Document ID: SEC-2009-1391-0001
Agency: sec
Document Type: Notice
Title: Temporary Exemptions: Sections 5 and 6 of the Exchange Act for Broker-Dealers and Exchanges Effecting Transactions in Credit Default Swaps
Posted Date: 2009-10-01T04:00Z

[Federal Register: October 1, 2009 (Volume 74, Number 189)]
[Notices]               
[Page 50862-50864]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr01oc09-132]                         

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-60718; File No. S7-35-08]

 
Order Pursuant to Section 36 of the Securities Exchange Act of 
1934 Extending Temporary Exemptions from Sections 5 and 6 of the 
Exchange Act for Broker-Dealers and Exchanges Effecting Transactions in 
Credit Default Swaps

September 25, 2009.
    On December 24, 2008, in connection with its efforts to facilitate 
the establishment of one or more central counterparties for clearing 
credit default swap (``CDS'') transactions,\1\ the Securities and 
Exchange Commission (``Commission'') granted temporary, conditional 
exemptions from the registration requirements under Sections 5 and 6 of 
the Securities Exchange Act of 1934 (``Exchange Act'') to certain 
exchanges and broker-dealers (``December Order'').\2\ Subject to 
conditions specified in the December Order, any exchange that effects 
or reports transactions in CDS that are not swap agreements (``non-
excluded CDS'') \3\ and is not otherwise subject to the requirements 
under Sections 5 and 6 of the Exchange Act,\4\ and the rules and 
regulations thereunder, is exempt from the requirement to register as a 
national securities exchange.\5\ In addition, any broker or dealer that 
effects or reports transactions in non-excluded CDS on such an exchange 
is exempt from the prohibition on trading activity in Section 5 of the 
Exchange Act. The December Order expires on September 25, 2009. 
Pursuant to its authority under Section 36 of the Exchange Act,\6\ for 
the reasons described herein, the Commission is today extending the 
exemption granted in the December Order until March 24, 2010.
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    \1\ A CDS is a bilateral contract between two parties, known as 
counterparties. The value of this financial contract is based on 
underlying obligations (``reference obligations'') of a single 
entity (a ``reference entity'') or on a particular security or other 
debt obligation (``reference security''), or an index of several 
such entities, securities, or obligations. The obligation of a 
seller under a CDS to make payments under a CDS contract is 
triggered by a default or other credit event as to such entity or 
entities or such security or securities. Investors may use CDS for a 
variety of reasons, including to offset or insure against risk in 
their fixed-income portfolios, to take positions in bonds or in 
segments of the debt market as represented by an index, or to 
capitalize on the volatility in credit spreads during times of 
economic uncertainty. The over-the-counter (``OTC'') market for CDS 
poses systemic risk to the financial system as well as operational 
risks, risks relating to manipulation and fraud, and regulatory 
arbitrage risks.
    \2\ Securities Exchange Act Release No. 59165 (December 24, 
2008), 74 FR 133 (January 2, 2009).
    \3\ Section 3A of the Exchange Act limits the Commission's 
authority over swap agreements, as defined in Section 206A of the 
Gramm-Leach-Bliley Act. 15 U.S.C. 78c-1. Section 3A excludes both a 
non-security-based and a security-based swap agreement from the 
definition of ``security'' under Section 3(a)(10) of the Exchange 
Act, 15 U.S.C. 78c(a)(10). Section 206A of the Gramm-Leach-Bliley 
Act defines a ``swap agreement'' as ``any agreement, contract, or 
transaction between eligible contract participants (as defined in 
section 1a(12) of the Commodity Exchange Act * * *) * * * the 
material terms of which (other than price and quantity) are subject 
to individual negotiation.'' 15 U.S.C. 78c note.
    \4\ 15 U.S.C. 78e and 78f.
    \5\ A national securities exchange that effects transactions in 
CDS would continue to be required to comply with all requirements 
under the Exchange Act applicable to such transactions. A national 
securities exchange could form subsidiaries or affiliates that 
operate exchanges exempt under this order. Any subsidiary or 
affiliate of a registered exchange could not integrate, or otherwise 
link, the exempt CDS exchange with the registered exchange, 
including the premises or property of such exchange for effecting or 
reporting a transaction, without being considered a ``facility of 
the exchange.'' See Section 3(a)(2) of the Exchange Act, 15 U.S.C. 
78c(a)(2).
    \6\ 15 U.S.C. 78mm.
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    Section 5 of the Exchange Act states that ``[i]t shall be unlawful 
for any broker, dealer, or exchange, directly or indirectly, to make 
use of the mails or any means or instrumentality of interstate commerce 
for the purpose of using any facility of an exchange * * * to effect 
any transaction in a security, or to report any such transactions, 
unless such exchange (1) is registered as a national securities 
exchange under section 6 of [the Exchange Act], or (2) is exempted from 
such registration * * * by reason of the limited volume of transactions 
effected on such exchange * * * .'' Section 6 of the Exchange Act sets 
forth a procedure whereby an exchange \7\ may register as a national 
securities exchange.\8\
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    \7\ Section 3(a)(1) of the Exchange Act, 15 U.S.C. 78c(a)(1), 
defines ``exchange.'' Rule 3b-16 under the Exchange Act, 17 CFR 
240.3b-16, defines certain terms used in the statutory definition of 
exchange. See Securities Exchange Act Release No. 40760 (December 8, 
1998), 63 FR 70844 (December 22, 1998) (``Regulation ATS Adopting 
Release'') (adopting Rule 3b-16 in addition to Regulation ATS).
    \8\ 15 U.S.C. 78f. Section 6 of the Exchange Act also sets forth 
various requirements to which a national securities exchange is 
subject.
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    Section 36 of the Exchange Act provides that the Commission, ``by 
rule, regulation, or order, may conditionally or unconditionally exempt 
any person, security, or transaction, or any class or classes of 
persons, securities, or transactions, from any provision or provisions 
of [the Exchange Act] or of any rule or regulation thereunder, to the 
extent that such exemption is necessary or appropriate in the public 
interest, and is consistent with the protection of investors.'' \9\ To 
facilitate the establishment of one or more exchanges for non-excluded 
CDS, the Commission in the December Order exercised its authority under 
Section 36 to temporarily exempt any exchange, broker, or dealer that 
effects transactions in non-excluded CDS from the prohibition in 
Section 5 of the Exchange Act and (in the case of exchanges) the 
requirements in Section 6 of the Exchange Act and the rules and 
regulations thereunder.
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    \9\ 15 U.S.C. 78mm(a)(1).
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    The exemptions were conditioned on an exchange providing notice to 
the Commission of its reliance on the December Order, and certain other 
requirements that generally mirror those applicable to alternative 
trading systems under Regulation ATS.\10\ As we noted at the time, the 
temporary exemptions from Sections 5 and 6 of the Exchange Act in the 
December Order were designed to allow brokers, dealers, and exchanges 
to effect transactions in non-excluded CDS on exchanges, while 
providing an opportunity for the Commission to gain experience with the

[[Page 50863]]

CDS marketplace and consider public input regarding appropriate 
regulation and oversight.
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    \10\ See Regulation ATS, 17 CFR 242.300 et seq. In 1998, the 
Commission exercised its exemptive authority under Section 36 of the 
Exchange Act and its general authority under Section 11A of the 
Exchange Act, 15 U.S.C. 78k-1, to establish a regulatory framework 
for ``alternative trading systems,'' which perform many of the same 
functions as exchanges. Under this framework, an entity that, like 
an exchange, matches the orders in securities of multiple buyers and 
sellers according to established, non-discretionary methods is 
exempt from the definition of ``exchange'' if it instead registers 
as a broker-dealer and complies with Regulation ATS. Regulation ATS 
is designed, among other things, ``to adopt a regulatory framework 
that addresses [the Commission's] concerns without jeopardizing the 
commercial viability of these markets.'' Regulation ATS Adopting 
Release, supra note 7, 63 FR at 70846.
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    During the ensuing period, the Commission has reviewed the CDS 
marketplace and been in contact with various market participants. Our 
effort has been to understand the operation of the CDS marketplace, 
evaluate the application of the exemptions in the December Order, and 
consider whether the conditions we imposed should be modified. In 
particular, consistent with our December Order, we have considered 
whether Regulation ATS, with or without modifications, should apply to 
systems that match orders in non-excluded CDS of multiple buyers and 
sellers.
    Based on its review of the CDS marketplace, the Commission 
preliminarily believes that an exchange effecting transactions in non-
excluded CDS should register under Sections 5 and 6 of the Exchange Act 
or structure itself as an alternative trading system and comply with 
the requirements of Regulation ATS. Among other things, Regulation ATS 
requires that the operator of an alternative trading system be 
registered as a broker-dealer. The Commission preliminarily believes 
that broker-dealer registration for exchanges that trade non-excluded 
CDS, as for other alternative trading systems, provides important 
regulatory benefits, is in the public interest, and is consistent with 
the protection of investors. In particular, regulated broker-dealers 
that operate alternative trading systems are also required to be FINRA 
members.\11\ Membership in FINRA would allow FINRA to integrate trading 
of CDS on alternative trading systems into its surveillance of trading 
in economically similar investments, such as debt securities.
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    \11\ The Financial Industry Regulatory Authority (``FINRA'') is 
a national securities association registered with the Commission 
under Section 15A of the Exchange Act, 15 U.S.C. 78o-3, and thus is 
a self-regulatory organization (``SRO''), as defined in Section 
3(a)(26) of the Exchange Act, 15 U.S.C. 78c(a)(26). As an SRO, FINRA 
has authority to regulate and supervise its members for compliance 
with FINRA rules and the federal securities laws generally.
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    As noted, the conditions set out in the December Order under which 
CDS exchanges must operate are otherwise substantially similar to the 
requirements established under Regulation ATS.\12\ '' Like the December 
Order, Regulation ATS would require a CDS exchange to keep records 
about its operations, its subscribers, and their orders; \13\ provide 
the Commission with trading information on a quarterly basis; \14\ 
establish procedures to ensure the confidential treatment of trading 
information; \15\ permit the Commission to examine its premises, 
systems, and records; and cooperate with the examination of its 
subscribers.\16\ In addition, the CDS exchange could not: (a) Set rules 
governing the conduct of subscribers other than the conduct of such 
subscribers trading on such exchange; or (b) discipline subscribers 
under the Exchange Act other than by exclusion from trading.\17\ Thus, 
with regard to these requirements, compliance with Regulation ATS 
should not create any significant additional regulatory burden for a 
CDS exchange now relying on the December Order.
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    \12\ See December Order, supra note 2, 74 FR at 136; Regulation 
ATS, 17 CFR 242.300 et seq. Generally, these requirements are 
designed to allow the Commission to monitor market developments, to 
ascertain how new entrants are affecting the national market system, 
and to promote compliance with the federal securities laws 
generally.
    \13\ See 17 CFR 242.301(b)(8), 242.302, and 242.303.
    \14\ See 17 CFR 242.301(b)(9).
    \15\ See 17 CFR 242.301(b)(10).
    \16\ See 17 CFR 242.301(b)(7).
    \17\ These prohibitions are based on the Commission's belief 
that an organization, association, or group of persons that could 
exercise self-regulatory authority over its subscribers should be 
registered as an SRO and subject to the full responsibilities and 
supervision that registration entails. The Comission continues to 
believe that rules governing exchange subscriber conduct may be 
imposed and enforced only by SROs because of the potential that they 
may be applied for anti-competitive purposes. However, like any 
alternative trading system, a CDS exchange could apply credit 
standards to its subscribers or require subscribers to provide 
financial information relevant to their activity on the system. See 
Regulation ATS Adopting Release, supra note 7, 63 FR at 70859.
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    The Commission is sensitive not to disrupt existing CDS markets 
unnecessarily or impose unreasonable burdens on market participants 
providing or using CDS exchanges. We recognize that restructuring 
current business activity and registration as a national securities 
exchange or alternative trading system may reasonably be expected to 
take some time. Accordingly, the Commission has determined to extend 
the December Order through March 24, 2010 to permit exchanges 
facilitating transactions in non-excluded CDS sufficient time to 
register pursuant to Sections 5 and 6 of the Exchange Act, or comply 
with the requirements of Regulation ATS, which include registration as 
a broker-dealer. The conditions specified in the December Order will 
continue to apply.\18\
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    \18\ See December Order, supra note 2, 74 FR at 138-39.
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    Likewise, the Commission is extending the exemption it granted in 
the December Order to brokers and dealers effecting transactions in 
non-excluded CDS on an exchange that is not a national securities 
exchange because of that exchange's reliance on the December Order. 
Absent an exemption, Section 5 of the Exchange Act would prohibit 
brokers and dealers from effecting transactions in non-excluded CDS on 
such an exchange. As we found in the December Order, the temporary 
exemption for brokers and dealers is necessary and appropriate in the 
public interest and is consistent with the protection of investors 
because it will facilitate brokers' and dealers' use of CDS exchanges, 
which, for reasons noted in the December Order, the Commission believes 
would be beneficial. This exemption also provides legal certainty to 
broker-dealers effecting transactions in CDS. Without also exempting 
brokers and dealers from this Section 5 requirement, the Commission's 
temporary exemption of CDS exchanges would be ineffective, because 
brokers and dealers would not be permitted to effect transactions on 
those exchanges.
    Section 5 of the Exchange Act recognizes that there are situations 
where brokers and dealers should be permitted to trade on an exchange 
that is not registered as a national securities exchange. Section 5 
provides in relevant part that brokers and dealers may effect 
transactions on an exchange that the Commission, by reason of the 
limited volume of transactions effected on such exchange, has exempted 
from registration under Section 6. Brokers and dealers are also 
permitted to effect transactions on alternative trading systems, which 
are exempted from the definition of ``exchange'' and thus do not fall 
within the restriction of Section 5. Therefore, the Commission finds 
that it is consistent with the public interest and the protection of 
investors to extend the December Order, which granted a temporary 
exemption from Section 5 of the Exchange Act to any broker or dealer 
that effects transactions in non-excluded CDS, or reports such 
transactions, on an exchange that is exempted pursuant to the December 
Order.
    Finally, the Commission notes that, absent comments that articulate 
a substantial need for further relief, the Commission is unlikely to 
further extend the December Order beyond March 24, 2010.
    Accordingly,
    It is ordered, pursuant to Section 36 of the Exchange Act,\19\ that 
any exchange that effects transactions in non-excluded CDS and is not 
otherwise subject to the requirements under

[[Page 50864]]

Sections 5 and 6 of the Exchange Act,\20\ and the rules and regulations 
thereunder, will continue to be exempt from the requirement to register 
as a national securities exchange under Section 6 of the Exchange Act, 
and from the prohibition in Section 5 of the Exchange Act against 
effecting transactions as an exchange unless it is registered as a 
national securities exchange or exempt from registration due to the 
limited volume of its transactions through March 24, 2010, subject to 
the following conditions:
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    \19\ 15 U.S.C. 78mm.
    \20\ 15 U.S.C. 78e and 78f.
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    (1) The exchange must not: (a) Set rules governing the conduct of 
subscribers other than the conduct of such subscribers trading on such 
exchange; or (b) discipline subscribers other than by exclusion from 
trading;
    (2) The exchange must make and keep for a period of not less than 
three years, the first two years in an easily accessible place, the 
following records:
     A record of subscribers in the exchange (identifying any 
affiliations between the exchange and subscribers in the exchange, 
including common directors, officers, or owners);
     Daily summaries of trading, including (a) information 
identifying CDS in which transactions are effected; and (b) transaction 
volume, expressed in terms of number of trades and total U.S. dollar 
notional value; and
     Time-sequenced records of order information, including: 
(a) Identity of the party entering an order; (b) identification of non-
excluded CDS contract (including the reference entity, security, or 
index, and notional value); (c) date and time that order was received; 
(d) price (whether expressed as credit spread, rate, strike, or 
coupon); (e) whether the order is to buy or sell and any order 
conditions; (f) any subsequent modification or cancellation of the 
order; (g) date and time the order was executed, the size (e.g., 
notional value amount) executed, and the price; and (h) identity of the 
parties to the transaction;
    (3) The exchange must preserve the following records:
     For a period of not less than three years, the first two 
years in an easily accessible place, all notices provided by such 
exchange to subscribers generally, whether written or communicated 
through automated means, including, but not limited to, notices 
addressing hours of system operations, system malfunctions, changes to 
system procedures, maintenance of hardware and software, instructions 
pertaining to access to the market and denials of, or limitations on, 
access to the exchange; and
     During the life of the enterprise and of any successor 
enterprise, the exchange's organizational documents and copies of 
reports filed with the Commission pursuant to this exemption;
    (4) An exchange must, within five days of commencing operation, 
submit a notice to the Commission that includes the following 
information:
     Full legal name of the exchange;
     A description of the exchange's ownership structure;
     Contact person and contact information;
     A general description of what CDS contracts trade on the 
exchange; and
     A description of how the exchange operates;
    (5) An exchange must report the following information to the 
Commission within 30 days of the end of each quarter:
     The total dollar volume of transactions executed during 
the quarter, broken down by reference entity, security, or index;
     The total unit volume and/or notional amount executed 
during the quarter, broken down by reference entity, security, or 
index; and
     A list of all subscribers that effected transactions on 
the exchange during the quarter;
    (6) The exchange must establish adequate safeguards and procedures 
to protect subscribers' confidential trading information. Such 
safeguards and procedures shall include: (a) Limiting access to the 
confidential trading information of subscribers to those employees of 
the exchange who are operating the system or responsible for its 
compliance with this exemption or any other applicable rules; and (b) 
implementing standards controlling employees of the exchange trading 
for their own accounts. The exchange must adopt and implement adequate 
oversight procedures to ensure that the safeguards and procedures 
established pursuant to this condition are followed; and
    (7) The exchange must provide access to the Commission to conduct 
on-site inspections of its facilities (including automated systems and 
systems environment), records, and personnel related to exchange 
activities. The exchange must cooperate with the Commission in 
connection with the investigation of any exchange subscribers.
    It is further ordered, pursuant to Section 36 of the Exchange 
Act,\21\ that until March 24, 2010, a broker or dealer that effects 
transactions in non-excluded CDS, or reports such transactions, on an 
exchange that is exempted pursuant to this Order will also continue to 
be exempt from the prohibition on trading activity in Section 5 of the 
Exchange Act.
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    \21\ 15 U.S.C. 78mm.

    By the Commission.
Florence E. Harmon,
Deputy Secretary.
[FR Doc. E9-23622 Filed 9-30-09; 8:45 am]

BILLING CODE 8011-01-P