SEC Revamps Security-Based Swap Transactions

Wednesday June 29, 2011 marked the unveiling of proposed rules brought forth by U.S. securities regulators and aimed at protecting investors. The proposals which were issued by the Securities and Exchange Commission (SEC) are designed to set standards for how dealers treat customers entering into "security-based" swap transactions, and are part of the SEC’s plan to begin policing the over-the-counter derivatives market and to help prevent another financial crisis.

Security-based swaps are connected to the performance of a small basket of securities stock, or bond. This then allows investors to bet on the possibility a company or government will default on its debt. During the housing boom, the credit-default-swaps market found its footing and swelled after banks began tying the instruments to the performances of risky mortgage bonds. American International Group Inc. (AIG) and other institutions that sold the swaps were badly burned when the housing balloon burst and companies that had bet against the market demanded payment on their swaps.

In 2010, the Dodd-Frank law delegated responsibilities to the SEC and the Commodity Futures Trading Commission to draft rules requiring all swaps, a type of derivatives contract in which one asset or liability is exchanged for another in the future, to be traded on exchanges and other open platforms. The law also requires swaps dealers and major players in the market to follow certain standards when dealing with counterparties.

Swaps dealers would be required to recommend to their customers only transactions and strategies deemed suitable, using a standard that is already applied broadly to the brokerage industry by the Financial Industry Regulatory Authority.

Dealers would have to communicate with their customers in a fair manner, disclose information about the transaction's risks and any conflicts of interest, and verify that counterparty meets the financial threshold for entering into a swap. They would also have to appoint a chief compliance officer.

The obligations would be even tougher for dealers selling swaps to pension plans, municipalities, endowments or other similar entities. Dealers advising such entities on their swap transactions or strategies, rather than serving as a counterparty to the transaction, would have to act in the customer's best interest.

Ultimately, the proposals issued Wednesday would "level the playing field" in the swaps market and "ensure that customers in these transactions are treated fairly," SEC Chairman Mary Schapiro said at the meeting.

Last fall the CFTC proposed similar standards for the rest of the swaps market—and drew fire from banks that serve as swap dealers. The banks said the plan wouldn't give them enough legal certainty that they are serving as a counterparty rather than an adviser on swap transactions and therefore not under obligation to serve the customer's best interest.

The SEC sought to address these concerns by clarifying what counts as advice on a swaps transaction. Under its proposal, parties also could agree contractually that the dealer isn't serving as an adviser to a customer as long as certain tests are met, such as the customer has its own independent adviser, and the dealer discloses that it isn't acting in the customer's best interest. That would allow a dealer selling swaps to make recommendations to pension plans and similar entities without triggering the stiffer obligations.