-based swap exposures.\1159\ Failure of a large financial
entity or of a group of smaller financial entities with significant
derivatives exposures could lead to large dealer losses, dealer
failures, or significant market dislocations. The rule limits the
potential impact of financial entities' defaults by: (1) Reducing the
probability of their occurrence; (2) reducing their scale; and (3)
reducing losses to nonbank SBSDs from transaction with the defaulted
counterparties. The first two effects follow from reductions in such
firms' leverage. The third effect follows from a nonbank SBSD's ability
to collateralize its exposures from the positons with a financial
entity counterparty, prior to the default of the counterparty.
---------------------------------------------------------------------------

    \1158\ See Better Markets 11/19/2018 Letter.
    \1159\ For example, hedge funds are not generally subject to
regulatory capital requirements. Therefore, in the absence of a
requirement to post initial margin, the scale of their derivatives
exposures is not directly constrained by available capital.
---------------------------------------------------------------------------

    As noted above, under the final rule, a nonbank SBSD can defer
collecting initial margin for up to two months following the month in
which a counterparty no longer qualifies for the fixed-dollar $50
million threshold exception for the first time. This one-time deferral
is designed to provide the counterparty with sufficient time to take
the steps necessary to begin posting initial margin pursuant to the
final rule. Thus, the deferral should support the benefits of the
initial margin requirement discussed above by ensuring that
counterparties have enough time to execute agreements, establish
processes for exchanging initial margin, and take other steps to comply
with the initial margin requirement. A nonbank SBSD that chooses to use
the one-time deferral will continue to take a capital deduction in lieu
of margin or credit risk charge. As noted above, the requirement to
take this capital deduction or charge may impose costs on SBSDs and may
create benefits for market participants.\1160\ These costs could be
limited to the extent that the nonbank SBSD and its counterparty have
an existing agreement and processes that can be readily modified to
incorporate the $50 million threshold and thus help shorten the
deferral period.
---------------------------------------------------------------------------

    \1160\ See section VI.B.1.b.iii. of this release.
---------------------------------------------------------------------------

    Regulatory margin requirements on non-cleared transactions make
them relatively less attractive vis-[agrave]-vis similar cleared
transactions, and thereby encourage the use of cleared transactions.
Cleared contracts significantly reduce the contagion risk inherent in
bilateral contracts. When an OTC derivatives contract between two
counterparties is submitted for clearing, it is replaced by two new
contracts: Separate contracts between the CCP and each of the two
original counterparties. At that point, the original counterparties no
longer have credit risk exposures to each other. Instead, both are left
with a

credit risk exposure to the CCP.\1161\ Structured and operated
appropriately, CCPs can improve the management of counterparty risk,
reduce uncertainty, and provide additional benefits such as
multilateral netting of trades.\1162\ However, prudent risk management
at CCPs will generally take the form of requirements on participants to
frequently post initial and variation margin and requirements to
contribute to a general guarantee fund.\1163\ These measures impose
costs on counterparties to cleared transactions. These costs can be
avoided through non-cleared transactions if regulatory margin
requirements are absent or the costs of regulatory margin requirements
are lower.
---------------------------------------------------------------------------

    \1161\ See Stephen Cecchetti, Jacob Gyntelberg, and Mark
Hollanders, Central Counterparties for Over-the-counter Derivatives,
BIS Quarterly Review (Sept. 2009).
    \1162\ See Daniel Heller and Nicholas Vause, Expansion of
Central Clearing, BIS Quarterly Review (June 2011) (arguing
expansion of central clearing within or across segments of the
derivatives market could economize both on margin and non-margin
resources). See also Process for Submissions of Security-Based
Swaps, 77 FR at 41602.
    \1163\ See Standards for Covered Clearing Agencies, 81 FR 70786.
---------------------------------------------------------------------------

    By imposing regulatory margin requirements on nonbank SBSDs for
non-cleared security-based swap transactions that, in large part,
mirror certain margin requirements imposed by a clearinghouse on its
participants, namely to collect variation and initial margin, the rule
decreases the cost advantage of non-cleared security-based swap
transactions relative to central clearing. For parties that derive
sufficiently large private benefits from their collateral and who
generally prefer to transact with more limited use of margin, the
rule's requirements may, at the margin, increase the costs of non-
cleared security-based swap transactions relative to cleared security-
based swap transactions, encouraging these parties to clear their
security-based swap transactions. Insofar as the final margin rule
causes previously non-cleared transactions to be cleared, an important
net benefit of the rule is promoting central clearing.
    The final margin rule should also improve the information set for
regulatory oversight of nonbank SBSDs and MSBSPs. The rule requires
nonbank SBSDs and MSBSPs to perform margin calculations as of the close
of each business day with respect to each account carried by the firm
for a counterparty to a non-cleared security-based swap transaction.
Even if the counterparty is not required to deliver collateral, the
calculations will provide examiners with enhanced information about
non-cleared security-based swaps, allowing the Commission and other
appropriate regulators to gain ``snapshot'' information at a point in
time for examination purposes.\1164\
---------------------------------------------------------------------------

    \1164\ See Recordkeeping and Reporting Requirements for
Security-Based Swap Dealers, Major Security-Based Swap Participants,
and Broker-Dealers; Capital Rule for Certain Security-Based Swap
Dealers, 79 FR at 25206.
---------------------------------------------------------------------------

    The principal costs resulting from the final margin rule arise from
the requirement on a nonbank SBSD to collect initial margin from non-
excepted counterparties to which the SBSD has a significant exposure
(i.e., an exposure that is above the $50 million initial margin
threshold under the rule). As noted above, currently, nonbank dealers
do not always collect initial margin from their counterparties on non-
cleared security-based swap transactions.\1165\ Thus, by requiring the
collection of initial margin, absent an exception, the rule has the
effect of increasing the demand for a market participant's unpledged
collateral, and thereby raises the cost of engaging in non-cleared
security-based swap transactions. This can reduce the efficiency of
risk sharing through the non-cleared security-based swap market. The
increased cost is also likely to lead to a reduction in the quantity of
transactions. Reductions in the quantity of transactions can have
negative implications for market liquidity, price discovery and on
dealer profitability.\1166\ Similarly, the additional margin required
under the rule can reduce the availability of collateral for other
transactions and limit the effective leverage of participants in the
non-cleared security-based swap market. Finally, by reducing effective
leverage, the requirements may reduce the profitability (e.g., the
expected returns) of investment strategies that currently take
advantage of the leverage created by uncollateralized exposures in this
market.
---------------------------------------------------------------------------

    \1165\ See section VI.A.2.d. of this release.
    \1166\ Concerns with these costs were highlighted by several
commenters. One commenter believed the proposed initial margin
requirement would severely impact liquidity in the non-cleared
security-based swap market and make non-cleared security-based swaps
significantly more expensive because of the costs of initial margin.
This commenter stated that these costs include not only the costs of
the actual initial margin but also the operational burdens of
complex daily posting and reconciliation of initial margin. This
commenter stated that the OTC derivatives market is critical to the
functioning of the overall economy and provided examples of non-
clearable security-based swaps that the commenter believed are
critical to key sectors of the global economy that would be harmed
by the imposition of initial margin requirements. See ISDA 1/23/13
Letter.
---------------------------------------------------------------------------

    Several commenters argued that initial margin is unnecessary, and
potentially counterproductive.\1167\ One commenter believed that in
lieu of initial margin, systemic risk could be effectively mitigated by
daily variation margining with zero thresholds, implementation of
appropriate capital requirements, and mandatory clearing of liquid
standardized security-based swaps.\1168\ The Commission believes that
while all of the aforementioned mechanisms can play an important role
in maintaining financial stability, they do not fully address it. In
particular, as noted earlier, due to various market frictions,
variation margin alone does not offer adequate protection against
unexpected counterparty defaults in times of stress when such defaults
are precipitated by the counterparty's losses in the same positions,
and liquidity is scarce.\1169\
---------------------------------------------------------------------------

    \1167\ A commenter asserted that ``VM, with daily collection
(subject to limited exceptions for illiquid collateral) and zero
thresholds, effectively protects against accumulated and unrealized
losses in over-the-counter (``OTC'') derivatives positions.'' See
ISDA 1/23/2013 Letter. Another commenter stated that ``[r]igorous
variation margin requirements have the potential to significantly
reduce systemic risk by eliminating the accumulation of
uncollateralized current exposures while avoiding the potentially
destabilizing and pro-cyclical effects of initial margin . . .'' See
SIFMA 2/23/2013 Letter.
    \1168\ See ISDA 1/23/13 Letter.
    \1169\ As discussed earlier in this section, liquidity shortages
during times of market stress can prevent timely replacement of
defaulted CDS positions, and delays in replacement can lead to
losses for the non-defaulting counterparty. Moreover, the occurrence
of unexpected credit-related events at the reference entity can
precipitate a counterparty default. Under such conditions, the
exchange of variation margin may--by itself--be inadequate at
limiting counterparty credit risk as unexpected credit events at the
reference entity can contribute to both the development of current
exposures to a counterparty and its default.
---------------------------------------------------------------------------

    Another commenter argued that the Commission should not accept
claims that the full margining of security-based swap transactions will
make it difficult to use them for hedging purposes, or will shrink the
size of the global security based swap market.\1170\ This commenter
also argued that the use of uncollateralized or under-collateralized
security-based swaps does not reduce risk, it increases it, even if
users claim the security-based swaps are ``hedges.'' This commenter
also believed that to the degree the unregulated security-based swap
market in place prior to the Dodd-Frank Act was overleveraged, it was
also too large because full social costs of the market were not
incorporated into user decisions.
---------------------------------------------------------------------------

    \1170\ See Americans for Financial Reform Letter.
---------------------------------------------------------------------------

    Several comments raised concerns about certain technical aspects of
the proposed initial margin calculation. Some commenters asked the

Commission to revise the standardized haircuts (which would be used to
calculate initial margin if the firm was not authorized to use a model)
to better reflect the historical market volatility and losses given
default associated with CDS positions. A few commenters argued that
methods (e.g., using a model) other than the Appendix A methodology
should be permitted to calculate initial margin for equity security-
based swaps.\1171\ One commenter stated that the Appendix A methodology
is inadequate and inefficient for a proper initial margin calculation
and does not sufficiently recognize portfolio margining.\1172\ This
commenter also stated that the Appendix A methodology does not
incorporate critical factors such as volatility, and, as a result,
initial margin on equity security-based swaps would likely be
insufficient in times of stressed markets (in contrast to a model-based
approach). Another commenter raised concerns that applying the Appendix
A methodology would result in initial margin requirements that are
substantially less sensitive to the economic risks of a security-based
swap portfolio than a model-based approach, and suggested the
Commission permit a nonbank SBSD to use either the Appendix A
methodology or an internal model to compute the initial margin amount
for equity security-based swaps.\1173\ Another commenter requested that
the Commission permit the use of models for both debt and equity
security-based swaps.\1174\
---------------------------------------------------------------------------

    \1171\ See ISDA 1/23/2013 Letter; SIFMA 2/22/2013 Letter.
    \1172\ See ISDA 1/23/2013 Letter.
    \1173\ See SIFMA 2/22/2013 Letter.
    \1174\ See SIFMA AMG 2/22/2013 Letter.
---------------------------------------------------------------------------

    In response to commenters' concerns regarding the use of the
Appendix A methodology to compute initial margin for equity security-
based swaps, the Commission modified the final margin rule to permit a
stand-alone SBSD to use a model to calculate initial margin for non-
cleared equity-based security-based swaps, provided the account does
not hold equity security positions other than equity security-based
swaps and equity swaps.\1175\ Permitting the model-based approach under
these limited circumstances strikes an appropriate balance in terms of
addressing commenters' concerns and maintaining regulatory parity
between the cash equity and the equity security-based swap markets.
---------------------------------------------------------------------------

    \1175\ See paragraph (d)(2)(ii) of Rule 18a-3, as adopted.
---------------------------------------------------------------------------

    Broker-dealer SBSDs will not be permitted to use a model to compute
initial margin for equity security-based swaps. The Commission has also
considered the objections of commenters to requiring the use of the
Appendix A methodology to calculate the initial margin amount for non-
cleared equity security-based swaps (rather than permitting a
model).\1176\ While the Commission agrees that the Appendix A
methodology has certain limitations, particularly with respect to
recognizing offsets arising from correlated positions, it notes that
the use of models in this context is unlikely to address these
limitations, and moreover, can introduce additional problems. Due to
the volatility of equity returns, correlations in these returns are
difficult to estimate without significant modeling assumptions. To the
extent that parties in security-based swap transactions wish to
minimize the total amount of initial margin devoted to such
transactions, incentives to adopt optimistic assumptions can lead to
models that overestimate negative correlations, underestimate positive
correlations, and lead to inadequate margin levels. These are some of
the reasons why the final capital and margin rules impose qualitative
and quantitative requirements on the use of models and why the final
capital rules impose higher capital requirements for (and increased
monitoring of) nonbank SBSDs that use models.
---------------------------------------------------------------------------

    \1176\ Nonbank SBSDs may also use the non-portfolio based
standardized approach to calculate the haircut/margin for equity
security-based swaps. In most cases, the deduction is the notional
amount of the equity security-based swap multiplied by the deduction
(haircut) that would apply to the underlying instrument referenced
by the equity security-based swap.
---------------------------------------------------------------------------

    In addition, the Commission recognizes the concerns commenters
raised about the historical accuracy of the standardized haircuts. As
discussed sections VI.A.7. and VI.B.1.iv. of this release, the
Commission has provided an analysis that compares the standardized
haircuts to the actual losses on credit default swap positions observed
from historical data. In response to the commenters, the Commission
notes that the standardized haircut grids for non-cleared CDS in the
final rules are based on existing Rule 15c3-1 and, in part, on FINRA
Rule 4240. The Commission further notes that in the analysis for CDS
positions referencing single-name obligors, the maximum loss on a
position scaled by its corresponding haircut--the so-called loss
coverage ratio--exceeds 1 in all sample years. However, this is not
always the case in the analysis for CDS positions referencing an index.
These results suggest that the standardized haircuts in the final rules
are generally not set at the most conservative level, as losses on some
positions exceed the corresponding standardized haircuts. In general,
haircuts are intended to strike a balance between being sufficiently
conservative to cover losses in most cases, including in stressed
market conditions, and being sufficiently nimble to allow dealers to
operate efficiently in all market conditions. Based on the results of
the analysis, as described above, the Commission believes that the
standardized haircuts in the final rules take into account this
tradeoff.\1177\
---------------------------------------------------------------------------

    \1177\ As discussed above in section VI.B.1. of this release, a
standardized haircut grid calibrated to historical volatilities and
recoveries will generally not be accurate going forward, due to
variation in volatilities and recoveries over time.
---------------------------------------------------------------------------

    Several commenters argued against the adoption of initial margin
requirements for certain types of counterparties. One commenter
believed that substantial initial margin requirements could impose
significantly greater costs on life insurers and suggested that dealers
and major participants in the security-based swap market have the
flexibility to determine whether and to what extent life insurers
should be required to pledge initial margin to financial firms.\1178\
One commenter argued that, as proposed, the initial margin requirements
will ``severely challenge the resiliency of the financial system and
will severely curtail the use of non-cleared swaps for hedging.''
\1179\ Another commenter believed that the initial margin requirement
is a new and costly requirement for most financial end users, while the
variation margin requirement may undermine the ability of an end-user
to negotiate the best terms for a security-based swap.\1180\ This
commenter stated that a survey found that a 3% initial margin
requirement on the S&P 500 companies could be expected to reduce
capital spending by $5.1 billion to $6.7 billion, and that United
States would lose 100,000 to 130,000 jobs from both direct and indirect
effects. One commenter urged the Commission to except counterparties
with material swaps exposure of less than $8 billion from the margin
requirements to be consistent with the margin rules adopted by the
prudential regulators, the CFTC, and non-U.S. regulators.\1181\ Other
commenters opposed margin requirements for certain types of

transactions. One commenter opposed margin requirements for inter-
affiliate transactions and stated that this requirement would cause
artificial and inefficient capital allocation for end-users, increase
consumer costs, and undermine efficiencies that end-users currently
realize through centralized treasury units.\1182\ Another commenter
argued that nonprofit sovereign institutions should be granted an
exception to the posting of margin requirement because these
institutions do not trade for profit-seeking reasons and they benefit
from explicit or implicit guarantees from their sovereign
governments.\1183\ In addition, the commenter argued that the
Commission's requirement to collect margin from this type of
institution is not consistent with the margin requirements adopted by
the CFTC and the prudential regulators.\1184\
---------------------------------------------------------------------------

    \1178\ See American Council of Life Insurers 2/22/2013 Letter.
    \1179\ See ISDA 1/23/13 Letter.
    \1180\ See Coalition for Derivatives End-Users 2/22/2013 Letter.
    \1181\ See ICI 11/19/2018 Letter.
    \1182\ See Coalition for Derivatives End-Users 2/22/2013 Letter.
    \1183\ See KFW Bankengruppe Letter.
    \1184\ See CFTC Margin Final Release, 81 FR at 696 (providing
that the term ``financial end user'' (meaning an entity from whom
margin must be collected) does not generally include any
counterparty that is: A sovereign entity, a multilateral development
bank, the BIS, a captive finance company that qualifies for the
exemption from clearing under Section 2(h)(7)(C)(iii) of the
Commodity Exchange Act and implementing regulations, or a person
that qualifies for the affiliate exemption from clearing pursuant to
Section 2(h)(7)(D) of the Commodity Exchange Act or Section 3C(g)(4)
of the Securities Exchange Act and implementing regulations). See
also Prudential Regulator Margin and Capital Final Release, 80 FR at
74855.
---------------------------------------------------------------------------

    Several commenters provided estimates of the additional collateral
that would be required to satisfy the proposed rules.\1185\ One
commenter estimated that the potential impact of initial margin
requirements assuming the use of models and a zero threshold, would be
$1.7 trillion for universal two-way margin and $1.2 trillion for dealer
only collection, as proposed by the Commission.\1186\ This commenter
also estimated that under proposed Alternative A (nonbank SBSDs
exchange only variation margin) the total initial margin requirements
would drop to $500 billion, assuming full use of models.
---------------------------------------------------------------------------

    \1185\ See ISDA 1/23/2013 Letter; SIFMA 3/12/2014 Letter; SIFMA
2/22/2013 Letter.
    \1186\ See ISDA 1/23/13 Letter.
---------------------------------------------------------------------------

    This commenter stated that its member firms have estimated that the
liquidity demands associated with mandatory initial margin requirements
are likely to range between approximately $1.1 trillion (if dealers are
not required to collect initial margin from each other) to $3 trillion
(if dealers must collect initial margin from each other) to $4.1
trillion (if dealers must post initial margin to non-dealers).\1187\
Moreover, in stressed conditions, the commenter estimated that initial
margin amounts collected by firms that use internal models could
increase by more than 400%. A final commenter requested that
multilateral development banks be exempt from the Commission's
regulatory margin requirements, noting specifically that the
International Bank for Reconstruction ``could face a potential posting
requirement over the medium term of $20-30 billion under plausible
scenarios,'' with a ``possible cost of carry in the range of $40-90
million per year,'' which could be problematic, given that none of the
multilateral development banks have access to a liquidity facility of
last resort.\1188\
---------------------------------------------------------------------------

    \1187\ See SIFMA 2/22/2013 Letter.
    \1188\ See World Bank Letter. In response to these comments, in
the final rule, the Commission is adopting additional exceptions
from the margin rule for the BIS, European Stability Mechanism,
multilateral development banks, sovereign entities that have minimal
credit risk, and affiliates. See Rule 18a-3, as adopted. These
modifications to the final rule should alleviate commenters'
concerns to some extent regarding the overall impact of the rule.
---------------------------------------------------------------------------

    Estimates of the aggregate impact of the Commission's margin rule
are subject to two major uncertainties. First, as discussed below in
section VI.D.2. of this release, the aggregate impact of the
Commission's margin rule will largely depend on the SBSD organizational
structure chosen by the large banking groups that dominate security-
based swap trading activity. To the extent that security-based swap
trades continue to be conducted primarily through entities subject to
the prudential regulators' supervision (i.e., bank SBSDs), relatively
few transactions will be subject to the Commission's margin rules. To
the same extent, the additional collateral required, and the costs
associated with this additional collateral will, in the aggregate, be
minimal. If however, security-based swap trading migrates to nonbank
affiliates (i.e., nonbank SBSDs), the aggregate impact of the rule
could be considerably larger to the extent it imposes requirements that
differ from the requirements of the prudential regulators' margin
rules. Second, as discussed below in section VI.B.4. of this release,
the aggregate amount of collateral required to satisfy the final margin
rule will also depend on counterparties' choices with respect to
segregation. The Exchange Act provides counterparties of nonbank SBSDs
a choice of several alternatives to the segregation of their initial
margin, including the option to waive segregation (though only
affiliated counterparties can waive segregation in the case of a stand-
alone broker-dealer or broker-dealer SBSD). As discussed below in
section VI.B.4. of this release, when segregation is waived, the
private costs associated with the requirement to collect initial margin
can be significantly reduced as the SBSD collecting said initial margin
would obtain the benefit of using the collected collateral in its
operations.
    One commenter \1189\ suggested that the Commission estimate the
additional collateral required to satisfy the margin requirements.
However, as noted above, the collateral required to satisfy the
Commission's rule will depend in large part on the business decisions
of entities currently operating in the security-based swap market. To
estimate the eventual collateral demand resulting from the Commission's
new margin rule, the Commission would have to make significant
assumptions about individual firms' ultimate organizational structure.
In particular, the Commission would have to make assumptions about how
much of U.S. security-based swap dealing activity would eventually be
housed in nonbank SBSDs, rather than in bank SBSDs not subject to the
Commission's margin rule; such assumptions would be highly speculative.
Further, estimates of collateral demand resulting from the Commission's
margin rule would also be significantly affected by market
participant's contracting arrangements with respect to segregation of
collateral. Because the Commission's new rules do not prevent re-
hypothecation of collateral and permit the waiving of segregation,
counterparties' choices in these areas will ultimately play a major
role in determining the additional collateral demand; the Commission
does not have information on the private contracting arrangements of
counterparties or the preferences for particular segregation regimes
that would allow for meaningful estimates of the use of segregation and
re-hypothecation.
---------------------------------------------------------------------------

    \1189\ See ISDA 1/23/13 Letter.
---------------------------------------------------------------------------

    Finally, to obtain estimates for the entire security-based swap
market, the Commission would have to make significant assumptions about
unobserved security-based swap activity (i.e., those transactions that
are not single-name CDS). Although the Commission has provided
estimates of the scale of such activity, such broad estimates are
generally inadequate for quantifying the collateral required to support
this activity under the final margin rule: To do so with some degree of
accuracy would require detail on the non-CDS positions at the
counterparty

level of entities that will register as nonbank SBSDs.\1190\ Because
the Commission would have to make several layers of assumptions that
cannot be rigorously justified with available data, the Commission does
not believe that attempts to quantify the cost of the final margin rule
would provide reliable estimates of the true collateral demand
resulting from it.
---------------------------------------------------------------------------

    \1190\ In this and other Title VII releases, the Commission has
stated its belief that single-name CDS data are sufficiently
representative of the security-based swap market to directly inform
the analysis of the current state of the market. Moreover, in prior
releases, the Commission has used its estimate that single-name CDS
represent 82% of the total security-based swap market to make
inferences about unobserved security-based swap activity. See Trade
Acknowledgment and Verification of Security-Based Swap Transactions,
81 FR 39808. In those cases, a specific regulatory requirement--as
well as the cost of the requirement--did not depend on the nature of
the particular security-based swap. For example, security-based swap
entities must provide trade acknowledgments to their counterparties
for all security-based swaps. The requirement does not vary with the
type of security-based swap. In contrast, margin requirements vary
across security-based swaps. For example, initial margin
requirements for non-cleared CDS that reference a narrow-based
security index vary with the maturity and credit spread of the
contract, as well as whether the dealer is approved to use models.
As another example, broker-dealer SBSDs are not permitted to use
models to calculate initial margin requirements for equity security-
based swaps. Thus, in contrast to previous releases, any estimate of
collateral costs will depend greatly on the composition of
unobserved activity.
---------------------------------------------------------------------------

    The final rule's requirements for the collection and posting of
variation margin by nonbank SBSDs and MSBSPs may also lead to
additional collateral funding costs for participants in the non-cleared
security-based swap market. These costs, however, are likely to be of a
smaller magnitude. Unlike segregated initial margin, variation margin
does not ``consume'' collateral: Variation margin posted by one party
can be used to satisfy margin requirements of the party collecting it.
Moreover, the amount of required variation margin reflects the
receiving party's mark-to-market gain (receivable) and delivering
party's mark-to-market loss (payable) on the transaction. The exchange
of variation margin settles the daily mark-to-market change in the
value of the position (i.e., it settles the receivable and payable).
However, to the extent that collateral other than U.S. dollars or
short-term U.S. government securities is used to meet a variation
margin requirement, the final margin rule requires haircuts to be
applied to the collateral. These haircuts could impose an incremental
need to hold additional collateral to meet variation margin
requirements. The Commission expects that cash and U.S. government
securities (which require no or minimal haircuts) will predominantly be
used to meet variation margin requirements and, therefore, the
aggregate additional collateral required as a result of the haircuts
should not be substantial.\1191\ Thus, imposing variation margin
requirements on security-based swap transactions where variation margin
has not previously been collected may not significantly increase the
overall amount of collateral required to support those transactions.
However, the knowledge that variation margin must be posted on a daily
basis can be expected to result in affected parties maintaining larger
buffer stocks of unpledged collateral to ensure that margin calls can
be satisfied.\1192\ While this can indirectly increase the amount of
collateral that is required to support such transactions and in so
doing increase their cost, this effect is likely to be limited as the
regular exchange of variation margin is a relatively common market
practice under the baseline.
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    \1191\ See ISDA Margin Survey 2012 at 8, Table 2.1.
    \1192\ See Central Clearing and Collateral Demand, Journal of
Financial Economics 116, no. 2, 237-256.
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    The impact of the Commission's margin rules on the non-cleared
security-based swaps is expected to be qualitatively similar to the
impact of the prudential regulators' margin rules for non-cleared
security-based swaps and swaps and the CFTC's margin rules on non-
cleared swaps. Quantitatively however, the scale of the impact will be
much less significant. As of the end of 2017, non-cleared security-
based swap positions represented less than 2% of the outstanding non-
cleared swap positions.\1193\ Nevertheless, if the Commission's final
margin rule makes trading in the security-based swap market
prohibitively expensive, the cost of this lost investment opportunity
to market participants that currently are very active in the security-
based swap market would be very significant.
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    \1193\ This figure is based on global notional amounts of swaps
outstanding. See BIS, OTC derivatives outstanding, Tables D5.1 and
D5.2.
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    The additional collateral funding costs resulting from the
Commission's final margin rule are mitigated by the broad range of
eligible collateral permitted by the rule, which may consist of cash,
securities, money market instruments, a major foreign currency, the
settlement currency of the non-cleared security-based swap, or gold.
Because of the relation between security-based swaps and other
securities positions, permitting various types of securities to count
as collateral may be more practical for margin arrangements involving
security-based swaps than for other types of derivatives. This
flexibility to accept a broad range of securities, along with
consistency with existing margin requirements,\1194\ takes advantage of
efficiencies that result from correlations between securities and
security-based swaps.\1195\ One commenter supported the use of a broad
range of collateral noting that it is important that the Commission
recognize that the proposed rules could impose significantly greater
costs on life insurers due to the potential narrowing of the securities
categories eligible to be used as margin.\1196\ Another commenter
supported the Commission's broad approach to permissible collateral,
arguing that a narrower approach could increase costs and liquidity
pressures on market participants by increasing demand for and placing
undue pressure on the supply of such collateral.\1197\ However, another
commenter believed that the collateral requirements under the proposal
would nonetheless significantly increase the cost of using non-cleared
security-based swaps, penalizing end users, including the pension
plans, mutual funds and other vehicles for which commenter serves as a
fiduciary.\1198\
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    \1194\ See 12 CFR 220.1 et seq. (Regulation T); FINRA Rule 4210
(SRO margin rule); CBOE Rule 12.3 (SRO margin rule).
    \1195\ An ISDA margin survey states, with regard to the types of
assets used as collateral, that the use of cash and government
securities as collateral remained predominant, constituting 90.4% of
collateral received and 96.8% of collateral delivered. See ISDA
Margin Survey 2012 at 8, Table 2.1.
    \1196\ See American Council of Life Insurers 2/22/2013 Letter
(arguing that ``[n]arrow limits on the types of permitted collateral
could greatly impair liquidity in the derivatives marketplace and
thwart constructive risk management'').
    \1197\ See SIFMA 2/22/2014 Letter.
    \1198\ See PIMCO Letter (suggesting two modifications to the
proposed margin rule to mitigate costs: (1) Model-based margin
calculations should be based on a shorter liquidation period; and
(2) the required haircuts on collateral should be adjusted to expand
the range of collateral that can effectively be used).
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    The final margin rule is generally modeled on broker-dealer margin
rules in terms of establishing an ``account equity'' requirement;
requiring nonbank SBSDs to collect collateral to meet the requirement;
and allowing a range of securities for which there is a ready market to
be used as collateral. This approach promotes consistency with existing
rules, which will generally reduce the implementation costs for
entities with affiliates already subject to the Commission's broker-
dealer financial responsibility rules, and the broker-dealer margin
rules. It also facilitates the ability to provide portfolio margining
of security-based swaps with other types of securities, and in
particular single-name CDS with bonds

referenced by the CDS. This consistent approach can also reduce the
potential for regulatory arbitrage and lead to simpler interpretation
and enforcement of applicable regulatory requirements across U.S.
securities markets.
    Finally, the Commission has modified the final margin rule in
response to commenters' concerns about the rule excluding collateral
types that are permitted by the CFTC and the prudential regulators. As
noted above, the final rule permits cash, securities, money market
instruments, a major foreign currency, the settlement currency of the
non-cleared security-based swap, or gold to serve as eligible
collateral.\1199\ This will avoid the operational burdens of having
different sets of collateral that may be used with respect to a
counterparty depending on whether the nonbank SBSD is entering into a
security-based swap (subject to the Commission's rule) or a swap
(subject to the CFTC's rule) with the counterparty. It also will avoid
potential unintended competitive effects of having different sets of
collateral for non-cleared security-based swaps under the margin rules
for nonbank SBSDs and bank SBSDs. Finally, by giving the option of
aligning with the requirements of the CFTC and the prudential
regulators, the final rule should avoid the necessity of amending
existing collateral agreements that may specifically reference the
forms of margin permitted by those requirements.
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    \1199\ See paragraph (c)(4)(i)(C) of Rule 18a-3, as adopted. The
additional collateral requirements in the final rule are discussed
below.
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c. Alternatives Considered
i. Alternative B: Inter-Dealer margin
    As discussed above in section II.B.2.b.i. of this release, the
Commission proposed two alternatives (Alternatives A and B) with
respect to inter-dealer margin requirements. Under Alternative A, a
nonbank SBSD would need to collect variation margin but not initial
margin from the other SBSD. Under alternative B, a nonbank SBSD would
be required to collect variation and initial margin from the other SBSD
and the initial margin needed to be held at a third-party custodian.
    Alternative B was generally consistent with the recommendations in
the BCBS/IOSCO Paper and the margin rules of the CFTC, prudential
regulators, and European authorities in that it would have required
nonbank SBSDs to exchange initial (in addition to variation margin).
Further, it was consistent with the margin rules of the CFTC and the
prudential regulators in that it would have required that initial
margin be held at an unaffiliated third-party custodian.\1200\ The
BCBS/IOSCO Paper recommends that ``[i]nitial margin collected should be
held in such a way as to ensure that (i) the margin collected is
immediately available to the collecting party in the event of the
counterparty's default, and (ii) the collected margin must be subject
to arrangements that protect the posting party to the extent possible
under applicable law in the event that the collecting party enters
bankruptcy.'' \1201\ The EU's margin rule requires the collecting
counterparty to provide the posting counterparty with the option to
segregate its collateral from the assets of the other posting
counterparties.\1202\
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    \1200\ See Prudential Regulator Margin and Capital Adopting
Release, 80 FR at 74863; CFTC Margin Adopting Release, 81 FR 636.
    \1201\ See BCBS/IOSCO Paper at 20 (``There are many different
ways to protect provided margin, but each carries its own risk. For
example, the use of third-party custodians is generally considered
to offer the most robust protection, but there have been cases where
access to assets held by third-party custodians has been limited or
practically difficult. The level of protection would also be
affected by the local bankruptcy regime, and would vary across
jurisdictions.'').
    \1202\ The margin rules of the European Union require that
initial margin be segregated on the books and records of a third-
party holder or custodian; or via other legally binding arrangements
so that the initial margin is protected from the default or
insolvency of the collecting counterparty. Where cash is collected
as initial margin, it must be deposited with an unaffiliated third-
party holder or custodian or with a central bank. Initial margin
cannot be re-hypothecated.
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    Alternatives A and B would have required nonbank SBSDs to collect
variation and initial margin from non-excepted counterparties.
Therefore, both alternatives would protect nonbank SBSDs from the
consequences of one of these counterparties defaulting. However,
because Alternative B would have required a nonbank SBSD also to
collect variation and initial margin from an SBSD counterparty and
segregate it with an independent third-party custodian, this
alternative would have provided greater protection to nonbank SBSDs
from the consequences of one of these counterparties defaulting than
Alternative A. By providing greater protection against the consequences
of non-excepted counterparties and SBSDs defaulting, Alternative B
would have further reduced the likelihood of sequential dealer failure
as a result of defaulting counterparties relative to Alternative A.
This would have enhanced the safety and soundness of nonbank SBSDs in
terms of this risk. As noted earlier in this release, most of the
benefits of this enhancement would accrue to market participants that
rely on nonbank SBSDs for liquidity provision in security-based swap
market and other services.
    However, Alternative B would likely impose more costs than
Alternative A. As discussed above, there is a trade-off in terms of the
benefits of requiring a nonbank SBSD to collect initial margin from
another financial market intermediary: Namely, the liquidity of the
delivering firm is reduced by the amount of initial margin posted to
the nonbank SBSD. Thus, while the initial margin collected by the
nonbank SBSD enhances the firm's safety and soundness, the delivery of
liquid capital by the other financial market intermediary diminishes
that firm's safety and soundness because it cannot use the delivered
liquid capital to protect itself from losses or to meet liquidity
demands. Thus, Alternative B would have reduced the safety and
soundness of nonbank SBSDs in terms of this risk. In addition, the
requirement that the initial margin be segregated at a third-party
custodian could have contributed to the instability of the nonbank SBSD
for whom the initial margin was posted if the initial margin was not
immediately available to the nonbank SBSD upon the default of the SBSD
counterparty.\1203\ During periods of general market unrest, even a
brief delay in access to liquid collateral, could increase
instability.\1204\ Further, Alternative B's negative impact on nonbank
SBSDs' liquidity could have reduced their ability to trade in non-
cleared security-based swaps. Nonbank SBSDs likely would have passed on
these costs to other market participants who, in turn, may have had
less of an incentive to trade in the security-based swap market.
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    \1203\ For example, the defaulting SBSD counterparty could claim
that the secured nonbank SBSD is not entitled to access the initial
margin held by the third-party custodian and bring a court action to
bar such access. The resolution of this claim in court could
substantially delay the secured nonbank SBSD's access to the
collateral.
    \1204\ Importantly, as discussed below in section VI.B.4. of
this release, the ultimate market effects will also depend on the
approach adopted by market participants with regard to the
segregation of initial margin.
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    In summary, although Alternative B would provide greater protection
against a defaulting SBSD counterparty, it would also impose more costs
on dealers and other market participants, relative to Alternative A.
ii. Third-Party Segregation Requirements
    The final margin rules of the CFTC and the prudential regulators
generally require that initial margin to be held at a third-party
custodian. The purpose of using a third-party custodian is to have

the initial margin held in a manner that is bankruptcy-remote from the
secured party. The Commission's final margin rule does not require that
initial margin posted by a counterparty to the nonbank SBSD be held at
a third-party custodian. However, Section 3E(f) of the Exchange Act
provides counterparties the right to elect to have the initial margin
they post to a nonbank SBSD to be held at an independent third-party
custodian. Given the limited use of third-party segregation under
existing market practice in security-based swap transactions, the
circumstances in which third-party segregation is elected may be
limited.
    As an alternative, the Commission's margin rule could have required
that initial margin posted to nonbank SBSDs be held at a third-party
custodian. This would have provided more counterparties (i.e., ones
that would not have otherwise elected to have their initial margin held
at a third-party custodian) with the benefit of having their initial
margin protected from the consequences of the nonbank SBSD's
bankruptcy. The main benefit of such an approach would be that the
return of the initial margin to the counterparty would not be subject
to the delay caused by having to make a claim in a bankruptcy
proceeding and the subsequent processing of that claim.
    However, mandating (rather than permitting) initial margin to be
held at a third-party custodian would entail costs. For example, under
existing market practice, initial margin is not typically employed in
inter-dealer transactions; rather, it is largely limited to dealer
transactions with non-dealer counterparties, where the non-dealers are
the parties posting initial margin.\1205\ Non-dealer counterparties
typically have not required that initial margin they post to dealers be
held at a third-party custodian. This may reflect a preference for
granting dealers more flexibility with respect to the use of their
collateral over its safety, given the added costs associated with
establishing and maintaining tri-party custodial arrangements and
potentially imposed by dealers when they cannot directly hold the
initial margin. Mandating that initial margin be held at a third-party
custodian could increase these costs.
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    \1205\ See section VI.A.2.d. of this release.
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iii. Eligible Collateral
    The margin rules of the CFTC and the prudential regulators permit
the following types of assets to serve as collateral: (1) Cash; (2)
U.S. Treasury securities; (3) certain securities guaranteed by the
U.S.; (4) certain securities issued or guaranteed by the European
Central Bank, a sovereign entity, or the BIS; (5) certain corporate
debt securities; (6) certain equity securities contained in major
indices; (7) certain redeemable government bond funds; (7) a major
foreign currency; (8) the settlement currency of the non-cleared
security-based swap or swap; or (9) gold.\1206\ The Commission's final
margin rule permits cash, securities, money market instruments, a major
foreign currency, the settlement currency of the non-cleared security-
based swap, or gold. Consequently, unlike the margin rules of the CFTC
and the prudential regulators, the Commission's final margin rule does
not list the specific types of securities that can serve as eligible
collateral. However, the Commission's final margin rule requires, among
other things, that the collateral have a ready market.
---------------------------------------------------------------------------

    \1206\ See Prudential Regulator Margin and Capital Adopting
Release, 80 FR at 74870; CFTC Margin Adopting Release, 81 FR at 701-
2.
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    In addition, the margin rules of the CFTC and the prudential
regulators generally require that cash be used to meet a variation
margin requirement in a transaction between dealers. The Commission's
final margin rule does not place this limit on the collateral that must
be used to meet a variation margin requirement.
    As an alternative, the Commission could have specifically
identified the types of securities that can serve as collateral and
could have required that cash be used to meet a variation margin
requirement of a financial market intermediary.
    A benefit of this alternative is that with respect to the cash
collateral requirement for variation margin in inter-dealer
transactions it would limit the potential for losses resulting from
liquidating non-cash collateral in times of stress, reduce the
likelihood of fire-sale dynamics, and reduce uncertainty and disputes
with respect to collateral valuation.\1207\ A second benefit is that it
would more closely align the Commission's margin rule with the margin
rules of the CFTC and the prudential regulators. Commenters supported
such consistency. One commenter urged consistency so that different
rules would not apply to economically related transactions, or to
transactions involving different types of counterparties, which could,
in turn, lead to increased costs for end users.\1208\ Another commenter
requested that the Commission develop a list of permissible collateral
that is consistent across jurisdictions to ``improve the efficiency of
the derivatives market.'' \1209\ These comments were aimed at the