SEC proposes conduct rules for swap dealers

Swap dealers would need to disclose more information to customers and provide added protection to clients like pension funds and municipalities under new rules proposed by securities regulators on Wednesday.

The Securities and Exchange Commission proposal aims to deter abusive practices, help swap users manage risk, and to provide more clarity to dealers on what constitutes advice and the limits that advice places on their role.

The swap dealer behavior rules are required by the Dodd-Frank Wall Street overhaul law that split responsibility between the SEC and Commodity Futures Trading Commission for the nearly $600 trillion over-the-counter derivatives market.

A parallel CFTC proposal has been criticized by the swap industry for its definition of "advice," possibly preventing them from serving some clients.

The 200-page-plus SEC proposal would apply to security-based swap traders and dealers such as Goldman Sachs, Morgan Stanley and JPMorgan Chase that deal in products like credit-default swaps and equity derivatives.

The SEC voted 5-0 to issue the proposal and take public comments until the end of August.

Swaps are financial products that allow parties to protect themselves from risky exposures, such as interest-rate fluctuations or a default on a company's bonds.

In dealing with customers broadly, the SEC's proposed rule would require dealers to disclose information about material risks, incentives and conflicts of interest. They would also need to supply information about regulations governing central clearing, communicate fairly, establish a compliance structure and hire a chief compliance officer.

If a dealer makes a recommendation to a customer about a trade, the dealer will also need to ensure the suggestion is suitable for the client, similar to a rule the Financial Industry Regulatory Authority imposes on brokers.

In addition to establishing rules for customer dealings broadly, the SEC's proposal also contains extra requirements for dealers who act as either counterparties or advisers to "special entities," including municipalities, endowments and pension plans, which may be less sophisticated and at greater risk.

Special Entities

The law requires dealers who advise special entities to act in their clients' best interests. Dealers who act as counterparties to the trades, meanwhile, have to make sure the special entities have an independent representative to act in their best interest.

"The rules we are proposing today would level the playing field in the security-based swap market by bringing needed transparency to this market and by seeking to ensure that customers in these transactions are treated fairly," SEC Chairman Mary Schapiro said.

The SEC estimates that about 1,200 pension funds, endowments and government entities use some type of credit-default swap. The vast majority of these already use advisers to help them make investment decisions on derivative transactions.

How the term "adviser" is defined has become a major source of controversy in the CFTC's plan, which was proposed late last year.

The swaps industry has said the CFTC's plan takes a sweeping view on what constitutes providing "advice" to special entities. Swap dealers fear they could suddenly be dubbed advisers and be required to act in their clients' best interest.

This in turn would effectively preclude them from selling swaps to customers, because it would be impossible to act in their clients' best interest and simultaneously trade with them for their own financial gain.

The SEC's plan aims to tackle that concern by providing more clarity on what constitutes giving advice and allowing dealers to choose between acting as advisers or as trading partners with pension funds and other special entities.

It is not known exactly how many "special entities" may fall under the SEC's plan. Many municipalities use interest-rate derivatives, a product under the CFTC's jurisdiction.

[Source: By Sarah N. Lynch, Reuters, Washington, 29Jun11]

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