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Statement On Commission Action Regarding Capital, Margin, And Segregation Requirements For Security-Based Swap Dealers And Major Security-Based Swap Participants And Capital Requirements For Broker-Dealers, SEC Commissioner Kara M. Stein, Oct. 11, 2018

Date 11/10/2018

I want to join the Chairman in thanking the staff for the hard work that went into this release. In particular, I would like to thank Mike Macchiaroli, Tom McGowan, Randall Roy, Ray Lombardo, Sheila Swartz, Tim Fox, and Valentina Deng from the Division of Trading and Markets.

Ten years ago, the U.S. government pledged $180 million to rescue American International Group (AIG).[1] AIG was brought to its knees by credit default swaps trading, and in particular, by its failure to adequately determine and account for the risk of its positions. To most people, these financial products, credit default swaps, are complex and mysterious.

Swaps and security-based swaps are complicated. And they are not transparent.[2] In effect, credit default swaps can be thought of as a form of insurance on bonds. But the calculations and triggering events are not straight-forward. In just one day, the amounts AIG owed on its positions rose to $32 billion.[3] Simply put, AIG bet big, and AIG lost big (over $99 billion). And because of these bets, AIG, the global, behemoth company, with nearly $1 trillion in assets, was on the brink of failure. AIG couldn’t pay. But if it went down, AIG was so interconnected with other financial firms that it was going to pull the U.S. financial system down with it.[4]

Indeed, the Financial Crisis Inquiry Commission found that AIG had to be rescued by the federal government because “its enormous sales of credit default swaps were made without putting up initial collateral, setting aside capital reserves, or hedging its exposure.”[5] This means, AIG bet without having the financial wherewithal to do so. Without such a bailout, AIG would have brought down some of our largest banks and investment firms, resulting in a cascade of failures throughout the financial system – a domino effect. And, because of the opacity of this market, no one knew the size or scale of AIG’s bets or the impact they could have on our financial system.

According to former Federal Reserve Chairman Ben Bernanke, the failure of just one firm “could have resulted in a 1930s-style global financial and economic meltdown, with catastrophic implications for production, income, and jobs.”

In recognition of the hidden risks posed by unregulated credit default swaps, Congress mandated that security-based swap dealers, such as AIG, be known (registered) and that they abide by capital, margin, and segregation rules.[6] We call these financial responsibility rules. Financial responsibility rules not only protect investors, but also the financial system by helping ensure the safety and soundness of security-based swap dealers.[7] So, in effect, Congress wanted swap dealers to be registered and to be financially responsible. In October 2012, the Commission proposed these financial responsibility rules, but has never finalized them. [8]

This was almost exactly six years ago. Six years is a long time in the financial markets. So, I commend the Chairman for bringing this rule proposal before us. I only wish I had seen it sooner. It is long overdue. I also applaud the Chairman for giving the public a chance to comment on this rule again.

That being said, there are significant policy shifts buried within this “reopening of the comment period” document. For example, the Commission’s proposed financial responsibility rules would be changed so that margin for security-based swaps would no longer need to be collected from dealers. There would also be significant changes to both the calculation of capital and the calculation of margin amounts for security-based swap transactions. This could mean that less money would be available if problems arise. And, more importantly, if the market believes that adequate financial resources are not available; this could spark a run in the market, creating asset calls that spiral out of control.

Interestingly, in 2012, the Commission made the decision to limit the application of “portfolio margining” to different types of equity-based products.[9] However, today’s rule proposal sets forth rule text that would significantly expand the comingling of swaps and security-based swaps. The expanded methodology could cause uncertainty in treatment of comingled security-based swaps, swaps, futures positions, and collateral in the event of liquidation. Who owns what? Which customers get what? How does liquidation occur with mixed accounts? Collateral should provide market participants with security and certainty in their trading. Just as with AIG in 2008, uncertainty could lead to a disorderly and inefficient market, and perhaps increase the need for future government intervention.

In addition, the Commission’s re-proposal sets forth proposed rules that materially differ from accepted international standards—the same international standards that the Commission staff worked hard to adopt in 2013. [10] What effect will this have on the ability to trade in a global environment? Will this increase regulatory arbitrage?

Moreover, I am troubled by this new approach to rulemaking. In effect, there are some big changes here, some that we are all seeing for the first time. The nature and extent of the proposed rule text changes appear to me to be more akin to a “re-proposal” than simply the reopening of a comment period.

If it was a re-proposal, the Commission would need to do an economic analysis to explain how these proposed changes would affect efficiency, competition, and capital formation. However, in today’s release, such an analysis is absent. Nor does today’s document discuss the potential costs and benefits of this new language on the marketplace. Over and over again, I have found economic analysis to be a tool that meaningfully contributes to the rulemaking process, and I wish it had been included here.

Likewise, the Commission’s 2012 proposal set forth a baseline that included data on the OTC derivatives market from 2011. I am certain that the derivatives market has dramatically changed in the past seven years, but new baseline data is not included in this re-proposal. In fact, commenters are directed to the Commission’s old analysis in 2012, and left wondering about the state of today’s market. I believe that setting forth a current baseline, and including new economic data, would have greatly improved the quality of this proposal.

We do need additional comment on rules that were proposed so many years ago, but that comment must be informed. Financial stability rules for security-based swap dealers are an area in which hard choices must be made and competing interests weighed. Before making these choices, we should give the public the all the relevant information they need to understand the issues so that they can provide thoughtful, informed comments. As I mentioned earlier, the markets of today are not the markets of 2011. We need to understand those changes in the market, the potential overlap of regulations, and let the public know why we think the proposed language before us today is the right answer. We owe that to the American public.

Indeed, the Commission has long history of including economic analysis in its proposed rules for this very reason.[11] In 2012, the Commission instituted a formal policy of including economic analysis in its proposed rules.[12] This policy was in response to court decisions,[13] a report of the U.S. Government Accountability Office,[14] Congressional inquiries, and a report by the SEC’s Office of Inspector General.[15] The guidance states that “[t]he proposing release should include a substantially complete analysis of the most likely economic consequences of the rule proposal.”[16] I agree, especially when the crafting final rules after six years. We should rigorously look at the facts at every point in rulemaking.

This is particularly important in situations such as this one where the choices we are making can have profound effects not only on the financial markets, but on our economy as a whole.

In summary, I am pleased that we are seeking additional comment and finally moving forward on adopting financial responsibility rules for swap dealers and major swap participants. I hope the public will weigh in on the extremely important and significant changes being proposed in this document. However, it would have been more appropriate and helpful to both the Commission and the public to include a current baseline of what we know about the marketplace, and its risks and uncertainties. This would allow both the public and the Commission to weigh the qualitative and quantitative costs and benefits of this new proposal, and to assess the impact that these changes may have on competition.

I do not agree with today’s approach which appears to be a type of “shadow rulemaking”. Today’s Commission release is much more than simply a reopening of the comment period. It contains a significant change in policy, which is cleverly hidden in questions.

The best we can do is to take what we have learned from the past crisis and ensure that it cannot repeat itself. I’m not sure this new proposal strikes the right balance. But, I look forward to receiving thoughtful comments on this re-proposal of the Commission’s capital, margin, and segregation requirements for those trading in security-based swaps.

Thank you.


[1] See The AIG Rescue, Its Impact on Markets, and the Government’s Exit Strategy,” June 2010, at 23, available at https://fraser.stlouisfed.org/title/5139.

[2] As of December 31, 2007, AIG had written credit default swaps with a notional value of $527 billion. Due to accounting conventions, the credit default swaps do not directly show up on AIG’s balance sheet. AIG also had an additional $1.5 trillion of other derivative exposures, including over $1 trillion in interest rate swaps. See McDonald, Robert L., & Anna Paulson, AIG in Hindsight, J. of Economic Perspectives, at 29(2): 81–106 (2014), available at https://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.29.2.81.

[3] See id.

[4] The experience of American International Group, Inc. (“AIG”), a Delaware corporation based in New York, and its subsidiary, AIG Financial Products Corp. (“AIG FP”), a Delaware corporation based in Connecticut, during and after the 2008 financial crisis both illustrates spillovers and contagion arising from security-based swap transactions and demonstrates how cross-border transactions could contribute to the destabilization of the U.S. financial system if the security-based swap market were not adequately regulated.

[5] See Financial Crisis Inquiry Commission, Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States, at 352 (Feb. 25, 2011), available at https://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.

[6] See Dodd-Frank Wall Street Reform and Consumer Protection Act, Title VII.

[7] Congress gave us this direction over 8 years ago. In October 2012—six years ago, the Commission proposed its initial financial responsibility rules. See Capital, Margin, and Segregation Requirements for Security-Based Swap Dealers and Major Security-Based Swap Participants and Capital Requirements for Broker-Dealers, Exchange Act Release No. 68071 (Oct. 18, 2012), 77 FR 70214 (Nov. 23, 2012), available at https://www.sec.gov/rules/proposed/2012/34-68071.pdf.

[8] More generally, the Lehman Brothers Holding Inc. bankruptcy offers an example of how risk can spread across affiliated entities of multinational financial institutions. See Lehman Brothers International (Europe) in Administration, Joint Administrators’ Progress Report for the Period 15 September 2008 to 14 March 2009 (Apr. 14, 2009), available at http://www.pwc.co.uk/assets/pdf/lbie-progress-report-140409.pdf.

[9] See, e.g., Order Granting Conditional Exemption Under the Securities Exchange Act of 1934 in Connection with Portfolio Margining of Swaps and Security-Based Swaps, Exchange Act Release No. 68433 (Dec. 14, 2012), 77 FR 75211 (Dec. 19, 2012).

[10] For example, this re-proposal may result in a final rule that diverges from the 2013 Working Group on Margin Requirements (WGMR), which served as an international framework for non-cleared bilateral derivatives. Individual regulatory authorities across jurisdictions have since started to develop their own margin rules consistent with the final framework. The proposed margin changes included in this rule re-proposal may have effects on financial firms, the marketplace, and international coordination concerning the risks and potential contagion effects of these products.

[11] See Memo from RSFI and OGC to Staff of the Rulewriting Divisions and Offices re Current Guidance on Economic Analysis in SEC Rulemakings, at 3 (March 16, 2012), available at https://www.sec.gov/divisions/riskfin/rsfi_guidance_econ_analy_secrulemaking.pdf (“SEC chairmen have informed Congress since at least the early 1980s—and as rulemaking releases since that time reflect—the Commission considers potential costs and benefits as a matter of good regulatory practice whenever it adopts rules.”)

[12] See id.

[13] See generally American Equity Inv. Life Ins. Co. v. SEC, 613 F.3d 166 (D.C. Cir. 2010); Chamber of Commerce v. SEC, 412 F.3d 133 (D.C. Cir. 2005); Business Roundtable v. SEC, 647 F.3d 1144 (D.C. Cir. 2011).

[14] See U. S. Gov’t Accountability Office Report to Congressional Addressees, Dodd-Frank Act Regulations: Implementation Could Benefit from Additional Analyses and Coordination (Nov. 2011), available at https://www.gao.gov/assets/590/586210.pdf.

[15] See SEC Office of Inspector General, Follow-Up Review of Cost-Benefit Analyses in Selected SEC Dodd-Frank Act Rulemakings, Report No. 499, at 31-36 (Jan. 27, 2012).

[16] See id., at 16.