On June 21, 2019, the Securities and Exchange Commission (“SEC”) adopted rules and rule amendments (the “Rules”) to establish capital, margin, and segregation requirements under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act aimed at enhancing the risk mitigation practices of broker-dealers that enter into security-based swaps (“SBS”) and certain security-based swap dealers (“SBSDs”) and major security-based swap participants (“MSBSPs”). The full text of the Rules can be found here.

The Rules address four key areas:

1. minimum capital requirements for SBSDs and MSBSPs that are not regulated by a prudential regulator (“Non-Bank SBSDs and MSBSPs”), as well as for broker-dealers that compute net capital using internal models that the SEC has approved (“ANC Broker-Dealers”) and capital requirements tailored to SBS and swap positions that apply to broker-dealers that are not registered as an SBSD or MSBSP (“Stand-alone Broker-Dealers”);
2. margin requirements for Non-Bank SBSDs and MSBSPs with respect to SBS;
3. collateral segregation requirements for SBSDs and broker-dealers that enter into SBS; and
4. the SEC’s cross-border rule providing a means to request substituted compliance regarding the capital and margin requirements for foreign SBSDs and MSBSPs.

Capital Rules for Non-Bank SBSDs and Broker-Dealers

Minimum Capital Requirements

Non-Bank SBSDs that also are registered as broker-dealers (other than registered over-the-counter derivatives dealers (“OTCDDs”)) (“Broker-Dealer SBSDs”) will be subject to existing net capital requirements in Rule 15c3-1 of the Securities Exchange Act (“SEA”), as amended by the Rules to account for SBS and swap activities of broker-dealers. All other Non-Bank SBSDs (“Stand-alone SBSDs”) will become subject to the new SEA Rule 18a-1, which is substantially modeled after Rule 15c3-1.

Non-Bank SBSDs that compute net capital using internal models (“Non-Bank ANC SBSDs”) and ANC Broker-Dealers (including ANC Broker-Dealers that are registered as SBSDs) will be subject to minimum tentative net capital requirements, which are based on figures that do not take into account standardized haircut deductions or market and credit risk charges. Additionally, minimum net capital requirements for Non-Bank SBSDs and ANC Broker-Dealers will be set at the greater of a fixed dollar amount and an amount equal to 2% of the firm’s exposure to its SBS customers (“2% Margin Factor”) plus, in the case of broker-dealers, the existing ratio-based minimum net capital requirements in Rule 15c3-1.

The following table summarizes the minimum net capital requirements for Non-Bank SBSDs as of the compliance date of the Rules:

Type of Registrant	SEA Rule	Tentative Net Capital	Net Capital
			Fixed-Dollar	Financial Ratio
Stand-alone SBSD (not using internal models)	18a-1	N/A	$20 million	2% Margin Factor
Stand-alone SBSD (using internal models)*	18a-1	$100 million	$20 million	2% Margin Factor
Broker-dealer SBSD (not using internal models)	15c3-1	N/A	$20 million	2% Margin Factor + Rule 15c3-1 ratio
Broker-dealer SBSD (using internal models)	15c3-1	$5 billion	$1 billion	2% Margin Factor + Rule 15c3-1 ratio

* Includes a Stand-alone SBSD that also is an OTCDD.

Computing Net Capital

When computing net capital, Non-Bank SBSDs and Stand-alone Broker-Dealers must first determine their net worth under U.S. generally accepted accounting principles. Then, they will need to make certain adjustments (e.g., deductions and haircuts) to their net worth, which is designed to result in having each dollar of their unsubordinated liabilities being matched by more than a dollar of highly liquid assets. Non-Bank SBSDs and Stand-alone Broker-Dealers will be required to deduct 100% of the value of most unsecured receivables because those assets are not readily convertible into cash.

Unsecured Current Exposure. If a Non-Bank SBSD elects not to collect variation margin (“VM”) from a counterparty to a non-cleared SBS or swap, then it will be required to deduct 100% of the amount that would have been collected from the counterparty if the Non-Bank SBSD had not made that election. Rather than having to take the 100% deduction, however, Non-Bank ANC SBSDs and ANC Broker-Dealers will be permitted to deduct a credit risk charge based in part on the creditworthiness of the counterparty. Non-Bank ANC SBSDs will not be subject to caps placed on this credit risk charge, but ANC Broker-Dealers’ credit risk charge deductions will be capped at 10% of their tentative net capital.

Unsecured Potential Future Exposure. Similarly, if a Non-Bank SBSD elects not to collect initial margin (“IM”) from a counterparty to an SBS or swap pursuant to an exception in the Commodity Futures Trading Commission’s (“CFTC’s”) or SEC’s margin rules, then it will be required to deduct 100% of the amount that would have been collected from the counterparty if the Non-Bank SBSD had not made that election. However, Non-Bank ANC SBSDs will be permitted to deduct a credit risk charge rather than take the 100% deduction.

Standardized Haircuts. If Non-Bank SBSDs and broker-dealers are not approved to use model-based haircuts, they must apply the following standardized haircuts to their proprietary positions:

1. cleared SBS and swaps: the applicable clearing agency or derivatives clearing organization margin requirement;
2. non-cleared credit default swaps (“CDS”) that are SBS or swaps: the haircut will be based on the time to maturity and basis point spread of the CDS; and
3. all other non-cleared SBS or swaps: the notional amount of the position multiplied by the standardized haircut that applies to the reference instrument or obligation.

Model-Based Haircuts. Non-Bank SBSDs and Stand-alone Broker-Dealers may apply to the SEC for approval to use a model to calculate market and credit risk charges (model-based haircuts) instead of applying the standardized haircuts.

Margin Requirements for Non-Bank SBSDs

Calculation

SEA Rule 18a-3, which prescribes margin requirements for Non-Bank SBSDs with respect to non-cleared SBS, requires Non-Bank SBSDs to calculate with respect to each account of a counterparty as of the close of business each day: (1) the account’s current exposure (i.e., VM), and (2) the account’s potential future exposure (i.e., IM). VM will be calculated by marking the position to market, and IM will be calculated by applying standardized haircuts or a margin model approved by the SEC, which is subject to quantitative and qualitative requirements. A firm’s use of and governance over these models remains subject to SEC oversight.
For SBS referencing equity securities and indexes, Broker-Dealer SBSDs must use the standardized haircuts—a limitation designed to maintain parity with the margin rules for cash market equity positions—but Broker-Dealer SBSDs are permitted to use a margin model for all other types of SBS, such as CDS. While Non-Bank SBSDs are permitted to use models to calculate IM for all types of SBS, with respect to SBS referencing equity securities or indexes, they may use models only if the account does not hold another type of equity securities.

Collecting Collateral

Non-Bank SBSDs will be required to collect IM and/or VM from a counterparty if the margin calculations require the counterparty to post margin. Additionally, Non-Bank SBSDs will be required to deliver only VM, and not IM (though not prohibited), to a counterparty if the margin calculations require posting collateral. SEA Rule 18a-3 includes exceptions under which Non-Bank SBSDs will not be required to collect IM and/or VM or post VM, however, which the following table summarizes:

Exceptions in Rule 18a-3 Regarding IM and VM Collection and Delivery	Required to Collect Margin?		Required to Deliver VM?
	IM	VM
Commercial End User	No	No	No
BIS or European Stability Mechanism	No	No	No
Multilateral Development Bank	No	No	No
Financial Market Intermediary	No	Yes	Yes
Affiliate	No	Yes	Yes
Sovereign with Minimal Credit Risk	No	Yes	Yes
Legacy Account	No	No	No
IM Below $50 Million Threshold	No	Yes	Yes
Minimum Transfer Amount	No	No	No

The Rules permit collateral in the form of cash, securities, money market instruments, major foreign currencies, the settlement currency of the SBS, or gold, so long as the collateral has a “ready market.” Non-Bank SBSDs must “haircut” collateral using the standardized haircuts in the SEC’s net capital rules or the CFTC’s margin rules, but Non-Bank SBSDs cannot “cherry-pick” the lesser haircuts between the SEC and CFTC rules (i.e., the Non-Bank SBSD must apply the chosen set of deductions consistently with respect to a particular counterparty).

Segregation Requirements for Broker-Dealers and SBSDs

Amendments to SEA Rule 15c3-3 codify the segregation requirements for Stand-alone Broker-Dealers and Broker-Dealer SBSDs, and SEA Rule 18a-4 codifies the segregation requirements for Stand-alone SBSDs, OTCDDs, and bank SBSDs. SBSDs and broker-dealers will be required to segregate cash, securities, and property of an SBS customer relating to cleared or non-cleared SBS but in a manner that permits commingling of the SBS customer’s assets with the assets of other non-SBS customers (i.e., omnibus segregation).

The omnibus segregation requirements are mandatory with respect to collateral held by an SBSD or broker-dealer relating to cleared SBS (i.e., customers cannot waive segregation). With respect to non-cleared SBS for Stand-alone Broker-Dealers and Broker-Dealer SBSDs, affiliates of such firms can waive segregation while customers that are not affiliates of such firms cannot do so. However, Stand-alone SBSDs (other than OTCDDs) will be exempt from Rule 18a-4’s segregation requirements if they do not clear SBS and meet certain other conditions specified in the Rules.

The omnibus segregation requirements require an SBSD or Stand-alone Broker-Dealer to maintain: (1) possession or control over excess securities collateral (i.e., securities and money market instruments delivered to meet a counterparty’s IM requirement and any collateral held in excess of the applicable IM requirement and not used to meet a counterparty’s VM requirement); and (2) an SBS customer reserve account to segregate cash and/or qualified securities in an amount equal to the net cash owed to SBS customers, calculated on a weekly basis.

Alternative Compliance Mechanism and Cross-Border Application

Under SEA Rule 18a-10, an SBSD that (1) is not a broker-dealer, (2) is registered as a swap dealer, and (3) predominantly engages in a swaps business may elect to comply with the capital, margin, and segregation requirements of the Commodity Exchange Act and the CFTC’s rules instead of those of the SEC if certain conditions specified in the Rules are met.

Foreign SBSDs and MSBSPs may be able to avail themselves of substituted compliance to satisfy the SEC’s capital and margin requirements. Notably, Rule 18a-4 (but not Rule 15c3-3) contains exceptions that make substituted compliance available even when a foreign SBSD transacts with a U.S. person, provided that certain conditions in the Rules are met. Generally, substituted compliance may be available to a foreign SBSD if the SEC determines that compliance with specified requirements under a foreign financial regulatory system by a registered SBSD may satisfy the corresponding SEC requirements.

Compliance Date

The Rules will become effective 60 days after publication in the Federal Register, but the compliance date for the Rules is 18 months after the later of: (1) the effective date of the final rules establishing recordkeeping and reporting requirements for SBSDs and MSBSPs, and (2) the effective date of the final rules addressing the cross-border application of certain security-based swap requirements; however, both rules are still in their proposal stages and have not yet been finalized.

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