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SEC and FINRA Adopt CDS Risk Monitoring Procedures

In a move that may signal a trend toward more rulemaking on monitoring risk,  the SEC and FINRA have adopted an interim pilot program (SEC Release No. 34-59955 and FINRA Regulatory Notice 09-30) aimed at OTC and exchange traded credit default swaps ("CDS").  The requirements of the pilot program apply to CDS transactions executed by a FINRA members, regardless of the type of account in which the transaction is booked.  The rules of the pilot program apply to open or outstanding CDS transactions and CDS executed from May 22, 2009 to September 25, 2009, the term of the pilot program.  This program is intended to augment the SEC's recent interim final temporary rules allowing the federal government and private groups to designate central clearing entities, and devise a comprenhensive framework for OTC derivatives, as a prelude to reform of the US financial regulatory system. 

Mandated Risk Management Procedures

Among the pilot program's other requirements, section (d) of the pilot program rules requires FINRA members to engage in risk monitoring of any customer or broker-dealer accounts having CDS exposure, and mandates certain specific risk monitoring procedures for these accounts:
  • obtaining appropriate financial and account documentation for opening an account with the member;
  • reviewing the credit limits of each broker-dealer and customer of the member;
  • monitoring the credit risk exposure to the member from CDS;
  • the use of stress testing by the member;
  • managing the effect that the member’s extension of credit for CDS has on the member itself; and
  • the determination of the need to collect additional margin from a broker-dealer or customer.
In addition, FINRA members wishing to establish any clearing arrangement relating to CDS transactions that make use of central counterparty clearing services, must notify FINRA in advance and submit for review by FINRA their monitoring procedures and controls.  Bearing in mind that this program is part of a FINRA pilot program, it is notable that FINRA and the SEC have mandated not only that risk management procedures be implemented as part of the conditions of participation, but that they have explicitly laid out what procedures are required.  While it is expected that notions of risk management will arise in other rulemaking contexts over the next few months and years, it will be interesting to see if regulators and the industry feel comfortable with mandating specific procedures in areas outside the CDS market. 

The full text of the SEC's Release. No. 34-59955 adopting Rule 4240 is available at: http://www.sec.gov/rules/sro/finra/2009/34-59955.pdf

The full text of FIRA's Regulatory Notice 09-30 is available at:  http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p118837.pdf