Federal Register, Volume 77 Issue 240 (Thursday, December 13, 2012)[Federal Register Volume 77, Number 240 (Thursday, December 13, 2012)]
[Rules and Regulations]
[Pages 74283-74339]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-29211]
[[Page 74283]]
Vol. 77
Thursday,
No. 240
December 13, 2012
Part II
Commodity Futures Trading Commission
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17 CFR Parts 39 and 50
Clearing Requirement Determination Under Section 2(h) of the CEA; Final
Rule
Federal Register / Vol. 77 , No. 240 / Thursday, December 13, 2012 /
Rules and Regulations
[[Page 74284]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 39 and 50
RIN 3038-AD86
Clearing Requirement Determination Under Section 2(h) of the CEA
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rule.
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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)
is adopting regulations to establish a clearing requirement under new
section 2(h)(1)(A) of the Commodity Exchange Act (CEA or Act), enacted
under Title VII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank Act). The regulations require that certain
classes of credit default swaps (CDS) and interest rate swaps,
described herein, be cleared by a derivatives clearing organization
(DCO) registered with the Commission. The Commission also is adopting
regulations to prevent evasion of the clearing requirement and related
provisions.
DATES: The rules will become effective February 11, 2013. Specific
compliance dates are discussed in the supplementary information.
FOR FURTHER INFORMATION CONTACT: Sarah E. Josephson, Deputy Director,
202-418-5684, [email protected]; Brian O'Keefe, Associate Director,
202-418-5658, [email protected]; or Erik Remmler, Associate Director,
202-418-7630, [email protected], Division of Clearing and Risk, Camden
Nunery, Economist, 202-418-5723, [email protected], Office of the Chief
Economist, Commodity Futures Trading Commission, Three Lafayette
Centre, 1155 21st Street NW., Washington, DC 20581.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background
A. Clearing Requirement Proposal
B. Financial Crisis
C. Central Role of Clearing in the Dodd-Frank Act
D. G-20 and International Commitments on Clearing
E. Overview of Section 2(h) and Sec. 39.5
F. Submissions From DCOs
II. Comments on the Notice of Proposed Rulemaking
A. Overview of Comments Received
B. Generally Applicable Comments
C. Credit Default Swaps
D. Determination Analysis for Credit Default Swaps
E. Interest Rate Swaps
F. Determination Analysis for Interest Rate Swaps
III. Final Rule
A. Regulation 50.1: Definitions
B. Regulation 50.2: Treatment of Swaps Subject to a Clearing
Requirement
C. Regulation 50.3: Notice to the Public
D. Regulation 50.4: Classes of Swaps Required To Be Cleared
E. Regulation 50.5: Clearing Transition Rules
F. Regulation 50.6: Delegation of Authority
G. Regulation 50.10: Prevention of Evasion of the Clearing
Requirement and Abuse of an Exception or Exemption to the Clearing
Requirement
IV. Implementation
V. Cost Benefit Considerations
A. Statutory and Regulatory Background
B. Overview of Swap Clearing
C. Consideration of the Costs and Benefits of the Commission's
Action
D. Consideration of Alternative Swap Classes for Clearing
Determination
E. Section 15(a) Factors
VI. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
I. Background
A. Clearing Requirement Proposal
On August 7, 2012, the Commission published a notice of proposed
rulemaking (NPRM) to establish a clearing requirement under new section
2(h)(1)(A) of the CEA, as provided for under section 723 of Title VII
of the Dodd-Frank Act.\1\ The Commission proposed that swaps meeting
the specifications identified in two classes of CDS and four classes of
interest rate swaps, and available for clearing by an eligible DCO,
would be required to be cleared. The Commission also proposed rules
related to the prevention of evasion of the clearing requirement and
prevention of abuse of an exception or exemption to the clearing
requirement. The Commission is hereby adopting Sec. Sec. 50.1-50.6 and
Sec. 50.10, subject to the changes discussed below.
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\1\ Clearing Requirement Determination Under Section 2(h) of the
CEA; Proposed Rule, 77 FR 47170 (Aug. 7, 2012).
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B. Financial Crisis
In the fall of 2008, a series of large financial institution
failures triggered a financial and economic crisis that threatened to
freeze U.S. and global credit markets. As a result of these failures,
unprecedented governmental intervention was required to ensure the
stability of the U.S. financial system.\2\ These failures revealed the
vulnerability of the U.S. financial system and economy to widespread
systemic risk resulting from, among other things, poor risk management
practices of financial firms and the lack of supervisory oversight for
a financial institution as a whole.\3\
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\2\ On October 3, 2008, President Bush signed the Emergency
Economic Stabilization Act of 2008, which was principally designed
to allow the U.S. Department of the Treasury and other government
agencies to take action to restore liquidity and stability to the
U.S. financial system (e.g., the Troubled Asset Relief Program--also
known as TARP--under which the U.S. Department of the Treasury was
authorized to purchase up to $700 billion of troubled assets that
weighed down the balance sheets of U.S. financial institutions). See
Public Law 110-343, 122 Stat. 3765 (2008).
\3\ See Financial Crisis Inquiry Commission, ``The Financial
Crisis Inquiry Report: Final Report of the National Commission on
the Causes of the Financial and Economic Crisis in the United
States,'' Jan. 2011, at xxviii, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
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The financial crisis also illustrated the significant risks that an
uncleared, over-the-counter (OTC) derivatives market can pose to the
financial system. As the Financial Crisis Inquiry Commission explained:
The scale and nature of the [OTC] derivatives market created
significant systemic risk throughout the financial system and helped
fuel the panic in the fall of 2008: millions of contracts in this
opaque and deregulated market created interconnections among a vast
web of financial institutions through counterparty credit risk, thus
exposing the system to a contagion of spreading losses and
defaults.\4\
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\4\ See id. at 386.
Certain OTC derivatives, such as CDS, played a prominent role
during the crisis. According to a white paper by the U.S. Department of
the Treasury, ``the sheer volume of these [CDS] contracts overwhelmed
some firms that had promised to provide payment of the CDS and left
institutions with losses that they believed they had been protected
against.'' \5\ In particular, AIG reportedly issued uncleared CDS
transactions covering more than $440 billion in bonds, leaving it with
obligations that it could not cover as a result of changed market
conditions.\6\ As a result of AIG's CDS exposure, the Federal
government bailed out the firm with over $180 billion of taxpayer money
in order to prevent AIG's failure and a possible contagion event in the
broader economy.\7\
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\5\ Financial Regulatory Reform: A New Foundation, June 2009,
available at http://www.treasury.gov/initiatives/Documents/FinalReport_web.pdf and cited in S. Rep. 111-176 at 29-30 (Apr. 30,
2010).
\6\ Adam Davidson, ``How AIG fell apart,'' Reuters, Sept. 18,
2008, available at http://www.reuters.com/article/2008/09/18/us-how-aig-fell-apart-idUSMAR85972720080918.
\7\ Hugh Son, ``AIG's Trustees Shun `Shadow Board,' Seek
Directors,'' Bloomberg, May 13, 2009, available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aaog3i4yUopo&refer=us.
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More broadly, the President's Working Group (PWG) on Financial
Markets noted shortcomings in the OTC
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derivative markets as a whole during the crisis. The PWG identified the
need for an improved integrated operational structure supporting OTC
derivatives, specifically highlighting the need for an enhanced ability
to manage counterparty risk through ``netting and collateral agreements
by promoting portfolio reconciliation and accurate valuation of
trades.'' \8\ These issues were exposed in part by the surge in
collateral required between counterparties during 2008, when the
International Swaps and Derivatives Association (ISDA) reported an 86%
increase in the collateral in use for OTC derivatives, indicating not
only the increase in risk, but also circumstances in which positions
may not have been collateralized.\9\
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\8\ The President's Working Group on Financial Markets, ``Policy
Statements on Financial Market Developments,'' Mar. 2008, available
at http://www.treasury.gov/resource-center/fin-mkts/Documents/pwgpolicystatemktturmoil_03122008.pdf.
\9\ ISDA, ISDA Margin Survey, 2009, available at http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2009.pdf.
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With only limited checks on the amount of risk that a market
participant could incur, great uncertainty was created among market
participants. A market participant did not know the extent of its
counterparty's exposure, whether its counterparty was appropriately
hedged, or if its counterparty was dangerously exposed to adverse
market movements. Without central clearing, a market participant bore
the risk that its counterparty would not fulfill its payment
obligations pursuant to a swap's terms (counterparty credit risk). As
the financial crisis deepened, this risk made market participants wary
of trading with each other. As a result, markets quickly became
illiquid and trading volumes plummeted. The dramatic increase in ``TED
spreads'' evidenced this mistrust.\10\ These spreads increased from a
long-term average of approximately 30 basis points to 464 basis
points.\11\
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\10\ The TED spread measures the difference in yield between
three-month Eurodollars as represented by London Interbank Offered
Rate (LIBOR), and three-month Treasury Bills. LIBOR contains credit
risk while T-bills do not. As the spread got larger, it meant that
lenders demanded more return to compensate for credit risk than they
would need if they loaned the money to the U.S. Department of the
Treasury without any credit risk.
\11\ The U.S. Financial Crisis: Credit Crunch and Yield Spreads,
by James R. Barth et al., page 5, available at http://apeaweb.org/confer/bei08/papers/blp.pdf.
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The failure to adequately collateralize the risk exposures posed by
OTC derivatives, along with the contagion effects of the vast web of
counterparty credit risk, led many to conclude that OTC derivatives
should be centrally cleared. For instance, in 2008, the Federal Reserve
Bank of New York (FRBNY) began encouraging market participants to
establish a central counterparty to clear CDS.\12\ For several years
prior, the FRBNY had led a targeted effort to enhance operational
efficiency and performance in the OTC derivatives market by increasing
automation in processing and by promoting sound back office practices,
such as timely confirmation of trades and portfolio reconciliation.
Beginning with CDS in 2008, the FRBNY and other primary supervisors of
OTC derivatives dealers increasingly focused on central clearing as a
means of mitigating counterparty credit risk and lowering systemic risk
to the markets as a whole. Both regulators and market participants
alike recognized that risk exposures would have been monitored,
measured, and collateralized through the process of central clearing.
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\12\ See Federal Reserve Bank of New York, Press Release, ``New
York Fed Welcomes Further Industry Commitments on Over-the-Counter
Derivatives,'' Oct. 31, 2008, available at http://www.newyorkfed.org/newsevents/news/markets/2008/an081031.html, which
references documents prepared by market participants describing the
importance of clearing. See also Ciara Linnane and Karen Brettell,
``NY Federal Reserve pushes for central CDS counterparty,'' Reuters,
Oct. 6, 2008, available at http://www.reuters.com/article/2008/10/06/cds-regulation-idUSN0655208920081006.
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C. Central Role of Clearing in the Dodd-Frank Act
Recognizing the peril that the U.S. financial system faced during
the financial crisis, Congress and the President came together to pass
the Dodd-Frank Act in 2010. Title VII of the Dodd-Frank Act establishes
a comprehensive new regulatory framework for swaps, and the requirement
that swaps be cleared by DCOs is one of the cornerstones of that
reform. The CEA, as amended by Title VII, now requires a swap: (1) To
be cleared through a DCO if the Commission has determined that the
swap, or group, category, type, or class of swap, is required to be
cleared, unless an exception to the clearing requirement applies; (2)
to be reported to a swap data repository (SDR) or the Commission; and
(3) if the swap is subject to a clearing requirement, to be executed on
a designated contract market (DCM) or swap execution facility (SEF),
unless no DCM or SEF has made the swap available to trade.\13\
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\13\ The Commission has proposed rules that would establish a
separate process for determining whether a swap has been made
``available to trade'' by a DCM or SEF. Those rules, and any
determinations made under those rules, will be finalized separately
from the clearing requirements discussed herein. See Process for a
Designated Contract Market or Swap Execution Facility to Make a Swap
Available to Trade Under Section 2(h)(8) of the Commodity Exchange
Act, 76 FR 77728 (Dec. 14, 2011).
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Clearing is at the heart of the Dodd-Frank financial reform.
According to the Senate Report: \14\
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\14\ S. Rep. 111-176, at 32 (April 30, 2010). See also Letter
from Senators Christopher Dodd and Blanche Lincoln to Congressmen
Barney Frank and Collin Peterson (June 30, 2010) (``Congress
determined that clearing is at the heart of reform--bringing
transactions and counterparties into a robust, conservative, and
transparent risk management framework.'').
As a key element of reducing systemic risk and protecting
taxpayers in the future, protections must include comprehensive
regulation and rules for how the OTC derivatives market operates.
Increasing the use of central clearinghouses, exchanges, appropriate
margining, capital requirements, and reporting will provide
safeguards for American taxpayers and the financial system as a
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whole.
The Commission believes that a clearing requirement will reduce
counterparty credit risk and provide an organized mechanism for
collateralizing the risk exposures posed by swaps. According to the
Senate Report: \15\
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\15\ S. Rep. 111-176, at 33.
With appropriate collateral and margin requirements, a central
clearing organization can substantially reduce counterparty risk and
provide an organized mechanism for clearing transactions. * * *
While large losses are to be expected in derivatives trading, if
those positions are fully margined there will be no loss to
counterparties and the overall financial system and none of the
uncertainty about potential exposures that contributed to the panic
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in 2008.
Notably, Congress did not focus on just one asset class, such as CDS;
rather, Congress determined that all swaps that a DCO plans to accept
for clearing must be submitted to the Commission for a determination as
to whether or not those swaps are required to be cleared pursuant to
section 2(h)(2)(D) of the CEA.
D. G-20 and International Commitments on Clearing
The financial crisis generated international consensus on the need
to strengthen financial regulation by improving transparency,
mitigating systemic risk, and protecting against market abuse. As a
result of the widespread recognition that transactions in the OTC
derivatives market increased risk and uncertainty in the global economy
and became a significant contributor to the financial crisis, a series
of policy initiatives were undertaken to better regulate the financial
markets.
[[Page 74286]]
In September 2009, leaders of the Group of 20 (G-20)--whose
membership includes the United States, the European Union, and 18 other
countries--agreed that: (1) OTC derivatives contracts should be
reported to trade repositories; (2) all standardized OTC derivatives
contracts should be cleared through central counterparties and traded
on exchanges or electronic trading platforms, where appropriate, by the
end of 2012; and (3) non-centrally cleared contracts should be subject
to higher capital requirements.
In June 2010, the G-20 leaders reaffirmed their commitment to
achieve these goals. In its October 2010 report on Implementing OTC
Derivatives Market Reforms (the October 2010 Report), the Financial
Stability Board (FSB) made 21 recommendations addressing practical
issues that authorities may encounter in implementing the G-20 leaders'
commitments.\16\ The G-20 leaders again reaffirmed their commitments at
the November 2011 Summit, including the end-2012 deadline. The FSB has
issued three implementation progress reports. The most recent report
urged jurisdictions to push forward aggressively to meet the G-20 end-
2012 deadline in as many reform areas as possible. On mandatory
clearing, the report observed that ``[j]urisdictions now have much of
the information they requested in order to make informed decisions on
the appropriate legislation and regulations to achieve the end-2012
commitment to centrally clear all standardised OTC derivatives.'' \17\
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\16\ See ``Implementing OTC Derivatives Market Reforms,''
Financial Stability Board, Oct. 25, 2010, available at http://www.financialstabilityboard.org/publications/r_101025.pdf.
\17\ OTC Derivatives Working Group, ``OTC Derivatives Market
Reforms: Third Progress Report on Implementation,'' Financial
Stability Board, June 15, 2012, available at http://www.financialstabilityboard.org/publications/r_120615.pdf.
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Specifically with regard to required clearing, the Technical
Committee of the International Organization of Securities Commissions
(IOSCO) has published a final report, Requirements for Mandatory
Clearing, outlining recommendations that regulators should follow to
carry out the G-20's goal of requiring standardized swaps to be
cleared.\18\
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\18\ IOSCO's report, published in February 2012, is available at
https://www.iosco.org/library/pubdocs/pdf/IOSCOPD374.pdf.
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Nations around the world have been preparing for the move to
mandatory clearing. For example, the Japanese Financial Services
Authority (JFSA) has proposed requiring certain financial institutions
to clear yen-denominated interest rate swaps that reference LIBOR and
CDS that reference the Japanese iTraxx indices by the end of 2012.
After that, the requirement will be expanded to other entities engaging
in these swaps. In addition, the JFSA is considering expanding its
mandatory clearing coverage to include U.S. dollar- and euro-
denominated interest rate swaps, as well as yen-denominated interest
rate swaps referencing TIBOR. The JFSA also will consider mandating
single-name CDS referencing Japanese reference entities, and index and
single-name CDS on North American and European reference entities.
The Monetary Authority of Singapore (MAS) released a consultation
paper addressing mandatory clearing on February 13, 2012. Based on a
preliminary review MAS expects Singapore dollar interest rate swaps,
U.S. dollar interest rate swaps, and Asian currency non-deliverable
forwards to meet its proposed mandatory clearing criteria. Additional
swaps will be considered for mandatory clearing via clearinghouse
submission or upon the review of MAS.
The Securities and Futures Commission and Hong Kong Monetary
Authority jointly released a consultation paper addressing mandatory
clearing on October 17, 2011. This consultation plan described a phased
implementation approach where clearing requirements will initially
cover standardized interest rate swaps and non-deliverable forwards.
Hong Kong regulators have said they will consider extending the
mandatory clearing requirements in subsequent phases. In July, the Hong
Kong regulators published consultation conclusions and stated that the
precise mandatory clearing obligations would be set out in subsidiary
legislation which they will be consulting on in the fourth quarter of
2012.
On April 18, 2012, the Australian Council of Financial Regulators
published a consultation on a number of OTC derivatives, including
mandatory clearing. The Council of Financial Regulators is developing
advice for the government which is expected to adopt legislation by
end-2012.
Finally, in the European Union, specific clearing determinations
have yet to be made. However, the European Markets Infrastructure
Regulation (EMIR) provides that contracts become subject to the
clearing obligation through either a ``bottom up'' approach or a ``top
down'' approach. The ``bottom up'' approach is where a national
authority authorizes a central counterparty (CCP) to clear certain
classes of OTC derivatives. The ``top down'' approach is where the
European Securities and Markets Authority (ESMA) identifies classes of
OTC derivatives which should be subject to the clearing obligation but
for which no CCP is authorized to clear. Based on this framework, ESMA
has the authority to make clearing determinations for classes of OTC
derivative contracts.
With the adoption of these final rules, the Commission is taking a
critical step toward meeting the G-20 commitment and fulfilling the
requirements of the Dodd-Frank Act. The Commission has consulted with
authorities from around the globe to ensure that our efforts are as
coordinated as possible.
E. Overview of Section 2(h) and Sec. 39.5
The Commission promulgated Sec. 39.5 of its regulations to
implement procedural aspects of section 2(h) of the CEA.\19\ Regulation
39.5 establishes procedures for: (1) Determining the eligibility of a
DCO to clear swaps; (2) the submission of swaps by a DCO to the
Commission for a clearing requirement determination; (3) Commission
initiated reviews of swaps; and (4) the staying of a clearing
requirement.
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\19\ See 76 FR 44464 (July 26, 2011); 17 CFR 39.5.
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The determinations and rules adopted in this release implement the
clearing requirement under section 2(h) of the CEA for certain swaps
and require that those swaps must be submitted for clearing to
Commission-registered DCOs. Under section 2(h)(1)(A), ``it shall be
unlawful for any person to engage in a swap unless that person submits
such swap for clearing to a [DCO] that is registered under [the CEA] or
a [DCO] that is exempt from registration under [the CEA] if the swap is
required to be cleared.'' \20\
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\20\ See section 2(h) of the CEA. The Commission also may
conduct a Commission-initiated review of swaps for required
clearing. Section 2(h)(2)(A)(i) of the CEA requires the Commission
on an ongoing basis to ``review each swap, or any group, category,
type, or class of swaps to make a determination as to whether the
swap, category, type or class of swaps should be required to be
cleared.''
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A clearing requirement determination may be initiated by a swap
submission. Section 2(h)(2)(B)(i) of the CEA requires a DCO to ``submit
to the Commission each swap, or any group, category, type or class of
swaps that it plans to accept for clearing, and provide notice to its
members of the submission.'' In addition under section 2(h)(2)(B)(ii)
of the CEA, ``[a]ny swap or group, category, type, or class of swaps
listed for clearing by a [DCO] as of the date of enactment shall be
considered submitted to the Commission.''
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F. Submissions from DCOs
On February 1, 2012, Commission staff sent a letter requesting that
DCOs submit all swaps that they were accepting for clearing as of that
date, pursuant to Sec. 39.5 of the Commission's regulations.\21\ The
Commission received submissions relating to CDS and interest rate swaps
from: The International Derivatives Clearinghouse Group (IDCH) \22\ on
February 17, 2012; the CME Group (CME), ICE Clear Credit, and ICE Clear
Europe, each dated February 22, 2012; and a submission from
LCH.Clearnet Limited (LCH) on February 24, 2012.\23\
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\21\ The letter made it clear that DCOs should submit both pre-
enactment swaps and swaps for which DCOs have initiated clearing
since enactment of the Dodd-Frank Act. Pre-enactment swaps refer to
those swaps that DCOs were accepting for clearing as of July 21,
2010, the date of enactment of the Dodd-Frank Act.
\22\ As discussed in detail below, IDCH has been purchased by
LCH.Clearnet Group.
\23\ Other swaps submissions were received from Kansas City
Board of Trade (KCBT) and the Natural Gas Exchange (NGX). KCBT and
NGX do not accept any CDS or interest rate swaps for clearing.
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The clearing requirement determinations and rules adopted in this
release cover certain CDS and interest rate swaps currently being
cleared by a DCO. The Commission intends subsequently to consider other
swaps submitted by DCOs, such as agricultural, energy, and equity
indices.
As stated in the NPRM, the decision to focus on CDS and interest
rate swaps in the initial clearing requirement determinations is a
function of both the market importance of these swaps and the fact that
they already are widely cleared. In order to move the largest number of
swaps to required clearing in its initial determinations, the
Commission believes that it is prudent to focus on those swaps that
have the highest market shares and, accordingly, the biggest market
impact. Further, for these swaps there is already a blueprint for
clearing and appropriate risk management. CDS and interest rate swaps
fit these considerations and therefore are well suited for required
clearing consideration.\24\
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\24\ The Commission will consider all other swaps submitted
under Sec. 39.5(b) as soon as possible after this determination is
published. These other swaps include certain CDS that were submitted
to the Commission after the initial February 2012 submissions
discussed above. If the Commission determines that additional swaps
should be required to be cleared, such determination likely will be
proposed as a new class under Sec. 50.4.
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Notably, market participants recommended that the Commission take
this approach, and comments received on the NPRM supported this
approach as well.\25\ In addition, interest rate swaps account for
about $500 trillion of the $650 trillion global OTC swaps market, in
notional dollars--the highest market share of any class of swaps.\26\
LCH claims to clear about $302 trillion of those--meaning that, in
notional terms, LCH clears approximately 60% of the interest rate swap
market.\27\ While CDS indices do not have as prominent a market share
as interest rate swaps, CDS indices are capable of having a sizeable
market impact, as they did during the 2008 financial crisis. Overall,
the CDS marketplace has almost $29 trillion in notional outstanding
across both single and multi-name products.\28\ CDS on standardized
indices accounts for about $10 trillion of the global OTC market in
notional dollar amount outstanding.\29\ Since March 2009, the ICE Clear
Credit and ICE Clear Europe have combined to clear over $30 trillion in
gross notional for all CDS.\30\ Because of the market shares and market
impacts of these swaps, and because these swaps are currently being
cleared, the Commission decided to review CDS and interest rate swaps
in its initial clearing requirement determinations. The Commission
recognizes that while this is an appropriate basis for the initial
determinations, swap clearing is likely to evolve and clearing
requirement determinations made at later times may be based on a
variety of other factors beyond the extent to which the swaps in
question are already being cleared.
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\25\ See, e.g., letters from the CME Group (CME), the Futures
Industry Association (FIA), the Managed Funds Association (MFA), and
Americans for Financial Reform (AFR).
\26\ Bank of International Settlements (BIS) data, December
2011, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.
\27\ Id.; LCH data.
\28\ BIS data, December 2011, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.
\29\ Id.
\30\ ICE Clear Credit data, as of the April 26, 2012 clearing
cycle.
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II. Comments on the Notice of Proposed Rulemaking
The Commission received 29 comments during the 30-day public
comment period following publication of the NPRM, and four additional
comments after the comment period closed. The Commission considered
each of these 33 comments in formulating the final regulations.\31\
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\31\ Comment letters received in response to the NPRM may be
found on the Commission's Web site at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1252.
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The Chairman and Commissioners, as well as Commission staff,
participated in numerous meetings with clearinghouses, market
participants, trade associations, public interest groups, and other
interested parties. In addition, the Commission has consulted with
other U.S. financial regulators including: (i) The Securities and
Exchange Commission (SEC); (ii) the Board of Governors of the Federal
Reserve System; (iii) the Office of the Comptroller of the Currency;
and (iv) the Federal Deposit Insurance Corporation (FDIC). Staff from
each of these agencies has had the opportunity to provide oral and/or
written comments to this adopting release, and the final regulations
incorporate elements of the comments provided.
The Commission is mindful of the benefits of harmonizing its
regulatory framework with that of its counterparts in foreign
countries. The Commission has therefore monitored global advisory,
legislative, and regulatory proposals, and has consulted with foreign
regulators in developing the final regulations.
A. Overview of Comments Received
None of the 33 comments received expressed outright opposition to
the Commission's clearing requirement proposal.\32\ Indeed, 22 of the
comment letters strongly supported the Commission's proposal and urged
the Commission to finalize its proposal promptly.\33\ These comments
also supported the Commission's analysis under the five-factor
statutory test, and agreed with the Commission's conclusion that swaps
within the four proposed classes of interest rate swaps and the two
proposed classes of CDS were appropriate for required clearing.\34\ All
three DCOs clearing the swaps subject to the final rules expressed
strong support for the proposal and agreed with the overall approach
taken by the Commission.\35\
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\32\ An unsigned comment submitted on September 4, 2012,
questioned the need for additional regulation as a general matter.
\33\ See letters from Futures Industry Association Principle
Traders Group (FIA PTG), Arbor Research and Trading, LLC, R.J.
O'Brien & Associates, Svenokur, LLC, Chris Barnard, CRT Capital
Group (Robert Gorham), LLC, DRW Trading Group, Javelin, The Swaps
and Derivatives Market Association (SDMA), Knight Capital Americas
LLC, Bart Sokol (CRT Capital Group), Jefferies & Company, Inc.,
MarketAxess, Eris Exchange, Coherence Capital Partners LLC, Citadel,
Americans for Financial Reform (AFR), D.E. Shaw Group,
AllianceBernstein, LCH.Clearnet Group Limited (LCH), CME Group Inc.
(CME), and IntercontinentalExchange, Inc. (ICE).
\34\ See, e.g., letter from Citadel (reviewing each of the five
statutory factors and supporting the Commission's analysis).
\35\ CME applauded the Commission's decision to require classes
of swaps be cleared rather than take a product-by-product approach.
CME also commended the decision not to propose classes of swaps on a
DCO-by-DCO basis.
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However, a number of commenters requested that the Commission make
specific modifications to the proposed
[[Page 74288]]
rules,\36\ and, in several instances, commenters requested
clarification of various points.\37\ A number of commenters requested
that the Commission delay implementation of the clearing requirement
until certain milestones are met.\38\ Each of these comments is
discussed in detail below.
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\36\ See, e.g., letter from ISDA (requesting changes to the
delegation provisions of proposed Sec. 50.6).
\37\ See, e.g., letter from The Financial Services Roundtable
(FSR) (requesting that the Commission clarify the meaning of
``conditional notional amount'').
\38\ See, e.g., letter from ISDA (requesting that no
determination take effect until there is ``a further determination
that a product has an adequate clearing history to support a finding
of operational readiness to clear by DCOs and market
participants''), and letter from Vanguard (requesting that the
Commission delay mandatory clearing until new rules for segregation
of customer funds and swap positions are fully operational and
capable of being tested for three months).
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The Futures Industry Association (FIA) expressed concern about the
30-day comment period providing sufficient time to comment on the
proposal, and recommended that the Commission provide a longer comment
period for future proposals.\39\ The Commission is cognizant of the
importance of affording the public sufficient time to comment on
important proposals. However, given the CEA's requirement that the
Commission make its clearing requirement determinations within 90 days,
in most instances, providing a 30-day comment period will be
appropriate. In fact, some commenters stressed the importance of
completing the determination process in an efficient manner. As R.J.
O'Brien noted in its comment letter, implementing the clearing mandate
as soon as possible ``will improve the financial industry's credibility
and show the rest of the world we are serious about improving the
financial safety of our markets.'' Providing for a longer comment
period likely would impede the Commission's ability to meet the 90-day
statutory deadline for completing the determination process.
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\39\ FIA specifically mentioned its inability to respond to
questions asked in the NPRM with regard to competitiveness, which it
viewed as important to the Commission's analysis of competitiveness
under one of the five statutory factions. See Sections II.D and II.F
below.
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Lastly, two commenters encouraged the Commission to issue proposed
determinations for energy, agricultural, and equity swaps as soon as
possible.\40\ As required under the CEA, the Commission will continue
to review swap submissions received from DCOs for purposes of the
clearing requirement in as timely a manner as possible.
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\40\ See letters from AFR and Chris Barnard.
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B. Generally Applicable Comments
A number of comments are equally applicable to both the CDS and
interest rate swap proposals. While most of these issues are discussed
in Section III below, certain threshold comments are addressed at the
outset.
i. Submission of Swaps Required To Be Cleared and Failures to Clear
CME sought clarification that market participants do not have to
clear those swaps that fall within a class of swaps under Sec. 50.4,
but for which no DCO provides clearing or for which the DCO provides
clearing to only a limited number of market participants. Other
commenters expressed similar concerns about not requiring clearing
where no DCO offers customer clearing.\41\ Freddie Mac requested
clarification regarding the legal status of a swap that is submitted
for clearing to a DCO, but fails to clear.
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\41\ See Section II.D for a discussion of iTraxx and the
availability of client clearing.
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The Commission confirms that if no DCO clears a swap that falls
within a class of swaps under Sec. 50.4, then the clearing requirement
does not apply to that swap. In essence, it is a two-step process to
determine whether the clearing requirement applies to a particular
swap. First, a market participant must determine whether its swap falls
within one of the classes under Sec. 50.4. Then, if the swap falls
within one of the classes, the market participant must determine if any
of the eligible DCOs clear that swap. The second step requires market
participants to determine if all the product specifications required
under the DCO's rules are met. If no eligible DCO will accept the swap
for clearing because there is a different product specification, then
the swap is not required to be cleared. Market participants need not
submit swaps to a DCO if they know that the DCO does not clear that
particular swap.\42\
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\42\ The rule text of Sec. 50.2(a) has been modified to clarify
this two-step process.
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In response to Freddie Mac's request for clarification, if
counterparties submit their swap to a DCO for clearing and the swap
fails to clear because it contains a term or terms that prevent any
eligible DCO from clearing the swap, then the swap is not subject to
the Commission's clearing requirement. On the other hand, if the swap
fails to clear because one or both of the counterparties have not met
the DCO's or their clearing members' credit requirements,\43\ then the
swap remains subject to the clearing requirement and must be cleared as
soon as technologically practicable after the counterparties learn of
the credit issue. The Commission notes that section 739 of the Dodd-
Frank Act amended section 22(a)(4)(B) of the CEA to provide that,
regarding contract enforcement between two eligible counterparties,
``[n]o agreement, contract, or transaction between eligible contract
participants or persons reasonably believed to be eligible contract
participants shall be void, voidable, or unenforceable * * * under this
section or any other provision of Federal or State law, based solely on
the failure of the agreement, contract, or transaction * * * to be
cleared in accordance with section 2(h)(1).'' Accordingly, a swap that
fails to clear because of credit issues may not be voided by either
eligible counterparty solely for the failure of the swap to be cleared
in accordance with section 2(h)(1), but the basis for the failure to
clear must be addressed by the counterparties and they must promptly
resubmit the swap for clearing.
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\43\ It is the Commission's understanding that clearing failures
generally arise under two circumstances: (1) Failure of the swap to
meet the product specifications required by the DCO; or (2) a credit
issue with one or both of the counterparties to the swap. Generally
speaking, identification of a product specification problem can be
identified extremely quickly.
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With regard to clearing that is not available to all market
participants, the Commission will not require a swap to be cleared
unless clearing is generally available to all types of market
participants.\44\
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\44\ See Section II.D for a discussion of iTraxx and the
availability of client clearing.
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ii. Adequacy of DCO Clearing History and Commission Review
ISDA raised a general issue regarding whether the clearing
requirement determination for CDS and interest rate swaps properly
differentiates between swaps that a DCO currently clears and those that
are not currently cleared by a DCO. ISDA expressed concern about
delegating to the Director of the Division of Clearing and Risk the
authority to determine whether newly-cleared swaps fall within a
previously-established class. ISDA's specific comments and
recommendations are discussed, and in part adopted, in Section III
below. However, ISDA's general recommendation is that the Commission
not impose a clearing requirement until there is ``a further
determination that a product has an adequate clearing history to
support a finding of operational readiness to clear by DCOs and market
participants.'' Specifically, ISDA requests that each product have been
actually cleared by a DCO and exhibit
[[Page 74289]]
non-zero open interest (for both inter-dealer and customer clearing) on
each day during a six-month period prior to the effective date of the
clearing requirement determination.
In contrast with ISDA's comments, the three DCOs eligible to clear
swaps within the classes under proposed Sec. 50.4 praised the
Commission for taking the class-based approach rather than a product-
by-product approach.\45\ In addition, CME and ICE both endorsed the
Commission's decision not to limit applicability of the clearing
requirement to individual DCOs.
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\45\ Many other commenters also agreed with this approach. See,
e.g., TriOptima and Citadel.
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The Commission observes that ISDA's recommendation that each DCO
demonstrate non-zero open interest for six months may be inconsistent
with section 2(h)(2) of the CEA, which requires each DCO to submit to
the Commission all swaps that ``it plans to accept for clearing.'' The
use of the phrase ``plans to accept'' indicates that Congress intended
for the Commission to review swap submissions prior to a DCO's
commencing clearing operations for those swaps. Under these
circumstances, the DCO would not be able to demonstrate open interest.
In addition, adopting ISDA's suggestion could pose a significant
deterrent to competition among DCOs insofar as DCOs seeking to offer
swaps for required clearing would have to wait until they attract open
interest and retain it for six months before they would be on a level
playing field with incumbent DCOs.
The Commission believes that it can address ISDA's concerns about
DCO product expansion and risk management through its ongoing
supervision and risk surveillance programs.\46\ In addition, under
Sec. 39.5(a)(1) the Commission can review the presumption of
eligibility for any DCO offering new swaps falling into a class that it
is already clearing, and under Sec. 39.5(a)(2), the Commission must
review the eligibility of any DCO that wishes to clear a swap that is
not within a class already being cleared by that DCO.\47\ The many
benefits of a class-based approach are discussed with regard to both
CDS and interest rate swaps below.
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\46\ See discussion of the Commission's DCO examination and risk
surveillance programs in the NPRM, 77 FR at 47173-74.
\47\ In its comment letter, Freddie Mac questioned how the
Commission would review a proposal from a DCO to clear swaps that
are required to be cleared under Sec. 50.4. In addition to its
general authority to ensure compliance with the core principles, the
Commission has authority to review a DCO's eligibility to clear
swaps subject to a clearing requirement at any time under Sec.
39.5(a).
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iii. Customer Segregation for Swaps
Under section 2(h)(2)(D)(ii)(V) of the CEA, in making a clearing
requirement determination, the Commission must take into account the
existence of reasonable legal certainty in the event of the insolvency
of the relevant DCO or one or more of its clearing members with regard
to the treatment of customer and swap counterparty positions, funds,
and property.\48\ Several commenters raised general concerns about
customer segregation for cleared swaps.
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\48\ This factor is discussed further in Sections II.D and II.F
below.
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Vanguard recommended that the Commission should not implement
mandatory clearing for any swaps until the Commission's final swap
customer segregation rules under the legally segregated, operationally
commingled (LSOC) model are fully operational and capable of being
tested for at least three months prior to mandatory clearing.
The Securities Industry and Financial Markets Association's Asset
Management Group (SIFMA AMG) expressed similar concerns about
unresolved issues concerning LSOC rules and the operational readiness
of futures commission merchants (FCMs) and DCOs to comply with those
rules. SIFMA AMG requested clarification of certain matters related to
the LSOC model and requests that the Commission issue new rules to
require FCMs to issue reports as frequently as technologically
feasible, require DCOs to take all steps necessary to ensure reported
information is accurate, and require DCOs to complete margin
calculations as frequently as technologically feasible. SIFMA AMG
recommended that the Commission implement a three-month testing period
for LSOC rule implementation after the Commission and the market have
completed their ongoing rule clarification efforts.
Both Vanguard and SIFMA AMG requested that all customer margin,
including excess margin above the amount required by the DCO, be
protected from fellow-customer risk.
ISDA noted that the commodity broker liquidation provisions under
the U.S. bankruptcy code and the Commission's Part 190 regulations have
never been applied to a DCO. In addition, ISDA stated that the Orderly
Liquidation Authority under Title II of the Dodd-Frank Act has never
been applied to any entity. For clearinghouses located in the United
Kingdom, ISDA observed that the Commission is relying on legal
opinions, noting the lack of practical experience with DCO insolvency
in the United Kingdom. In light of the absence of practical experience
with DCO insolvency, ISDA recommended that the Commission study the
issue with the goal of documenting uncertainties and proposing
solutions.
In response to these comments, the Commission observes that the
compliance date for LSOC was November 13, 2012. The Commission worked
with market participants to ensure that compliance by that date was
accomplished \49\ For reasons discussed below, the compliance schedule
for this first clearing requirement will commence on March 11,
2013.\50\ Accordingly, as requested by SIFMA AMG, parties in the first
compliance category \51\ will have more than 3 months of experience
under the LSOC rules prior to required clearing taking effect. Those
parties in the second and third categories will have over 6 and 9
months of testing prior to required clearing, respectively.\52\ During
this time, the Commission will continue to work with market
participants to resolve matters that require clarification regarding
LSOC.
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\49\ The Commission notes that under Sec. 22.13 a DCO may,
subject to certain conditions contained therein, accept cleared
swaps customer collateral in excess of the amount required by the
DCO. Acceptance of this excess collateral is entirely at the
election of the DCO. Thus, the timing of resolution of any issues
that may arise as a result of the optional acceptance of such
collateral is separate and apart from the November 13th compliance
date for implementation of the regulatory requirements set forth in
the Part 22 rules.
\50\ See Section IV for a complete discussion of compliance
dates.
\51\ Under the compliance schedule for required clearing, Sec.
50.25, Category 1 Entities are swap dealers, security-based swap
dealers, major swap participants, major security-based swap
participants, and active funds. This category must come in
compliance with the clearing requirement by March 11, 2013.
\52\ Category 2 Entities are commodity pools, private funds, and
persons predominantly engaged in activities that are in the business
of banking, or in activities that are financial in nature according
to section 4(k) of the Bank Holding Company Act, provided that such
participants are not third-party subaccounts. Category 2 Entities
must comply with the clearing requirement by June 10, 2013, for all
swaps entered into on or after that date. Category 3 Entities are
all other counterparties not electing an exception for a swap under
section 2(h)(7), including third-party subaccounts and ERISA plans.
Category 3 Entities must comply with the clearing requirement by
September 9, 2013, for all swaps entered into on or after that date.
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Moreover, in response to requests for enhanced LSOC protections,
the Commission understands that the industry is working toward a
February implementation date for DCO rules regarding acceptance of
excess collateral. The Commission recognizes
[[Page 74290]]
that this issue is of particular concern to third-party subaccounts
that will be required to begin clearing swaps executed on or after
September 9, 2013. Given the industry's February goal, the Commission
believes that issues regarding the acceptance of excess collateral will
be resolved before the beginning of September.
In response to ISDA's request that the Commission conduct a study
regarding insolvencies of DCOs and clearing members, the Commission
observes that its staff have actively participated in, and taken
leading roles in, a number of international efforts related to
clearinghouse and clearing member insolvency, including an important
cross-border study regarding insolvency regimes.\53\ In addition, the
Commission and other U.S. authorities, including the FDIC, have been
engaged, and continue to engage, in regulatory coordination and
cooperation, related to insolvencies under Title II.
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\53\ See, e.g., ``Survey of Regimes for the Protection,
Distribution, and/or Transfer of Client Assets'' (Technical
Committee of the International Organization of Securities
Commissions, March, 2011); ``Consultative Report on the Recovery and
Resolution of Financial Market Infrastructures'' (Committee on
Payment and Settlement Systems and the International Organization of
Securities Commissions, July, 2012). Staff are also actively
participating in further efforts in these contexts by the
International Organization of Securities Commissions and the
Resolution Steering Group of the Financial Stability Board.
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C. Credit Default Swaps
i. DCO Submissions
Pursuant to Sec. 39.5, the Commission received filings with
respect to CDS cleared by CME, ICE Clear Credit, and ICE Clear Europe,
each a registered DCO.\54\ The CME and ICE Clear Credit submissions
included the CDS that each clears on North American corporate indices,
covering various tenors and series.\55\ The ICE Clear Europe submission
included, among other swaps, the CDS contracts on European corporate
indices that they clear, with information on each of the different
tenors and series. Each of the submissions contained information
relating to the five statutory factors set forth in section 2(h)(2)(D)
of the CEA and other information required under Sec. 39.5.
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\54\ In the case of CME and ICE Clear Europe, the submissions
also included other swaps beyond those in the CDS and interest rate
swap categories. These submissions, including a description of the
specific swaps covered, are available on the Commission's Web site
at: http://sirt.cftc.gov/sirt/sirt.aspx?Topic=ClearingOrganizationProducts.
\55\ The Commission has received subsequent submissions from CME
and ICE Clear Credit relating to CDS. In particular, CME submitted a
filing with regard to the current series of each of the CDX.NA.IG
and CDX.NA.HY (Series 19). ICE Clear Credit made filings with regard
to the clearing of the 3-year tenor of the CDX.HY Series 15 and the
clearing of the CDX.EM indices. With the exception of the CDX.EM
submission, upon which the Commission has not yet begun the
determination process, the substance of each of the other
submissions was addressed in both the proposed clearing
determination and the final clearing determination set forth herein.
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CME, ICE Clear Credit, and ICE Clear Europe provided notice of
their Sec. 39.5 swap submissions to their members by posting their
submissions on their respective Web sites.\56\ The submissions also are
published on the Commission's Web site.\57\
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\56\ Available at http://www.cmegroup.com/market-regulation/rule-filings.html and https://www.theice.com/publicdocs/regulatory_filings/ICEClearCredit_022212.pdf. ICE Clear Europe did not provide
a link to its relevant Web page.
\57\ See http://sirt.cftc.gov/sirt/sirt.aspx?Topic=ClearingOrganizationProducts.
---------------------------------------------------------------------------
Regulation 39.5(b)(3)(viii) also directs a DCO's submission to
include a summary of any views on the submission expressed by members.
CME's submission did not address this. In their submissions, ICE Clear
Credit and ICE Clear Europe stated that neither has solicited nor
received any comments to date and will notify the Commission of any
such comments. The Commission did not receive any additional feedback
from DCOs beyond the information included in comment letters posted on
the Commission's Web site.
The CDS cleared by CME, ICE Clear Credit, and ICE Clear Europe that
were submitted to the Commission are standardized contracts providing
credit protection on an untranched basis, meaning that settlement is
not limited to a specific range of losses upon the occurrence of credit
events among the reference entities included within an index. Besides
single-name CDS, untranched CDS on indices are the only type of CDS
being cleared by these DCOs. Other swaps, such as credit index
tranches, options, and first- or Nth-to-default baskets on these
indices, are not currently cleared.
CME and ICE Clear Credit each clear CDS on indices administered by
Markit. The Markit CDX family of indices is the standard North American
credit default swap family of indices, with the primary corporate
indices being the CDX North American Investment Grade (consisting of
125 investment grade corporate reference entities) (CDX.NA.IG) and the
CDX North American High Yield (consisting of 100 high yield corporate
reference entities) (CDX.NA.HY). The standard currency for CDS on these
indices is the U.S. dollar.
CME offers the CDX.NA.IG at the 3-, 5-, 7- and 10-year tenors for
Series 9 and each subsequent series, to the extent that those contracts
that have not reached their termination date.\58\ CME also offers the
CDX.NA.HY at the 5-year tenor for Series 11, and each subsequent
series. ICE Clear Credit offers the CDX.NA.IG Series 8, and each
subsequent series of that index that is still outstanding, at the 3-,
5-, 7- and 10-year tenors.\59\ ICE Clear Credit also offers the
CDX.NA.IG. Series 8 to Series 10, at the 7-year tenor. For the high
yield index, ICE Clear Credit clears all series from the current series
through the CDX.NA.HY Series 9 at the 5-year tenor.\60\ Each of these
cleared CDX.NA contracts is denominated in U.S. dollars.
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\58\ As administrator of these indices, Markit reviews the
composition of underlying reference entities in the indices every
six months. Once Markit establishes the constituents to be included
within the indices, a new series of the respective index is created.
The most recent series is identified as the ``on-the-run'' series,
with all older series being identified as ``off-the-run.''
Additionally, each time one of the reference entities within an
index suffers a credit event, a new version of an existing series of
the index is created. In addition to the series and version
variations that may exist on the index, the parties can choose the
tenor of the CDS on a given index. While the 5-year tenor is the
most common, and therefore most liquid, other standard tenors may
include the 1-, 2-, 3-, 7-, and 10-year.
\59\ ICE Clear Credit began clearing the 3- and 7-year tenors on
the CDX.NA.IG after its initial Sec. 39.5 submission of February
22, 2012.
\60\ ICE Clear Credit also made a Sec. 39.5 submission with
regard to the 3-year tenor of CDX.NA.HY, Series 15. The Commission
is not including this contract within the clearing determination at
this time.
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ICE Clear Europe made a submission covering the index CDS that it
clears. As with CME's and ICE Clear Credit's submissions, the contracts
that ICE Clear Europe clears are based on Markit indices with corporate
reference entities, though in this case, the entities are based in
Europe. ICE Clear Europe clears euro-denominated contracts referencing
the three primary indices: iTraxx Europe (covering 125 European
investment grade corporate reference entities); the iTraxx Europe
Crossover (covering 50 European high yield reference entities); and the
iTraxx Europe High Volatility (a 30-entity subset of the European
investment grade index).
For the iTraxx Europe and Crossover, ICE Clear Europe clears
outstanding contracts in the Series 7 and 8, respectively, through the
current series. For the High Volatility index, ICE Clear Europe clears
outstanding contracts in the Series 9 through the current series. In
terms of tenors, ICE Clear Europe clears the 5-year tenor for all
swaps, as well as the 10-year tenor for the iTraxx Europe index.
[[Page 74291]]
Based upon those portions of the CME, ICE Clear Credit, and ICE
Clear Europe swap submissions relating to the CDS contracts discussed
above, as well as the analysis conducted by the Commission pursuant to
Sec. 39.5(b) and set forth below, the Commission has reviewed the
following classes of swaps for purposes of the clearing requirement
determination.
ii. Identification of CDS Specifications
Under Sec. 39.5, the decision of the Commission to require that a
group, category, type, or class of swaps be required to be cleared is
informed by a number of factors. As an initial matter, the Commission
has looked to the DCOs' submissions with regard to the swaps they
currently clear. After analyzing the key attributes of the swaps
submitted, the Commission proposed establishing two classes of CDS to
be subject to the clearing requirement and, pursuant to this final
rulemaking, is finalizing those classes as proposed. The first class is
based on the untranched indices covering North American corporate
credits, the CDX.NA.IG and the CDX.NA.HY. The second class is based on
the untranched indices covering European corporate credits, the iTraxx
Europe, the iTraxx Europe Crossover, and the iTraxx Europe High
Volatility. Given the different markets that the CDS indices cover, the
different standard currencies, and other logistical differences in how
the CDS markets and documentation work, the Commission believes this is
an appropriate basis for creating these two classes.
The following table sets forth the specific specifications of each
class:
Table 1
------------------------------------------------------------------------
North American Untranched CDS
Specification Indices Class
------------------------------------------------------------------------
1. Reference Entities............. Corporate.
2. Region......................... North America.
3. Indices........................ CDX.NA.IG.
CDX.NA.HY.
4. Tenor.......................... CDX.NA.IG: 3Y, 5Y, 7Y, 10Y.
CDX.NA.HY: 5Y.
5. Applicable Series.............. CDX.NA.IG 3Y: Series 15 and all
subsequent Series, up to and
including the current Series.
CDX.NA.IG 5Y: Series 11 and all
subsequent Series, up to and
including the current Series.
CDX.NA.IG 7Y: Series 8 and all
subsequent Series, up to and
including the current Series.
CDX.NA.IG 10Y: Series 8 and all
subsequent Series, up to and
including the current Series.
CDX.NA.HY 5Y: Series 11 and all
subsequent Series, up to and
including the current Series.
6. Tranched....................... No.
------------------------------------------------------------------------
Specification European Untranched CDS Indices
Class
------------------------------------------------------------------------
1. Reference Entities............. Corporate.
2. Region......................... Europe.
3. Indices........................ iTraxx Europe.
iTraxx Europe Crossover.
iTraxx Europe HiVol.
4. Tenor.......................... iTraxx Europe: 5Y, 10Y.
iTraxx Europe Crossover: 5Y.
iTraxx Europe HiVol: 5Y.
5. Applicable Series.............. iTraxx Europe 5Y: Series 10 and all
subsequent Series, up to and
including the current Series.
iTraxx Europe 10Y: Series 7 and all
subsequent Series, up to and
including the current Series.
iTraxx Europe Crossover 5Y: Series
10 and all subsequent Series, up to
and including the current Series.
iTraxx Europe HiVol 5Y: Series 10
and all subsequent Series, up to
and including the current Series.
6. Tranched....................... No.
------------------------------------------------------------------------
The Commission believes that indices based on other types of
entities would be viewed as a separate class and would be subject to a
separate determination by the Commission. For example, given the
differences that exist with regard to volumes and risk management of
indices based on sovereign issuers, as opposed to corporate issuers, it
is likely that such CDS would represent their own class of swaps.
Similarly, to the extent indices from other regions were submitted by a
DCO, it is likely that the Commission would take the view that they are
part of their own class of swaps as well.
The Commission believes it appropriate to define the classes of
swaps as untranched CDS contracts referencing Markit's broad-based
corporate indices. These corporate indices have the most net notional
outstanding, the most trading volumes, and the best available pricing.
The risk management frameworks for the corporate index swaps are the
most well-established, and have the most available data in terms of CDS
spreads and corporate default studies for analysis of the underlying
constituents of the indices. Agreements based on these indices also are
widely accepted and use standardized terms.\61\
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\61\ To the extent other vendors successfully develop similar
indices, the Commission would conduct the analysis required by Sec.
39.5, either on its own initiative or based on a DCO submission. If
based on that analysis the Commission issued a clearing requirement
determination, it is likely that such indices would be considered to
be part of an existing class of CDS that are required to be cleared.
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Both of the CDS classes presented herein assume that the relevant
CDS agreement will use the standardized terms established by Markit/
ISDA with regard to the specific index and be denominated in a currency
that is accepted for clearing by DCOs. To the extent that a CDS
agreement on an index listed within the classification is not accepted
for clearing by any DCO because it uses non-standard terms or is
denominated in a currency that makes it ineligible for clearing, that
CDS is not subject to the requirement that it be cleared,
notwithstanding that the CDS is based on such index.
Also as proposed, this clearing determination is limited to only
those series of the referenced indices that are currently being
cleared.\62\ Further, to the
[[Page 74292]]
extent that any swap on a CDS index is of a tenor such that it is
scheduled to terminate prior to July 1, 2013, such a swap is not part
of this clearing determination. Given the implementation periods
provided for under Sec. 50.25, discussed below in Section IV, the
Commission does not want to create a situation where certain market
participants will be required to clear a contract based upon their
status under the implementation provisions, but other parties will
never be required to clear that same contract before its scheduled
termination.
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\62\ As discussed in further detail below, the clearing
requirement does not require existing swaps in the older series to
be cleared. The requirement is prospective, only requiring newly
executed swaps in these older series to be cleared.
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Similarly, the classes only include those tenors of contracts which
are currently being cleared. AFR commented that both the 1- and 2-year
tenors of the CDX.NA.IG should be included in the clearing requirement
determination, citing concerns that if market participants shift to
these shorter tenors, that shift would undermine a clearing requirement
that included only longer tenors. Because no DCO clears the 1- or 2-
year tenor of CDX.NA.IG, the Commission has decided to include within
today's clearing determination only those tenors of the CDX.NA.IG that
were proposed. The Commission will monitor the market's use of shorter
tenors. To the extent that the market generates significant volumes of
such shorter tenors of CDX.NA.IG, the Commission would expect that one
or more DCOs will begin offering those tenors for clearing.
If no DCO were to offer these swaps for clearing, the Commission
has the authority to commence a Commission-initiated review under
section 2(h)(2)(A)(i) of the CEA to determine whether the swaps should
be required to be cleared. Under section 2(h)(4), to the extent that
the Commission finds that a particular swap or group, category, type,
or class of swaps would otherwise be subject to mandatory clearing but
no DCO has listed the swap, group, category, type, or class of swaps
for clearing, the Commission shall (i) investigate the relevant facts
and circumstances; (ii) issue a public report containing the results of
the investigation within 30 days; and (iii) take such actions as the
Commissions determines to be necessary and in the public interest,
which may include requiring the retaining of adequate margin or capital
by parties to the swap.
The clearing requirement determination will also cover each new
series of these indices that is created every six months. The
Commission believes this will provide certainty to the market, as
opposed to awaiting a new determination for each new series.\63\
Recognizing that there may be changes to indices and their
constituents,\64\ the Commission will analyze each new series to ensure
that the indices should continue to be included within the existing
class of swaps subject to a clearing determination. To the extent that
the new series raises issues, such as a DCO's ability to risk manage
the contracts, the Commission can issue a stay of the clearing
requirement for that series under Sec. 39.5(d). No commenter raised
any questions regarding new series.
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\63\ The timing of announcement of index constituents would make
it impossible for the Commission to analyze the index and issue a
clearing determination on the roll date, given the timeframes
imposed on the Commission by Sec. 39.5.
\64\ See Financial Times, ``CDS Market--Markit's Weird
Selection,'' September 27, 2012, discussing the inclusion of
constituents (CIT, Calpine, and Charter Communications) in the
latest series of the CDX.NA.HY that do not have actively traded CDS
contracts.
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As proposed, the Commission has decided that the classes be limited
to untranched CDS on the aforementioned indices. With these untranched
CDS, the contract covers the entire index loss distribution of the
index, and settlement is not linked to a specified number of defaults.
Tranched swaps, first- or ``Nth'' to-default, options, or any other
product variations on these indices are excluded from these classes.
These other swaps based on the indices, such as tranches, have very
different profiles in terms of the Sec. 39.5 analysis. Besides very
different notional and trading volumes, the risk management processes
and operations may be significantly different. The Commission believes
it appropriate to exclude tranched swaps, and other variations on the
indices, from the classes of swaps set forth herein. Such swaps, if
accepted by DCOs and submitted for Commission review, likely would be
viewed as a separate class or as separate classes.
AFR notes that market participants can use tranched CDS on the
indices to replicate contracts and portfolios that would otherwise be
subject to a clearing requirement. The Commission recognizes this
concern and will continue to monitor activity in tranched CDS indices,
as well as how the development of risk management processes at DCOs
could allow for the clearing of those products. Today's clearing
determination does not foreclose the possibility that tranched products
may be subject to another clearing determination in the future.
D. Determination Analysis for Credit Default Swaps
Section 2(h)(2)(D)(i) of the CEA requires the Commission to review
whether a swap submission under section 2(h)(2)(B) is consistent with
section 5b(c)(2) of the CEA (DCO core principles). Section
2(h)(2)(D)(ii) of the CEA also requires the Commission to consider five
factors in a determination based on swap submission: (1) The existence
of significant outstanding notional exposures, trading liquidity, and
adequate pricing data; (2) the availability of rule framework,
capacity, operational expertise and resources, and credit support
infrastructure to clear the contract on terms that are consistent with
the material terms and trading conventions on which the contract is
then traded; (3) the effect on the mitigation of systemic risk, taking
into account the size of the market for such contract and the resources
of the DCO available to clear the contract; (4) the effect on
competition, including appropriate fees and charges applied to
clearing; and (5) the existence of reasonable legal certainty in the
event of the insolvency of the relevant DCO or one or more of its
clearing members with regard to the treatment of customer and swap
counterparty positions, funds, and property.\65\
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\65\ ISDA highlighted the possibility that a CDS index subject
to a clearing requirement determination could undergo such
significant changes to its underlying constituents during its
lifecycle that such an index would no longer be considered a broad-
based index, subject to the Commission's jurisdiction. The
Commission notes that the indices subject to the clearing
requirement determinations discussed herein contain a minimum of 30
constituents of equal weighting, limiting the likelihood of such
scenario. Nonetheless, in the event of such a scenario, the
Commission could review the determination, and if appropriate, stay
the determination under Sec. 39.5(d) with regard to the index and/
or series so impacted.
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i. Consistency With Core Principles for Derivatives Clearing
Organizations
Section 2(h)(2)(D)(i) of the CEA requires the Commission to review
whether a submission is consistent with the core principles for DCOs.
Each of the DCO submissions relating to CDS provided data to support
the Commission's analysis of the five factors under section 2(h)(2)(D)
of the CEA. The Commission also was able to call upon independent
analysis conducted with regard to the CDS market, as well as its
knowledge and reviews of the registered DCOs' operations and risk
management processes, covering topics such as product selection
criteria, pricing sources, participant eligibility, and other relevant
rules. The discussion of all of these factors is set forth below.
[[Page 74293]]
The swaps submitted by CME, ICE Clear Credit, and ICE Clear Europe
pursuant to Sec. 39.5(b) are currently being cleared by those
organizations. As discussed above, the risk management, rules, and
operations used by each DCO to clear these swaps are subject to review
by the Commission's risk management, legal, and examinations staff on
an on-going basis.
Additionally, each of the DCOs has established procedures to review
any new swaps it may consider offering for clearing. Before the indices
referenced herein were accepted for clearing by any of the DCOs, they
were subject to review by the risk management functions of those
organizations. Such analysis generally focuses on the DCO's ability to
risk manage positions in the prospective swaps and on any specific
operational issues that may arise from the clearing of such swaps. In
the case of the former, this involves ensuring that adequate pricing
data is available, both historically and on a ``going forward'' basis,
such that a margining methodology could be established, back-tested,
and used on an on-going basis. Operational issues may include analysis
of additional contract terms for new swaps that may require different
settlement procedures. Each of the contracts submitted by CME, ICE
Clear Credit, and ICE Clear Europe and discussed herein has undergone
an internal review process by the respective DCO and found to be within
their product eligibility standards.
In their submissions, CME and ICE Clear Credit enclosed their risk
management procedures. In its submission, ICE Clear Europe references
its risk management procedures, which it had previously submitted to
the Commission in connection with its application to register as a DCO.
As part of its risk management and examination functions, the
Commission reviews each DCO's risk management procedures, including its
margining methodologies.
ICE Clear Credit uses a multi-factor model to margin the CDX.NA.IG
and CDX.NA.HY indices, as well as the single-name CDS it clears. The
margining methodology is designed to capture the risk of movements in
credit spreads, liquidation costs, jump-to-default risk for those names
on which credit protection has been sold, large position concentration
risks, interest rate sensitivity, and basis risk associated with
offsetting index derived single names and opposite ``outright'' single
names. These factors are similarly used by ICE Clear Europe to
calculate the margining requirements for their iTraxx swap listings and
the underlying single-name constituents.
CME's CDS model also weighs a number of factors to calculate the
initial margin for a portfolio of CDS positions. These include macro-
economic risk factors, such as movements associated with systematic
risk resulting in large shifts in credit spreads across a portfolio,
shifts in credit spreads based on tenors, and changes in relative
spreads between investment grade and high yield spreads. Additional
factors include specific sector risks, the idiosyncratic risk of
extreme moves in particular reference entities, and the liquidity risk
associated with unwinding the portfolio. In all cases, the
methodologies are designed to protect against any 5-day move in the
value of the given CDS portfolio, with a 99% confidence level.
In addition to initial margin, each of the DCOs collects variation
margin on a daily basis to capture changes in the mark-to-market value
of the positions. To do this, the DCOs calculate end-of-day settlement
prices using clearing members' price submissions for cleared swaps.
Each of the DCOs maintains processes for ensuring the quality of
clearing member price submissions, including the ability to compel
trades at quoted prices on a random basis and to enforce fines on
incomplete or incorrect submissions. ICE Clear Credit and ICE Clear
Europe also use Markit services for CDX and iTraxx price submissions.
CME uses other third-party data providers for pricing support as
necessary on its cleared CDS products.
As part of their rule frameworks, each of these three DCOs also
maintains participant eligibility requirements. On April 20, 2012, CME
filed its amended rule concerning CDS Clearing Member Obligations and
Qualifications (Rule 8H04). Pursuant to the amended rule, published to
comply with Commission Regulation 39.12(a)(2), a CDS clearing member
would have to maintain at least $50 million of capital. The amended
rule would also require a CDS clearing member's minimum capital
requirement to be ``scalable'' to the risks it poses. Furthermore, CME
already has client clearing available for its CDS index contracts.
Similarly, on March 23, 2012, ICE Clear Credit filed its amended
Rule 201(b) to incorporate the $50 million minimum capital requirement
for clearing members. ICE Clear Europe has adopted similar rules to
comply with Sec. 39.12(a)(2). ICE Clear Credit also has client
clearing available for its CDX index contracts.
In addition to the CDS indices discussed above, ICE Clear Credit
and ICE Clear Europe offer single-name CDS for clearing.\66\ As part of
their margining methodology, they are seeking approval to offer
portfolio margining for the single-name CDS and the CDS indices co-
mingled as a single portfolio.\67\ Given that the single-name reference
entities will likely also be constituents of a given index within a
portfolio, the Commission generally believes that such portfolio
margining initiatives are consistent with the sound risk management
policies for DCOs that are required under Sec. 39.13(g)(4). Moreover,
DCOs such as ICE Clear Credit already use margining methodologies that
provide for appropriate portfolio margining treatment with regard to
clearing members' proprietary positions.\68\ The Commission is
committed to working toward establishing similar portfolio margining
programs for DCOs clearing customer positions in CDS indices and
single-name CDS.\69\ Specifically, the Commission anticipates
addressing ICE's portfolio margining petitions for CDS in the near
term.
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\66\ Such single-name CDS are defined as ``security-based
swaps'' under section 721(a) of the Dodd-Frank Act.
\67\ See ICE Clear Credit's petitions to the Commission and SEC,
dated October 4, 2011. The petition to the Commission is available
at http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/iceclearcredit100411public.pdf. See also ICE Clear
Europe's petition available at http://www.cftc.gov/stellent/groups/public/@requestsandactions/documents/ifdocs/icecleareurope4dfrequest.pdf.
\68\ See ICE Clear Credit's certification to the Commission,
dated as of November 25, 2011. The certification is available at
http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/rul112511icecc001.pdf.
\69\ A discussion of comments concerning portfolio margining is
included below.
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Based upon the Commission's on-going reviews of DCOs' risk
management frameworks and clearing rules, and its annual examinations
of the DCOs, the Commission believes that the submissions of CME, ICE
Clear Credit, and ICE Clear Europe are consistent with section 5b(c)(2)
of the CEA and the related Commission regulations. In analyzing the CDS
products submissions discussed herein, the Commission does not believe
that a clearing determination with regard to the specified CDS products
would be inconsistent with CME, ICE Clear Credit, or ICE Clear Europe's
continued ability to maintain such compliance with the DCO core
principles set forth in Part 39 of the Commission's regulations.
[[Page 74294]]
ii. Consideration of the Five Statutory Factors for Clearing
Requirement Determinations
a. Outstanding Notional Exposures, Trading Liquidity, and Adequate
Pricing Data
Section 2(h)(2)(D)(ii)(I) of the CEA requires the Commission to
take into account the existence of outstanding notional exposures,
trading liquidity, and adequate pricing data.
The most recent BIS study \70\ found that, as of December 2011, the
size of the overall CDS marketplace exceeded $28.6 trillion in notional
amount outstanding. Of that amount, $11.8 trillion was in multi-name
CDS agreements. Within this sub-category of CDS, CDS on indices
accounted for more than 89% of the total notional amount outstanding,
with over $10 trillion in notional outstanding. Overall, CDS on index
products account for 37% of all notional amounts of CDS contracts
outstanding.
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\70\ See BIS data, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.
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The predominant provider of CDS indices is Markit. Markit offers
indices covering corporate and sovereign entities, among others, in the
United States, Europe, and Asia. Recent Markit data shows daily
transaction volumes of 1,559 transactions using its licensed family of
CDX indices, and 1,828 daily transactions in its European iTraxx
indices.\71\ Further, it shows a rolling month gross notional amount of
$745 billion in gross notional amount for the CDX family of indices and
[euro]680 billion for the iTraxx family. Nearly all of the CDX
contracts and volumes come from indices that are subject to the
clearing requirement determination. With regard to the European iTraxx,
more than 80% of those daily contract volumes and 84% of the daily
gross notional volumes come from the iTraxx investment grade and high
yield indices contemplated by the clearing requirement determination.
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\71\ Based on data published on www.markit.com as of September
27, 2012.
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One point highlighted by this data, however, is the declining
trading liquidity in the off-the-run series that can occur. Of the
volumes noted by Markit, nearly 60% was in the current on-the-run
series, as compared to all other outstanding series combined.\72\ The
submissions of ICE Clear Credit, ICE Clear Europe, and CME also note
the decline in average weekly gross notional amounts and contracts for
benchmark tenors for off-the-run indices. The decline however can be
more precipitous among older off-the-run indices. While many market
factors can contribute to the actual volumes for a specific off-the-run
contract, subject to certain exceptions, the trend is generally toward
lower volumes.\73\
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\72\ The term ``on-the-run'' refers to current series of an
index, while older series are referred to ``off-the-run.'' Each six
months when a new series is created (or ``rolls'' using market
terminology), the new series is considered the ``on-the-run'' index,
and all others are considered ``off-the-run.''
\73\ The current ``on-the-run'' series tend to have the most
liquidity, while the older ``off-the-run'' series tend to have less
liquidity, as many investors exit positions in an existing series
and enter new positions in the new series when it becomes available
(i.e., they ``roll'' their positions to the new series) thereby
increasing liquidity in the ``on-the-run'' series.
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Set forth below is a table of data taken from DTCC as of November
7, 2012, highlighting the net notional amounts and outstanding CDS
index contracts, across all tenors, for each index and series included
in this clearing determination.\74\
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\74\ Data from November 7, 2012, available at www.dtcc.com. In
2006, DTCC began providing warehouse services for confirmed CDS
trades through its Trade Information Warehouse (TIW). With the
commitment of global market participants in 2009 to ensure that all
OTC derivatives trades are recorded by a central repository, TIW has
become a global repository for all CDS trades. With all major market
participants submitting their trades to the TIW, it is estimated
that 98% of all CDS trades are included within the warehouse, making
it the primary source of CDS transaction data.
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[[Page 74295]]
[GRAPHIC] [TIFF OMITTED] TR13DE12.000
Notwithstanding the declining volumes that occur when an index is
no longer on-the-run, the Commission does not believe that is
sufficient reason to exclude the older series from the classes of CDS
that are subject to the clearing requirement. As the DTCC data
indicates, there are still significant volumes and outstanding notional
amounts in each of these series.\75\ From the perspective of the DCO,
the risk management of the older series of swaps should not provide
significant additional challenges. With the significant notional and
contract volumes still outstanding according to DTCC, many clearing
members already have these positions on their books and are meeting
their risk management requirements, even in the face of declining
trading volumes. While the volumes may decline, the data included in
the submissions indicates that volume still does exist, and parties
should be able to trade these CDS indices as necessary. Additionally,
as discussed further below, the clearing requirement would apply only
to new swaps executed in the off-the-run indices.
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\75\ The Commission is monitoring volumes in the on-the-run
iTraxx Europe HiVol. With the newest roll of the indices occurring
on September 20, 2012, this index has yet to show significant
volumes in the latest series based on DTCC data. The Commission will
continue to monitor these volumes and take action as appropriate.
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Both AFR and ISDA specifically supported the inclusion of ``off-
the-run'' CDS indices in the clearing determination. AFR noted that
without including those indices, the market might enter into such swaps
so as to avoid the clearing requirement. In addition, ISDA expressed
concern about the potential negative impact on the relative liquidity
between cleared and uncleared CDS swaps should a clearing requirement
cease to apply during the lifecycle of the CDS.
Given the contract and notional volumes listed above, there is
adequate data available on pricing. The pricing for the CDS on these
indices is fairly consistent across clearinghouses. The DCOs generally
require a clearing member with open interest in a particular index to
provide a price on that index for end-of-day settlement purposes. After
applying a process to remove clear outliers, a composite price is
calculated using the remaining prices. To ensure the integrity of the
submissions, clearing members' prices may be ``actionable,'' meaning
that they may form the basis of an actual trade that the member will be
forced to enter. DCOs also have compliance programs that may result in
fines for clearing members that fail to submit accurate pricing data.
Beyond clearing member submissions, there are a number of third-
party vendors that provide pricing services on these swaps. Third-party
vendors typically source their data from a broader range of dealers.
The data includes both direct contributions as well as feeds to
automated trading
[[Page 74296]]
systems. This data is reviewed for outliers and aggregated for
distribution.
b. Availability of Rule Framework, Capacity, Operational Expertise and
Resources, and Credit Support Infrastructure
Section 2(h)(2)(D)(ii)(II) of the CEA requires the Commission to
take into account the availability of rule framework, capacity,
operational expertise and resources, and credit support infrastructure
to clear the contract on terms that are consistent with the material
terms and trading conventions on which the contract is then traded. The
Commission has determined that this factor is satisfied by each of CME,
ICE Clear Credit, and ICE Clear Europe.
CME, ICE Clear Credit, and ICE Clear Europe, respectively,
currently are clearing the swaps each submitted under Sec. 39.5. They
have developed respective rule frameworks, capacity, operational
expertise and resources, and credit support infrastructure to clear the
contracts on terms that are consistent with the material terms and
trading conventions on which the contracts currently are trading. The
Commission believes that these are scalable and that CME, ICE Clear
Credit, and ICE Clear Europe would be able to risk manage the
additional swaps that might be submitted due to the clearing
requirement determination.
Following the financial crisis, the major market participants
committed in 2009 to the substantial reforms to the OTC derivatives
markets.\76\ Among the commitments from CDS dealers and buy side
participants was to actively engage with central counterparties to
broaden the range of cleared swaps and market participants. These
changes were in addition to those generated through organizations like
ISDA and their protocols standardizing CDS. For broadly traded swaps
like the CDS indices, the ultimate impact of these initiatives was
operational platforms,\77\ rule frameworks, and other infrastructure
initiatives that replicated the uncleared market and supported the move
of these CDS to a centrally cleared environment. In this way, the CDS
clearing services offered by DCOs, including CME, ICE Clear Credit, and
ICE Clear Europe, were designed to be cleared in a manner that is
consistent with the material terms and trading conventions of a
bilateral, uncleared market.
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\76\ See the June 2, 2009 letter to The Honorable William C.
Dudley, President of the Federal Reserve Bank of New York, available
at http://www.newyorkfed.org/newsevents/news/markets/2009/060209letter.pdf.
\77\ In its comment letter supporting the NPRM, MarketAxess
Holdings Inc. (MarketAxess) noted that the electronic trading
platform it operates supports the trading of CDX and iTraxx
products. MarketAxess stated that it intends to apply for
registration as a SEF once the Commission issues related final
rules.
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In addition, CME, ICE Clear Credit, and ICE Clear Europe are
registered DCOs. To be registered as such, CME, ICE Clear Credit, and
ICE Clear Europe have, on an on-going basis, demonstrated to the
Commission that they are each in compliance with the DCO core
principles set forth in the CEA and Commission regulations, as
discussed above. As a general matter, any DCO that does not have the
rule framework, capacity, operational expertise and resources, and
credit support infrastructure to clear the swaps that are subject to
required clearing is not in compliance with the core principles or the
Commission regulations promulgating these principles.
Commenters raised issues with regard to the operational
capabilities of clearinghouses to manage the clearing of iTraxx for
customers. Commenters such as ISDA, FIA, MFA, and D.E. Shaw all
highlighted the fact that no registered DCO currently offers customer
clearing for iTraxx. Besides the lack of approved customer clearing of
the iTraxx indices at any DCO, the commenters noted substantive
concerns about the ability of clearinghouses to manage the
``restructuring'' credit event applicable to iTraxx (and certain other
CDS indices) in the context of customer clearing. For the CDX.NA.IG and
CDX.NA.HY indices, credit events are limited to a ``failure to pay'' or
the bankruptcy of the companies included in the index. A credit event
results in the removal of the defaulted constitute from the index, with
the protection seller settling the amounts owed to the protection buyer
with regard to that individual constituent. The standardized terms of
the iTraxx, however, also include ``restructuring'' as a credit event.
When a restructuring event occurs with regard to an index constituent,
the impacted company is removed from the index by the creation of a
single-name CDS referencing that entity. The protection buyer and
seller have the option to continue that single-name CDS or to settle
the contract with regard to the restructured credit.
ISDA, MFA, and FIA note that this process raises issues for DCOs.
Specifically highlighted were those situations where a DCO does not, in
fact, already offer clearing of the single-name CDS that is subject to
the restructuring event. To the extent that the SEC or foreign
regulator prohibits the DCO from clearing a particular single-name CDS,
a process would need to be developed to address such circumstances.
Similarly, the customer account in which the new single-name CDS would
be held, in the absence of portfolio margining, would need to be
addressed. MFA comments that the approval of portfolio margining
petitions would remove much of the complexity of the ``spin-off'' of
the single-name CDS from the iTraxx indices. Given the inclusion of the
iTraxx within the clearing determination, MFA states that the petitions
need to be approved so that the new single-name CDS can be held within
the cleared swap account and margined with the iTraxx index CDS.
Finally, the commenters believe that DCOs need to demonstrate that
their customer clearing platforms are technologically viable and
sufficiently tested before a clearing determination with regard to the
iTraxx indices is finalized. For these reasons, these commenters
believe a delay in the implementation of a clearing requirement for the
iTraxx indices would be appropriate until such time as customer
clearing platforms have been established, the necessary regulatory
approvals have been granted and operational testing has been conducted
for an appropriate period of time. In MFA's view the delay should be 60
to 90 days, and in ISDA's view, the testing period should consist of
voluntary client clearing for at least 90 days.
On the other hand, ICE supports the Commission's inclusion of
iTraxx CDS indices within its clearing requirement determination. ICE
states that ICE Clear Europe has already begun the process of pursuing
regulatory approval for client clearing of iTraxx, and indicates that
ICE Clear Credit will do the same.\78\
[[Page 74297]]
While recognizing that the standard credit events under the iTraxx add
some complexity relative to the CDX indices, ICE notes that it has
worked with market participants and DTCC to develop industry-wide
solutions to the ``restructuring'' event. Further, ICE states that ICE
Clear Credit has already implemented applicable parts of this solution
with regard to the clearing of the CDX.EM CDS index of emerging market
sovereign constituents.\79\ ICE claims that any additional processes
necessary with regard to clearing iTraxx index CDS are being addressed
currently by the industry, and will not present any insurmountable
challenges.
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\78\ ICE Clear Europe's submission, pursuant to Commission
Regulation 40.6, amending its rulebook to accommodate client
clearing is available on the Commission's Web site at: http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/rul091312iclreu001.pdf. ICE Clear Europe is registered as a
recognized clearing house with the United Kingdom's Financial
Services Authority (U.K. FSA) and requires approval from the U.K.
FSA to offer iTraxx clearing to customers. ICE Clear Credit's
submission with regard to iTraxx clearing for both proprietary and
customer accounts is available on the Commission's Web site at
http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/rul092812icc001.pdf. To the extent that ICE Clear
Credit successfully launches iTraxx clearing, it would address
ISDA's concern with regard to the Commission issuing a clearing
determination for swaps that cannot be cleared at a U.S.-based DCO.
It should be noted, however, that the Commission does not believe a
DCO clearing a particular swap needs to be based in the U.S. for the
Commission to find a swap subject to a clearing determination, to
the extent that swap satisfies the factors required by statute and
regulation to be included in the Commission's analysis.
\79\ It is not clear, however, the extent to which clearing
members are in fact offering customer clearing of the CDX.EM indices
cleared by ICE Clear Credit.
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Citadel also commented that they did not believe that there were
any substantive reasons why the iTraxx index CDS should not be required
to be cleared. The ``restructuring'' credit event and the spinning out
of a newly cleared single-name CDS do not, in Citadel's view, present
any new issues to market participants. Further, because DCOs already
offer clearing on the iTraxx on a dealer-to-dealer basis, they have the
necessary processes upon which to build out the client clearing
platform. Citadel also states that even if the ICE Clear Credit's and
ICE Clear Europe's petitions to the SEC for portfolio margining were
not approved generally,\80\ limited exemptions may be available for the
single names associated with the spun-off single name. Citadel does
agree with other commenters that to the extent that client clearing
cannot be offered with sufficient lead time to allow for proper
operational testing, a delay may be appropriate in implementing a
clearing requirement for the iTraxx indices. Citadel believes 60 days
voluntary customer clearing should be sufficient for such testing.
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\80\ It should be noted that the Commission strongly supports
the petitions for the portfolio margining of single-name CDS and CDS
indices. The Commission believes that all customers should be able
to benefit from the reasonable application of portfolio margining,
and that the benefits thereof should not just be available to the
proprietary positions in the house accounts of clearing members.
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The Commission believes that the introduction of client clearing
must occur before any clearing determination could become effective
with regard to the iTraxx indices, or any other CDS indices that the
Commission may consider.\81\ The Commission agrees with all commenters
that subject to resolution of all operational issues surrounding client
clearing of the iTraxx indices, specifically the iTraxx Europe,
Crossover, and High Volatility, these indices are appropriate for
inclusion in a clearing requirement. The Commission is encouraged by
the work currently being done by the DCOs, by other regulators, and by
the market as a whole, to establish client clearing in the near term.
The Commission recognizes that additional time may be necessary to
allow for the DCOs to obtain the necessary regulatory approvals and
design a workable framework for dealing with the issues presented by
the client clearing of the iTraxx indices, before the clearing of this
class of indices can be required of market participants.
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\81\ The Commission agrees with the comments of MFA that the
availability of client clearing should be considered when making
clearing determinations. Consequently, DCOs accepting, or planning
to accept, swaps for clearing should make client clearing available
in compliance with Commission regulations. In the absence of such
client clearing, the Commission will delay compliance with required
clearing of iTraxx indices.
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As part of this clearing requirement determination, the Commission
is including the iTraxx class of CDS, as proposed. The Commission
believes that the compliance schedule outlined in Section IV below
should provide adequate time for market participants to resolve the
outstanding issues with regard to client clearing of the iTraxx
indices. Under this schedule, the requirement for market participants
to begin clearing would commence on March 11, 2013, for swaps entered
into on or after that date between Category 1 Entities. Category 2
Entities would be required to clear swaps beginning on June 10, 2013,
for swaps entered into on or after that date, and Category 3 Entities
would be required to clear swaps beginning on September 9, 2013, for
swaps entered into on or after that date. However, if no DCO has begun
offering client clearing for iTraxx by February 11, 2013, then
compliance with the required clearing of iTraxx will commence sixty
days after the date on which iTraxx is first offered for client
clearing by an eligible DCO.
If an eligible DCO offers client clearing for iTraxx on or before
September 9, 2013, the following phased implementation schedule will
apply: Category 1 Entities would be required to clear iTraxx indices
entered into on or after the date 60 days after the date on which
iTraxx is first offered for client clearing by an eligible DCO;
Category 2 Entities would be required to clear iTraxx entered into on
or after the date 150 days after the date on which iTraxx is first
offered for client clearing by an eligible DCO; and Category 3 Entities
would be required to clear iTraxx entered into on or after the date 240
days after the date on which iTraxx is first offered for client
clearing by an eligible DCO. There will be no phasing of compliance if
an eligible DCO offers client clearing for iTraxx after September 9,
2013. Rather, all three categories of market participants will be
expected to come into compliance by 60 days after the date on which
iTraxx is first offered for client clearing by an eligible DCO.
c. Effect on the Mitigation of Systemic Risk
Section 2(h)(2)(D)(ii)(III) of the CEA requires the Commission to
take into account a clearing requirement's effect on the mitigation of
systemic risk, taking into account the size of the market for the
contract subject to the clearing requirement and the resources of the
DCOs clearing the contract. The Commission agrees with the Sec. 39.5
swap submissions of CME, ICE Clear Credit, and ICE Clear Europe that
requiring certain classes of CDS to be cleared would reduce systemic
risk in this sector of the swaps market. As CME noted, the 2008
financial crisis demonstrated the potential for systemic risk arising
from the interconnectedness of OTC derivatives market participants and
the limited transparency of bilateral, i.e., uncleared, counterparty
relationships. According to the Quarterly Report (Second Quarter 2012)
on Bank Trading and Derivatives Activities of the Office of the
Comptroller of the Currency (OCC Report),\82\ CDS index products
account for a significant percentage of the notional value of swaps
positions held by financial institutions. According to ICE Clear
Credit, the CDS indices it offers for clearing are among the most
actively traded swaps with the largest pre-clearing outstanding
positions, and ICE Clear Credit's clearing members are among the most
active market participants. ICE Clear Credit also noted that its
clearing members clear a significant portion of their clearing-eligible
portfolio.
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\82\ Available at http://occ.treas.gov/topics/capital-markets/financial-markets/trading/derivatives/dq212.pdf.
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Clearing the CDS indices subject to this determination will reduce
systemic risk in the following ways: mitigating counterparty credit
risk because the DCO would become the buyer to every seller of CDS
indices subject to this determination and vice-versa; providing
counterparties with daily mark-to-market valuations and exchange of
[[Page 74298]]
variation margin pursuant to a risk management framework set by the DCO
and reviewed by the Commission's Division of Clearing and Risk; posting
initial margin with the DCO in order to cover potential future
exposures in the event of a default; achieving multilateral netting,
which substantially reduces the number and notional amount of
outstanding bilateral positions; reducing swap counterparties'
operational burden by consolidating collateral management and cash
flows; and eliminating the need for novations or tear-ups because
clearing members may offset opposing positions.
As discussed in the NPRM, the DCOs collect substantial amounts of
collateral in the form of initial margin and guaranty fund
contributions to cover potential losses on CDS portfolios. The
methodologies for calculating these amounts are based on covering 5-day
price movements on a portfolio with a 99% confidence level for initial
margin, and longer liquidation periods and higher confidence levels
under ``extreme but plausible'' conditions in the case of guaranty fund
requirements. Beyond these financial resources, the clearinghouses have
in place established risk monitoring processes, system safeguards, and
default management procedures, which are subject to testing and review,
to address potential systemic shocks to the financial markets.
AFR specifically supported the Commission's analysis on the
mitigation of systemic risk with regard to the CDS clearing
determination.\83\ ISDA commented generally that the Commission's
analysis of this factor should have addressed the centralization of
risk at DCOs as a result of the determinations, and the new capital,
collateral, and disclosure requirements that have decreased risk in
uncleared swaps.\84\ The Commission believes its analysis of other
factors did in fact focus on the management of risk at DCOs and their
ability to manage the risks associated with the untranched CDS indices
included within the determination. In connection with future
determinations, the Commission will continue to take those issues
raised by ISDA into consideration.
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\83\ Other commenters such as Citadel generally agreed with the
Commission's analysis of the reduction of systemic risk for both the
interest rates and CDS determinations.
\84\ See Section II.F for further discussion of this comment.
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d. Effect on Competition
Section 2(h)(2)(D)(ii)(IV) of the CEA requires the Commission to
take into account the effect on competition, including appropriate fees
and charges applied to clearing. Of particular concern to the
Commission is whether this determination would harm competition by
creating, enhancing, or entrenching market power in an affected product
or service market, or facilitating the exercise of market power.\85\
Under U.S. Department of Justice guidelines, market power is viewed as
the ability ``to raise price [including clearing fees and charges],
reduce output, diminish innovation, or otherwise harm customers as a
result of diminished competitive constraints or incentives.'' \86\
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\85\ See U.S. Department of Justice and the Federal Trade
Commission, Horizontal Merger Guidelines [hereinafter ``Horizontal
Merger Guidelines''] at Sec. 1 (Aug. 19, 2010), available at http://www.justice.gov/atr/public/guidelines/hmg-2010.pdf.
\86\ Id.; see also U.S. Department of Justice (DOJ) and the
Federal Trade Commission (FTC), Antitrust Guidelines for
Collaborations Among Competitors at Sec. 1.2 (April 2000),
available at http://www.ftc.gov/os/2000/04/ftcdojguidelines.pdf
(``The central question is whether the relevant agreement likely
harms competition by increasing the ability or incentive profitably
to raise price above or reduce output, quality, service, or
innovation below what likely would prevail in the absence of the
relevant agreement'').
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In the NPRM, the Commission identified the following putative
product and service markets as potentially affected by this clearing
determination: a DCO service market encompassing those clearinghouses
that currently (or with relative ease in the future could) clear the
CDS subject to this determination, and a CDS product market or markets
encompassing the CDS that are subject to this determination.\87\
Without defining the precise contours of these markets at this
time,\88\ the Commission recognizes that, depending on the interplay of
several factors, this clearing determination potentially could impact
competition within the affected markets. Of particular importance to
whether any impact is, overall, positive or negative, is: (1) Whether
the demand for these clearing services and swaps is sufficiently
elastic that a small but significant increase above competitive levels
would prove unprofitable because users of the CDS products and DCO
clearing services would substitute other products/clearing services co-
existing in the same market(s), and (2) the potential for new entry
into these markets. The availability of substitute products/clearing
services to compete with those encompassed by this determination, and
the likelihood of timely, sufficient new entry in the event prices do
increase above competitive levels, each operate independently to
constrain anticompetitive behavior.
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\87\ Included among these could be a separate product market for
CDS indices licensing. AFR stated that this factor should not focus
on Markit as an index provider, but rather on clearing entities. For
purposes of its consideration of this factor, the Commission
believes its analysis appropriately covers competition as it relates
to clearinghouses, as well as to other market participants.
\88\ The federal antitrust agencies, the DOJ and FTC, use the
``hypothetical monopolist test'' as a tool for defining antitrust
markets for competition analysis purposes. The test ``identif[ies] a
set of products that are reasonably interchangeable with a
product,'' and thus deemed to reside in the same relevant antitrust
product or service market. ``[T]he test requires that a hypothetical
profit-maximizing firm, not subject to price regulation, that was
the only present and future seller of those products (`hypothetical
monopolist') likely would impose at least a small but significant
and non-transitory increase in price (`SSNIP') on at least one
product in the market.'' In most cases, a SSNIP of five percent is
posited. If consumers would respond to the hypothesized SSNIP by
substituting alternatives to a significant degree to render it
unprofitable, those alternative products/services are included
within the relevant market. This methodological exercise is repeated
until it has been determined that consumers have no further
interchangeable products/services available to them. Horizontal
Merger Guidelines at Sec. 4.1.
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The Commission recognized in the NPRM that, depending on the
interplay of several factors, the clearing requirement potentially
could impact competition within the affected market and discussed
various factors that could impact that market.
In response to the Commission's recognition of the fact that
currently no DCO clears CDS indices licensed by any provider other than
Markit, Markit commented that it did not believe the determination
would foreclose or materially impact competition in the CDS products,
including licensing. Markit noted that its open licensing policy
encourages competition among DCOs, SEFs, market makers, and others.
Markit further commented that, given the costs associated with
clearing, CDS indices that are not subject to a determination may be at
a competitive advantage, including those that may be established by
other index providers.
In support of the NPRM, Citadel stated that the clearing
requirement will have a strong positive impact on competition in the
swap market and the market for clearing services. Citadel noted that
central clearing will remove a significant barrier to entry for
alternative swap market liquidity providers and will enable smaller
entities to compete on more equal terms because central clearing
eliminates the consideration of counterparty credit risk from the
selection of execution counterparties. Citadel further commented that
buy-side market participants will benefit from a wider range of
potential execution counterparties and asserted that this increased
competition yields benefits to market participants including narrower
bid-ask spreads, improved access to best
[[Page 74299]]
execution, and increased market depth and liquidity, all of which
facilitate the emergence of an all-to-all market with electronic and/or
anonymous execution. Citadel also commented that substitution of the
DCO for the bilateral counterparty decouples execution from post-trade
processing and settlement.\89\ Finally, Citadel commented that the
certainty as to when the first clearing requirement will begin gives
DCOs and FCMs the confidence to invest in their client clearing
offerings, and to compete actively for buy-side business both on the
quality and efficiency of their services as well as on price.
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\89\ The Commission observes that issues regarding the bundling
of clearing services and execution are beyond the scope of this
rulemaking. See generally Swap Dealer and Major Swap Participant
Recordkeeping, Reporting, and Duties Rules; Futures Commission
Merchant and Introducing Broker Conflicts of Interest Rules; and
Chief Compliance Officer Rules for Swap Dealers, Major Swap
Participants, and Futures Commission Merchants, 77 FR 20128, 20154-
55 (Apr. 3, 2012) (discussing the application of Sec. 1.71(d)(2)).
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While FIA commented that the NPRM included a full discussion of the
potential competitive impact of the clearing proposal, as discussed
above, FIA indicated that it was unable to conduct the analysis it
believes would be necessary to respond to the Commission's questions in
the NPRM within the 30-day comment period provided.
In response to FIA's comment, as discussed above, the Commission
notes that the 30-day public comment period was necessary for the
Commission to adhere to the CEA's 90-day determination process.
Moreover, while FIA indicated that it would like more time to conduct
further analysis of competitive issues for future determinations, FIA
did not identify any specific concerns about the competitiveness issue
analysis that could materially change the Commission's determination if
such additional information were made available to the Commission. The
comments provided by Markit and Citadel are consistent with the NPRM's
conclusion that the clearing requirement potentially could impact
competition within the affected market, but both commenters go on to
assert that such an impact would not be negative. Accordingly, the
Commission believes that its consideration of competitiveness as
described in the NPRM is sufficient for purposes of finalizing the
clearing requirement rule.
e. Legal Certainty in the Event of the Insolvency
Section 2(h)(2)(D)(ii)(V) of the CEA requires the Commission to
take into account the existence of reasonable legal certainty in the
event of the insolvency of the relevant DCO or one or more of its
clearing members with regard to the treatment of customer and swap
counterparty positions, funds, and property. The Commission proposed
this clearing requirement based on its view that there is reasonable
legal certainty with regard to the treatment of customer and swap
counterparty positions, funds, and property in connection with cleared
swaps, namely the CDS indices subject to this determination, in the
event of the insolvency of the relevant DCO (CME, ICE Clear Credit, or
ICE Clear Europe) or one or more of the DCO's clearing members.
In the case of a clearing member insolvency at CME or ICE Clear
Credit, subchapter IV of Chapter 7 of the U.S. Bankruptcy Code (11
U.S.C. 761-767) and Part 190 of the Commission's regulations would
govern the treatment of customer positions.\90\ Pursuant to section
4d(f) of the CEA, a clearing member accepting funds from a customer to
margin a cleared swap, must be a registered FCM. Pursuant to 11 U.S.C.
761-767 and Part 190 of the Commission's regulations, the customer's
CDS positions, carried by the insolvent FCM, would be deemed
``commodity contracts.'' \91\ As a result, neither a clearing member's
bankruptcy nor any order of a bankruptcy court could prevent either CME
or ICE Clear Credit from closing out/liquidating such positions.\92\
However, customers of clearing members would have priority over all
other claimants with respect to customer funds that had been held by
the defaulting clearing member to margin swaps, such as the customers'
positions in CDS indices subject to this determination.\93\ Customer
funds would be distributed to swaps customers, including CDS customers,
in accordance with Commission regulations and section 766(h) of the
Bankruptcy Code. Moreover, the Bankruptcy Code and the Commission's
rules thereunder (in particular 11 U.S.C. 764(b) and 17 CFR 190.06)
permit the transfer of customer positions and collateral to solvent
clearing members.
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\90\ The Commission observes that an FCM or DCO also may be
subject to resolution under Title II of the Dodd-Frank Act to the
extent it would qualify as covered financial company (as defined in
section 201(a)(8) of the Dodd-Frank Act).
\91\ If an FCM is also registered as a broker-dealer, certain
issues related to its insolvency proceeding would also be governed
by the Securities Investor Protection Act.
\92\ See 11 U.S.C. 556 (``The contractual right of a commodity
broker [which term would include a DCO or FCM] * * * to cause the
liquidation, termination or acceleration of a commodity contract * *
* shall not be stayed, avoided, or otherwise limited by operation of
any provision of [the Bankruptcy Code] or by order of a court in any
proceeding under [the Bankruptcy Code].'').
\93\ See 11 U.S.C. 766(h).
---------------------------------------------------------------------------
Similarly, 11 U.S.C. 761-767 and Part 190 would govern the
bankruptcy of a DCO, in conjunction with DCO rules providing for the
termination of outstanding contracts and/or return of remaining
clearing member and customer property to clearing members.
With regard to ICE Clear Europe, the Commission understands that
the default of a clearing member of ICE Clear Europe would be governed
by the rules of that DCO. ICE Clear Europe, a DCO based in the United
Kingdom, has represented that under English law its rules would
supersede English insolvency laws. Under its rules, ICE Clear Europe
would be permitted to close out and/or transfer positions of a
defaulting clearing member that is an FCM pursuant to the U.S.
Bankruptcy Code and Part 190 of the Commission's regulations. According
to ICE Clear Europe's submission, the insolvency of ICE Clear Europe
itself would be governed by both English insolvency law and Part 190.
ICE Clear Europe has obtained legal opinions that support the
existence of such legal certainty in relation to the protection of
customer and swap counterparty positions, funds, and property in the
event of the insolvency of one or more of its clearing members. In
addition, ICE Clear Europe has obtained a legal opinion from U.S.
counsel regarding compliance with the protections afforded to FCM
customers under New York law.
In response to the NPRM, Citadel commented that it agreed with the
Commission's analysis that reasonable certainty exists in the event of
an insolvency of a DCO or one or more DCO members. As discussed above,
the Commission received three comments related to customer segregation.
In essence, Vanguard and SIFMA AMG recommend that the Commission delay
implementation of the clearing requirement until three months after the
LSOC model is implemented, clarified, and perhaps supplemented with
additional rulemaking. ISDA requests that the Commission further study
the issue of insolvency for DCOs.
As stated above, the Commission believes that the concerns of
Vanguard and SIFMA AMG are largely addressed by the delayed
implementation timeframe for this determination. With regard to ISDA's
request, as discussed above, the Commission is actively engaging in
efforts to study and prepare for potential scenarios involving
[[Page 74300]]
clearinghouse and clearing member insolvency.
iii. Conclusions Regarding the Five Statutory Factors and Clearing
Requirement Determination
Based on the foregoing discussion and analysis, the Commission has
taken into account each of the five factors provided for under section
2(h)(2)(D)(ii) of the CEA. Based on these considerations, and having
reviewed the relevant DCOs' submissions for consistency with section
5b(c)(2) of the CEA, the Commission is determining that the two classes
of CDS identified in Sec. 50.4(b) are required to be cleared.
E. Interest Rate Swaps
i. Introduction
Interest rate swaps are agreements wherein counterparties agree to
exchange payments based on a series of cash flows over a specified
period of time typically calculated using two different rates
multiplied by a notional amount. The BIS estimated that, as of December
2011, over $500 trillion in notional amount of single currency interest
rate swaps were outstanding representing 75% to 80% of the total
estimated notional amount of derivatives outstanding.\94\ Based on
these factors and on the swap submissions received under Sec. 39.5(b),
the Commission believes that interest rate swaps represent a
substantial portion of the swaps market and warrant consideration by
the Commission for required clearing.
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\94\ BIS, OTC Derivatives Market Activity as of December 2011,
Table 1, available at http://www.bis.org/statistics/otcder/dt1920a.pdf. The BIS data provides the broadest market-wide
estimates of interest rate swap activity available to the
Commission.
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The Commission's proposal for interest rate swaps was presented in
two parts. The first part, Section II.E of the NPRM, discussed the
Commission's rationale for determining how to classify and define the
interest rate swaps identified in the DCO submissions (IRS submissions)
to be considered for the clearing requirement. The second part, Section
II.F, presented the Commission's consideration of the IRS submissions
in accordance with section 2(h)(2)(D) of the CEA. This final release
follows the same basic two-part structure. In each part, the discussion
in the NPRM preamble for the corresponding part is summarized. Comments
received from the public are summarized where appropriate together with
the Commission's consideration of the comments.
ii. DCO Submissions
The Commission received submissions from three registered DCOs
eligible to clear interest rate swaps: LCH.Clearnet Limited (LCH), the
clearing division of the Chicago Mercantile Exchange Inc. (CME), and
International Derivatives Clearinghouse, LLC (IDCH).\95\ On August 14,
2012, LCH acquired IDCH and changed the name of IDCH to LCH.Clearnet
LLC (LCH.LLC). LCH.LLC has submitted a request to the CFTC for approval
of changes to its DCO rules that would result in LCH.LLC clearing the
same interest rate swaps that LCH clears. As noted in the NPRM, IDCH
had no cleared swap positions. Accordingly, the change in ownership of
IDCH would not change the Commission's proposal in terms of swap class
assessments or volume and liquidity considerations. The proposed
clearing requirement rule is not DCO specific. Upon approval of
LCH.LLC's application for its DCO rule changes, LCH.LLC would become a
U.S.-domiciled DCO capable of accepting the full range of interest rate
swap products contemplated in the proposal.\96\
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\95\ The IRS submissions received by the Commission are
available at http://www.cftc.gov/IndustryOversight/IndustryFilings/index.htm. Submission materials marked by the submitting DCO for
confidential treatment pursuant to Sec. Sec. 39.5(b)(5) and
145.9(d) are not available for public review.
\96\ IDCH was eligible under Sec. 39.5 to clear interest rate
swaps. When LCH.LLC assumed IDCH's DCO license, LCH.LLC was deemed
eligible to clear interest rate swaps as well.
---------------------------------------------------------------------------
The following table summarizes the interest rate swap classes and
relevant specifications that each DCO identified in its IRS submission.
---------------------------------------------------------------------------
\97\ LCH.LLC (formerly IDCH) has applied to the Commission for
DCO rule change approvals that would effectively implement clearing
of the same interest rate swaps that LCH now clears. LCH.LLC is not
accepting interest rate swaps for clearing until such time as it
launches under its new clearing rules. Accordingly, IDCH's product
list that was included in the NPRM has been removed from the
summary.
\98\ Subsequent to its original submission, CME has added
clearing of OIS for USD, EUR, GBP, and JPY.
\99\ In this final rule, currencies are identified either by
their full name or by the three letter ISO currency designation for
the currency.
Table 3--Interest Rate Swap Submissions Summary \97\
------------------------------------------------------------------------
LCH CME
------------------------------------------------------------------------
Swap Classes................ Fixed-to-floating, basis, Fixed-to-
forward rate agreements floating.\98\
(FRAs), overnight index
swaps (OIS)..
Currencies \99\............. USD, EUR, GBP, JPY, AUD, USD, EUR, GBP,
CAD, CHF, SEK, CZK, DKK, JPY, CAD, and
HKD, HUF, NOK, NZD, PLN, CHF.
SGD, ZAR.
Rate Indexes................ For Fixed-to-floating, USD-LIBOR, CAD-
basis, FRAs: LIBOR in BA, CHF-LIBOR,
seven currencies, BBR- GBP-LIBOR, JPY-
BBSW, BA-CDOR, PRIBOR, LIBOR, and
CIBOR-DKNA13, CIBOR2- EURIBOR.
DKNA13, EURIBOR-
Telerate, EURIBOR-
Reuters, HIBOR-HIBOR,
HIBOR-HKAB, HIBOR-ISDC,
BUBOR-Reuters, NIBOR,
BBR-FRA, BBR-Telerate,
PLN-WIBOR, PLZ-WIBOR,
STIBOR, SOR-Reuters,
JIBAR.
For OIS: FEDFUNDS, SONIA,
EONIA, TOIS.
Maximum Stated Termination For Fixed-to-floating and USD, EUR, and
Dates. basis: USD, EUR, and GBP GBP out to 50
out to 50 years, AUD, years, and
CAD, CHF, SEK and JPY CAD, JPY, and
out to 30 years and the CHF out to 30
remaining nine years.
currencies out to 10
years..
For OIS and FRAs: USD,
EUR, GBP, and CHF out to
two years.
------------------------------------------------------------------------
iii. Interest Rate Swap Market Conventions and Risk Management
The NPRM described how interest rate swaps present a wide range of
variable product classes and product specifications within each class.
Notwithstanding the large variety of contracts, there are commonalities
that make it possible to categorize interest rate swaps for clearing,
pricing, and risk purposes. Firstly, the vast majority of interest rate
swaps use the ISDA definitions and contract conventions that allow
market participants to agree quickly on common terms for each
transaction. In fact, the DCOs clearing interest rate swaps all use
ISDA definitions in their product specifications.
Secondly, counterparties enter into swaps to achieve particular
economic
[[Page 74301]]
results. While the results desired may differ in small ways depending
on each counterparty's specific circumstances and goals, there are
certain common swap conventions that are used to identify and achieve
commonly desired economic results when entering into interest rate
swaps. For example, a party that is trying to hedge variable interest
rate risk may enter into a fixed rate to floating rate swap, or a party
that is seeking to fix interest rates for periods in the future may
enter into a forward rate agreement.
The IRS submissions identified commonly known classes of swaps that
they clear including: fixed rate to floating rate swaps, that are
sometimes referred to as plain vanilla swaps (fixed-to-floating swaps);
floating rate to floating rate swaps, also referred to as basis swaps
(basis swaps); overnight index swaps (OIS); and forward rate agreements
(FRAs).\100\ These class terms are also being used in industry efforts
to develop a taxonomy for interest rate swaps.\101\
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\100\ These are sometimes also referred to as ``types,''
``categories,'' or ``groups.'' For purposes of the clearing
requirement determination, the Commission uses the term ``class,''
in order to be consistent with the approach taken by the European
Securities and Markets Authority (ESMA) in its Discussion Paper,
``Draft Technical Standards for the Regulation on OTC Derivatives,
CCPs, and Trade Repositories,'' (Feb. 16, 2012), available at http://www.esma.europa.eu/system/files/2012-95.pdf. It is also noted that
other categorizations are sometimes used for certain purposes.
However, these four classes are common terms used by the DCOs and
are common terms used in industry taxonomies.
\101\ See, e.g., ISDA Swap Taxonomies, available at http://www2.isda.org/identifiers-and-otc-taxonomies/; Financial Products
Markup Language, available at http://www.fpml.org/; and Federal
Reserve Bank of New York Staff Reports, ``An Analysis of OTC
Interest Rate Derivatives Transactions: Implications for Public
Reporting'' (March 2012) at 3, available at http://www.newyorkfed.org/research/staff_reports/sr557.pdf.
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Furthermore, within these general classes, certain specifications
are essential for defining the economic result and the value of the
swap. Each of the IRS submissions naturally used these common
specifications when identifying the swaps that the DCO clears. Within
each of those specifications, there are common terms used by the DCOs
and markets, which allows for further classification of the full range
of interest rate swaps that are executed. Accordingly, as described in
the NPRM, while there are a wide variety of interest rate swaps when
taking into account all possible contract specifications, certain
specifications are commonly used by the DCOs and market participants.
This allows for the identification of classes of swaps and primary
specifications within each class.
The DCOs also risk manage and set margins for interest rate swaps
on a portfolio basis rather than on a transaction- or product-specific
basis. In other words, the DCOs analyze the cumulative risk of a
party's portfolio. By looking at risk on a portfolio basis, the DCOs
effectively take into account how swaps with different attributes, such
as underlying currency, stated termination dates, underlying floating
rate indexes, swap classes, etc., are correlated and thus can offset
risk across attributes. This is possible because, although individual
transactions may have unique contract terms, given the commonalities of
transactions as discussed above, swap portfolios can be risk managed on
a cumulative value basis taking into account correlations among the
cleared swaps. Consequently, DCOs can be expected to fairly rapidly,
and efficiently manage the risk of portfolios of interest rate swaps
within and across classes in a default scenario through a small number
of large hedging transactions that hedge large numbers of similarly
correlated positions held by the defaulting party.\102\ As such,
liquidity for specific, individual swaps is not the focus of DCOs from
a risk management perspective. Rather, liquidity is viewed as a
function of whether a portfolio of swaps has common specifications that
are determinative of the economics of the swaps in the portfolio such
that a DCO can price and risk manage the portfolio through block
hedging and auctions in a default situation.\103\
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\102\ After putting on these hedging positions, the DCO has the
time needed to address any residual risk of the defaulted portfolio
through auctioning off the defaulted portfolio together with the
hedging transactions.
\103\ See 77 FR at 47188 and LCH IRS submission, at 4
(discussing LCH's management of the Lehman Brothers' bankruptcy in
September 2008, where upon Lehman's default, LCH needed to risk
manage a portfolio of approximately 66,000 interest rate swaps,
which it hedged with approximately 100 new swap trades in less than
five days and only used approximately 35% of the initial margin
Lehman had posted).
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iv. Interest Rate Swap Classification for Clearing Requirement
Determinations
Section 2(h)(2)(A) of the CEA provides that the Commission ``shall
review each swap, or any group, category, type, or class of swaps to
make a determination as to whether'' any thereof shall be required to
be cleared. In reviewing the IRS submissions, the Commission considered
in the NPRM whether its clearing requirement determination should
address individual swaps, or categories, types, classes, or other
groups of swaps.
Based on the market conventions as discussed above, and the DCO
recommendations in the IRS submissions, the Commission proposed a
clearing requirement for four classes of interest rate swaps: Fixed-to-
floating swaps, basis swaps, OIS, and FRAs. At the time the IRS
submissions were submitted to the Commission, LCH offered all four
classes for clearing, as did IDCH, and CME offered one of them for
clearing. Subsequent to the publication of the NPRM, CME has added
clearing of OIS, and has stated publicly that it intends to add
clearing of basis swaps and FRAs in the near future. In addition, upon
launch of LCH.LLC, it is expected that LCH.LLC will begin clearing the
same swaps cleared by LCH that are included in the swap classes
designated by the Commission.
These four classes represent a substantial portion of the interest
rate swap market. The following table provides an indication of the
outstanding positions in each class.
Table 4--Interest Rate Swaps Notional and Trade Count by Class \104\
----------------------------------------------------------------------------------------------------------------
Notional amount Gross notional Total trade count
Swap class (USD BNs) percent of total Total trade count percent of total
----------------------------------------------------------------------------------------------------------------
Fixed-to-Floating................... 299,818 60 3,239,092 75
FRA................................. 67,145 13 202,888 5
OIS................................. 43,634 9 109,704 3
Basis............................... 27,593 5 119,683 3
Other \105\......................... 65,689 13 617,637 14
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[[Page 74302]]
Total........................... 503,879 100 4,289,004 100
----------------------------------------------------------------------------------------------------------------
\104\ TriOptima data, as of March 16, 2012. See Section II.F below for a description of the TriOptima data. The
TriOptima data provided information on nine other classes of swaps, none of which is included in the IRS
submissions.
\105\ In the NPRM, the total notional amount for the ``Other'' category was incorrectly listed as $132,162
billion as a result of inadvertently including the FRA amounts in the ``Other'' category. Correcting this
error also resulted in changes to the ``Gross Notional Percent of Total'' column. These corrections do not
change the Commission's analysis in the NPRM. The fact that the four classes of interest rate swaps included
in the clearing requirement represent a larger proportion of the total notional amount of interest rate swaps
outstanding is consistent with Congressional intent to mitigate systemic risk by implementing clearing of
swaps as discussed in the NPRM. See 77 FR 47171.
For purposes of the clearing requirement determination, the
Commission developed the following class definitions based on
information provided by the submitting DCOs and market conventions.
1. ``Fixed-to-floating swap'': A swap in which the payment or
payments owed for one leg of the swap is calculated using a fixed rate
and the payment or payments owed for the other leg are calculated using
a floating rate.
2. ``Floating-to-floating swap'' or ``basis swap'': A swap in which
the payments for both legs are calculated using floating rates.
3. ``Forward Rate Agreement'' or ``FRA'': A swap in which payments
are exchanged on a pre-determined date for a single specified period
and one leg of the swap is calculated using a fixed rate and the other
leg is calculated using a floating rate that is set on a pre-determined
date.
4. ``Overnight indexed swap'' or ``OIS'': A swap for which one leg
of the swap is calculated using a fixed rate and the other leg is
calculated using a floating rate based on a daily overnight rate.
As described in the NPRM, the LCH and CME IRS submissions addressed
issues of classification for purposes of the interest rate swap
clearing requirement. In its submission, LCH discussed the
classification of interest rate swaps and recommended establishing
clearing requirements for classes of interest rate swaps. In effect,
LCH recommended the use of a set of basic product specifications to
identify and describe each class of swaps subject to the clearing
requirement. CME recommended a clearing determination for all non-
option interest rate swaps denominated in a currency cleared by any
qualified DCO.
As an alternative, the Commission considered whether to establish
clearing requirements on a product-by-product basis. The Commission
noted in the NPRM that such a determination would need to identify the
multitude of specifications of each product that would be subject to
the clearing requirement. In this regard, LCH stated in its IRS
submission that the clearing requirement ``would be sub-optimal for the
overall market if participants are forced to read pages of rules to
decipher whether or not a swap is required to be cleared, or to have to
make complex and time consuming decisions at the point of execution.''
\106\ A class-based approach would allow market participants to
determine quickly as a threshold matter whether they might need to
submit a swap to a DCO for clearing by checking initially whether the
swap has the basic specifications that define each class subject to the
clearing requirement.\107\
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\106\ LCH IRS submission, at 6.
\107\ In addition, as noted by LCH, in its IRS submission, a
product-by-product requirement may be evaded more easily because the
specifications of a particular swap contract would need to match the
specifications of each product subject to a clearing requirement.
The clearing requirement could be evaded by adding, deleting, or
modifying one or more of the contract's specifications, including
minor specifications that have little or no impact on the economics
of the swap. By using a class-based approach that allows for ranges
of contract specifications established by the DCOs within each
class, the Commission is reducing the potential for evasion in
accordance with section 2(h)(4)(A) of the CEA, which directs the
Commission to prescribe rules necessary to prevent evasion of the
clearing requirements.
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A product-by-product designation also would be difficult to
administer because the Commission would be required to consider each
and every product submitted. On the other hand, designating classes of
interest rate swaps for the clearing requirement provides a cost
effective, workable method for the Commission to review variations in
new swap products that DCOs will submit for clearing determinations on
a going forward basis without undertaking a full Commission review of
each and every swap to determine if those variations are consistent
with the five factors the Commission is directed to consider under
section 2(h)(2)(D) of the CEA. For such swaps, as described in greater
detail below in Section III.F, the Commission proposed delegating to
the Director of the Division of Clearing and Risk, with the
consultation of the General Counsel, the authority to confirm whether
the swap fits within the identified class and is therefore subject to
the clearing requirement.
After consideration of the issues summarized above, the Commission
proposed in the NPRM to follow the general approach recommended by LCH
and CME of establishing the clearing requirement for classes of
interest rate swaps, rather than for individual swap products.
v. Interest Rate Swap Specifications
In the NPRM, after consideration of the appropriateness of
classifying interest rate swaps, the Commission analyzed the IRS
submissions and proposed to set out the parameters of the four classes
of interest rate swaps submitted by using the following affirmative
specifications for each class: (i) Currency in which the notional and
payment amounts are specified; (ii) rates referenced for each leg of
the swap; and (iii) stated termination date of the swap. The Commission
further proposed three ``negative'' or ``limiting'' specifications for
each class: (i) No optionality (as specified by the DCOs); (ii) no dual
currencies; and (iii) no conditional notional amounts.\108\
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\108\ The term ``conditional notional amount'' refers to
notional amounts that can change over the term of a swap based on a
condition established by the parties upon execution such that the
notional amount of the swap is not a known number or schedule of
numbers, but may change based on the occurrence of some future
event. This term does not include what are commonly referred to as
``amortizing'' or ``roller coaster'' notional amounts for which the
notional amount changes over the term of the swap based on a
schedule of notional amounts known at the time the swap is executed.
Furthermore, it would not include a swap containing early
termination events or other terms that could result in an early
termination of the swap if a DCO clears the swap with those terms.
The Commission discusses this definition and comments received on it
below.
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The Commission proposed the three affirmative specifications
because they are fundamental specifications used in the swap market to
determine the economic result of a swap transaction. Counterparties
enter into swaps to achieve particular economic results. For
[[Page 74303]]
example, counterparties may enter into interest rate swaps to hedge an
economic risk, to facilitate a purchase, or to take a view on the
future direction of an interest rate. The counterparties enter into a
swap that they believe will best achieve their desired economic result
at a reasonable cost.
As noted in the NPRM, the IRS submissions identified four different
classes of swap contracts that are being cleared at this time: fixed-
to-floating swaps, basis swaps, OIS, and FRAs. These classes of
interest rate swaps reflect industry categorization and allow
counterparties to achieve a particular economic result. For example, a
fixed-to-floating swap may be used by a counterparty to hedge interest
rate risk related to bonds it has issued or which it owns.
All three DCO submitters identified currency as a specification for
distinguishing swaps that are subject to clearing. A swap that requires
calculation or payment in a currency different than the currency of the
related underlying purposes of the swap would introduce currency
risk.\109\ Thus, the currency designated for the swap is a basic factor
in pricing the swap and achieving the economic results of the swap
desired by each party.
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\109\ For example, parties seeking to hedge interest rate risk
in connection with bonds or to invest funds using swaps are more
likely to enter into swaps that designate the same currency in which
the bonds are payable or that the funds to be invested are held.
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Furthermore, the swaps listed by all three DCOs in their IRS
submissions all identified the interest rates used for each leg of the
swap as a basic term that defines the swap. The rates are basic
determinants of the economic value of each stream of payments of an
interest rate swap.
Finally, the stated termination date, or maturity, of a swap is a
basic specification for establishing the value of a swap transaction
because interest rate swaps are based on an exchange of payments over a
specified period of time ending on the stated termination date. The
value of a swap at any one point in time depends in part on the value
of each payment stream over the remaining life of the swap. For
example, if a party wants to hedge variable interest rate risk for
bonds it has issued that mature in ten years, it will generally enter
into a swap with a stated termination date that matches the final
maturity date of the bonds being hedged.\110\ To terminate the swap
prior to such date would result in only a partial hedge and to execute
a swap with a stated termination date that is later than the final bond
maturity date would simply create exposed rate risk during the extended
period beyond the final maturity date of the bonds.
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\110\ Although hedging an economic risk expected to remain
outstanding for, say, ten years with a matching ten year swap may
generally be the most efficient and precise approach, the Commission
recognizes that parties may achieve a similar result by using swaps
with different stated termination dates. However, such substitution
generally provides a less precise hedge.
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As noted above, the Commission also considered in the NPRM whether
there are product specifications that the Commission should explicitly
exclude from the initial clearing requirement determination. In this
regard, the Commission considered swaps with optionality, multiple
currency swaps, and swaps with conditional notional amounts. The
Commission proposed that these three specifications should be included
as so-called ``negative'' or ``limiting'' specifications.
By using the three affirmative specifications and three limiting
specifications to further identify the swaps within each class that are
subject to the clearing requirement, counterparties contemplating
entering into a swap can determine quickly as a threshold matter
whether the particular swap may be subject to a clearing requirement.
If the swap is in a specified class and has the six specifications, the
parties will know that they need to verify whether a DCO will clear
that particular swap. This will reduce the burden on swap
counterparties related to determining whether a particular swap may be
subject to the clearing requirement.
The Commission also considered in the NPRM whether to define
classes of swaps on the basis of other product specifications. Other
potential specifications are numerous because of the nearly limitless
alternative interest rate swaps that are theoretically possible. In the
NPRM, the Commission summarized its consideration by breaking down
alternative specifications into two general categories: Specifications
that are commonly used to address mechanical issues for most swaps, and
specifications that are less common and address idiosyncratic issues
related to the particular needs of a counterparty. The Commission noted
that certain specifications are specifically identified for most swap
transactions, but asserted that many such specifications are not,
generally speaking, fundamental to determining the economic result the
parties are trying to achieve. For example, the day count fraction
selected affects calculation periods and therefore the amounts payable
for each payment period. The parties, and the DCOs, can make mechanical
adjustments to period pricing at the time a swap is cleared based on
the day count fraction alternative selected by the parties and the day
count fraction does not drive the overall economic result the parties
are trying to achieve or substantially differentiate the pricing and
risk management of the swap relative to other swaps in the same class
and having the same basic class defining specifications.
Furthermore, as noted in the NPRM, DCOs can provide clearing for
the standard alternatives of each of these specifications without
affecting risk management. Using the same day count fraction example,
LCH will accept U.S. dollar-LIBOR trades for clearing with nine
alternative day count fractions based on the common day count fractions
used in the market.\111\ While this specification, and other
specifications of this kind, may affect the amounts owed on a swap,
they can be accounted for mechanically in the payment amount
calculations and do not change the basic substantive economic result
the parties want to achieve.
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\111\ Each DCO identifies the standard term or range of terms it
will accept for each specification. Accordingly, swap counterparties
can review the DCO's product specifications to determine whether a
swap will satisfy the DCO's requirements for these specifications.
Additionally, CME has developed, and LCH has committed to developing
by the time the clearing requirement must be complied with in
accordance with the Commission's implementation schedule, product
screening mechanisms by which parties can determine whether the DCO
will clear a particular swap. As discussed in greater detail
throughout this release, if counterparties want to enter into a swap
that is in a class subject to required clearing and no DCO will
clear the swap because it has other specifications that no DCO will
accept, then the parties can still enter into that transaction on an
uncleared basis.
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Regarding the latter, idiosyncratic specifications, examples
include special representations added to address particular legal
issues, unique termination events, special fees, and conditions tied to
events specific to the parties. None of the DCOs clear interest rate
swaps with terms in the second group. Accordingly, such specifications
are not included in the classes of swaps subject to the clearing
requirement proposed by this rule, and the Commission considered only
the first group of more common specifications that are identified by
the submitting DCOs in their product specifications.
In short, the Commission recognizes that these other specifications
may have an effect on the economic result to be
[[Page 74304]]
achieved with the swap.\112\ However, counterparties and DCOs may
account for the effects of such specifications with adjustments to
other specifications or in the price of the swap. Furthermore, DCOs
account for various alternatives or range of alternatives for these
terms without impairing risk management. Finally, as described above in
more detail, including these specifications in the description of the
swaps subject to a clearing requirement could increase the burden on
counterparties when checking whether a swap may be subject to required
clearing. Accordingly, the Commission has determined not to include
other, non-class defining specifications in the swap class definition.
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\112\ LCH recommended in its submission that floating rate tenor
(also known as frequency) also be a class level specification and
the Commission acknowledges that floating rate tenor can, in some
cases, be a fundamental specification for achieving the economic
benefits of an interest rate swap. However, it is the Commission's
view that floating rate tenor is more akin to the other non-class
specifications in that it is not fundamental to all economic results
that may be considered by parties when contemplating a swap and it
is a specification for which the DCOs can fairly easily offer all of
the standard tenors that parties may consider.
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vi. General Comments Received Regarding the Specifications
Determination
Numerous commenters expressed support for including the
Commission's four interest rate swap classes and six class
specifications in the clearing requirement and were of the view that
the classes satisfy the five statutory factors the Commission is
required to consider for the clearing requirement determination.\113\
CME expressed support for the class-based approach in the rulemaking
rather than swap-by-swap and stated that the Commission ``struck an
appropriate balance for the initial slate of classes subject to the
requirement.'' LCH commented that the six swap specifications selected
are consistent with its recommendation in its IRS submission and
reaffirmed the reasons cited in the NPRM for using these
specifications.
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\113\ AllianceBernstein, R.J. O'Brien, Citadel, Eris Exchange,
CME, FIA, D.E. Shaw, Arbor Research, LCH, Knight Capital, Jefferies,
Coherence Capital, CRT Capital, Javelin Capital, SDMA, Chris
Barnard, and Svenokur.
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Citadel agreed with the Commission's class-based approach rather
than a product-by-product based approach. Citadel stated that the class
designation approach ``reflects the risk management approach utilized
across the industry, and most importantly by DCOs'' to determine margin
levels and other safeguards and is therefore the starting point for the
approved classes. Citadel further noted that different tenors or series
of the same instruments, while displaying different characteristics,
can be priced both based on market activity and by reference to more
liquid contracts of the same instruments and are risk managed with the
same risk management frameworks. Finally, Citadel expressed concern
that not including products that otherwise share essential
characteristics as swaps that are otherwise required to be cleared and
that can be priced with reference to cleared swaps could risk the
development of separate markets that avoid the clearing requirement.
AFR noted that the interest rate swap classes selected properly
reflect the risk profile of the interest rate swap market and will
avoid uncertainty and complexity for the Commission and market
participants. AFR also noted that details of product specifications
such as slightly different tenors, are largely irrelevant, especially
in the interest rate market and stated that any suggestion of a
product-by-product approach should be interpreted as a tactic to delay
implementation. Furthermore, AFR encouraged the Commission to designate
swap classes to include low volume swaps that can be risk managed in
ways that high-volume swaps in the class are risk managed. AFR's
concern is that if the low-volume swaps are not included, they could be
used to avoid the clearing requirement by replicating the swaps that
are required to be cleared with the low-volume swaps. Citadel's and
AFR's comments are consistent with the Commission's rationale for
establishing the four classes of swaps and the six specifications for
each class on which the Commission based its consideration of the five
factors set forth in section 2(h)(2)(D)(ii) of the CEA. As noted in the
NPRM, the Commission is directed under the CEA to make its
determination for ``each swap, or any group, category, type, or class
of swaps.'' The Commission first needed to establish the classes and
class-defining specifications to which would then consider using the
five statutory factors.
ISDA commented that the Commission should not use what ISDA
characterized as a newly-articulated standard for choosing the swap
class-defining specifications based on whether they are ``fundamental
to determining the economic result that parties are trying to
achieve.'' ISDA expressed concern with what it characterized as a
standard that it is not grounded in the five statutory factors of
section 2(h)(2)(D)(ii) of the CEA and will fail to discriminate between
swaps that may differ in terms of the five factors. Furthermore, in
ISDA's view, the fundamental economic result depends on facts and
circumstances of each transaction and the parties.
The phrase ``fundamental to determining the economic result that
parties are trying to achieve'' used by the Commission in the NPRM does
not establish a new standard or replace the statutory five factor
determination required by the CEA. Rather, the Commission used this
phrase to describe one of several reasons for establishing which
product specifications to use in defining each class to which the
statutory five factor analysis was then applied. The phrase was used in
the context of identifying the primary product specifications the
submitting DCOs and the market use to value or price swaps within a
class. As described at length in Section II.D of the NPRM, in
establishing the swap classes to be considered, the Commission looked
at how DCOs grouped the cleared interest rate swaps by certain defining
types and specifications, how markets trade and view the products as
classes, and how swaps that share certain common specifications can be
priced and risk managed together as a class. The Commission's analysis
for establishing the classes to be considered was not based on any new
standard. Rather, the aforementioned phrase summarizes one element of
the Commission's analysis of how to define the classes to be considered
under the five factors established in the CEA.
Furthermore, the five factor statutory analysis was separately
undertaken for each class. For the reasons stated in defining the
classes and class specifications, the Commission believes that the
swaps within each class are sufficiently similar to apply the statutory
analysis to each class. As noted above, many commenters agreed with
this conclusion.
Finally, regarding ISDA's view that the fundamental economic result
depends on facts and circumstances of each transaction and the parties,
the Commission recognizes that individual swap counterparties may have
highly specific economic results they are trying to achieve with a swap
and accordingly set the terms of the swap to achieve those specific
results. However, the Commission's use of the phrase in the NPRM can be
more clearly understood in context. The Commission was addressing
whether certain specifications, other than the six specifications used
to define each class, should be considered to be class-defining
specifications. The Commission noted that certain specifications
``affect the value of the swap in a mechanical way, they are not,
[[Page 74305]]
generally speaking, fundamental to determining the economic result.''
The Commission provided an example of how other specifications may
affect the amounts payable on a swap on each payment date, but when
valuing a swap for pricing and risk management purposes, together with
other swaps within a class, these other specifications can be accounted
for by making price adjustments off a standard price curve and
therefore do not change the basic pricing economics of the swap to an
extent that would necessitate classifying the swap separately from
other swaps defined by the six specifications identified by the
Commission.
ISDA further commented that, although an overly intricate set of
product specifications would impose burdens on the market, broad class
designations impose greater burdens by creating the need for filtering
products that a DCO will accept for clearing from the designated class.
In ISDA's view, the Commission's statement in the NPRM that DCOs and
vendors are ``likely'' to develop screening tools acknowledges the
issue, but does not provide a solution. ISDA recommended that limiting
clearing to swaps with prior clearing history supplemented by an
advance DCO notice process would strike a reasonable balance.
In response, the Commission notes that the identification of the
four interest rate swap classes and the parameters for the six
specifications within each class provides a fairly detailed and easy to
use initial screening mechanism for market participants to determine
whether a particular swap needs to be submitted for clearing. If a
market participant determines that a swap falls into a class under
Sec. 50.4, then the party will need to take reasonable efforts to
determine whether any eligible DCO will accept the swap for
clearing.\114\ The Commission noted in the NPRM that the DCOs or other
vendors would likely develop screening tools for this purpose. The
Commission further notes that each DCO and its members and the FCMs who
clear through the DCO, in effect, already have the capability through
their own onboarding processes and transaction affirmation platforms to
screen swap transactions nearly instantaneously to determine whether
the transactions will be accepted by the DCO. While those systems alone
should be able to serve as a screening mechanism sufficient to allow
for compliance with the clearing requirement, the Commission encourages
the DCOs to create a tool to provide all market participants with the
ability to independently screen potential swap transactions quickly and
easily. CME commented that it already has a tool to screen particular
swaps for eligibility. LCH stated in its comments that while the
current information on its Web site is designed for dealer use, LCH is
committed to revising the information to be easily understandable by
all counterparties.
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\114\ See Section III.B for a discussion of the reasonable
efforts standard in this context.
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Furthermore, the Commission does not agree that ISDA's proposal to
limit the determination to swaps with prior clearing history would ease
the screening process. DCOs, particularly LCH, already have prior
clearing history for swaps with tens of thousands of different product
specification combinations.\115\ Accordingly, even if the Commission
adopted such an approach, the result would have the problems that a
product-by-product approach would have, as acknowledged by ISDA. Also,
the Commission agrees that an appropriate DCO notice framework will
facilitate product screening and addresses this comment in Section III
below.
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\115\ See, e.g., http://www.swapclear.com/why/ (stating that
since 1999, LCH has cleared more than 2.2 million OTC interest rate
swaps, $329 trillion notional, and compressed more than $145
trillion (as of September 2012)).
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In addition, ISDA expressed concern that the discussion of
specifications that are not included in the six class-specific
specifications identified by the Commission could be read as a
directive to abandon such other specifications to the extent they are
not included in the swaps DCOs will accept for clearing. ISDA requested
confirmation that footnote 97 of the NPRM (revised as footnote 111 in
this final release) establishes that if a DCO does not accept a swap
because the swap contains terms that the DCO does not clear, then
entering into the swap as an uncleared transaction is permissible. ISDA
further requested that the Commission state that entering into a swap
that is not accepted for clearing does not raise a presumption of
evasion.
Similarly, Freddie Mac also expressed concern that the discussion
of fundamental specifications and ``mechanical specifications'' may
signal the Commission's judgment that parties are required to clear
swaps that have sufficiently close substitutes. Freddie Mac requested
that the Commission clarify the treatment of swaps that no DCO will
clear and that parties may enter into uncleared swaps within a
designated class if a DCO will not accept the swap provided that the
variation in specifications is for a legitimate business purpose.
Freddie Mac noted that section 2(h)(1)(A) of the CEA refers to an
obligation to ``submit'' the swap for clearing rather than requiring
that a swap must be successfully cleared. Freddie Mac expressed concern
that failure to clarify this issue would lead to uncertainty as to the
legality of uncleared swaps and that executing swap dealers or other
market participants could use that uncertainty to insist on contractual
rights to have the option to terminate a swap that fails to clear.
The Commission confirms that the discussion of the class-defining
swap specifications and other specifications served only to explain the
Commission's differentiation between the class specifications and other
specifications market participants use. The Commission is not requiring
parties to take affirmative steps to substitute a clearable swap for an
unclearable swap within a designated class.\116\
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\116\ See Sections II and III for further discussion of this
issue.
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Regarding issues of what constitutes evasion of the clearing
requirement when using a close substitute swap that is not cleared by a
DCO and ISDA's request regarding a presumption regarding evasion of the
clearing requirement, this issue, along with other evasion and abuse
issues, are addressed in Section III.G of this release.
With respect to the ``negative specifications,'' AFR commented that
some of these specifications, such as dual currency and optionality,
are composites of two derivatives including a basic interest rate swap
that may be subject to the clearing requirement and that market
participants should be required to clear components of such swaps that
can be cleared to prevent evasion.
This initial determination is based on the IRS submissions and
because none of them include swaps that have the negative
specifications, the Commission believes it is beneficial for swap
market participants to expressly exclude those specifications so that
parties that execute swaps with those specifications will know
definitively that they are not subject to the clearing requirement.
While the Commission is sensitive to concerns that the clearing
requirement could be evaded by adding negative specifications to a swap
to make it non-clearable, no data or other information is available at
this time to indicate that compound swaps are being used for evasion.
If the Commission observes such behavior or otherwise becomes aware
that is occurring, it will consider
[[Page 74306]]
taking appropriate action under its authority provided in the CEA.
The FSR requested clarification regarding the conditional notional
amount specification. The FSR interpreted footnote 93 of the NPRM
(footnote 108 of this adopting release) to mean that interest rate
swaps entered into in connection with loans to hedge interest rate risk
(the notional amounts of which are tied at all times to the outstanding
principal amount of the loan) would not be subject to the clearing
requirement if the principal amount of the loan would foreseeably vary
over its term in an unscheduled or unpredictable manner.\117\ The FSR
used the examples of a swap used to hedge a construction loan, where
the loan would be drawn over time based on the needs of the
construction project, and without a fixed draw schedule, or a swap
entered into in connection with a revolving credit agreement or a
credit agreement that permits voluntary prepayments. The FSR noted that
such adjustment may be implemented through a partial termination event,
permitting or requiring the lender/swap provider to reduce the
outstanding notional amount of the swap so as to protect both the
customer and the lender/swap provider from over-hedging.
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\117\ In a similar vein, ISDA commented that exclusions from the
clearing requirements should be available if a party enters into one
swap to hedge another swap and the hedge would no longer be
functional if one trade of the pair would be cleared and the other
not. Section 2(h)(7) of the CEA is clear with respect to this issue,
and provides that only certain non-financial entities may elect not
to clear certain swaps that hedge or mitigate commercial risk of the
entity. The CEA does not extend this election to financial entities.
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In response to the FSR, the Commission clarifies that a
``conditional notional amount'' is a specification included in the swap
at the time of execution that provides that the notional amount will
change during the stated term of the swap in an unscheduled manner upon
the occurrence of defined events or conditions. There are two elements
to such a specification: First, the change in notional amount must be
triggered by a defined event or condition, and second, the change must
not be clearly predictable at the time the swap is executed.
Accordingly, the two examples provided by the FSR might be swaps that
have a conditional notional amount if the swaps include specifications
or terms that provide for a change in notional amount triggered by an
event tied to the hedged loan or credit line and the specific timing of
that event is not sufficiently foreseeable or predictable when the swap
is entered into such that the swap notional amount change could have
been scheduled in advance. For example, a swap in which the parties
agree that the notional amount will automatically be reduced upon a
draw on a related construction loan identified in the swap or a
prepayment of a loan identified in the swap would qualify as a swap
with a conditional notional amount.
However, the Commission notes that such a specification would not
qualify if the reduction in the notional amount is voluntary. In this
regard, a voluntary partial or full termination right is not an
indication of a conditional notional amount. A party to a cleared swap
can affect the same result as exercising a voluntary termination right
at any time by entering into an equal and offsetting cleared swap.
Clearing eliminates bilateral counterparty credit risk and therefore
entering into an offsetting swap that is cleared with any party has the
same effect as terminating the original swap. Accordingly, including a
voluntary termination right in a swap that otherwise would be clearable
and is subject to the clearing requirement serves no economic purpose
that would distinguish the swap from other swaps in the class that are
required to be cleared.
As noted in the beginning of this Section II.E, the preceding
analysis identified the classes of interest rate swaps and
specifications within the classes to be considered by the Commission in
the clearing requirement determination. In the following section in the
NPRM, as summarized in this final release, the Commission took into
account the statutory provisions under section 2(h)(2)(D) of the CEA
with respect to the four classes of interest rate swaps and, within
each class, the six identified product specifications.
F. Proposed Determination Analysis for Interest Rate Swaps
i. Consistency With Core Principles for Derivatives Clearing
Organizations
As noted above, section 2(h)(2)(D)(i) of the CEA requires the
Commission to review whether a swap submission is consistent with the
core principles for DCOs in making a clearing determination. As
discussed in the NPRM, LCH and CME already clear all swaps identified
in their respective IRS submissions and therefore each is subject to
the Commission's review and surveillance procedures summarized in the
NPRM. Accordingly, LCH and CME already are required to comply with the
core principles set forth in section 5b(c)(2) of the CEA with respect
to the swaps being considered by the Commission for the clearing
requirement. The Commission further described in the NPRM its
activities as a regulator to monitor and effect ongoing compliance with
the core principles applicable to DCOs including periodic examinations
and daily risk surveillance. Further, the Commission stated that the
Commission does not believe that subjecting any of the interest rate
swaps identified in the IRS submissions to a clearing requirement would
alter compliance by the respective DCOs with the core principles.
Based upon the Commission's ongoing reviews of DCOs' risk
management frameworks and clearing rules, and its annual examinations
of the DCOs, the Commission believes that the submissions of LCH and
CME are consistent with section 5b(c)(2) if the CEA and the related
Commission regulations. In analyzing the IRS submissions discussed
herein, the Commission does not believe that a clearing requirement
with regard to the specified interest rate swap classes would be
inconsistent with LCH or CME's continued ability to maintain such
compliance with the DCO core principles set forth in part 39 of the
Commission's regulations.
ii. Consideration of the Five Statutory Factors for Clearing
Requirement Determinations
Section 2(h)(2)(D)(ii) of the CEA identifies five factors the
Commission shall consider in making a clearing requirement
determination. The process for submission and review of swaps for a
clearing requirement determination is further detailed in Sec. 39.5 of
the Commission's regulations. This section summarizes the Commission's
consideration the four classes of swaps identified in the preceding
section under the statutory five factors in the context of the process
established by regulation.
a. Outstanding Notional Exposures, Trading Liquidity, and Adequate
Pricing Data
Section 2(h)(2)(D)(ii)(I) of the CEA requires the Commission to
take into account the existence of outstanding notional exposures,
trading liquidity, and adequate pricing data. In the NPRM, the
Commission considered available market data and LCH cleared swap
information. Unlike CDS for which substantially all of the trading data
has been collected in one place, there is no single data source for
notional exposures and trading liquidity for the
[[Page 74307]]
entire interest rate swap market.\118\ However, the Commission
considered several sources of data on the interest rate swap market
that collectively provides the information the Commission needs to make
a clearing requirement determination. As described in the NPRM, the
data sources that the Commission considered include: general estimates
published by the Bank for International Settlements (BIS data); market
data published weekly by TriOptima (TriOptima data) covering swap trade
information submitted voluntarily by 14 large derivatives dealers (G14
Dealers); trade-by-trade data provided voluntarily by the G14 Dealers
to the OTC Derivatives Supervisors Group for a three month period
between June and August 2010 (ODSG data); and trade-by-trade data for
swaps cleared by LCH for the first calendar quarter of 2012 (LCH
data).\119\
---------------------------------------------------------------------------
\118\ See Bank of England, ``Thoughts on Determining Central
Clearing Eligibility of OTC Derivatives,'' Financial Stability Paper
No. 14, March 2012, at 11, available at http://www.bankofengland.co.uk/publications/Documents/fsr/fs_paper14.pdf.
\119\ All DCOs were required to begin providing daily position
data to the Commission as of November 8, 2012. CME's available data
was considered too limited to provide any indication of the complete
interest rate swap market. Because LCH clears a large portion of the
swap products it offers clearing for (based on available
information, LCH claims to have cleared approximately 50 to 90
percent of the dealer open interest in the different interest rate
swap products that it clears), its data provides some indication of
the possible notional exposures and liquidity in the products
submitted by LCH that the Commission considered. Given the
limitations on other available data, the Commission believes it is
useful to consider the LCH data along with the market-wide BIS data,
ODSG data, and TriOptima data.
---------------------------------------------------------------------------
The NPRM explained in detail that each data source used has a
number of limitations that are important to understand when considering
the data. The Commission incorporates the discussion of those
limitations found in the NPRM into this final release.
For this determination, the Commission only considered the swaps
identified in the IRS submissions. Accordingly, where possible, the
Commission presented and discussed only the data for swaps identified
in the submissions. The analysis of interest rate swap data in the NPRM
was presented based on the four swap classes and the class
specifications. This information was used by the Commission to
determine whether there exists significant outstanding notional
amounts, trading liquidity, and pricing data to include each class and
specification identified in the IRS submissions.
For purposes of this final release, the Commission is incorporating
the data tables in the NPRM by reference and the considerations and
conclusions drawn by the Commission following review of the data is
summarized below.\120\ Readers are encouraged to refer to the NPRM to
review the data presented. None of the comments received in response to
the NPRM raised issues with the data analyzed in the NPRM.
---------------------------------------------------------------------------
\120\ The ODSG data has not been updated since 2010. The BIS
data that was available when the NPRM was published was from the
second half of 2011 and the TriOptima and LCH data used was from the
first quarter of 2012. The BIS has not published updated data as of
this writing. TriOptima stopped publishing the interest rate swap
data in April, 2012. DTCC began collecting similar data at that time
and is now provisionally registered by the Commission as a SDR. The
Commission has reviewed data from DTCC and LCH and confirmed that
the recent data available is consistent with the data used in the
NPRM to develop the interest rate swap clearing requirement rule,
taking into consideration normal changes in market activity.
---------------------------------------------------------------------------
1. Interest Rate Swap Class
In the NPRM, the Commission considered data relevant to the
different interest rate swap classes included in the IRS submissions.
The BIS data provided certain big picture information. It indicated
that interest rate swaps in total constituted nearly 80% of the
derivatives market and interest rate swap notional amounts generally
increased for all three kinds of swaps between 2008 and 2011 with total
interest rate swap notional amounts reported growing by about 15%
during that period. Additionally, all three classes of swaps identified
by the BIS data have substantial notional amounts outstanding. As of
December 2011, FRAs had about $50.5 trillion outstanding, optional
swaps had about $51 trillion outstanding, and other interest rate swaps
had about $403 trillion outstanding. Given this information, the
Commission concluded that none of the kinds of swaps identified by the
BIS should be eliminated from consideration by the Commission for a
clearing requirement based on the BIS data alone. However, the BIS data
did not provide enough detail to reach further conclusions regarding
the swaps identified in the IRS submissions.
The TriOptima data and the ODSG data sets were used to identify
notional amounts and trade counts for all four classes of swaps
identified in the IRS submissions. Trading liquidity as an indication
of how effectively DCOs can risk manage a portfolio of swaps can be
evidenced in several ways. The data available for this purpose included
total notional amount outstanding, total number of swaps outstanding,
and the average number of transactions over a given period of time.
The TriOptima data showed that all four classes have significant
outstanding notional amounts with basis swaps being the lowest at about
$27.6 trillion and the highest being fixed-to-floating swaps at $288.8
trillion. Total trade counts for each type were also significant with
the lowest being 109,704 for OIS and the highest being fixed-to-
floating swaps at 3,239,092.
The average number of swap trades per week for each class of swaps
was evidenced by the ODSG data. According to the ODSG data set, basis
swaps were traded at the lowest frequency compared to the other three
classes at 240 times on average each week during the ODSG data period.
Because the ODSG data is from the summer of 2010 and gross notional
amounts and trading activity in interest rate swaps have both increased
generally, the Commission believes that trading activity has likely
increased for all classes since the ODSG data was collected.
The LCH data generally confirmed the assessment of market-wide
data. There is substantial outstanding notional volumes and trade
liquidity for each of the four classes already being cleared at LCH.
LCH cleared the following percentage of each class of swap as
reported by TriOptima: \121\
---------------------------------------------------------------------------
\121\ Percentages are calculated based on total notional amount
cleared by LCH divided by total notional outstanding as reported by
TriOptima. The TriOptima data is used because it is the most current
data set that provides data broken out according to the classes
being cleared.
---------------------------------------------------------------------------
75% of the Fixed-to-Floating swaps,
41% of FRAs,\122\
---------------------------------------------------------------------------
\122\ LCH started clearing FRAs in December 2011 and cleared
volumes have increased significantly each month since the start
date. As of March 31, 2012, the date for which the data was
presented in the NPRM, LCH had a total notional amount outstanding
of cleared FRAs of $27.7 trillion. As of October 15, 2012, that
amount had increased to $58.6 trillion.
---------------------------------------------------------------------------
84% of OIS, and
41% of Basis Swaps.
Accordingly, a substantial portion of each class is already being
cleared voluntarily.
Swap Class Conclusion
The Commission concluded in the NPRM that the four classes of swaps
currently being cleared have significant outstanding notional amounts
and trading liquidity. The Commission further noted that a substantial
percentage of each of the four classes was already being cleared.
A number of commenters commented that the four interest rate swap
classes are cleared in material volumes at this
[[Page 74308]]
time and expressed support for including the four interest rate swap
classes in the clearing requirement designation based on the data
available.\123\ Citadel agreed with the Commission's conclusion that
the data presented in the NPRM demonstrate substantial outstanding
notional exposures and a high level of trading liquidity in the
relevant classes of swaps. Citadel commented that liquidity, for
purposes of the clearing requirement, should be determined on grounds
other than trading activity alone. Specifically, market depth can be
evidenced by the number of dealers quoting two-way markets in a
product, and the notional sizes of the quoted bids and offers, is also
a liquidity indicator. Citadel noted that multiple dealers regularly
quote two-way markets in the swaps covered by the proposed rule in
meaningful sizes through a variety of mediums, including in periods of
market stress, and therefore it believes there is ample trading
liquidity to support a clearing requirement for the classes designated.
For the reasons described above, the Commission reaffirms the
aforementioned conclusions provided in the NRPM regarding the classes
of interest rate swaps proposed in the NPRM for required clearing.
---------------------------------------------------------------------------
\123\ See letters from FIA PTG, Arbor Research and Trading, LLC,
R.J. O'Brien, Svenokur, LLC, Chris Barnard, CRT Capital Group
(Robert Gorham), LLC, DRW Trading Group, Javelin, SDMA, Knight
Capital Americas LLC, Bart Sokol (CRT Capital Group), Jefferies &
Company, Inc., MarketAxess, Eris Exchange, Coherence Capital
Partners LLC, Citadel, AFR, D.E. Shaw Group, AllianceBernstein, LCH,
CME, and ICE.
---------------------------------------------------------------------------
2. Currency
As discussed above in Section II.E, the currency in which the
notional and payment amounts are specified is a primary product
specification and all four data sources provide interest rate swap data
by currency.
The BIS data addressed seven of the seventeen currencies identified
in the submissions individually. All seven currencies had substantial
outstanding notional amounts as of December 2011, ranging from nearly
$5.4 trillion for the Swiss franc to about $185 trillion in euro. For
all currencies, the outstanding notional amounts were higher at the end
of the most recent three-year period as compared to the beginning of
the period.
The Commission believes that the BIS data supports the conclusion
that there exists significant outstanding notional amounts in each
currency identified in the BIS data and that there is no indication
that notional amounts in those currencies are decreasing at a rate that
would warrant elimination of those currencies from consideration for a
clearing requirement.
The TriOptima data showed that total outstanding notional amounts
as of March 16, 2012, ranged from $400 billion for Czech koruna to over
$176 trillion notional amount for euro.\124\ While there may be
sufficient outstanding notional amounts in all seventeen currencies,
the Commission noted in the NPRM that there is a clear demarcation
between the four currencies with the highest outstanding notional
amounts: euro, U.S. dollar, British pound, and yen, and all other
currencies. The four top currencies ranged from about 9% to 36% of the
total notional amount of all interest rate swaps outstanding and 11% to
33% of the total number of swap trades. The remaining currencies ranged
from about 2% down to 0.1% of the total notional amount traded and 3%
down to 0.2% of total number of trades. In fact, the four major
currencies accounted for about 93% of the total notional amount
outstanding in the TriOptima data set.
---------------------------------------------------------------------------
\124\ TriOptima data, as of March 16, 2012.
---------------------------------------------------------------------------
The ODSG data provided an indication of trading liquidity in terms
of average weekly notional amount traded and number of new trades
completed during the period covered by the data set. Of the four major
currencies, Japanese yen had the lowest weekly average notional at $323
billion and the British pound had the lowest average number of trades
each week at 1,233.
The TriOptima data provided an overall, more current view of trades
outstanding, which provides a broader picture of the trading potential
for each currency for purposes of DCO risk management. As of March 16,
2012, all but one of the seventeen currencies had outstanding trade
counts in excess of 14,000 with the exception being the Danish krone at
6,849. Again, the four highest currencies by trade count: euro, U.S.
dollar, British pound, and yen, accounted for about 85% of the total
number of trades recorded and outstanding at the time the data was
collected.
The LCH data showed that the relative notional amount and number of
swaps in each currency cleared is generally correlated with the
notional amount and number of swaps of each currency reported by the
more general market data sets. As a percentage of the total notional
amount outstanding as reported by TriOptima, LCH cleared the following
percentages: \125\
---------------------------------------------------------------------------
\125\ The TriOptima data is used for this calculation because it
is the most current data set that provides data broken out according
to the classes currently being cleared.
---------------------------------------------------------------------------
66% of euro,
61% of U.S. dollars,
58% of British pounds,
59% of Japanese yen, and
42% of other currencies.
Of the interest rate swaps identifying U.S. dollars, euro, British
pounds or yen as the applicable currency, significantly more than half
were already being cleared by LCH. While the level of clearing of other
currencies was, on a combined basis reasonably high at 42%, the
Commission noted the level is noticeably lower than the percentage of
swaps being cleared for the top four currencies.
Currency Specification Conclusion
The Commission concluded in the NPRM that all of the data sets
demonstrate the existence of significant outstanding notional amounts
and trading liquidity in the seventeen currencies identified in the IRS
submissions. However, the Commission noted that swaps using the four
currencies with the highest outstanding notional amounts and trade
frequency: euro, U.S. dollar, British pound, and yen, account for an
outsized portion of both notional amounts outstanding and trading
volumes. Furthermore, the Commission noted that these four currencies
are already being cleared more than the other currencies generally.
While it is important that this determination include a substantial
portion of the interest rate swaps traded to have a substantive,
beneficial impact on systemic risk, the Commission also recognized that
the final rule is the Commission's first swap clearing requirement
determination. As noted in the phased implementation rules for the
clearing requirement, the Commission believes that introducing too much
required clearing too quickly could unnecessarily increase the burden
of the clearing requirement on market participants. In recognition of
these considerations, the Commission determined in the NPRM to focus
the remainder of this initial clearing requirement determination
analysis on swaps referencing the four most heavily traded currencies.
The Commission noted that the decision not to include the other
thirteen currencies at this time does not limit the Commission's
authority to reconsider required clearing of those currencies in the
future.
[[Page 74309]]
LCH commented that it supports the Commission's decision to
initially limit the interest rate swap clearing determination to swaps
with USD, EUR, GBP, and JPY as the underlying currency, and recommended
that the Commission propose mandatory clearing of swaps in the other 13
currencies identified in the IRS submission after the initial phase of
the clearing requirement is well-established. LCH stated that there is
ample volume and liquidity in swaps denominated in those currencies to
support a clearing requirement determination and that it would be
beneficial for the market if the Commission would clarify whether and/
or when it plans to make clearing of swaps denominated in other
currencies mandatory.
The Commission reaffirms the conclusions in its proposed
determination to limit the interest rate swap clearing determination to
interest rate swaps with USD, EUR, GBP, and JPY as the underlying
currency, at this time. In response to LCH, the Commission reiterates
that not including interest rate swaps in the other 13 currencies in
this determination in no way forestalls the Commission from initiating
a new clearing requirement determination for interest rate swaps in
those currencies. The decision not to include them at this time was
based on the fact that this is the initial clearing requirement
determination and the Commission is mindful that market participants
will be undertaking significant activity to implement compliance for
the first time. Accordingly, the Commission has effectively delayed
consideration of these currencies so that the market will have time to
adapt to mandatory clearing of interest rate swaps in the four primary
currencies, with the expectation that thereafter, the additional
currencies can be added fairly easily. The Commission expects to
initiate a clearing determination for interest rate swaps in the 13
currencies at some time in 2013.
3. Floating Rate Index Referenced
The ODSG data and LCH data provided an indication of the rate
indices used on a transaction-by-transaction basis. Rate indexes are
currency specific. The ODSG data showed minimal activity for the EUR-
LIBOR index with about $1 billion of notional amount and five trades
made for the three month period in 2010 that the ODSG data covers. EUR-
LIBOR does not appear on the LCH data table because, although swaps
referencing that index can be cleared at LCH, LCH had no open interest
for that index as of March 31, 2012. Given the minimal notional amounts
and trade liquidity for the EUR-LIBOR index, the Commission determined
in the NPRM not to include EUR-LIBOR under the clearing requirement.
The other rate indexes all showed significant notional amounts and
trading liquidity. The rates with the least activity, the U.S. dollar
Fedfund index and British pound-LIBOR index, each have over one
trillion dollars in notional outstanding already cleared at LCH and $93
billion and $82 billion in notional amount, respectively, were cleared
per week on average. In terms of number of trades cleared at LCH, swaps
referencing Fedfunds were cleared on average 116 times per week and
swaps referencing British pound-LIBOR were cleared 888 times per week
on average. All of the other indices cleared have similar or
substantially higher numbers of trades and notional amounts cleared.
In the NPRM, the Commission noted that the rate indexes used for
over-the-counter interest rate swaps reference not only the generic
index, but a reference definition for the index such as the ISDA
definition or Reuters definition. While the Commission recognized the
importance of these reference definitions for each swap contract, the
Commission concluded that such definitions are not relevant for
purposes of the clearing requirement determination. Furthermore, if the
parties to a swap identify a specific reference definition for an
index, they need only confirm whether any eligible DCO accepts that
reference definition. If none do, then the swap in question is not
accepted for clearing and it is not subject to the clearing
requirement.
Rate Index Specification Conclusion
The Commission concluded in the NPRM that with the exception of the
EURO-LIBOR index, swaps using all of the rate indexes identified in the
IRS submissions have significant outstanding notional amounts and
trading liquidity and that significant notional amounts of swaps using
these rate indexes are already cleared by DCOs.
The Commission received no comments on the rate index specification
determination, and confirming its conclusions regarding the rate index
specifications identified in the NPRM.
4. Stated Termination Dates
Stated termination date (sometimes referred to as ``maturities'')
data is often presented by aggregating stated termination dates for
swaps into specified term periods or ``buckets.'' The IRS submissions
showed that the DCOs have been clearing interest rate swaps with final
termination dates out to at least ten years for all seventeen
currencies noted above and out to 50 years for some classes and
currencies.
Stated termination dates can fall on any day of the year. Given
this continuum of termination dates, the DCOs have indicated that they
manage the cleared swap portfolio risk using a swap curve.\126\ Swap
curves are also used by market participants to price interest rate
swaps. By pricing swaps in this way, the economic results of an
interest rate swap can be fairly closely approximated, and therefore
hedged, using two or more other swaps with different maturities
principally by matching the weighted average duration of those swaps
with the duration of the swap being hedged.\127\ In the same manner, a
large portfolio of interest rate swaps can be hedged fairly closely
with a small number of hedging swaps that have the same duration as the
entire portfolio or subsets of related swaps within the portfolio. In
effect, for DCO risk management purposes, the termination dates of
interest rate swaps are assessed based on how they affect the overall
duration aspects of the portfolio of swaps cleared.\128\ Accordingly,
the primary determination with respect to the stated termination date
specification is, for each class and currency, at what point, if any,
along the continuum of swap maturities does the notional outstanding
and trading liquidity become insufficient to structure the swap curve
effectively for DCO risk management purposes.
---------------------------------------------------------------------------
\126\ The ``swap curve'' is the term generally used by market
participants for interest rate swap pricing and is similar to, and
is sometimes established, in part, based on, ``yield curves'' used
for pricing bonds.
\127\ Other factors, such as convexity, may also be taken into
account in determining the appropriate hedge ratio between the
initial swap and the other swaps used to hedge its exposure.
\128\ For further discussion of the use of portfolio risk
management by DCOs, see the discussion of interest rate swap market
conventions and risk management in Section II.E above.
---------------------------------------------------------------------------
The TriOptima data provided sufficient detail to discern notional
amounts and trade counts only for each swap class. The ODSG data
provided sufficient detail to discern notional amounts and trade counts
only for each currency. The LCH data provided enough detail for both
swap class and currency.
The TriOptima data and LCH data summarized in the NPRM showed that
for fixed-to-floating swaps and basis swaps, there was significant
outstanding notional amounts and number of trades for all maturity
buckets being cleared.
[[Page 74310]]
For FRAs, the TriOptima data showed a steep drop off after two
years, although in the two to five year bucket, there is still over $1
trillion dollars of outstanding notional amount and 1,646 trades. The
LCH data showed substantial outstanding notional amounts of FRAs out to
two years and none thereafter. The IRS submissions provide that the
DCOs do not clear FRAs with payment dates beyond three years.
Accordingly, the Commission need not consider FRAs with maturities
beyond three years until such time as a DCO submits such swaps for
clearing.
For OIS, the TriOptima data showed notional amounts for all
maturity buckets, but the drop off was steep beyond two years. After
ten years, outstanding notional amounts drop below $100 billion for
each maturity bucket. The LCH data showed no outstanding notional
amounts cleared beyond two years. The IRS submissions provide that the
DCOs do not accept for clearing OIS swaps beyond two years.
Accordingly, the Commission did not consider OIS swaps beyond two years
in this clearing requirement determination.
The ODSG data and LCH data presented in the NPRM showed notional
amounts traded for maturity buckets by currency. There were traded and
cleared notional amounts for euro, U.S. dollars, and British pounds out
to the 30 to 50 year bucket and for yen out to the twenty to thirty
year bucket. The LCH data confirms that substantial notional amounts of
swaps in euro, U.S. dollars, and British pounds are being cleared out
to 50 years and yen out to 30 years.
Stated Termination Date Specification Conclusion
For the classes of swaps considered by the Commission in the NPRM,
the TriOptima data showed that there were significant outstanding
notional amounts and number of trades out to 50 years for fixed-to-
floating swaps and basis swaps, out to 10 years or more for OIS, and
out to 2 years for FRAs. With respect to currencies, the ODSG data and
LCH data show significant outstanding notional amounts and number of
trades in swaps out to 50 years for U.S. dollars, euro, and British
pounds and out to 30 years for yen.
Citadel noted that different tenors of the same instruments, while
displaying incrementally different characteristics, are priceable both
based on market activity and also with reference to more liquid or on-
the-run (or, as the case may be, already cleared) transactions of the
same instruments, and are risk managed using the same risk management
frameworks. Accordingly, swaps within a designated class with
incrementally different tenors do not require a new review that would
incur excessive delay. For the aforementioned reasons, the Commission
confirming its conclusions regarding required clearing for interest
rate swaps with the stated termination date specifications as proposed
in the NPRM.
5. Adequate Pricing Data
In the NPRM, the Commission took into account the adequacy of the
pricing data for the four classes of interest rate swaps. LCH stated in
its IRS submission that there is adequate pricing data for risk and
default management. It explained that its risk and default management
is based on the following factors under normal and stressed conditions:
Outstanding notional, by maturity bucket and currency;
Number of participants with live open positions, by
maturity bucket and currency;
Notional throughput of the market, by maturity bucket and
currency;
Size tradable that would not adjust the market price, by
maturity bucket;
Number of potential direct clearing members clearing the
products that are part of the mutualized default fund and default
management process;
Interplay between on-the-run and off-the-run contracts;
and
Product messaging components and structure.
LCH carries out a fire drill of its default management procedures
and readiness twice a year. According to LCH, the fire drill presents
an opportunity to further benchmark market liquidity and behavior and
for models and assumptions to be recalibrated based on practitioner
input. LCH also tests liquidity assumptions from the outset when
developing clearing capabilities for a new product and thereafter, on a
daily basis. This testing informs how LCH develops and modifies its
risk management framework to provide adequate risk coverage in
compliance with the core principles applicable to DCOs. Based on this
framework, LCH contends that there is adequate pricing data for the
swaps offered for clearing.
CME represented in its IRS submission that its interest rate swap
valuations are fully transparent and rely on pricing inputs obtained
from wire service feeds. Further, CME uses conventional pricing
methodologies, including OIS discounting, to produce its zero coupon
curve off of which cleared swaps of all stated termination dates are
priced. In addition, customers are provided with direct access to daily
reports showing curve inputs, daily discount factors, and valuations
for each cleared swap position.
It is also worth noting that those interest rate swaps that are the
subject of this proposal are capable of being priced off of deep and
liquid debt markets. Because of the stability of access to pricing data
from these markets, the pricing data for non-exotic interest rate swaps
that are currently being cleared is generally viewed as non-
controversial.
In response to the NPRM, Citadel commented that its experience
regarding trading liquidity further lead it to conclude that there is
sufficient data in the market for DCOs to perform required pricing and
risk management of the classes of swaps included in the proposed rule.
Finally, Citadel commented that access to reliable pricing data will
only improve over time as the Dodd-Frank rules promoting transparency
are implemented. No other comments were received on this factor.
Based on consideration of the existence of significant outstanding
notional exposures, trading liquidity, and adequate pricing data, as
described in the NPRM, the Commission is reaffirming in this release
its decision to include interest rate swaps with the following
specifications in the clearing requirement rule and to consider the
other four factors identified in section 2(h)(2)(D) of the CEA with
respect to these swaps.
Table 5--Interest Rate Swap Determination
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Specification Fixed-to-floating swap class
----------------------------------------------------------------------------------------------------------------
1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).
2. Floating Rate Indexes........ LIBOR............. EURIBOR........... LIBOR............. LIBOR.
3. Stated Termination Date Range 28 days to 50 28 days to 50 28 days to 50 28 days to 30
years. years. years. years.
4. Optionality.................. No................ No................ No................ No.
5. Dual Currencies.............. No................ No................ No................ No.
[[Page 74311]]
6. Conditional Notional Amounts. No................ No................ No................ No.
----------------------------------------------------------------------------------------------------------------
Specification Basis Swap Class
----------------------------------------------------------------------------------------------------------------
1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).
2. Floating Rate Indexes........ LIBOR............. EURIBOR........... LIBOR............. LIBOR.
3. Stated Termination Date Range 28 days to 50 28 days to 50 28 days to 50 28 days to 30
years. years. years. years.
4. Optionality.................. No................ No................ No................ No.
5. Dual Currencies.............. No................ No................ No................ No.
6. Conditional Notional Amounts. No................ No................ No................ No.
----------------------------------------------------------------------------------------------------------------
Specification Forward Rate Agreement Class
----------------------------------------------------------------------------------------------------------------
1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).
2. Floating Rate Indexes........ LIBOR............. EURIBOR........... LIBOR............. LIBOR.
3. Stated Termination Date Range 3 days to 3 years. 3 days to 3 years. 3 days to 3 years. 3 days to 3 years.
4. Optionality.................. No................ No................ No................ No.
5. Dual Currencies.............. No................ No................ No................ No.
6. Conditional Notional Amounts. No................ No................ No................ No.
----------------------------------------------------------------------------------------------------------------
Specification Overnight Index Swap Class
----------------------------------------------------------------------------------------------------------------
1. Currency..................... U.S. Dollar (USD). Euro (EUR)........ Sterling (GBP).
2. Floating Rate Indexes........ FedFunds.......... EONIA............. SONIA.
3. Stated Termination Date Range 7 days to 2 years. 7 days to 2 years. 7 days to 2 years.
4. Optionality.................. No................ No................ No.
5. Dual Currencies.............. No................ No................ No.
6. Conditional Notional Amounts. No................ No................ No.
----------------------------------------------------------------------------------------------------------------
b. Availability of Rule Framework, Capacity, Operational Expertise and
Resources, and Credit Support Infrastructure
Section 2(h)(2)(D)(ii)(II) of the CEA requires the Commission to
take into account the availability of rule framework, capacity,
operational expertise and resources, and credit support infrastructure
to clear the proposed classes of swaps on terms that are consistent
with the material terms and trading conventions on which they are now
traded. The Commission stated in the NPRM that it believed that LCH and
CME,\129\ have developed rule frameworks, capacity, operational
expertise and resources, and credit support infrastructure to clear the
interest rate swaps they currently clear on terms that are consistent
with the material terms and trading conventions on which those swaps
are being traded. The Commission noted that LCH already clears more
than half the global interest rate swaps in the four proposed classes
of the clearing requirement and that CME also already cleared the more
commonly traded swaps under this clearing requirement proposal. The
Commission further notes that CME has recently added, or has stated
publicly that it intends to add by the end of 2012, swaps in all four
classes and at least the four currencies included in the final rule.
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\129\ IDCH was also included in this discussion in the NPRM.
However, as discussed above, IDCH has been acquired by LCH and is
now LCH.LLC and its rules and product offering are being revised to
be substantially the same as LCH's. Accordingly, the rule
frameworks, capacity, operational expertise and resources, and
credit support infrastructure for IDCH is not discussed in this
final release, but is being assessed by the Commission as part of
LCH.LLC's request for approval of its rulebook and risk management
framework revisions.
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The Commission also noted that the DCOs each developed their
interest rate swap clearing offerings in conjunction with market
participants and in response to the specific needs of the marketplace.
In this manner, the clearing services of each DCO are designed to be
consistent with the material terms and trading conventions of a
bilateral, uncleared market.
LCH submitted that it has the capability and expertise to manage
the risks inherent in the current book of interest rate swaps cleared
and the increased volume that the clearing requirement could generate
for all of its currently clearable products. LCH has developed
operational models, controls, and risk algorithms to ensure that it can
process trades, and is capable of calculating the level of risk it has
with any counterparty--both direct clearing members and their
customers.
CME's IRS submission cited to its rule books to demonstrate the
availability of rule framework, capacity, operational expertise and
resources, and credit support infrastructure to clear qualified,
interest rate swap contracts on terms that are consistent with the
material terms and trading conventions on which the contracts are then
traded.
After considering the information provided by the DCOs in the IRS
submissions and the nature and extent of clearing already undertaken by
the DCOs of existing bilateral swaps, the Commission concluded in the
NPRM that there is available rule framework, capacity, operations
expertise and resources, and credit support infrastructure consistent
with the material terms and trading conventions on which the swaps
included in the four interest rate swap classes are designated.
Citadel commented that the fact that all swaps included in the four
interest rate swap classes are being cleared in material volumes
provides clear evidence that there is the rule framework, capacity,
operational expertise and resources, and credit support infrastructure
necessary to clear each of the swaps that are included in the
Commission's determination. Further, Citadel stated that because
registered DCOs are required to be in compliance on an on-going basis
with the DCO core principles in the CEA, they ``by definition'' have
demonstrated that they satisfy this factor. In addition, Citadel noted
that the DCOs have been preparing for and anticipating increased
volumes as a result of the clearing requirement since the enactment of
the Dodd-Frank Act, if not earlier. Also, under the Commission's
implementation rule,\130\ there is a 270-
[[Page 74312]]
day period provided to allow DCOs, customers, FCMs, and all others
engaged in the clearing process to test and ramp up customer clearing
volumes voluntarily, and be in position to manage full production
clearing volumes during the phase-in of the clearing requirement.
Citadel stated that it believed the DCOs and FCMs are well prepared for
a surge in clearing volumes and have the framework, capacity,
expertise, resources and infrastructure to support it in a safe and
sound manner and that Citadel's own experience in commencing voluntary
clearing of swaps confirms its observations.
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\130\ 77 FR at 44441-44456.
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For the reasons described above, and as discussed in the NPRM, the
Commission reaffirms that there is available rule framework, capacity,
operations expertise and resources, and credit support infrastructure
consistent with the material terms and trading conventions on which the
swaps included in the four interest rate swap classes are designated.
c. Effect on the Mitigation of Systemic Risk
Section 2(h)(2)(D)(ii)(III) of the CEA requires the Commission to
consider the effect on the mitigation of systemic risk, taking into
account the size of the market for such contract and the resources of
the DCO available to clear the contract. CME, LCH, and IDCH stated in
their IRS submissions that subjecting interest rate swaps to central
clearing would help mitigate systemic risk. As stated above in the
analysis of interest rate swap market data, the Commission believes
that the market for these swaps is significant and mitigating
counterparty risk through clearing likely would reduce systemic risk in
the swap market and the financial system as a whole.
According to LCH's IRS submission, if all clearable swaps are
required to be cleared, the inevitable result will be a less disparate
marketplace from a systemic risk perspective. CME submits that the 2008
financial crisis demonstrated the potential for systemic risk arising
from the interconnectedness of OTC derivatives market participants and
that centralized clearing will reduce systemic risk.
IDCH stated in its IRS submission that, given the tremendous size
of the interest rate derivatives market, the potential mitigation of
systemic risk through centralized clearing of interest rate swaps is
significant. IDCH asserted that clearing such swaps brings the risk
mitigation and collateral and operational efficiency afforded to
cleared and exchange-traded futures contracts to bilaterally negotiated
OTC interest rate derivatives. The submission of interest rate swaps
for clearing affords the parties the credit, risk management, capital,
and operational benefits of central counterparty clearing of such
transactions, and facilitates collateral efficiency. Cleared swaps
allow market participants to free up counterparty credit lines that
would otherwise be committed to open bilateral contracts. Additionally,
according to IDCH, an efficient system for centralized clearing allows
parties to mitigate the risk of a bilateral OTC derivative. Instead of
holding offsetting positions with different counterparties and being
exposed to the risk of each counterparty, a party may enter into an
economically offsetting position that is cleared. Although the
positions are not offset, the initial margin requirement will be
reduced to close to zero. To eliminate risk without using centralized
clearing, the party must enter into a tear-up agreement with the
counterparty, or enter into a novation.
While the clearing requirement would remove a large portion of the
interconnectedness of current OTC markets that leads to systemic risk,
the Commission noted in the NPRM that central clearing concentrates
risk in a handful of entities. However, the Commission observed that
central clearing was developed and designed to handle such
concentration of risk. LCH has extensive experience risk managing very
large volumes of interest rate swaps. Based on available data, it is
believed that about half of all interest rate swaps transacted are
cleared by LCH. CME submitted that it has the necessary resources
available to clear the swaps that are the subject of its submission.
The Commission notes that CME or its predecessors have cleared futures
since 1898 and is the largest futures clearinghouse in the world. CME
has not defaulted during that time.
Accordingly, the Commission stated in the NPRM, and reaffirms in
this release that it believes that LCH and CME have the resources
needed to clear the interest rate swaps included in its determination
and to manage the risk posed by clearing interest rate swaps that are
required to be cleared. In addition, the Commission believes that the
central clearing of the interest rate swaps that are the subject of
this determination and final rule would serve to mitigate counterparty
credit risk thereby having a positive effect on reducing systemic risk.
In support of the Commission's determination regarding systemic
risk, Citadel commented that the transition from an interconnected
network of bilateral derivatives exposures to central clearing in
regulated clearing houses will mitigate systemic risk. In support of
this assertion, Citadel cited a New York Federal Reserve Board staff
paper \131\ and noted that central clearing stands as a pillar of the
Dodd-Frank Act. Citadel explained that central clearing eliminates the
prospect of firms becoming too interconnected to fail by virtue of
their bilateral swap positions and ensures that sufficient margin is
reserved against each side of each swap, while further mitigating any
default event through mutualization funds, clearing member obligations,
and the additional financial safeguards of the regulated DCO.
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\131\ See, e.g., Policy Perspectives on OTC Derivatives Market
Infrastructure by Duffie, Li, and Lubke (March 2010), available at
http://www.newyorkfed.org/research/staff_reports/sr424.pdf.
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Citadel further asserted that the Commission's determination takes
the decisive step, long anticipated and prepared for by the market, of
making mandatory central clearing of the most liquid and standardized
swaps a reality. Citadel went on to express confidence that the
transition to required clearing of liquid swaps will support and
incentivize the expansion of the cleared product set, because it will
be more economically efficient for market participants to hold as much
of their portfolios as possible in a single margined basket at a DCO.
Citadel concluded that the Commission's clearing requirement rule thus
provides the certainty needed for market participants to transition
more of their swap portfolios from bilateral to cleared trades, thereby
reducing or eliminating bilateral counterparty credit risk, and by
extension, systemic risk.
By contrast, ISDA commented on how mandatory clearing may
centralize risk in DCOs and questioned the risk-mitigating aspects of
central clearing as contrasted with the new regulatory regime for
uncleared swaps. ISDA also questioned the Commission's assertion that
central clearing was designed to address the concentration of risk. In
response to ISDA's comment, the Commission observes that while the
regime for bilateral, uncleared swaps will be greatly improved after
full implementation of the Dodd-Frank Act reforms, central clearing
provides for certain risk management features that cannot be replicated
on a bilateral basis. To name just one critical distinction, a
clearinghouse addresses the tail risk of open positions through
mutualization. Each clearing member must contribute to a default fund
that protects the system as a whole.
[[Page 74313]]
d. Effect on Competition
Section 2(h)(2)(D)(ii)(IV) of the CEA requires the Commission to
take into account the effect on competition, including appropriate fees
and charges applied to clearing. Of particular concern to the
Commission is whether the determination would harm competition by
creating, enhancing, or entrenching market power in an affected product
or service market, or facilitating the exercise of market power. Market
power is viewed as the ability to raise price, including clearing fees
and charges, reduce output, diminish innovation, or otherwise harm
customers as a result of diminished competitive constraints or
incentives.\132\
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\132\ See Section II.D above for a more detailed discussion of
these issues.
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In the NPRM, the Commission identified one putative service market
as potentially affected by this proposed clearing determination: a DCO
service market encompassing those clearinghouses that currently (or
with relative ease in the future could) clear the interest rate swaps
subject to this proposal. The Commission recognized that, depending on
the interplay of several factors, the clearing requirement potentially
could impact competition within the affected market and discussed
various factors that could impact that market.
As discussed above, in support of the NPRM, Citadel stated that the
clearing requirement will have a strong positive impact on competition
in the swap market and the market for clearing services. Citadel noted
that central clearing will remove a significant barrier to entry for
alternative swap market liquidity providers and will enable smaller
entities to compete on more equal terms because central clearing
eliminates the consideration of counterparty credit risk from the
selection of execution counterparties. Citadel further commented that
buy-side market participants will benefit from a wider range of
potential execution counterparties and asserted that this increased
competition yields benefits to market participants including narrower
bid-ask spreads, improved access to best execution, and increased
market depth and liquidity, all of which establish a prerequisite for
the emergence of an all-to-all market with electronic and/or anonymous
execution. Citadel also commented that substitution of the DCO for the
bilateral counterparty decouples execution from post-trade processing
and settlement. Finally, Citadel commented that the certainty as to
when the first clearing requirement will begin gives DCOs and FCMs the
confidence to invest in their client clearing offerings, and to compete
actively for buy-side business both on the quality and efficiency of
their services as well as on price.
FIA commented that the NPRM included a full discussion of the
potential competitive impact of the clearing proposal. However, as
discussed above, FIA indicated that it was unable to conduct the
analysis it believes would be necessary to respond to the Commission's
questions in the NPRM within the 30-day comment period provided.
In response to FIA's comment, the Commission notes that the 30-day
public comment period was necessary for the Commission to adhere to the
CEA's 90-day determination process. Moreover, while FIA indicated that
it would like more time to conduct further analysis of competitive
issues for future determinations, FIA did not identify any specific
concerns about the competitiveness issue analysis that could materially
change the Commission's determination if such additional information
were made available to the Commission. The comments provided by Citadel
are consistent with the NPRM's conclusion that the clearing requirement
potentially could impact competition within the affected market, but go
on to assert that such an impact would not be negative. Accordingly,
the Commission believes that its consideration of competitiveness as
described in the NPRM is sufficient for purposes of finalizing the
clearing requirement rule.
e. Legal Certainty in the Event of the Insolvency
Section 2(h)(2)(D)(ii)(V) of the CEA requires the Commission to
take into account the existence of reasonable legal certainty in the
event of the insolvency of the relevant DCO or one or more of its
clearing members with regard to the treatment of customer and swap
counterparty positions, funds, and property. The Commission's proposal
was based on its view that there is reasonable legal certainty with
regard to the treatment of customer and swap counterparty positions,
funds, and property in connection with cleared swaps, namely the
interest rate swaps subject to the proposal, in the event of the
insolvency of the relevant DCO or one or more of the DCO's clearing
members.
In the case of a clearing member insolvency at CME or IDCH (now,
LCH.LLC), i.e., DCOs subject to the bankruptcy laws of the United
States, subchapter IV of Chapter 7 of the U.S. Bankruptcy Code (11
U.S.C. 761-767) and Part 190 of the Commission's regulations would
govern the treatment of customer positions.\133\ Pursuant to section
4d(f) of the CEA, a clearing member accepting funds from a customer to
margin a cleared swap, must be a registered FCM. Pursuant to 11 U.S.C.
761-767 and Part 190 of the Commission's regulations, the customer's
interest rate swap positions, carried by the insolvent FCM, would be
deemed ``commodity contracts.'' \134\ As a result, neither a clearing
member's bankruptcy nor any order of a bankruptcy court could prevent a
United States domiciled DCO from closing out/liquidating such
positions.\135\ However, customers of clearing members would have
priority over all other claimants with respect to customer funds that
had been held by the defaulting clearing member to margin swaps, such
as the interest rate swaps included in the clearing determination.\136\
Customer funds would be distributed to swap customers, including
interest rate swap customers, in accordance with Commission regulations
and section 766(h) of the Bankruptcy Code. Moreover, the Bankruptcy
Code and the Commission's rules thereunder (in particular 11 U.S.C.
764(b) and 17 CFR 190.06) permit the transfer of customer positions and
collateral to solvent clearing members.
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\133\ The Commission observes that an FCM or DCO also may be
subject to resolution under Title II of the Dodd-Frank Act to the
extent it would qualify as covered financial company (as defined in
section 201(a)(8) of the Dodd-Frank Act).
\134\ If an FCM is also registered as a broker-dealer, certain
issues related to its insolvency proceeding would also be governed
by the Securities Investor Protection Act.
\135\ See 11 U.S.C. 556 (``The contractual right of a commodity
broker [which term would include a DCO or FCM] * * * to cause the
liquidation, termination or acceleration of a commodity contract * *
* shall not be stayed, avoided, or otherwise limited by operation of
any provision of [the Bankruptcy Code] or by order of a court in any
proceeding under [the Bankruptcy Code]'').
\136\ See 11 U.S.C. 766(h).
---------------------------------------------------------------------------
Similarly, 11 U.S.C. 761-767 and Part 190 would govern the
bankruptcy of a DCO, in conjunction with DCO rules providing for the
termination of outstanding contracts and/or return of remaining
clearing member and customer property to clearing members.
With regard to LCH, the Commission understands that the default of
a clearing member of LCH would be governed by the rules of that DCO.
LCH, a DCO based in the United Kingdom, has represented that under
English law its rules would supersede English insolvency laws. Under
its rules, LCH would be permitted to close out and/or transfer
positions of a defaulting clearing member that is an FCM
[[Page 74314]]
pursuant to the U.S. Bankruptcy Code and Part 190 of the Commission's
regulations. According to LCH's submission, the insolvency of LCH
itself would be governed by both English insolvency law and Part 190.
LCH has obtained legal opinions that support the existence of such
legal certainty in relation to the protection of customer and swap
counterparty positions, funds, and property in the event of the
insolvency of one or more of its clearing members. In addition, LCH has
obtained a legal opinion from U.S. counsel regarding compliance with
the protections afforded to FCM customers under New York law.
In response to the NPRM, Citadel commented that it agreed with the
Commission's analysis that reasonable certainty exists in the event of
an insolvency of a DCO or one or more DCO members. As discussed above,
the Commission received three comments related to customer segregation.
In essence, Vanguard and SIFMA AMG recommend that the Commission delay
implementation of the clearing requirement until three months after the
LSOC model is implemented, clarified, and perhaps supplemented with
additional rulemaking. ISDA requests that the Commission further study
the issue of insolvency for DCOs.
As stated above, the Commission believes that the concerns of
Vanguard and SIFMA AMG are largely addressed by the delayed
implementation timeframe for this determination. With regard to ISDA's
request, as discussed above, the Commission is actively engaging in
efforts to study and prepare for potential scenarios involving
clearinghouse and clearing member insolvency.
iii. Conclusions Regarding the Five Statutory Factors and Clearing
Requirement Determination
In the foregoing discussion and analysis, the Commission has taken
into account each of the five factors provided for under section
2(h)(2)(D)(ii) of the CEA for the interest rate swap classes that are
the subject of this determination. Based on these considerations, and
having reviewed the relevant DCOs' submissions for consistency with
section 5b(c)(2) of the CEA, the Commission is determining that the
four classes of interest rate swaps identified in Sec. 50.4(a) are
required to be cleared.
III. Final Rules
The Commission is adopting the following rules under section
2(h)(2), as well as its authority under sections 5b(c)(2)(L) and 8a(5)
of the CEA. In issuing a determination regarding whether a swap or
class of swaps is required to be cleared, ``the Commission may require
such terms and conditions to the requirement as the Commission
determines to be appropriate.'' \137\
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\137\ Section 2(h)(2)(D)(iii) of the CEA.
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A. Regulation 50.1: Definitions
As proposed, Sec. 50.1 set forth two defined terms: ``business
day'' and ``day of execution.'' The definition of business day excluded
Saturdays, Sundays, and legal holidays. The definition of ``day of
execution'' served as a means of addressing situations where executing
counterparties are located in different time zones. It was intended to
avoid difficulties associated with end-of-day trading by deeming swaps
executed after 4:00 p.m., or on a day other than a business day, to
have been executed on the immediately succeeding business day. The
Commission recognized that market participants should not be required
to maintain back-office operations 24 hours a day or 7 days a week in
order to meet the proposed deadline for submitting swaps that are
required to be cleared to a DCO. The Commission also was attempting to
be sensitive to possible concerns about timeframes that may discourage
trade execution late in the day. To account for time-zone issues, the
``day of execution'' was defined to be the calendar day of the party to
the swap that ends latest, giving the parties the maximum amount of
time to submit their swaps to a DCO while still requiring such
submission on a same-day basis.
The Commission received two comments on these definitions. LCH
commended the Commission for including flexibility on the timing of
swap submission for those swaps executed late in the day, but requested
that the Commission clarify that DCOs can continue to accept swaps for
clearing late in the day. In response to this request, the Commission
confirms that the 4:00 p.m. cut off for same-day submission to a DCO is
intended to give market participants flexibility and respond to
concerns about counterparties in different time zones. This definition
should not be interpreted as a prohibition on late-day submission of
swaps to DCOs or as impeding DCO's ability to accept such swaps.
FIA observed an apparent conflict between the proposed definitions
of ``business day'' and ``day of execution'' and regulation
23.506(b).\138\ As with LCH, FIA's concern focused on the ability of
DCOs to expand their business hours. As explained above, the
definitions do not proscribe a DCO's ability to set business hours.
Accordingly, the Commission is adopting the definitions as proposed.
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\138\ This regulation directs swap dealers and major swap
participants to submit swaps subject to the clearing requirement to
a DCO as soon as technologically practicable after execution, but no
later than the close of business on the day of execution. See 17 CFR
23.506(b), 77 FR 21278, 21307 (Apr. 9, 2012). To the extent that a
swap dealer or major swap participant is subject to both Sec.
23.506(b) and Sec. 50.2(a), the entity should comply with Sec.
23.506(b) when its counterparty is another swap dealer or major swap
participant, but if the swap is between a swap dealer and a non-swap
dealer, then the non-swap dealer counterparty can elect to follow
the timing requirements of Sec. 50.2(a) or Sec. 23.506(b).
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B. Regulation 50.2: Treatment of Swaps Subject to a Clearing
Requirement
As proposed, Sec. 50.2(a) required all persons, other than those
who elect the exception in accordance with Sec. 39.6 (now Sec.
50.50),\139\ to submit a swap that is part of the class described in
Sec. 50.4 for clearing by a DCO as soon as technologically practicable
and no later than the end of the day of execution. The objective of
this provision was to ensure that swaps subject to a clearing
requirement are submitted to DCOs for clearing in a timely manner.
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\139\ The Commission is recodifying Sec. 39.6 as Sec. 50.50 so
that market participants are able to locate all rules related to the
clearing requirement in one part of the Code of Federal Regulations.
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ISDA recommended that the Commission clarify the rule text to
recognize that non-clearing members are deemed to have met the
requirements of Sec. 50.2 once they submit the swap to their FCM
clearing member. ISDA also requested that the Commission recognize that
in some cross-border transactions clearing members will not necessarily
be FCMs. Similarly, ISDA asked that there be an exclusion for foreign
governments and governmental entities as set forth in the end-user
exception final rulemaking. Lastly, ISDA asked that there be an
exception in the rule for system outages and force majeure events.
In response to ISDA's first comment, the Commission is modifying
the rule text by adding new paragraph (c) to clarify that submission of
a swap to an FCM or a DCO clearing member is sufficient to meet the
timeliness requirements of the rule. For U.S. customers, this will mean
submission to a registered FCM. For cross-border transactions, the
Commission recognizes that submission of the swap may be to a non-FCM
clearing member when the customer is not a U.S. person.\140\
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\140\ If the person submitting the swap is a customer, as Sec.
1.3(k) defines that term, then only a registered FCM may accept that
swap for clearing, even if the customer seeks to clear the swap on a
DCO located outside of the U.S.
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[[Page 74315]]
With regard to foreign governments and governmental entities, the
Commission reiterates the position taken in the end-user exception
rulemaking that ``foreign governments, foreign central banks, and
international financial institutions should not be subject to Section
2(h)(1) of the CEA.'' \141\ Finally, the Commission declines to include
an explicit exception for unforeseen outages and other events. The
Commission recognizes that these situations may occur and has adopted
rules relating to system safeguards and disaster recovery for market
infrastructures \142\ and market participants.\143\ However, none of
the straight-through-processing rules adopted by the Commission
included carve-outs for system outages or force majeure events,\144\
and the Commission does not believe it is necessary to include such
provisions in this rule. In the case of serious market-wide
disruptions, the Commission would take this mitigating fact into
account in reviewing compliance with Sec. 50.2.
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\141\ See End-User Exception to the Clearing Requirement for
Swaps, 77 FR 42560, 42562 (July 19, 2012).
\142\ See, e.g., Derivatives Clearing Organization General
Provisions and Core Principles, 76 FR 69334, 69443-69444 (Nov. 8,
2011) (adopting Sec. 39.18 relating to system safeguards).
\143\ See Swap Dealer and Major Swap Participant Recordkeeping,
Reporting, and Duties Rules, 77 FR 20128, 20208-20209 (Apr. 3, 2012)
(adopting Sec. 23.603 relating to business continuity and disaster
recovery).
\144\ Customer Clearing Documentation, Timing of Acceptance for
Clearing, and Clearing Member Risk Management, 77 FR 21278, 21307
(Apr. 9, 2012).
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Additionally, in an effort to clarify that a market participant
does not have to submit a swap that falls within the Sec. 50.4
classes, but that the entity knows are not offered for clearing by any
DCO because the swap contains specifications that are not accepted for
clearing, the Commission is modifying the text of Sec. 50.2 to include
a reference to ``eligible'' DCOs that offer such swaps for clearing.
Proposed Sec. 50.2(b) would require persons subject to Sec.
50.2(a) to undertake reasonable efforts to determine whether a swap is
required to be cleared. In the NPRM, the Commission indicated that it
would consider such reasonable efforts to include checking the
Commission's Web site or the DCO's Web site for verification of whether
a swap is required to be cleared, or consulting third-party service
providers for such verification.
CME commented on the Commission's observation in the NPRM that DCOs
could design and develop systems that will enable market participants
and trading platforms to check whether or not their swap is subject to
a clearing requirement and be provided with an answer within seconds
(or faster). CME stated that its platform already provides market
participants with a tool to screen a particular swap for eligibility
for clearing upon submission to CME. The Commission recognizes that
this technological capability will be beneficial to market
participants, particularly pre-execution, and is necessary to ensure
timely clearing of swaps subject to the clearing requirement.
Freddie Mac observed that Sec. 50.2(a) and (b) could be
interpreted to require two different standards of care: strict
liability for the former and a reasonable inquiry standard for the
latter. In response to Freddie Mac's comment, the Commission clarifies
that Sec. 50.2(a) establishes a requirement regarding the timely
submission of swaps to DCOs. It is a bright-line standard, but it is
not intended to introduce a new scienter requirement regarding
submission for clearing beyond that provided for in the statute.\145\
With regard to Sec. 50.2(b), the Commission's objective was to afford
market participants clarity about what efforts they must expend in
determining whether their swaps are required to be cleared. In the
absence of some central screening mechanism available to all market
participants for the purpose of immediately determining whether any
eligible DCO offers a particular swap for clearing,\146\ the Commission
believes it appropriate to provide clarity regarding what constitutes
reasonable search or verification efforts.\147\
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\145\ See Section III.G for further discussion regarding
scienter.
\146\ See discussion in Section II.E regarding LCH's and CME's
efforts to provide such a screening mechanism.
\147\ The Commission notes that it will consider whether
verification efforts are reasonable in light of all the facts and
circumstances of a market participant's particular situation.
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C. Regulation 50.3: Notice to the Public
The Commission proposed Sec. 50.3(a) to require each DCO to post
on its Web site a list of all swaps that it will accept for clearing
and clearly indicate which of those swaps the Commission has determined
are required to be cleared pursuant to part 50 of the Commission's
regulations and section 2(h)(1) of the CEA.
ISDA commented that DCOs should provide swap information, including
product specifications, in a manner that is easy to access and use.
ISDA also called upon DCOs to provide at least one-month's advance
notice for new swaps that they plan to accept for clearing and to
provide a description of the margin methodology used in clearing the
swap. The Commission agrees that DCOs should provide information in a
manner that is easy to use and accessible to the public. Regulation
Sec. 50.3(b) builds upon the requirements of Sec. 39.21(c)(1), which
requires each DCO to disclose publicly information concerning the terms
and conditions of each contract, agreement, and transaction cleared and
settled by the DCO. The Commission also welcomes ISDA's suggestion that
DCOs voluntarily provide advance notice of new swaps that they plan to
clear and make relevant information regarding their margining
methodologies available.\148\
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\148\ 17 CFR 39.21 requires that DCOs provide market
participants with ``sufficient information to enable the market
participants to identify and evaluate accurately the risks and costs
associated with using the services'' of the DCO.
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LCH commented that it is committed to revising the information on
its Web site so that it is provided in a format that is easily
understandable by all swaps counterparties, including customers.
Regulation Sec. 50.3(b) requires the Commission to post on its Web
site a list of those swaps it has determined are required to be cleared
and all DCOs that are eligible to clear such classes of swaps. No
comments were received on this provision. The Commission is adopting
the rule as proposed in order to provide market participants with
sufficient notice regarding which swaps are subject to a clearing
requirement. For clarification, the Commission will include on its Web
site any swaps that it has determined through delegated authority under
Sec. 50.6 fall within a class of swaps described in Sec. 50.4.
D. Regulation 50.4: Classes of Swaps Required To Be Cleared
As discussed at length above, proposed Sec. 50.4 set forth the
classes of interest rate swaps and CDS that the Commission proposed for
required clearing. Proposed Sec. 50.4(a) included a table listing
those types of interest rate swaps the Commission would require to be
cleared, and proposed Sec. 50.4(b) included a table listing those
types of CDS indices the Commission would require to be cleared.
ISDA recommended that the Commission clarify that the stated
termination date ranges in Sec. 50.4(a) be applied only at trade
inception for purposes of determining whether the swap is required to
be cleared. The Commission confirms ISDA's
[[Page 74316]]
understanding of the stated termination date range applying only at
trade inception or upon an ownership event change, as discussed in
detail below.
As discussed above, the Commission is adopting Sec. 50.4(a) and
(b). The Commission believes that this format provides market
participants with a clear understanding of which swaps are required to
be cleared. By using basic specifications to identify the swaps subject
to the clearing requirement, counterparties contemplating entering into
a swap can determine quickly as a threshold matter whether or not the
particular swap may be subject to a clearing requirement. If the swap
has the basic specifications of a class of swaps determined to be
subject to a clearing requirement, the parties will know that they need
to verify whether an eligible DCO will clear that particular swap. This
will reduce the burden on swap counterparties related to determining
whether a particular swap may be subject to the clearing requirement.
i. Disentangling Complex Swaps
TriOptima commented that the complete swap must be assessed against
the clearing requirement and parties should not be required to
disentangle non-clearable swaps in order to clear the clearable
components. The Commission confirms TriOptima's view regarding those
swaps that may have components that can be cleared, but would require
disentangling the clearable part of the swap. Adherence to the clearing
requirement does not require market participants to structure their
swaps in a particular manner or disentangle swaps that serve legitimate
business purposes.\149\
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\149\ See discussion below regarding Sec. 50.10 and the evasion
and abuse standards.
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ii. Swaptions and Extendible Swaps
In response to the Commission's inquiry in the NPRM regarding how
to treat a swap that becomes effective upon the exercise of a swaption,
ISDA suggested that the resulting swap should only be required to be
cleared if the underlying swap and the counterparties to the swap were
subject to a clearing requirement at the time that the swaption was
executed. ISDA also commented that the same approach should apply to
extendible swaps, i.e., a swap for which a party has the option to
extend the term of the swap. ISDA reasoned that the parties to a
swaption or an extendible swap would not have taken into account the
cost of clearing the resultant swap if they negotiated the price of the
option before a clearing requirement was applicable to the underlying
swap or extended swap. LCH similarly commented that a swaption entered
into before a clearing requirement is applicable to the underlying swap
would not have been priced with an expectation that the swap created on
exercise would be cleared. For this reason, LCH also stated that an
underlying swap of a swaption should be subject to an applicable
clearing requirement only if the swaption was entered into after the
clearing requirement applicable to the underlying swap becomes
effective.
The Commission agrees that the cost of clearing may not be
reflected in the pricing of the swaption or extendible swap if the
clearing requirement for the underlying swap or the extendable swap
arises after the execution of the swaption or extendible swap. The
Commission is thus clarifying that the clearing requirement only
applies to swaps resulting from the exercise of a swaption or
extendible swap extension if the clearing requirement would have been
applicable to the underlying swap or the extended swap at the time the
counterparties executed the swaption or extendible swap.
iii. Ownership Event Changes
In the NPRM, the Commission asked whether it should clarify that
the clearing requirement applies to all new swaps and changes in the
ownership of a swap, including assignment, novation, exchange,
transfer, or conveyance. ISDA responded that a swap that is not subject
to the clearing requirement at the time it is executed should not
become subject to it upon an ownership event change unless the parties
can agree on pricing and other terms necessary to reflect the costs of
clearing and until the swap can be transitioned from uncleared to
cleared with accuracy.\150\
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\150\ Aside from a general assertion about the challenges of
selecting a DCO for clearing, ISDA did not elaborate on its implied
assertion that swaps subject to ownership changes may be difficult
to transition to clearing accurately.
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As the Commission acknowledged above, the cost of clearing may not
be reflected in the pricing of a swap if the clearing requirement
arises after the execution of that swap. However, unlike with the
exercise of a swaption, typically, the original counterparties to a
swap that is assigned, novated, exchanged, transferred, or conveyed,
along with the new party in ownership, each have an opportunity to
revisit the terms of the original swap and account for new costs.\151\
While there may be cost implications for the remaining party when its
counterparty changes, these cost implications can arise for any number
of foreseeable or unforeseeable reasons,\152\ and if the remaining
party is concerned about potential cost implications resulting from a
change of its counterparty, it would be able to protect itself through
the terms of the swap, such as including consent rights or required
price adjustments upon such an event.\153\ The Commission is concerned
that if such swaps are not treated as new swaps for the purposes of the
clearing requirement, it could be creating incentives to ``trade''
historical swaps through the assignment, novation, exchange, transfer,
or conveyance processes to avoid required clearing. Accordingly, for
purposes of this rule, a change in ownership of a swap would subject
the swap to required clearing under section 2(h)(1) of the CEA in the
same manner and to the same extent as a newly executed swap.
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\151\ Going forward, prior to or at the time of ownership
change, parties will have to account for any additional costs of
clearing.
\152\ For example, an ownership change for a bilateral swap may
have foreseeable or unforeseeable credit or tax implications for the
remaining party.
\153\ The Commission observes that the ISDA Master Agreement
used for most bilateral swaps requires the prior written consent of
the remaining party for any transfer of the agreement other than for
certain limited transfers of payments upon default or upon a merger,
acquisition, or transfer of all assets.
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Furthermore, for swaps executed after the clearing requirement is
in place, the Commission also believes it is important to clarify that
a change in ownership may result in a requirement to clear. For
example, a financial entity and an end user under section 2(h)(7) of
the CEA enter into a swap that is not required to be cleared, and later
if the end user transfers its ownership interest in the swap to another
party that is a financial entity not eligible to claim an exception
under section 2(h)(7), then the swap would be required to be cleared if
the other prerequisites to the requirement exist.
E. Regulation 50.5: Clearing Transition Rules
As proposed, Sec. 50.5 would codify section 2(h)(6) of the CEA.
Under proposed Sec. 50.5(a), swaps that are part of a class described
in Sec. 50.4 but were entered into before the enactment of the Dodd-
Frank Act would be exempt from clearing so long as the swap is reported
to an SDR pursuant to Sec. 44.02 and section 2(h)(5)(A) of the CEA.
Similarly, under proposed Sec. 50.5(b), swaps entered
[[Page 74317]]
into after the enactment of the Dodd-Frank Act but before the
application of the clearing requirement would be exempt from the
clearing requirement if reported pursuant to Sec. 44.03 and section
2(h)(5)(B) of the Act.
LCH suggested that the Commission change the citations in Sec.
50.5(a) from Sec. 44.02 to Sec. 46.3, and in Sec. 50.5(b) from Sec.
44.03 to Sec. 45.3 for swaps entered after the enactment of the Dodd-
Frank Act but prior to the compliance date for reporting to an SDR and
to Sec. 45.3 for swaps entered into after the compliance date for SDR
reporting but prior to the application of a clearing requirement. The
Commission agrees with LCH and is modifying the rule to provide more
accurate cross references to parts 45 and 46. In addition, under Sec.
50.5(b), the Commission cross references Sec. 46.3 or Sec. 45.3, as
appropriate, because until April 2013, certain market participants may
properly rely on Sec. 46.3 for reporting swaps executed after the
enactment of the Dodd-Frank Act.
F. Regulation 50.6: Delegation of Authority
Under proposed Sec. 50.6(a), the Commission would delegate to the
Director of the Division of Clearing and Risk, or the Director's
designee, with the consultation of the General Counsel or the General
Counsel's designee, the authority to determine whether a swap falls
within a class of swaps described in Sec. 50.4 and to communicate such
a determination to the relevant DCOs.
ICE supported the Commission's proposal and agreed that this
approach would allow DCOs to add new swaps in a timely and efficient
manner and rely on the DCOs' risk management processes and governance
for adding new products to an existing class. Citadel also supported
the proposed delegation provision based on the view that the Commission
carefully oversees DCO risk management and it is beneficial to move
products into clearing without excessive delay. LCH generally supported
the Commission's proposal, but requested confirmation that if the DCO
makes a material change to an existing type of swap, the Commission
would follow the full clearing requirement determination process.
By contrast, ISDA objected to proposed Sec. 50.6 based on a
concern that the Commission would be delegating the clearing
determination for DCO product expansions to the DCOs themselves, which
would contradict the requirement that the Commission review each DCO
submission under section 2(h)(2)(B)(iii)(II) of the CEA. Based on the
breadth of the swaps classes under Sec. 50.4, ISDA commented that DCOs
will be able to add new swaps under the clearing requirement without
review by the Commission under the five statutory factors. ISDA
recommended that the delegation provision be supplemented to include
(1) a requirement that new DCO product offerings raise no materially
different considerations regarding the Commission's determination; (2)
a public comment period; and (3) a compliance phase-in period of 90
days.
In response to LCH's request for clarification, the Commission
confirms that if a DCO makes a material change to an existing type of
swap, the Commission would follow the full clearing requirement
determination process. Under the example provided by LCH--extending the
tenor of swaps clearing--the DCO's change would require a change to the
rule text under Sec. 50.4, which would require Commission action.
In response to ISDA's comments, the Commission observes that the
proposed delegation provision was not intended to displace Commission
review under section 2(h)(2)(B)(iii)(II) of the CEA. With respect to
swaps within the classes identified in Sec. 50.4 that are already
being cleared by at least one DCO, the delegation provision will
facilitate other DCOs' ability to offer new swaps for required clearing
so long as those swaps fall within one of the classes previously
established by the Commission. With respect to swaps that meet the
specifications identified in Sec. 50.4, but have not been previously
offered for clearing by any DCO, the Commission agrees with ISDA that
the delegation is limited to those swaps that are consistent with the
prior determination. For instance, if a new swap falls within a class
under Sec. 50.4, but clearing the swap requires that DCOs adopt a new
margining methodology or pricing methodology, the Commission would
subject that swap to a new clearing requirement determination
process.\154\ Accordingly, the Commission is modifying the rule to
limit the delegation authority to those instances where the newly
submitted swap falls within the class under Sec. 50.4 and is
consistent with the Commission's clearing requirement determination for
that class of swaps. In addition, the Commission is modifying the rule
to require that the Director of the Division of Clearing and Risk
notify the Commission prior to exercising any authority delegated under
Sec. 50.6.
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\154\ Without this delegation process a new swap that falls
within a class under Sec. 50.4 could have automatically been
included in the clearing requirement without review. The delegation
provision provides a check on that process.
---------------------------------------------------------------------------
The Commission declines to adopt ISDA's other recommendations.
Provided that inclusion of the new swaps under Sec. 50.4 is consistent
with the Commission's previous clearing requirement determination,
there is no need for an additional public comment period beyond that
provided for as part of the initial clearing requirement determination
process. Moreover, under the CEA and Commission regulation, any
counterparty to a swap can apply for a stay of the clearing
requirement.\155\ This stay provision would serve to notify the
Commission of objections to inclusion of a particular swap in a
previously-defined class. In addition, the Commission does not believe
that an additional phase-in period is necessary. Provided that
including the new swap is consistent with the prior determination, the
compliance phasing for the original class will afford sufficient time
for operational and systems implementation. If such time had not been
sufficient, the Director of the Division of Clearing and Risk could
submit the matter to the Commission for its consideration, or the
Commission could itself exercise the delegated authority, under Sec.
50.6(b).
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\155\ See section 2(h)(3) of the CEA and regulation 39.5(d).
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G. Regulation 50.10: Prevention of Evasion of the Clearing Requirement
and Abuse of an Exception or Exemption to the Clearing Requirement
The Commission proposed Sec. 50.10 under the rulemaking authority
in sections 2(h)(4)(A), 2(h)(7)(F), and 8a(5) of the CEA. Proposed
Sec. 50.10 would prohibit evasions of the requirements of section 2(h)
of the CEA and abuse of any exemption or exception to the requirements
of section 2(h), including the end-user exception or any other
exception or exemption that the Commission may provide by rule,
regulation, or order.\156\
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\156\ As noted in the proposing release, the Commission
preliminarily viewed evasion of the clearing requirement and abuse
of an exemption or exception to the clearing requirement, including
the end-user exception, to be related concepts and are informed by
new enforcement authority under the Dodd-Frank Act, which added new
sections 6(e)(4)-(5), and 9(a)(6), to the CEA. See Proposed Clearing
Requirement Determination, 77 FR 47170, 47207 (Aug. 7, 2012).
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Proposed Sec. 50.10(a) would make it unlawful for any person to
knowingly or recklessly evade, participate in, or facilitate an evasion
of any of the requirements of section 2(h).\157\ This
[[Page 74318]]
would apply to any requirement under section 2(h) of the CEA or any
Commission rule or regulation promulgated thereunder.\158\ In the
proposing release, the Commission noted, however, that section
2(h)(1)(A) of the CEA provides that it ``shall be unlawful for any
person to engage in a swap unless that person submits such swap for
clearing'' to a DCO if the swap is required to be cleared. Unlike the
knowing or reckless standard under proposed Sec. 50.10(a), section
2(h)(1)(A) imposes a non-scienter standard on swap market
participants.\159\
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\157\ Proposed Sec. 50.10(a) was informed by and consistent
with section 6(e)(4) and (5) of the CEA, which states that any DCO,
swap dealer, or major swap participant that ``knowingly or
recklessly evades or participates in or facilitates an evasion of
the requirements of section 2(h) shall be liable for a civil
monetary penalty in twice the amount otherwise available for a
violation of section 2(h).''
\158\ These requirements include the clearing requirement under
section 2(h)(1), reporting of data under section 2(h)(5), and the
trade execution requirement under section 2(h)(8), among other
requirements. For example, it would be a violation of proposed Sec.
50.10(a) for a SEF to knowingly or recklessly evade or participate
in or facilitate an evasion of the trade execution requirement under
section 2(h)(8).
\159\ Any person engaged in a swap that would be required to be
cleared under section 2(h) and Part 50 of the Commission's
Regulations, and such person did not submit the swap for clearing,
absent an exemption or exception, would be subject to a Commission
enforcement action regardless of whether the person knowingly or
recklessly failed to submit the swap for clearing.
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Proposed Sec. 50.10(b) would make it unlawful for any person to
abuse the end-user exception to the clearing requirement as provided
under section 2(h)(7) of the CEA and Sec. 39.6 (now Sec. 50.50).\160\
The proposing release stated that an abuse of the end-user exception to
the clearing requirement may also, depending on the facts and
circumstances, be an evasion of the requirements of section 2(h). The
Commission's preliminary view was informed by section 9(a)(6) of the
CEA, which cross-references both the prevention of evasion authority in
section 2(h)(4) and prevention of abuse to the exception to the
clearing requirement in section 2(h)(7)(F).\161\ Thus, the Commission
proposed to interpret a violation of section 9(a)(6) of the CEA to also
be a violation of proposed Sec. 50.10(b).
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\160\ See End-User Exception to the Clearing Requirement for
Swaps, 77 FR 42560 (July 19, 2012).
\161\ Proposed Sec. 50.10(b) is adopted under the authority in
both section 2(h)(4)(A) and section 2(h)(7)(F).
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Proposed Sec. 50.10(c) would make it unlawful for any person to
abuse any exemption or exception to the requirements of section 2(h) of
the CEA, including any exemption or exception, as the Commission may
provide by rule, regulation, or order.\162\
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\162\ This provision was informed by the Dodd-Frank Act
amendments in section 2(h)(4)(A) to prescribe rules necessary to
prevent evasions of the clearing requirements; section 2(h)(7)(F) to
prescribe rules necessary to prevent abuse of the exceptions to the
clearing requirements; and the Commission's general rulemaking
authority in section 8a(5) to promulgate rules that, in the judgment
of the Commission, are reasonably necessary to accomplish any
purposes of the CEA.
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In the preamble to the NPRM, the Commission proposed to adopt a
``principles-based'' approach to applying proposed Sec. 50.10 and
declined to provide a bright-line test of non-evasive or abusive
conduct, because such an approach may be a roadmap for engaging in
evasive or abusive conduct or activities. The Commission, however, did
propose additional guidance to provide clarity to market participants.
The Commission proposed to determine on a case-by-case basis in light
of all the relevant facts and circumstances, whether particular
transactions or other activities constitute a violation of Sec. 50.10.
Similar to its approach in the final rules further defining the term
``swap'' (the ``Product Definition Rules''), the Commission proposed
that it would not consider transactions or other activities structured
in a manner solely motivated by a legitimate business purpose to
constitute evasion or abuse.\163\
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\163\ The Commission's discussion of Sec. 50.10 is similar to
its approach for the anti-evasion rules Sec. Sec. 1.3(xxx)(6) and
1.6 that it recently adopted in a joint final rulemaking with the
Securities and Exchange Commission. See Further Definition of
``Swap,'' ``Security-Based Swap,'' and ``Security-Based Swap
Agreement''; Mixed Swaps; Security-Based Swap Agreement
Recordkeeping, 77 FR 48208, 48350-48354 (Aug. 13, 2012).
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i. In General
Four commenters discussed different aspects of proposed Sec.
50.10, including the standard of intent that proposed Sec. 50.10
requires and the proposed legitimate business purpose guidance. After
considering the comments as discussed more fully below, the Commission
has determined that Sec. 50.10 is necessary to prevent evasion of the
requirements of section 2(h) and abuses of any exemption or exception
to the requirements of section 2(h). Therefore, the Commission is
adopting Sec. 50.10 as proposed, but the Commission is providing
additional interpretive guidance regarding Sec. 50.10 as set out
below.
ii. Standard of Intent
Two commenters discussed the relevant standard of intent for
proposed Sec. 50.10. ISDA commented that Sec. 50.10(a), (b), and (c)
should be governed by a single standard of intent. ISDA noted that
proposed Sec. 50.10(a) would make it unlawful for any person to
``knowingly or recklessly'' evade the requirements of section 2(h);
whereas, proposed Sec. 50.10(b) and (c) would make it unlawful to
``abuse'' exceptions or exemptions to the requirements of section 2(h).
ISDA requested the Commission clarify that all three provisions are
subject to a scienter standard.
FreddieMac commented that the statutory ``knowing or reckless''
standard for evasion indicates that Congress intended that parties to a
swap should be deemed in compliance with the clearing requirement at
least where they have submitted a swap for clearing in good faith and
have a reasonable expectation of clearing.
In consideration of the comments, the Commission clarifies that it
interprets the ``knowingly or recklessly'' standard in Sec. 50.10(a)
to be the same as the ``abuse'' standard in Sec. 50.10(b) and (c). The
Commission believes that a ``knowingly or recklessly'' standard is
consistent with and an appropriate standard of intent for any ``abuse''
of any exemption or exception to the requirements of section 2(h).
Additionally, the purpose of Sec. 50.10 is to prevent evasion of the
requirements under section 2(h) or to prevent an abuse of an exception
or exemption to the requirements under section 2(h). Therefore, the
Commission confirms that it would not constitute a violation of Sec.
50.10 where a party submits a swap for clearing in good faith and the
party has a reasonable expectation of clearing.
iii. Legitimate Business Purpose
Four commenters discussed the proposed guidance on what constitutes
a legitimate business purpose. TriOptima supported the proposed
principles-based approach to prevent evasion and the proposed guidance.
TriOptima also requested the Commission clarify that activities and
transactions carried out for the purpose of reducing counterparty
credit risk constitute a legitimate business purpose.
FreddieMac commented that the proposing release creates ambiguity
as to the circumstances in which a swap is required to be submitted for
clearing. In particular, FreddieMac commented that the NPRM appears to
represent the Commission's view that swaps that differ in regard to
``mechanical'' terms may be sufficiently close substitutes such that
parties may be required to use such a ``substitute swap'' (where one is
available) that is subject to a clearing
[[Page 74319]]
requirement.\164\ FreddieMac asserted that the Commission should not
pre-judge when a swap that is required to be cleared is a close
substitute for a swap that is not subject to a clearing requirement.
Furthermore, FreddieMac commented that the Commission should clarify
that a swap that would otherwise be required to be cleared but for a
variation in one or more material contract terms should not also be
required to be submitted for clearing, provided that such variation of
the terms is for legitimate business purposes.
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\164\ See NRPM at 47191, fn. 97 (discussing a category of
interest rate swap specifications ``that are commonly used to
address mechanical issues'').
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In response to the proposed guidance, ISDA asserted that the
Commission did not clearly respond to its comment to the Product
Definition Rules that variations based on considerations of the costs
and burdens of regulation should be considered to have a legitimate
business purpose.\165\ ISDA requested the Commission clarify that if a
business has a choice, in the absence of fraud, deceit, or unlawful
activity, of entering into an uncleared swap, rather than a cleared
swap, ``because [the uncleared swap] is cheaper, or free of unwanted
aspects of clearing or trading, then that choice should be identified
by the Commission as legitimate.'' ISDA also asserted that presence of
fraud, deceit, or unlawful activity is a proper prerequisite to evasion
or abuse violations. Furthermore, ISDA argued that market participants
will be subject to constant uncertainty when structuring and
transacting in markets that offer legitimate alternatives if the
proposal were adopted.
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\165\ See Product Definition Rules, 77 FR at 48302, fn. 1052.
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The Commission is guided by the central role that clearing plays
under the Dodd-Frank Act. As noted in the proposing release, ``the
requirement that swaps be cleared by DCOs is one of the cornerstones of
that reform.'' \166\ But even given the importance of central clearing
as a means to mitigate counterparty credit risk, reduce systemic risk,
and protect U.S. taxpayers, the Commission accepts that a person may
have legitimate business purposes for entering into swaps that are not
subject to the clearing requirement.
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\166\ NPRM at 47171.
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In that regard, commenters requested that the Commission confirm
that considering the costs and burdens of regulation, or reduction of
counterparty credit risk, are legitimate business purposes. As stated
in the proposing release, the Commission will not provide a bright-line
test of non-evasive or abusive conduct because such an approach may be
a roadmap for engaging in evasive or abusive conduct or
activities.\167\ The Commission expects, however, that a person acting
for legitimate business purposes will naturally weigh many costs and
benefits associated with different transactions, including different
swap classes and swap specifications that may or may not be subject to
the clearing requirement. Therefore, the Commission clarifies that a
person's specific consideration of, for example, costs or regulatory
burdens, including the avoidance thereof, is not, in and of itself,
dispositive that the person is acting without a legitimate business
purpose in a particular case.\168\ The Commission will view legitimate
business purpose considerations on a case-by-case basis in conjunction
with all other relevant facts and circumstances.
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\167\ NPRM at 47207.
\168\ Examples described in the guidance are illustrative and
not exhaustive of the conduct or activities that could be considered
evasive or abusive. In considering whether conduct or activities is
evasive or abusive, the Commission will consider the facts and
circumstances of each situation.
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In the context of the clearing requirement and Sec. 50.10(a),
however, the Commission does not believe it would be sufficient to
satisfy the legitimate business purpose test where a person's principal
purpose of entering into a swap that is not subject to the clearing
requirement is to circumvent the costs of clearing.\169\ Circumventing
the costs of clearing may be a consideration, but cannot be the
principal consideration in order to satisfy the legitimate business
purpose test. The Commission notes ISDA's comment regarding evasion,
and the Commission has determined that to permit such an outcome would
create an exception that would swallow the rule and could render the
central clearing objectives and benefits under the Dodd-Frank Act
meaningless. Moreover, section 2(h)(4)(A) requires the Commission
prescribe the rules that the Commission determines ``to be necessary to
prevent evasions of the mandatory clearing requirements,'' \170\ which
evinces Congress's concern that evasion of the clearing requirement
would undermine a central purpose of the Dodd-Frank Act. As noted
above, the Commission determines that the proposed rules are necessary
to prevent evasions of the mandatory clearing requirements, and is
therefore adopting them.
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\169\ ISDA also requested clarification that avoiding ``unwanted
aspects of clearing or trading'' should be considered to be a
legitimate business purpose. ISDA did not specify what it means by
``unwanted aspects,'' nor did it explain how avoiding aspects of
clearing or trading could be distinguished from evasion.
Accordingly, the Commission is declining to include this concept as
part of its guidance regarding legitimate business purposes.
\170\ Section 2(h)(4)(A) of the CEA, 7 U.S.C. 2(h)(4)(A).
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Furthermore, the Commission believes that this standard will not
subject market participants to significant uncertainty, and the
benefits of central clearing will outweigh the costs and burdens of any
such uncertainty. In response to Freddie Mac's comment regarding the
Commission discussion of ``mechanical'' specifications in the NPRM,
that discussion served only to explain the Commission's decision not to
include those specifications in the set of class-defining
specifications identified by the Commission for its class-based
clearing requirement determination. The Commission is not pre-judging
whether a swap that contains non class-defining specifications that are
not accepted by a DCO would constitute evasion. The Commission
recognizes that including such specifications in a swap could serve a
legitimate business purpose if, for example, such specifications would
legitimately result in a more accurate hedge of a business risk. In
keeping with the Commission's guidance that it will use a principles-
based approach, assessing whether any particular swap that includes
such terms would constitute evasion will be done on a case-by-case
basis in light of all the relevant facts and circumstances.
Finally, the Commission declines to adopt ISDA's suggestion that
the presence of fraud, deceit, or other unlawful activity is a
prerequisite to establishing a violation of evasion or abuse under
Sec. 50.10. Although it is likely that fraud, deceit, or unlawful
activity will be present where knowing or reckless evasion or abuse has
occurred, the Commission does not believe that these factors are
prerequisites to a violation of Sec. 50.10. Rather, the presence or
absence of fraud, deceit, or unlawful activity is one circumstance the
Commission will consider when evaluating a person's conduct or
activities.
IV. Implementation
The Commission proposed to require compliance with the clearing
requirement for the classes of swaps identified in proposed Sec. 50.4
according to the compliance schedule contained in
[[Page 74320]]
Sec. 50.25.\171\ Under this schedule, compliance with the clearing
requirement would be phased by type of market participant entering into
a swap subject to the clearing requirement.
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\171\ 17 CFR 50.25, Swap Transaction Compliance and
Implementation Schedule: Clearing Requirement Under Section 2(h) of
the CEA, 77 FR 44441 (July 30, 2012). Regulation 50.25 defines the
terms Category 1 Entity and Category 2 Entity; this release uses the
term Category 3 Entity to refer to counterparties to swaps falling
under Sec. 50.25(b)(3).
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The Commission received no comments specifically addressing the use
of Sec. 50.25. Vanguard recommended that the Commission should not
implement mandatory clearing for any swaps until market participants
have time to negotiate and execute all necessary documentation.
Vanguard recommended the Commission delay compliance with the clearing
requirement until six months after August 29, 2012, the date on which
ISDA and FIA published a standard form of the futures agreement
addendum for cleared swaps, i.e., February 28, 2013. SIFMA AMG also
expressed concern about legal documentation and negotiations taking
many months, and the difficulty buy-side clients face in finding FCMs
to clear for them. SIFMA AMG also recommended the clearing requirement
be delayed for six months.
In response to Vanguard's and SIFMA AMG's comments and light of the
circumstances discussed below, compliance with the clearing requirement
will not be required for any swaps until March 11, 2013. This extension
of at least 6 months beyond publication of the FIA-ISDA clearing
addendum applies to all market participants and addresses Vanguard's
and SIFMA AMG's concerns about documentation. The Commission accounted
for precisely this type of documentation issue in its adoption of Sec.
50.25. Accordingly, Category 2 Entities and Category 3 Entities have 90
and 180 days beyond March 11, 2013, to come into compliance with the
new clearing requirement, which is well beyond the six months from
August 29, 2012, as requested by Vanguard and SIFMA AMG. The Commission
also notes that any market participant may petition for relief under
Sec. 140.99 if that entity is unable to find an FCM to clear its swaps
or if it needs additional time to complete requisite
documentation.\172\
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\172\ 17 CFR 140.99 sets for the process for addressing requests
for exemptive, no-action, and interpretative letters.
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On September 10, 2012, the Commission clarified the timing of its
swap dealer registration rules. The swap dealer registration
regulations go into effect on October 12, 2012, and entities that have
more than the de minimis level of dealing (swaps entered into after
October 12) must register by no later than two months after the end of
the month in which they surpass the de minimis level. By way of
example, if an entity reaches $8 billion in swap dealing the day after
October 12, then the entity would have to register within two months
after the end of October, or by December 31, 2012.
Given that swap dealers will not be required to register until the
end of the year, and in light of requests for clarification regarding
the application of Sec. 50.25, the Commission is clarifying that swaps
executed prior to specific compliance dates set forth below are not
subject to the clearing requirement.
To promote certainty for market participants, the Commission is
setting specific dates for compliance. Accordingly, the requirement for
Category 1 Entities to begin clearing will commence on Monday, March
11, 2013, for swaps they enter into on or after that date. Category 2
Entities are required to clear swaps beginning on Monday, June 10,
2013, for swaps entered into on or after that date, and Category 3
Entities would be required to clear swaps beginning on Monday,
September 9, 2013, for swaps entered into on or after that date.
For example, no swap executed between two Category 1 Entities prior
to March 11, 2013, is required to be cleared. In other words, Category
1 Entities entering into swaps falling within one of the classes
identified in Sec. 50.4 on or after March 11, 2013, are required to
clear those swaps. Category 2 Entities must begin clearing swaps
pursuant to the new clearing requirement on or after June 10, 2013, and
Category 3 Entities must begin clearing such swaps if they are entered
into on or after the September 9, 2013.
The above schedule will apply to compliance with required clearing
for iTraxx. However, if no DCO has begun offering client clearing for
iTraxx by February 11, 2013, then compliance with the required clearing
of iTraxx will commence sixty days after the date on which iTraxx is
first offered for client clearing by an eligible DCO. If an eligible
DCO offers client clearing for iTraxx on or before September 9, 2013,
the following phased implementation schedule will apply: Category 1
Entities are required to clear iTraxx indices entered into on or after
the date 60 days after the date on which iTraxx is first offered for
client clearing by an eligible DCO; Category 2 Entities are required to
clear iTraxx entered into on or after the date 150 days after the date
on which iTraxx is first offered for client clearing by an eligible
DCO; and Category 3 Entities are required to clear iTraxx entered into
on or after the date 240 days after the date on which iTraxx is first
offered for client clearing by an eligible DCO. There will be no
phasing of compliance if an eligible DCO offers client clearing for
iTraxx after September 9, 2013. Rather, all three categories of market
participants will be expected to come into compliance by 60 days after
the date on which iTraxx is first offered for client clearing by an
eligible DCO.
This clarification avoids the possibility that Active Funds that
are included in Category 1 Entities would be required to clear before
swap dealers, and provides market participants with certainty as to
when they must begin clearing swaps.
With regard to Active Funds, in order to promote orderly
implementation of part 23 and the part 50 rules, both of which refer to
Active Funds, the Commission is harmonizing the annual calculation
period for both implementation of part 23's swap trading relationship
documentation requirements under Sec. 23.504 \173\ and the clearing
requirement compliance schedule under Sec. 50.25. For purposes of
implementing Sec. 23.504, the Commission defined an Active Fund, as
any private fund as defined in section 202(a) of the Investment
Advisers Act of 1940, that is a not a third party subaccount and that
executes 200 or more swaps per month based on a monthly average over
the 12 months preceding the adopting release, i.e., September 11,
2012.\174\ For purposes of Sec. 50.25, the Commission defined Active
Fund in the same manner except that the monthly average over the 12
months would be preceding the date of publication of the clearing
requirement determination in the Federal Register, i.e., whatever date
this adopting release is published.\175\ Market participants have asked
the Commission to harmonize these two dates so that there will be one
self-identified list of Active Funds for purposes of both
implementation schedules under parts 23 and 50. The Commission agrees
with this approach and is modifying both compliance schedules to
require private funds to calculate the number of swaps they enter into
as a monthly average
[[Page 74321]]
over the past 12 months preceding November 1, 2012.
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\173\ Confirmation, Portfolio Reconciliation, Portfolio
Compression, and Swap Trading Relationship Documentation
Requirements for Swap Dealers and Major Swap Participants, 77 FR
55904 (Sept. 11, 2012).
\174\ See 77 FR at 55940.
\175\ See Swap Transaction Compliance and Implementation
Schedule: Clearing Requirement Under Section 2(h) of the CEA, 77 FR
at 44456.
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In addition, the Commission clarifies that for purposes of
calculating the number of swaps a fund executes as a monthly average
over the 12 months preceding November 1, 2012, for both part 23 and
part 50, private funds as defined in section 202(a) of the Investment
Advisers Act of 1940 are not required to include foreign exchange
swaps, in light of the final determination from the Secretary of the
Treasury to exempt such swaps from the CEA.\176\
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\176\ See http://www.treasury.gov/press-center/press-releases/Documents/11-16-2012%20FX%20Swaps%20Determination%20pdf.pdf
(finalizing Determinations of Foreign Exchange Swaps and Forwards,
75 FR 66829 (Oct. 28, 2010)).
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Finally, ISDA commented that the inter-affiliate exemption should
be finalized prior to requiring compliance with the clearing
requirement. The Commission has proposed its inter-affiliate exemption
rules \177\ and anticipates that it will finalize those rules prior to
the aforementioned compliance dates for these clearing requirement
determinations.
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\177\ Clearing Exemption for Swaps Between Certain Affiliated
Entities, 77 FR 50425 (Aug. 21, 2012).
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V. Cost-Benefit Considerations
A. Statutory and Regulatory Background
As discussed in the NPRM, and above, certain OTC derivatives, such
as credit default swaps (CDS) played a prominent role in the financial
crisis in the fall of 2008, highlighting the risk that opaque OTC
markets can create for the financial system by linking together
financial institutions in ways that are not well-understood.\178\ The
failure to adequately collateralize the risk exposures posed by OTC
derivatives, along with the contagion effects of the vast web of
uncollateralized counterparty credit risk, led many to conclude that
OTC derivatives should be centrally cleared.
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\178\ 77 FR 47170 (Aug. 7, 2012). See also Section I.B above.
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A fundamental premise of the Dodd-Frank Act is that the use of
properly functioning central clearing can reduce systemic risk.
Congress included the statutory clearing requirement in the Dodd-Frank
amendments to the CEA to standardize and reduce counterparty risk
associated with swaps, and, in turn, mitigate the potential systemic
impact of such risks and reduce the likelihood for swaps to cause or
exacerbate instability in the financial system. The clearing
requirement determinations and regulations contained in this adopting
release identify certain classes of swaps that are required to be
cleared pursuant to the Dodd-Frank Act's \179\ clearing requirement
incorporated within amended section 2(h)(1)(A) of the CEA.\180\
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\179\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, 124 Stat. 1376 (2010).
\180\ This section states: ``It shall be unlawful for any person
to engage in a swap unless that person submits such swap for
clearing to a derivatives clearing organization that is registered
under this Act or a derivatives clearing organization that is exempt
from registration under this Act if the swap is required to be
cleared.''
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The Commission's regulations establishing the process for the
review of swaps that are submitted for a mandatory clearing
determination are found in Part 39 of the Commission's regulations.
Regulation 39.5 provides an outline for the Commission's review of
swaps for required clearing.\181\ Regulation 39.5 requires the
Commission to review all swaps submitted by DCOs or those swaps that
the Commission opts to review on its own initiative.\182\ Under section
2(h)(2)(D) of the CEA, in reviewing swaps for required clearing, the
Commission must take into account the following factors: (1)
Significant outstanding notional exposures, trading liquidity and
adequate pricing data, (2) the availability of rule framework,
capacity, operational expertise and credit support infrastructure, (3)
the effect on the mitigation of systemic risk, (4) the effect on
competition and (5) the existence of reasonable legal certainty in the
event of the insolvency of the DCO or one or more of its clearing
members.\183\ Regulation 39.5 also directs DCOs to provide to the
Commission other information, such as product specifications,
participant eligibility standards, pricing sources, risk management
procedures, a description of the manner in which the DCO has provided
notice of the submission to its members and any additional information
requested by the Commission. This information is designed to assist the
Commission in identifying those swaps that are required to be cleared.
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\181\ 76 FR 44464 (July 26, 2011).
\182\ See Sec. 39.5(b), Sec. 39.5(c). Under section
2(h)(2)(B)(ii) of the CEA, ``[a]ny swap or group, category, type, or
class of swaps listed for clearing by a [DCO] as of the date of
enactment shall be considered submitted to the Commission.''
\183\ Section 2(h)(2)(D) of the CEA and Sec. 39.5(b)(ii).
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On February 1, 2012, Commission staff sent a letter requesting that
registered DCOs submit all swaps that they were accepting for clearing
as of that date, pursuant to Sec. 39.5 of the Commission's
regulations. The Commission received submissions relating to CDS and
interest rate swaps, as well as agricultural and energy swaps.
This initial Commission determination addresses certain interest
rate swaps and CDS, and is the first of a series of determinations that
the Commission anticipates making as part of a phased approach to
implementing mandatory clearing. The Commission chose to issue its
first clearing requirement proposal for interest rate swaps and CDS
because those swaps represent a significant share of the market in the
case of interest rate swaps, and pose a unique risk profile in the case
of CDS. In addition, the market has been clearing both types of swaps
for some time, and market participants asked that the Commission begin
with interest rate swaps and CDS. The Commission intends subsequently
to consider other swaps submitted by DCOs, such as agricultural,
energy, and equity indices.
As stated in both the NPRM and above, the decision to initially
focus on CDS and interest rate swaps from amongst the swaps submitted
to the Commission for mandatory clearing determinations pursuant to
section 2(h)(2) is a function of both the market importance of these
swaps and the fact that they already are widely cleared. In order to
move the largest number of swaps to required clearing in its initial
determinations, the Commission believes that it is prudent to focus on
those swaps that have the highest market shares and market impact.
Further, for these swaps there is already a blueprint for clearing and
appropriate risk management. CDS and interest rate swaps fit these
considerations and therefore are well suited for required clearing
consideration.\184\ In the discussion that follows, the importance of
central clearing is explained and highlighted to provide the background
for the Commission's consideration of the costs and benefits in this
rulemaking as the Commission exercises its discretion under section
2(h)(2)(D) of the CEA to determine whether swaps that are submitted for
a mandatory clearing determination are required to be cleared.
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\184\ 77 FR 47172 (August 7, 2012). See also Section I.F above.
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B. Overview of Swap Clearing
The following background discussion provides context for the
Commission's consideration of the costs and benefits of its clearing
determinations in this rulemaking.
[[Page 74322]]
i. How Clearing Reduces Risk
When a bilateral swap is cleared, the clearinghouse becomes the
counterparty to each of the original counterparties to the swap. This
standardizes counterparty credit risk for the original swap
participants in that they each bear the same risk--i.e., the risk
attributable to facing the clearinghouse as counterparty. In addition,
clearing mitigates counterparty risk to the extent that the
clearinghouse is a more creditworthy counterparty relative to the
original swap participants. Clearinghouses have demonstrated resilience
in the face of past market stress. Most recently, they remained
financially sound and effectively settled positions in the midst of
turbulent events in 2007-2008 that threatened the financial health and
stability of many other types of entities.
Given the variety of effective clearinghouse tools to monitor and
manage counterparty credit risk, the Commission believes that DCOs will
continue to be some of the most creditworthy counterparties in the swap
markets. These tools include the contractual right to: (1) Collect
initial and variation margin associated with outstanding swap
positions; (2) mark positions to market regularly (usually one or more
times per day) and issue margin calls whenever the margin in a
customer's account has dropped below predetermined levels set by the
DCO; (3) adjust the amount of margin that is required to be held
against swap positions in light of changing market circumstances, such
as increased volatility in the underlying; and (4) close out the swap
positions of a customer that does not meet margin calls within a
specified period of time.
Moreover, in the event that a clearing member defaults on their
obligations to the DCO, the latter has a number of remedies to manage
associated risks, including transferring the swap positions of the
defaulted member, and covering any losses that may have accrued with
the defaulting member's margin and other collateral on deposit. In
order to transfer the swap positions of a defaulting member and manage
the risk of those positions while doing so, the DCO has the ability to:
(1) Hedge the portfolio of positions of the defaulting member to limit
future losses; (2) partition the portfolio into smaller pieces; (3)
auction off the pieces of the portfolio, together with their
corresponding hedges, to other members of the DCO; and (4) allocate any
remaining positions to members of the DCO. In order to cover the losses
associated with such a default, the DCO would typically draw from (in
order): (1) The initial margin posted by the defaulting member; (2) the
guaranty fund contribution of the defaulting member; (3) the DCO's own
capital contribution; (4) the guaranty fund contribution of non-
defaulting members; and (5) an assessment on the non-defaulting
members. These mutualized risk mitigation capabilities are largely
unique to clearinghouses, and help to ensure that they remain solvent
and creditworthy swap counterparties even when dealing with defaults by
their members or other challenging market circumstances.
ii. Movement of Swaps Into Clearing
There is significant evidence that some parts of the OTC swap
markets (the interest rate swaps and CDS markets in particular) have
been migrating into clearing over the last number of years in response
to market incentives as well as in anticipation of the Dodd-Frank Act's
clearing requirement. LCH data, for example, shows that the outstanding
volume of interest rate swaps cleared by LCH has grown steadily since
at least November 2007, as has the monthly registration of new trade
sides.\185\ Data provided to the Commission shows that the notional
amount of cleared interest rate swaps is approximately $72 trillion as
of January 2007, and just over $236 trillion in September 2010, an
increase of 228% in three and a half years.\186\ Together, those facts
indicate increased demand for LCH clearing services related to interest
rate swaps, a portion of which preceded the Dodd-Frank Act.\187\ Data
available through CME and TriOptima indicate similar patterns of
growing demand for interest rate swap clearing services, although their
publically available data does not provide a picture of demand prior to
the passage of the Dodd-Frank Act.\188\
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\185\ As a measure of volume, LCH accounts for each swap it
clears as one trade side, which represents one counterparty to each
two-sided trade.
\186\ Data provided to the Commission by LCH. In the context of
interest rate swaps, the notional amount refers to the specified
amount on which the exchanged swap payments are calculated. It is a
nominal amount that is not exchanged between counterparties.
\187\ See http://www.lchclearnet.com/swaps/volumes/. Since the
Dodd-Frank Act was passed in July 2010, outstanding trade sides at
LCH have increased from approximately 1.6 million to 2.3 million in
September of 2012, an increase of approximately 44%. Indeed, the
number of new trade sides being submitted for clearing per month
increased from approximately 55,000 trade sides per month to 150,000
trade sides per month, an increase of approximately 270%.
\188\ See http://www.cmegroup.com/trading/interest-rates/cleared-otc/index.html#data and http://www.trioptima.com/repository/historical-reports.html. Notably, CME launched its interest rate
swap clearing service in the fall of 2010, after the Dodd-Frank Act
was passed.
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In addition to interest rate swap clearing, major CDS market
participants are clearing their CDS indices and single names in
significant volumes. As explained above, in 2008, prior to the
enactment of the Dodd-Frank Act, the Federal Reserve Bank of New York
(FRBNY) began encouraging market participants to establish a central
counterparty to clear CDS.\189\ In the past four years CDS clearing has
grown significantly. As a representation of this growth, CME now has
initial margin for CDS in excess of $1.8 billion and a guaranty fund of
approximately $629 million,\190\ and ICE Clear Credit has initial
margin on deposit for CDS of $10.8 billion and a guaranty fund equal to
$4.4 billion.\191\ ICE Clear Europe has initial margin for CDS totaling
$6.8 billion and a guaranty fund of $2.7 billion.\192\
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\189\ See Federal Reserve Bank of New York, Press Release, ``New
York Fed Welcomes Further Industry Commitments on Over-the-Counter
Derivatives,'' Oct. 31, 2008, available at http://www.newyorkfed.org/newsevents/news/markets/2008/an081031.html, which
references documents prepared by market participants describing the
importance of clearing. See also Ciara Linnane and Karen Brettell,
``NY Federal Reserve pushes for central CDS counterparty,'' Reuters,
Oct. 6, 2008.
\190\ See http://www.cmegroup.com/clearing/cme-clearing-overview/safeguards.html for data regarding CME's guaranty fund,
posted as of May 10, 2012.
\191\ See https://www.theice.com/clear_credit.jhtml for data on
the size of guaranty fund, posted as of May 10, 2012.
\192\ Id. The data is not adequate to enable the Commission to
determine how much of the movement into clearing is attributable to
natural market forces or anticipated requirements under the Dodd-
Frank Act.
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iii. The Clearing Requirement and Role of the Commission
In the Dodd-Frank Act, Congress directed that clearing shift from a
voluntary practice to a mandatory practice for certain swaps and gave
the Commission responsibility for determining which swaps would be
required to be cleared. Under section 2(h)(2) of the CEA, the
Commission is required to review each swap, or group, category, type,
or class of swaps that a DCO clears and submits to the Commission in
order to determine whether the submitted swaps are required to be
cleared. In making these clearing determinations and promulgating the
final rules, the Commission has taken its direction from the statutory
text and is implementing the statute by determining, in accordance with
the five factors set forth in the statute, whether swaps submitted to
the Commission for a mandatory
[[Page 74323]]
clearing determination are required to be cleared. As described above,
the Commission has decided to initially focus on interest rate swaps
and CDS because of the market importance of these swaps and the fact
that they already are widely cleared.
In determining pursuant to section 2(h)(2)(D) whether these
particular swaps should be required to be cleared, the Commission has
taken into account the fact that voluntary clearing of swaps has
increased over the past years (perhaps due in part to anticipation of
the clearing requirement to be imposed under the Dodd-Frank Act, but
perhaps due in part to a realization of the benefits of clearing after
the financial crisis). These industry efforts and the extent to which
voluntary clearing of swaps has already occurred provide a useful
reference point for the Commission's consideration of the costs and
benefits of its actions in determining whether particular swaps should
be required to be cleared.\193\
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\193\ The Commission also recognizes that there might not be a
linear relationship between the quantity of swaps that are cleared
(whether measured by number of swaps, the notional value of swaps,
or some other measure of swap quantity, such as the exposure
resulting from the swaps) and the costs and benefits resulting from
clearing. For example, if the Commission were to assume that the
rule would result in a doubling of the quantity of a certain type of
swap that is cleared, it would not necessarily be the case that the
costs and benefits of clearing that type of swap would double.
Rather, the relationship could be non-linear for a variety of
reasons (such as variations among the users of that type of swap).
In fact, it may be reasonable to assume that where the costs of
clearing are relatively low and the benefits are relatively high,
market participants already voluntarily clear swaps even in the
absence of a clearing requirement.
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In the discussion that follows, the Commission summarizes and
evaluates the costs and benefits of the new clearing requirements
resulting from the Commission's clearing determinations in this
rulemaking. In the context of this relevant statutory provision and
ongoing industry initiatives, in the sections that follow, the
Commission also has considered its clearing determinations in light of
cost-benefit issues raised by commenters and suggested alternatives.
In general, the Commission believes that the costs and benefits
related to the required clearing of the classes of interest rate swaps
and CDS resulting from this rulemaking are attributable, in part to (1)
Congress's stated goal of reducing systemic risk by, among other
things, requiring clearing of swaps and the statutory clearing mandate
in section 2(h) of the CEA to achieve that objective; and (2) the
Commission's determination under section 2(h)(2)(D) that these
particular classes of swaps should be required to be cleared. The
Commission will discuss the costs and benefits of the overall move from
voluntary clearing to required clearing for the particular swaps
subject to this new clearing requirement.\194\ However, in so doing,
the Commission believes that it is not readily ascertainable whether an
increased use of clearing following such determinations should be
attributed to statutory or regulatory requirements that particular
swaps be required to be cleared, as compared to swap market
participants' market-based decisions to increase the use clearing to
reduce risks and costs.\195\
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\194\ Embedded in this approach is the assumption that costs and
benefits of increased clearing prior to the determination is not a
function of the Dodd-Frank Act or the clearing determination
contained herein. As stated above, the Commission acknowledges that
some increases in clearing that have already occurred are likely the
result of anticipated clearing requirements. However, it is not
possible to estimate how much of the increases in clearing are the
result market forces, and how much is a function of expected
requirements related to clearing. Both factors have likely
contributed to the increases in clearing that have occurred prior to
this rule.
\195\ It is also possible that some market participants would
respond to the current rule's requirement that certain types of
swaps be cleared by decreasing their use of such swaps. This
possibility contributes to the uncertainty regarding how the current
rule will affect the volume of swaps that are cleared.
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C. Consideration of the Costs and Benefits of the Commission's Action
i. CEA Section 15(a)
Section 15(a) of the CEA requires the Commission to consider the
costs and benefits of its actions before promulgating a regulation
under the CEA or issuing certain orders. Section 15(a) further
specifies that the costs and benefits shall be evaluated in light of
the following five broad areas of market and public concern: (1)
Protection of market participants and the public; (2) efficiency,
competitiveness and financial integrity of futures markets; (3) price
discovery; (4) sound risk management practices; and (5) other public
interest considerations. Accordingly, the Commission considers the
costs and benefits resulting from its discretionary determinations with
respect to the section 15(a) factors.
As stated above, the Commission received a total of 33 comment
letters following the publication of the NPRM, many of which strongly
supported the proposed regulations. Some commenters generally addressed
the cost-and-benefit aspect of the current rule; none of them, however,
provided any quantitative data in response to the Commission's requests
for comment. In the sections that follow the Commission considers: (1)
Costs and benefits of required clearing for the classes of swaps
identified in this adopting release; (2) alternatives contemplated by
the Commission and the costs and benefits relative to the approach
adopted herein; (3) the impact of required clearing for swaps under the
identified classes of swaps in light of the 15(a) factors. The
Commission also discusses the corresponding comments accordingly.
ii. Costs and Benefits of Required Clearing Under the Final Rule
In order to comply with required clearing under this adopting
release, market participants are likely to face certain startup and
ongoing costs relating to technology and infrastructure, new or updated
legal agreements, ongoing fees from service providers, and costs
related to collateralization of their positions. The per-entity costs
related to changes in technology, infrastructure, and legal agreements
are likely to vary widely, depending on each market participant's
existing technology infrastructure, legal agreements, operations, and
anticipated needs in each of these areas. For market participants that
already use clearing services, some of these costs may be expected to
be lower, while the opposite will likely be true for market
participants that must begin to use clearing services only because of
the new clearing requirement. The costs of collateralization, on the
other hand, are likely to vary depending on a number of factors,
including whether an entity is subject to capital requirements or not,
and the differential between the cost of capital for the assets the
entity uses as collateral, and the returns the entity realizes on those
assets.
There are also significant benefits associated with increased
clearing, including reducing and standardizing counterparty credit
risk, increased transparency, and easier access to the swap markets.
These effects together will contribute significantly to the stability
and efficiency of the financial system. The Commission lacks data to
quantify these benefits with any degree of precision. The Commission
notes, however, that the extraordinary financial system turbulence of
2008 has had profound and long-lasting adverse effects on the economy,
and therefore reducing systemic risk provides significant, if
unquantifiable, benefits.\196\ Also, as is the case for the
[[Page 74324]]
costs related to clearing, these benefits would be relatively less to
the extent that market participants are already using clearing in the
absence of a requirement.
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\196\ For example, the PEW Economic Policy Group estimates total
costs of the acute stage of the crisis for U.S. interests were
approximately $12.04 trillion, including lost GDP, wages, real
estate wealth, equity wealth, and fiscal costs. Their estimates
include $7.4 trillion in losses in the equity markets between June
2008 and March 2009, but do not include subsequent gains in equity
markets that restored markets to their mid-2008 levels by the end of
2009. In addition, their calculations do not include continued
declines in real estate markets subsequent to March 2009. See Pew
Economic Policy Group, ``The Cost of the Financial Crisis: The
Impact of the September 2008 Economic Collapse,'' March 2010. The
IMF estimated that the cost to the banking sector of the financial
crisis through 2010 was approximately $2.2 trillion and reported a
range of estimates for total cost to the taxpayer of GSE bailouts
that ranged from $160 billion (Office of Management and Budget,
February 2010) to $500 billion (Barclays Capital, December 2009).
See IMF, ``Global Financial Stability Report: Responding to the
Financial Crisis and Measuring Systemic Risks,'' October 2010. Both
studies acknowledge that the estimates are subject to uncertainties.
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a. Technology, Infrastructure, and Legal Costs
With respect to technology and infrastructure, for market
participants that already use swap clearing services or trade futures,
many of the backend requirements for technology and infrastructure that
supports cleared swaps are likely to be quite similar, and therefore
necessary changes to those systems are likely to require relatively
lower costs. Market participants that are not currently using swap
clearing services or trade futures, however, may need to implement
appropriate infrastructure and technology to connect with an FCM that
will clear swaps on their behalf.
Similarly for legal fees, the costs related to clearing the swaps
that are subject to this clearing requirement are likely to vary widely
depending on whether market participants already use clearing services
or trade futures. For those market participants that have not already
engaged an FCM, it has been estimated, in response to another
rulemaking, that smaller financial institutions will spend between
$2,500 and $25,000 reviewing and negotiating legal agreements when
establishing a new business relationship with an FCM.\197\ Commenters
on this rulemaking did not provide data that would enable the
Commission to determine to what degree these estimates would apply to
larger entities establishing a relationship with an FCM or to determine
costs associated with entities that already have established
relationships with one or more FCMs, but need to revise those
agreements.\198\ Even accepting the data provided for smaller financial
institutions, the Commission lacks sufficient data to calculate a
reasonable estimate of the potential costs that are likely to depend
significantly on the specific business needs of each entity and
therefore are expected to vary widely among market participants.
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\197\ See comments to End-User Exception to Mandatory Clearing
of Swaps; Proposed Rule, 75 FR 80747 (Dec. 23, 2011), including
Chatham Financial letter at 2, available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=58077, and
Webster Bank letter at 3, available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=58076.
\198\ In its letter, FIA stated that it does not collect
information from its members concerning fees charged for particular
services, and thus is unable to respond to the Commission's request
for date regarding FCM fees. No other commenter responded to the
request for information regarding legal fees.
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Citadel commented that the fact that all the interest rate swaps
and CDS included in the Commission's proposal are already being cleared
by registered DCOs in material volumes provides clear evidence that
there is the rule framework, capacity, operational expertise and
resources, and credit support infrastructure necessary to clear each of
the swaps that are the subject of the Commission's determination.
SIFMA AMG and Vanguard expressed concern about legal documentation
and negotiations taking many months, and recommended the clearing
requirement be delayed. They also raised doubt about the readiness of
market participants to comply with the Commission's upcoming swap
customer segregation rules. Vanguard further stated that it has
``serious reservations about the potential impact on cost, liquidity,
and heightened margin risk which could result from the premature roll-
out of the clearing mandate.''
In light of the ``lack of experience and practical know-how''
related to DCO insolvency, ISDA recommended that the Commission conduct
a study on insolvency. Citadel, on the other hand, stated that
reasonable legal certainty exists in the event of an insolvency of a
DCO or one or more DCO members with regard to the treatment of customer
and swap counterparty positions, funds, and property.
Commission Response
In response to Vanguard and SIFMA AMG's concerns about legal
documentation and operational readiness, the Commission has clarified
that compliance with the clearing requirement will not be required for
any swaps until March 11, 2013, which responds to commenters'
recommendation that the clearing requirement by delayed for six months
to allow for documentation. Moreover, Category 2 and Category 3
entities will have until June 10, 2013, and September 9, 2013,
respectively, to come into compliance with the new requirement.\199\ In
response to ISDA's statements regarding insolvency, as explained above,
Commission staff actively participates in a number of international
efforts related to clearinghouses and clearing member insolvency, as
well as in coordination efforts with U.S. authorities.\200\
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\199\ See Section IV above, clarifying that compliance for
Category I, II, and III Entities will apply, respectively, to swaps
executed on or after March 11, 2013, June 10, 2013, and September 9,
2013.
\200\ See Section II.B above.
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Additionally, the Commission is exercising the anti-evasion
rulemaking authority granted to it by the Dodd-Frank Act. In terms of
legal costs, market participants will be responsible for complying with
the new anti-evasion requirements. Generally, rule Sec. 50.10 states
that it is unlawful for any person to knowingly or recklessly evade or
participate in or facilitate an evasion of the requirements of section
2(h) of the CEA, to abuse the exception to the clearing requirement as
provided under section 2(h)(7) of the CEA and Commission rules, or to
abuse any exemption or exception to the requirements of section 2(h) of
the CEA, including any exemption or exception as the Commission may
provide by rule, regulation, or order.
This rule is expected to help ensure that would-be evaders cannot
engage in conduct or activities that constitute an evasion of the
requirements of section 2(h) or an abuse of any exemption or exception
to such requirements. The Commission also sets forth guidance as to how
it would determine if such evasion or abuse has occurred, while at the
same time preserving the Commission's ability to determine, on a case-
by-case basis, with consideration given to all the facts and
circumstances, that other types of transactions or activities
constitute an evasion or abuse under Sec. 50.10.\201\
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\201\ The Commission has not adopted a ``bright-line'' standard
for evasion in order to avoid providing a ``road-map'' for evasion.
The Commission's discussion of Sec. 50.10 is similar to its
approach for the anti-evasion rules Sec. Sec. 1.3(xxx)(6) and 1.6
that it recently adopted in a joint final rulemaking with the
Securities and Exchange Commission. See Further Definition of
``Swap,'' ``Security-Based Swap,'' and ``Security-Based Swap
Agreement''; Mixed Swaps; Security-Based Swap Agreement
Recordkeeping, 77 FR 48208, 48350-48354 (Aug. 13, 2012).
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The Commission believes that participants in the swap markets
should have policies and procedures already in place to ensure that
their employees, affiliates, and agents will refrain from engaging in
activities, including devising transactions, for the purpose of
[[Page 74325]]
evading, or in reckless disregard of, the requirements of section 2(h)
of the CEA and Commission regulations or to abuse any exemption or
exception to such requirements. The Commission believes that it will
not be necessary for firms that currently have adequate compliance
programs to hire additional staff or significantly upgrade their
systems to comply with the proposed rule. Firms may, however, incur
some costs, such as costs associated with training staff on the new
clearing requirement rules.
In addition, market participants may incur costs when determining
whether they are properly relying on a legitimate business purpose. The
Commission in choosing a principles-based approach rather than a
bright-line test, recognizes that there may be direct costs and
indirect costs due to perceived uncertainty related to determining what
constitutes a legitimate business purpose for entering into swaps that
are not subject to the clearing requirement. As stated above, the
Commission will not provide a bright-line test of non-evasive or
abusive conduct because such an approach may be a roadmap for engaging
in evasive or abusive conduct or activities. However, the Commission
has provided guidance above regarding what is meant by certain key
terms in Sec. 50.10, and the Commission has clarified its belief that
where a person's principal purpose in entering into a swap that is not
subject to the clearing requirement is to circumvent the costs of
clearing, the legitimate business purpose test would not be satisfied.
The Commission anticipates that this guidance will mitigate costs
related to determining whether particular conduct or activity could be
construed as being an evasion of the requirements of section 2(h) or an
abuse of any exemption or exception to the requirements.\202\
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\202\ See above at Section III.G.
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b. Ongoing Costs Related to FCMs and Other Service Providers
In the NPRM, the Commission considered ongoing costs associated
with fees charged by FCMs that market participants will bear, in
addition to costs associated with technological and legal
infrastructure. Regarding fees, DCOs typically charge FCMs an initial
transaction fee for each of the FCM's customers' interest rate swaps
that are cleared, as well as an annual maintenance fee for each of
their customers' open positions. Not including customer-specific and
volume discounts, the transaction fees for interest rate swaps at the
CME range from $1 to $24 per million notional amount for interest rate
swaps and the maintenance fees are $2 per year per million notional
amount for open positions.\203\ LCH transaction fees for interest rate
swaps range from $1-$20 per million notional amount, and the
maintenance fee ranges from $5-$20 per swap per month, depending on the
number of outstanding swap positions that an entity has with the
clearinghouse.\204\ For CDS, ICE Clear Credit charges an initial
transaction fee of $6 per million notional amount. There is no
maintenance fee charged by ICE for maintaining open CDS positions.\205\
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\203\ See CME pricing charts at: http://www.cmegroup.com/trading/cds/files/CDS-Fees.pdf;
http://www.cmegroup.com/trading/interest-rates/files/CME-IRS-Customer-Fee.pdf;
and http://www.cmegroup.com/trading/interest-rates/files/CME-IRS-Self-Clearing-Fee.pdf.
\204\ See LCH pricing for clearing services related to OTC
interest rate swaps at: http://www.lchclearnet.com/swaps/swapclear_for_clearing_members/fees.asp.
\205\ See ICE Clear Credit fees for CDS at: https://www.theice.com/publicdocs/clear_credit/circulars/ICEClearCredit%20Fee%20Schedule%20Notice_FINAL.pdf.
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FCMs will also bear additional fees with respect to their house
accounts at the DCO to the extent that they clear more swaps due to the
clearing requirement. For example, for interest rate swaps that they
clear through CME, clearing members are charged a transaction fee that
ranges from $0.75 to $18.00 per million notional, depending on the
transaction maturity.\206\ Members, however, are not charged annual
maintenance fees for their open house positions.\207\ For CDS, clearing
members at ICE Clear Credit are charged $5-6 per transaction per
million notional and there is no maintenance fee.\208\
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\206\ See CME pricing charts.
\207\ See id.
\208\ See ICE Clear Credit fees for CDS at: https://www.theice.com/publicdocs/clear_credit/circulars/ICEClearCredit%20Fee%20Schedule%20Notice_FINAL.pdf.
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As discussed above, it is difficult to predict precisely how the
requirement to clear the classes of swaps covered by this new
requirement will increase the use of swap clearing, as compared to the
use of clearing that would occur in the absence of the requirement.
However, the Commission expects that application of the clearing
requirement to the swaps covered by the new rule will generally
increase the use of clearing, leading to the ongoing transaction costs
noted above.
In addition, the Commission understands that FCM customers that
only transact in swaps occasionally are typically required to pay a
monthly or annual fee to each FCM that ranges from $75,000 to $125,000
per year.\209\ Again, although it is difficult to predict precisely how
many FCM customers would be subject to such fees based on the clearing
requirement for CDS and interest rate swaps, the Commission expects
that some market participants that previously did not use clearing
would be subject to the requirements of the current rule.
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\209\ See letters from Chatham and Webster Bank. The Commission
is not aware of similar annual fees charged to larger customers. The
Commission believes that FCMs are more likely to charge such fees to
smaller customers in order to cover the fixed costs that are not
likely covered through fees charged on a per-swap basis to customers
that use swaps less frequently.
---------------------------------------------------------------------------
In the NPRM, the Commission asked a series of questions related to
FCM fees and invited comment on the fee information presented. No
commenter responded to the questions asked or provided any additional
information with regard to clearing fees. As noted above, FIA raised
the issue only to explain that it does not collect such information
from its members.
c. Costs Related to Collateralization of Cleared Swap Positions
As mentioned above, market participants that enter into swaps with
the specifications identified in the classes subject to this adopting
release will be required to post collateral with their FCM and/or at
the DCO. The incremental cost of collateral resulting from the
application of the clearing requirement depends on the extent to which
such swaps are already being cleared (even in the absence of the
requirement) or otherwise collateralized bilaterally. The incremental
cost also depends on whether such swaps are, if not collateralized,
priced to include implicit contingent liabilities and counterparty
credit risk born by the counterparty to the swap.
1. Quantitative Approach Presented in the NPRM
A conservative approach would be to assume that all the swaps that
are currently not cleared would be covered by the new clearing
requirement, and that they are completely uncollateralized, and not
priced to include implicit contingent liabilities and counterparty
credit risk born by the counterparty. Under this approach, imposition
of the clearing requirement for those types of swaps would create
additional costs due to: (1) The difference between cost of capital and
returns on that capital for assets posted to meet initial margin for
the entire term of the swap; and (2) the difference
[[Page 74326]]
between cost of capital and returns on that capital for assets paid to
meet the cost of capital for variation margin to the extent a party is
``out of the money'' on each swap. Under the assumptions mentioned
above, if every interest rate swap and CDS that is not currently
cleared were moved into clearing, the additional initial margin that
would need to be posted is approximately $19.2 billion for interest
rate swaps and $53 billion for CDS.\210\
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\210\ The numbers calculated above may either over-estimate or
under-estimate the amount of additional initial margin that would
need to be posted under the conservative assumptions stated above.
For instance, differences in the amount of netting that is possible
within portfolios currently being cleared versus those not currently
being cleared could have a significant impact on the amount of
additional margin that is required to be posted. Other factors such
as differences in liquidity among swaps currently being cleared and
those not being cleared could also impact the amount of additional
margin that is posted.
---------------------------------------------------------------------------
In the NPRM, the Commission calculated its estimated additional
initial margin amounts based on the following assumptions. According to
representations made to the Commission by LCH, they clear approximately
51% of the interest rate swaps market. The total amount of initial
margin on deposit at LCH for interest rate swaps is approximately $20
billion.\211\ Therefore, if all remaining interest rate swaps were
moved into clearing, approximately $19.2 billion ($20B/0.51-$20B =
19.2B) would have to be posted in initial margin.
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\211\ The total amount of initial margin on deposit at CME for
interest rate swaps is $5 billion, but for purposes of this
estimate, the Commission is not including that amount.
---------------------------------------------------------------------------
Similarly, the initial margin related to CDS currently on deposit
at CME, ICE Clear Credit, and ICE Clear Europe is approximately $21.4
billion.\212\ This amount includes initial margin based on both index-
based CDS and single-name CDS positions. BIS data indicates that
approximately 36.6% of the CDS market comprises index-based CDS.\213\
In the NPRM, the Commission noted that if it is assumed that
approximately 36.6% of the overall portfolio-based CDS margin (i.e.,
CDS indices and single-name CDS margined together) currently held by
DCOs for CDS positions is related to index-based CDS, and then add any
margin held by DCOs attributable solely to index-based CDS, it can be
estimated that approximately $9.0 billion in margin currently held by
those DCOs is related to index-based CDS. ISDA data indicates that
14.5% of the index-based CDS market is currently cleared.\214\
Therefore, the Commission noted in the NPRM that if the entire index-
based CDS market moved into clearing, $53 billion ($9.0B/0.145-$9.0 =
$53B) in initial margin would have to be posted at DCOs.
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\212\ The total amount of initial margin on deposit only
includes those amounts reported to the Commission by registered
DCOs. Other clearinghouses, such as LCH.Clearnet.SA, clear the
indices included in the proposed determination, however, the
relative size of the open interest in the relevant CDS indices is
substantially smaller than each of the DCOs included in this
calculation.
\213\ BIS estimates that the gross notional value of outstanding
CDS contracts is $28.6 trillion, and that $10.5 trillion of that is
index related CDS. See BIS data, available at http://www.bis.org/statistics/otcder/dt21.pdf.
\214\ In the NPRM, the Commission noted that ISDA has estimated
that 14.5% of the index-based CDS market is currently being cleared,
whereas the total outstanding notional at CME, ICE Clear Europe, and
ICE Credit represents approximately 7.5% of the global index-based
CDS market estimated by BIS. Such a discrepancy would be expected if
one or more of the following occurred: (1) If ISDA overestimated the
percentage of the index-based CDS that is currently being cleared;
(2) if BIS overestimated the size of the global index-based swap
market; (3) if a significant amount of compression occurs as index-
based CDS are moved into clearing; and/or (4) if a significant
portion of the cleared index-based CDS market is held at
clearinghouses other than CME, ICE Clear Europe, and ICE Clear
Credit. The Commission noted in the NPRM that it believes that the
compression of CDS positions moving into clearing is the most likely
explanation and therefore used the ISDA estimate.
---------------------------------------------------------------------------
Both of the above estimates assume that additional interest rate
swaps brought into clearing would have similar margin requirements per
unit of notional amount to those interest rate swaps that are already
in clearing, and assumes that additional CDS brought into clearing
would have similar margin requirements per unit of notional amount to
those CDS that are already being cleared. These assumptions, in turn,
assume similar levels of liquidity, compression, netting, and similar
tenors for the swaps that are currently cleared and those that are not.
While the Commission recognizes that these factors are unlikely to be
identical among both groups of products, adequate information to
quantify the impact of each of these possible differences between the
two groups of swaps on the amount of additional collateral that would
have to be posted is not available.
In any case, the Commission noted that it is probable that the
estimates in the NPRM significantly overstate the amount of additional
capital that would be posted for a number of reasons described below.
First, these estimates are based upon the assumption that every
interest rate swap and index-based CDS not currently cleared is brought
into clearing as a result of the Commission's determinations herein.
However, in this adopting release the Commission has set forth clearing
requirements only for certain classes of interest rate swaps and CDS,
and not for all interest rate swaps and CDS. Therefore, there will
still be certain types of interest rate swaps, such as those related to
the thirteen additional currencies cleared by LCH, that are not
required to be cleared. Moreover, the clearing requirement will apply
only to new swap transactions \215\ whereas market estimates include
legacy transactions. In addition, these estimates assume that no
additional voluntary clearing would be taking place in the absence of
the Commission's determinations. The Commission also observes that, to
the extent that portfolio margining for products such as CDS is
expanded to all market participants, it is likely to reduce the
additional margin that is required. In some instances, these margin
reductions for well-balanced portfolios could be significant.
---------------------------------------------------------------------------
\215\ As well as, applying to swaps subject to a change in
ownership, as explained above in Section III.D.
---------------------------------------------------------------------------
In addition, non-financial entities entering into swaps for the
purpose of hedging or mitigating commercial risk are not required to
use clearing under section 2(h)(7) of the CEA. As a consequence, many
entities will not be required to clear, even when entering into
interest rate swaps or CDS that are otherwise required to be cleared.
Third, some interest rate swaps and CDS involve cross border
transactions to which the Commission's clearing requirement will not
apply.\216\ Fourth, collateral is already posted with respect to many
non-cleared interest rate swaps and CDS. ISDA conducted a recent survey
which reported that 93.4% of all trades involving credit derivatives,
and 78.1% of all trades involving fixed income derivatives are subject
to collateral agreements.\217\ Moreover, although the Commission cannot
verify the accuracy of the estimate, ISDA estimated that the aggregate
amount of collateral in circulation in the non-cleared OTC derivatives
market at the end of 2011 was approximately $3.6 trillion.\218\
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\216\ Cross-Border Application of Certain Swaps Provisions in
the Commodity Exchange Act, 77 FR 41214 (July 12, 2012).
\217\ See ISDA Margin Survey 2012, at 15, available at http://www2.isda.org/functional-areas/research/surveys/margin-surveys/.
Although it is unclear exactly how many of the derivatives covered
by this survey are swaps, it is reasonable to assume that a large
part of them are.
\218\ This estimate, however, does not adjust for double
counting of collateral assets. The same survey reports that as much
as 91.1% of cash used as collateral and 43.8% of securities used as
collateral are being reused, and therefore are counted two or more
times in the ISDA survey. See ISDA Margin Survey 2012, at 20 and 11,
respectively.
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[[Page 74327]]
2. Comments Received in Response to NPRM Consideration of Costs and
Benefits
In the NPRM, the Commission requested comment regarding the total
amount of additional collateral that would be required due to the
proposed clearing requirement. In particular, the Commission sought
quantifiable data and analysis.\219\ No commenter addressed the
quantitative approach laid out by the Commission in the NPRM. Nor did
any commenter provide quantifiable data and analysis to support or
refute such analysis. Citadel stated that the Commission's
determination is justified on a cost-benefit basis, but did not address
the costs of collateral directly. FIA noted that the NPRM's cost-
benefit discussion ``is among the more thoughtful and comprehensive the
Commission has ever prepared,'' but did not address the costs of
collateral, fees, or other costs.
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\219\ 77 FR at 47214.
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3. Additional Research Reviewed by the Commission
Despite the lack of feedback from commenters regarding the costs of
collateral, the Commission continued to research market and academic
literature in the public domain for additional data. The Commission
identified and obtained two relevant papers. These papers are presented
as additional informative background regarding the costs of mandatory
clearing. The Commission has reviewed, but has not been able to verify,
the conclusions reached in these papers.
In a recent research note, Morgan Stanley estimated the global
increase in initial margin for interest rate swaps trades as a result
of the swap clearing requirements.\220\ Its ``bull case'' figure of $20
billion is largely consistent with the Commission's estimate of $19.2
billion in the NPRM calculated above, though its methodology is
different. Morgan Stanley obtained this figure in several steps. First,
it considered two main groups of interest rate swaps traders: dealers
and buy-side investors, which Morgan Stanley believes have interest
rate swaps with notional values of approximately $339 trillion and $89
trillion, respectively, outstanding. Next, Morgan Stanley projected
that the amount of new interest rate swaps that will be cleared as a
percentage of current notional would be 10% for dealers and 80% for
buy-side participants, assuming that ``most of the eligible dealer-to-
dealer trades are already centrally cleared.'' Finally, Morgan Stanley
multiplied the resulting amount of new interest rate swaps that will be
cleared for each group of traders by an initial margin to notional
ratio that they estimated.\221\ Currently, according to Morgan Stanley,
``the aggregate dealer initial margin as a percentage of notional
reported by LCH is approximately 0.005%.'' For dealers, the value of
0.00005 was therefore chosen as their initial margin to notional ratio.
For buy-side investors, however, Morgan Stanley scaled up LCH's
benchmark ratio of 0.00005 by a growth factor of 5 to ``[capture] the
extent to which buy-side portfolios are less diversified than dealers
and may enjoy less netting efficiencies.'' Overall, the report argued,
dealers and buy-side participants should expect their aggregate initial
margin to increase by $2 billion ($339,000B x 10% x 0.00005 [ap] $2B)
and $18 billion ($89,000B x 80% x 0.00005 x 5 [ap] $18B), respectively,
resulting in a total estimate of $20 billion in additional margin for
the bull case scenario. By scaling up LCH's benchmark ratio by a growth
factor in the range between 10-20 for each group of investors, Morgan
Stanley further obtained a ``base case'' figure of $480 billion and a
``bear case'' figure of $1.3 trillion. The difference between the
Commission's estimate and Morgan Stanley's base case figure or bear
case figure can largely be attributed to the following: the Commission
used LCH's current overall initial margin to notional ratio in its
calculations, whereas Morgan Stanley used LCH's current dealer initial
margin to notional ratio; more importantly, the Commission made the
simplifying assumption that the initial margin to notional ratio will
stay more or less constant, whereas Morgan Stanley scaled up its
benchmark ratio by a growth factor in a range between 10-20 based on
its ``discussions with clearing and banking industry professionals and
estimates made by [BIS]'' as well as its internal estimates.\222\
Putting aside the growth factor effect, it is worth emphasizing that
Morgan Stanley's estimates refer to the global increase in initial
margin, which may potentially be much larger than the additional amount
of initial margin required for those entities under the Commission's
jurisdiction.
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\220\ See Morgan Stanley, Morgan Stanley Research, ``Swap
Central Clearing: What is the Impact on Collateral?'' (August 2012).
\221\ This ratio is the initial margin divided by the notional
outstanding.
\222\ In particular, Morgan Stanley assumed that ``dealer
[initial margin] may grow over time due to higher CCP collateral
requirements and counterparty diversification regulations.''
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Also, the Commission notes that in Morgan Stanley's calculations,
the additional collateral required for buy-side swaps represents the
vast majority of the additional collateral required in each scenario
(approximately 95%, 74%, and 81% of the total additional capital
required for the ``bull case,'' ``base case,'' and ``bear case,''
respectively). A critical assumption driving each of these calculations
is that swaps with 80% of the total buy-side notional amount are moved
into clearing as a result of the mandate. However, the Commission
believes this assumption may be high in light of the end-user
exception, which includes an exemption for small financial institutions
with less than $10 billion in assets.\223\ Adjusting this assumption
downward would result in dramatic reductions in Morgan Stanley's
calculations regarding the amount of additional collateral that may be
required as a result of the mandate.
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\223\ See End User Exception to the Clearing Requirement for
Swaps, 77 FR 42560 (July 19, 2012).
---------------------------------------------------------------------------
TABB Group has also conducted a study recently that estimated the
global ``margin shortfall'' (i.e., the additional amount of initial
margin that will be required) for all OTC swaps due to clearing
requirements and anticipated margin requirements for uncleared
swaps.\224\ According to their model, the total amount of margin that
will be required for both cleared and uncleared swaps is estimated to
be between $2.9 trillion to $4.1 trillion, depending on the degree of
netting for each type of traders. Further, they estimate that $1.34
trillion of margin is already posted for all OTC swaps, leaving an
additional $1.56-2.76 trillion in margin that would need to be posted
for all swaps, including both cleared and uncleared positions. The
table below summarizes TABB Group's margin estimates by trader type.
---------------------------------------------------------------------------
\224\ See TABB Group, ``The New Global Risk Transfer Market:
Transformation and the Status Quo,'' (Sept. 2012).
[[Page 74328]]
Table 6--Margin Estimates by Trader Type in Billions of U.S. Dollars \225\
----------------------------------------------------------------------------------------------------------------
Gross
Gross margin Estimated netting Estimated
Trader type notional (1.5% of benefit margin
notional) posted
----------------------------------------------------------------------------------------------------------------
Dealers with CCP.................................. 248,561 3,728 3,710 (99.5%) 19
Other Dealers..................................... 305,624 4,584 1,605-2,521 (35-55%) 2,063-2,980
Financial Institutions............................ 59,964 899 225-405 (25-45%) 495-675
Non-Financial End Users........................... 33,851 508 76-178 (15-35%) 330-432
Others............................................ 60,000
-------------------------------------------------------------
Total......................................... ........... ........... ..................... 2,906-4,105
----------------------------------------------------------------------------------------------------------------
As shown in the table, if the amount for non-financial end-users
is excluded, then the margin shortfall will be adjusted down to $1.23-
2.33 trillion. Like the Commission, the TABB Group considered all the
OTC swaps, some of which are not covered by the clearing requirement.
---------------------------------------------------------------------------
\225\ Id.
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The TABB Group estimates are considerably higher than those of the
Commission and of Morgan Stanley largely because of different estimates
about what amount of netting will be possible for swaps not currently
being cleared, and in particular, for the swaps between dealers that do
not involve a CCP.
4. Collateral Costs and Costs of Capital
Given the increased collateral demands that required clearing of
interest rate swaps and CDS is likely to bring, there will be
corresponding demand for capital. To calculate the additional
collateral cost to market participants, the Commission in the NPRM
estimated the difference between the cost of capital for the additional
collateral and the returns on that capital. Although no comments
discussed this issue in comments on the NPRM, the Commission notes that
in comments regarding other Commission rules, commenters have sometimes
taken the view that the difference between the cost and returns on
capital for funds that are used as collateral is substantial.
The Commission described a comment on behalf of the Working Group
of Commercial Energy Firms in the NPRM. In this comment, an economic
consulting firm, NERA, used an estimate of 13.08% for the pre-tax
weighted average cost of capital for the firm, and an estimate of 3.49%
for the pre-tax yield on collateral, for a difference as 9.59% which
NERA used as the net pre-tax cost of collateral.\226\ However, as noted
in the NPRM, these estimates use the borrowing costs for the entire
firm, but only consider the returns on capital for one part of the
firm, when determining the spread between the two.\227\ The result is
an over-stated difference, and therefore a higher cost associated with
collateral than would result if the costs of capital and returns of
capital were compared on a consistent basis.\228\
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\226\ The NERA study is available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=50037 and their comments
defending their cost of capital are available in their letter at
http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=57015.
\227\ Moreover, according to Morgan Stanley's research note
cited above, many dealers and buy-side investors currently hold
enough unencumbered collateral to meet at least part of the
incremental initial margin requirements. In other words, each of
these entities will need to raise only a portion of the additional
capital required.
\228\ This aspect of the NERA study has been described in
greater detail by MIT professors John Parsons and Antonio Mello,
available at http://bettingthebusiness.com/2012/01/22/phantom-costs-to-the-swap-dealer-designation-and-otc-reform/ and http://bettingthebusiness.com/2012/03/19/nera-doubles-down/.
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However, as the Commission noted in the NPRM, this cost is not only
likely overstated, for the reasons mentioned above, but it also may not
be a new cost. Rather, it is a displacement of a cost that is embedded
in uncleared, uncollateralized (or under-collateralized) swaps.
Entering into a swap is costly for any market participant because of
the default risk posed by its counterparty, whether the counterparty is
a DCO, swap dealer, or other market participant. When a market
participant faces the DCO, the DCO accounts for that counterparty risk
by requiring collateral to be posted, and the cost of capital for the
collateral is part of the cost that is necessary in order to maintain
the swap position. When a market participant faces a dealer or other
counterparty in an uncleared swap, however, the uncleared swap contains
an implicit line of credit upon which the market participant
effectively draws when its swap position is out of the money.
Counterparties charge for this implicit line of credit in the spread
they offer on uncollateralized, uncleared swaps. It can be shown that
the cash flows of an uncollateralized swap (i.e., a swap with an
implicit line of credit) are, over time, substantially equivalent to
the cash flows of a collateralized swap with an explicit line of
credit.\229\ Moreover, because the counterparty credit risk created by
the implicit line of credit is the same as the counterparty risk that
would result from an explicit line of credit provided to the same
market participant, to a first order approximation, the charge for each
should be the same as well.\230\ This means that the cost of capital
for additional collateral posted as a consequence of requiring
uncollateralized swaps to be cleared does not introduce an additional
cost, but rather takes a cost that is implicit in an uncleared,
uncollateralized swap and makes it explicit. This observation applies
to capital costs associated with both initial margin and variation
margin.
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\229\ Antonio S. Mello, and John E. Parsons, ``Margins,
Liquidity, and the Cost of Hedging,'' MIT Center for Energy and
Environmental Policy Research, May 2012.
\230\ See id. at 12; Mello and Parsons state in their paper,
``Hedging is costly. But the real source of the cost is not the
margin posted, but the underlying credit risk that motivates
counterparties to demand that margin be posted.'' The paper goes on
to demonstrate that, ``To a first approximation, the cost charged
for the non-margined swap must be equal to the cost of funding the
margin account. This follows from the fact that the non-margined
swap just includes funding of the margin account as an embedded
feature of the package.'' Id. at 15-16.
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The Commission received no comment regarding the costs of
collateral it presented in the NPRM.
5. Regulatory Capital Implications
Another potential impact of the new clearing requirement that the
Commission described in the NPRM may result from the fact that
financial institutions are required to hold additional capital with
respect to their swap positions pursuant to prudential regulatory
capital requirements. Basel III standards are designed to incentivize
central clearing of derivatives by applying a lower capital weighting
to
[[Page 74329]]
them than for similar uncleared derivatives positions.\231\ Moreover,
bilateral margining regulations are currently being developed by the
Commission and U.S. prudential regulators that will subject uncleared
swaps entered into by swap dealers and major swap participants to
increased margin requirements in the near future.\232\ Therefore, the
Commission expects that, all things being equal, the capital that
certain financial institutions are required to hold is likely to be
reduced as a consequence of their increased use of swap clearing.
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\231\ See Basel Committee on Banking Supervision reforms--Basel
III, available at http://www.bis.org/bcbs/basel3/b3summarytable.pdf
(indicating that Basel III reforms will create capital incentives
for banks to use central counterparties for derivatives).
\232\ The Commission's proposed is Margin Requirements for
Uncleared Swaps for Swap Dealers and Major Swap Participants, 76 FR
23732 (Apr. 28, 2011); and the U.S. prudential regulators proposed a
similar requirement, Margin and Capital Requirements for Covered
Swap Entities, 76 FR 27564 (May 11, 2011).
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The Commission received no comment regarding the regulatory capital
discussion it presented in the NPRM.
6. Operational Issues Related to Collateralization
The Commission also discussed in the NPRM the operational costs
that may result from the collateral requirements that apply to the
clearing requirement. With uncleared swaps, the Commission noted,
counterparties may agree not to collect variation margin until certain
thresholds of exposure are reached, thus reducing or perhaps entirely
eliminating the need to exchange variation margin as exposure changes.
DCOs, on the other hand, collect and pay variation margin on a daily
basis and sometimes more frequently. As a consequence, more required
clearing may increase certain operational costs associated with moving
variation margin to and from the DCO. On the other hand, increased
clearing is also likely to lead to benefits from reduced operational
costs related to valuation disputes, as parties to cleared swaps agree
to abide by the DCO's valuation procedures. To the extent that the
requirement to clear the types of swaps covered by the new clearing
requirement leads to increased use of clearing, these costs and
benefits are likely to result.
The Commission received no comment regarding the operational costs
of collateral discussion it offered in the NPRM.
7. Guaranty Fund Contribution as a Collateral Cost
As explained in the NPRM, increases in clearing as a result of the
clearing requirement also may result in additional costs for clearing
members in the form of guaranty fund contributions. However, the
Commission noted, it may be that increased clearing of swaps would
decrease guaranty fund contributions for certain clearing members.
Market participants that currently transact swaps bilaterally, and do
not clear such swaps, must either become clearing members of an
eligible DCO or submit such swaps for clearing through an existing
clearing member of an eligible DCO, once the clearing requirement
applies to such swaps. A party that chooses to become a clearing member
of a DCO must make a guaranty fund contribution based on the risk that
its positions pose to the DCO. A party that chooses to clear swaps
through an existing clearing member may have a share of the clearing
member's guaranty fund contribution passed along to it in the form of
fees. While the addition of new clearing members and new customers for
existing clearing members may result in existing clearing members
experiencing an increase in their guaranty fund requirements, it should
be noted that if (1) new clearing members are not among the two
clearing members used to calculate the guaranty fund and (2) any new
customers trading through a clearing member do not increase the size of
uncollateralized risks at either of the two clearing members used to
calculate the guaranty fund, all else held constant, existing clearing
members may experience a decrease in their guaranty fund requirement.
The Commission received no comment regarding the guaranty fund
costs discussion it presented in the NPRM.
d. Benefits of Clearing
In the NPRM, the Commission also described the benefits of swap
clearing, which in general, are significant. Thus, to the extent that
the new clearing requirement for certain classes of interest rate swaps
and CDS leads to increased use of clearing, these benefits are likely
to result. As is the case for the costs noted above, it is difficult to
predict the precise extent to which the use of clearing will increase
as a result of the new requirement, and therefore the benefits of the
requirement cannot be precisely quantified. But the Commission believes
that the benefits of increased clearing resulting from this requirement
will be significant, because the classes of swaps required to be
cleared represent a substantial portion of the total swap markets.
Currently outstanding interest rate swaps and CDS indices represent
about 77.8% and 1.6%, respectively, of the total global swaps market,
when measured by notional amount.\233\ As noted above, the new clearing
requirement requires that only certain classes of interest rate swaps
and CDS indices be cleared, but such classes likely represent the most
common swaps within those overall asset classes, and therefore are
likely to comprise a relatively large portion of those asset classes.
The Commission reiterates the conclusion stated in the NPRM, which is
that by requiring these particular swaps to be cleared, the benefits of
clearing are expected to be realized across a relatively large portion
of the market.
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\233\ BIS data, December 2011, available at http://www.bis.org/statistics/derstats.htm. As explained above, the Commission observes
that while CDS accounts for a smaller portion of the total swaps
market, its unique risk profile involving jump-to-default risk
contributed to the Commission's decision to include it in among the
first clearing determinations.
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The new clearing requirement that swaps within certain classes be
cleared is expected to increase the number of swaps in which market
participants will face a DCO, and therefore, will face a highly
creditworthy counterparty. DCOs are some of the most creditworthy
counterparties in the swap market because, as explained above, they
have at their disposal a number of risk management tools that enable
them to manage counterparty risk effectively. Those tools include
contractual rights that enable them to use margin to manage current and
potential future exposure, to close out and transfer defaulting
positions while minimizing losses that result from such defaults, and
to protect solvency during the default of one or more members through a
waterfall of financial resources from which they can draw, as outlined
above. Also, clearing protects swap customers from the risk of having
to share losses in the event of the default of another clearing member.
Under Sec. 50.2(a) of this adopting release, swaps meeting the
specifications of the classes of swaps that are required to be cleared
must be submitted to clearing ``as soon as technologically practicable
after execution, but in any event by the end of the day of execution.''
\234\ This conforms to the requirements established in the recently
finalized rule
[[Page 74330]]
regarding timing of acceptance for clearing,\235\ which is designed to
promote rapid submission of these swaps for clearing and reduce the
unnecessary counterparty risk that can develop between the time of
execution and submission to clearing.\236\
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\234\ See Sec. 50.2(a) (setting for the timeframe for
submission of swaps to DCOs).
\235\ See Client Clearing Documentation, Timing of Acceptance
for Clearing, and Clearing Member Risk Management, 77 FR 21278 (Apr.
9, 2012).
\236\ The Commission notes that if a market participant executed
a swap that is required to be cleared on a SEF or DCM, then that
market participant will be deemed to have met their obligation to
submit the swap to a DCO because of the straight-through processing
rules previously adopted by the Commission.
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As it noted in the NPRM, the Commission expects that the
requirement for rapid submission, processing, and acceptance or
rejection of swaps for clearing will be beneficial in several respects.
It is important to note that when two parties enter into a bilateral
swap with the intention of clearing it, each party bears counterparty
risk until the swap is cleared. Once the swap is cleared, the
clearinghouse becomes the counterparty to each of the original parties,
which minimizes and standardizes counterparty risk.
Where swaps of the type covered by the new clearing requirement are
not executed on an exchange, the requirements of Sec. 50.2(a) should
significantly reduce the amount of time needed to process them.
Although costs associated with latency-period counterparty credit risk
cannot be completely eliminated in this context, the rules will reduce
the need to discriminate among potential counterparties in executing
off-exchange swaps, as well as the potential costs associated with
swaps that are rejected from clearing. By reducing the counterparty
risk that could otherwise develop during the latency period, these
rules promote a market in which all eligible market participants have
access to counterparties willing to trade on terms that approximate the
best available terms in the market. This is likely to improve price
discovery and promote market integrity.
Another benefit of the new clearing requirement is the mitigation
of systemic risk. Counterparty risk readily develops into systemic risk
in an interconnected financial system especially in times of financial
stress due to various types of contagion effects.\237\ By ensuring that
outstanding potential future and current exposures are collateralized
in a timely fashion for more swaps, this new clearing requirement
contributes to the mitigation of systemic risk.
---------------------------------------------------------------------------
\237\ For a comprehensive discussion of the various types of
contagion effects in times of financial stress, see Brunnermeier,
M., A. Crocket, C. Goodhart, A. Persaud, and H. Shin: ``The
Fundamental Principles of Financial Regulation,'' (2009), available
at http://www.princeton.edu/~markus/research/papers/Geneva11.pdf.
---------------------------------------------------------------------------
The Commission's consideration of the effect on the mitigation of
systemic risk is generally supported by comments, which provided
general observations regarding the mitigation of systemic risk. Citadel
and Eris Exchange both stated that implementing the clearing
requirement is a significant milestone toward ``achieving the Dodd-
Frank Act's objectives of reducing interconnectedness, mitigating
systemic risk, increasing transparency, and promoting competition in
the swaps market.'' Freddie Mac commented that it ``supports the
Commission's goal to reduce systemic risk through central clearing of
swaps where appropriate.'' On the other hand, ISDA urged the Commission
to consider the argument that ``clearing involves a greater
centralization of risk than the over-the counter markets ever did.''
ISDA also questioned the risk-mitigating aspects of central clearing as
contrasted with the new regulatory regime for uncleared swaps. In
response to ISDA's comment, the Commission observes that while the
regime for bilateral, uncleared swaps will be greatly improved after
full implementation of the Dodd-Frank Act reforms, central clearing
provides for certain risk management features that cannot be replicated
on a bilateral basis. To name just one critical distinction, a
clearinghouse addresses the tail risk of open positions through
mutualization. Each clearing member must contribute to a default fund
that protects the system as a whole. Also, recent experience indicates
that all DCOs were able to withstand the 2008 financial crisis in a
relatively sound manner.\238\
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\238\ No DCO required government assistance, and all DCOs were
able to manage their open positions in both swaps and futures. Even
difficult default situations were handled in an orderly fashion. For
example, during the Lehman Brothers' bankruptcy in September 2008,
LCH was able to manage the default of Lehman's significant swap
portfolio. See 77 FR at 47188 and LCH IRS submission, at 4
(discussing LCH's management of the Lehman Brothers' bankruptcy in
September 2008, where upon Lehman's default, LCH needed to risk
manage a portfolio of approximately 66,000 interest rate swaps,
which it hedged with approximately 100 new swap trades in less than
five days and only used approximately 35% of the initial margin
Lehman had posted).
---------------------------------------------------------------------------
Regarding competition, Markit stated that the new clearing
requirement might lower barriers to entry in the index provider market
``because new indices would not necessarily be subject to the clearing
mandate, which can be costly.'' Citadel commented that the framework
established by the Commission promotes competition among swap dealers,
as ``counterparty credit risk no longer features as a consideration in
the selection of executive counterparties.''
In addition, Sec. 50.10 and related guidance provides market
participants with a useful framework for behavior under the
requirements of section 2(h), which will promote the benefits of swap
clearing without introducing uncertainty regarding market behavior.
Activity conducted principally for a legitimate business purpose,
absent other indicia of evasion or abuse, would not constitute a
violation of Sec. 50.10 as described in the Commission's
interpretation.
D. Consideration of Alternative Swap Classes for Clearing
Determinations
The Commission's determination to require initially the clearing of
certain CDS and interest rate swaps is a function of both the market
importance of these products and the fact that they already are widely
cleared. In order to move the largest number of swaps to required
clearing in its initial determination, the Commission continues to
believe that it is prudent to focus on swaps that are widely used and
for which there is already a blueprint for clearing and appropriate
risk management. CDS and interest rate swaps that match these factors
are therefore well suited for required cleared.
As noted in the NPRM and discussed above, interest rate swaps with
a notional amount of $504 trillion are currently outstanding--the
highest proportion of the $648 trillion global swaps market of any
class of swaps.\239\ CDS indices with a notional amount of about $10.4
trillion are currently outstanding.\240\ While CDS indices do not have
as prominent a share of the entire swaps market as interest rate swaps,
uncleared CDS is capable of having a sizeable market impact, as it did
during the 2008 financial crisis. In addition, many of the swaps within
each of the classes that will now be subject to required clearing are
already cleared by one or more clearinghouses. LCH claims to clear
interest rate swaps with a notional amount of about $284 trillion--
meaning that, in notional terms, LCH represents that they clear just
over 50% of the interest rate swap market.\241\ The swap market has
made a smooth transition into clearing CDS on its own initiative. As a
result, DCOs, FCMs, and many market participants
[[Page 74331]]
already have experience clearing the types of swaps that will be
subject to required clearing. The Commission expects, therefore, that
DCOs and FCMs are equipped to handle the increases in volume and
outstanding notional amount in these swaps that is likely to be cleared
as the result of this rule. Because of the wide use of these swaps and
their importance to the market, and because these swaps are already
cleared safely, the Commission continues to believe it is reasonable to
initially subject certain types of interest rate swaps and CDS to the
clearing requirement.
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\239\ BIS data, June 2011, available at http://www.bis.org/publ/otc_hy1111.pdf.
\240\ See id.
\241\ See id.
---------------------------------------------------------------------------
In reviewing the swap submissions provided by DCOs, the Commission
decided to classify swaps according to certain key specifications for
CDS and interest rate swaps. These specifications inform whether a
particular swap falls within one of the classes of swaps that the
Commission has determined are required to be cleared. The two classes
of CDS that are required to be cleared are (1) U.S. dollar-denominated
CDS covering North America corporate credits and (2) euro-denominated
CDS referencing European corporate obligations. The four classes of
interest rate swaps required to be cleared are (1) fixed-to-floating
swaps, (2) basis swaps, (3) OIS, and (4) FRAs. In formulating each of
the six classes under this adopting release, the Commission considered
a number of alternatives.
Regarding CDS, the Commission outlined three key specifications
comprising (1) region and nature of reference entity, (2) the nature of
the CDS itself, and (3) tenor. Each of these specifications will assist
market participants in determining whether a swap falls within the CDS
classes of swaps required to be cleared. For the first, a
distinguishing characteristic is whether the reference entity is in
North American or European and whether it is one of Markit's CDX.NA.IG,
CDX.NA.HY, iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe
High Volatility indices. The second key specification relates to
whether the CDS is tranched or untranched. The classes that are
required to be cleared include only untranched CDS where the contract
covers the entire index loss distribution of the index and settlement
is not linked to a specified number of defaults. Tranched swaps, first-
or ``Nth'' to-default, options, or any other product variations on
these indices are excluded from these classes. Finally, the third key
specification entails whether a swap falls within a tenor, specific to
an index, that is required to be cleared. The Commission has determined
that each of the 3-, 5-, 7-, and 10-year tenors be included within the
class of swaps subject to the clearing requirement determination for
CDX.NA.IG; the 5-year tenor be included for CDX.NA.HY; each of the 5-
and 10-year for iTraxx Europe; the 5-year for iTraxx Europe Crossover;
and, the 5-year for iTraxx Europe High Volatility. In addition, it
should be noted that only certain series will be viewed as required to
be cleared.
The Commission considered a number of possible alternatives. First,
the Commission could have used a narrower or broader group of reference
entities. For example, the Commission has not included the
CDX.NA.IG.HVOL within the North American swap class, but it considered
doing so. The Commission concluded that while doing so would have
increased the number of swaps required to be cleared, there is not
sufficient liquidity to justify required clearing at this time given
that the recent series of CDX.NA.IG.HVOL has not been cleared by ICE
(and is not offered at all by CME).
Several commenters raised issues regarding the operational
capabilities of clearinghouses to manage the clearing of iTraxx CDS
indices for customers.\242\ More specifically, they pointed out that no
registered DCO currently offers customer clearing for iTraxx and
expressed concerns about the ability of clearinghouses to manage
restructuring credit events applicable to iTraxx. On the other hand,
Citadel and ICE both supported the inclusion of iTraxx CDS indices in
the clearing requirement. In particular, ICE stated that ICE Clear
Europe has begun the process of pursuing regulatory approval for
clearing of iTraxx and that ICE Clear Credit will do the same;
moreover, ICE said that it has worked closely with market participants
and DTCC to develop an industry wide solution for processing a
restructuring credit event.
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\242\ ISDA, FIA, MFA, and D.E. Shaw.
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Having considered the different views, the Commission is including
the iTraxx class of CDS as proposed. The Commission believes that the
uncertainty surrounding the implementation of customer clearing for
iTraxx will be resolved within the next few months, which will allow
this standard and liquid class of CDS to be cleared. If no eligible DCO
offers iTraxx for client clearing, compliance with the required
clearing of iTraxx will commence sixty days after the date on which
iTraxx is first offered for client clearing by an eligible DCO.
The Commission also considered whether it could include tranched
CDS in the clearing requirement. The Commission recognized in the NPRM
that there is a significant market for tranched swaps using the
indices. In these transactions, parties to the CDS contract agree to
address only a certain range of losses along the entire loss
distribution curve. Other swaps such as first or ``Nth'' to default
baskets, and options, also exist on the indices. However, these swaps
are not being cleared currently and were not submitted by a DCO for
consideration under Sec. 39.5. As a result, including tranched CDS was
not a viable alternative for this determination.
AFR noted that requiring clearing of only untranched CDS indices
may give rise to arbitrage opportunities, as the payoff properties
desired from an index can be closely replicated by trading tranches of
that index. The Commission recognizes this concern and will take into
account the possibility of arbitrage opportunities in its future
reviews of tranched CDS for clearing determination.
Regarding tenor, the Commission could have included more of those
offered within the classes of swaps required to be cleared. For
example, the Commission noted in the NPRM that the CDX.NA.IG has 1- and
2-year tenors and the CDX.NA.HY, has 3-, 7-, and 10-year tenors that
have not been included among the specified tenors. The iTraxx Europe
has 3- and 7-year tenors and the Crossover and High Volatility each
have 3-, 7-, and 10-year tenors that have not been included. In
addition, the Commission could have included all series of active
indices. The Commission's concern, regarding both tenors and series, is
that certain tenors and series have lower liquidity and may be
difficult for a DCO to adequately risk manage, which is reflected in
the fact that those tenors and series are not currently cleared by any
DCO. While including more tenors and series would have increased the
volume of swaps required to be cleared to some degree, the Commission
concluded that doing so could raise costs for DCOs and other market
participants and be less desirable relative to the factors established
in Sec. 39.5.
AFR commented that both the 1- and 2-year tenors of the CDX.NA.IG
should be included in the clearing requirement. It is concerned that
``market participants might shift to those tenors to avoid mandatory
clearing [of the longer tenors].'' The Commission notes that no DCO
currently clears the 1- or 2-year tenor of CDX.NA.IG, making the
clearing of either swap infeasible. However, the Commission recognizes
that requiring mandatory clearing of these shorter tenors may prevent
[[Page 74332]]
arbitrage opportunities if they generate sufficient trading volumes in
the future.
With regard to interest rate swaps, as mentioned above, the
Commission is finalizing a clearing requirement for four classes of
interest rate swaps: Fixed-to-floating swaps, basis swaps, OIS, and
FRAs. Within those four classes, there are three affirmative
specifications for each class ((i) Currency in which the notional and
payment amounts are specified, (ii) rates referenced for each leg of
the swap, and (iii) stated termination date of the swap). There are
also three ``negative'' specifications for each class ((i) No
optionality (as specified by the DCOs); (ii) no dual currencies; and
(iii) no unknown notional amounts). The Commission considered whether
to establish clearing requirements on a product-by-product basis. As
noted in the NPRM, such a determination would need to identify the
multitude of legal specifications of each product that would be subject
to the clearing requirement. Although the industry uses standardized
definitions and conventions, the product descriptions would be lengthy
and require counterparties to compare all of the legal terms of their
particular swap against the terms of the many different swaps that
would be included in a clearing requirement. The Commission continues
to believe that for interest rate swaps, a product-by-product
determination would be unnecessarily burdensome for market participants
in trying to assess whether each swap transaction is subject to the
requirement. A class-based approach allows market participants to
determine quickly whether they need to submit their swap to a DCO for
clearing by checking initially whether the swap has the basic
specifications that define each class subject to the clearing
requirement.
As an alternative to the classes selected, LCH recommended in its
IRS submission that the Commission use the following specifications to
classify interest rate swaps for purposes of making a clearing
determination: (i) Swap class (i.e., what the two legs of the swap are
(fixed-to-floating, basis, OIS, etc.)); (ii) floating rate definitions
used; (iii) the currency designated for swap calculations and payments;
(iv) stated final term of the swap (also known as maturity); (v)
notional structure over the life of the swap (constant, amortizing,
roller coaster, etc.); (vi) floating rate frequency; (vii) whether
optionality is included; and (viii) whether a single currency or more
than one currency is used for denominating payments and notional
amount. In its submission, CME recommended a clearing determination for
all non-option interest rate swaps denominated in a currency cleared by
any qualified DCO.
The Commission noted in the NPRM that these alternative
specifications fall into two general categories: specifications that
are commonly used to address mechanical issues for most swaps, and
specifications that are less common and address idiosyncratic issues
related to the particular needs of a counterparty. Examples of the
latter are special representations added to address particular legal
issues, unique termination events, special fees, and conditions tied to
events specific to the parties. None of the DCOs clear interest rate
swaps with terms in the second group. While such specifications may
affect the value of the swap, such specifications are not, generally
speaking, fundamental to determining the economic result the parties
are trying to achieve.\243\ The Commission is finalizing the three
affirmative specifications described above because it believes that
they are fundamental specifications used by counterparties to determine
the economic result of a swap transaction for each party.\244\
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\243\ As noted in Section II.E above, mechanical specifications
include characteristics such as floating rate reset tenors,
reference city for business days, business day convention, and
others that have some small impact on valuation but that do not
fundamentally alter the economic consequence of the swap for the
parties that enter into it.
\244\ In a comment, ISDA questioned the Commission's description
of mechanical and idiosyncratic factors. In response, the Commission
clarified that it is not introducing a new test for interest rate
swaps, but was merely setting forth and describing relevant class-
defining specifications. See Section II.D above for a full
discussion.
---------------------------------------------------------------------------
The Commission also noted in the NPRM that it could have not
included the negative specifications for interest rate swaps, which
would have had the potential effect of including more interest rate
swaps within the universe of those required to be cleared. However, the
Commission continues to believe that swaps with optionality (such as
swaptions or swaps with embedded options), multiple currency swaps, and
swaps with notional amounts that are not specified at the time of
execution raise concerns regarding adequate pricing measures and
consistency across swap contracts. Additionally, at this time, no DCO
is offering them for clearing.
Another alternative considered by the Commission and discussed in
the NPRM was that of stating the clearing requirement in terms of a
particular type of swap, rather than using broad characteristics to
describe the type of swaps for which clearing would be required. For
example, rather than requiring that all interest rate swaps that meet
the six specifications in Sec. 50.4(a) be cleared, the Commission
noted in the NPRM that the rule could have specified that only certain
sub-types of those interest rate swaps--such as all such interest rate
swaps with a term of five years--are required to be cleared. Such an
approach might permit the Commission to account for variation in
liquidity and outstanding notional values among different sub-types of
swap, and thereby focus the clearing requirement on very particular
swaps to account for these differences within the same general class.
Also, generally speaking, limiting the clearing requirement to fewer
swaps could reduce some costs associated with clearing.
However, this advantage was weighed against an important
disadvantage of this approach. A highly focused clearing requirement
could increase the ability for market participants to replicate the
economic results of a swap that is required to be cleared by
substituting a swap not required to be cleared; this greater latitude
for clearing avoidance, in turn, could increase systemic risk and
dampen the beneficial effects of clearing noted above.\245\ Under the
approach proposed by the Commission, all swaps that fall within
identified classes are covered by the clearing requirement, provided an
eligible DCO offers the swap for clearing, which reduces the risk of
such avoidance and the associated reduction of benefits. Moreover,
stating the clearing requirement in more general terms reduces the
costs associated with determining whether or not a particular swap is
subject to the clearing requirement.
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\245\ For instance, in the example noted above, swaps with a
term of five years and one day would not be required to be cleared.
---------------------------------------------------------------------------
Numerous commenters expressed support for the Commission's
specifications determination.\246\ CME stated that ``the Commission has
struck an appropriate balance for the initial slate of classes subject
to the requirement.'' LCH commented that ``the Commission's decision to
classify interest rate swaps based on six principle swap specifications
* * * is sound.'' Citadel stated that the Commission's class
designation approach ``reflects the risk management approach utilized
across the industry, and most importantly by DCOs'' to
[[Page 74333]]
determine necessary margin and other safeguards.
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\246\ AllianceBernstein, R.J. O'Brien, Citadel, Eris Exchange,
CME, FIA, D.E. Shaw, Arbor Research, LCH, Knight Capital, Jefferies,
Coherence Capital, CRT Capital, Javelin Capital, SDMA, Chris
Barnard, and Svenokur.
---------------------------------------------------------------------------
On the other hand, regarding interest rate swaps, ISDA is concerned
that the Commission's class-based approach will impose great burdens
and uncertainties in terms of ``the search efforts needed to filter out
from among the broad class those specific products that a DCO will
accept for clearing.'' The Commission notes that ISDA's concern may not
be justified, as CME already has a platform in place that ``provides
market participants with a tool to screen a particular swap for
eligibility for clearing upon submission of the swap to CME.''
The Commission also considered requiring clearing for all seventeen
currencies of interest rate swaps that are currently offered for
clearing, but decided instead to require clearing at this time for
interest rate swaps in four currencies (EUR, USD, GBP, and JPY). As
noted in the NPRM, the Commission recognizes that requiring interest
rate swaps in all seventeen currencies submitted by LCH to be cleared
would provide the benefit of some incremental reduction in overall
counterparty, and thus systemic, risk attendant to clearing a greater
portion of interest rate swaps. However, as noted above, the Commission
continues to believe that initiating the clearing requirement in a
measured manner with respect to interest rate swaps in the four
specified currencies familiar to many market participants is the
preferable approach at this time because it would give market
participants an opportunity to identify and address any operational
challenges related to required clearing. Moreover, the currencies
included in the required classes constitute approximately 93% of
cleared interest rate swaps, which suggests that significant reductions
in counterparty risk and gains in systemic protection will be
accomplished by limiting the clearing determination to them.\247\
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\247\ See Section II.F above for more thorough discussion of the
data.
---------------------------------------------------------------------------
LCH supported the Commission's determination, and recommended that
the Commission propose mandatory clearing of swaps denominated in the
other 13 currencies once the initial phase of mandatory clearing is
well-established. LCH stated that there is ``ample volume and liquidity
in swaps denominated in these currencies to support mandatory
clearing.'' The Commission will evaluate the benefits of this
recommendation against the cost burdens in its future determinations.
Similarly, the Commission considered requiring clearing of all CDS
that are currently being cleared, but did not propose to include, in
the initial clearing requirement, certain types of CDS that have a less
significant role in the current market.\248\
---------------------------------------------------------------------------
\248\ For instance, the Commission decided not to include
CDX.NA.IG.HiVol from the proposed determination given the lack of
volume in the current on-the-run and recent off-the-run series. In
addition, CME currently does not clear any HiVol contracts, and ICE
Clear Credit no longer clears the most recent series.
---------------------------------------------------------------------------
AFR and Chris Barnard both urged the Commission to rapidly
designate energy, agriculture and equity swaps for mandatory clearing
as well. The Commission reiterates that it will continue to review swap
submissions received from DCOs and will issue clearing requirement for
other classes of swaps so as to realize the benefits of clearing in a
timely manner.
E. Section 15(a) Factors
As noted above, the requirement to clear swaps within the classes
of swaps covered by this adopting release is expected to result in
increased use of clearing, although it is difficult to quantify the
extent of that increase. Thus, this section discusses the expected
results from an overall increase in the use of swap clearing in terms
of the factors set forth in section 15(a) of the CEA.
i. Protection of Market Participants and the Public
As described above, required clearing of CDS and interest rate
swaps resulting from this clearing determination is expected to reduce
counterparty credit risk for market participants that will now be
required to clear those swaps because they will face the DCO rather
than another market participant that lacks the full array of risk
management tools that the DCO has at its disposal. This increase in
clearing of CDS and interest rate swaps also reduces uncertainty in
times of market stress because market participants facing a DCO are
less concerned with the impact of such stress on the solvency of their
counterparty for cleared trades. Moreover, by reducing uncertainty
about counterparty solvency for market participants facing a DCO, the
clearing determinations under this adopting release are likely to
reduce the risk of contagion if one or more DCO customers or clearing
members fails during a time of market stress, which creates benefits
for the public.
By requiring clearing of swaps within certain classes, all of which
are already available for clearing, the Commission continues to expect,
as it stated in the NPRM, that this rule will encourage a smooth
transition to clearing by creating an opportunity for market
participants to work out challenges related to required clearing of
swaps while operating in familiar terrain. More specifically, the DCOs
will clear an increased volume of swaps that they already understand
and have experience managing. Similarly, FCMs likely will realize
increased customer and transaction volume as the result of the
requirement, but will not have to simultaneously learn how to
operationalize clearing for new types of swaps. Additionally, the
experience that current FCMs have with these swaps is likely to benefit
customers that are new to swap clearing, as the FCM guides them through
initial process of clearing swaps.\249\
---------------------------------------------------------------------------
\249\ As discussed in Section II.C and II.E above, DCOs offering
clearing for CDS and interest rate swaps have established extensive
risk management practices, which focus on the protection of market
participants. See also Sections II.D and II.F for a discussion of
the effect on the mitigation of systemic risk in the CDS market and
in the interest rate swaps market, as well as the protection of
market participants during insolvency events at either the clearing
member or DCO level.
---------------------------------------------------------------------------
In addition, uncleared swaps subject to collateral agreements can
be the subject of valuation disputes. These valuation disputes
sometimes require several months, or longer, to resolve.
Uncollateralized exposure can grow significantly during that time,
leaving one of the two parties exposed to counterparty credit risk that
was intended to be covered through a collateral agreement. DCOs
eliminate, or reduce, valuation disputes for cleared swaps as well as
the risk that uncollateralized exposure can develop and accumulate
during the time when such a dispute would have otherwise occurred, thus
providing additional protection to market participants that transact in
swaps subject to required clearing.\250\
---------------------------------------------------------------------------
\250\ See Sections II.D and II.F above for a further discussion
of how DCOs obtain adequate pricing data for the CDS and interest
rate swaps that they clear. Based on this pricing data, valuation
disputes are minimized, if not eliminated for cleared swaps.
---------------------------------------------------------------------------
As far as costs are concerned, market participants that do not
currently have established clearing relationships with an FCM will have
to set up and maintain such a relationship in order to clear swaps that
are required to be cleared. As discussed above, market participants
that conduct a limited number of swaps per year will likely be required
to pay monthly or annual fees that FCMs charge to maintain both the
relationship and outstanding swap positions belonging to the customer.
In addition, the FCM is likely to pass along fees charged by the DCO
for establishing and maintaining open positions.
[[Page 74334]]
ii. Efficiency, Competitiveness, and Financial Integrity of Swap
Markets
The Commission continues to expect, as it explained in the NPRM,
that increased clearing of the CDS and interest rate swaps subject to
this adopting release is expected to reduce uncertainty regarding
counterparty credit risk in times of market stress and promote
liquidity and efficiency during those times. Increased liquidity
promotes the ability of market participants to limit losses from
exiting positions effectively when necessary in order to manage risk
during a time of market stress.
In addition, to the extent that positions move from facing multiple
counterparties in the bilateral market to being run through a smaller
number of clearinghouses, clearing likely facilitates increased
netting. This netting effect reduces operational risk and may reduce
the amount of collateral that a party must post or pay in terms of
initial and variation margin.
As discussed in Sections II.D and II.F above, in setting forth this
new clearing requirement, the Commission took into account a number of
specific factors that relate to the financial integrity of the swap
markets. Specifically, the NPRM and the discussion above includes an
assessment of whether the DCOs clearing CDS and interest rate swaps
have the rule framework, capacity, operational expertise and resources,
and credit support infrastructure to clear CDS and interest rate swaps
on terms that are consistent with the material terms and trading
conventions on which the contract is then traded. The Commission also
considered the financial resources of DCOs to handle additional
clearing, as well as the existence of reasonable legal certainty in the
event of a clearing member or DCO insolvency.\251\
---------------------------------------------------------------------------
\251\ See Sections II.D and II.F.
---------------------------------------------------------------------------
As discussed above, bilateral swaps create counterparty risk that
may lead market participants to discriminate among potential
counterparties based on their creditworthiness. Such discrimination is
expensive and time consuming insofar as market participants must
conduct due diligence in order to evaluate a potential counterparty's
creditworthiness. Requiring the certain types of swaps subject to this
clearing determination to be cleared reduces the number of transactions
for which such due diligence is necessary, thereby contributing to the
efficiency of the swap markets.
In setting forth a clearing requirement for both CDS and interest
rate swaps, the Commission considered the effect on competition,
including appropriate fees and charges applied to clearing. As
discussed in more detail in Sections II.D and II.F above, there are a
number of potential outcomes that may result from required clearing.
Some of these outcomes may impose costs, such as if a DCO possessed
market power and exercised that power in a anticompetitive manner, and
some of the outcomes would be positive, such as if the clearing
requirement facilitated a stronger entry-opportunity for competitors.
As far as costs are concerned, the markets for some swaps within
the classes that are required to be cleared may be less liquid than
others. All other things being equal, swaps for which the markets are
less liquid have the potential to develop larger current
uncollateralized exposures after a default on a cleared position, and
therefore will require posting of relatively greater amounts of initial
margin.
iii. Price Discovery
As the Commission noted in the NPRM, clearing of CDS and interest
rate swaps subject to this new clearing requirement is likely to
encourage better price discovery because it eliminates the importance
of counterparty creditworthiness in pricing swaps cleared through a
given DCO. That is, by making the counterparty creditworthiness of all
swaps of a certain type essentially the same, prices should reflect
factors related to the terms of the swap, rather than the idiosyncratic
risk posed by the entities trading it.\252\
---------------------------------------------------------------------------
\252\ See Chen, K., et al., ``An Analysis of CDS Transactions:
Implications for Public Reporting,'' September 2011, Federal Reserve
Bank of New York Staff Reports, at 14, available at http://www.newyorkfed.org/research/staff_reports/sr517.pdf.
---------------------------------------------------------------------------
As discussed in Sections II.D and II.F above, DCOs obtain adequate
pricing data for the CDS and interest rate swaps that they clear. Each
DCO establishes a rule framework for its pricing methodology and
rigorously tests its pricing models to ensure that the cornerstone of
its risk management regime is as sound as possible.
iv. Sound Risk Management Practices
If a firm enters into swaps to hedge certain positions and then the
counterparty to those swaps defaults unexpectedly, the firm could be
left with large outstanding exposures and unhedged positions. As
explained in the NPRM and stated above, when a swap is cleared, the DCO
becomes the counterparty facing each of the two original counterparties
to the swap. This standardizes and reduces counterparty credit risk for
each of the two original participants. To the extent that a market
participant's hedges comprise swaps that are required to be cleared,
the requirement enhances their risk management practices by reducing
their counterparty risk. Accordingly, for counterparties required to
clear those CDS and interest rate swaps subject to this requirement,
risk management will be enhanced.
In addition, from systemic perspective, required clearing reduces
the complexity of unwinding/transferring swap positions from large
entities that default. Procedures for transfer of swap positions and
mutualization of losses among DCO members are already in place, and the
Commission continues to anticipate that they are much more likely to
function in a manner that enables efficient transfer of positions than
legal processes that apply to uncleared, bilateral swaps.\253\
---------------------------------------------------------------------------
\253\ As discussed in Sections II.C and II.E above, sound risk
management practices are critical for all DCOs, especially those
offering clearing for CDS and interest rate swaps. In the discussion
above, the Commission considered whether each DCO submission under
review was consistent with the core principles for DCOs. In
particular, the Commission considered the DCO submissions in light
of Core Principle D, which relates to risk management. See also
Sections II.D and II.F for a discussion of the effect on the
mitigation of systemic risk in the CDS market and in the interest
rate swaps market, as well as the protection of market participants
during insolvency events at either the clearing member or DCO level.
---------------------------------------------------------------------------
v. Other Public Interest Considerations
In September 2009, the President and the other leaders of the
``G20'' nations met in Pittsburgh and committed to a program of action
that includes, among other things, central clearing of all standardized
swaps.\254\ Together, interest rate swaps and CDS represent more than
75% of the notional amount of outstanding swaps, and therefore,
requiring the most active, standardized classes of swaps within those
groups to be cleared represents a significant step toward the
fulfillment of that commitment.
---------------------------------------------------------------------------
\254\ A list of the G20 commitments made in Pittsburgh can be
found at: http://www.g20.utoronto.ca/analysis/commitments-09-pittsburgh.html.
---------------------------------------------------------------------------
VI. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA) requires that agencies
consider whether the rules they propose will have a
[[Page 74335]]
significant economic impact on a substantial number of small entities
and, if so, provide a regulatory flexibility analysis respecting the
impact.\255\ As stated in the NPRM, the clearing requirement
determinations and rules proposed by the Commission will affect only
eligible contract participants (ECPs) because all persons that are not
ECPs are required to execute their swaps on a DCM, and all contracts
executed on a DCM must be cleared by a DCO, as required by statute and
regulation; not by operation of any clearing requirement.\256\
Accordingly, the Chairman, on behalf of the Commission, certified
pursuant to 5 U.S.C. 605(b) that the proposed rules would not have a
significant economic impact on a substantial number of small entities.
The Commission then invited public comment on this determination. The
Commission received no comments.
---------------------------------------------------------------------------
\255\ See 5 U.S.C. 601 et seq.
\256\ To the extent that this rulemaking affects DCMs, DCOs, or
FCMs, the Commission has previously determined that DCMs, DCOs, and
FCMs are not small entities for purposes of the RFA. See,
respectively and as indicated, 47 FR 18618, 18619, Apr. 30, 1982
(DCMs and FCMs); and 66 FR 45604, 45609, Aug. 29, 2001 (DCOs).
---------------------------------------------------------------------------
The Commission has previously determined that ECPs are not small
entities for purposes of the RFA.\257\ However, in its proposed
rulemaking to establish a schedule to phase in compliance with certain
provisions of the Dodd-Frank Act, including the clearing requirement
under section 2(h)(1)(A) of the CEA, the Commission received a joint
comment (Electric Associations Letter) from the Edison Electric
Institute (EEI), the National Rural Electric Cooperative Association
(NRECA) and the Electric Power Supply Association (EPSA) asserting that
certain members of NRECA may both be ECPs under the CEA and small
businesses under the RFA.\258\ These members of NRECA, as the
Commission understands, have been determined to be small entities by
the Small Business Administration (SBA) because they are ``primarily
engaged in the generation, transmission, and/or distribution of
electric energy for sale and [their] total electric output for the
preceding fiscal year did not exceed 4 million megawatt hours.'' \259\
Although the Electric Associations Letter does not provide details on
whether or how the NRECA members that have been determined to be small
entities use the interest rate swaps and CDS that are the subject of
this rulemaking, the Electric Associations Letter does state that the
EEI, NRECA, and EPSA members ``engage in swaps to hedge commercial
risk.'' \260\ Because the NRECA members that have been determined to be
small entities would be using swaps to hedge commercial risk, the
Commission expects that they would be able to use the end-user
exception from the clearing requirement and therefore would not be
affected to any significant extent by this rulemaking.
---------------------------------------------------------------------------
\257\ See 66 F.R. 20740, 20743 (Apr. 25, 2001).
\258\ See joint letter from EEI, NRECA, and ESPA, dated Nov. 4,
2011, (Electric Associations Letter), commenting on Swap Transaction
Compliance and Implementation Schedule: Clearing and Trade Execution
Requirements under Section 2(h) of the CEA, 76 FR 58186 (Sept. 20,
2011).
\259\ Small Business Administration, Table of Small Business
Size Standards, Nov. 5, 2010.
\260\ See Electric Associations Letter, at 2. The letter also
suggests that EEI, NRECA, and EPSA members are not financial
entities. See id., at note 5, and at 5 (the associations' members
``are not financial companies'').
---------------------------------------------------------------------------
Thus, because nearly all of the ECPs that may be subject to the
proposed clearing requirement are not small entities, and because the
few ECPs that have been determined by the SBA to be small entities are
unlikely to be subject to the clearing requirement, the Chairman, on
behalf of the CFTC, hereby certifies pursuant to 5 U.S.C. 605(b) that
the rules herein will not have a significant economic impact on a
substantial number of small entities.
B. Paperwork Reduction Act
The Paperwork Reduction Act (PRA) \261\ imposes certain
requirements on federal agencies (including the Commission) in
connection with conducting or sponsoring any collection of information
as defined by the PRA. As stated in the NPRM, Sec. 50.3(a), would
require each DCO to post on its Web site a list of all swaps that it
will accept for clearing and clearly indicate which of those swaps the
Commission has determined are required to be cleared, builds upon the
requirements of Sec. 39.21(c)(1), which requires each DCO to disclose
publicly information concerning the terms and conditions of each
contract, agreement, and transaction cleared and settled by the DCO.
The Commission received no comments related to PRA. Thus, this
rulemaking will not require a new collection of information from any
persons or entities.
---------------------------------------------------------------------------
\261\ 44 U.S.C. 3507(d).
---------------------------------------------------------------------------
List of Subjects
17 CFR Part 39
Business and industry, Reporting requirements, Swaps.
17 CFR Part 50
Business and industry, Clearing, Swaps.
For the reasons stated in the preamble, amend 17 CFR parts 39 and
50 as follows:
PART 39--DERIVATIVES CLEARING ORGANIZATIONS
0
1. The authority citation for part 39 continues to read as follows:
Authority: 7 U.S.C. 2 and 7a-1 as amended by Pub. L. 111-203,
124 Stat. 1376.
Sec. 39.6 [Removed and Reserved]
0
2. Remove and reserve Sec. 39.6.
PART 50--CLEARING REQUIREMENT AND RELATED RULES
0
3. The authority citation to part 50 is revised to read as follows:
Authority: 7 U.S.C. 2(h) and 7a-1 as amended by Pub. L. 111-203,
124 Stat. 1376.
0
4. Add subpart A, consisting of Sec. Sec. 50.1 through 50.24 to read
as follows:
Subpart A--Definitions and Clearing Requirement
Sec.
50.1 Definitions.
50.2 Treatment of swaps subject to a clearing requirement.
50.3 Notice to the public.
50.4 Classes of swaps required to be cleared.
50.5 Swaps exempt from a clearing requirement.
50.6 Delegation of authority.
50.7-50.9 [Reserved]
50.10 Prevention of evasion of the clearing requirement and abuse of
an exception or exemption to the clearing requirement.
50.11-50.24 [Reserved]
Subpart A--Definitions and Clearing Requirement
Sec. 50.1 Definitions.
For the purposes of this part,
Business day means any day other than a Saturday, Sunday, or legal
holiday.
Day of execution means the calendar day of the party to the swap
that ends latest, provided that if a swap is:
(1) Entered into after 4:00 p.m. in the location of a party; or
(2) Entered into on a day that is not a business day in the
location of a party, then such swap shall be deemed to have been
entered into by that party on the immediately succeeding business day
of that party, and the day of execution shall be determined with
reference to such business day.
Sec. 50.2 Treatment of swaps subject to a clearing requirement.
(a) All persons executing a swap that:
(1) Is not subject to an exception under section 2(h)(7) of the Act
or Sec. 50.50 of this part; and
[[Page 74336]]
(2) Is included in a class of swaps identified in Sec. 50.4 of
this part, shall submit such swap to any eligible derivatives clearing
organization that accepts such swap for clearing as soon as
technologically practicable after execution, but in any event by the
end of the day of execution.
(b) Each person subject to the requirements of paragraph (a) of
this section shall undertake reasonable efforts to verify whether a
swap is required to be cleared.
(c) For purposes of paragraph (a) of this section, persons that are
not clearing members of an eligible derivatives clearing organization
shall be deemed to have complied with paragraph (a) of this section
upon submission of such swap to a futures commission merchant or
clearing member of a derivatives clearing organization, provided that
submission occurs as soon as technologically practicable after
execution, but in any event by the end of the day of execution.
Sec. 50.3 Notice to the public.
(a) In addition to its obligations under Sec. 39.21(c)(1), each
derivatives clearing organization shall make publicly available on its
Web site a list of all swaps that it will accept for clearing and
identify which swaps on the list are required to be cleared under
section 2(h)(1) of the Act and this part.
(b) The Commission shall maintain a current list of all swaps that
are required to be cleared and all derivatives clearing organizations
that are eligible to clear such swaps on its Web site.
Sec. 50.4 Classes of swaps required to be cleared.
(a) Interest rate swaps. Swaps that have the following
specifications are required to be cleared under section 2(h)(1) of the
Act, and shall be cleared pursuant to the rules of any derivatives
clearing organization eligible to clear such swaps under Sec. 39.5(a)
of this chapter.
----------------------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------------
Specification Fixed-to-floating swap class
----------------------------------------------------------------------------------------------------------------
Currency........................ U.S. dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).
Floating Rate Indexes........... LIBOR............. EURIBOR........... LIBOR............. LIBOR.
Stated Termination Date Range... 28 days to 50 28 days to 50 28 days to 50 28 days to 30
years. years. years. years.
Optionality..................... No................ No................ No................ No.
Dual Currencies................. No................ No................ No................ No.
Conditional Notional Amounts.... No................ No................ No................ No.
----------------------------------------------------------------------------------------------------------------
Specification Basis swap class
----------------------------------------------------------------------------------------------------------------
Currency........................ U.S. dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).
Floating Rate Indexes........... LIBOR............. EURIBOR........... LIBOR............. LIBOR.
Stated Termination Date Range... 28 days to 50 28 days to 50 28 days to 50 28 days to 30
years. years. years. years.
Optionality..................... No................ No................ No................ No.
Dual Currencies................. No................ No................ No................ No.
Conditional Notional Amounts.... No................ No................ No................ No.
----------------------------------------------------------------------------------------------------------------
Specification Forward rate agreement class
----------------------------------------------------------------------------------------------------------------
Currency........................ U.S. dollar (USD). Euro (EUR)........ Sterling (GBP).... Yen (JPY).
Floating Rate Indexes........... LIBOR............. EURIBOR........... LIBOR............. LIBOR.
Stated Termination Date Range... 3 days to 3 years. 3 days to 3 years. 3 days to 3 years. 3 days to 3 years.
Optionality..................... No................ No................ No................ No.
Dual Currencies................. No................ No................ No................ No.
6. Conditional Notional Amounts. No................ No................ No................ No.
----------------------------------------------------------------------------------------------------------------
Specification Overnight index swap class
----------------------------------------------------------------------------------------------------------------
Currency........................ U.S. dollar (USD). Euro (EUR)........ Sterling (GBP).
Floating Rate Indexes........... FedFunds.......... EONIA............. SONIA.
Stated Termination Date Range... 7 days to 2 years. 7 days to 2 years. 7 days to 2 years.
Optionality..................... No................ No................ No.
Dual Currencies................. No................ No................ No.
Conditional Notional Amounts.... No................ No................ No.
----------------------------------------------------------------------------------------------------------------
(b) Credit default swaps. Swaps that have the following
specifications are required to be cleared under section 2(h)(1) of the
Act, and shall be cleared pursuant to the rules of any derivatives
clearing organization eligible to clear such swaps under Sec. 39.5(a)
of this chapter.
----------------------------------------------------------------------------------------------------------------
Specification North American untranched CDS indices class
----------------------------------------------------------------------------------------------------------------
Reference Entities............................................... Corporate.
Region........................................................... North America.
Indices.......................................................... CDX.NA.IG; CDX.NA.HY.
Tenor............................................................ CDX.NA.IG: 3Y, 5Y, 7Y, 10Y; CDX.NA.HY: 5Y.
Applicable Series................................................ CDX.NA.IG 3Y: Series 15 and all subsequent
Series, up to and including the current
Series.
CDX.NA.IG 5Y: Series 11 and all subsequent
Series, up to and including the current
Series.
CDX.NA.IG 7Y: Series 8 and all subsequent
Series, up to and including the current
Series.
CDX.NA.IG 10Y: Series 8 and all subsequent
Series, up to and including the current
Series.
CDX.NA.HY 5Y: Series 11 and all subsequent
Series, up to and including the current
Series.
Tranched......................................................... No.
----------------------------------------------------------------------------------------------------------------
[[Page 74337]]
Specification European untranched CDS indices class
----------------------------------------------------------------------------------------------------------------
Reference Entities............................................... Corporate.
Region........................................................... Europe.
Indices.......................................................... iTraxx Europe.
iTraxx Europe Crossover.
iTraxx Europe HiVol.
Tenor............................................................ iTraxx Europe: 5Y, 10Y.
iTraxx Europe Crossover: 5Y.
iTraxx Europe HiVol: 5Y.
Applicable Series................................................ iTraxx Europe 5Y: Series 10 and all
subsequent Series, up to and including the
current Series.
iTraxx Europe 10Y: Series 7 and all
subsequent Series, up to and including the
current Series.
iTraxx Europe Crossover 5Y: Series 10 and all
subsequent Series, up to and including the
current Series.
iTraxx Europe HiVol 5Y: Series 10 and all
subsequent Series, up to and including the
current Series.
Tranched......................................................... No.
----------------------------------------------------------------------------------------------------------------
Sec. 50.5 Swaps exempt from a clearing requirement.
(a) Swaps entered into before July 21, 2010 shall be exempt from
the clearing requirement under Sec. 50.2 of this part if reported to a
swap data repository pursuant to section 2(h)(5)(A) of the Act and
Sec. 46.3(a) of this chapter.
(b) Swaps entered into before the application of the clearing
requirement for a particular class of swaps under Sec. Sec. 50.2 and
50.4 of this part shall be exempt from the clearing requirement if
reported to a swap data repository pursuant to section 2(h)(5)(B) of
the Act and either Sec. 46.3(a) or Sec. Sec. 45.3 and 45.4 of this
chapter, as appropriate.
Sec. 50.6 Delegation of Authority.
(a) The Commission hereby delegates to the Director of the Division
of Clearing and Risk or such other employee or employees as the
Director may designate from time to time, with the consultation of the
General Counsel or such other employee or employees as the General
Counsel may designate from time to time, the authority:
(1) After prior notice to the Commission, to determine whether one
or more swaps submitted by a derivatives clearing organization under
Sec. 39.5 falls within a class of swaps as described in Sec. 50.4,
provided that inclusion of such swaps is consistent with the
Commission's clearing requirement determination for that class of
swaps; and
(2) To notify all relevant derivatives clearing organizations of
that determination.
(b) The Director of the Division of Clearing and Risk may submit to
the Commission for its consideration any matter which has been
delegated in this section. Nothing in this section prohibits the
Commission, at its election, from exercising the authority delegated in
this section.
Sec. 50.7-50.9 [Reserved].
Sec. 50.10 Prevention of evasion of the clearing requirement and
abuse of an exception or exemption to the clearing requirement.
(a) It shall be unlawful for any person to knowingly or recklessly
evade or participate in or facilitate an evasion of the requirements of
section 2(h) of the Act or any Commission rule or regulation
promulgated thereunder.
(b) It shall be unlawful for any person to abuse the exception to
the clearing requirement as provided under section 2(h)(7) of the Act
or an exception or exemption under this chapter.
(c) It shall be unlawful for any person to abuse any exemption or
exception to the requirements of section 2(h) of the Act, including any
exemption or exception as the Commission may provide by rule,
regulation, or order.
0
5. Designate Sec. 50.25 under new subpart B under the following
heading and add reserved Sec. Sec. 50.26 through 50.49.
Subpart B--Compliance Schedule
Sec.
50.25 Clearing requirement compliance schedule.
50.26-50.49 [Reserved]
0
6. Add subpart C, consisting of Sec. 50.50, to read as follows:
Subpart C--Exceptions and Exemptions to Clearing Requirement
Sec. 50.50 Exceptions to the clearing requirement.
(a) Non-financial entities. (1) A counterparty to a swap may elect
the exception to the clearing requirement under section 2(h)(7)(A) of
the Act if the counterparty:
(i) Is not a ``financial entity'' as defined in section
2(h)(7)(C)(i) of the Act;
(ii) Is using the swap to hedge or mitigate commercial risk as
provided in paragraph (c) of this section; and
(iii) Provides, or causes to be provided, the information specified
in paragraph (b) of this section to a registered swap data repository
or, if no registered swap data repository is available to receive the
information from the reporting counterparty, to the Commission. A
counterparty that satisfies the criteria in this paragraph (a)(1) and
elects the exception is an ``electing counterparty.''
(2) If there is more than one electing counterparty to a swap, the
information specified in paragraph (b) of this section shall be
provided with respect to each of the electing counterparties.
(b) Reporting. (1) When a counterparty elects the exception to the
clearing requirement under section 2(h)(7)(A) of the Act, one of the
counterparties to the swap (the ``reporting counterparty,'' as
determined in accordance with Sec. 45.8 of this part) shall provide,
or cause to be provided, the following information to a registered swap
data repository or, if no registered swap data repository is available
to receive the information from the reporting counterparty, to the
Commission, in the form and manner specified by the Commission:
(i) Notice of the election of the exception;
(ii) The identity of the electing counterparty to the swap; and
(iii) The following information, unless such information has
previously been provided by the electing counterparty in a current
annual filing pursuant to paragraph (b)(2) of this section:
(A) Whether the electing counterparty is a ``financial entity'' as
defined in section 2(h)(7)(C)(i) of the Act, and if the electing
counterparty is a financial entity, whether it is:
(1) Electing the exception in accordance with section
2(h)(7)(C)(iii) or section 2(h)(7)(D) of the Act; or
(2) Exempt from the definition of ``financial entity'' as described
in paragraph (d) of this section;
[[Page 74338]]
(B) Whether the swap or swaps for which the electing counterparty
is electing the exception are used by the electing counterparty to
hedge or mitigate commercial risk as provided in paragraph (c) of this
section;
(C) How the electing counterparty generally meets its financial
obligations associated with entering into non-cleared swaps by
identifying one or more of the following categories, as applicable:
(1) A written credit support agreement;
(2) Pledged or segregated assets (including posting or receiving
margin pursuant to a credit support agreement or otherwise);
(3) A written third-party guarantee;
(4) The electing counterparty's available financial resources; or
(5) Means other than those described in paragraphs
(b)(1)(iii)(C)(1), (2), (3) or (4) of this section; and
(D) Whether the electing counterparty is an entity that is an
issuer of securities registered under section 12 of, or is required to
file reports under section 15(d) of, the Securities Exchange Act of
1934, and if so:
(1) The relevant SEC Central Index Key number for that
counterparty; and
(2) Whether an appropriate committee of that counterparty's board
of directors (or equivalent body) has reviewed and approved the
decision to enter into swaps that are exempt from the requirements of
sections 2(h)(1) and 2(h)(8) of the Act.
(2) An entity that qualifies for an exception to the clearing
requirement under this section may report the information listed in
paragraph (b)(1)(iii) of this section annually in anticipation of
electing the exception for one or more swaps. Any such reporting under
this paragraph shall be effective for purposes of paragraph (b)(1)(iii)
of this section for swaps entered into by the entity for 365 days
following the date of such reporting. During such period, the entity
shall amend such information as necessary to reflect any material
changes to the information reported.
(3) Each reporting counterparty shall have a reasonable basis to
believe that the electing counterparty meets the requirements for an
exception to the clearing requirement under this section.
(c) Hedging or mitigating commercial risk. For purposes of section
2(h)(7)(A)(ii) of the Act and paragraph (b)(1)(iii)(B) of this section,
a swap is used to hedge or mitigate commercial risk if:
(1) Such swap:
(i) Is economically appropriate to the reduction of risks in the
conduct and management of a commercial enterprise, where the risks
arise from:
(A) The potential change in the value of assets that a person owns,
produces, manufactures, processes, or merchandises or reasonably
anticipates owning, producing, manufacturing, processing, or
merchandising in the ordinary course of business of the enterprise;
(B) The potential change in the value of liabilities that a person
has incurred or reasonably anticipates incurring in the ordinary course
of business of the enterprise;
(C) The potential change in the value of services that a person
provides, purchases, or reasonably anticipates providing or purchasing
in the ordinary course of business of the enterprise;
(D) The potential change in the value of assets, services, inputs,
products, or commodities that a person owns, produces, manufactures,
processes, merchandises, leases, or sells, or reasonably anticipates
owning, producing, manufacturing, processing, merchandising, leasing,
or selling in the ordinary course of business of the enterprise;
(E) Any potential change in value related to any of the foregoing
arising from interest, currency, or foreign exchange rate movements
associated with such assets, liabilities, services, inputs, products,
or commodities; or
(F) Any fluctuation in interest, currency, or foreign exchange rate
exposures arising from a person's current or anticipated assets or
liabilities; or
(ii) Qualifies as bona fide hedging for purposes of an exemption
from position limits under the Act; or
(iii) Qualifies for hedging treatment under:
(A) Financial Accounting Standards Board Accounting Standards
Codification Topic 815, Derivatives and Hedging (formerly known as
Statement No. 133); or
(B) Governmental Accounting Standards Board Statement 53,
Accounting and Financial Reporting for Derivative Instruments; and
(2) Such swap is:
(i) Not used for a purpose that is in the nature of speculation,
investing, or trading; and
(ii) Not used to hedge or mitigate the risk of another swap or
security-based swap position, unless that other position itself is used
to hedge or mitigate commercial risk as defined by this rule or Sec.
240.3a67-4 of this title.
(d) For purposes of section 2(h)(7)(A) of the Act, a person that is
a ``financial entity'' solely because of section 2(h)(7)(C)(i)(VIII)
shall be exempt from the definition of ``financial entity'' if such
person:
(1) Is organized as a bank, as defined in section 3(a) of the
Federal Deposit Insurance Act, the deposits of which are insured by the
Federal Deposit Insurance Corporation; a savings association, as
defined in section 3(b) of the Federal Deposit Insurance Act, the
deposits of which are insured by the Federal Deposit Insurance
Corporation; a farm credit system institution chartered under the Farm
Credit Act of 1971; or an insured Federal credit union or State-
chartered credit union under the Federal Credit Union Act; and
(2) Has total assets of $10,000,000,000 or less on the last day of
such person's most recent fiscal year.
Issued in Washington, DC, on November 29, 2012, by the
Commission.
Sauntia S. Warfield,
Assistant Secretary of the Commission.
Note: The following appendices will not appear in the Code of
Federal Regulations: Appendices to Clearing Requirement
Determination Under Section 2(h) of the CEA--Commission Voting
Summary and Statement of the Chairman.
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendix 1--Commission Voting Summary
On this matter, Chairman Gensler and Commissioners Sommers,
Chilton, O'Malia and Wetjen voted in the affirmative; no
Commissioner voted in the negative.
Appendix 2--Statement of Chairman Gary Gensler
I support the final rule requiring certain interest rate swaps
and credit default swap (CDS) indices to be cleared, as provided by
the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act).
Central clearing is one of the three major building blocks of
Dodd-Frank swaps market reform--in addition to promoting market
transparency and bringing swap dealers under comprehensive
oversight--and this rule completes the clearing building block.
Central clearing lowers the risk of the highly interconnected
financial system. It also democratizes the market by eliminating the
need for market participants to individually determine counterparty
credit risk, as now clearinghouses stand between buyers and sellers.
In a cleared market, more people have access on a level playing
field.
Small and medium-sized businesses, banks and asset managers can
enter the market and trade anonymously and benefit from the market's
greater competition.
Clearinghouses have lowered risk for the public and fostered
competition in the futures markets since the late 19th century.
Following the 2008 financial crisis, President Obama convened the G-
20 leaders in Pittsburgh in 2009, and an international
[[Page 74339]]
consensus formed that standardized swaps should be cleared by the
end of 2012.
The CFTC has already completed a number of significant Dodd-
Frank reforms laying the foundation of risk management for
clearinghouses, futures commission merchants and other market
participants that participate in clearing. Other reforms paving the
way for this rule include straight-through processing for swaps and
protections for customer funds.
This rule, which fulfills President Obama's G-20 commitment on
clearing, is the last step on the path to required central clearing
between financial entities. It benefited from significant domestic
and international consultation. Moving forward, we will work with
market participants on implementation. I would like to thank my
fellow Commissioners and the CFTC staff for all of their hard work
and dedication so that now clearing will be a reality in the swaps
market.
For this first set of determinations, the Commission looked to
swaps that are currently cleared by four derivatives clearing
organizations (DCOs).
This set includes standard interest rate swaps in U.S. dollars,
euros, British pounds and Japanese yen, as well as five CDS indices
on North American and European corporate names.
With this rule, swap dealers and the largest hedge funds will be
required to clear these swaps in March. Compliance would be phased
in for other market participants through the summer of 2013.
I believe that the Commission's determination for each class
satisfies the five factors provided for by Congress in the Dodd-
Frank Act, including the first factor that addresses outstanding
exposures, liquidity and pricing data.
Under the rule, a DCO must post on its Web site a list of all
swaps it will accept for clearing and must indicate which swaps the
Commission had determined are required to be cleared. In addition,
the Commission will post this information on our Web site.
[FR Doc. 2012-29211 Filed 12-12-12; 8:45 am]
BILLING CODE 6351-01-P
Last Updated: December 13, 2012