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SEC: Go Ahead and Hose Derivatives Counterparties

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Many people are surprised that investment banks want their customers to buy things that they are selling. If a customer buys a bond, then the bank doesn't own it any more - but isn't that a conflict of interest? Wasn't that bond designed to fail? Shouldn't the banks only sell bonds to their customers that they'd rather keep themselves?

Given that mindset, we've seen many calls to turn market makers into fiduciaries for their customers. But Dodd-Frank started small, changing the rules mainly for derivatives dealers who interact with "special entities" (muni issuers, pension plans and endowments - who are presumed to be less sophisticated / more likely to blow all their money on sewer swaps), providing that those dealers will be treated as "advisers" and will have to act in the best interests of their special-entity counterparties if they recommend transactions to them.

The SEC recently released proposed business conduct rules under Dodd-Frank, and today law firm Cleary Gottlieb gave them a pretty positive review. In particular, they like that there's a way for dealers to get out of the best-interests rules:

[A dealer] would not be deemed an advisor under the safe harbor if (1) the Special Entity represents in writing that it will not rely on recommendations provided by the [dealer] and will instead rely on advice from a qualified independent representative; (2) the [dealer] has a reasonable basis to believe that the Special Entity is advised by a qualified independent representative; and (3) the [dealer] discloses to the Special Entity that it is not undertaking to act in the best interests of the Special Entity.

The best interests rules may pose real challenges for banks (remember: if you think that The City of Toad Suck, Arkansas should be long this particular swap, why are you on the other side of it?). Which means that this SEC safe harbor might actually prove pretty attractive, even though it requires banks to tell their customers "we're planning to screw you" in so many words. And if it does, that could create a lucrative market for non-bank "qualified independent representatives" to advise municipalities, pensions and endowments on their derivatives transactions.

And I'd be available at very reasonable rates.

SEC Proposes Business Conduct Standards [Cleary Gottlieb]

SEC Proposes Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants [SEC]