Commission's proposed margin rule. The Commission's final margin rule
has been modified to permit the types of collateral that are eligible
under the margin rules of the CFTC and the prudential regulators as
discussed above in section II.B.2.b.i. of this release.
---------------------------------------------------------------------------

    \1207\ See Gary Gorton and Guillermo Ordo[ntilde]ez, Collateral
Crises, Yale University Working Paper (Mar. 2012) (arguing that
during normal times collateral values are less precise, but during
volatile times are reassessed). This reassessment can possibly lead
to large negative shocks in their values, which by deduction can
lead to market disruptions if collateral needs to be liquidated.
    \1208\ See SIFMA AMG 2/22/2013 Letter.
    \1209\ See ISDA 2/5/2014 Letter.
---------------------------------------------------------------------------

    On the other hand, the alternative approach could increase demand
for the types of securities enumerated in the margin rules of the CFTC
and the prudential regulators and potentially cause shortages in their
supply.\1210\ Moreover, such forms of collateral may not be readily
available to counterparties wishing to engage in non-cleared security-
based swap transactions, significantly restricting their ability to
engage in such transactions, and limiting the ability of these markets
to facilitate risk transfer in the economy.
---------------------------------------------------------------------------

    \1210\ See IMF, Global Financial Stability Report: The Quest for
Lasting Stability, 96 and 120 (Apr. 2012), available at http://www.imf.org/External/Pubs/FT/GFSR/2012/01/pdf/text.pdf.
---------------------------------------------------------------------------

    A commenter identified 3 adverse consequences of limiting
collateral in the manner of the CFTC and the prudential
regulators.\1211\ First, the commenter argued that investors may be
forced to hold unnecessarily low-yielding securities. Second, the
commenter argued that the securities that investors will be forced to
deliver as initial margin may be different from the transactions or
portfolios hedged by the security-based swap, thereby creating
undesirable basis risk and running counter to clients' desire to match
benchmark composition. Third, the commenter argued that investors
seeking to avoid this unnecessary cost or basis risk may look to
``collateral transformation'' approaches to convert holdings to assets
that satisfy the posting requirements. The commenter argued that these
collateral transformations will typically include haircuts on
securities that will create additional costs for the funding component
of the transformation.
---------------------------------------------------------------------------

    \1211\ See PIMCO Letter.
---------------------------------------------------------------------------

    The Commission broadly agrees with this commenter and believes that
the alternative could unduly restrict the ability of entities to
participate in the security-based swap market. It also could impede the
ability to portfolio

margin security-based positions with related securities positions.
Further, by granting participants in security-based swap transactions
the flexibility to post a wider range of securities, the Commission's
final margin rule may reduce the collateral costs for participants in
the security-based swap market. Finally, the ready market requirement
and collateral haircuts are designed to ensure that the collateral
adequately covers the credit exposures that variation and initial
margin are designed to address.
iv. Excluding Certain Assets From List of Eligible Collateral
    The Commission's proposed margin rule permitted cash, securities,
and money market instruments to serve as collateral to meet variation
and initial margin requirements. Therefore, unlike the margin rules of
the CFTC and the prudential regulators, it did not permit a major
foreign currency, the settlement currency of the non-cleared security-
based swap, or gold from serving as collateral. The margin rules of the
CFTC and the prudential regulators permit major foreign currencies, the
currency of settlement for the security-based swap, and gold to serve
as eligible collateral. The Commission's final margin rule has been
modified to permit the types of collateral that are eligible under the
margin rules of the CFTC and the prudential regulators as discussed
above in section II.B.2.b.i. of this release.
    As an alternative, the Commission's margin rule could have
continued to exclude a major foreign currency, the settlement currency
of the non-cleared security-based swap, or gold from serving as
collateral. However, differences between the sets of permitted
collateral under the margin rules of the Commission and the CFTC and
the prudential regulators could have imposed operational burdens on a
nonbank SBSD. For example, a nonbank SBSD that is registered as a swap
dealer would have been required to adhere to a different set of
permitted collateral depending on whether it was entering into a
security-based swap (subject to the Commission's rule) or a swap
(subject to the CFTC's rule) with the counterparty. In addition, the
nonbank SBSD and its counterparties would likely have had to incur
costs to amend existing collateral agreements that may specifically
reference the forms of margin permitted by CFTC and prudential
requirements.
    Further, prudential regulators permitting major foreign currencies,
the currency of settlement for the security-based swap, and gold to
serve as collateral (while the Commission did not) would have meant
that a bank SBSD and its counterparties had more options when sourcing
for permitted collateral compared to a nonbank SBSD. This greater range
of options, in turn, could have allowed the bank SBSD to obtain
eligible collateral at lower cost than a nonbank SBSD, even if both
entities were entering into economically equivalent non-cleared
security-based swap transactions. This could have allowed bank SBSDs to
gain a competitive advantage over nonbank SBSDs.
    In light of the operational burden, costs, and competitive
disparity associated with the alternative, the Commission believes that
final margin rule, which permits a major foreign currency, the
settlement currency of the non-cleared security-based swap, and gold to
serve as eligible collateral, is preferable to the alternative.
v. Not Permitting the Option To Use Collateral Haircuts Adopted by CFTC
and Prudential Regulators
    As discussed above in section II.B.2.b.i. of this release, the
Commission's proposed margin rule provided that the fair market value
of securities and money market instruments held in the account of a
counterparty needed to be reduced by the amount of the standardized
haircuts the nonbank SBSD would apply to the positions pursuant to the
proposed capital rules for the purpose of determining whether the level
of equity in the account met the minimum margin requirements. The
proposed haircuts and the haircuts in the margin rules of the CFTC and
the prudential regulators (which are based on the recommended
standardized haircuts in the BCBS/IOSCO Paper) are largely comparable.
However, there were differences. In order to promote greater
harmonization with the margin rules of the CFTC and the prudential
regulators, the Commission's final margin rule provides nonbank SBSDs
with the option of choosing to use the standardized haircuts in the
capital rules or the standardized haircuts in the CFTC's margin rule.
    As an alternative, the Commission could have adopted the proposed
requirement that did not provide the option to use the standardized
haircuts in the CFTC's margin rule. However, this could have imposed
operational burdens on nonbank SBSDs. For example, a nonbank SBSD that
was also registered as a swap dealer would have been required to adhere
to a different set of collateral haircuts depending on whether it was
entering into a security-based swap (subject to the Commission's rule)
or a swap (subject to the CFTC's rule) with the counterparty. In
addition, the nonbank SBSD and its counterparties would likely have had
to incur costs to amend existing collateral agreements that may
specifically reference the haircuts in the margin rules of the CFTC and
the prudential regulators.
    This alternative also could have resulted in competitive
disparities between bank SBSDs and nonbank SBSDs. To the extent that
the prudential regulators' collateral haircuts result in more favorable
treatment of a counterparty's collateral, the counterparty might have
preferred to trade with a bank SBSD rather than with a nonbank SBSD,
even if both SBSDs are equally attractive liquidity providers in all
other respects. Thus, the alternative could have allowed bank SBSDs to
gain a competitive advantage over nonbank SBSDs.
    The Commission believes that final margin rule, which provides
nonbank SBSDs with the option of using the CFTC's collateral haircuts,
is preferable to the alternative as it will avoid the operational
burdens, costs, and competitive disparities discussed above.
vii. Risk-Based Threshold
    In the 2018 comment reopening, the Commission requested comment on
whether it would be appropriate to establish a risk-based threshold
where a nonbank SBSD would not be required to collect initial margin
from a counterparty to the extent the amount does not exceed the lesser
of: (1) 1% of the SBSD's tentative net capital; or (2) 10% of the net
worth of the counterparty.\1212\ As an alternative, the Commission
could have adopted this risk-based initial margin threshold instead of
the fixed-dollar $50 million initial margin threshold.
---------------------------------------------------------------------------

    \1212\ Capital, Margin, and Segregation Comment Reopening, 83 FR
at 53013.
---------------------------------------------------------------------------

    One commenter was concerned that, were the Commission to adopt an
initial margin threshold tied to counterparty net worth, nonbank SBSDs
would effectively be required to collect initial margin from all in-
scope counterparties because they would be unable to confirm that the
calculated initial margin amounts had not crossed the 10% net worth
threshold. The commenter believed that such a requirement would put
nonbank SBSDs at a significant competitive disadvantage relative to
bank SBSDs and foreign SBSDs.\1213\ The commenter also noted that the
1% tentative net capital threshold would effectively

increase the prices offered by smaller nonbank SBSDs to counterparties
relative to their competitors. Additionally, the commenter pointed out
that the costs of overhauling systems and re-documenting initial margin
agreements to incorporate the proposed thresholds would have a
disproportionate impact on smaller firms, since such costs do not
generally scale to a firm's size. These substantial disadvantages would
likely reduce the ability of smaller nonbank SBSDs to attract
counterparties, which would cause greater market concentration and less
efficient pricing. A commenter argued that the Commission did not
explain its views on why a counterparty-specific unsecured threshold
(e.g., $50 million) should be rejected in favor of a measure that would
relate to a percentage of the nonbank SBSD's tentative net capital,
which captures counterparty exposures only indirectly, or the
counterparty's overall net worth unrelated to a specific counterparty
relationship.\1214\
---------------------------------------------------------------------------

    \1213\ See SIFMA 11/19/2018 Letter.
    \1214\ See Better Markets 11/19/2018 Letter.
---------------------------------------------------------------------------

    In response to the comments above, the Commission is adopting a
fixed $50 million initial margin threshold below which initial margin
need not be collected.\1215\ This fixed threshold is consistent with
the threshold adopted by the prudential regulators. Having a more
consistent threshold will minimize potential competitive disparities
and address operational concerns raised by commenters. The Commission
recognizes that a fixed-dollar threshold (as opposed to a scalable
threshold) does not necessarily bear a relation to the financial
condition of the nonbank SBSD and its counterparty. To address this
consequence, as discussed above, and as suggested by a commenter, a
nonbank SBSD will be required to take a capital deduction in lieu of
margin or credit risk charge if it does not collect initial margin
pursuant to the fixed-dollar $50 million threshold exception.
Furthermore, the nonbank SBSD will be required to establish, maintain,
and document procedures and guidelines for monitoring counterparty
risk. Consequently, the Commission does not believe the fixed-dollar
$50 million threshold exception will unduly increase systemic risk as
suggested by a commenter.
---------------------------------------------------------------------------

    \1215\ See paragraph (c)(1)(iii)(G) of Rule 18a-3, as adopted.
---------------------------------------------------------------------------

4. The Segregation Rules--Rules 15c3-3 and 18a-4
a. Overview
    As discussed above in section II.C. of this release, Section 3E(b)
of the Exchange Act provides that, for cleared security-based swaps,
the money, securities, and property of a security-based swap customer
shall be separately accounted for and shall not be commingled with the
funds of the broker, dealer, or SBSD or used to margin, secure, or
guarantee any trades or contracts of any security-based swap customer
or person other than the person for whom the money, securities, or
property are held. However, Section 3E(c)(1) of the Exchange Act also
provides that, for cleared security-based swaps, customers' money,
securities, and property may, for convenience, be commingled and
deposited in the same one or more accounts with any bank, trust
company, or clearing agency. Section 3E(c)(2) further provides that,
notwithstanding Section 3E(b), in accordance with such terms and
conditions as the Commission may prescribe by rule, regulation, or
order, any money, securities, or property of the security-based swaps
customer of a broker, dealer, or security-based swap dealer described
in Section 3E(b) may be commingled and deposited as provided in Section
3E with any other money, securities, or property received by the
broker, dealer, or security-based swap dealer and required by the
Commission to be separately accounted for and treated and dealt with as
belonging to the security-based swaps customer of the broker, dealer,
or security-based swap dealer.
    Section 3E(f) of the Exchange Act establishes a program by which a
counterparty to non-cleared security-based swaps with an SBSD or MSBSP
can elect to have initial margin held at an independent third-party
custodian (individual segregation). Section 3E(f)(4) provides that if
the counterparty does not choose to require segregation of funds or
other property, the SBSD or MSBSP shall send a report to the
counterparty on a quarterly basis stating that the firm's back office
procedures relating to margin and collateral requirements are in
compliance with the agreement of the counterparties. The statutory
provisions of Sections 3E(b) and (f) are self-executing.
    The Commission is adopting omnibus segregation rules pursuant to
which money, securities, and property of a security-based swap customer
relating to cleared and non-cleared security-based swaps must be
segregated but can be commingled with money, securities, or property of
other customers. The omnibus segregation requirements for stand-alone
broker-dealers and broker-dealer SBSDs are codified in amendments to
Rule 15c3-3. The omnibus segregation requirements for stand-alone SBSDs
(including those also registered as OTC derivatives dealers) and bank
SBSDs are codified in Rule 18a-4.
    The omnibus segregation requirements are mandatory with respect to
money, securities, or other property that is held by a stand-alone
broker-dealer or SBSD and that relate to cleared security-based swap
transaction (i.e., customers cannot waive segregation). With respect to
non-cleared security-based swap transactions, the omnibus segregation
requirements are an alternative to the statutory provisions discussed
above pursuant to which a counterparty can elect to have initial margin
individually segregated or waive segregation. With respect to non-
cleared security-based swap transactions, the omnibus segregation
requirements are an alternative to the statutory provisions discussed
above pursuant to which a counterparty can elect to have initial margin
individually segregated or waive segregation. However, under the final
omnibus segregation rules for stand-alone broker-dealers and broker-
dealer SBSDs codified in Rule 15c3-3, counterparties that are not an
affiliate of the firm cannot waive segregation. Affiliated
counterparties of a stand-alone broker-dealer or broker-dealer SBSD can
waive segregation. Under Section 3E(f) of the Exchange Act and Rule
18a-4, all counterparties (affiliated and non-affiliated) to a non-
cleared security-based swap transaction with a stand-alone or bank SBSD
also can waive segregation The omnibus segregation requirements are the
``default'' requirement if the counterparty does not elect individual
segregation or to waive segregation (in the cases where a counterparty
is permitted to waive segregation).
    Under the final segregation rules, an SBSD or stand-alone broker-
dealer must maintain a security-based swap customer reserve account to
segregate cash and/or qualified securities in an amount equal to the
net cash owed to security-based swap customers. The SBSD or stand-alone
broker-dealer must at all times maintain, through deposits into the
account, cash and/or qualified securities in amounts computed weekly in
accordance with the formula set forth in the rules. In the case of a
broker-dealer, this account must be separate from the reserve accounts
it maintains

for traditional securities customers and broker-dealers.
    The formula in the final segregation rules requires the SBSD or
stand-alone broker-dealer to add up various credit items (amounts owed
to security-based swap customers) and debit items (amounts owed by
security-based swap customers). If, under the formula, credit items
exceed debit items, the SBSD or stand-alone broker-dealer must maintain
cash and/or qualified securities in that net amount in the security-
based swap customer reserve account. For purposes of the security-based
swap reserve account requirement, qualified securities are: Obligations
of the United States; obligations fully guaranteed as to principal and
interest by the United States; and, subject to certain conditions and
limitations, general obligations of any state or a political
subdivision of a state that are not traded flat and are not in default,
are part of an initial offering of $500 million or greater, and are
issued by an issuer that has published audited financial statements
within 120 days of its most recent fiscal year end.
    With respect to non-cleared security-based swaps, Section
3E(f)(1)(A) of the Exchange Act provides that an SBSD and an MSBSP
shall be required to notify a counterparty of the SBSD or MSBSP at the
beginning of a non-cleared security-based swap transaction that the
counterparty has the right to require the segregation of the funds or
other property supplied to margin, guarantee, or secure the obligations
of the counterparty. SBSDs and MSBSPs must provide this notice in
writing to a duly authorized individual prior to the execution of the
first non-cleared security-based swap transaction with the counterparty
occurring after the compliance date of the rule. SBSDs also must obtain
subordination agreements from a counterparty that affirmatively elects
to have initial margin held at a third-party custodian or that waives
segregation.
    The final segregation rules modify the proposed definition of
``excess securities collateral'' to exclude securities collateral held
in a ``third-party custodial account'' as that term is defined in the
rules.\1216\ The final segregation rules also incorporate the
definition of ``third-party custodial account'' that was included in
the 2018 comment reopening but with modifications suggested by the
commenters to broaden the definition to include domestic registered
clearing organizations and depositories and foreign supervised banks,
clearing organizations, and depositories.\1217\ The final segregation
rules also modify the proposed definition of ``qualified registered
security-based swap dealer account'' to remove the limitation that the
account be held at an unaffiliated SBSD.
---------------------------------------------------------------------------

    \1216\ See paragraph (p)(1)(ii)(B) of Rule 15c3-3, as amended;
paragraph (a)(2)(ii) of Rule 18a-4, as adopted.
    \1217\ See paragraph (p)(1)(viii) of Rule 15c3-3, as amended;
paragraph (a)(10) of Rule 18a-4, as adopted.
---------------------------------------------------------------------------

    MSBSPs collect initial margin from security-based swap
counterparties under a house margin requirement are subject to Section
3E(f) of the Exchange Act under the baseline, which--as discussed
above--establishes a program by which a counterparty to non-cleared
security-based swaps with an MSBSP can elect to have initial margin
held at an independent third-party custodian.
b. Benefits and Costs of the Segregation Rules
    Under the baseline, the Section 3E(b) of the Exchange Act provides
that, for cleared security-based swaps, the money, securities, and
property of a security-based swap customer shall be separately
accounted for and shall not be commingled with the funds of the broker,
dealer, or SBSD or used to margin, secure, or guarantee any trades or
contracts of any security-based swap customer or person other than the
person for whom the money, securities, or property are held. Therefore,
under the baseline, stand-alone broker-dealers and SBSDs must segregate
collateral for cleared security-based swaps and, therefore, the
benefits of segregation (i.e., protecting initial margin) will accrue
to market participants to the extent they clear security-based swaps
through stand-alone broker-dealers and SBSDs. However, the Section
3E(c)(1) of the Exchange Act also provides that, for cleared security-
based swaps, customers' money, securities, and property may, for
convenience, be commingled and deposited in the same one or more
accounts with any bank, trust company, or clearing agency. The
Commission's final omnibus segregation rules will permit stand-alone
broker-dealers and SBSDs to commingle customers' initial margin for
cleared security-based swaps. Therefore, these entities will benefit
from the efficiencies and lower costs of treating initial margin for
cleared security-based swaps in this manner as compared to individually
segregating each customer's initial margin. The benefits of these
efficiencies and lower costs will accrue to market participants in the
form of quicker executions of cleared security-based swap transactions
and lower transaction fees.
    Stand-alone broker-dealers and SBSDs will incur costs to develop
systems, controls, and procedures to comply with the omnibus
segregation requirements and to operate those systems, controls, and
procedures. These costs may be passed on to market participants to the
extent they clear security-based swaps through stand-alone broker-
dealers and SBSDs. However, these costs will be lower than the costs
that would have been incurred under the baseline segregation
requirement for cleared security-based swaps because it would not have
permitted commingling of customers' initial margin. Thus, under the
baseline, the stand-alone broker-dealers and SBSDs would have needed to
develop and operate systems, controls, and procedures to individually
segregate each customer's initial margin in separate accounts. This
would have been a much more complex undertaking than it will be to
develop and operate systems to comply with the omnibus segregation
requirements where commingling customers' initial margin in a single
account is permitted.
    With respect to non-cleared security-based swaps, the final omnibus
segregation rules are not mandatory. Counterparties that are affiliates
of the stand-alone broker-dealer or broker-dealer SBSD with whom they
are transacting the non-cleared security-based swap can potentially
elect individual segregation, omnibus segregation, or to waive
segregation. Counterparties (regardless of whether they are affiliates)
potentially can elect any of these alternatives if they are a
counterparty to a non-cleared security-based transaction with a stand-
alone or bank SBSD. Counterparties that are not affiliates of the
stand-alone broker-dealer or broker-dealer SBSD with whom they are
transacting the non-cleared security-based swap can potentially elect
either individual segregation or omnibus segregation (they cannot waive
segregation).
    Therefore, the direct benefits and costs of the Commission's final
omnibus segregation rules as applied to non-cleared security-based swap
transactions will depend, in large part, on the entities with whom
counterparties choose to transact: Stand-alone broker-dealers and
broker-dealer SBSDs (where the option to waive segregation is not
available to non-affiliates) or stand-alone and bank SBSDs (where the
option to waive segregation is potentially available to all
counterparties and where the option for the stand-alone or bank SBSD to
operate

under the exemption from the omnibus segregation rules is available).
    Because segregation (individual or omnibus) is mandatory when a
non-affiliated counterparty enters into a non-cleared security-based
swap with a stand-alone broker-dealer or broker-dealer SBSD, and
because omnibus segregation is the default requirement for a stand-
alone SBSD or bank SBSD, the final rules could incrementally increase
the amount of collateral that is segregated for non-cleared security-
based swaps. The amount of this increase will depend on whether
counterparties elect individual segregation or, if permitted, to waive
segregation. It also will depend on whether counterparties elect to
transact with stand-alone or bank SBSDs operating under the exemption
to the omnibus segregation requirements or with stand-alone SBSDs
operating pursuant to the alternative compliance mechanism. If
counterparties elect these alternatives to omnibus segregation, the
final rules (themselves) will have a limited impact on the amount of
collateral that is segregated. However, if they do increase the amount
of collateral that is segregated, SBSDs may pass these costs to market
participants.
    However, these costs may be limited. In general, the Commission
expects most non-cleared security-based swap dealing will be conducted
by stand-alone and bank SBSDs (where waiver by non-affiliated
counterparties will be permitted). This is because the Commission
expects that dealers in non-cleared security-based swaps will organize
themselves as stand-alone SBSDs to take advantage of the more favorable
capital requirements applicable to stand-alone SBSDs under the final
rules (i.e., the absence of a portfolio concentration charge and the
ability to use the alternative compliance mechanism).
    Furthermore, the Commission expects that dealers in non-cleared
security-based swaps will generally seek exemption from the omnibus
segregation requirements in Rule 18a-4, which is available to stand-
alone and bank SBSDs. While qualifying for the exemption means they
will not be able to clear security-based swap transactions for others,
the Commission does not believe that will discourage dealers in non-
cleared security-based swaps from organizing as stand-alone or bank
SBSDs to take advantage of the exemption.\1218\ Moreover, the
Commission does not believe that an entity will register solely as an
SBSD to clear security-based swap transactions for others, given the
relative size of the cleared security-based swap market as compared to
the cleared swap market. Therefore, entities that want to clear
security-based swaps will also want to clear swaps and, therefore, need
to register as FCMs. This creates a strong incentive to effect brokered
cleared transactions through entities that are dually registered as
broker-dealers and FCMs, and to deal in non-cleared transactions in
stand-alone SBSDs and swap dealers.
---------------------------------------------------------------------------

    \1218\ In particular, to clear swaps for others, a swap dealer
must be registered as an FCM under the CFTC's rules. The FCM capital
rule prescribes a net liquid asset test similar to the broker-dealer
net capital rule (Rule 15c3-1). Bank swap dealers in particular
appear to avoid clearing swaps for customers (and limit their swap
dealing activities to non-cleared swaps), as engaging in such
business would subject them to the capital requirements for FCMs in
addition to the capital requirements that would apply to them under
the bank capital rules.
---------------------------------------------------------------------------

    Finally, based on FOCUS information, the Commission believes that
the broker-dealers most active in dealing in non-cleared security-based
swaps will trade mostly with affiliates that will be permitted to waive
segregation under the final omnibus segregation rule for stand-alone
broker-dealers and broker-dealer SBSDs. For these reasons, the
Commission does not expect the limitation in Rule 15c3-3 that prohibits
a non-affiliated counterparty from waiving segregation will
significantly increase the amount of collateral segregated for non-
cleared security-based swap transactions.
    In the context of transactions where the waiver limitation does not
apply, the benefits and costs of the final segregation rule will depend
on whether counterparties elect individual segregation or to waive
segregation under Section 3E(f) of the Exchange Act, or, alternatively,
elect to have their initial margin held directly by the stand-alone
broker-dealer or SBSD subject to the omnibus segregation requirements.
Thus, in evaluating the costs and benefits of the final segregation
rules, the Commission considers the implications of optionality on the
segregation choices of market participants, and the impact of those
choices on the costs and benefits of the rules. In this regard,
available information suggests that customer assets related to
security-based swap transactions are currently not consistently
segregated from dealer proprietary assets. With respect to non-cleared
security-based swaps, available information suggests that there is no
uniform segregation practice but that collateral for most accounts is
not segregated.\1219\ According to an ISDA margin survey, where
independent amounts (initial margin) are collected, ISDA members
reported that most (72%) was commingled with variation margin and not
segregated, and less than 5% of the amount received was segregated with
a third party-custodian.\1220\
---------------------------------------------------------------------------

    \1219\ See generally ISDA Margin Survey 2012. More recent ISDA
margin surveys do not include the relevant statistics.
    \1220\ See ISDA Margin Survey 2012. The survey also notes that
while the holding of the independent amounts and variation margin
together continues to be the industry standard both contractually
and operationally, the ability to segregate has been made
increasingly available to counterparties over the past three years
on a voluntary basis, and has led to adoption of 26% of independent
amounts received and 27.8% of independent amounts delivered being
segregated in some respects. See also ISDA, Independent Amounts,
Release 2.0.
---------------------------------------------------------------------------

    As a general matter, more restrictive segregation regimes (i.e.,
individual segregation, omnibus segregation, or similar privately
negotiated arrangements) provide more protection to the posting party.
However, they ``lock up'' collateral to varying degrees, restricting
its use by the collecting party, and raise the overall cost of the
transaction. Avoiding segregation can lower the costs of the
transaction by permitting the recipient of collateral to obtain
benefits from its use. However, collateral that is not segregated may
be difficult to recover when the holder of the collateral is in
distress. Thus, the absence of segregation can potentially contribute
to instability in times of stress.
    In response to the 2018 comment reopening, one commenter
recommended that the Commission not impose the omnibus segregation
requirements on bank SBSDs, foreign SBSDs, stand-alone SBSDs, and OTC
derivatives dealers that do not clear for customers.\1221\ This
commenter argued that the proposed omnibus segregation requirements
could conflict with bank liquidation or resolution, may cause
jurisdictional disputes, and are not consistent with the Exchange Act.
In addition, this commenter stated that omnibus segregation
requirements would impair hedging and funding activities for stand-
alone SBSDs and OTC derivatives dealers because the exclusions related
to the use of excess securities collateral admit only a narrow range of
hedging activities. In particular, the commenter was concerned that a
failure to recognize hedging strategies using instruments other than
security-based swaps would create undue regulatory incentives to
transact using one type of instrument versus another.
---------------------------------------------------------------------------

    \1221\ See SIFMA 11/19/2018 Letter.

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

    As discussed above, the final segregation rule for stand-alone and
bank SBSDs will exempt these entities from the requirements of the rule
if the SBSD meets certain conditions, including that the SBSD does not
clear security-based swap transactions for other persons, provides
statutory notice to the counterparty regarding the right to segregate
initial margin at an independent third-party custodian, and discloses
in writing that any collateral received by the SBSD will not be subject
to a segregation requirement and how a counterparty's claim on
collateral would be treated in a bankruptcy or other formal liquidation
proceeding of the SBSD. This modification from the proposed rule will
lessen the costs imposed on stand-alone and bank SBSDs that do not
clear security-based swaps for other persons by avoiding conflict with
other regulations and minimizing the impact on hedging activity. As
discussed above, the Commission expects these firms will not choose to
clear security-based swaps for others because, from an economic
perspective, it is more attractive to clear security-based swaps and
swaps for others. Clearing swaps for others requires registration as an
FCM and, therefore, compliance with the CFTC's capital requirements for
FCMs.
    However, the exemption to the final segregation rule may also
impose costs on market-participants. A stand-alone or bank SBSD that is
making use of this exemption would be able to comingle the collateral
collected from counterparties with its own assets. In particular, the
firm would be able to use a counterparty's collateral to collateralize
a transaction with another counterparty (i.e., collateral re-
hypothecation). In the event of the stand-alone or bank SBSD's failure,
counterparties may have difficulty recovering their collateral in a
timely manner, or at all.
    The omnibus segregation requirements are the default requirement
for non-cleared security-based swaps if the counterparty does not
affirmatively elect individual segregation or to waive segregation (and
if the SBSD is not operating pursuant to the exemption for bank and
stand-alone SBSDs). A large body of behavioral economics literature has
documented the power of defaults in driving individual behavior.\1222\
In addition, the final segregation rules require a foreign SBSD to
disclose to a U.S. security-based swap customer the potential treatment
of the assets segregated by the SBSD pursuant to Section 3E of the
Exchange Act, and the rules and regulations thereunder, in insolvency
proceedings under U.S. bankruptcy law and applicable foreign insolvency
laws. This requirement may cause SBSDs' customers to devote more
attention to the choice of segregation regime and may potentially
trigger greater reluctance to transact without segregation.\1223\ Thus,
the rule's requirement that omnibus segregation be the default approach
for non-cleared security-based swaps could have the effect of
increasing the use of some form of segregation in non-cleared security-
based swap transactions. However, the Commission cannot determine the
extent to which having omnibus segregation be the default requirement
will increase the use of segregation. In particular, the Commission
lacks information on the extent to which market participants prefer
various segregation options, as well as data on the extent to which
defaults determine the behavior of market participants active in the
security-based swap market.\1224\
---------------------------------------------------------------------------

    \1222\ See William Samuelson and Richard Zeckhauser, Status Quo
Bias in Decision Making, Journal of Risk and Uncertainty 7-59
(1988).
    \1223\ See Victor Stango and Jonathan Zinman, Limited and
varying consumer attention evidence from shocks to the salience of
bank overdraft fees, Review of Financial Studies (2014).
    \1224\ Broadly, the evidence for behavioral biases tends to be
more limited in ``professional'' contexts. See, e.g., John A. List,
Does Market Experience Eliminate Market Anomalies? Quarterly Journal
of Economics (Feb. 2003); Zur Shapira and Itzhak Venezia. Patterns
of behavior of professionally managed and independent investors,
Journal of Banking & Finance 25.8 (2001): 1573-1587.
---------------------------------------------------------------------------

    The Commission cannot predict the ultimate magnitude of the use of
segregation by counterparties to non-cleared security-based swap
transactions under the final rules. Counterparties to non-cleared
security-based swap transactions may find it privately beneficial to
waive segregation. For example, a hedge fund customer of a dealer may
consider the risk of dealer insolvency to be too remote to warrant
requiring the segregation of its initial margin if waiving segregation
results in the dealer offering better terms, or providing other non-
pecuniary benefits.\1225\ Alternatively, two dealers with bilateral
security-based swap exposures that require similar amounts of initial
margin can reduce the total collateral required to support those
exposures by waiving segregation. Waiving segregation allows collateral
posted by the first dealer to be used by the second dealer to satisfy
its margin obligation to the first: the end result is similar to when
initial margin is not required. In addition, other factors may
contribute to a lower use of segregation. For example, a dealer's
counterparties may not be fully aware of the implications of the lack
of segregation,\1226\ or have insufficient bargaining power to extract
the desired segregation arrangements.\1227\
---------------------------------------------------------------------------

    \1225\ Similar concerns were raised by a commenter who argued
that by not mandating individual segregation, ``cost considerations
will lead [SBSDs] to pressure counterparties not to elect
segregation.'' See PIMCO Letter. Another commenter stated that the
costs for imposing omnibus segregation on foreign SBSDs would be
significant. See IIB 11/19/2018 Letter.
    \1226\ See Alarna Carlsson-Sweeny, Trends in Prime Brokerage,
Practical Law: The Journal (Apr. 2010) (``Few US hedge funds fully
comprehended the repercussions of allowing their assets to be
transferred offshore'' to avoid the Commission's segregation
requirements.).
    \1227\ See id. (``Before Lehman's collapse, the relationship
between hedge funds and prime brokers was one-sided, with prime
brokers holding most of the bargaining power.'').
---------------------------------------------------------------------------

    Importantly, parties that decide that it is privately optimal to
waive segregation for non-cleared security-based swaps may not take
into account the potential externalities of their decisions. If
customers generally do not avail themselves of the option to segregate
collateral for non-cleared security-based swaps, this will reduce the
potential positive contribution of the final segregation rules to
financial stability. For example, the emergence of doubts about a
dealer can lead to sudden demands for segregation, which during times
of market stress may be difficult for dealers to satisfy, precipitating
distress or failure. Moreover, if a dealer fails, the likelihood that
its counterparties can recover their collateral in a timely manner is
decreased, raising questions about the financial condition of those
counterparties. In addition, to the extent that actual insolvency
contributes to the dealer's failure, counterparties' collateral may
never be fully recovered. Delays in recovery of collateral, realized
losses, and the potential of such losses, could potentially lead to
contagion, and destabilizing runs.
    Conversely, to the extent that the final segregation rules
ultimately increase the use of segregation for non-cleared security-
based swaps, they could impose costs on SBSDs (and their
counterparties). These costs would primarily result from limitations on
SBSDs' use of initial margin. As discussed above in section VI.A.5.a.
of this release, margin requirements have been adopted by the CFTC,
prudential regulators, and foreign regulators, but they are being
phased-in over time. Further, current market practice (in the absence
of regulatory requirements)

does not generally involve posting initial margin. Therefore, the
impact of any restrictions on the use of such collateral strictly
relative to the baseline should be quite limited. More specifically,
under the baseline scenario where the exchange of initial margin for
non-cleared security-based swaps is largely voluntary, segregation
requirements that impose restrictions on how SBSDs can use collateral
posted by their counterparties should have minimal economic effect, as
the final segregation rules would be unlikely to bind. However, the
margin requirements of the CFTC, prudential regulators, and the
Commission (as they come into full effect) are expected to increase the
prevalence of initial margin in non-cleared security-based swap
transactions, and the Commission believes it is meaningful to also
analyze the interaction of the new margin and segregation requirements.
In this context, the impact of the Commission's final segregation rules
is likely to be more significant.\1228\ If, as a result of the final
margin and segregation rules, security-based swap counterparties
increase demand for segregation of initial margin for non-cleared
security-based swaps, dealers' costs of engaging in security-based swap
transactions will increase. Having unhindered access to customers'
collateral represents a significant benefit to a dealer. Such
collateral can be used by the dealer in its hedging and proprietary
trading activities. In its absence, the dealer will bear the cost of
financing the collateral to support these activities. Depending on the
level of segregation required by the dealer's counterparties, the
collateral required to support current levels of security-based swap
activity could be significantly greater than in a regime without
segregation and no restrictions on re-hypothecation. To the extent that
the provisions of the final segregation rules increase demand for
segregation in non-cleared security-based swap transactions, a dealer's
costs of hedging these transactions may be higher than under existing
market practice. Similarly, increased use of segregation for non-
cleared security-based swaps would reduce dealers' ability to otherwise
benefit from the use of customers' collateral. Both of these factors
could potentially lead to higher apparent transaction costs in the
security-based swap market.\1229\
---------------------------------------------------------------------------

    \1228\ See section VI.B.3. of this release for estimates of the
use of margin under the Commission's final margin rules.
    \1229\ In the absence of segregation, part of the consideration
offered by the SBSD's counterparty to the SBSD in an OTC derivatives
transaction is non-pecuniary: the right to make use of the
counterparty's collateral. In the absence of this benefit, the SBSD
can be expected to require additional (likely pecuniary)
consideration from the counterparty. This would appear as higher
transaction costs. It is important to note that there would be a
corresponding benefit realized by security-based swap
counterparties: increased collateral safety.
---------------------------------------------------------------------------

    Additional operational and up-front costs resulting from the final
rules as applied to cleared and non-cleared security-based swaps
include costs of establishing qualifying bank accounts, costs of third-
party custody services and associated legal fees, as well as costs of
building systems to maintain custody of customer securities and to
perform the required calculations.\1230\ The final rules require that
stand-alone broker-dealers and SBSDs compute the amount required to be
maintained in the special reserve account for the exclusive benefit of
security-based swap customers at least weekly. This requirement
supports the benefits of segregation described above, by ensuring that
the assets subject to segregation more accurately reflect the risks to
the posting party in the event that the holder of collateral fails. The
final rules permit more frequent computations. Such flexibility will be
valuable to those broker-dealers and standalone SBSDs that have the
operational capability and resources to perform daily computations.
These entities may choose to perform daily computations if the benefits
of doing so--for example, being able to more rapidly take advantage of
investment opportunities using cash withdrawn from the reserve
account--outweigh the costs associated with daily computations.
---------------------------------------------------------------------------

    \1230\ See Rule 15c3-3, as amended; Rule 18a-4, as adopted. See
section VI.C. of this release (discussing implementation costs).
---------------------------------------------------------------------------

    In cases of a broker-dealer SBSD, the costs of adapting existing
systems to account for cleared and non-cleared security-based swap
transactions may not be material in light of the similarities between
the systems and procedures currently required by Rule 15c3-3 and those
that will be required by final segregation rules. For bank and stand-
alone SBSDs without such systems, the operational up-front costs could
be higher. However, even in these cases it is likely that the entities
in question will have access to similar systems and expertise from
their broker-dealer affiliates.\1231\
---------------------------------------------------------------------------

    \1231\ As discussed above in section VI.A. of this release,
dealing activity in the security-based swap and swap market is
concentrated in affiliates of large diversified bank holding
companies. Such firms can be expected to have access to expertise
and systems of their broker-dealer affiliates.
---------------------------------------------------------------------------

    As discussed above, the extent to which segregation will be used by
market participants for non-cleared security-based swaps is unknown. In
particular, the Commission lacks data on the preferences of current
market participants for various segregation options, as well as the
private benefits and costs described qualitatively above that may
inform a market participant's choice of whether to use individual
segregation or omnibus segregation, or to waive segregation. In the
absence of a material increase in the use of segregation for non-
cleared security-based swaps, the direct costs of the final segregation
rules borne by counterparties to security-based swaps should be
minimal. Moreover, for market participants electing omnibus segregation
for non-cleared security-based swaps, the direct costs should be lower
than counterparties that elect individual segregation where the stand-
alone broker-dealer or SBSD will not hold the collateral directly and
will not be able to use it for the limited purpose permitted in the
final rules (i.e., hedging the customer's transaction). Thus, firms
running matched books that collect initial margin from end-users should
not have to fund additional collateral to support hedging transactions
with other SBSDs. For these reasons, the costs of omnibus segregation
should be lower as compared with individual segregation.\1232\
---------------------------------------------------------------------------

    \1232\ In addition, and as noted by one commenter, individually
segregated accounts impose increased administrative burdens and
related costs. See MFA 2/22/2013 Letter.
---------------------------------------------------------------------------

c. Alternatives Considered
i. Mandatory Individual Segregation
    A potential alternative to the final rules would be to mandate
individual segregation for non-cleared security-based swaps in a manner
that is consistent with the margin rules of the CFTC and the prudential
regulators.\1233\ This alternative would not give an SBSD's
counterparty to a non-cleared security-based swap the option to elect
omnibus segregation or to waive segregation altogether (if such a
waiver is permitted). Thus, the alternative is considerably more
restrictive. As discussed above, the magnitude of the costs and
benefits of segregation depends on the extent to which it is adopted by
market participants. Under this alternative, individual segregation
would be mandatory and thus universally practiced. As a result, it
would be more costly to market participants primarily due to
significant additional collateral funding costs,

while also providing financial stability benefits.
---------------------------------------------------------------------------

    \1233\ See CFTC Margin Adopting Release, 81 FR 636; Prudential
Regulator Margin and Capital Adopting Release, 80 FR 74840.
---------------------------------------------------------------------------

    Mandatory individual segregation would likely reduce the risk of
contagion. Third-party segregation with no re-hypothecation minimizes
the risk of delays and losses in the recovery of collateral for
transactions involving an entity that enters into financial
distress.\1234\ Under such arrangements, the counterparties of the
troubled entity can be confident in their ability to recover their
collateral in the event of its default. This reduces the incentives for
counterparties to ``run'' on the troubled entity. In addition, it
increases market participants' confidence in the financial condition of
the troubled entity's counterparties in the event of its default: in
such an event counterparties can be expected to recover their
collateral and the collateral posted by the defaulting party. Access to
the latter compensates the surviving counterparties for losses incurred
in replacing the defaulted transaction. Together, these effects can
stabilize the market in times of stress. Relatedly, this alternative
would restrict the implicit leverage in non-cleared security-based swap
transactions. By preventing re-hypothecation, the alternative would tie
growth in the gross notional amounts of non-cleared security-based swap
activity to the amount of collateral devoted to this activity. Similar
to other forms of leverage limits, this can contribute to financial
stability. Finally, by increasing the collateral costs of non-cleared
security-based swap transactions, this alternative would create
incentives for central clearing. Together, the aforementioned benefits
could further reduce the likelihood of sequential counterparty failure
in the security-based swap market beyond the rules the Commission is
adopting.
---------------------------------------------------------------------------

    \1234\ These risks are not entirely eliminated. Delays may still
occur due to legal disputes that prevent the third-party custodian
from releasing the collateral. Similarly, losses may still occur if
the third-party custodian suffers from financial distress. However,
under individual segregation with no re-hypothecation, the potential
for such delays and losses is expected to be relatively limited.
---------------------------------------------------------------------------

    However, these benefits of mandatory individual segregation with no
re-hypothecation come with a cost. The alternative would deprive the
SBSD of the use of collected collateral for re-hypothecation in related
transactions, or in support of its trading operations. As discussed in
the prior section, the locking up of collateral would raise the SBSD's
costs of facilitating security-based swap transactions.
    Aside from the additional collateral funding costs, this
alternative may further increase costs by reducing the SBSD's access to
defaulting counterparties' collateral in typical default scenarios. A
typical defaulting counterparty is not expected to be another SBSD, but
rather an end-user who does not collect collateral from the SBSD. In
such scenarios, third-party segregation can complicate the SBSD's
attempts to make use of the defaulting counterparty's collateral:
Rather than having immediate access to collateral in its possession or
control, the SBSD would need to obtain the collateral from a third
party. This could create delays that harm the SBSD's ability to
liquidate and reestablish the positions of the insolvent counterparty,
and may cause the SBSD to incur losses.
    The Commission has considered the costs and benefits of requiring
segregation at a third-party custodian and prohibiting re-
hypothecation. Based on its judgment and prior experience, the
Commission determines that the potential benefits to financial
stability do not justify the potentially considerable additional costs
that would need to be borne by market participants under this
alternative approach.
ii. Daily Computations To Determine Reserve Account Requirement
    The proposed rule provided that the computations necessary to
determine the amount required to be maintained in the SBS Customer
Reserve Account must be made daily as of the close of the previous
business day and any deposit required to be made into the account must
be made on the next business day following the computation no later
than one hour after the opening of the bank that maintains the account.
A commenter requested that the Commission require a weekly computation
rather than a daily computation.\1235\ The commenter stated that
calculating the reserve account formula is an onerous process that is
operationally intensive and requires a significant commitment of
resources. The commenter further stated that the Commission can achieve
its objective of decreasing liquidity pressures on SBSDs while limiting
operational burdens by requiring weekly computations and permitting
daily computations. The Commission acknowledges that a daily reserve
calculation will increase operational burdens as compared to a weekly
computation. Therefore, in response to comments, the Commission is
modifying the final rules to require a weekly SBS Customer Reserve
Account computation.\1236\
---------------------------------------------------------------------------

    \1235\ See SIFMA 2/22/2013 Letter.
    \1236\ See paragraphs (p)(3)(A) and (B) of Rule 15c3-3, as
amended; paragraphs (c)(3)(i) and (ii) of Rule 18a-4, as adopted.
---------------------------------------------------------------------------

iii. Including Securities Collateral Held in a Third-Party Custodial
Account in the Definition of ``Excess Securities Collateral''
    The proposed definition of ``excess securities collateral'' did not
include securities collateral held in a third-party custodial account.
As discussed above in section II.C.3.a.i. of this release, the proposed
definition would have prevented a stand-alone broker-dealer or SBSD
from posting a customer's securities collateral to a third-party
custodian in accordance with the requirements of the prudential
regulators. This consequence could have increased the cost incurred by
the stand-alone broker-dealer or nonbank SBSD to enter into a non-
cleared security-based swap with another SBSD to hedge a non-cleared
security-based swap with a customer under the conditions in the final
segregation rules. Under the proposed definition of ``excess securities
collateral,'' a broker-dealer or SBSD would have had to use proprietary
securities or cash to enter into a hedging transaction with a bank
SBSD. To the extent that the firm incurs a cost to obtain the
proprietary securities or cash, that cost would add to the cost of
entering into the hedging transaction with the bank SBSD and thus raise
the overall cost of hedging the transaction with the customer.
Alternatively, the broker-dealer or SBSD would have had to limit its
hedging transactions to nonbank SBSDs and avoid trading with bank
SBSDs. This approach would have avoided the need to use proprietary
securities or cash to enter into a hedging transaction, as discussed
above. However, by limiting itself to a smaller set of potential
counterparties (i.e., other SBSDs), the firm would have reduced the
competition among potential counterparties to provide hedging services
to the firm. If the reduced competition resulted in higher prices for
liquidity provision, for example, wider bid-ask spreads, the broker-
dealer or SBSD may have incurred a higher cost to enter into a hedging
transaction. To the extent that the firm passed on the increased
hedging cost to the customer by charging a higher price for providing
liquidity to the customer, transaction costs in the security-based swap
market could have risen, which may have discouraged participation in
the security-based swap market and

impeded the use of this market for hedging economic exposures. In light
of this concern, the Commission believes that the definition of
``excess securities collateral'' in the final rules is preferable to
this alternative.
iv. Including ``Unaffiliated'' in the Definition of ``Qualified
Registered Security-Based Swap Dealer Account''
    The proposed definition of ``qualified registered security-based
swap dealer account'' included the term ``unaffiliated,'' which meant
that an affiliated SBSD would not fall within the scope of the proposed
definition. As the Commission has discussed elsewhere, entities that
engage in security-based swap dealing activities may lay off the risk
associated with a security-based swap transaction to another affiliate
via a back-to-back transaction or an assignment of the security-based
swap.\1237\ To the extent that a broker-dealer or SBSD enters into a
non-cleared security-based swap with an affiliated SBSD to hedge a non-
cleared security-based swap with a customer as part of its risk
management, the proposed definition could impede the firm's risk
management because it could not use the counterparty's initial to meet
the margin requirement of the affiliated SBSD under the conditions of
the final rules. As a consequence, the broker-dealer or SBSD could have
incurred a higher cost to enter into a non-cleared security-based swap
with an affiliated SBSD for hedging purposes as permitted under the
conditions in the final rules. If the broker-dealer or SBSD chose to
enter into a hedging transaction with an affiliated SBSD, it would had
to use proprietary securities or cash to meet the affiliate SBSD's
margin requirement. To the extent that the nonbank SBSD incurred a cost
to obtain the proprietary securities or cash, that cost would add to
the cost of entering into the hedging transaction with the affiliated
SBSD and thus raise the overall cost of hedging the firm's transaction
with the counterparty. Alternatively, the nonbank SBSD could enter into
a hedging transaction with an unaffiliated SBSD that satisfies the
proposed definition of ``qualified registered security-based swap
dealer account'' so that it could use the counterparty's initial margin
to meet the margin requirement of the unaffiliated SBSD. However, the
nonbank SBSD may have still incurred a higher cost to enter into the
hedging transaction, if the unaffiliated SBSD charges a higher price
for providing liquidity than the affiliated SBSD. More generally, to
the extent that cost efficiencies are realized through the use of the
affiliated SBSD for risk management purposes, those efficiencies would
be lost if the broker-dealer or SBSD enters into a hedging transaction
with an unaffiliated SBSD, which would raise the overall cost of the
hedging transaction. To the extent that the broker-dealer or SBSD
passed on the increased hedging cost to the counterparty by charging a
higher price for providing liquidity to the counterparty, transaction
costs in the security-based swap market could have risen, which could
have discouraged participation in the security-based swap market and
impede the use of this market for hedging economic exposures. In light
of this concern, the Commission believes that the definition of
``qualified registered security-based swap dealer account'' in the
final rules is preferable to this alternative.
---------------------------------------------------------------------------

    \1237\ See Proposed Guidance and Rule Amendments Addressing
Cross-Border Application of Certain Security-Based Swap
Requirements, 84 FR 24206.
---------------------------------------------------------------------------

5. Cross-Border Application
a. Overview
    As the Commission has previously indicated, security-based swap
market is global, and market data presented in the economic baseline
demonstrates extensive cross-border participation in the market.\1238\
For example, approximately half of price-forming North American
corporate single-name CDS transactions from January 2008 to December
2015 were cross-border transactions between a U.S.-domiciled
counterparty and a foreign-domiciled counterparty. Counterparties in
the security-based swap market are highly interconnected; dealers
transact with hundreds of counterparties, and most non-dealers transact
with multiple dealers. The global scale of the security-based swap
market allows counterparties to access liquidity across jurisdictional
boundaries, providing market participants with opportunities to share
these risks with counterparties around the world. Because dealers
facilitate the great majority of security-based swap transactions, with
bilateral relationships that extend to potentially thousands of
counterparties spanning multiple jurisdictions, the safety and
soundness of non-U.S. dealers can have significant implications for
U.S. financial stability.
---------------------------------------------------------------------------

    \1238\ See, e.g., Application of ``Security-Based Swap Dealer''
and ``Major Security-Based Swap Participant'' Definitions to Cross-
Border Security-Based Swap Activities; Republication, 79 FR at
47280; Application of Certain Title VII Requirements to Security-
Based Swap Transactions Connected With a Non-U.S. Person's Dealing
Activity That Are Arranged, Negotiated, or Executed by Personnel
Located in a U.S. Branch or Office or in a U.S. Branch or Office of
an Agent, 80 FR at 27454; Business Conduct Standards for Security-
Based Swap Dealers and Major Security-Based Swap Participants, 81 FR
29960.
---------------------------------------------------------------------------

    As discussed above in section II.E.1. of this release, the
Commission is treating the capital and margin requirements of the
Exchange Act the final rules as entity-level requirements. The
Commission also is amending Rule 3a71-6 to make a substituted
compliance available with respect to the capital and margin
requirements of Section 15F(e) of the Exchange Act and Rules 18a-1,
18a-2, and/or 18a-3.
    The Commission is treating the segregation requirement as a
transaction-level requirement. Further, substituted compliance is not
available with respect to the final segregation requirements. However,
the final segregation rule for stand-alone and bank SBSDs and MSBSPs
has exceptions under which a foreign firm need not comply with the
segregation requirements of Section 3E of the Exchange Act and Rule
18a-4 for certain transactions. The final rule also requires a foreign
stand-alone or bank SBSD to make certain disclosures to a U.S.
security-based swap customer relating to segregation and U.S.
bankruptcy and foreign insolvency laws. There are no exceptions from
the segregation rule for cross-border transactions of a broker-dealer
SBSD or MSBSP.
b. Benefits and Costs
    In considering the economic effects of this cross-border approach,
the Commission recognizes that the economic baseline reflects markets
as they exist today, in which no population of registered SBSDs and
MSBSPs exists and compliance with capital, margin, and segregation
requirements for security-based swaps is not required. Therefore, these
final rules will apply with respect to security-based swap transactions
intermediated by entities where they currently do not.
    Imposing the new capital and margin requirements on non-U.S. SBSDs
and MSBSPs has the potential to significantly impact the willingness of
foreign entities to transact with U.S. counterparties in the security-
based swap market, especially firms for which the U.S. market
represents a relatively small fraction of total security-based swap
business. For such firms, the additional costs resulting from having to
comply with the capital and margin requirements of the Exchange Act the
Commission's final rules in addition to corresponding regulations
applicable in their own jurisdiction may not justify the benefits of
conducting security-based swap transactions with U.S.

entities. The exit of foreign firms from the U.S. security-based swap
market could potentially harm liquidity in these markets, and more
importantly, would likely reduce valuable risk-sharing opportunities
for U.S. counterparties.
    However, as noted earlier, the global and inter-connected nature of
the security-based swap market implies that the safety and soundness of
non-U.S. firms operating in this market can have a significant impact
on U.S. financial stability. Moreover, failing to apply capital and
margin regulations to such foreign entities would potentially create
incentives for regulatory arbitrage as participants in U.S. markets
would seek to locate in jurisdictions with the most favorable capital
and margin treatment.
    With respect to capital requirements, the Commission believes that
imposing the same entity-level requirements that are applicable to U.S.
firms on non-U.S. entities with the opportunity for substituted
compliance in cases where the foreign jurisdiction imposes comparable
requirements reflects appropriate consideration of potential compliance
costs and benefits to U.S. markets. By allowing non-U.S. entities to
satisfy comparable requirements in foreign jurisdictions, the rule
mitigates the compliance burden on these non-U.S. entities. At the same
time, by requiring compliance with capital requirements at the entity
level, the rule should reduce the likelihood that entities operating in
the U.S. market will impose negative financial stability externalities
on the U.S. market by locating in a foreign jurisdiction. The
Commission did not receive comments addressing the proposed treatment
of capital as an entity-level requirement.
    Similar considerations apply to the Commission's approach in
treating the final margin requirements as entity-level requirements. A
number of commenters suggested that the Commission should apply margin
requirements on a transaction-level basis instead of on an entity-level
basis, with several arguing that this was necessary for consistency
with other domestic and foreign regulators.\1239\ Some of these
commenters also pointed to the costs and operational complications that
could result from subjecting a foreign registrant to both Commission
and home country margin requirements.\1240\
---------------------------------------------------------------------------

    \1239\ See Better Markets 8/21/2013 Letter (arguing that
treating margin as a transaction-level requirement ``is more
consistent with the CFTC's cross-border guidance''); IIB 8/21/2013
Letter (stating that the Commission's divergence from the CFTC's
rules and those envisioned by the EMIR would be ``impracticable''
and ``could also lead to significant competitive distortions'');
ISDA 1/23/2013 Letter (generally requesting that the Commission
recognize local margin requirements for SBSDs outside the United
States, and coordinate with the CFTC and other domestic and foreign
regulators to achieve consistency in the treatment of swaps and
security-based swaps involving multiple jurisdictions); Japan SDA
Letter (urging the Commission and the CFTC to align their rules to
avoid ``hamper[ing] efficient management of derivatives
transactions'').
    \1240\ See IIB 8/21/2013 Letter (stating that it would be
``cost-intensive'' to ``negotiate and execute separate credit
support documentation, make separate margin calculations and have
separate operational procedures across its swap and [security-based
swap] transactions''); Japan SDA Letter (inconsistent rules would
``hamper efficient management of derivatives transactions'').
---------------------------------------------------------------------------

    While there are potential consistency issues and operational
complications to applying the Commission's margin requirements at the
entity-level rather than at the transaction-level, these considerations
have to be considered in the context of the economic function of margin
requirements. The primary economic function of the Commission's final
margin requirements is to enhance financial stability to help ensure
the safety and soundness of nonbank SBSDs and nonbank MSBSPs.
Permitting substantially different margin requirements based on the
location of the counterparty would not be consistent with this
objective and could undermine the stability of U.S. markets. Moreover,
as above discussed in section VI.B.3. of this release, the Commission
expects market participants to employ industry standard models in the
calculation of initial margin amounts. It is reasonable to expect that
such models will be designed in a manner to comply with the margin
requirements of the key jurisdictions implementing margin regulations,
thereby reducing the potential for significant discrepancies. Finally,
minor differences in margin requirements across jurisdictions can be
addressed through applications for substituted compliance.
    While Commission's final capital and margin requirements primarily
serve to ensure the safety and soundness of regulated entities and
thereby enhance financial stability, a primary economic function of the
Commission's final segregation requirements is to protect the assets of
U.S. customers and counterparties in the event of an SBSD's insolvency
and to align the final segregation requirements with U.S. insolvency
laws. As such, the Commission proposed transaction-level requirements
tailored to address the risks faced by U.S. customers of non-U.S.
entities. The Commission did not receive comments addressing the
transaction-level treatment of the segregation requirements. However,
one commenter stated that it ``support[s] the Commission's overall
proposal to distinguish between entity-level and transaction-level
requirements'' and that it ``generally support[s] the Commission's
proposed cross-border application of segregation requirements to
foreign SBSDs.'' \1241\ The main considerations in the design of the
Commission's segregation requirements with respect to non-U.S. SBSDs
and MSBSPs are of a legal rather than economic nature. They are
discussed in section II.D.1. of this release.
---------------------------------------------------------------------------

    \1241\ See IIB 8/21/2013 Letter.
---------------------------------------------------------------------------

6. Rule 18a-10
a. Overview
    As discussed above in section II.D. of this release, the final
capital, margin, and segregation rules include an alternative
compliance mechanism (codified in Rule 18a-10) pursuant to which a
stand-alone SBSD that is registered as a swap dealer and predominantly
engages in a swaps business may elect to comply with the capital,
margin, and segregation requirements of the CEA and the CFTC's rules
applicable to swap dealers instead of complying with Rules 18a-1, 18a-
3, and 18a-4.\1242\ In order to qualify for the alternative compliance
mechanism, the firm must: (1) Be registered as an SBSD pursuant to
Section 15F(b) of the Exchange Act and the rules thereunder; (2) be
registered as a swap dealer pursuant to Section 4s of the Commodity
Exchange Act and the rules thereunder; (3) not be registered as a
broker-dealer pursuant to Section 15 of the Exchange Act or the rules
thereunder; (4) meet the conditions to be exempt from Rule 18a-4
specified in paragraph (f) of that section; and (5) as of the most
recently ended quarter of the fiscal year, have an aggregate gross
notional amount of the security-based swap positions of the that do not
exceed the lesser of the maximum fixed-dollar amount specified in
paragraph (f) of the rule or 10 percent of the combined aggregate gross
notional amount of the security-based swap and swap positions of the
SBSD. The maximum fixed-dollar amount is set at a transitional level of
$250 billion for the first 3 years after the compliance date of the
rule and then drops to $50 billion thereafter unless the Commission
issues an order: (1) Maintaining the $250 billion maximum fixed-dollar
amount for an additional period of time or indefinitely; or (2)
lowering the maximum fixed-dollar

amount to an amount between $250 billion and $50 billion.
---------------------------------------------------------------------------

    \1242\ See Rule 18a-10. As discussed above in section II.D. of
this release, while a bank SBSD could theoretically use the
alternative compliance mechanism, the Commission does not expect
such an entity will do so.
---------------------------------------------------------------------------

    The rule further requires a stand-alone SBSD operating pursuant the
alternative compliance mechanism to provide a written disclosure to its
counterparties before the first transaction with the counterparty after
the firm begins operating pursuant to the mechanism notifying the
counterparty that the firm is complying with the applicable capital,
margin, segregation, recordkeeping, and reporting requirements of the
CEA and the CFTC's rules in lieu of complying with Rules 18a-1, 18a-3,
and 18a-4. The rule further requires, among other things, that the firm
comply with the capital, margin, and segregation requirements of the
CEA and the CFTC's rules applicable to swap dealers and treat security-
based swaps and related collateral pursuant to those requirements to
the extent the requirements do not specifically address security-based
swaps and related collateral.
b. Benefits and Costs of Rule 18a-10
    The final rule provides stand-alone SBSDs that are also registered
as swap dealers and that engage predominantly in swap activity with
flexibility to comply with a single set of requirements under the CEA
and the CFTC's rules. The primary benefit of the alternative compliance
mechanism is that it will avoid the costs of complying with two sets of
capital, margin, and segregation requirements for a firm that is dually
registered as a stand-alone SBSD and a swap dealer. This benefit is
perhaps best illustrated through how it will permit a stand-alone SBSD
to comply with the capital requirements of the CEA and the CFTC's rules
exclusively rather than comply both with those requirements and with
the capital requirements of the Commission's rules. For example, a
stand-alone SBSD operating pursuant to the alternative compliance will
not need to perform two capital computations and monitor its capital
position and financial condition to ensure it is complying with the
Commission's capital requirements (in addition to the capital
requirements of the CEA and the CFTC's rules).
    Moreover, as discussed above, the Commission's final capital rules
impose certain requirements with respect to swap positions that are not
imposed by the CFTC's proposed capital rules and that could have
important economic implications for firms that engage in swap trading
activity. These requirements include a requirement that a stand-alone
SBSD will need to take a capital deduction if the firm posts initial
margin to a counterparty in a swap transaction pursuant to the margin
rules of the CFTC. The Commission is providing guidance in this release
to as to how a firm could avoid this capital deduction. While some
firms may be able to take advantage of this guidance, others may not.
Thus, generally, the requirement may impose costs on those firms that
cannot use the guidance.
    In addition, stand-alone SBSDs also will be required to take a
capital deduction in lieu of margin or credit risk charge for
uncollateralized exposures from swap positions that are subject to an
exception in the margin rules of the CFTC. For example, one such
exception in the CFTC's margin rules is that swap dealers are not
required to collect initial margin on swaps from counterparties that
are not ``covered swap entities'' or ``financial end users,'' as those
terms are defined in the rules. Because reallocating capital from other
activities to support the swap trading activity or raising capital is
generally costly, the requirement may impose a cost on those firms that
carry uncollateralized exposures from swap transactions.
    Another requirement is that stand-alone SBSDs will be required to
take a capital deduction or credit risk charge for margin collateral
required of a counterparty pursuant to the CFTC's margin rule that is
held at a third-party custodian. The final capital rules contain an
exception from having to take this capital charge. The conditions for
the exception are designed to recognize existing agreements entered
into pursuant the margin rules of the CFTC. However, to the extent
firms cannot meet all the conditions for the exception, they may not be
able to avoid taking the capital charges associated with this
requirement, and therefore may incur potential costs.
    The proposed capital rules of the CFTC do not include some
requirements being adopted by the Commission, and therefore swap
dealers that are not dually registered as SBSDs may not face the
potential costs associated with these requirements. From this
perspective, stand-alone SBSDs that can meet the conditions of the
alternative compliance mechanism will have an incentive to take
advantage of it. The larger the potential costs associated with the
differences between the final capital rules of the CFTC (when adopted)
and the Commission, the larger the potential impact of the overlapping
regulatory regimes on the swap trading activity. The alternative
compliance mechanism will reduce the potential impact of these costs on
the swap trading activity of stand-alone SBSDs, which, in turn, could
benefit the swap market participants to the extent that stand-alone
SBSDs that use the alternative compliance mechanism pass on the
associated cost savings to their counterparties in the form of lower
prices for liquidity provision.
    Firms that face potential costs associated with differences between
the capital, margin, and segregation requirements of the Commission's
rules and the CFTC's rules may be at a competitive disadvantage
relative to firms that are subject to the CFTC's rules only, and, as a
result, the latter category of firms may be able to offer better prices
to swap market participants. Therefore, the primary benefit of the
alternative compliance mechanism is that it will avoid these costs and
the corresponding competitive impact of them.
    However, using the alternative compliance mechanism will also
impose costs on stand-alone SBSDs. In particular, the requirement to
provide written disclosure to all counterparties prior to the first
transaction that would be subject to the alternative compliance
mechanism will impose costs. These implementation costs are discussed
in more detail in section VI.C. below.
    The maximum fixed-dollar amount is set at a transitional level of
$250 billion for the first 3 years after the compliance date of the
rule and then drops to $50 billion thereafter unless the Commission
issues an order: (1) Maintaining the $250 billion maximum fixed-dollar
amount for an additional period of time or indefinitely; or (2)
lowering the maximum fixed-dollar amount to an amount between $250
billion and $50 billion.
    Analysis by Commission staff indicates that the 10% threshold
likely will be the greater of the two thresholds for stand-alone SBSDs
that are also registered as swap dealers. Thus, the following
discussion focuses on the maximum fixed-dollar threshold. Commission
staff estimates that up to seven stand-alone SBSDs that are also
registered as swap dealers have aggregate gross notional amount of
single-name CDS positions that fall under the $250 billion threshold.
Out these 7 stand-alone SBSDs that are also swap dealers, Commission
staff estimates that between 1 and 4 \1243\ may engage in levels of
security-based swap activity such that the aggregate gross notional
amount of their single-name CDS positions may fall under the $50
billion threshold.
---------------------------------------------------------------------------

    \1243\ The upper bound estimate of 4 accounts for data
limitations and measurement errors.

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

    To the extent that the aggregate gross notional amount of these
stand-alone SBSDs' single-name CDS positions remains unchanged, the
lowering of the maximum fixed-dollar amount from $250 billion to $50
billion could impose costs on certain stand-alone SBSDs that may seek
to use the alternative compliance mechanism. In particular, stand-alone
SBSDs with aggregate gross notional amount of less than $250 billion
but above $50 billion will be able to use alternative compliance
mechanism in the first 3 years and benefit from the associated cost
savings discussed above. If the maximum fixed-dollar amount is lowered
to $50 billion after 3 years, these stand-alone SBSDs would not be able
to use alternative compliance mechanism and would begin to incur the
costs described above. To the extent that these stand-alone SBSDs have
to incur higher costs in order to operate their dealing businesses,
they may be at a competitive disadvantage relative to dealers that are
subject to CFTC requirements. In addition, to the extent that
differences between Commission and CFTC capital, margin, and
segregation requirements result in different implementation
requirements (e.g., different information technology infrastructures)
these stand-alone SBSDs may have to incur costs to modify their
existing systems and operations to support compliance with the
Commission's capital, margin, and segregation requirements. However,
the Commission believes these costs would be mitigated by the fact the
final rules adopted today are harmonized with those of the CFTC to the
maximum extent practicable. Moreover, if the Commission lowers the
maximum fixed-dollar amount to a level that is between $250 billion and
$50 billion, some of the firms with aggregate gross notional amount of
single-name CDS positions may be able to continue to use the
alternative compliance mechanism.

C. Implementation Costs

    As discussed above, Rules 18a-1 through 18a-4, and 18a-10, as well
as the amendments to Rules 15c3-1 and 15c3-3, will impose certain
implementation costs on SBSDs and MSBSPs. The Commission expects that
the highest economic cost impact as a result of the final rules will
likely result from the additional capital that nonbank SBSDs and MSBSPs
may need to hold as a result of the capital rules, and the additional
margin that nonbank SBSDs and MSBSPs, and other market participants may
need to post and/or collect as a result of the Commission's margin
requirements.
    Other costs may include start-up costs, including personnel and
other costs, such as technology costs, to comply with the final rules.
As discussed above in section IV.D. of this release, the Commission has
estimated the burdens and related costs of these implementation
requirements for SBSDs and MSBSPs.\1244\ These costs are summarized
below.
---------------------------------------------------------------------------

    \1244\ See section IV.D. of this release (discussing the total
initial and annual recordkeeping and reporting burdens of the new
rules and rule amendments).
---------------------------------------------------------------------------

    A stand-alone SBSD that applies to use internal models will be
required under Rule 18a-1 to create and compile various documents to be
included with the application, including documents related to the
development of its models, and to provide additional documentation to,
and respond to questions from, Commission staff throughout the
application process.\1245\ These firms also will be required to review
and backtest these models annually. The requirements are estimated to
impose one-time and annual costs in the aggregate of approximately
$1.34 million \1246\ and $6.6 million,\1247\ respectively. It is also
estimated that these firms will incur initial technology costs of $32
million \1248\ in the aggregate.
---------------------------------------------------------------------------

    \1245\ See section IV.A.1. of this release.
    \1246\ This consists of external costs of $400,000, plus
internal costs of $938,000. See section IV.D.1. of this release.
    \1247\ This consists of external costs of $2.496 million, plus
internal costs of $4.12 million. See section IV.D.1. of this
release.
    \1248\ See section IV.D.1. of this release.
---------------------------------------------------------------------------

    Rule 18a-1 also will require stand-alone SBSDs to establish,
document, and maintain a system of internal risk management controls
required under Rule 15c3-4, as well as to review and update these
controls.\1249\ This requirement will impose one-time and annual costs
in the aggregate of $6.1 million \1250\ and $606,000,\1251\
respectively. These firms also may incur aggregate initial and ongoing
information technology costs of $192,000 and $246,000,
respectively.\1252\
---------------------------------------------------------------------------

    \1249\ See section IV.A.1. of this release.
    \1250\ See section IV.D.1. of this release.
    \1251\ See id.
    \1252\ See id.
---------------------------------------------------------------------------

    As discussed above, the Commission staff estimates that 4 broker-
dealer SBSDs and 2 standalone SBSDs not authorized to use models will
utilize the CDS haircut provisions under the amendments to Rules 15c3-1
and 18a-1, respectively. Consequently, these firms will use an industry
sector classification system that is documented for the credit default
swap reference obligors. The Commission staff estimates that nonbank
SBSDs not using models will incur an aggregate annual cost of $2,226
\1253\ to document these industry sectors.
---------------------------------------------------------------------------

    \1253\ See id.
---------------------------------------------------------------------------

    Under paragraph (h) of Rule 18a-1, a nonbank SBSD is required to
file certain notices with the Commission relating to the withdrawal of
equity capital. The Commission staff estimates that stand-alone SBSDs
will incur an aggregate annual cost of $2,226 \1254\ to file such
notices.
---------------------------------------------------------------------------

    \1254\ See id.
---------------------------------------------------------------------------

    Under Rule 18a-1d, a nonbank SBSD is required to file a proposed
subordinated loan agreement with the Commission (including
nonconforming subordinated loan agreements). In connection with this
provision, the Commission staff estimates that stand-alone SBSDs will
incur aggregate one-time and annual costs of $50,640 and $25,320,
respectively.\1255\
---------------------------------------------------------------------------

    \1255\ See id.
---------------------------------------------------------------------------

    Rule 18a-1, as adopted, and Rule 15c3-1, as amended, will also
require the execution of an account control agreement by nonbank SBSDs.
This will require firms to execute each account control agreement
internally, and they may engage outside counsel to review the account
control agreement and potentially to draft and review an opinion that
an account control agreement is (or a set of account control agreements
are) legally valid, binding, and enforceable in all material respects.
These requirements are estimated to impose one-time and annual costs in
the aggregate of approximately $345,620 \1256\ and $1.86 million,\1257\
respectively.
---------------------------------------------------------------------------

    \1256\ Calculated as $176,000 (outside counsel to draft and
review account control agreement) + $88,000 (opinion of counsel) +
$81,620 (written `in-house' analysis) = $345,620. See section
IV.D.1. of this release.
    \1257\ This is the estimated industry-wide annual burden of
$1,856,800. See section IV.D.1. of this release.
---------------------------------------------------------------------------

    Rule 18a-2 also will require nonbank MSBSPs to establish, document,
and maintain a system of internal risk management controls required
under Rule 15c3-4, as well as to review and update these
controls.\1258\ This requirement is estimated to impose one-time and
annual costs in the aggregate of $2.77 million \1259\ and $252,500
\1260\ for nonbank MSBSPs, respectively. These nonbank MSBSPs also may
incur initial and ongoing information

technology costs of $80,000 and $102,500, respectively.\1261\
---------------------------------------------------------------------------

    \1258\ See section IV.A.2. of this release.
    \1259\ This consists of external costs of $400,000, plus
internal costs of $2.37 million. See section IV.D.2. of this
release.
    \1260\ See section IV.D.2. of this release.
    \1261\ See id.
---------------------------------------------------------------------------

    Rule 18a-3 will require nonbank SBSDs to establish a written risk
analysis methodology, which will need to be reviewed and updated.\1262\
This requirement is estimated to impose one-time and annual costs in
the aggregate of $1.62 million \1263\ and $489,720,\1264\ respectively.
---------------------------------------------------------------------------

    \1262\ See section IV.A.3. of this release.
    \1263\ See section IV.D.3. of this release. This consists of
external costs of $12,000, plus internal costs of $1.61 million.
    \1264\ See id.
---------------------------------------------------------------------------

    Rule 18a-3, as adopted will require nonbank SBSDs to seek
Commission approval to use an internal model to calculate initial
margin.\1265\ This requirement is estimated to impose one-time and
annual costs in the aggregate of $464,200 and $1,575,750,
respectively.\1266\
---------------------------------------------------------------------------

    \1265\ See section IV.A.3. of this release.
    \1266\ See section IV.D.3. of this release.
---------------------------------------------------------------------------

    SBSDs and MSBSPs will incur various one-time and ongoing costs in
the aggregate in order to comply with the segregation and notification
requirements of Rule 18a-4 and the amendments to Rule 15c3-3.\1267\
Each SBSD will incur one-time and annual costs in establishing special
bank accounts required by the rule. This requirement is estimated to
impose one-time and annual costs of $2.9 million \1268\ and $367,290
\1269\ in the aggregate on SBSDs, respectively. In addition, SBSDs will
be required to perform a reserve computation required by Exhibit A to
Rule 18a-4 or Exhibit B to Rule 15c3-3, which is estimated to impose on
these firms annual costs in the aggregate of approximately $1.69
million.\1270\
---------------------------------------------------------------------------

    \1267\ See section IV.A.4. of this release.
    \1268\ See section IV.D.4. of this release.
    \1269\ See id.
    \1270\ See id.
---------------------------------------------------------------------------

    In addition, both SBSDs and MSBSPs will be required to prepare and
send to their counterparties segregation-related notices pursuant to
Section 3E(f) of the Exchange Act.\1271\ This requirement is estimated
to impose one-time and annual costs in the aggregate to SBSDs and
MSBSPs of $870,857 \1272\ and $130,143,\1273\ respectively.
---------------------------------------------------------------------------

    \1271\ See section IV.A.4. of this release.
    \1272\ See section IV.D.4. of this release. This consists of
external costs of $220,000, plus internal costs of $650,857.
    \1273\ See section IV.D.4. of this release.
---------------------------------------------------------------------------

    Rule 15c3-3, as amended, and Rule 18a-4, as adopted, will require
each SBSD to draft, prepare, and enter into subordination agreements
with certain counterparties.\1274\ This requirement is estimated to
impose on these firms one-time and annual costs in the aggregate of
$43.7 million \1275\ and $8.4 million,\1276\ respectively.
---------------------------------------------------------------------------

    \1274\ See section IV.A.4. of this release.
    \1275\ See section IV.D.4. of this release. Calculated as
$1,603,600 (drafting and preparation of subordination agreements) +
$152,000 (review by outside counsel) + $41,990,000 (entering into
subordination agreements with counterparties) = $43,745,600.
    \1276\ See section IV.D.4 of this release (estimating that 19
SBSDs will incur an industry-wide annual burden of $8,398,000 in
connection with establishing account relationships with new
counterparties per year).
---------------------------------------------------------------------------

    Rule 15c3-3, as amended, and Rule 18a-4, as adopted, will require
registered foreign SBSDs to provide disclosures to their U.S.
counterparties. This requirement is estimated to impose on these firms
one-time and annual costs in the aggregate of $6,034,600 \1277\ and
$46,420,\1278\ respectively.
---------------------------------------------------------------------------

    \1277\ This consists of 3,300 hours of in-house attorney time in
addition to 11,000 of in-house counsel hours required to create and
incorporate disclosure language in trading documentation, at a rate
of $422 per hour. See section IV.D.4. of this release.
    \1278\ This consists of 110 hours of in-house attorney time
multiplied by $422 per hour. See section IV.D.4. of this release.
---------------------------------------------------------------------------

    The Commission estimates that 31 SBSDs (25 bank SBSDs and 6 stand-
alone SBSDs) will incur costs in connection with the disclosure
condition under paragraph (f)(3) of Rule 18a-4. These SBSDs are
estimated to incur one-time and annual costs in the aggregate of
$130,885,410,\1279\ and $65,410,\1280\ respectively.
---------------------------------------------------------------------------

    \1279\ Calculated as cost of developing new disclosure language
(155 in-house counsel hours x $422 per hour = $65,410) + cost of
incorporating new disclosure language into trading documentation
(310,000 in-house counsel hours x $422 per hour = $130,820,222) =
$130,885,410. See section IV.D.4. of this release.
    \1280\ Calculated as 155 in-house counsel hours x $422 per hour
= $65,410. See section IV.D.4. of this release.
---------------------------------------------------------------------------

    Rule 18a-10 prescribes an alternative compliance mechanism pursuant
to which a stand-alone that is registered as a swap dealer and
predominantly engages in a swaps business may elect to comply with the
capital, margin, and segregation requirements of the CEA and the CFTC's
rules in lieu of complying with Rules 18a-1, 18a-3, and 18a-4 (as
applicable). As discussed above, the Commission estimates that 3 stand-
alone SBSDs will elect to operate under Rule 18a-10. In connection with
the disclosure requirements under paragraph (b)(2) of Rule 18a-10,
these stand-alone SBSDs are estimated to incur one-time and annual
costs in the aggregate of $12,666,330,\1281\ and $6,300,\1282\
respectively. The Commission estimates that the notice requirement of
paragraph (b)(3) of Rule 18a-10 will impose an aggregate annual cost of
$185.50.\1283\
---------------------------------------------------------------------------

    \1281\ Calculated as cost of developing new disclosure language
(15 in-house counsel hours x $422 per hour = $6,330) + cost of
incorporating new disclosure language into trading documentation
(30,000 in-house counsel hours x $422 per hour = $12,660,000) =
$12,666,300. See section IV.D.5. of this release.
    \1282\ Calculated as 15 in-house counsel hours x $422 per hour =
$6,330. See section IV.D.5. of this release.
    \1283\ See section IV.D.5. of this release estimating that an
internal compliance attorney of one stand-alone SBSD will take 30
minutes to file one notice annually with the Commission. Therefore,
the estimated cost = 30 minutes at $371 per hour = $185.50.
---------------------------------------------------------------------------

    Rule 3a71-6 gives firms the option of applying for substituted
compliance with regard to the final capital and margin rules. This
requirement is estimated to impose on these firms a one-time cost in
the aggregate of $341,280.\1284\
---------------------------------------------------------------------------

    \1284\ This consists of 240 initial burden hours times $422 an
hour for in-house attorney ($101,280), in addition to the $240,000
estimated costs for outside counsel. See section IV.D.6. of this
release.
---------------------------------------------------------------------------

D. Effects on Efficiency, Competition, and Capital Formation

    The OTC swaps and security-based swap market is characterized by
complex bilateral exposure networks. Currently, such networks are
opaque. Consequently, it is not possible for market participants to
accurately ascertain counterparty exposures to other market
participants. During times of market stress, market participants'
uncertainty about the financial condition of their OTC derivative
counterparties can lead markets to become illiquid. Distress at dealers
or at other major participants is a particular source of concern. The
lack of information about individual market participants' exposures to
such troubled firms can lead to widespread ``contagion'' which may lead
markets to break down. Disruptions to the OTC derivative markets can
shut down critical risk-transfer mechanisms and further exacerbate
concerns about the exposures of important financial intermediaries.
This, in turn, can lead to disruptions in credit provision to the real
economy. Moreover, the opacity of these markets can foster excessive
risk taking, which can both instigate and exacerbate the breakdown of
these markets.
    The final capital, margin, and segregation rules work together to
help improve the stability of the security-based swap market, and in so
doing mitigate the inefficiencies in these markets arising from the
existence of default risk of derivative counterparties. The final
capital and margin rules will reduce a nonbank SBSD's

uncollateralized derivative exposures and require firms to hold
additional capital to address uncollateralized exposures. This will
reduce potential losses from these exposures in the event of a
counterparty default. In cases where nonbank SBSDs are not required to
collect margin or where the collected margin is not under the SBSD's
control, the final capital rules require nonbank SBSDs to allocate
capital to reduce the potential losses from uncollateralized
counterparty exposure. In this way, the capital rules complement the
margin rule to reduce a nonbank SBSD's probability of default, reduce
incentives for excessive risk-taking, and reduce the probability of
sequential counterparty failure. Finally, the capital requirements for
nonbank MSBSPs should reduce the likelihood of a MSBSP's failure and
the potential losses to nonbank SBSD counterparties in the event of
MSBSP's failure. In this way, the capital and margin rules are designed
to reduce the risk that the failure of one entity propagates to its
counterparties.
    Furthermore, the margin rule will reduce a nonbank SBSD's incentive
for excessive risk taking and will restrict the amount of implicit
leverage that market participants can achieve through non-cleared
security-based swaps. In addition, the margin rule will also reduce the
potential cost advantages of non-cleared transactions relative to
cleared transactions, and thereby encourage the clearing of such
transactions. While the final margin rule provides protection for the
margin collector against the default of the margin poster, it
simultaneously exposes the poster of initial margin to additional risk.
The Commission's final segregation rules, however, are designed to
complement the margin rule by ensuring that posted margin is adequately
protected.
    Through the aforementioned channels, the Commission's capital,
margin, and segregation rules are expected to have a generally positive
effect on economic efficiency, and capital formation. However, because
of the complex, overlapping regulatory environment of the security-
based swap market, the final rules' effects on competition are more
uncertain. In this section, the Commission considers each of these
effects in turn.
1. Efficiency and Capital Formation
    In principle, the security-based swap market improves efficiency by
facilitating risk transfer in the economy. In addition, by mitigating
market imperfections in underlying securities markets (such as limited
liquidity), it can help improve price discovery with attendant positive
effects on firms' borrowing costs. However, the extent to which the
security-based swap market improves efficiency is limited due to
counterparty credit risk. Specifically, the imperfection in the
security-based swap market resulting from counterparty default can
facilitate excessive and opaque risk-taking and have negative effects
on the stability of this market.\1285\ The final capital, margin, and
segregation rules help address these market imperfections.
---------------------------------------------------------------------------

    \1285\ See BCBS/IOSCO Paper.
---------------------------------------------------------------------------

    Excessive risk-taking by dealers and other major participants in
the security-based swap market can arise from misaligned incentives of
the firms' manager-owners and those of other investors due to limited
liability.\1286\ More generally, contracting frictions can cause
similar incentive misalignments between managers and shareholders,
other investors, counterparties, and customers. Because the costs of
monitoring large financial intermediaries are significant, the
creditors and customers of such firms are generally not in a position
to monitor their management. This lack of monitoring can lead financial
firms to pursue inefficient risk management policies.
---------------------------------------------------------------------------

    \1286\ See Michael C. Jensen and William H. Meckling, Theory of
the Firm: Managerial Behavior, Agency Costs and Ownership Structure,
Journal of Financial Economics (Oct. 1976).
---------------------------------------------------------------------------

    Even absent these incentive conflicts and monitoring limitations,
firms may choose to engage in trading activity that, while privately
optimal, reduces overall financial stability. Unexpected losses on
derivatives positions at one firm can threaten the financial viability
of its counterparties, with the potential to precipitate sequential
counterparty failures. Moreover, due to the opacity of financial firms,
market fears of such contagion can lead to anticipatory ``runs'' on
financial institutions, further undermining financial stability.
Importantly, the costs associated with the reductions in financial
stability that result from a given firm's policies and strategies are
not fully internalized by the firm.\1287\ The final capital, margin,
and segregation rules help to mitigate the inefficiencies resulting
from this negative externality.
---------------------------------------------------------------------------

    \1287\ One commenter noted that the dollar cost of the financial
collapse will exceed $12.8 trillion, and argued that Congress's
resolve to prevent another massively costly financial crisis
overrides any industry-claimed cost concerns under the Dodd-Frank
Act. See Better Markets 2/22/2013 Letter.
---------------------------------------------------------------------------

    The final capital, margin, and segregation rules for participants
in the security-based swap market being adopted by the Commission can
improve efficiency by addressing the aforementioned market failures. By
imposing a set of minimum risk management standards on affected
entities, these requirements reduce the scope for incentive conflicts
that may arise among these entities, their investors, counterparties,
and customers, which can lead to more efficient investment policies. In
addition, these new requirements can reduce the degree to which an
individual firm's risk-taking imposes negative externalities on the
market as a whole by: (1) Reducing uncertainty about exposures to non-
cleared security-based swaps and the resulting potential for contagion;
(2) reducing the ability of entities to engage in excessive risk
taking; (3) promoting central clearing of sufficiently standardized
products; and (4) promoting a uniform set of standards across
regulatory agencies that limit opportunities for regulatory arbitrage.
By improving financial stability in these ways, the final capital,
margin, and segregation rules may also facilitate capital formation. In
particular, because financial crises are typically associated with
large reductions in the supply of aggregate capital, financial
instability and financial crises resulting from such instability can
have large negative economic consequences, including significant harm
to capital formation. By reducing the likelihood of such crises, the
Commission expects the capital, margin, and segregation rules will
enhance capital formation.
    The Commission acknowledges that nonbank SBSDs might pass on a
portion of the costs incurred as a result of the capital, margin, and
segregation rules to end users. To the extent that end users bear these
costs, they might reduce investments. This potential impact on
investment depends in part on the degree of competition among SBSDs. In
particular, robust competition among SBSDs would limit their ability to
pass on costs to end users and in turn mitigate any adverse impact on
investment.
    As acknowledged in section VI.C. of this release, the degree to
which the aforementioned benefits improve efficiency depends on the
costs imposed by these measures. These costs include the costs of
funding additional collateral to meet margin requirements, the costs of
additional capital, and the costs of implementation and compliance. In
isolation, these additional costs would be expected to increase
transaction costs of security-based swap trading, suppressing trading,
and liquidity. Insofar as the benefits of the regulations do not
counteract these effects, price discovery may be harmed and
opportunities for risk sharing may be

reduced. This, in turn, can potentially reduce the supply of credit to
the real economy.
    Although data limitations discussed above prevent the Commission
from quantifying efficiency gains or losses from the rules being
adopted, based on its judgment and experience, the Commission believes
that the final rules will have a positive contribution to the overall
efficiency of the market. The final rules work together to help improve
the financial stability of participants in security-based swap market,
and in so doing help address the market failures resulting from the
possibility of counterparty defaults. By imposing margin requirements
on nonbank SBSDs, the final margin rules reduce counterparty exposures
and the expected costs borne by non-defaulting counterparties in the
event of a counterparty default. While these new margin requirements
provide protection for the margin collector against the default of the
margin poster, they could simultaneously expose the poster of initial
margin to additional credit risk. To address this risk, the
Commission's segregation rules help ensure that posted initial margin
is adequately protected. Finally, by imposing capital requirements on
nonbank SBSDs and MSBSPs, the capital rules help reduce the probability
of their default and moreover, increase the likelihood of recoveries in
the event of default.
    As mentioned earlier, several commenters urged the Commission to
harmonize with other regulatory regimes when developing these rules.
One commenter cited impacts on efficiency, competition, and capital
formation, while another was concerned about the loss of netting and
risk management efficiencies caused by fragmentation of trading
activities.\1288\ In developing its rules on capital, margin, and
segregation for SBSDs and MSBSPs, the Commission has sought to minimize
costs to the affected entities and other participants in the security-
based swap market while still achieving the broader economic objective
of enhancing financial stability. One key feature of the Commission's
approach has been maintaining consistency with existing regulations
applicable to broker-dealers. This consistency reduces compliance costs
for entities with affiliates already subject to the Commission's
broker-dealer financial responsibility rules. This consistent approach
to regulation across firms subject to the Commission's rules can also
reduce the potential for regulatory arbitrage and lead to simpler
interpretation and enforcement of applicable regulatory requirements
across U.S. securities markets. Moreover, the final rules reflect the
Commission's consideration of rules promulgated by the CFTC and the
prudential regulators. For example, Rule 18a-3, while modeled on the
broker-dealer margin rule, includes significant modifications that
further harmonize it with the final margin rules of the CFTC and the
prudential regulators.\1289\
---------------------------------------------------------------------------

    \1288\ See MFA/AIMA 11/19/2018 Letter; Mizuho/ING Letter.
    \1289\ See section II.B. of this release.
---------------------------------------------------------------------------

    For entities that choose to consolidate security-based swap dealing
under a broker-dealer, the Commission's approach helps to simplify and
streamline risk management, allows for the more efficient use of
capital, and creates operational efficiencies such as avoiding the need
for multiple netting and other agreements. It also facilitates the
ability to provide portfolio margining of security-based swaps with
other types of securities, and in particular single-name CDS along with
bonds that serve as reference obligations for the CDS. This can yield
additional efficiencies for clients conducting business in securities
and security-based swaps, including netting benefits,\1290\ a reduction
in the number of account relationships required with affiliated
entities, and a reduction in the number of governing agreements.
---------------------------------------------------------------------------

    \1290\ See, e.g., paragraph (c)(5) of Rule 18a-3, as adopted.
See MFA 2/22/2013 Letter.
---------------------------------------------------------------------------

    The final rules also offer various flexibilities that aim to
minimize compliance burdens without subverting the objectives of the
rules, such as allowing counterparties the flexibility to post a
variety of collateral types to meet margin requirements, providing a
$50 million initial margin threshold, and permitting the use of third-
party models in margin calculations. Similarly, the omnibus segregation
requirements of Rule 15c3-3, as amended, and Rule 18a-4, as adopted,
provide a less expensive segregation alternative to individual
segregation.\1291\
---------------------------------------------------------------------------

    \1291\ See 15 U.S.C. 78c(f)(1)(B).
---------------------------------------------------------------------------

2. Competition
    The final capital, margin, and segregation rules significantly
alter the regulatory environment for registered nonbank SBSDs and
MSBSPs, and in the case of the segregation requirements, all SBSDs and
MSBSPs participating in the U.S. security-based swap market. Thus,
these new regulations are likely to have direct implications for
competition among SBSDs and MSBSPs subject to the Commission's
jurisdiction. As discussed in this section and elsewhere in this
release, and notwithstanding uncertainties about potential effects on
competition, the Commission believes that the final rules and
amendments are appropriate because they achieve the purposes of the
Exchange Act, including by improving financial stability. Because the
Commission does not have sole rulemaking authority for all SBSDs and
MSBSPs in the U.S. security-based swap market, and because the
security-based swap market is global with competition across
jurisdictional boundaries, consideration of the effects of the
Commission's rules on competition is not limited to entities directly
affected by the Commission's rules. In particular, U.S. banks operating
in these markets are subject to capital and margin regulations already
adopted by the prudential regulators.\1292\ These entities may compete
in the security-based swap market with entities regulated by the
Commission. Similarly, foreign banking entities subject to foreign
capital, margin, and segregation requirements may actively compete with
these same entities. In the following subsection the Commission
considers the impact of its rules on competition in these various
contexts.
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    \1292\ See Prudential Regulator Margin and Capital Adopting
Release, 80 FR 74840.
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a. Nonbank SBSDs
    The rules and amendments being adopted by the Commission are
expected to have a significant impact on the regulatory environment of
nonbank SBSDs; namely, stand-alone SBSDs and broker-dealer SBSDs. Under
the baseline, stand-alone SBSDs are largely unregulated and hence not
subject to capital or margin requirements on security-based swap
transactions. Generally speaking, broker-dealers have historically not
engaged in security-based swap transactions due to--among other
factors--the relatively high capital costs of such transactions and the
segregation requirements under existing broker-dealer capital and
segregation rules. Thus, security-based swap dealing activity has been
concentrated in stand-alone SBSDs and banks, which were not subject to
the Commission's rules.\1293\ The new rules and amendments create a
harmonized regulatory environment

for all nonbank SBSDs. By improving the financial stability of nonbank
SBSDs, the final capital, margin, and segregation rules are likely to
promote trade between nonbank SBSDs and a wide range of non-dealer
counterparties, with potential benefits to competition. However, as
discussed in more detail below, a harmonized set of rules for both
stand-alone and broker-dealer SBSDs may also provide broker-dealers
certain economies of scale and scope. These economies of scale and
scope may provide incentives for market participants to migrate their
security-based swap transaction activity away from stand-alone SBSDs.
The Commission acknowledges that such migration could lead to further
concentration in dealing activity.
---------------------------------------------------------------------------

    \1293\ The references to the historical activities of ``nonbank
SBSDs'' in this discussion is somewhat imprecise as it refers to
entities that operated prior to the Commission's adoption of
security-based swap entity definitions and registration
requirements. Such references should be interpreted to refer to
entities that would have been required to register as SBSDs had the
Commission's security-based swap entity registration requirements
been in effect at the time. See Registration Process for Security-
Based Swap Dealers and Major Security-Based Swap Participants, 80 FR
48964.
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    Under the baseline, security-based swap dealing activity is
dominated by a few large financial firms, reflecting in part the
counterparty credit risk concerns of counterparties. The Commission's
capital, margin, and segregation rules are expected to enhance the
financial stability of entities subject to its rules, namely stand-
alone and broker-dealer SBSDs. This may, in turn, favorably increase
the views of market participants about the creditworthiness of nonbank
SBSDs, increasing the amount of trade with these dealers and attracting
new entrants to the industry. However, prospective new entrants will
have to evaluate the costs of establishing and maintaining compliance
with the Commission's new rules against the value of dealing in
security-based swaps. As discussed above in sections VI.B.1. and
VI.B.3. of this release, nonbank SBSDs will be subject to capital and
margin requirements that vary depending on whether the nonbank SBSD
obtains approval to use internal models. Although the costs of
obtaining approval to use such models would likely not be large for the
five ANC broker-dealers currently using models to compute net capital,
for prospective dealers that are not ANC broker-dealers these costs
could be large and place the nonbank SBSD at a competitive disadvantage
relative to those nonbank SBSDs already are authorized to use internal
models. In particular, a nonbank SBSD authorized to use internal models
can make more efficient use of its capital and pass on some of the
benefits to customers in the form of competitive pricing. Therefore,
the success of a new entrant to attract order flow in the security-
based swap business would also depend on the extent to which the
entrant would be able to obtain the Commission's approval to use
internal models.\1294\ As several commenters observed, nonbank SBSDs
lacking such approvals will generally find it difficult to compete with
SBSDs that have obtained approvals.\1295\ However, as discussed above,
the use of models for capital purposes is standard in financial market
regulation. Indeed, the prudential regulators' rules for bank SBSDs and
bank swap dealers, as well as the Commission's own rules for ANC
broker-dealers, permit the use of internal models for capital purposes.
Furthermore, the CFTC has proposed permitting nonbank swap dealers to
use models for capital purposes. While the Commission acknowledges the
potential competitive advantage identified by commenters, the
Commission believes it is appropriate to promote consistency with these
other regulatory approaches.
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    \1294\ See, e.g., Alternative Net Capital Requirements for
Broker-Dealers That Are Part of Consolidated Supervised Entities, 69
FR at 34455 (stating that the ``major benefit for the broker-
dealer'' of using an internal model ``will be lower deductions from
net capital for market and credit risk''). See also OTC Derivatives
Dealer Release, 63 FR 59362. Given the significant benefits of using
models in reducing the capital required for security-based swap
positions, it is likely that for new entrants to capture substantial
volume in security-based swaps they will need to use models.
    \1295\ See CFA Institute Letter; Systemic Risk Council Letter;
SIFMA 11/19/2018 Letter.
---------------------------------------------------------------------------

    As noted above, while the Commission's rules may encourage
competition in the security-based swap market by increasing the safety
and soundness of nonbank SBSDs (and thereby favorably increasing market
participants' views about the creditworthiness of these dealers), they
may also incentivize migration of dealing activities to broker-dealer
SBSDs. Aggregating security-based swaps business with other securities
businesses in a single entity, such as a broker-dealer SBSD, can help
simplify and streamline risk management, allow more efficient use of
capital, and avoid the need for multiple netting and other agreements.
This increase in operating flexibility may yield efficiencies for
clients conducting business in securities and security-based swaps,
including netting benefits, portfolio margining, a reduction in the
number of account relationships required with affiliated entities, and
a reduction in the number of governing agreements. In particular,
broker-dealer SBSDs could gain a competitive edge over stand-alone
SBSDs by passing on some of the benefits from the added operating
flexibility to their customers. Similar considerations may make it
relatively costly for customers to transact through multiple dealers.
To the extent that customers consolidate their positions with a single
dealer, opportunities for smaller, more specialized dealers may be
diminished. Moreover, customers consolidating their positions at a
single and more efficient broker-dealer SBSD may find it more
operationally difficult to change SBSDs in the future.
    On the other hand, the less restrictive capital requirements
applicable to stand-alone SBSDs could result in lower costs to these
firms and, in turn, lower fees for their security-based swap customers.
This could draw business away from broker-dealer SBSDs in the favor of
stand-alone SBSDs.
    The Commission acknowledges the various aforementioned competitive
impacts, including the potential advantages held by broker-dealer and
stand-alone SBSDs approved to use models over entities that must use
standardized haircuts. However, overall, the Commission does not expect
these competitive impacts to have a major net effect on competition
among entities currently operating as nonbank SBSDs or those likely to
do so in the immediate future. As noted in the baseline discussion
above, security-based swap dealing activity is highly concentrated in a
few entities affiliated with large national and international banking
groups. This concentrated market structure reflects the importance of
counterparty credit quality, scale, and financial sophistication to
operating in the security-based swap market. The importance of these
factors is not expected to be materially affected by the Commission's
rules, nor are the rules expected to have significant disproportionate
impacts on particular subsets of entities that currently operate as
dealers in the security-based swap market.
b. Nonbank SBSDs and Bank SBSDs
    The final margin, capital, and segregation rules have the potential
to affect domestic competition in the security-based swap market
significantly due to differences in the regulation of bank and nonbank
SBSDs. As discussed above in sections I and II of this release, the
rules adopted by the prudential regulators were considered in
developing the Commission's capital, margin, and segregation
requirements for SBSDs and MSBSPs. Nevertheless, the Commission's final
rules differ in certain respects from the rules adopted by the
prudential regulators. While some differences are based on differences
in the activities of securities firms and banks, other differences
reflect an alternative approach to balancing relevant policy choices
and considerations.

    Large national and international banking groups that dominate
dealing activity in the security-based swap market enjoy considerable
flexibility in organizing their operations. Such entities can be
expected to minimize the private compliance costs of participating in
the security-based swap market by organizing their activities to take
advantage of differences in regulators' policy choices. Prior to the
passage of the Dodd-Frank Act and subsequent rulemaking, these entities
have been able to conduct security-based swap dealing from either their
prudentially regulated bank affiliates or affiliated nonbank entities.