Security-based swaps might comprise a small fraction of the entire multi-trillion dollar over-the-counter derivatives market, but that’s little solace to operations, IT and regulatory specialists who will eventually have to follow the Securities and Exchange Commission’s rules on reporting transactions in these contracts to a swap data repository (SDR).
Just who must do the reporting, which SDR should receive the data and the nitty-gritty of the type of data which must be divulged have become bones of contention between the SEC, swap participants and SDRs. Adding fuel to the dissent are the minor differences between the SEC’s pending rules and the Commodity Futures Trading Commission’s existing rules which could end up being gamechangers, say respondents to the SEC’s request for comments and others who spoke with FinOps Report.
The SEC has finalized some of its reporting requirements — such as who should do the reporting — while the details on what should be reported to which SDR are still under review. The comment period ended on May 4, but compliance won’t take place anytime soon. The SEC suggests that reporting in a particular assert class would begin about six months after the first registered security-based swap data repository that accepts reports on swap trades in that category begins operations. Market players are calling for an even longer transition period and for a definitive single date, rather than multiple dates or an uncertain timeline.
“Two years after we have adjusted to the CFTC’s requirements we are now compelled to deal with the SEC’s new policies which means an additional learning curve for compliance specialists who have to understand just who is responsible for reporting what part of the trade,” says one operations director at a US broker-dealer. “In some cases, we also have no control of just where the trade is reported and we still don’t know all of the specifics on what has to be reported.” Such uncertainty will make it far more difficult for operations and data management specialists to come up with the correct workflow and data formats.
The Commodity Futures Modernization Act of 2000 prohibited either the CFTC or the SEC from imposing any reporting requirements on swap transactions, but ten years later the financial crisis motivated Congress to reverse the policy after a lack of transparency in the swaps market was thought to have contributed to the economic downturn. The Dodd-Frank Wall Street Reform Act gave the CFTC jurisdiction over interest rate, some credit default, commodities and foreign exchange swap contracts and the SEC oversight over everything else. That “everything else” category included swaps based on a single security or loan or narrow-based group or index of securities or events.
What happens with so-called mixed swap trades which fall under both categories? “A separate report will have to be made to a swap data repository that is registered with the CFTC and one that is registered with the SEC, unless the repository is registered with both regulators,” says Lanny Schwartz, a partner with the law firm of Davis Polk & Wardwell in New York City. “Those reports will have to follow separate rules, which could be difficult since the CFTC and SEC requirements don’t exactly match up.” Case in point: a swap that contains both an equity element and a commodity element will have to be reported twice to different repositories using diverse mandatory time frames, distinct reporting fields, taxonomies, IDs and data elements. Even the counterparty responsible for reporting the trade could vary.
Hail to the Hierarchy
Like the CFTC, the SEC is requiring transactions in swap contracts under its jurisdiction to be reported to a security-based swap data repository. In some instances, however, the SEC differs in just who should do the reporting when it comes to so-called alpha, beta and gamma transactions. In bi-lateral contracts between two counterparties outside of a swap execution facility (SEF), the SEC agrees with the CFTC that if one of the counterparties a security-based swap dealer (SBSD), reporting responsibility falls on its shoulders. If both of the counterparties happen to be major security-based swap participants (MSBSPs) or buy-side firms, they will have to agree between themselves who will do the reporting.
When a trade is executed on a platform, the SEC has proposed that for swap deals intended to be cleared, the platform should report the alpha transaction — that is the initial transaction executed between two counterparties. If a security-based swap deal will not be cleared, then the execution platform has no responsibility to report the alpha trade. Conversely, the CFTC requires the trade execution platform to report the alpha transaction to a swap data repository regardless of whether or not the trade will be cleared. For trades which are processed through a clearinghouse, both the proposed SEC rules and the CFTC’s rules call for the clearinghouse to report on the beta and gamma transactions. Those are the transactions which arise following the clearing process whereby the clearinghouse faces each of the initial counterparties to the bilateral trade.
The SEC’s reporting hierarchy follows in large part what the CFTC already requires with a notable exception: The SEC also wants counterparties to take into account indirect participants or those guaranteeing a direct counterparty’s performance on the trade.
Why would the inclusion of guarantors — typically parent firms or affiliates– to the SEC’s reporting hierarchy be that problematic? If the counterparty that is responsible for reporting also has a guarantor for the deal, the SEC will expect that the direct counterparty and its guarantor have agreed between themselves which will do the reporting. “The ultimate decision will require more phone calls or correspondence between regulatory reporting and compliance departments,” says the operations director of a New York-based broker-dealer. “It would be a lot easier if just counterparties could make the decision.”
Agreeing with this complaint are the swaps industry trade group International Swaps and Derivatives Association (ISDA) and the broker-dealer trade group Securities Industry and Financial Markets Association (SIFMA). In a joint response letter to the SEC, they cite the “new build” requirements and the extra work that would result from the need to consider an “indirect” participant when deciding who should do the reporting.
“Determination of whether there is an indirect counterparty on either side of an SBS [security-based swap] that is a registered SBSD, registered MSBSP, and/or a US person may not be determined by static data on a party level but must be determined for each SBS,” write the ISDA and SIFMA in their joint letter to the SEC. “Significant changes will be required to trading practices, systems, workflows and reporting architectures across the industry to determine and capture indirect counterparty identity in order to leverage the status of such party to determine reporting eligibility, the reporting side and to report whether both sides of an SBS include a registered SBSD.”
And what about the reporting of the alpha, beta and gamma transactions being handled by different parties? Such a breakout didn’t sit well with some of the respondents to the SEC’s request for comment. Some acknowledged that the clearinghouses should report beta and gamma trades, but they didn’t want the clearinghouse have the choice of security-based swap data repository to the beta and gamma transactions are reported. Instead, many advocated that that beta and gamma transactions be reported to the same data repository where the original alpha trade is located to ensure better data aggregation and data integrity.
Swaps data provider Markit and the US market infrastructure Depository Trust & Clearing Corp. (DTCC) insist the SEC’s rationale that it would be more cost-effective, easier and reliable for a clearinghouse to make the choice is flawed. Such a reasoning, says Markit, ignores the benefits and reduced costs offered by middleware reporting agencies and doesn’t foster competition between swap data repositories (SDRs). “The likelihood of data discrepancies and errors would be reduced if the Commission empowered market participants and platforms to select the SDR [they wanted to send the information to] and for the SDRs to compete with one another based on quality of service and cost,” writes Markit, which operates an over-the-counter derivatives reporting and trade processing service called MarkitServ.
“In a competitive market for SDR services,” Markit continued, “SDRs would be incentivized to compete with one another to provide value-added services, such as reporting agent services, recordkeeping tools and portfolio and transaction level analytics, or in the case of platforms capabilities that would facilitate surveillance activities. SDRs are unlikely to make investments to develop these capabilities if the SDR and post-trade processing market is not competitive and not responsive to market forces.”
Likewise, DTCC took issue with the SEC’s rationale that “greatest ease of use” is having the clearinghouse to a cleared trade report the beta and gamma transactions to the swap data repository of its choice. “Clearing agencies would have to report to the original swaps data repository whether or not it has accepted the alpha trade for clearing,” writes the DTCC. “As a result, clearing agencies would already need to incur costs with other SDRs regardless of whether they are permitted to report beta and gamma trades to an SB SDR of their choice.”
DTCC, which previously objected to a rule adopted by the CME requiring trades cleared by the CME to be reported to the CME’s own repository, did not comment on the potential anti-competitive aspects of the SEC’s proposal to give clearinghouses the final say on which repository would receive the information on beta and gamma transactions. However, Markit was quick to criticize the SEC’s reasoning to follow the CFTC’s decision in favor of CME as ill-conceived. “The CFTC’s decision to approve Rule 1001 was predicated on the fact that the CME repository has a market share of [less than 30 percent] on cleared swap transactions.” That’s seems to be far from a monopoly. Not so with single-name credit default swaps, covered under the SEC’s proposed rules, where ICE holds an 88 percent market share.
The SEC is also proposing the use of identifiers that go well beyond the already-standard legal entity identifier (LEI). The additional identifiers include trader ID, trading desk ID and product ID. DTCC and other respondents are none too happy about this. Such details are far more than what the CFTC now requires and with no accepted industry standards, SDRs have to assign such codes, giving rise to the potential for discrepancy. A far better idea, according to the DTCC, is to have the SEC work out such standards with market players and give SDRs at least six months to adjust to any agreed upon branch, trading desk, and product identifiers. SDRs should have at least nine months to adjust to any IDs adopted for traders.
Not Really One-Sided
Although the SEC is only requiring the single reporting party to the trade to identify itself on the report it submits, that doesn’t leave the other counterparty or the swaps data repository entirely off the hook. The swaps data repository and other non-reporting counterparty will likely have to communicate those details with each other and some fund management firms are not pleased about being forced into that interaction.
“The SEC called for one-sided reporting, but the proposed new reporting requirements ultimately come down to reporting and a half, and we will have to develop costly communication protocols with swap trade repositories,” an operations manager at a fund management firm tells FinOps.
Likewise, the DTCC sees problems with the scenario. In its letter to the SEC, DTCC argues that SDRs shouldn’t have the sole responsibility to confirm the accuracy and completeness of the data submitted by non-reporting entities. Such an onus falls far beyond a swap data repository’s role and would require it to develop costly robust matching and confirmation systems. What’s more, the DTCC says, there is no way for an SDR to compel a non-reporting side to respond to its requests to verify identifiers. Such verification, the DTCC suggests, could be undertaken by the reporting side. Alternatively, the non-reporting counterparty could onboard with the SDR and do the verification of its identifiers itself.
As for the data fields which must be filled out, the SEC has left the matter to SDRs to work out on their own while the CFTC has been far more specific in its requirements. The SEC’s final rule only gives general categories of what needs to be reported without explaining specific data elements on the grounds it will review the specifications adopted by the swap data repositories at the time they register with the SEC to accept reports for the security-based swaps market.
This kind of leeway doesn’t sit well any of the IT and operations specialists that spoke with FinOps. “It makes it almost impossible for us to plan,” says the operations director at a New York-broker dealer, “not with any certainty we’ve got the details right.”