Federal Register, Volume 78 Issue 70 (Thursday, April 11, 2013)[Federal Register Volume 78, Number 70 (Thursday, April 11, 2013)]
[Rules and Regulations]
[Pages 21749-21785]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2013-07970]
[[Page 21749]]
Vol. 78
Thursday,
No. 70
April 11, 2013
Part III
Commodity Futures Trading Commission
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17 CFR Part 50
Clearing Exemption for Swaps Between Certain Affiliated Entities; Final
Rule
Federal Register / Vol. 78 , No. 70 / Thursday, April 11, 2013 /
Rules and Regulations
[[Page 21750]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 50
RIN 3038-AD47
Clearing Exemption for Swaps Between Certain Affiliated Entities
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 exempt swaps between certain affiliated
entities within a corporate group from the clearing requirement under
the Commodity Exchange Act (CEA or Act), enacted by Title VII of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank
Act). The regulations include specific conditions, as well as reporting
requirements, that affiliated entities must satisfy in order to elect
the inter-affiliate exemption from required clearing.
DATES: This final rule is effective June 10, 2013.
FOR FURTHER INFORMATION CONTACT: Sarah E. Josephson, Deputy Director,
202-418-5684, [email protected]; Nadia Zakir, Associate Director,
202-418-5720, [email protected]; Eric Lashner, Special Counsel, 202-418-
5393, [email protected]; Meghan Tente, Law Clerk, 202-418-5785,
[email protected]; Division of Clearing and Risk, Erik Remmler, Associate
Director, 202-418-7630, [email protected]; 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
II. Comments on the Notice of Proposed Rulemaking
A. Overview of Comments Received
B. Section 4(c) Authority
C. Definition of Affiliate Status
D. Inter-Affiliate Swap Documentation
E. Centralized Risk Management Program
F. Variation Margin
G. Treatment of Outward-Facing Swaps and Relief
H. Reporting Requirements and Annual Election
I. Implementation
III. Cost-Benefit Considerations
A. Statutory and Regulatory Background
B. Costs and Benefits of Exemption for Eligible Affiliate
Counterparties
C. Costs and Benefits of Exemption's Conditions
D. Costs and Benefits to Market Participants and the Public
E. Costs and Benefits Compared to Alternatives
F. Consideration of CEA Section 15(a) Factors
IV. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
I. Background
On August 21, 2012, the Commission published a notice of proposed
rulemaking proposing to exempt swaps between certain affiliated
entities from the clearing requirement under section 2(h)(1)(A) of the
CEA (NPRM).\1\ As proposed, Sec. 39.6(g) provides that counterparties
to a swap may elect an inter-affiliate exemption from the clearing
requirement if: (1) The financial statements of both counterparties are
reported on a consolidated basis, and either one counterparty directly
or indirectly holds a majority ownership interest in the other, or a
third party directly or indirectly holds a majority ownership interest
in both counterparties; (2) both counterparties comply with the
conditions set forth in the proposed rule; and (3) one of the
counterparties provides certain information on behalf of both
affiliated counterparties to either a registered swap data repository
(SDR) or the Commission if a registered SDR does not accept the
information. The Commission is hereby adopting proposed Sec. 39.6(g),
finalized as Sec. 50.52,\2\ subject to the changes discussed below.
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\1\ Clearing Exemption for Swaps Between Certain Affiliated
Entities, 77 FR 50425 (Aug. 21, 2012).
\2\ For ease of reference, the Commission is re-codifying
proposed Sec. 39.6(g) as Sec. 50.52 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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Section 723(a)(3) of the Dodd-Frank Act amended the CEA to provide,
under new section 2(h)(1)(A) of the CEA, that 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 (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.\3\ Section 2(h)(2)
of the CEA charges the Commission with the responsibility for
determining whether a swap is required to be cleared, through one of
two means: (1) Pursuant to a Commission-initiated review; or (2)
pursuant to a submission from a DCO of each swap, or any group,
category, type, or class of swaps that the DCO ``plans to accept for
clearing.'' On November 29, 2012, the Commission adopted its first
clearing requirement determination, requiring that swaps meeting the
specifications outlined in four classes of interest rate swaps and two
classes of credit default swaps (CDS) are required to be cleared.\4\
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\3\ Section 2(h)(7) of the CEA provides an exception to the
clearing requirement when one of the counterparties to a swap (i) is
not a financial entity, (ii) is using the swap to hedge or mitigate
commercial risk, and (iii) notifies the Commission how it generally
meets its financial obligations associated with entering into a non-
cleared swap.
\4\ Clearing Requirement Determination Under Section 2(h) of the
CEA, 77 FR 74284 (Dec. 13, 2012) (hereinafter ``Clearing Requirement
Determination'').
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The Clearing Requirement Determination adopting release provided a
specific compliance schedule for market participants to bring their
swaps into compliance with the clearing requirement.\5\ Swap dealers
(SDs), major swap participants (MSPs), and private funds active in the
swaps market were required to comply beginning on March 11, 2013, for
swaps they enter into on or after that date.\6\ Accounts managed by
third-party investment managers, as well as ERISA pension plans, have
until September 9, 2013, to begin clearing swaps entered into on or
after that date. All other financial entities are required to clear
swaps beginning on June 10, 2013, for swaps entered into on or after
that date. With regard to the CDS indices on European corporate names,
iTraxx, the Clearing Requirement Determination provided that, if no DCO
offered iTraxx for client clearing by February 11, 2013, the Commission
would delay compliance for those swaps until 60 days after an eligible
DCO offers iTraxx indices for client clearing. On February 25, 2013,
the Commission received notice from ICE Clear Credit LLC that it had
begun offering customer clearing of the iTraxx CDS indices that are
subject to the clearing requirement under Sec. 50.4(b). In accordance
with the timeframe previously set forth by the Commission,\7\ the
following compliance
[[Page 21751]]
dates shall apply to the clearing of iTraxx indices: Category 1
Entities: Friday, April 26, 2013; Category 2 Entities: Thursday, July
25, 2013; and all other entities: Wednesday, October 23, 2013.\8\
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\5\ See Clearing Requirement Determination at 74319-21.
\6\ The first compliance date for required clearing applies to
Category 1 Entities, as defined in Sec. 50.25(a). SDs and MSPs and
private funds active in the swaps market are defined as Category 1
Entities. Security-based swap dealers and major security-based
participants also are included in the definition. However, as the
Commission has stated, if a security-based swap dealer or a major
security-based swap participant is not yet required to register with
the Securities and Exchange Commission (SEC) at such time as the
Commission issues a clearing determination, then the security-based
swap dealer or a major security-based swap participant would be
treated as a Category 2 Entity, as defined in Sec. 50.25(a). See
Swap Transaction Compliance Implementation Schedule: Clearing and
Trade Execution Requirements under Section 2(h) of the CEA, 76 FR
58186, 58190 n.38 (Sept. 20, 2011).
\7\ Clearing Requirement Determination at 74319-21.
\8\ See Press Release, CFTC's Division of Clearing and Risk
Announces Revised Compliance Schedule for Required Clearing of
iTraxx CDS Indices (Feb. 25, 2013), available at http://www.cftc.gov/PressRoom/PressReleases/pr6521-13.
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II. Comments on the Notice of Proposed Rulemaking
The Commission received 13 comments during the 30-day public
comment period following publication of the NPRM on August 21, 2012,
and one additional comment after the comment period ended. The
Commission considered each of these comments in formulating the final
regulation, Sec. 39.6(g) (finalized as Sec. 50.52).
During the process of proposing and finalizing this rule, the
Chairman and Commissioners, as well as Commission staff, participated
in informational meetings with 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 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
authorities in developing the final regulations.
A. Overview of Comments Received
Of the 14 comment letters received by the Commission in response to
its NPRM, ten commenters expressed general support for the concept of
an inter-affiliate exemption from the clearing requirement.\9\ These
commenters offered comments addressing the proposed rule generally and
comments addressing specific provisions of the proposed rule. Comments
addressing specific provisions of the proposed rule are discussed in
detail below.
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\9\ Cravath, Swaine & Moore LLP (Cravath), the Coalition for
Derivatives End-Users (CDEU), the Financial Services Roundtable
(FSR), Chris Barnard, the Commercial Energy Working Group (The
Working Group), the Edison Electric Institute (EEI), The Prudential
Insurance Company of America (Prudential), Metropolitan Life
Insurance Company (MetLife), the International Swaps and Derivatives
Association and Securities Industry and Financial Markets
Association, (together, ISDA & SIFMA), and DLA Piper.
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A number of commenters requested a broader exemption with few or no
conditions. Cravath and DLA Piper requested that the Commission exempt
swaps between affiliates from all clearing, margining, and reporting
obligations. The Working Group, Cravath, CDEU, ISDA & SIFMA, DLA Piper,
and EEI \10\ recommended that the Commission eliminate, simplify or
minimize the conditions imposed, or unconditionally exempt inter-
affiliate swaps from clearing. These commenters stated that inter-
affiliate swaps pose little or no risk to the U.S. financial system and
do not increase the interconnectedness between major financial
institutions, particularly if affiliates' financial statements are
consolidated for accounting purposes. The Working Group commented that
entities use inter-affiliate trades not only to net risk related to
market-facing swaps, but also to transfer physical commodity or futures
exposure between affiliates for compliance with international tax law,
customs, or accounting laws. Similarly, MetLife and Prudential
supported the proposed exemption and noted that transactions between
affiliates do not present the same risks as market-facing swaps.
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\10\ EEI commented that ``corporate families typically face
bankruptcy together'' and that it is ``unusual for only one member
of a corporate group to go bankrupt.'' EEI also noted that a
bankruptcy could cause increased risk to clearinghouses that would
face multiple entities going into default at the same time if all
affiliates of one corporate group were required to clear their
inter-affiliate swaps.
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ISDA & SIFMA commented that inter-affiliate swaps provide important
benefits to corporate groups by enabling centralized management of
market, liquidity, capital, and other risks, and allowing affiliated
groups to realize associated hedging efficiencies and netting benefits.
Imposing mandatory clearing on inter-affiliate swaps, according to ISDA
& SIFMA, could compromise the ability of affiliated groups to realize
these benefits.\11\ ISDA & SIFMA also commented that third parties face
no increased risk from inter-affiliate swaps. In their view, the credit
risks faced by a third party entering into an uncleared swap with a
group member are a function of the group member's entire portfolio of
assets and liabilities and other credit factors.
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\11\ ISDA & SIFMA commented that inter-affiliate swaps do not
introduce risk into a corporate group, stating, ``[b]ecause capital,
liquidity and risk allocation decisions, as well as the exercise of
default remedies between group members are under unified management,
group entities do not face default risk of other group entities, so
long as the group as a whole is solvent.''
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Along the same lines, CDEU commented that non-financial entities
typically enter into external swaps with swap dealers and other large
banks that typically evaluate the risks of entering into swaps based on
the overall creditworthiness of their counterparties. These financial
entity counterparties, according to CDEU, have the opportunity to
review financial statements, the creditworthiness of any guarantor, and
a number of other credit-related items. After the credit review,
according to CDEU, the counterparties may request credit risk mitigants
such as corporate parent guarantees, collateral, and credit-based legal
terms.
On the other hand, Americans for Financial Reform (AFR) commented
that a wide-ranging exemption for inter-affiliate swaps could create
systemic risk and threaten the U.S. financial system. AFR cited a
number of reasons for its concern such as: the risk transfer between
separate corporate entities; the possibility for financial contagion to
be transferred from one part of a large financial institution to
different groups within the institution; restrictions on access to
affiliate assets across national boundaries; and reduction in volumes
at DCOs that could hurt liquidity and risk management. AFR further
noted that because the end-user exception is available for non-
financial and small financial entities in connection with swaps that
hedge or mitigate systemic risk, the inter-affiliate exemption is
primarily available for large financial institutions and speculative
trades by large commercial institutions with many affiliates.
Better Markets Inc. (Better Markets) also expressed concern that an
inter-affiliate exemption could be contrary to Congressional intent, as
expressed in the Dodd-Frank Act, if it is not a very narrow and
strictly implemented exemption.
Two individual persons commented against the proposed exemption.
Steve Wentz requested that the Commission not issue any exemptions
because the exemptions ``would just open the door to divert trades
through that open door to avoid protective oversight.'' Aaron D. Small
commented that the ``unregulated derivatives market has been a disaster
for the U.S. and world economy and must be reined in.''
Having considered these comments, and the specific comments
discussed below, the Commission is adopting the
[[Page 21752]]
proposed inter-affiliate exemption rule, subject to several important
modifications. The Commission recognizes the need for an exemption from
clearing for inter-affiliate swaps, but believes it is important to
establish certain conditions for entities electing the exemption. In
reaching this conclusion, the Commission considered the benefits of
clearing as recognized by the fact that Congress included a clearing
requirement in the Dodd-Frank Act, against the benefit to market
participants of being able to continue entering into inter-affiliate
swaps on an uncleared basis. The Commission believes it has reached an
appropriate balance by allowing an exemption from required clearing for
certain inter-affiliate swaps while imposing necessary conditions on
that exemption in order to ensure that all inter-affiliate swaps
exempted from required clearing meet certain risk-mitigating
conditions.
1. Benefits of Clearing and Its Role in the Dodd-Frank Act
As the Commission has previously stated,\12\ in the fall of 2008, a
series of large financial institution failures triggered a financial
and economic crisis that led to unprecedented governmental intervention
to ensure the stability of the U.S. financial system. The financial
crisis made clear that an uncleared, over-the-counter (OTC) derivatives
market can pose significant risks to the U.S. financial system.\13\
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\12\ See Clearing Requirement Determination at 74284-86; Cross-
Border Application of Certain Swaps Provisions of the Commodity
Exchange Act, 77 FR 41214, 41215-17 (July 12, 2012) (hereinafter
``Proposed Cross-Border Interpretive Guidance'').
\13\ 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 386, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf (``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.'').
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One of the most significant examples of this risk was the
accumulation of uncleared CDS entered into by an affiliate in the AIG
corporate group providing default protection on more than $440 billion
in bonds, leaving it with obligations that the AIG corporate family
could not cover as a result of changed market conditions.\14\ As a
result of the CDS exposure of this one affiliate, the U.S. Federal
government bailed out the AIG corporate group with over $180 billion of
taxpayer money in order to prevent AIG's failure and a possible
contagion event in the broader economy.\15\ While the downfall of AIG
was not caused by inter-affiliate swaps, the events surrounding AIG
during the 2008 crisis demonstrate how the risks of uncleared swaps at
one affiliate can have significant ramifications for the entire
affiliated business group.
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\14\ 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.
\15\ 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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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 certain swaps be cleared by DCOs is one of the cornerstones of
that reform. The CEA, as amended by Title VII, now requires a swap to
be cleared through a DCO if the Commission has determined that the
swap, or group, category, type, or class of swaps, is required to be
cleared, unless an exception to the clearing requirement applies. As
noted above, the only exception to the clearing requirement provided by
Congress was the end-user exception in section 2(h)(7) of the CEA.\16\
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\16\ Congress did not provide for an exception or exemption for
inter-affiliate swaps in the Dodd-Frank Act. However, commenters
have pointed to legislative history and statements made by members
of Congress supporting such an exemption at the time the Dodd-Frank
Act was enacted.
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The benefits of clearing derivatives have been recognized
internationally, as well. 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 by the end of 2012; and (3) non-centrally
cleared contracts should be subject to higher capital requirements.
The Commission believes that required clearing through a DCO is the
best means of mitigating counterparty credit risk and providing an
organized mechanism for collateralizing the risk exposures posed by
swaps. By clearing a swap, each counterparty no longer needs to rely on
the individual creditworthiness of the other counterparty for payment.
Both original counterparties now look to the DCO that has cleared their
swap to ensure that the payment obligations associated with the swap
are fulfilled. The DCO manages the risk of failure of a counterparty
through appropriate margining, a mutualized approach to default
management among clearinghouse members, and other risk management
mechanisms that have been developed over the more than 100 years that
modern clearinghouses have been in operation. Clearing can avert the
development of systemic risk by reducing the potential knock-on, or
domino, effect resulting from counterparties with large outstanding
exposures defaulting on their swap obligations and causing their
counterparties--counterparties that would otherwise be financially
sound if they had been paid--to default. Failure of those
counterparties could lead to the failure of yet other counterparties,
cascading through the economy and potentially causing systemic harm to
the U.S. financial system. Required clearing reduces this risk by
ensuring that uncollateralized risk does not accumulate in the
financial system.
2. Risks and Benefits Posed by Inter-affiliate Swaps
The Commission is not persuaded by comments suggesting that inter-
affiliate swaps pose no risk to the financial system or that clearing
would not mitigate those risks. Entities that are affiliated with each
other are separate legal entities notwithstanding their affiliation. As
separate legal entities, affiliates generally are not legally
responsible for each other's contractual obligations. This legal
reality becomes readily apparent when one or more affiliates become
insolvent.\17\ Affiliates, as separate legal entities, are managed in
bankruptcy as separate estates and the trustee for each debtor estate
has a duty to the creditors of the affiliate, not the corporate family,
the parent of the affiliates, or the corporate family's creditors.\18\
This potential for separate
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treatment in bankruptcy, calls into question commenters' claims that
third parties can rely on the creditworthiness of the entire corporate
group when entering into swaps with affiliates.
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\17\ Note, for example, that while the Rule 1015 of the Federal
Rules of Bankruptcy Procedure (FRBP) permits a court to consolidate
bankruptcy cases between a debtor and affiliates, FRBP Rule 2009
provides that, among other things, if the court orders a joint
administration of two or more estates under FRBP Rule 1015, the
trustee shall keep separate accounts of the property and
distribution of each estate. See Federal Rules of Bankruptcy
Procedure (2011).
\18\ See In re L & S Indus., Inc., 122 B.R. 987, 993-994 (Bankr.
N.D. Ill. 1991), aff'd 133 B.R. 119, aff'd 989 F.2d 929 (7th Cir.
1993) (``A trustee in bankruptcy represents the interests of the
debtor's estate and its creditors, not interests of the debtor's
principals, other than their interests as creditors of estate.'');
In re New Concept Housing, Inc., 951 F.2d 932, 938 (8th Cir. 1991)
(quoting In re L & S Indus., Inc.). While the concept of
``substantive consolidation'' of affiliates in a business enterprise
when they all enter into bankruptcy is sometimes used by a
bankruptcy court, substantive consolidation is generally considered
an extraordinary remedy to be used in limited circumstances. See
Substantive Consolidation--A Post-Modern Trend, 14 Am. Bankr. Inst.
L. Rev. 527 (Winter 2006).
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On the other hand, inter-affiliate swaps offer certain risk-
mitigating, hedging, and netting benefits as described by several
commenters including ISDA & SIFMA, The Working Group, CDEU, and EEI.
Furthermore, because affiliates in a corporate family generally
internalize the risks of inter-affiliate transactions in the affiliated
group, as described in the NPRM, the corporate family could face
serious reputational harm if affiliates default on their swaps.
Consequently, the entities within an affiliated group are incentivized
to fulfill their inter-affiliate swap obligations to each other, to
support each other to prevent outward-facing failures, and to resolve
any disagreements about the terms of inter-affiliate swaps more quickly
and amicably. As noted by ISDA & SIFMA, when an affiliated business
group is fiscally sound, the capital, liquidity, and risk allocation
decisions and default remedies between group members may be centrally
managed thereby reducing the likelihood of group entities facing
default risk of other group entities, ``so long as the group as a whole
is solvent.''
While in many circumstances, these characteristics of inter-
affiliate swaps may mitigate the risk of an affiliate defaulting on its
obligations--particularly when the group as a whole is financially
healthy--they do not constitute legally enforceable obligations pre-
bankruptcy or in bankruptcy.\19\ Accordingly, despite the existence of
mutual support incentives, a corporate group facing insolvency risk may
ultimately make the decision to allow some affiliates to fail and
default on their swap obligations so that other affiliates can survive
without becoming insolvent.\20\ In cases where an insolvent affiliate
has multiple obligations to third parties (swap-related or otherwise),
those third parties may be subject to a pro rata distribution along
with other creditors if the trust estate of the defaulting affiliate
does not have sufficient liquid assets to cover losses on its uncleared
swaps. It is at such times of financial stress that central clearing
serves as the most effective systemic risk mitigant.
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\19\ See Bankrupt Subsidiaries: The Challenges to the Parent of
Legal Separation, 25 Emory Bankr. Dev. J. 65 (2008); Liability of a
Parent Corporation for the Obligations of an Insolvent Subsidiary
Under American Case Law and Argentine Law, 10 Am. Bankr. Inst. L.
Rev. 217 (Spring 2002).
\20\ See, e.g., the bankruptcy of Residential Capital (ResCap)
and its subsidiaries. ResCap was a mortgage subsidiary of Ally
Financial Inc. ResCap declared bankruptcy independent of Ally
Financial Inc., which is not part of the bankruptcy proceeding and
continues to operate as a legally separate, solvent entity. See In
re Residential Capital, LLC, No. 12-12020 (MG) (Bankr. S.D.N.Y.
2012), available at http://www.kccllc.net/rescap. While the
bankruptcy of ResCap was not the direct result of inter-affiliate
swaps, ResCap's bankruptcy demonstrates that an affiliate can be put
into bankruptcy without forcing the affiliated parent to declare
bankruptcy or to be legally responsible for the affiliate's debts.
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3. The Commission's Consideration of the Risks and Benefits
In providing an inter-affiliate exemption from required clearing,
the Commission has considered the benefits that inter-affiliate swaps
offer corporate groups against the risk of allowing an exemption from
required clearing for swaps entered into by separate, but affiliated,
legal entities. In considering the risks and benefits, the Commission
was guided, in part, by comments pointing to the risk-mitigating
characteristics of inter-affiliate swaps and the sound risk management
practices of corporate groups that rely on inter-affiliate swaps. In
crafting the rule, the Commission sought to codify these
characteristics as eligibility criteria, or conditions, for the
exemption from required clearing. The conditions imposed are designed
to increase the likelihood that affiliates will take into consideration
their mutual interests when entering into, and fulfilling, their inter-
affiliate swap obligations. For example, the inter-affiliate exemption
may be elected only if the affiliates are majority owned and their
financial statements are consolidated, thereby increasing the
likelihood that entities will be mutually obligated to meet the group's
swap obligations. Additionally, the affiliates must be subject to a
centralized risk management program, the swaps and the trading
relationship between affiliates must be documented, and outward-facing
swaps must be cleared or subject to an exemption or exception from
clearing.
Despite the conditions to the exemption adopted in this final rule,
the Commission reminds market participants that the conditions included
in the final rule do not mitigate potential losses between inter-
affiliates to the extent that clearing would, particularly if one or
more affiliated entities become insolvent.
B. Section 4(c) Authority
Section 4(c)(1) of the CEA grants the Commission the authority to
exempt any transaction or class of transactions, including swaps, from
certain provisions of the CEA, including the clearing requirement, in
order to ``promote responsible economic or financial innovation and
fair competition.'' Section 4(c)(2) of the Act further provides that
the Commission may not grant exemptive relief unless it determines
that: (1) The exemption is appropriate for the transaction and
consistent with the public interest; (2) the exemption is consistent
with the purposes of the CEA; (3) the transaction will be entered into
solely between ``appropriate persons''; and (4) the exemption will not
have a material adverse effect on the ability of the Commission or any
contract market to discharge its regulatory or self-regulatory
responsibilities under the CEA.\21\ In enacting section 4(c), Congress
noted that the purpose of the provision is to give the Commission a
means of providing certainty and stability to existing and emerging
markets so that financial innovation and market development can proceed
in an effective and competitive manner.\22\
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\21\ 7 U.S.C. 6(c)(2).
\22\ House Conf. Report No. 102-978, 1992 U.S.C.C.A.N. 3179,
3213.
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In the NPRM, the Commission requested comment as to whether
exempting inter-affiliate swaps from the clearing requirement under
certain terms and conditions would be an appropriate exercise of its
section 4(c) authority.\23\ A number of commenters supported the
Commission's use of its section 4(c) authority to exempt inter-
affiliate swaps from clearing. According to MetLife and Prudential, the
inter-affiliate exemption as proposed promotes responsible economic or
financial innovation and fair competition by allowing corporate groups
to use inter-affiliate swaps to engage in effective and efficient risk
management activities. As an example, MetLife and Prudential explained
that corporate groups can use a single conduit in the market on behalf
of multiple affiliates within the group, which permits the corporate
group to net affiliates' trades. This netting effectively reduces the
overall risk of the corporate group and the number of open positions
with external market participants, which in turn reduces operational,
market, counterparty credit, and settlement risk. MetLife and
Prudential both expressed the view that inter-affiliate swaps do not
pose risks to
[[Page 21754]]
corporate groups and third parties, and both stated that inter-
affiliate swaps may pose less risk to corporate groups given efficient
netting across the corporate group. EEI also supported the Commission's
use of its section 4(c) authority for similar reasons to those stated
by MetLife and Prudential.
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\23\ See NPRM at 50428.
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ISDA & SIFMA stated that the Commission's proposed exemption meets
the requirements of section 4(c) of the CEA by promoting innovation and
competition, and the exemption serves the public interest. ISDA & SIFMA
noted that inter-affiliate swaps are integral to the strategies
consolidated financial institutions rely upon to meet customer needs in
an efficient, competitive, and sound manner. According to ISDA & SIFMA,
inter-affiliate swaps maximize hedging efficiencies and allow customers
to transact with a single client-facing entity in the customer's
jurisdiction, which increases the scope of risk-reducing netting with
individual customers as well as risk-reducing netting of offsetting
positions within the financial group. This allows the institution to
meet customer needs across jurisdictions and provide improved pricing
or other risk management benefits to customers, thereby promoting
financial innovation and competition. ISDA & SIFMA also commented that
inter-affiliate swaps allocate and transfer risks among members of a
corporate group rather than increasing risks.
CDEU also supported the Commission's use of its section 4(c)
authority. CDEU stated that the inter-affiliate exemption would promote
financial innovation, fair competition, and the public interest by
preserving the ability of corporate entities to centrally hedge the
risks of their affiliates. CDEU stated that without such an exemption
firms that currently use a central hedging model will be disadvantaged
as compared to direct competitors that do not use the same, efficient
risk management model. CDEU also noted the additional costs that would
be incurred from subjecting inter-affiliate swaps to clearing.
In the NPRM, the Commission requested comments on whether the
inter-affiliate exemption would be in the public interest. In addition
to responses noted above with regard to the public interest,\24\ the
Commission received two comment letters questioning whether the
proposed exemption serves the public interest.
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\24\ As noted above, CDEU, MetLife, Prudential, and ISDA & SIFMA
stated that an inter-affiliate exemption is consistent with the
public interest.
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According to AFR, there are serious doubts about whether the inter-
affiliate exemption is in the public interest. AFR stated that any
hedging and netting benefits gained from corporate groups engaging in
inter-affiliate swaps must be weighed against the benefits of full
novation to a central counterparty in the form of a clearinghouse,
which is a more comprehensive level of risk management. Given the
experience of the 2008 financial crisis, AFR noted that any risk-
reducing benefit of corporate group risk management practices assumes
that the corporate group actually implements and adheres to sufficient
risk management procedures. AFR is concerned about relying on such an
assumption in light of the fact that there was a large-scale failure of
proper risk management prior to and during the 2008 financial crisis.
Better Markets similarly commented that only a very narrow and
strict inter-affiliate exemption could be in the public interest.
Better Markets suggested ways in which the Commission should strengthen
the proposed exemption to satisfy the public interest standard,
including requiring a 100% majority ownership interest standard,
requiring that both initial and variation margin be exchanged, and
banning rehypothecation of posted collateral.\25\
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\25\ As discussed further below, both AFR and Better Markets
contend that all the proposed conditions must be retained and the
conditions must be strengthened in a number of ways.
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After considering the complete record in this matter, the
Commission has determined that the requirements of section 4(c) of the
Act have been met with respect to the exemptive relief described above.
The Commission believes that the exemption, as modified in this
release, is consistent with the public interest and with the purposes
of the CEA. The Commission's determination is based, in large part, on
the transactions that are covered under the exemption. Namely, as most
commenters noted, inter-affiliate transactions provide an important
risk management role within corporate groups. In addition, and as
discussed in the NPRM, the Commission recognizes that swaps entered
into between corporate affiliates, if properly risk-managed, may be
beneficial to the entity as a whole. Accordingly, in promulgating this
rule, the Commission concludes that an exemption subject to certain
conditions is appropriate for the transactions at issue, promotes
responsible financial innovation and fair competition, and is
consistent with the public interest. As the Commission noted in the
NPRM and as reiterated in AFR's comment, any benefits to the corporate
entity have to be considered in light of the risks that uncleared swaps
pose to corporate groups and market participants generally. For this
reason, the Commission is adopting an inter-affiliate exemption that is
narrowly tailored and subject to a number of important conditions,
including that affiliates seeking eligibility for the exemption
document and manage the risks associated with the swaps.
Further, the Commission finds that the exemption is only available
to ``appropriate persons.'' Section 4(c)(3) of the CEA includes within
the term ``appropriate person'' a number of specified categories of
persons, including ``such other persons that the Commission determines
to be appropriate in light of their financial or other qualifications,
or the applicability of appropriate regulatory protections.'' \26\
Given that only eligible contract participants (ECPs) can enter into
uncleared swaps and that the elements of the ECP definition (as set
forth in section 1a(18)(A) of the CEA and Commission regulation 1.3(m))
generally are more restrictive than the comparable elements of the
enumerated ``appropriate person'' definition, the Commission finds that
ECPs are appropriate persons within the scope of section 4(c)(3)(K) for
purposes of this final release and that in so doing, the class of
persons eligible to rely on the exemption will be limited to
``appropriate persons'' within the scope of section 4(c)(3) of the CEA.
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\26\ 7 U.S.C. 6(c)(3)(K).
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Finally, the Commission finds that this exemption will not have a
material effect on the ability of the Commission to discharge its
regulatory responsibilities. This exemption is limited in scope and, as
described further below, the Commission will have access to information
regarding the inter-affiliate swaps subject to this exemption because
they will be reported to an SDR pursuant to the conditions of the
exemption. In addition to the reporting conditions in the rule, the
Commission retains its special call, anti-fraud, and anti-evasion
authorities, which will enable it to adequately discharge its
regulatory responsibilities under the CEA.
For the reasons described in this release, the Commission believes
it is appropriate and consistent with the public interest to adopt such
an exemption.
[[Page 21755]]
C. Definition of Affiliate Status
As proposed, Sec. 39.6(g)(1) provides that counterparties to a
swap may elect the inter-affiliate exemption to the clearing
requirement if the financial statements of both counterparties are
reported on a consolidated basis, and either one counterparty directly
or indirectly holds a majority ownership interest in the other, or a
third party directly or indirectly holds a majority ownership interest
in both counterparties. The proposed rule further specified that a
counterparty or third party directly or indirectly holds a majority
ownership interest if it directly or indirectly holds a majority of the
equity securities of an entity, or the right to receive upon
dissolution, or the contribution of, a majority of the capital of a
partnership.
1. Majority Ownership Interest
Four commenters supported proposed Sec. 39.6(g)(1), which set
forth the requirements of an affiliate status. CDEU commented that the
majority-ownership test strikes an appropriate balance between ensuring
that the rule is not overly broad and providing companies with the
flexibility to account for differences in corporate structures. EEI
stated that majority ownership is sufficient to mitigate what EEI
believes is ``minimal'' risk posed by uncleared inter-affiliate swaps.
In addition, EEI noted that majority-owned affiliates will have strong
incentives to internalize one another's risks because the failure of
one affiliate impacts all affiliates within the corporate group. The
Working Group generally supported the Commission's definition, but
stated that inter-affiliate swaps should be unconditionally exempt from
mandatory clearing when the affiliates are consolidated for accounting
purposes.\27\ MetLife stated that it would likely limit inter-affiliate
trading to ``commonly-owned'' affiliates, but agreed with the
flexibility of including majority-owned affiliates.\28\
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\27\ The Working Group also stated that it was unable to
determine the scope of the proposed rule until the Commission
provides further guidance on the definition of ``financial entity''
under section 2(h)(7) of the CEA. In particular, The Working Group
asked that the Commission clarify the status of treasury affiliates
acting on behalf of affiliates able to claim an exception or
exemption from required clearing. The Working Group further
requested that the Commission provide guidance regarding what
constitutes being predominantly engaged in activities that are in
the business of banking or in activities that are financial in
nature, as defined in section 4(k) of the Bank Holding Company Act
of 1956, and clarify that trading physical commodities is not
financial in nature. In response to The Working Group and other
comments regarding the applicability of the end-user exception for
certain inter-affiliate swaps, the Commission notes that it will
address the use of treasury affiliates under a separate Commission
action. With regard to the definition of financial entity, the
Commission provided additional guidance in the end-user exception
rulemaking, and declined to interpret statutory provisions within
the jurisdiction of other U.S. authorities. See End-User Exception
to the Clearing Requirement for Swaps, 77 FR 42560, 42567 (July 19,
2012) (explaining that ``business of banking'' is a term of art
found in the National Bank Act and is within the jurisdiction of,
and therefore subject to interpretation by, the Office of the
Comptroller of the Currency and section 4(k) of the Bank Holding
Company Act is within the jurisdiction of, and therefore subject to
interpretation by, the Board of Governors of the Federal Reserve
System). Accordingly, further guidance on this issue is beyond the
scope of this rulemaking, except as provided in note 76 of this
release.
\28\ Prudential stated that its affiliates are all wholly-owned
affiliates and expressed no view on the issue of majority-owned
affiliates.
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Two commenters objected to proposed Sec. 39.6(g)(1) and requested
the Commission require 100% ownership of affiliates. AFR stated that
the systemic impact of swaps is based on ownership, not on corporate
control. AFR also stated that permitting such a low level of joint
ownership would lead to evasion of the clearing requirement through the
creation of joint ventures set up to enable swap trading between banks
without the need to clear the swaps. Similarly, Better Markets agreed
that only 100% owned affiliates should be eligible for the exemption
because allowing the exemption for the majority owner permits that
owner to disregard the views of its minority partners \29\ and creates
an incentive to evade the clearing requirement by structuring
subsidiary partnerships. Finally, Better Markets stated that the
majority-ownership standard would result in corporate groups
transferring price risk and credit risk to different locations,
facilitating interconnectedness and potentially giving rise to systemic
risk during times of market stress.
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\29\ Two other commenters also discussed the issue of minority
investors. ISDA & SIFMA stated that any concerns about the
protection of minority investors in group entities is ``the province
of corporate and securities laws.'' EEI noted that ``to the extent
minority owners have an opinion about electing the exemption, they
may negotiate with majority-owners as they deem commercially
appropriate for the right to participate in inter-affiliate clearing
decisions.''
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Having considered these comments, the Commission is adopting
proposed Sec. 39.6(g)(1) (now Sec. 50.52(a)) with the modifications
discussed below. The Commission believes that the majority-owned
standard is not overly broad and provides entities with flexibility to
account for differences in corporate structure. In particular,
requiring majority ownership serves to ensure that counterparty credit
risk posed by inter-affiliate swaps is internalized by the corporate
group.
In addition, as the NPRM noted, it is important for the inter-
affiliate clearing exemption to be harmonized with foreign
jurisdictions that have or are developing comparable clearing regimes
consistent with the 2009 G-20 Leaders' Statement.\30\ For example, the
European Parliament and Council of the European Union have adopted the
European Market Infrastructure Regulation (EMIR).\31\ Subject to the
relevant provisions, technical standards, and regulations under EMIR,
certain OTC derivatives transactions between parent and subsidiary
entities, could be exempt from its general clearing requirement.
Generally speaking, it appears that the intragroup exemptions under
EMIR will require majority-ownership rights and consolidated accounting
and annual reporting.\32\
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\30\ At the G-20 meeting in Pittsburgh in 2009, as noted above,
the G-20 Leaders declared that, ``[a]ll standardized OTC derivative
contracts should be traded on exchanges or electronic trading
platforms, where appropriate, and cleared through central
counterparties by end-2012 at the latest.'' G-20 Leaders' Final
Statement at Pittsburgh Summit: Framework for Strong, Sustainable
and Balanced Growth (Sept. 29, 2009).
\31\ See Regulation (EU) No 648/2012 of the European Parliament
and of the Council on OTC Derivatives, Central Counterparties and
Trade Repositories, 2012 O.J. (L 201) (hereinafter ``EMIR'')
available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2012:201:0001:0059:EN:PDF.
\32\ Id. at Articles 3 and 4.
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In response to the concerns of AFR and Better Markets regarding the
need for the Commission to adopt a stricter requirement of 100%
ownership, the Commission recognizes the potential for corporate
entities to structure their affiliates in such a manner as to evade the
clearing requirement. However, the Commission believes it has carefully
crafted a narrow exemption based on the condition that the affiliate is
majority-owned, along with the other conditions imposed under this
exemption. In terms of the interests of minority shareholders, the
Commission believes that the views of all shareholders should be taken
into account when an entity decides whether to clear a swap, but
ultimately, the decision is a matter for corporate and securities laws.
2. Consolidated Financial Statements
In addition to the majority-ownership requirement, proposed Sec.
39.6(g)(1) provided that counterparties to a swap may elect the inter-
affiliate exemption to the clearing requirement if the financial
statements of both counterparties are reported on a consolidated basis.
The Commission received several comments on this provision. The FSR
requested that the
[[Page 21756]]
Commission clarify that alternative accounting standards can be used
for purposes of meeting the requirement that the financial statements
of both affiliates be reported on a consolidated basis. In response to
a question in the NPRM regarding whether the exemption should be
limited to the ownership threshold based on section 1504 of the
Internal Revenue Code, MetLife and Prudential both explained that a
U.S. taxpayer cannot file consolidated U.S. tax returns with its non-
U.S. affiliate. Accordingly, both MetLife and Prudential stated that
they did not support such a limitation on the exemption.
In an effort to clarify the consolidated financial reporting
condition, the Commission is modifying the requirement that financial
statements be reported on a consolidated basis in two ways. First, the
Commission is clarifying which entities are subject to the consolidated
reporting condition. Under revised Sec. 50.52(a)(1)(i), if one of the
two affiliate counterparties claiming the exemption holds a majority
interest in the other affiliate counterparty (the ``majority-interest
holder''), then the financial statements of the majority-interest
holder must be reported on a consolidated basis and such statements
must include the financial results of the majority-owned counterparty.
On the other hand, under revised Sec. 50.52(a)(1)(ii), if a third
party is the majority-interest holder of both affiliate counterparties
claiming the exemption (the ``third-party majority-interest holder''),
then the financial statements of the third-party majority-interest
holder must be reported on a consolidated basis and such statements
must include the financial results of both affiliate counterparties to
the swap. In essence, the rule requires that the financial statements
of the majority-owner (whether a third party or not) are subject to
consolidation under accounting standards and must include either the
other affiliate counterparty's or both majority-owned affiliate
counterparties' financial results. The Commission is using the term
``financial results'' to refer to the financial statements, reports, or
other material of the majority-owned counterparty or counterparties
that must be consolidated with the majority owner's financial
statements.
The second modification to the proposed rule responds to FSR's
request that the Commission clarify that alternative accounting
standards are permitted. Accordingly, the consolidated financial
statements of the majority-interest holder or the third-party majority-
interest holder, as appropriate, may be prepared under either Generally
Accepted Accounting Principles (GAAP) or International Financial
Reporting Standards (IFRS). The modification reflects the fact that
entities claiming the exemption may be subject to different accounting
standards.
The Commission is not modifying the rule to limit the exemption to
an ownership threshold based on section 1504 of the Internal Revenue
Code.
D. Inter-Affiliate Swap Documentation
As proposed, Sec. 39.6(g)(2)(ii) provided that eligible affiliate
counterparties that elect the inter-affiliate exemption must enter into
swaps with a swap trading relationship document that is in writing and
includes all the terms governing the relationship between the
affiliates. These terms include, but are not limited to, payment
obligations, netting of payments, transfer of rights and obligations,
governing law, valuation, and dispute resolution. This requirement will
be satisfied if an eligible affiliate counterparty is an SD or MSP that
complies with the swap trading relationship documentation requirements
of Sec. 23.504. Regulation 23.504 includes all the proposed terms
under proposed Sec. 39.6(g)(2)(ii) plus a number of other specific
requirements. The NPRM stated that the burden on affiliates would not
be onerous because all affiliates should be able to use a master
agreement to document their swaps, however, in the NPRM the Commission
did not require the use of such a master agreement.
The Commission received a number of comments both supporting and
opposing the swap documentation requirement. Better Markets, MetLife,
and Prudential all supported the proposed documentation requirement.
Specifically, MetLife and Prudential did not believe that the
documentation requirement would be any more ``burdensome or costly''
for them because they already document all of their swaps.
Additionally, MetLife and Prudential commented that the proposed
documentation method is ``preferable'' to any other method and
represents industry best practice. Better Markets agreed with the
conditions imposed on the exemption, including the documentation
requirements, and stated that the conditions should not be
weakened.\33\
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\33\ While it did not address the documentation requirements
specifically, AFR stated that the proposed conditions on the
exemption should be fully retained. Similarly, Chris Barnard
generally expressed support for the proposed rules but did not
specifically mention the documentation provisions.
---------------------------------------------------------------------------
Cravath, EEI, CDEU, and DLA Piper opposed the proposed
documentation requirement. Cravath stated that the costs associated
with the imposition of documentation requirements outweigh any benefits
to the financial system, and that the Commission should leave the
determination as to the appropriate level of documentation to boards of
directors and management of companies, to determine based on the
``reasonable exercise of their fiduciary responsibilities.'' DLA Piper
commented that inter-affiliate swaps are typically documented by a
simple intercompany agreement, trade ticket or accounting entry rather
than ISDA Master Agreements, and that the documentation requirements
would be burdensome.
CDEU expressed concern that proposed Sec. 39.6(g)(2)(ii)(B) would
require that full ISDA Master Agreements be used to document inter-
affiliate swaps. CDEU explained that while many market participants use
master agreements, some end users many not have full master agreements
because inter-affiliate swaps are purely internal and do not increase
systemic risk.\34\ CDEU recommended that the proposed rule be revised
to require that the swap documentation ``include all terms necessary
for compliance with its centralized risk management program'' and
eliminate the list of required terms. CDEU also requested that the
Commission clarify that (1) market participants can continue to use
documentation required by their risk management programs, and (2) the
rule does not require market participants to use the ISDA Master
Agreements.
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\34\ CDEU recognized that SDs and MSPs and their counterparties,
including affiliates, will be subject to the requirements of Sec.
23.504, but stated that it is not appropriate to apply the same
requirements to non-registrant affiliates.
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EEI recommended that the Commission eliminate the documentation
requirement because the requirement is duplicative of corporate
accounting records that affiliates maintain as a matter of prudent
business practice. According to EEI, current accounting practices will
address the Commission's tracking and proof-of-claim concerns related
to inter-affiliate swaps. EEI commented that a documentation
requirement imposes ``an additional, costly layer of ministerial
process and documentation that is unnecessary to achieve the
Commission's stated objectives.'' \35\ EEI
[[Page 21757]]
requested that the Commission allow market participants ``to document
their inter-affiliate risk transfers pursuant to standard commercial
accounting and business records practices.''
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\35\ EEI commented on the NPRM's consideration of costs and
benefits and stated that the costs of the proposed documentation
requirement are unjustified. The NPRM included an estimate that
there would be a one-time cost of $15,000 to develop appropriate
documentation for use by an entity's affiliates. EEI objected to
this estimate because, in its view, the legal costs associated with
individually negotiating and amending standard agreements between
individual affiliates would exceed the NPRM's estimates. In
addition, EEI objected to the NPRM's estimate of 22 affiliated
counterparties for each corporate group as ``far too low'' for U.S.
energy companies. However, EEI did not provide specific,
quantitative information in terms of either the legal costs of
complying with the proposed documentation requirement or number of
affiliates for a corporate group subject to this rule.
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ISDA & SIFMA stated that the documentation requirements were overly
prescriptive and would impose unnecessary costs on affiliates.
Specifically, ISDA & SIFMA identified the valuation and dispute
resolution requirements as serving little purpose. ISDA & SIFMA
recommended a more flexible approach that would require adequate
documentation of ``all transaction terms under applicable law.''
The Commission considered all of the comments relating to the
proposed documentation requirement and is retaining the swap
documentation requirement subject to certain modifications recommended
by commenters. As discussed in the NPRM, the Commission is concerned
that without adequate documentation entities will be unable to track
and manage the risks arising from inter-affiliate swaps. Equally
important, affiliates must be able to offer sufficient proof of claim
in the event of insolvency. The Commission is adopting proposed Sec.
39.6(g)(2)(ii)(A) (now Sec. 50.52(b)(2)(i)), which essentially
confirms the applicability of Sec. 23.504 to swaps between affiliates
where one of the affiliates is an SD or MSP. However, with regard to
swaps between affiliates that are not SDs or MSPs, and in response to
commenters' requests for a more flexible standard, the Commission is
adopting ISDA & SIFMA's recommendation that the focus of the
documentation requirement be on documenting all of an inter-affiliate
transaction's terms. Accordingly, the Commission is modifying proposed
Sec. 39.6(g)(2)(ii)(B) (now Sec. 50.52(b)(2)(ii)), to require that
``the terms of the swap are documented in a swap trading relationship
document that shall be in writing and shall include all terms governing
the trading relationship between the eligible affiliate
counterparties.''
Under this modification, the Commission is eliminating the non-
exclusive list of terms, which included payment obligations, netting of
payments, transfer of rights and obligations, governing law, valuation,
and dispute resolution. The change responds to commenters' requests for
a more flexible approach that reflects current market best practices.
While, in most instances, the Commission anticipates that documentation
between affiliates will include all of the previously enumerated terms,
the more general rule formulation signals that market participants
retain the ability to craft appropriate documentation for their
affiliated entities. This modification also serves to address concerns
that the intent of the proposed rule was to require formal master
agreements, such as the ISDA Master Agreement. As explained above, the
proposed rule was not intended to require affiliates to enter into
formal master agreements. Rather, the Commission observed that parties
that already use master agreements to document their inter-affiliate
swaps would likely meet the requirements of the inter-affiliate
exemption without additional costs.\36\ This observation was supported
by commenters such as MetLife and Prudential.
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\36\ See Confirmation, Portfolio Reconciliation, Portfolio
Compression, and Swap Trading Relationship Documentation
Requirements for Swap Dealers and Major Swap Participants, 77 FR
55904, 55906 (Sept. 11, 2012) (recognizing that the ISDA Master
Agreement, and other associated documents in their pre-printed form
as published by ISDA are capable of compliance with the rules, but
noting that such agreements are subject to customization by
counterparties and such customization may or may not comply with
Commission requirements).
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This modification also responds, in part, to CDEU's request that
the documentation ``include all terms necessary for compliance with its
centralized risk management program.'' While the Commission is
modifying the rule to delete the specific references to valuation and
dispute resolution procedures, ensuring that affiliates entering into
swaps have sound procedures in place to value their swaps and resolve
any disputes is critical to risk management. Accordingly, as discussed
further below, the Commission anticipates that affiliates will include
rigorous valuation provisions and procedures for elevating and
resolving disputes in their risk management programs.
In response to comments from Better Markets and AFR that the
proposed regulations should be retained and not weakened, the
Commission does not believe that eliminating the non-exclusive list of
terms and replacing it with a simple requirement that all terms of the
swap transaction and the relationship between the affiliates be
documented will weaken the rule. Rather, eligible affiliates will have
some discretion, but also have the obligation to ensure that their
documentation contains an accurate and thorough written record of their
swaps. The Commission clarifies, however, that book entries would not
suffice for purposes of complying with the swap documentation condition
because such entries do not contain sufficient information to
adequately document the swap or the trading relationship between
affiliates.
EEI requested that, if the Commission retains the documentation
requirement, the Commission clarify that swap confirmations are not
required because executing confirmations would impose substantial
costs. In response to this request, the Commission clarifies that for
swaps between affiliates where one or both of the affiliates is an SD
or MSP, the confirmation rules under Sec. 23.501 are incorporated into
Sec. 23.504.\37\ As a result, those affiliates must confirm all the
terms of their transactions according to the applicable timeframes set
forth under Sec. 23.501.\38\ By contrast, for swaps between affiliates
that are not SDs or MSPs, the provisions of Sec. 23.501 do not apply
and formal confirmation pursuant to Sec. 23.501 is not required.
However, the Commission notes that the terms of the swap will be
documented by the affiliates and confirmation of those terms will be
reported to an SDR under the Commission's reporting rules.\39\
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\37\ See 17 CFR 23.504(b)(2); 77 FR 55907-08.
\38\ See 17 CFR 23.501.
\39\ See, e.g., 17 CFR 45.3(c)(1)(iii) (requiring the reporting
counterparty to report all confirmation data for the swap as soon as
technologically practicable after confirmation, but no later than 30
minutes after confirmation if confirmation occurs electronically or
24 business hours after confirmation if confirmation does not occur
electronically).
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E. Centralized Risk Management Program
Proposed Sec. 39.6(g)(2)(iii) requires the swap to be subject to a
centralized risk management program that is ``reasonably designed to
monitor and manage the risks associated with the swap.'' If at least
one of the eligible affiliate counterparties is an SD or MSP, the
centralized risk management requirement is satisfied by complying with
the requirements of Sec. 23.600.\40\
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\40\ 17 CFR 23.600; Swap Dealer and Major Swap Participant
Recordkeeping, Reporting, and Duties Rules; Futures Commission
Merchant and Introducing Broker Conflict of Interest Rules; and
Chief Compliance Officer Rules for Swap Dealers, Major Swap
Participants, and Futures Commission Merchants, 77 FR 20128 (Apr. 2,
2012).
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[[Page 21758]]
Five commenters generally supported proposed Sec. 39.6(g)(2)(iii).
AFR supported the proposed risk management program requirement and
stated that dispensing with or weakening this condition, or any of the
conditions, would heighten systemic risk and call into question the
Commission's exemptive authority. Better Markets agreed that requiring
a centralized risk management program was wholly appropriate and should
be maintained as a requirement.
Prudential and MetLife confirmed that both companies currently have
centralized risk management programs and consider them to be consistent
with current practice in the industry. Prudential noted that it
structured its risk management system to allow only one affiliate to
enter into swaps with third parties, which permits Prudential to impose
a single credit limit on its market-facing counterparty relationships.
MetLife's enterprise-wide risk management system provides all
affiliates trading derivatives with affiliate-specific sets of
guidelines and limits that are also included in enterprise-wide
guidance and limits.
Finally, CDEU expressed support for the centralized risk management
program requirement, but requested that the Commission clarify that the
level of risk management for inter-affiliate swaps not be interpreted
as requiring the same level of risk management that end-users maintain
for external third-party swaps. CDEU noted that most end users that use
inter-affiliate swaps currently have robust centralized risk management
programs in place to monitor all external swap risks and affiliates are
required to follow group-wide risk polices. CDEU was supportive of the
proposal so long as the requirement is interpreted reasonably and
permits entities to ``implement risk policies and procedures
appropriate to the risks of a corporate group's inter-affiliate
swaps.''
Four commenters objected to the proposed requirement, suggested
alternatives, and/or requested clarification. FSR stated that the
condition should be eliminated because integrated risk management
systems ``are generally not established across international
boundaries'' and are not consistent with general risk practices in
large, multinational organizations. FSR suggested that the requirement
be dropped in favor of each entity making ``its own evaluations of the
risk associated with an inter-affiliate position.''
Cravath stated that in many cases, for companies outside of the
financial sector, the proposed rule will require a substantial change
in the processes and procedures currently maintained by such companies,
and the cost of complying with the risk management program requirements
outweigh any benefits to the financial system. Cravath commented that
rather than subject companies to a risk management rule, ``[c]ompanies
should have the flexibility to engage in prudent risk management for
their corporate group in a manner consistent with the overall level of
risks to their business.''
EEI suggested that the Commission eliminate the centralized risk
management program requirement on the grounds that it would be
duplicative for corporate groups that already have risk management
programs in place. According to EEI, it is standard industry practice
for both private and public companies to have a risk management
program. EEI accordingly does not see a ``need to impose a separate,
discrete regulatory requirement to document with an SDR or the
Commission the existence of a centralized risk management program.'' If
the Commission decides to retain the requirement, EEI requested that
the Commission require a program be ``reasonably designed to monitor
and manage the risks associated with the swap'' and provide the
flexibility to design risk management programs that address the unique
risks of an entity's business.
The Working Group requested that the Commission clarify whether
non-SDs and non-MSPs would be subject to the same enterprise-level risk
management program as required for SDs and MSPs under Sec. 23.600. If
the Commission intended to require the same level of risk management,
The Working Group commented that there are ``a number of commercially
and legally valid reasons'' why a centralized risk management program
in accordance with Sec. 23.600 would be inconsistent with current
industry practice. The Working Group cited cost as a reason companies
do not provide for centralized risk management on different continents,
in addition to antitrust and other regulatory reasons. The Working
Group requested that the Commission clarify that the rule requires only
that both counterparties be subject to a ``robust risk management
program.''
In response to comments, the Commission observes a general
consensus that market participants have risk management policies and
procedures in place, at least with regard to affiliates located in the
same jurisdiction. FSR and The Working Group questioned whether
entities have centralized risk management programs for affiliates in
different jurisdictions and whether such cross-border risk management
systems are prohibitively costly. In response to these comments, the
Commission points to comments stating that inter-affiliate swaps play a
critical role in an entity's overall management of risk and provide
netting benefits among affiliates. Consequently, it stands to reason
that inter-affiliate swaps between affiliates in different
jurisdictions are as much a part of an entity's overall risk management
framework as swaps between affiliates located in the same jurisdiction.
The Commission does not believe that it would be prudent business
practice for affiliates to enter into inter-affiliate swaps without
risk management systems integrated across international boundaries to
the extent that the entity permits affiliates across jurisdictions to
enter into swaps with one another.
In response to comments asking that the Commission clarify the
level of risk management required for non-SDs and non-MSPs, the
Commission confirms that the requirements of proposed Sec.
39.6(g)(2)(iii) (now Sec. 50.52(b)(3)) are intended to be flexible and
do not require the same level of policies and procedures as required
under Sec. 23.600 for SDs and MSPs. Under the rule, a company is free
to structure its centralized risk management program according to its
unique needs, provided that the program reasonably monitors and manages
the risks associated with its uncleared inter-affiliate swaps. In all
likelihood, if a corporate group has a centralized risk management
program in place that reasonably monitors and manages the risk
associated with its inter-affiliate swaps as part of current industry
practice, it is likely that the program would fulfill the requirements
of proposed Sec. 39.6(g)(2)(iii) (now Sec. 50.52(b)(3)).
The Commission did not receive comments regarding the requirement
that SD and MSP affiliates must comply with Sec. 23.600.\41\ The
Commission is adopting that provision of the rule as proposed.
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\41\ 17 CFR 23.600(c)(1)(ii) (``The Risk Management Program
shall take into account risks posed by affiliates and the Risk
Management Program shall be integrated into risk management at the
consolidated entity level.'').
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Given that a number of commenters stated that it is common practice
for market participants, including end users, to have risk management
programs in place, the Commission is not persuaded by Cravath's comment
that the rule will require a substantial change in the processes and
procedures currently maintained by companies to manage risk.
Accordingly, costs will be
[[Page 21759]]
limited where an entity only needs to make modifications to existing
risk management programs. Moreover, a corporate group may not have to
incur any costs if it already has a risk management system that meets
the requirements of the inter-affiliate exemption in place.
F. Variation Margin
Proposed Sec. 39.6(g)(2)(iv) required that variation margin be
collected for swaps between affiliates that are financial entities, in
compliance with the proposed variation margin requirements in proposed
Sec. 39.6(g)(3).\42\ The rule further proposed an exception to the
variation margin requirement for 100% commonly-owned and commonly-
guaranteed affiliates, provided that the common guarantor is under 100%
common ownership.
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\42\ The Commission also requested comments on, among other
things, whether the Commission should promulgate regulations that
set forth minimum standards for initial margin for inter-affiliate
swaps.
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Some commenters expressed support for the proposed variation margin
requirement. Prudential commented that it did not take issue with the
variation margin requirement, but noted that variation margin may not
be appropriate or required in every circumstance.\43\ Prudential also
commented that the Commission should not impose initial margin
requirements for the inter-affiliate exemption.\44\ Chris Barnard
agreed that the Commission should require the exchange of variation
margin for financial entities and noted that the exchange of variation
margin is consistent with the key principles proposed by the Basel
Committee on Banking Supervision (BCBS) and the Board of the
International Organization of Securities Commissions (IOSCO).\45\
Better Markets expressed support for the variation margin requirement
and commented that it should be expanded to non-financial entities.\46\
AFR expressed support for the variation margin proposal. Both Better
Markets and AFR also expressed support for the requirement that
affiliates post initial margin for inter-affiliate swaps subject to the
exemption.\47\
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\43\ Prudential also commented that there is ``no less costly
risk-management tool'' than variation margin.
\44\ MetLife also commented that the Commission should not
impose initial margin requirements for the inter-affiliate
exemption.
\45\ See Margin Requirements for Non-Centrally-Cleared
Derivatives, Consultative Report (July 2012), available at http://www.bis.org/publ/bcbs226.pdf.
\46\ Better Markets also suggested that the Commission ban the
rehypothecation of collateral.
\47\ Better Markets commented that initial margin should be
required because initial margin is the true ``statistical estimate
of the potential consequences of a default'' and that variation
margin is merely the ``daily recalibration'' of the risk estimation
of initial margin.
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Several commenters stated that the proposed variation margin
requirement for swaps between affiliates that are financial entities is
not necessary and should not be a condition of the inter-affiliate
exemption to clearing.\48\ ISDA & SIFMA commented that the benefits of
variation margin for inter-affiliate swaps are ``tenuous'' because the
third party to a swap is exposed to the credit risk of the entire group
not just the specific affiliate with which it enters into a swap. ISDA
& SIFMA maintain that it is not necessary to protect group entities
from the credit risk of other group entities because group management
possesses the tools needed to resolve potential defaults within the
group. According to ISDA & SIFMA, the Commission can fully achieve its
regulatory mandate to protect third-party swap counterparties through
the application of the clearing requirement to those outward-facing
swaps that are subject to the Commission's regulation, as well as
regulation of those group entities whose outward-facing swap activities
are sufficiently large to subject them to SD and MSP registration.\49\
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\48\ Cravath commented that variation margin requirements ``tie
up capital that could otherwise be used for investment purposes to
create jobs and goods and services for the economy.'' MetLife
commented that while it is subject to variation margin under state
insurance law, MetLife believes that the Commission should eliminate
the variation margin requirement for 100%-owned affiliates and
should not require ``inter-affiliate guarantees.'' DLA Piper also
urged the Commission to provide corporate groups with legal
certainty that no margin requirements will be imposed on any inter-
company swaps.
\49\ ISDA & SIFMA claimed that the additional liquidity demands
resulting from variation margin will distort the group's risk
management choices. ISDA & SIFMA further claimed that while they
have previously stated that inter-affiliate margin occurs
``routinely,'' this does not mean that it occurs ``uniformly'' or
that imposing variation margin would not increase cost.
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FSR commented that affiliates should be required to post margin
only in instances where their primary regulator imposes such a
requirement for affiliate transactions.\50\ FSR states that requiring
variation margin for inter-affiliate swaps involving non-bank financial
entities will limit the ability of companies to efficiently allocate
risk among affiliates and manage risk centrally.\51\ FSR further
commented that initial margin should not be required between
affiliates, and requested that the Commission clarify that the
exemption does not require the exchange of initial margin between
affiliates.
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\50\ Citing to sections 23A and 23B of the Federal Reserve Act
and Regulation W as well as public utility, insurance, and
investment company law, FSR commented that a number of regulated
entities may be subject to various restrictions on affiliate
transactions and that for purposes of the inter-affiliate exemption,
margin requirements should only apply ``to the extent other
applicable law . . . imposes such restrictions on affiliate
transactions.'' FSR also points out that subsidiaries of banks are
``generally not treated as `affiliates' '' within the restrictions
of sections 23A and 23B of the Federal Reserve Act.
\51\ FSR further requested that the Commission clarify that to
the extent that financial entities are required, through credit
support arrangements with their affiliates, to have minimum transfer
amounts, thresholds, and other similar arrangements in place, that
such arrangements would be permitted in connection with inter-
affiliate swaps relying on the inter-affiliate exemption.
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CDEU commented that the Commission should not require variation
margin, or initial margin, with respect to inter-affiliate swaps
between end-user affiliates. According to CDEU, while margin
requirements may serve as a risk-management tool for market-facing
swaps, inter-affiliate swaps do not increase counterparty credit risk
or contribute to interconnectedness among market participants. CDEU
stated that a number of specific entities, including banks and
insurance companies, already post variation margin for inter-affiliate
swaps, largely because of prudential requirements, and that applying
variation margin requirement to these entities is unnecessary.\52\ CDEU
requested that if the Commission retains the variation margin
requirement, that it limit the exchange of variation margin to SDs and
MSPs, and that the requirement should not apply to entities that are
considered ``financial entities.''
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\52\ Moreover, CDEU claims that many inter-affiliate swaps
between end-user corporate groups are not subject to variation
margin requirements, and that these entities likely will not have
the liquidity to exchange variation margin, and would likely be
required to borrow the money from the centralized hedging unit with
which it is entering the internal swap. Such an arrangement,
according to CDEU, would transfer the loan back to the centralized
hedging unit and effectively eliminate any perceived benefit from
the exchange of variation margin.
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With respect to the proposed common guarantor exception to the
variation margin requirement, ISDA & SIFMA commented that the
Commission has not provided adequate rationale for requiring a common
guarantor as a condition for exempting group members from the proposed
variation margin requirement, nor has the Commission made it clear
which obligations must be guaranteed. ISDA & SIFMA requested that the
Commission further clarify the guarantee exception in proposed Sec.
39.6(g)(2)(iv), including to clarify that it includes ``direct or
indirect'' ownership, and that swaps between the
[[Page 21760]]
common guarantor and its affiliates are eligible for the exception.\53\
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\53\ ISDA requested that the Commission clarify that the
shareholders of a publicly-owned holding company are the common
owners and that its 100% owned subsidiaries meet the definition of
``100% commonly owned,'' and further stated that the Commission
should address the consequences of a guarantee of a swap being
considered a swap itself.
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CDEU commented that the Commission should not limit the guarantee
exception to 100% commonly-owned affiliates and should allow the
exception for majority-owned affiliates. CDEU requested that the
Commission clarify that only the related market-facing swaps with third
parties are required to be guaranteed by the common owner or parent.
CDEU suggested that the Commission clarify that the parent company has
the option to act as the guarantor of the transactions.
FSR commented that the variation margin requirement should not
apply to 100% commonly-owned affiliates even if they do not have a
common guarantor that is under 100% common ownership. According to FSR,
the 100% common ownership requirement creates sufficient alignment of
interests between swap counterparties and places the risk of the swap
on the ultimate parent entity, and thus, the exchange of variation
margin would do little to mitigate intercompany risk.
MetLife and Prudential commented that inter-affiliate swaps should
not be commonly guaranteed by a 100% wholly-owned affiliate in order to
be exempt from the variation margin requirement. Specifically, MetLife
stated that the Commission should not require guarantees or explicit
credit support as a condition for an exception from the variation
margin requirement and should rely instead on the direct or indirect
common ownership requirement. Both MetLife and Prudential stated that
the corporate group of 100% wholly owned affiliates should be able to
decide whether internal swaps need to be guaranteed by an affiliate.
After considering the comments submitted in response to the
proposed variation margin requirement, the Commission is determining
not to require variation or initial margin as a condition for electing
the inter-affiliate exemption. In so doing, the Commission was guided
by comments expressing concern that a variation margin requirement will
limit the ability of U.S. companies to efficiently allocate risk among
affiliates and manage risk centrally. Notwithstanding the Commission's
determination not to impose variation margin as a condition of the
inter-affiliate exemption, the Commission is encouraged by comments
noting that many companies already exchange variation margin, and
agrees with commenters that collateralizing risk exposure with respect
to any swaps, including inter-affiliate swaps, is critical, and
encourages market participants to do so as a matter of sound business
practice.
G. Treatment of Outward-Facing Swaps and Relief
Proposed Sec. 39.6(g)(2)(v) provided that eligible affiliate
counterparties to a swap may elect the inter-affiliate exemption from
clearing provided that each affiliate counterparty either: (i) Is
located in the United States; (ii) is located in a jurisdiction with a
clearing requirement that is comparable and comprehensive to the
clearing requirement in the United States; (iii) is required to clear
swaps with non-affiliated parties in compliance with U.S. law; or (iv)
does not enter into swaps with non-affiliated parties.\54\
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\54\ In this release, the requirements of proposed Sec.
39.6(g)(2)(v), which are now being adopted in new Sec. 50.52(b)(4),
are referred to as the ``treatment of outward-facing swaps
condition.''
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The Commission received several comments both in support of and in
opposition to various aspects of the conditions related to the
treatment of outward-facing swaps in proposed Sec. 39.6(g)(2)(v). The
Commission has considered each of the comments and has determined to
adopt the treatment of outward-facing swaps conditions of the inter-
affiliate exemption, with certain modifications described below,
because such conditions are necessary to prevent evasion of the
clearing requirement and to help protect the U.S. financial markets.
The remainder of this Section II.G describes the comments received in
response to proposed Sec. 39.6(g)(2)(v) (now Sec. 50.52(b)(4)), along
with the Commission's responses and clarifications with respect to
those comments.
1. Basis for the Cross-border Conditions
While recognizing the benefits of exempting certain inter-affiliate
transactions from the clearing requirement, in the NPRM, the Commission
described two separate grounds for proposing the treatment of outward-
facing swaps condition to the inter-affiliate exemption. First, the
Commission explained that an inter-affiliate exemption from required
clearing could enable entities to evade the clearing requirement
through trades with affiliates that are located in foreign
jurisdictions that do not have a comparable and comprehensive clearing
regime. In addition, the Commission noted in the NPRM that uncleared
inter-affiliate swaps may pose risk to other market participants, and
therefore, the financial system if the affiliate enters into swaps with
third parties that are related on a back-to-back or matched book basis
with inter-affiliate swaps.
In support of the proposed treatment of outward-facing swaps
conditions, AFR stated that inter-affiliate swaps could, without
appropriate restrictions, bring risk back to the U.S. from foreign
affiliates. AFR commented that an inter-affiliate swap might be used to
move parts of the U.S. swaps market outside of U.S. regulatory
oversight by transferring risk to jurisdictions with little or no
regulatory oversight, whereby a non-U.S. affiliate of a U.S. entity
could enter into an outward-facing swap. AFR stated that an inter-
affiliate swap could contribute to financial contagion across different
groups within a complex financial institution, making it more difficult
to ``ring-fence'' risks in one part of an organization. AFR further
commented that laws and regulations of a foreign country might prevent
U.S. counterparties to swaps from having access to the financial
resources of an affiliate in the event of a bankruptcy or
insolvency.\55\ The inability of an affiliate to access resources in
other jurisdictions, according to AFR, may threaten the ability of U.S.
creditors to retrieve assets and may put U.S. taxpayers at risk.\56\
Better Markets also
[[Page 21761]]
supported the proposed treatment of outward-facing swaps condition.\57\
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\55\ AFR suggested that the Commission consult with the U.S.
banking agencies, such as the FDIC, regarding the potential issues
relating to bankruptcy of non-U.S. affiliates. As noted above, the
Commission has consulted with both U.S. and international
authorities in preparing this adopting release. In response to AFR's
comments pertaining to the limitations of foreign bankruptcy laws,
the Commission notes that the specific bankruptcy limitations
attendant to U.S. counterparties with respect to their non-U.S.
affiliates are outside the scope of this rulemaking. The Commission
further notes that the conditions imposed by the rules being adopted
in this release, in large part, are aimed at ensuring that the
benefits of central clearing, particularly with respect to
counterparty and systemic risk mitigation, are maintained with
respect to inter-affiliate swaps involving non-U.S. affiliates.
Specifically, the Commission believes that the conditions imposed by
the rules being adopted in this release will help to mitigate
potential issues that could arise in uncleared inter-affiliate swaps
when financial solvency is not an issue for the corporate
enterprise. Furthermore, these conditions may, to some extent,
diminish the impact of swaps in transmitting losses across
affiliates, and in turn, to third-party creditors, following a
default.
\56\ AFR also noted restrictions under U.S. banking law with
respect to the transfer of risk from non-depository to depository
institutions, and stated that it may be necessary to require ``ring-
fencing'' and separate capitalization of swaps affiliates. The
Commission believes that these issues are outside of the scope of
this rulemaking, and as AFR correctly noted, may be an issue that is
more appropriate for the prudential regulators of such entities to
consider.
\57\ Prudential also commented that in relation to its own
structure, it did not have concerns with the proposed cross-border
conditions applicable to inter-affiliate swaps involving foreign
affiliates.
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By contrast, ISDA & SIFMA, The Working Group, and CDEU all stated
that the treatment of outward-facing swaps condition of the proposed
rule is not necessary or appropriate and that the Commission should
eliminate it altogether. FSR commented that the inter-affiliate
exemption should extend to swaps between non-U.S. affiliates, such that
the swaps should not be subject to mandatory clearing or margin
requirements, even if the affiliated parties are financial entities.
Certain commenters stated that the proposed treatment of outward-
facing swaps condition is not necessary to prevent evasion. ISDA &
SIFMA noted that the Commission's existing anti-evasion authority \58\
can address the anti-evasion objectives of the proposed condition, and
the CDEU made a similar argument with respect to the Commission's new
anti-evasion authority under section 721(c) of the Dodd-Frank Act. ISDA
& SIFMA further noted that the Commission should limit application of
its anti-evasion authority to instances where a foreign affiliate
engages in a pattern of back-to-back swaps with the U.S. affiliate and
where neither the affiliates nor the third-party counterparty are
subject to capital regulation.\59\
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\58\ See e.g., Section 2(i)(2) of the CEA (providing authority
to promulgate rules addressing activities outside of the U.S. to
prevent evasion of the Dodd-Frank Act); section 2(h)(4) of the CEA
(requiring the Commission to issue rules to prevent evasion of the
mandatory clearing requirement); section 721(c) of the Dodd-Frank
Act (requiring the Commission to promulgate a rule defining certain
terms to prevent evasion of the Dodd-Frank Act).
\59\ Entities that are subject to capital regulations include
SDs, MSPs, and banking entities subject to prudential regulation.
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Other commenters opposed the proposed treatment of outward-facing
swaps condition based on their view that inter-affiliate swaps
involving non-U.S. affiliates do not pose a risk to the U.S. financial
markets. CDEU commented that the proposed ``comparable and
comprehensive'' condition is not necessary or appropriate to reduce
risk and prevent evasion because, according to CDEU, transactions
between affiliates do not increase systemic risk, regardless of the
location of the affiliate.\60\ ISDA & SIFMA stated that the concern
that foreign inter-affiliate swaps pose risk to the U.S. financial
system is unfounded because internal swaps have no conclusive effect on
systemic risk.\61\
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\60\ CDEU further stated that inter-affiliate swaps do not
create systemic risk.
\61\ Prudential also stated that it does not believe that there
are any additional risk implications of cross-border inter-affiliate
swaps for the U.S. market, to the extent that the market-facing
entity is located in the U.S.
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The Commission has considered these comments, and for the reasons
described below, has determined to retain the treatment of outward-
facing swaps condition to the inter-affiliate exemption, with certain
modifications and amendments, in order to address comments and provide
greater clarity.
i. Prevention of Evasion
As an initial matter, as discussed above, the Commission believes
that the benefits of inter-affiliate swaps for entities in affiliated
groups warrant the Commission's use of its exemptive authority under
section 4(c) of the Act to exclude certain inter-affiliate swaps from
the clearing requirement. However, the Commission must exercise its
exemptive authority in view of the Commission's charge under the CEA to
prevent evasion of the clearing requirement.\62\ The Commission remains
concerned that absent the treatment of outward-facing swaps condition,
the inter-affiliate exemption from clearing may create a ready means
through which some U.S. entities may be able to evade the clearing
requirement. Accordingly, the Commission believes that the treatment of
outward-facing swaps condition to the inter-affiliate clearing
exemption is necessary to address the potential for evasion.
---------------------------------------------------------------------------
\62\ See sections 2(h)(4) and 2(i)(2) of the CEA.
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Section 2(h)(4)(A) of the CEA requires that ``the Commission shall
prescribe rules * * * as determined by the Commission to be necessary
to prevent evasions of the clearing requirement under this Act.'' \63\
As the Commission explained in the NPRM, and as AFR also described in
its comments, a broad inter-affiliate exemption from the clearing
requirement could enable entities to evade the clearing requirement
potentially through third-party trades with their foreign affiliates
that are located in jurisdictions that do not have a clearing regime
that is comparable to, or as comprehensive as, the Commission's
clearing requirement. For example, rather than execute a swap opposite
a U.S. counterparty, which would be subject to the clearing
requirements of section 2(h) of the Act, a U.S. entity could execute an
uncleared swap with its foreign affiliate or subsidiary, which could
then execute a swap with a non-affiliated third-party in a jurisdiction
that is either unregulated or does not have a clearing requirement that
is comparable to or as comprehensive as the U.S. clearing requirement.
---------------------------------------------------------------------------
\63\ 7 U.S.C. 2(h)(4).
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The Commission disagrees with commenters that suggest that the
treatment of outward-facing swaps condition is not necessary to deter
evasion because the Commission can rely on its general anti-evasion
authority under the CEA or under section 721(c) of the Dodd-Frank Act
to address the Commission's evasion concerns pertaining to the inter-
affiliate exemption. The Commission notes that section 2(h)(4)(A) of
the CEA specifically imposes an obligation on the part of the
Commission to ``prescribe rules'' and ``issue interpretations of
rules'' that are necessary to prevent evasions of the clearing
requirement.\64\ Furthermore, from an enforcement perspective, a
specific regulation provides more transparency to market participants
with respect to the Commission's enforcement program. While the
Commission has ample general authority to prevent evasion of the CEA
and the swaps-related provisions of the Dodd-Frank Act, the Commission
believes it is appropriate to impose the treatment of outward-facing
swaps condition to the inter-affiliate exemption to prevent evasion of
the clearing requirement.
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\64\ Under the authority of sections 2(h)(4)(A), 2(h)(7)(F), and
8a(5) of the CEA, the Commission recently adopted Sec. 50.10 to
prohibit evasions of the requirements of section 2(h) of the CEA,
including the end-user exception or any other exception or exemption
that the Commission may provide by rule, regulation, or order. See
Clearing Requirement Determination at 74317-19.
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In response to ISDA & SIFMA's claim that anti-evasion authority
should only be applied in limited scenarios where there are back-to-
back trades involving affiliates and non-affiliates who are not subject
to capital requirements, the Commission declines to pre-judge the
potential incentives or ways of evading, or complying with, the
Commission's clearing requirement and the inter-affiliate exemption
from clearing. To the extent that ISDA & SIFMA suggest that the
treatment of outward-facing swaps condition should be limited to
transactions involving back-to-back trades where the affiliates and the
respective third-party are subject to capital requirements, the
Commission is not persuaded that the rule should be so narrowly
tailored to address only the scenario ISDA & SIFMA describe. In
particular, the Commission notes that back-to-back transactions may not
serve as the only potential means by which
[[Page 21762]]
affiliates can evade the U.S. clearing mandate, and for that matter,
transfer risk to one another. Accordingly, the Commission does not
believe that the treatment of outward-facing swaps condition should be
limited to the specific circumstances described by ISDA & SIFMA.
ii. Protection of Financial Markets
In addition to preventing evasion, the Commission believes that the
treatment of outward-facing swaps condition will help to limit the
potential transfer of risks to U.S. companies and financial markets
that may result from third-party swaps between affiliates and non-
affiliated entities domiciled in jurisdictions that do not regulate
swaps or where the regulation is not comparable to, or as comprehensive
as, the CEA and Commission regulations. As described in the preceding
sections of this adopting release, there are numerous benefits
associated with central clearing of swaps. In particular, clearing
mitigates counterparty credit risk, provides an organized mechanism for
collateralizing the risk exposures posed by swaps, and when applied on
a market-wide scale, clearing reduces systemic risk. The counterparty
and systemic risk mitigation benefits of central clearing are also
realized from clearing transactions between affiliates.
The benefits of clearing notwithstanding, the Commission recognized
in the NPRM, commenters' assertions that there is less counterparty
risk associated with inter-affiliate swaps than with swaps between
third parties to the extent that the affiliated counterparties that are
members of the same corporate group internalize each other's
counterparty credit risk.\65\ While the Commission recognizes,
generally, the benefits of inter-affiliate swaps and the incentives for
inter-affiliates to fulfill their inter-affiliate swap obligations to
each other, these swaps are not immune from some of the risks that are
associated with swaps between non-affiliated parties.
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\65\ See NPRM at 50427.
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In particular, the Commission is not persuaded that inter-affiliate
swaps, and swaps between affiliate counterparties outside the U.S. and
non-affiliated counterparties, pose no risks to the U.S financial
markets or that central clearing would not mitigate the risks
associated with such swaps. To the contrary, the counterparty and
systemic risks associated with inter-affiliate swaps are heightened
where, for example, the inter-affiliate transaction involves an
uncleared swap with a foreign affiliate counterparty that is
subsequently hedged with a third-party uncleared swap. Thus, the
Commission disagrees with commenters that suggested that inter-
affiliate swaps involving foreign affiliates do not have the potential
to create systemic risk. As the Commission noted in the NPRM, systemic
risk implications may be present where the foreign affiliate has large
inter-affiliate swap positions and enters into related outward-facing
swaps. If the foreign affiliate defaults on its obligations arising
from the inter-affiliate swaps, it then increases the likelihood that
the foreign affiliate could default on the outward-facing swaps,
potentially jeopardizing the financial integrity of the third-party
counterparty. Furthermore, to the extent that a foreign affiliate
enters into both inter-affiliate swaps and related third-party swaps,
any losses incurred by the foreign affiliate with respect to its inter-
affiliate swaps may flow not only to the unaffiliated third-party
counterparty, but conceivably, to the broader financial system.\66\
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\66\ In the Proposed Cross-Border Interpretive Guidance, the
Commission specifically discussed the flow of risk to the U.S. by
entities that facilitate a U.S. person's ability to execute swaps
outside the Dodd-Frank Act regulatory regime. 77 FR 41228-29, 41234.
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Moreover, the Commission notes AFR's comment that inter-affiliate
swaps can, in some circumstances, contribute to financial contagion
across different groups within a complex financial institution, making
it more difficult to contain risks in one part of an organization. As
evidenced by the events surrounding the 2008 financial crisis, many
large financial institutions are interconnected and highly inter-
dependent, with affiliated legal entities that are inextricably linked
to each other.\67\ The interconnected nature of corporate groups,
therefore, increases the potential that risk in any part of a corporate
group may spread throughout the organization, jeopardizing the
financial integrity of not only the U.S affiliate, but depending on the
scope of a potential default, the broader financial system.
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\67\ For a discussion of specific institutional risks leading up
to the 2008 financial crisis, see Proposed Cross-Border Interpretive
Guidance at 41215-16.
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For the aforementioned reasons, the Commission believes that the
risk of evasion of U.S. laws and the potential systemic risk associated
with uncleared inter-affiliate swaps involving foreign affiliates
necessitates that the inter-affiliate exemption include the treatment
of outward-facing swaps condition.
The treatment of outward-facing swaps condition that is being
adopted as part of the inter-affiliate clearing exemption in this final
release is aimed at addressing the potential risks associated with an
eligible foreign affiliate's swaps with non-affiliated counterparties.
As modified, the final rule requires that, as a condition to the inter-
affiliate exemption, each eligible affiliate counterparty must clear
all swaps that it enters into with an unaffiliated counterparty to the
extent that the swap is included in the Commission's clearing
requirement, i.e., in a class of swaps identified in Sec. 50.4.\68\ In
order to satisfy this requirement, eligible affiliate counterparties
must clear their third-party swaps pursuant to the Commission's
clearing requirement or comply with the requirements for clearing the
swap under a foreign jurisdiction's clearing mandate that is
comparable, and comprehensive but not necessarily identical, to the
clearing requirement of section 2(h) of the Act and part 50 of the
Commission's regulations, as determined by the Commission. In addition,
the Commission is modifying the inter-affiliate exemption to allow for
recognition of clearing exceptions and exemptions under the CEA and an
exception or exemption under a foreign clearing mandate provided that
the foreign jurisdiction's clearing mandate is comparable, and
comprehensive but not necessarily identical, to the clearing
requirement of section 2(h) of the Act and part 50 and the foreign
jurisdiction's exception or exemption is comparable to an exception or
exemption under the CEA or part 50, in each instance as determined by
the Commission.
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\68\ Currently, the scope of the Commission's clearing
requirement is limited to four classes of interest rate swaps and
two classes of CDS.
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For eligible affiliate counterparties that are not located in the
U.S. or in a comparable foreign jurisdiction, as determined by the
Commission, the rule permits such eligible affiliates to clear any
outward-facing swap that is required to be cleared under Sec. 50.4
through a registered DCO or a clearing organization that is subject to
supervision by appropriate government authorities in the home country
of the clearing organization and has been assessed to be in compliance
with the Principles for Financial Market Infrastructures (PFMIs).\69\
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\69\ See Principles for Financial Market Infrastructures, April
2012, available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD377.pdf.
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The Commission believes that this modified formulation of the
treatment of outward-facing swaps condition being adopted as part of
the final rule will
[[Page 21763]]
more clearly establish the conditions to the exemption and alternative
methods by which eligible affiliates may satisfy the requirements.
Moreover, in finalizing the requirement that eligible affiliate
counterparties clear their swaps with unaffiliated counterparties, the
Commission considered the approach adopted in EMIR. Articles 3, 4, and
13 of EMIR generally exempt from clearing OTC derivatives transactions
between intragroup counterparties, where one counterparty is located in
the European Union and the other counterparty is located outside the
European Union, provided that, among other things, the European
Commission determines that the foreign counterparty is established in a
country with ``equivalent'' requirements to EMIR.\70\ By requiring that
a foreign counterparty to an intragroup transaction be located in a
country with equivalent requirements to EMIR, including clearing, any
third-party swaps entered into by either the European Union
counterparty or the non-European Union counterparty would be subject to
a clearing requirement under EMIR or one that is equivalent to that
required under EMIR, respectively.
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\70\ See EMIR Article 13(1)-(3). The European Union has yet to
make determinations as to whether third countries have equivalent
requirements to EMIR. The European Commission (EC) has instructed
the European Securities and Markets Authority (ESMA) to prepare
possible implementing acts concerning the equivalence between the
legal and supervisory frameworks of certain third countries and
EMIR. Pursuant to the EC's instructions, ESMA must make its
determination regarding the United States' clearing requirement by
March 15, 2013. ``Formal Request to ESMA for Technical Advice on
Possible Implementing Acts Concerning Regulation 648/2012 on OTC
Derivatives, Central Counterparties and Trade Repositories (EMIR)''
available at http://www.esma.europa.eu/system/files/formal_request_for_technical_advice_on_equivalence.pdf.
---------------------------------------------------------------------------
In addition to the modifications to the treatment of outward-facing
swaps condition described above, the Commission also is providing a
transition period with alternative compliance frameworks, in response
to concerns raised by commenters pertaining to the timing and
sequencing of the implementation of the inter-affiliate exemption,
which are discussed below.
2. Time-limited Alternative Compliance Frameworks
A number of commenters expressed concern with respect to the
``comparable and comprehensive'' requirement of the proposed rule.
Several commenters expressed concern with respect to the timing and
sequencing of the Commission's comparability determination in relation
to the expected compliance date for the initial clearing requirement
under section 2(h) of the Act.\71\ These commenters noted that the
comparability requirement is dependent upon the adoption of clearing
regimes by other jurisdictions, and that because the U.S. clearing
requirement is likely to take effect in advance of other jurisdictions
adopting or finalizing their clearing regimes, non-U.S. affiliates
effectively will not be able to rely on the inter-affiliate exemption
from clearing when the Commission's initial clearing requirement takes
effect. Significantly, ISDA & SIFMA commented that the cross-border
condition may prove to be unnecessary because it is expected that the
major financial jurisdictions will implement their own clearing
regimes. However, ISDA & SIFMA and CDEU noted that questions of timing
and criteria for comparability render the proposed treatment of
outward-facing swaps condition problematic, and that unless the
condition is satisfactorily resolved, the condition could hamper the
ability of U.S.-based groups to compete in foreign markets. ISDA &
SIFMA further commented that if the Commission retains the cross-border
requirements, the Commission should provide an appropriate transition
period in order to allow foreign jurisdictions to implement their own
G-20 mandates.
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\71\ See Clearing Requirement at 74319-21 (discussing the
compliance dates for the first clearing requirement determination).
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The Working Group commented that because no other jurisdiction has
a comparable clearing requirement,\72\ the proposed rule would impose
an obligation on almost all non-U.S. persons to comply with the U.S.
clearing requirement in the event such entities wanted to engage in a
non-hedge swap that was subject to mandatory clearing with a U.S.
person affiliate. The Working Group claimed that this limitation would
render the exemption unusable and questioned the public policy benefit
of extending the clearing requirement in such instances. The Working
Group further commented that the proposed rule represents a broad
extension of U.S. law by, in effect, imposing the clearing requirement
under section 2(h)(1)(A) on non-U.S. persons that enter into swaps with
U.S. person affiliates in order to satisfy the conditions of the inter-
affiliate exemption. AFR supported the comparability condition and
suggested that the Commission should grant the inter-affiliate
exemption only with respect to foreign affiliate swaps once foreign
jurisdictions finalize and implement their own clearing requirements.
---------------------------------------------------------------------------
\72\ This assertion is no longer accurate. As discussed below,
Japan has adopted a clearing mandate for certain interest rate swaps
and CDS.
---------------------------------------------------------------------------
The Commission recognizes commenters' concerns pertaining to the
timing and sequencing of the inter-affiliate exemption in light of the
Commission's clearing requirement, and in view of the ongoing progress
of other jurisdictions to adopt and implement their respective clearing
regimes. Accordingly, the Commission has determined to modify the
proposed rule, as described in this release.
As an initial matter, and informed in large part by the reports of
relevant international organizations and ongoing dialogue with
international regulators, the Commission believes that many
jurisdictions have made significant progress in implementing their
clearing regimes. It is the Commission's understanding that the G-20
Leaders reaffirmed their commitment that all standardized OTC
derivatives should be cleared through central counterparties by end-
2012.\73\ Importantly, the majority of G-20 members with major
financial markets have been preparing for mandatory clearing, and
significant steps towards further implementation have been taken by the
United States, Japan, Singapore, and the European Union. In Japan, for
example, the Japanese Financial Services Authority (JFSA) cabinet
office ordinance regarding central counterparties and trade
repositories which, among other things, subjects certain transactions
to mandatory central clearing, became effective on November 1, 2012.
The JFSA initially requires certain financial institutions to clear
yen-denominated interest rate swaps that reference Yen-LIBOR, and CDS
based on the Japanese iTraxx indices at a licensed CCP.
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\73\ ``G20 Leaders Declaration Los Cabos Mexico'' (June 18-19,
2012) at paragraph 39. According to the October 2012 Report of the
Financial Stability Board (FSB), 10 out of the 19 members of the G-
20 group have either proposed or adopted legislation and/or
regulations to implement their clearing framework, as of the date of
that release. FSB, OTC Derivatives Market Reforms: Fourth Progress
Report on Implementation, Oct. 31, 2012 at 74-77, available at
https://www.financialstabilityboard.org/publications/r_121031a.pdf.
---------------------------------------------------------------------------
On November 15, 2012, the Singapore Parliament passed the
Securities and Futures (Amendment) Bill 2012 to amend the Singapore
Securities and Futures Act (SFA). This bill puts in place the
regulatory regime for OTC derivatives in Singapore. This legislation
institutes mandatory reporting and clearing requirements for financial
entities and large non-financial entities. The Monetary Authority of
[[Page 21764]]
Singapore is deliberating how to implement these legislative
requirements and is expected to issue further consultation in 2013.
In the European Union, EMIR entered into force on August 16, 2012,
and requires the clearing of all OTC derivatives subject to the
clearing obligation. Clearing determinations are made at the initiative
of the national authorities or the European Securities and Markets
Authority (ESMA). Within six months of ESMA receiving notification by a
national authority that a central counterparty has been authorized to
clear a class of OTC derivatives, ESMA must determine whether that the
class of OTC derivatives should be subject to the clearing obligation.
At its own initiative, ESMA can also identify classes of OTC
derivatives that should be subject to the clearing obligation.
Additional details regarding the specific manner in which clearing
determinations will be made have been set forth in implementing
regulations adopted by the European Commission on December 19,
2012.\74\
---------------------------------------------------------------------------
\74\ See http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm.
---------------------------------------------------------------------------
As evidenced by the progress of these jurisdictions, and others
that host major financial markets across the world in implementing
their clearing frameworks, the Commission agrees with ISDA & SIFMA that
the comparability requirement of the inter-affiliate exemption is
unlikely to pose a significant impediment to the use of the inter-
affiliate exemption by most foreign affiliates because it is expected
that the major financial jurisdictions will implement their own
mandatory clearing regimes. Notwithstanding the progress of other
jurisdictions to implement their clearing regimes, as discussed above,
the Commission is mindful of commenters' concerns that the compliance
timeframe for the clearing requirement in the U.S. is likely to precede
the adoption and/or implementation of the clearing regimes of most
other jurisdictions.
Accordingly, the Commission believes that it is important to
provide for a transition period for foreign regimes to implement their
clearing mandates to bring swaps into clearing. For certain eligible
affiliate counterparties located in jurisdictions that have adopted
swap clearing regimes and are currently in the process of
implementation, namely Japan, the European Union, and Singapore, the
Commission is modifying the proposed rule to allow for a transition
period of one year from the first compliance date of the U.S. clearing
mandate, until March 11, 2014, for those foreign jurisdictions that are
working to implement their mandatory clearing regimes.\75\ The
Commission believes that a transition period of 12 months after
required clearing began in the U.S. is appropriate given its
understanding of the progress being made on mandatory clearing in the
specified foreign jurisdictions. Regulation 50.52(b)(4)(ii)(A) provides
that during that one-year period, affiliates domiciled in such foreign
jurisdictions can satisfy the requirements of Sec. 50.52(b)(4)(i)
through the following: (i) Each eligible affiliate counterparty, or a
majority-interest holder on behalf of both eligible affiliate
counterparties, pays and collects full variation margin daily on all
its swaps with unaffiliated counterparties; or (ii) each eligible
affiliate counterparty, or a majority-interest holder on behalf of both
eligible affiliate counterparties, pays and collects full variation
margin daily on all its swaps with other eligible affiliate
counterparties.
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\75\ While the time-limited alternative compliance framework of
Sec. 50.52(b)(4)(ii) is limited to jurisdictions that currently
have the legal authority to adopt mandatory clearing regimes, any
jurisdiction that later adopts a mandatory clearing regime will be
eligible for a comparability determination for purposes of this
rule.
---------------------------------------------------------------------------
Moreover, the Commission has determined to provide further time-
limited relief for certain eligible affiliated counterparties located
in the European Union, Japan, or Singapore from complying with the
requirements of Sec. 50.52(b)(4)(i) (or (b)(4)(ii)(A)) as a condition
of electing the inter-affiliate exemption. In particular, Sec.
50.52(b)(4)(ii)(B) provides that if one of the eligible affiliate
counterparties is located in the European Union, Japan, or Singapore,
the requirements of paragraph (b)(4)(i) will not apply to such eligible
affiliate counterparty until March 11, 2014, provided that two
conditions are met. The first condition provides that the one
counterparty that directly or indirectly holds a majority ownership
interest in the other counterparty or the third party that directly or
indirectly holds a majority ownership interest in both counterparties
is not a ``financial entity'' as defined in section 2(h)(7)(C)(i) of
the Act.\76\ The second condition requires that neither eligible
affiliate counterparty is affiliated with an entity that is an SD or
MSP, as defined in Sec. 1.3. This condition essentially requires that
the eligible affiliate counterparties are not part of a corporate group
with a member affiliate that is an SD or MSP. Accordingly, eligible
affiliate counterparties that are located in European Union, Japan, or
Singapore and meet these two conditions, are exempt from the
requirements of Sec. 50.52(b)(4)(i) until March 11, 2014. The
Commission believes that providing the time-limited exemption in Sec.
50.52(b)(4)(ii)(B) to the specific entities described above is
consistent with comments requesting that the exchange of variation
margin requirement, to the extent retained, be limited to SDs and MSPs.
Specifically, ISDA & SIFMA noted in their comments that the scope of
the Commission's regulatory concern should be limited to SDs and MSPs,
and that the regulatory regime applicable to SDs already contained
applicable safeguards, including variation margin requirements.
Similarly, CDEU commented that any variation margin requirements be
limited to SDs and MSPs.
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\76\ For purposes of meeting the requirements of Sec.
50.52(b)(4)(ii)(B)(1) until March 11, 2014, the holding company
(i.e., the ultimate parent of the corporate group) may not be
considered to be a ``financial entity,'' as defined in section
2(h)(7)(C)(i) of the CEA, under certain circumstances. The holding
company must be able to identify all affiliates that meet the
requirements of Sec. 50.52(a). Of those identified affiliates, a
predominant number must qualify for the end-user exception under
Sec. 50.50. If a predominant number of the affiliates meeting the
requirements of Sec. 50.52(a) qualify for the end-user exception
under Sec. 50.50, then the holding company may treat the activities
of all of its affiliates meeting the requirements of Sec. 50.52(a)
as if the holding company was engaged directly in such activities
and consider such affiliates' activities on a cumulative basis with
the holding company's other activities when assessing whether the
holding company is ``predominantly engaged in activities that are in
the business of banking, or in activities that are financial in
nature, as defined in section 4(k) of the Bank Holding Company Act
of 1956'' under section 2(h)(7)(C)(i)(VIII) of the CEA. In effect,
the holding company may ``look through'' its investment in
affiliates to all of the activities of the affiliates meeting the
requirements of Sec. 50.52(a). Accordingly, the activities of
affiliates meeting the requirements of Sec. 50.52(a) that are not
in the business of banking or financial in nature, as defined in
section 4(k) of the Bank Holding Company Act of 1956, would be
attributed to the holding company. Conversely, if the affiliates
meeting the requirements of Sec. 50.52(a) are engaged in activities
that are in the business of banking or of a financial nature, then
those activities would be attributed to the holding company for
purposes of determining whether the holding company is a financial
entity for purposes of meeting the requirements of Sec.
50.52(b)(4)(ii)(B)(1).
---------------------------------------------------------------------------
For eligible affiliate counterparties that are located in
jurisdictions other than the European Union, Japan or Singapore, the
Commission also is providing another time-limited alternative
compliance framework for meeting the requirements of Sec.
50.52(b)(4)(i). Specifically, Sec. 50.52(b)(4)(iii) provides that if
an eligible affiliate counterparty located in the United States enters
into swaps (that are included in a class of swaps identified in Sec.
50.4), with eligible
[[Page 21765]]
affiliate counterparties located in jurisdictions other than the United
States, the European Union, Japan, and Singapore, and the aggregate
notional value of such swaps, which are included in a class of swaps
identified in Sec. 50.4 does not exceed five percent of the aggregate
notional value of all swaps, which are included in a class of swaps
identified in Sec. 50.4, in each instance the notional value as
measured in U.S. dollar equivalents and calculated for each calendar
quarter, held by the eligible affiliate counterparty located in the
United States, then such swaps shall be deemed to satisfy the
requirements of paragraph (b)(4)(i) until March 11, 2014, provided
that: (A) Each eligible affiliate counterparty, or a third party that
directly or indirectly holds a majority interest in both eligible
affiliate counterparties, pays and collects full variation margin daily
on all swaps entered into between the eligible affiliate counterparties
located in jurisdictions other than the United States, the European
Union, Japan, and Singapore and an unaffiliated counterparty; or (B)
each eligible affiliate counterparty, or a third party that directly or
indirectly holds a majority interest in both eligible affiliate
counterparties, pays and collects full variation margin daily on all of
the eligible affiliate counterparties' swaps with the other eligible
affiliate counterparties.
The options provided under the two alternative compliance
frameworks described above are intended to mitigate the risk associated
with uncleared third-party swaps. The payment and collection of
variation margin is a vital component of the clearing process. As the
Commission noted in the NPRM, variation margin is an essential risk-
management tool that serves both as a check on risk-taking that might
exceed a party's financial capacity and as a limitation on losses when
there is a failure.\77\ In addition to the risk-management benefits of
variation margin, certain commenters expressed support for the
inclusion of variation margin as a condition of the inter-affiliate
exemption, and thus, the inclusion of variation margin within the
alternative compliance frameworks is consistent with those comments.
The Commission further clarifies that eligible affiliate counterparties
that are eligible to comply with the alternative compliance frameworks
in Sec. 50.52(b)(4)(ii) or Sec. 50.52(b)(4)(iii) and choose to pay
and collect variation margin daily on either all of their inter-
affiliate swaps or all of their third party swaps, will have
flexibility in tailoring their daily variation margin arrangements,
including with respect to establishing appropriate prices for purposes
of marking to market and threshold levels at which margin will be
settled.
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\77\ As described in the NPRM, variation margin entails marking
open positions to their current market value each day and
transferring funds between the parties to reflect any change in
value since the previous time the positions were marked. This
process prevents uncollateralized exposures from accumulating over
time and thereby reduces the size of any loss resulting from a
default should one occur. NPRM at 50429.
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Notwithstanding the alternative compliance frameworks, the
Commission encourages all eligible affiliate counterparties to clear
their outward-facing swaps on a voluntary basis in order to best
mitigate the risks associated with those swaps. The Commission notes
that in lieu of complying with the alternative compliance frameworks
through March 11, 2014, eligible affiliate counterparties also may
satisfy the outward-facing swap condition by complying with Sec.
50.52(b)(4)(ii)(E) by clearing their third-party swaps through a
registered DCO or a clearing organization that is subject to
supervision by the appropriate government authorities in the home
country of the clearing organization and has been assessed to be in
compliance with the PFMIs.
The Commission believes that the alternative compliance framework
adopted in this release addresses commenters' concerns pertaining to
the timing and sequencing of the inter-affiliate exemption and the
effective date of the Commission's initial clearing determination, and
incorporates ISDA & SIFMA's recommendation to provide an appropriate
transition period for foreign jurisdictions to implement their clearing
regimes.
In response to The Working Group, the Commission notes that the
treatment of outward-facing swaps condition is needed to protect U.S.
financial markets and to prevent evasion of the clearing requirement.
The modified condition requires that eligible affiliate counterparties,
whether domiciled in the U.S. or in a foreign jurisdiction, that elect
the inter-affiliate exemption must clear their outward-facing swaps, if
such swaps fall within a class identified in Sec. 50.4, or satisfy one
the provisions in the alternative compliance frameworks, as applicable,
until March 11, 2014. The alternative compliance frameworks are a
direct response to concerns raised by The Working Group, and other
commenters, regarding providing other jurisdictions with sufficient
time to implement their clearing regimes. The alternative compliance
framework provides eligible affiliates that elect the inter-affiliate
exemption with other options, in addition to clearing, for managing the
risks associated with their outward-facing swaps. In response to
concerns that foreign-domiciled eligible affiliates would not be able
to enter into uncleared non-hedge swaps with third parties that are
foreign-domiciled end users, the Commission notes that it would take
into consideration any comparable exceptions or exemptions granted
under a comparable foreign jurisdiction's clearing regime.
In response to The Working Group's statement that the treatment of
outward-facing swap condition expands the cross-border application of
the clearing requirement to cover swaps between U.S. persons and non-
U.S. persons, the Commission observes that U.S. persons are subject to
the CEA's clearing requirement and part 50 of the Commission's
regulations. Furthermore, the Commission notes that the final rule
would permit eligible affiliate counterparties that are not located in
the U.S. or in a comparable and comprehensive jurisdiction, to elect
the inter-affiliate exemption provided that they clear any outward-
facing swaps that are required to be cleared under Sec. 50.4, through
a registered DCO or a clearing organization that is subject to
supervision by appropriate government authorities in the home country
of the clearing organization and has been assessed to be in compliance
with the PFMIs.\78\
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\78\ The Commission believes that the use of an international
standard that is substantially similar, though not identical, to the
requirements under part 39 imposed upon DCOs registered with the
Commission is appropriate for purposes of the condition. The PFMIs
were developed with broad participation and comment from entities
from multiple nations and have been approved by both IOSCO's
Technical Committee and the CPSS. The Commission further notes that
eligible affiliate counterparties that are not located in the U.S.
or in a comparable and comprehensive jurisdiction must comply with
the requirements of Sec. 50.52(b)(4)(i)(E). However, if such
entities prefer to clear their swaps pursuant to the clearing
requirement regime in the U.S. or in a jurisdiction that the
Commission has determined to have a comparable clearing requirement,
they also may comply with one of the conditions in Sec.
50.52(b)(4)(i)(A) or (b)(4)(i)(B).
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Although the Commission believes that the alternative frameworks
described above are necessary in the circumstances described, these
alternatives are not equivalent to clearing and would not mitigate
potential losses between swap counterparties in the same manner that
clearing would. Thus, notwithstanding the alternative compliance
frameworks, the Commission believes that the requirement that eligible
affiliates clear
[[Page 21766]]
swaps entered into with non-affiliated counterparties is the most
appropriate method in which to prevent evasion of the clearing
requirement and to help protect U.S. financial markets, and encourages
market participants to do so. As noted above, incorporated within the
requirement that eligible affiliate counterparties clear their outward-
facing swaps is the option to comply with the requirements of a foreign
jurisdiction's clearing mandate for the outward-facing swaps, including
any comparable exception or exemption granted under the foreign
clearing mandate, provided that such foreign jurisdiction's clearing
mandate is determined by the Commission to be comparable, and
comprehensive but not necessarily identical, to the clearing
requirement established under the CEA, and the exception or exemption
is determined by the Commission to be comparable to an exception or
exemption provided under the CEA or part 50.
In the next section of the release, the Commission describes the
specific comments raised with respect to the proposed ``comparable and
comprehensive'' standard and provides a discussion of the its
consideration of these comments, as well as an explanation of the
Commission's anticipated process for reviewing and issuing
comparability determinations in the context of the inter-affiliate
exemption from clearing.
3. Application of the Comparable and Comprehensive Standard to
Mandatory Clearing
Commenters raised questions as to the criteria the Commission would
consider in rendering a comparability determination. ISDA & SIFMA
requested that the Commission clarify that ``comparability'' does not
mean that the host country must have the ``same'' requirement. CDEU
questioned what specific criteria the Commission would consider in
making a comparability finding. CDEU recommended that the Commission
limit the applicability of the comparability requirement to SDs and
MSPs, and claimed that extending the condition to end-users would
disproportionately impact end-users that have global operations,
particularly in emerging markets.\79\ CDEU further suggested that the
Commission extend the inter-affiliate exemption to non-U.S. affiliates
that enter into 20 or less third-party swaps per month. The Working
Group noted that many commercial energy firms have operations in
foreign jurisdictions that have less commercially robust financial
markets than those in the U.S., and that the treatment of outward-
facing swaps condition may place significant limitations on the ability
of commercial enterprises to hedge risk associated with such
operations, thereby resulting in higher cost of doing business in the
foreign country or decreasing the business activity of the U.S. company
in the foreign jurisdiction. The Working Group further commented that
the proposed rule extends the reach of U.S. law on non-U.S. persons
``far beyond'' the immediate clearing requirement.\80\
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\79\ CDEU claimed that end users would be adversely impacted by
the increased costs for risk-mitigating transactions between
affiliates, and noted that the Dodd-Frank Act did not contemplate
regulation of end-user transactions in the same manner as SD and MSP
transactions.
\80\ According to The Working Group, the proposed rule, for
instance, would require certain non-U.S. persons to enter into an
agreement with a futures commission merchant (FCM), and to enter
into a commercial relationship in the U.S. including posting capital
in U.S. markets that would subject such entities to U.S. bankruptcy
law.
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AFR suggested that the final rule should specifically state that
the ``comparable and comprehensive'' requirement must apply to each
``specific type of swap'' being considered for the exemption. AFR
further stated that the Commission should provide a detailed
comparability procedure, such as the procedure described in the
proposed cross-border guidance. MetLife also suggested that rather than
broadly prohibiting non-U.S. affiliates (that are not located in a
comparable jurisdiction) from entering into any third-party swaps as a
condition of the inter-affiliate exemption, the Commission should
narrow the prohibition in the proposed rule to prohibit non-U.S.
affiliates (that are not located in a comparable jurisdiction) from
entering into ``similar swaps of the same product type'' with
unaffiliated third parties.
As described above, a number of commenters requested further
clarification on how the Commission will apply the ``comparable and
comprehensive'' standard in the context of the mandatory clearing. The
comparability requirement originally was discussed in the Commission's
Proposed Cross-Border Interpretive Guidance. Drawing on its experience
in exempting foreign brokers from certain registrations requirements
under its rule 30.10 ``comparability'' determinations, the Commission
proposed the ``comparable and comprehensive'' concept in the Proposed
Cross-Border Interpretive Guidance \81\ in order to permit certain
classes of non-U.S. registrants to substitute compliance with the
requirements of its home jurisdiction's law and regulations, in lieu of
compliance with the CEA and the Commission's regulations, if the
Commission finds that the relevant jurisdiction's laws and regulations
are comparable to the relevant requirements of the CEA and Commission
regulations.\82\
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\81\ Proposed Cross-Border Interpretive Guidance at 41232-35.
\82\ The Proposed Cross-Border Interpretive Guidance identified
transaction-level requirements to include mandatory clearing and
swap processing, margining, segregation, trade execution, swap
trading documentation, portfolio reconciliation and compression,
real time public reporting, trade confirmation, and daily trading
records requirements. The Proposed Cross-Border Interpretive
Guidance proposed to allow substituted compliance with respect to
transaction level requirements for swaps between a non-U.S. SD or
non-U.S. MSP with a non-U.S. person that is guaranteed by a U.S.
person, as well as swaps with non-U.S. affiliate conduits. See
Proposed Cross-Border Interpretive Guidance at 41230.
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In the Proposed Cross-Border Interpretive Guidance, the Commission,
in describing its intended approach to making comparability
determinations, noted that similar to its policy with respect to rule
30.10, the Commission would retain broad discretion to determine that
the objectives of any program elements are met, notwithstanding the
fact that the foreign requirements may not be identical to that of the
Commission.
i. Comparability of Foreign Clearing Mandate
In response to comments seeking additional clarity around the
Commission's comparability determination process, the Commission
clarifies that it will review the comparability and comprehensiveness
of a foreign jurisdiction's clearing mandate under Sec.
50.52(b)(4)(i)(B) by reviewing: (i) The foreign jurisdiction's laws and
regulations with respect to its mandatory clearing regime (i.e.,
jurisdiction-specific review), and (ii) the foreign jurisdiction's
clearing determinations with respect to each class of swaps for which
the Commission has issued a clearing determination under Sec. 50.4 of
the Commission's regulations (i.e., product-specific review).
As noted above, and in response to ISDA & SIFMA, the Commission
reiterates that for purposes of the treatment of outward-facing swaps
condition of the inter-affiliate exemption, comparability findings with
respect to a foreign jurisdiction's clearing regime will not require an
identical regime to the clearing framework established under the Act
and Commission regulations. Rather, the Commission anticipates that it
will
[[Page 21767]]
make jurisdiction-specific comparability determinations by comparing
the regulatory requirements of a foreign jurisdiction's clearing regime
with the requirements and objectives of the Dodd-Frank Act. Notably,
the Commission anticipates that the product-specific comparability
determination will necessarily be made on the basis of whether the
applicable swap is included in a class of swaps covered under Sec.
50.4, and if so, whether such swap or class of swaps is covered under
the foreign jurisdiction's clearing mandate.
ii. Comparability of Exemption or Exception Under Foreign Clearing
Regime
With respect to determining whether an exemption or exception under
a comparable foreign clearing mandate is comparable to an exception or
exemption under the CEA or part 50, as provided under Sec.
50.52(b)(4)(i)(D), the Commission anticipates that it would review for
comparability purposes the foreign jurisdiction's laws and regulations
with respect to its mandatory clearing regime, as well as the relevant
exception or exemption. In doing so, the Commission would exercise
broad discretion to determine whether the requirements and objectives
of such exemption or exception are consistent with those under the
Dodd-Frank Act and that such objectives are being met, notwithstanding
the fact that the exemption or exception from clearing under the
comparable foreign clearing regime may not be identical to those
established under the Act or the Commission's regulations. Accordingly,
the Commission anticipates that comparability determinations with
respect to a foreign jurisdiction's exemption or exception from
mandatory clearing could be made at either the entity level, or the
transaction type, as appropriate.
iii. Responses to Additional Comments
In response to comments seeking clarification on what will trigger
a Commission comparability determination, the Commission anticipates
that it will render jurisdiction-specific and product-specific
comparability determinations upon the adoption of clearing regimes by
foreign jurisdictions for classes of swaps covered under Sec. 50.4,
upon the request of a counterparty that is located in a foreign
jurisdiction, or upon receipt of a request from another appropriate
party.
The Commission further anticipates that once a comparability
determination is made with respect to the foreign jurisdiction's
clearing regime, and with regard to a particular class of swaps covered
under Sec. 50.4, eligible affiliates domiciled in such jurisdiction
may rely on such determinations for swaps included within the
applicable class, without further Commission action. To the extent that
the Commission proposes a change to its regulations governing the
clearing requirement generally or with respect to any particular
product class, the Commission will reevaluate whether the proposed
regulatory change would affect the basis upon which the Commission made
the comparability determination. To the extent that there are
discrepancies in the requirements between the foreign jurisdiction and
the Commission's proposed regulatory change, the Commission anticipates
that it would issue additional guidance or notifications to market
participants to determine how affected entities can address any
discrepancy in requirements.
The Commission declines to limit the condition that eligible
affiliates clear their outward-facing swaps to SDs and MSPs, as
suggested by CDEU. As explained throughout this release, the Commission
believes that the requirements of Sec. 50.52(b)(4) are necessary to
prevent evasion of the clearing requirement and to protect U.S.
financial markets. Moreover, the requirements of section 2(h)(1)(A)
apply to all market participants not able to elect an exception under
section 2(h)(7) of the CEA, not just to SDs and MSPs. The Commission
believes that the modified rule and time-limited alternative compliance
frameworks adopted in the final rule will provide end users, amongst
others, with substantial flexibility to comply with the conditions of
the exemption. Furthermore, the Commission notes that end users also
may elect the end-user exception from clearing for hedging transactions
that comply with the requirements of the CEA and Sec. 50.50.
For the reasons described in this release, the Commission is
adopting in Sec. 50.52(b) the conditions to the inter-affiliate
exemption, initially proposed as Sec. 39.6(g)(2)(v), pertaining to
swaps entered into with unaffiliated counterparties, with the
modifications described above.
H. Reporting Requirement and Annual Election
In the NPRM, the Commission explained that general reporting
requirements under sections 2(a)(13) and 4r of the CEA and part 45
apply to uncleared inter-affiliate swaps.\83\ In addition, the proposed
regulations require the reporting counterparty to provide, or cause to
be provided, to a registered SDR, or if no registered SDR is available,
to the Commission, certain additional information. Proposed Sec.
39.6(g)(4)(i) requires the reporting counterparty to confirm that both
counterparties to the inter-affiliate swap are electing not to clear
the swap and that both counterparties meet the requirements in proposed
Sec. 39.6(g)(1)-(2). Proposed Sec. 39.6(g)(4)(ii) requires the
reporting counterparty to submit information regarding how the
financial obligations of both counterparties are generally satisfied
with respect to uncleared swaps. Proposed Sec. 39.6(g)(4)(iii)
implements section 2(j) of the CEA for purposes of the inter-affiliate
exemption. Section 2(j) of the CEA applies to an issuer of securities
registered under section 12 of the Securities Exchange Act of 1934
(Exchange Act) \84\ or an entity required to file reports under
Exchange Act section 15(g) (``electing SEC Filers'') that elects an
exemption from the CEA's clearing requirement under section 2(h)(1)(A)
of the CEA. Section 2(j) requires that an appropriate committee of the
electing SEC Filer's board or governing body review and approve its
decision to enter into swaps subject to an exemption clearing. Proposed
Sec. 39.6(g)(4)(iii)(A) requires an electing SEC Filer to notify the
Commission of its SEC Filer status by submitting its SEC Central Index
Key number. In addition, proposed Sec. 39.6(g)(4)(iii)(B) requires the
counterparty to report whether an appropriate committee of its board of
directors (or equivalent governing body) has reviewed and approved the
decision to enter into the inter-affiliate swaps that are exempt from
clearing.\85\
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\83\ See NPRM at 50432.
\84\ 15 U.S.C. 78l.
\85\ The proposed requirements under regulations implementing
section 2(j) mirror the requirements that the Commission finalized
in its end-user exception rulemaking, End-User Exception to the
Clearing Requirement for Swaps, 77 FR 42560.
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Lastly, proposed Sec. 39.16(g)(5) permits a counterparty to
provide information related to how it generally meets its financial
obligations and information related to its status as an electing SEC
Filer on an annual basis in anticipation of electing the inter-
affiliate clearing exemption for one or more swaps. This election is
effective for inter-affiliate swaps entered into within 365 days
following the date of such reporting. During the 365-day period, the
affiliate counterparty would be required to amend the information as
necessary to
[[Page 21768]]
reflect any material changes to the reported information. Under the
proposal, confirmation that both counterparties are electing not to
clear the swap and that they both satisfy the other requirements of the
exemption would not be subject to an annual filing, but must be done on
a swap-by-swap basis.
The Commission received several comments in response to the
reporting obligations of affiliates. Prudential and MetLife both
commented that the Commission should clarify that only one counterparty
is required to report the swap to an SDR. In addition, both Prudential
and MetLife stated that annual reporting is more efficient than swap-
by-swap reporting.
EEI stated that the Commission should eliminate the transaction-by-
transaction reporting requirement under proposed Sec. 39.6(g)(4)(i)
for the election of the exemption and confirmation that the conditions
have the exemption have been met. Instead, EEI recommended that one of
the affiliates be permitted to file an annual notice on behalf of both
affiliates to exempt all of their swaps from clearing for an entire
year. EEI contended that it will increase costs if both affiliates have
to communicate that they elect not to clear the swap and meet the
conditions of the exemption for each swap. EEI also stated that the
Commission should state that part 45 does not apply to inter-affiliate
swaps because the Commission will be able to obtain information
regarding an inter-affiliate transaction based on reporting of a
corresponding market-facing swap.\86\
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\86\ EEI cited to a statement in the NPRM's consideration of
costs and benefits as support for an argument that the Commission
did not intend for part 45 reporting to apply to inter-affiliate
swaps. See NPRM at 50433. The statement in the cost-benefit
consideration of the NPRM merely drew a comparison between the
reporting requirements under the proposed exemption and the general
reporting requirements under parts 45 and 46, and those reporting
requirements applicable to SDs and MSPs under part 23. The statement
should not be read as calling into question the applicability of
part 45 to inter-affiliate swaps.
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CDEU also objected to reporting any information to an SDR on a
trade-by-trade basis for inter-affiliate swaps as such reporting would
be costly and onerous for parties. Instead, CDEU recommended that all
reporting be done on an annual basis through a board resolution.\87\
CDEU also requested that part 45 data be reported on a quarterly basis
for all inter-affiliate swaps between financial and non-financial end
users, and that inter-affiliate swaps not be subject to historical swap
reporting under part 46. Similarly, Cravath asked that the Commission
``provide meaningful relief from the reporting requirements of Part 45
and Part 46.''
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\87\ Cravath stated that the Commission has determined that part
43 reporting does not apply to inter-affiliate swaps.
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DLA Piper commented that the regulatory reporting requirements are
unnecessary for inter-affiliate swaps and should be eliminated.\88\ DLA
Piper claimed that the reporting of both the outward-facing swap and
the inter-affiliate swap would increase systemic risk by distorting the
risk to the financial system. DLA Piper also commented that the
imposition of recordkeeping obligations with respect to inter-affiliate
swaps would result in significant additional burdens on corporate
groups. DLA Piper stated that inter-affiliate swaps should be expressly
exempt from the part 45 and part 46 reporting requirements.
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\88\ According to its comment letter, DLA Piper's comments are
limited to corporate end-users who enter into intercompany hedging
transactions.
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Under sections 2(a)(13) and 4r of the CEA, all swaps must be
reported to an SDR (or the Commission if there is no available SDR) and
are subject to comprehensive recordkeeping obligations.\89\ Reporting
and recordkeeping obligations apply to both historical swaps \90\ and
those swaps executed after the applicable compliance date listed in
part 45 of the Commission's regulations.\91\ As indicated in the
preamble to the final end-user exception \92\ and the NPRM,\93\ parts
45 and 46 of the Commission's regulations apply to inter-affiliate
swaps.\94\ Whether an inter-affiliate swap is subject to the part 43
real-time reporting rules will depend on whether the transaction fits
within the definition of a ``publically reportable swap transaction.''
\95\
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\89\ See 17 CFR part 45; 17 CFR 45.2 (recordkeeping
obligations); Swap Data Recordkeeping and Reporting Requirements, 77
FR 2136 (Jan. 13, 2012); 17 CFR part 46; Swap Data Recordkeeping and
Reporting: Pre-Enactment and Transition Swaps, 77 FR 35200 (June 12,
2012).
\90\ As described in the part 46 rules, historical swaps include
pre-enactment swaps, that is, swaps still in existence after the
date of enactment of the Dodd-Frank Act, and transition swaps, that
is, swaps entered into on or after the date of enactment but before
the compliance date specified in part 45 and other no-action or
regulatory guidance issued by the Commission or one of the
Commission's divisions or offices.
\91\ These reporting obligations may be subject to no-action or
other regulatory guidance issued by the Commission or any of the
Commission's divisions or offices. See www.cftc.gov for a complete
list of the staff no-action letters, Frequently Asked Questions, and
other regulatory guidance.
\92\ See End-User Exception to the Clearing Requirement for
Swaps, 77 FR 42567 (``Congress did not exempt such inter-affiliate
swaps from the reporting requirements'' and ``inter-affiliate swaps
must be reported'').
\93\ NPRM at 50432 (noting that section 4r applies to uncleared
swaps and that counterparties must comply with proposed rule
39.6(g)(4) ``[i]n addition to any general reporting requirements
applicable under other applicable rules'').
\94\ In addition, under part 45 non-SDs and MSPs must keep
``full, complete, and systematic records, together with all
pertinent data and memoranda, with respect to each swap in which
they are a counterparty.'' 17 CFR 45.2(b). These recordkeeping
obligations applied to inter-affiliate swaps as early as October 14,
2010. See Interim Final Rule for Reporting Pre-Enactment Swap
Transactions, 75 FR 63090 (Oct. 14, 2010). Thus, as of the date of
this release, swap counterparties already have an obligation to
maintain swap records that has existed for more than two years.
\95\ See 17 CFR 43.2 (defining ``publicly reportable swap
transaction'' as an executed swap that is an arm's length
transaction between two parties that results in a change in the
market risk position between the two parties and citing ``internal
swaps between one-hundred percent owned subsidiaries of the same
parent entity'' as an example of a swap that does not meet the
definition); see also Real-Time Public Reporting of Swap Transaction
Data, 77 FR 1182, 1187 (Jan. 9, 2012) (discussing the real-time
public reporting of inter-affiliate swaps).
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In response to commenters' requests, the Commission is clarifying
that the reporting obligations under Sec. 39.6(g)(2)(i) (now Sec.
50.52(c)) can be fulfilled by one of the affiliate counterparties on
behalf of both counterparties. The selection of which affiliate will be
considered to be the reporting counterparty should be determined in
accordance with the provisions of Sec. 45.8 and, for part 43, the
reporting party under Sec. 43.3(a)(3).
As noted in the NPRM, the Commission believes that affiliates
within a corporate group may make independent determinations on whether
to submit an inter-affiliate swap for clearing. Given the possibility
that each affiliate may reach different conclusions regarding clearing
the swap, Sec. 39.6(g)(2)(i) would require that both counterparties
elect the proposed inter-affiliate clearing exemption. The Commission
is therefore adopting the electing requirement as proposed.
With regard to comments recommending that all reporting be done on
an annual basis rather than a swap-by-swap basis, the Commission
declines to modify the rule. The Commission believes it is appropriate
to provide for annual reporting of certain information, including how
affiliates generally meet their financial obligations and information
related to its status as an electing SEC Filer.\96\ However, it would
not be appropriate to allow one annual report to cover both
[[Page 21769]]
affiliate counterparties' election of the exemption from clearing and
the confirmation that both affiliates meet the conditions of the
exemption because each affiliate is under an ongoing obligation to
demonstrate its eligibility to claim the exemption and because
effective regulatory monitoring requires an indication of the election
on a swap-by-swap basis.\97\ Accordingly, the election of the exemption
and the confirmation that the exemption's conditions are met must be
made for each swap. The Commission does not believe that this reporting
requirement will impose a significant burden on affiliate
counterparties because, as discussed above, other detailed information
for every swap must be reported under sections 2(a)(13) and 4r of the
CEA and Commission regulations. This approach comports with the
approach adopted for market participants claiming the end-user
exception under section 2(h)(7) of the CEA.\98\
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\96\ The Commission is modifying the proposed reporting
requirements relating to section 2(j) of the CEA to make them
consistent with the approach adopted in the end-user exception to
required clearing. As finalized, under Sec. 50.52(c)(3)(ii), the
committee of the board of directors (or equivalent body) of the
eligible affiliate counterparty must have ``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.''
\97\ If reports to the SDR were made on an annual basis, but
included swap-by-swap information, regulators would not be able to
monitor the transmission of risk through the market in a timely
fashion. Regulators would have a one-year lag before such data could
be used effectively for such purposes. If reports to the SDR were
made on an annual basis and did not include swap-by-swap
information, the regulators would be permanently hindered in their
ability to monitor the swap markets. As noted above, inter-affiliate
swaps and outward-facing swaps both transfer risk, but they do so in
different ways and in differing degrees. Regulators must be able to
distinguish between inter-affiliate swaps and outward-facing swaps
in order to monitor markets effectively. If electing entities
provided an annual statement that they are electing the exemption,
and do not identify the individual swaps for which the exemption has
been elected, the data would not allow regulators to distinguish
between the two groups.
\98\ See End-User Exception to the Clearing Requirement for
Swaps, 77 FR 42565-66.
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The Commission does not agree with EEI's comment that the
Commission will be able to obtain information on inter-affiliate swaps
from the information reported on market-facing swaps, and disagrees
with DLA Piper's comment that reporting and recordkeeping obligations
are unnecessary or would increase systemic risk. The reporting and
recordkeeping requirements promote accountability and transparency, and
will aid the Commission in monitoring compliance with the inter-
affiliate exemption. Moreover, the Commission does not believe that the
information relating to inter-affiliate swaps will necessarily be
identical to market-facing swaps. Also, the Commission does not believe
that all inter-affiliate swaps will match up to market-facing swaps
because, as The Working Group commented, entities use inter-affiliate
trades to transfer physical commodity or futures exposure between
affiliates for compliance with international tax law, customs, or
accounting laws.
I. Implementation
The clearing requirement under section 2(h)(1)(A) of the CEA and
part 50 of the Commission's regulations shall not apply to a swap
executed between affiliated counterparties that have the status of
eligible affiliate counterparties, as defined in Sec. 50.52(a), and
elect not to clear such swap until the effective date of this
rulemaking. The effective date of this rulemaking shall be 60 days
after publication in the Federal Register.
III. Cost-Benefit Considerations
A. Statutory and Regulatory Background
Section 15(a) of the CEA \99\ 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
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. The Commission considers the costs and benefits
resulting from its discretionary determinations with respect to the
section 15(a) factors.
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\99\ 7 U.S.C. 19(a).
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Prior to the passage of the Dodd-Frank Act, swaps were not required
to be cleared. In the wake of the financial crisis of 2008, Congress
adopted the Dodd-Frank Act, which, among other things, amends the CEA
to impose a clearing requirement for swaps based on determinations by
the Commission regarding which swaps are required to be cleared through
a DCO.\100\ This clearing requirement is designed to reduce
counterparty risk associated with swaps and, in turn, mitigate the
potential systemic impact of such risk and reduce the risk that swaps
could cause or exacerbate instability in the financial system.\101\ In
amending the CEA, however, the Dodd-Frank Act preserved the
Commission's authority to ``promote responsible economic or financial
innovation and fair competition'' by exempting any transaction or class
of transactions, including swaps, from select provisions of the
CEA.\102\ For reasons explained above,\103\ the Commission proposes to
exercise its authority under section 4(c)(1) of the CEA to exempt
inter-affiliate swaps--that is, swaps between majority-owned affiliates
with financial statements that are reported on a consolidated basis
under GAAP or IFRS--from the clearing requirement under section
2(h)(1)(A) of the CEA, subject to certain conditions.
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\100\ See section 2(h)(1) of the CEA, 7 U.S.C. 2(h)(1).
\101\ When a bilateral swap is moved into clearing, the
clearinghouse becomes the counterparty to each of the original
participants in the swap. This standardizes counterparty risk for
the original swap participants in that they each bear the same 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
those that each participant in the trade might have otherwise faced.
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.
\102\ Section 4(c)(1) of the CEA, 7 U.S.C. 6(c)(1). Section
4(c)(1) is discussed in greater detail above in Section II.A.
\103\ See Section II.A above.
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In the discussion that follows, the Commission considers the costs
and benefits of the inter-affiliate exemption to the public and market
participants generally. The Commission also separately considers the
costs and benefits of the conditions placed on affiliates that would
elect the exemption: (1) Majority ownership and financial statements
that are reported on a consolidated basis under GAAP or IFRS as
conditions for status as an eligible affiliate counterparty; (2) swap
trading relationship documentation, which would require affiliates to
document in writing all terms governing the trading relationship; (3)
centralized risk management requirement, which would require affiliates
to subject the swap to centralized risk management; and (4) reporting
requirements, which would require counterparties to advise an SDR, or
the Commission if no SDR is available, that both counterparties elect
the inter-affiliate clearing exemption and to identify the types of
collateral used to meet financial obligations. In addition to the
foregoing reporting requirements, counterparties that are issuers of
securities registered under section 12 of the Securities Exchange Act
of 1934 or those that are required to file reports under section 15(d)
of that Act, would be required to identify the SEC central index key
number and confirm that an appropriate committee of board of directors
has approved of the affiliates' decision not to clear a swap. The rule
also would permit affiliates to report certain information on an annual
basis, rather
[[Page 21770]]
than swap-by-swap. Finally, the Commission considers the costs and
benefits of the condition regarding the treatment of outward-facing
swaps.
In the NPRM, where reasonably feasible, the Commission sought to
estimate quantifiable dollar costs. In some instances, however, the
Commission explained that certain costs were not susceptible to
meaningful quantification, and in those instances, the Commission
discussed proposed costs and benefits in qualitative terms. As stated
above, the Commission received a total of 14 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.\104\
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\104\ As discussed further below, EEI commented on the NPRM's
consideration of costs and benefits and stated that the costs of the
proposed documentation requirement are unjustified. The NPRM
included an estimate that there would be a one-time cost of $15,000
to develop appropriate documentation for use by an entity's
affiliates. EEI objected to this estimate because, in its view, the
legal costs associated with individually negotiating and amending
standard agreements between individual affiliates would exceed the
NPRM's estimates. In addition, EEI objected to the NPRM's estimate
of 22 affiliated counterparties for each corporate group as ``far
too low'' for U.S. energy companies. However, EEI did not provide
specific, quantitative information in terms of either the legal
costs of complying with the proposed documentation requirement or
number of affiliates for a corporate group subject to this rule.
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In the sections that follow the Commission considers: (1) Costs and
benefits of the exemption for eligible affiliate counterparties; (2)
costs and benefits of the exemption for market participants and the
public; (3) alternatives contemplated by the Commission and the costs
and benefits relative to the approach adopted herein; (4) the impact of
exemption in light of the 15(a) factors. The Commission also discusses
the corresponding comments accordingly.
B. Costs and Benefits of Exemption for Eligible Affiliate
Counterparties
Without the final rule exempting swaps between certain affiliated
counterparties, those entities would have to clear their inter-
affiliate swaps pursuant to section 2(h)(1)(A) of the CEA (unless one
of the affiliates is able to claim an exception under section 2(h)(7)
of the CEA and/or Sec. 50.50).\105\ This rule allows eligible
affiliates to exempt inter-affiliate swaps from clearing, which creates
both costs and benefits for those entities. Regarding costs, by
allowing affiliates not to clear certain swaps that would otherwise be
subject to required clearing, the rule may allow those affiliates to be
exposed to greater measures of counterparty credit risk with respect to
one another. On the other hand, the primary benefit of providing this
exemption for inter-affiliate swaps between eligible affiliate
counterparties is that each affiliate will not have to incur the costs
of required clearing. These costs include clearing fees, as well as
costs associated with margin and capital requirements. The rule also
facilitates affiliates' use of swaps to hedge various types of risk
more efficiently.
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\105\ Under the Sec. 50.50 exception, end users and small
financial institutions that are hedging or mitigating commercial
risk may elect not to clear their swaps, subject to certain
conditions. Because of this exception, as explained in the NPRM, the
Commission anticipates that the inter-affiliate exemption will be
elected only when the two counterparties are financial entities that
do not qualify for the end-user exception. See NPRM at 50426.
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1. Benefits of Clearing Inter-Affiliate Swaps
The benefits of required clearing have been well-documented by the
Commission.\106\ As described in the preceding sections of this
adopting release, there are numerous benefits associated with central
clearing of swaps. In particular, clearing mitigates counterparty
credit risk, provides an organized mechanism for collateralizing the
risk exposures posed by swaps, and when applied to channels where
systemic risk could be transmitted, clearing reduces systemic risk.
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\106\ See e.g., Clearing Requirement Determination at 74329.
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The counterparty and systemic risk mitigation benefits of central
clearing also are realized from clearing transactions between
affiliates. Central clearing would ensure that inter-affiliate swaps
are fully documented and abide by valuation procedures set by the DCO,
which would help to ensure that affiliates have current and accurate
information regarding the value of their positions and would help
prevent the possibility of valuation disputes.\107\ In addition, when a
bilateral swap is cleared, the clearinghouse becomes the counterparty
to each of the original counterparties to the swap. This reduces and
standardizes the counterparty risk borne by each of the original
parties to the swap.\108\ Moreover, clearing mitigates the risk of
financial contagion because the clearinghouse serves as a sort of
``buffer'' that protects each of the original counterparties from the
credit risk of the other. This would also be true for inter-affiliate
swaps. Novating the swap to a clearinghouse so that each affiliate
faces the clearinghouse would ensure that each affiliate is facing
minimal counterparty credit risk and would minimize the possibility of
inter-affiliate swaps becoming a mechanism through which financial
instability could pass from one affiliate to another.
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\107\ ISDA & SIFMA stated that valuation and dispute resolution
procedures would appear to serve little purpose among majority-owned
affiliates. This comment is discussed above in Section II.D, as well
as in Section III.C.2. below.
\108\ A clearinghouse is one of the most credit-worthy
counterparties available in the market because of the panoply of
risk management tools it has at its disposal. 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.
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This rule reduces these benefits by allowing affiliates to exempt
swaps from required clearing. In the absence of clearing, affiliated
entities will not be required to collect initial or variation margin,
or to implement other measures that clearinghouses typically use to
mitigate their own counterparty credit risk. As a consequence, the
affiliates may accumulate large outstanding positions with one another
as the value of their swap positions change value between payment
dates. If an affiliate with large, out-of-the-money, inter-affiliate
swap positions defaulted, it could cause financial instability in its
affiliates, leading to a cascading series of defaults among them. As
discussed below, the Commission expects that internalization of costs
and risks among
[[Page 21771]]
affiliated entities, as well as the conditions for electing the
exemption will mitigate this cost, but will not eliminate it entirely.
2. Reduced Clearing Costs
As stated above, by exempting qualified affiliates from clearing
inter-affiliate swaps that would otherwise be subject to the clearing
requirement, the rule ensures that each affiliate will not incur the
costs of required clearing for those swaps. These costs include
clearing fees as well as costs associated with margin and capital
requirements. Regarding clearing fees, assuming that the affiliated
counterparties cannot clear on their own behalves or through an
affiliated clearing member of a DCO, the affiliated counterparties
would have to arrange to clear their swaps through a futures commission
merchant (FCM) that is a member of a DCO. Regardless of whether the
affiliated counterparties clear on their own behalf or contract with an
FCM, they will incur fees from the DCO.
For customer clearing, DCOs typically charge FCMs an initial
transaction fee for each customer swap that is cleared, as well as an
annual maintenance fee for each of the customers' open positions. For
example, not including customer-specific and volume discounts, the
transaction fees for interest rate swaps at CME range from $1 to $24
per million notional amount and the maintenance fees are $2 per year
per million notional amount for open positions.\109\ LCH transaction
fees for interest rate swaps range from $1 to $20 per million notional
amount, and the maintenance fee ranges from $5 to $20 per swap per
month, depending on the number of outstanding swap positions that an
entity has with the DCO.\110\ It is within the FCM's discretion to
determine whether or how to pass these fees on to their customers.\111\
Accordingly, allowing affiliates to elect not to clear swaps that meet
the requirements of the final rule will result in the affiliates not
having to pay clearing-related fees, either directly or indirectly,
with respect to those swaps.
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\109\ 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.
\110\ See LCH pricing for clearing services related to OTC
interest rate swaps at: http://www.lchclearnet.com/swaps/swapclear_for_clearing_members/fees.asp.
\111\ See discussion of clearing fees in the Clearing
Requirement Determination, 77 FR 74324-25.
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Second, permitting an exemption from clearing for swaps between
affiliates, the final rule will reduce the amount of initial margin
that such entities are required to post or pay for those swaps. In the
clearing requirement determination, the Commission estimated that 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.\112\ While the estimates provided by the
Commission in its clearing requirement determination adopting release
did not include data related to inter-affiliate swaps,\113\ the
estimates do support a conclusion that the exemption will reduce the
amount of margin that affiliates would be obligated to allocate to
initial margin in order to clear inter-affiliate swaps that are subject
to the clearing requirement. As a consequence, the exemption is likely
to increase the amount of capital that affiliates may distribute to
their owners or put to other uses.
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\112\ See Clearing Requirement Determination at 74326
(explaining how this estimate was reached and noting that the
estimate may either over-estimate or under-estimate the amount of
additional initial margin that would need to be posted).
\113\ For example, swap data collected by the Bank of
International Settlements (BIS) does not contain information
regarding transactions between affiliates (i.e., branches and
subsidiaries) of the same institution. See, e.g., Statistical
release: OTC derivatives statistics at end-June 2012, Monetary and
Economic Department, Bank of International Settlements (Nov. 2012),
available at http://www.bis.org/publ/otc_hy1211.pdf. The Commission
relied on BIS data in calculating its additional initial margin
requirements for required clearing of certain interest rate swaps
and credit default swaps.
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Third, by exempting inter-affiliate swaps from required clearing,
inter-affiliate swaps would not be subject to variation margin
requirements under a DCO's rules. Exempting inter-affiliate swaps from
required clearing's variation margin requirements may help affiliates
and corporate entities as a whole manage their liquidity needs because
the entities would not have to routinely collateralize losses at the
DCO. It is also likely to reduce the operational costs that the
affiliates would otherwise bear in order to manage margin calls and
associated variation margin payments.
3. Risk Management Benefits of Inter-Affiliate Swaps
A number of commenters stated that executing swaps with the market
through one affiliate enables entities to more efficiently and
effectively manage corporate risk.\114\ In this arrangement, the one
affiliate engages in inter-affiliate swaps with other affiliated
entities in order to hedge the risks of those affiliates. The one,
central affiliate then engages in market-facing swaps to offset the
risk that it has taken on. Executing swaps through one affiliate may
enable corporate entities to concentrate their swap and hedging
expertise and activity within a single affiliate, which reduces
personnel costs. It also allows the corporation to net various
positions before facing the market, thus reducing the number of market
facing swaps, and the attendant fees.
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\114\ See, e.g., letters from The Working Group, EEI, and ISDA &
SIFMA.
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Moreover, these affiliate structures may not only reduce costs, but
certain types of risk for the corporation as well. By concentrating
personnel with swap and hedging expertise in one affiliate, and running
inter-affiliate and market facing swap activities through a single
entity, corporations may reduce the risk of operational errors. Such
errors can create considerable risk when engaging in large hedging
transactions. Moreover, the corporation's operational risk may be
further mitigated by reducing the total number of market facing swaps
into which the affiliated entities enter.\115\
Additionally, as stated above and as noted in the NPRM, affiliates
that are commonly owned internalize a portion of one another's
risk.\116\ To the extent that affiliated entities internalize one
another's risk, those entities have an economic incentive to perform on
their obligations with respect to one another, thus reducing the
counterparty risk that they bear as a consequence of their swaps with
one another. However, the qualification ``to the extent that affiliated
entities internalize one other's risk'' is significant. Two important
factors limit the degree to which affiliates internalize one another's
risk. First, if either of the affiliated entities has a portion of
ownership that is not held in common, then a corresponding portion of
the risks transferred to that entity will not be borne by the common
owners, and thus will not be internalized. In other words, a smaller
common ownership stake will cause less counterparty risk to be
internalized, and will lessen the incentive affiliates will have to
perform on their obligations toward one another. Second, as described
above, there are circumstances in bankruptcy where affiliates do not
internalize each other's risks, which may also reduce, or
[[Page 21772]]
eliminate, the affiliates' incentives to perform with respect to their
obligations they have toward one another.\117\
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\115\ Commenters also asserted that inter-affiliate swaps are
used in order to assist in tax management and compliance with
international laws, stating that the exemption would help to
preserve those benefits. Commenters did not provide sufficient
information regarding their operations, tax management strategies,
and international compliance requirements for the Commission to
evaluate these stated benefits.
\116\ See NPRM at 50426 and Section II.A.
\117\ See Section II.A.
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Reduced internalization of risk among affiliates may create
incentives for certain affiliates to use inter-affiliate swaps to shift
risk to other affiliates in ways that are not necessarily in the best
interests of minority stakeholders or counterparties to certain
affiliates. In order to address this concern, the Commission has
conditioned election of the exemption on several requirements that are
intended to mitigate the costs created by reduced internalization of
risk among affiliates, as well as the foregone benefits of required
clearing.
C. Costs and Benefits of Exemption's Conditions
The inter-affiliate exemption from required clearing sets forth
five conditions that must be satisfied in order to elect the exemption:
(1) Both affiliates must be majority-owned and their financial
statements must be reported on a consolidated basis; (2) the swap must
be documented in a written swap trading relationship document; (3) the
swap must be subject to a centralized risk management program; (4)
certain information regarding the swap must be reported to an SDR; and
(5) both affiliates must meet certain conditions with regard to their
outward-facing swaps. The Commission believes that entities will have
to incur costs to satisfy these conditions. Those costs may offset some
of the benefits that would otherwise result from the exemption.
However, the exemption is permissive, and therefore the Commission also
believes that an affiliate will elect the exemption only if these costs
are less than the costs that an affiliate will incur should it decide
not to elect the exemption. Moreover, as described below, the
conditions provide certain benefits to the affiliates' counterparties
and to the public that the Commission believes are essential in order
to mitigate counterparty credit risk in situations where affiliates do
not completely internalize each other's risks. Lastly, the Commission
believes that in some cases entities are already meeting some or all of
the requirements for electing the exemption, in which cases the
affiliates would bear less new costs, or no new costs at all, due to
the conditions.\118\
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\118\ See, e.g., letters from MetLife and Prudential (explaining
that it is current business practice to document inter-affiliate
swaps); letter from EEI (explaining that inter-affiliate swaps are
subject to risk management).
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1. Eligible Affiliate Counterparty Status
In order to qualify as an eligible affiliate counterparty under the
terms of the exemption, two factors must be met. First, one affiliate
must directly or indirectly hold a majority ownership interest in the
other, or a third party must hold a majority ownership interest in
both. Second, the financial statements of both affiliates are reported
on a consolidated basis under Generally Accepted Accounting Principles
(GAAP) or International Financial Reporting Standards (IFRS).
The Commission anticipates that in a relatively small number of
cases entities may alter their ownership structures in order to qualify
for the inter-affiliate exemption's majority-ownership condition. In
these cases, entities may bear certain legal costs, and in some cases,
costs associated with negotiations with other owners in the entity.
These costs could vary significantly, depending on the complexity of
the entity's existing ownership structure, including the number of
owners and the alignment or misalignment of their interests. The
Commission does not have adequate information to determine which
entities or how many entities may consider altering their ownership
structure in order to become eligible for the inter-affiliate
exemption, but notes again that entities would only do this if they
anticipate that the benefits of the exemption are greater than the
costs of meeting the qualifying criteria.
Four commenters supported proposed majority-ownership requirement.
CDEU commented that the majority-ownership test strikes an appropriate
balance between ensuring that the rule is not overly broad and
providing companies with the flexibility to account for differences in
corporate structures. EEI noted that majority-owned affiliates will
have strong incentives to internalize one another's risks because the
failure of one affiliate impacts all affiliates within the corporate
group. The Working Group generally supported the Commission's
definition, but stated that inter-affiliate swaps should be
unconditionally exempt from mandatory clearing when the affiliates are
consolidated for accounting purposes. MetLife stated that it would
likely limit inter-affiliate trading to ``commonly-owned'' affiliates,
but agreed with the flexibility of including majority-owned affiliates.
Two commenters objected to the proposal and requested the
Commission require 100% ownership of affiliates. AFR stated that
permitting such a low level of joint ownership would lead to evasion of
the clearing requirement through the creation of joint ventures set up
to enable swap trading between banks without the need to clear the
swaps. Similarly, Better Markets agreed that only 100% owned affiliates
should be eligible for the exemption because allowing the exemption for
the majority owner permits that owner to disregard the views of its
minority partners and creates an incentive to evade the clearing
requirement by structuring subsidiary partnerships. Finally, Better
Markets stated that the majority-ownership standard will result in
corporate groups transferring price risk and credit risk to different
locations facilitating interconnectedness and potentially giving rise
to systemic risk during times of market stress.
As discussed above, the degree to which one affiliate's risks are
internalized by another affiliate depends significantly on the
percentage of common ownership between them. For example, two
affiliates that are 100% commonly owned are likely to internalize much
of one another's risk. This creates a strong incentive for affiliates
to perform on their obligations to one another. Therefore, if the
Commission were to increase the common ownership requirement above a
majority stake, it would likely result in affiliate counterparties
internalizing more of one another's risk with respect to inter-
affiliate swaps in order to qualify for the exemption. This, in turn,
would provide additional incentives for affiliates to perform on their
inter-affiliate swap obligations. However, if the Commission were to
increase the common ownership percentage requirement, it also would
reduce the number of affiliates that could qualify for, and benefit
from, the exemption.
On the other hand, if the Commission lowered the percentage of
common ownership that is required to be eligible for the exemption
(i.e., made it 50% or less), it would increase the number of affiliates
that are eligible for the exception. This lower standard would allow
affiliates that internalize less of each other's risks and therefore
have weaker incentives to perform on their obligations to one another
to qualify for the exemption. Moreover, the absence of a majority
common ownership requirement could create opportunities for otherwise
unrelated entities to form joint ventures and transact swaps with one
another in order to claim the inter-affiliate exemption from clearing,
which would undermine the effectiveness of the clearing requirement.
The Commission considered each of these factors and concluded that
the majority stake requirement is sufficient to internalize costs and
incentivize affiliates to perform on their obligations
[[Page 21773]]
to one another. The Commission also believes that the potential for
evasion is mitigated through the conditions to the final rule, which
have been carefully crafted in order to narrow the exemption. For
example, two unrelated entities cannot each hold a majority stake in
the same affiliate. Consequently, such unrelated entities cannot use an
inter-affiliate swap as an indirect means of trading without being
subject to the clearing requirement under section 2(h) of the CEA and
part 50 of the Commission's regulations.
As an additional consideration, as noted above, the majority
requirement also harmonizes with Commission's understanding of the EMIR
requirements. Harmonizing with EMIR is likely to reduce compliance
monitoring costs for entities electing the affiliated entity exemption.
In terms of potential costs in the form of disregarding the interests
of minority shareholders, the Commission recognizes that a 100%
ownership requirement would eliminate the risk of minority
shareholders' interests not being aligned with decisions to elect the
exemption. However, the Commission is also cognizant that such a
requirement would reduce the number of affiliates that are able to
claim the exemption. The Commission believes that the majority-
ownership requirement appropriately considers the risk of the former
and the benefits of the latter.
With regard to the consolidation of financial statements, FSR
requested that the Commission clarify that alternative accounting
standards can be used for purposes of meeting the requirement that the
financial statements of both affiliates be reported on a consolidated
basis. The Commission considered this comment and is adopting the
alternative suggested by FSR. As modified the rule requires that the
financial statements of both counterparties be reported on a
consolidated basis under GAAP or IFRS. This change recognizes the fact
that some entities claiming the exemption may report their financial
statements under different accounting standards, and makes it possible
for those entities to elect the exemption as long as they would be
required to report their financial statements on a consolidated basis
under GAAP or IFRS. This likely increases the number of entities that
may elect the exemption relative to the form of the rule proposed in
the NPRM while maintaining the protections that were intended with the
requirement for consolidated financial statements. The Commission also
modified the rule to clarify which entities are subject to the
consolidated financial statement requirement.
2. Inter-Affiliate Swap Documentation
As proposed, the inter-affiliate exemption required that eligible
affiliate counterparties that elect the inter-affiliate exemption must
enter into swaps with a swap trading relationship document that is in
writing and includes all the terms governing the relationship between
the affiliates. These terms included, but were not limited to, payment
obligations, netting of payments, transfer of rights and obligations,
governing law, valuation, and dispute resolution. This requirement
would be satisfied if an eligible affiliate counterparty is an SD or
MSP that complies with the swap trading relationship documentation
requirements of Sec. 23.504.\119\
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\119\ For a discussion of the costs and benefits incurred by
swap dealers and major swap participants that must satisfy
requirements under Sec. 23.504, see Confirmation, Portfolio
Reconciliation, Portfolio Compression, and Swap Trading Relationship
Documentation Requirements for Swap Dealers and Major Swap
Participants, 77 FR 55904, 55906 (Sept. 11, 2012) (final rule) and
Swap Trading Relationship Documentation Requirements for Swap
Dealers and Major Swap Participants, 76 FR 6715, 6724-25 (Feb. 8,
2011) (proposed rule).
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The Commission received a number of comments both supporting and
opposing the swap documentation requirement. Better Markets, MetLife,
and Prudential all supported the proposed documentation requirement.
Specifically, MetLife and Prudential did not believe that the
documentation requirement would be any more ``burdensome or costly''
for them because they already document all of their swaps.
Cravath, EEI, CDEU, and DLA Piper opposed the proposed
documentation requirement. Cravath stated that the costs associated
with the imposition of documentation requirements outweigh any benefits
to the financial system, and that the Commission should leave the
determination as to the appropriate level of documentation to boards of
directors and management of companies, to determine based on the
``reasonable exercise of their fiduciary responsibilities.'' DLA Piper
commented that the documentation requirements are burdensome and
questioned the benefits of imposing documentation requirements on
transactions between two parties.
CDEU expressed concern that proposed documentation condition would
require that full ISDA Master Agreements be used to document inter-
affiliate swaps. CDEU explained that while many market participants use
master agreements, some end users many not have full master agreements
because inter-affiliate swaps are purely internal and do not increase
systemic risk. CDEU recommended that the proposed rule be revised to
require that the swap documentation ``include all terms necessary for
compliance with its centralized risk management program'' and eliminate
the list of required terms. CDEU also requested that the Commission
clarify that (1) market participants can continue to use documentation
required by their risk management programs and (2) the rule does not
require market participants use ISDA Master Agreements.
EEI recommended that the Commission eliminate the documentation
requirement because the requirement is duplicative of corporate
accounting records that affiliates currently maintain. EEI commented
that a documentation requirement imposes ``an additional, costly layer
of ministerial process and documentation that is unnecessary to achieve
the Commission's stated objectives.'' EEI commented on the NPRM's
consideration of costs and benefits and stated that the costs of the
proposed documentation requirement are unjustified. The NPRM included
an estimate that there would be a one-time cost of $15,000 to develop
appropriate documentation for use by an entity's affiliates. EEI
objected to this estimate because, in its view, the legal costs
associated with individually negotiating and amending standard
agreements between individual affiliates would exceed the NPRM's
estimates. In addition, EEI objected to the NPRM's estimate of 22
affiliated counterparties for each corporate group as ``far too low''
for U.S. energy companies.\120\ However, EEI did not provide specific,
quantitative information in terms of either the legal costs of
complying with the proposed documentation requirement or number of
affiliates for a corporate group subject to this rule. Accordingly, the
Commission is unable to verify whether the legal costs or average
number of affiliates estimates are too low.
---------------------------------------------------------------------------
\120\ This estimate appeared in the NPRM section regarding the
Paperwork Reduction Act not in the consideration of costs and
benefits section.
---------------------------------------------------------------------------
ISDA & SIFMA stated that the documentation requirements were overly
prescriptive and would impose unnecessary costs on affiliates. ISDA &
SIFMA recommended a more flexible approach that would require adequate
documentation of ``all transaction terms under applicable law.''
In response to commenters' requests for a more flexible standard,
the Commission modified the proposal for swaps between affiliates that
are not
[[Page 21774]]
SDs or MSPs. The Commission adopted ISDA & SIFMA's recommendation that
the focus of the documentation requirement be on documenting all of an
inter-affiliate transaction's terms.\121\
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\121\ The Commission is modifying the documentation condition to
require that ``the terms of the swap are documented in a swap
trading relationship document that shall be in writing and shall
include all terms governing the trading relationship between the
affiliates.''
---------------------------------------------------------------------------
Under this modification, the Commission is eliminating the non-
exclusive list of terms, which included payment obligations, netting of
payments, transfer of rights and obligations, governing law, valuation,
and dispute resolution. The change responds to commenters' requests for
a more flexible approach that reflects current market best practices,
and signals that market participants retain the ability to craft
appropriate documentation for their affiliated entities so long as such
documentation includes the terms of the swap and ``all terms governing
the trading relationship between the eligible affiliate
counterparties.'' \122\ This modification also serves to address
concerns that the intent of the proposed rule was to require formal
master agreements, such as the ISDA Master Agreement.\123\ The proposed
rule was not intended to require affiliates to enter into formal master
agreements. Rather, the Commission observed that parties that already
use master agreements (of any sort) to document their inter-affiliate
swaps would likely meet the requirements of the proposed rule without
additional costs. This observation was supported by commenters such as
MetLife and Prudential. The Commission believes that these
modifications to the proposal and clarifications respond to commenters'
concerns and will serve to reduce documentation costs for those
electing the inter-affiliate exemption.\124\
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\122\ See Sec. 50.52(b)(2)(ii).
\123\ In the NPRM, the Commission estimated that affiliates
could pay a law firm for up to 30 hours of work at $495 per hour to
modify an ISDA Master Agreement, resulting in a one-time cost of
$15,000, and there may be additional costs related to revising
documentation to address a particular swap. All salaries in these
calculations are taken from the 2011 SIFMA Report on Management and
Professional Earnings in the Securities Industry. Annual wages were
converted to hourly wages assuming 1,800 work hours per year and
then multiplying by 5.35 to account for bonuses, firm size, employee
benefits and overhead. The Commission also estimated that affiliates
would incur costs of less than $1,000 per year related to signing
swap documents and retaining copies.
\124\ In response to comments from Better Markets and AFR that
the proposed regulations should be retained and not weakened, the
Commission does not believe that eliminating the non-exclusive list
of terms and replacing it with a simple requirement that all terms
of the swap transaction and the relationship between the affiliates
be documented will weaken the rule. Rather, while affiliates will
have discretion to select the appropriate terms to document their
swap, they will still have an obligation to ensure that their
documentation contains an accurate and thorough written record of
their swaps. In most instances, this will necessarily include all of
the previously enumerated terms.
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Entities that have already established systems for documenting the
terms of their inter-affiliate swaps and all the terms of the trading
relationship between eligible affiliates will not bear any costs as a
consequence of this requirement.\125\ However, as noted in the NPRM,
the Commission understands that some affiliates may enter into inter-
affiliate swaps with little documentation regarding the terms of the
swaps.\126\ Such entities may not have systems to document the terms of
their inter-affiliate swaps or all the terms of the trading
relationship between eligible affiliates. They will bear some initial
costs and ongoing costs in order to comply with this requirement. In
the NPRM, the Commission estimated that the initial costs of up to
$15,000 to create such the necessary documentation, and less than
$1,000 per year on an ongoing basis to sign and retain appropriate
documentation.\127\
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\125\ See comments letters from MetLife and Prudential.
\126\ See NPRM at 50428-50429.
\127\ See id. at 50434.
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In response to EEI's comment regarding duplicative requirements, to
the extent that the documentation requirement is duplicative of an
affiliate's existing recordkeeping practices, it will not introduce new
costs. However, the Commission notes that if existing records do not
contain the terms of each inter-affiliate swap or all the terms of the
trading relationship between affiliates, affiliates will be required to
implement new documentation that creates incremental costs, as noted
above.
Regarding benefits, documentation of inter-affiliate swaps is
essential to effective risk management. In the absence of such
documentation, affiliates cannot track or value their swaps
effectively. Documentation also helps ensure that affiliates have proof
of claim in the event of bankruptcy. As explained earlier, insufficient
proof of claim could create challenges and uncertainty at bankruptcy
that could adversely affect affiliates and third party creditors. The
documentation requirement, to the extent that it requires entities to
document all the terms that are necessary in order to value inter-
affiliate swaps and to provide legal certainty in the event of
bankruptcy, will promote effective risk management and resolution of
claims in the event of insolvency.\128\
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\128\ As discussed in Section II.D above, the Commission expects
that, in most instances, documentation between affiliates will
include all of the previously enumerated terms, several of which are
essential to effective valuation of swaps and resolution in
bankruptcy. However, the Commission notes that a more flexible
approach makes it possible that some entities could document the
terms of their inter-affiliate swaps and all the terms of their
trading relationship without covering all of the terms that are
necessary for effective valuation or resolution in bankruptcy. If
this occurs, it would reduce the risk management and bankruptcy
benefits created by the documentation requirement.
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3. Centralized Risk Management
Another condition of the inter-affiliate exemption requires that
the swap be subject to a centralized risk management program that is
``reasonably designed to monitor and manage the risks associated with
the swap.'' If at least one of the eligible affiliate counterparties is
an SD or MSP, the centralized risk management requirement is satisfied
by complying with the requirements of Sec. 23.600.\129\
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\129\ For a discussion of the costs and benefits incurred by
swap dealers and major swap participants that must satisfy
requirements under Sec. 23.600, see 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 20173-75.
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Four commenters objected to the proposed requirement, suggested
alternatives, and/or requested clarification. FSR stated that the
condition should be eliminated because integrated risk management
systems ``are generally not established across international
boundaries'' and are not consistent with general risk practices in
large, multinational organizations. FSR suggested that the requirement
be dropped in favor of each entity making ``its own evaluations of the
risk associated with an inter-affiliate position.''
Cravath stated that in many cases, for companies outside of the
financial sector, the proposed rule will require a substantial change
in the processes and procedures currently maintained by such companies,
and the cost of complying with the risk management program requirements
outweigh any benefits to the financial system. Cravath commented that
rather than subject companies to a risk management rule, ``[c]ompanies
should have the flexibility to engage in prudent risk management for
their corporate group in a manner consistent with the overall level of
risks to their business.''
EEI suggested that the Commission eliminate the centralized risk
[[Page 21775]]
management program requirement on the grounds that it would be
duplicative for corporate groups that already have risk management
programs in place. According to EEI, it is standard industry practice
for both private and public companies to have a risk management
program. EEI accordingly does not see a ``need to impose a separate,
discrete regulatory requirement to document with an SDR or the
Commission the existence of a centralized risk management program.'' If
the Commission decides to retain the requirement, EEI requested that
the Commission require a program be ``reasonably designed to monitor
and manage the risks associated with the swap'' and provide the
flexibility to design risk management programs that address the unique
risks of an entity's business.
The Working Group requested that the Commission clarify whether
non-SDs and non-MSPs would be subject to the same enterprise-level risk
management program as required for SDs and MSPs under Sec. 23.600. The
Working Group proposed that the Commission require ``a robust risk
management program'' rather than ``a centralized risk management
program.''
In response to comments asking that the Commission clarify the
level of risk management required for non-SDs and non-MSPs, the
Commission confirms that the risk management condition is intended to
be flexible and does not require the same level of policies and
procedures as required under Sec. 23.600 for SDs and MSPs. Under the
rule, a company would be free to structure its centralized risk
management program according to its unique needs, provided that the
program reasonably monitors and manages the risks associated with its
uncleared inter-affiliate swaps. In all likelihood, if a corporate
group has a centralized risk management program in place that
reasonably monitors and manages the risk associated with its inter-
affiliate swaps as part of current industry practice, it is likely that
the program would fulfill the requirements of exemption and therefore
the exemption would not create new costs in such cases.
Given that a number of commenters stated that it is common practice
for market participants, including end users, to have risk management
programs in place,\130\ expects that the majority of companies with
eligible affiliates will not have to create centralized risk management
programs from scratch in order to meet the eligibility requirements for
the exemption. Those with existing systems may need to make some
changes in order to centralize them, but the Commission has provided
significant flexibility to companies in determining the specific
contours of the centralized risk management system. Given this
flexibility, and the fact that it is common practice for market
participants to have risk management programs in place, the Commission
is not persuaded by Cravath's comment that the rule will require a
substantial change in the processes and procedures currently maintained
by companies to manage risk. Accordingly, costs will be limited where
an entity only needs to make modifications to existing risk management
programs. Moreover, a corporate group may not have to incur any costs
if it already has in place a risk management system that meets the
requirements of the inter-affiliate exemption.
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\130\ See, e.g., letters from Prudential, MetLife, and CDEU.
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The Commission also declined to modify the requirement to state ``a
robust risk management program'' rather than ``a centralized risk
management program.'' While change proposed by the Working Group may
prevent certain entities from having to reorganize their risk
management program in order to meet the requirements of the inter-
affiliate exemption, it could also significantly reduce the ability of
the risk management program to mitigate counterparty risk among
affiliates. In the absence of variation margin, or clearing to mitigate
counterparty credit risk among affiliates, risk management committees
must have a clear line of sight into the financial health and
obligations of each affiliate involved in inter-affiliate swaps.
In the NPRM, the Commission explained that some affiliates may have
to create a risk management system to meet the risk management
condition.\131\ The Commission itemized a number of specific costs,
including the purchase of equipment and software to adequately evaluate
and measure inter-affiliate swap risk.\132\ In addition, in the NPRM,
the Commission estimated that centralized risk management could require
up to ten full-time staff at an average salary of $150,000 per
year.\133\ The Commission received no comments in response to its risk
management condition cost estimates.
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\131\ As pointed out above, industry commenters underscored the
fact that many corporate groups that currently use inter-affiliate
swaps have centralized-risk-management procedures in place.
\132\ See NPRM at 50434 (estimating such costs to be as high as
$150,000 for purchasing a computer network at approximately $20,000;
purchasing personal computers and monitors for 15 staff members at
approximately $30,000; purchasing software at approximately $20,000;
purchasing other office equipment, such as printers, at
approximately $5,000; and installation and unexpected costs that
could increase up-front costs).
\133\ This average annual salary is based on 15 senior credit
risk analysts only. The Commission appreciates that an affiliate
would likely choose to employ different positions as well, such as
risk management specialists at $130,000 per year, and computer
supervisors at $140,000. But for the purposes of this estimate, the
Commission has assumed salaries at the high end for risk management
professionals. The Commission also estimated a data subscription for
price and other market data may have to be purchased at cost of up
to $100,000 per year.
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There are benefits that derive from the centralized-risk management
condition. The Commission expects that centralized risk management
programs will establish appropriate measurements and procedures to
monitor the amount of risk that each individual affiliate bears, and to
monitor the condition of each entity's affiliate counterparties.
Because a centralized risk management program is more likely to have a
clear line of sight into the financial condition of all affiliated
entities, it is better positioned to manage each affiliate's exposure
to the counterparty risk of other affiliates than a risk management
program situated inside any single affiliate. As a consequence,
centralized risk management programs may reduce the likelihood that
individual affiliates could become insolvent because of their exposure
to other affiliates, which not only benefits the affiliates, but their
third party counterparties as well.
4. Reporting to an SDR
Another condition of electing the inter-affiliate exemption is that
certain information about the swap and the election of the exemption be
reported to an SDR. The reporting condition requires affiliates to
report specific information to an SDR, or to the Commission if no SDR
is available. Such information includes a notice that both affiliates
are electing the exemption and that they both meet the other conditions
of exemption, as well as information regarding how the financial
obligations of both affiliates are generally satisfied with respect to
uncleared swaps. The final rule also requires reporting certain
information if the affiliate is an SEC filer.
The Commission received several comments in response to the
reporting obligations of affiliates. Prudential and MetLife both
commented that the Commission should clarify that only one counterparty
is required to report the swap to an SDR. EEI stated that the
Commission should eliminate the transaction-by-transaction reporting
[[Page 21776]]
requirement for the election of the exemption and confirmation that the
conditions have the exemption have been met. Instead, EEI recommended
that one of the affiliates be permitted to file an annual notice on
behalf of both affiliates to exempt all of their swaps from clearing
for an entire year. EEI contended that it will increase costs if both
affiliates have to communicate that they elect not to clear the swap
and meet the conditions of the exemption for each swap.\134\ CDEU also
objected to reporting any information to an SDR on a trade-by-trade
basis for inter-affiliate swaps as such reporting would be costly and
onerous for parties. Instead, CDEU recommended that all reporting be
done on an annual basis through a board resolution.
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\134\ EEI also commented that the Commission should state that
part 45 does not apply to inter-affiliate swaps because the
Commission will be able to obtain information regarding an inter-
affiliate transaction based on reporting of a corresponding market-
facing swap. EEI cited to a statement in the NPRM's consideration of
costs and benefits as support for an argument that the Commission
did not intend for part 45 reporting to apply to inter-affiliate
swaps. See NPRM at 50433. As explained above, the statement in the
cost-benefit consideration of the NPRM merely drew a comparison
between the reporting requirements under the proposed exemption and
the general reporting requirements under parts 45 and 46, and those
reporting requirements applicable to SDs and MSPs under part 23. The
statement should not be read as calling into question the
applicability of part 45 to inter-affiliate swaps.
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In response to commenters' requests, the Commission clarified that
the reporting condition can be fulfilled by one of the affiliate
counterparties on behalf of both counterparties. As noted in the NPRM,
the Commission believes that affiliates within a corporate group may
make independent determinations on whether to submit an inter-affiliate
swap for clearing. Given the possibility that each affiliate may reach
different conclusions regarding clearing the swap, the final rule
requires that both counterparties elect the proposed inter-affiliate
clearing exemption.
DLA Piper commented that corporate groups do not maintain back-
office systems necessary to keep the level of detail required under
parts 45 and 46 with respect to their inter-company swaps. DLA Piper
further commented that many corporate groups will need to develop
costly systems and procedures, which will increase their hedging costs,
in order to comply with the reporting rules. The Commission observes
that the costs of parts 45 and 46 reporting have been addressed in
prior rulemakings and are beyond the scope of this rule.
With regard to comments recommending that all reporting be done on
an annual basis rather than a swap-by-swap basis, the Commission
declines to modify the rule. The Commission believes it is appropriate
to provide for annual reporting of certain information, including how
affiliates generally meet their financial obligations and information
related to its status as an electing SEC Filer. However, it would not
be sufficient to allow one annual report to cover both affiliate
counterparties' election of the exemption from clearing and the
confirmation that both affiliates meet the conditions of the exemption.
Eligible affiliates may choose to elect or not elect the exemption
on a swap-by-swap basis. As noted above, whether a swap is cleared or
not has a significant impact on its ability to transfer credit risk
from one entity to another. Regulators must know which swaps are
cleared and which swaps are not cleared in order to monitor potential
accumulations and transfers of risk within the financial system. In
addition, they must know which exemption is being used to exempt
certain swaps in order to monitor the use of each exemption and its
possible effect on systemic risk. Consequently, the election of the
exemption and the confirmation that the exemption's conditions are met
must be made for each swap.
The Commission does not believe that this reporting requirement
will impose a significant burden on affiliate counterparties because,
as discussed above, other detailed information for every swap must be
reported under sections 2(a)(13) and 4r of the CEA and Commission
regulations. This approach comports with the approach adopted for
market participants claiming the end-user exception under section
2(h)(7) of the CEA.\135\
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\135\ See End-User Exception to the Clearing Requirement for
Swaps, 77 FR 42565-66.
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In the NPRM, the Commission estimated specific costs for the
reporting condition, including entering a notice of election into the
reporting system.\136\ Cost estimates in the NPRM also included costs
of identifying how the affiliates expect to meet the financial
obligations associated with their uncleared swap and providing
information if either electing affiliate is an SEC Filer.\137\ The
Commission also estimated costs for entities to modify their reporting
systems to accommodate the additional data fields required by this
rule.\138\ The Commission also estimated costs for non-reporting
affiliates.\139\ Finally, in the NPRM, the Commission explained that
SDRs would bear costs associated with the reporting conditions insofar
as SDRs would be required to add or edit reporting data fields to
accommodate information reported by affiliates electing the inter-
affiliate clearing exemption.\140\ The Commission received no comments
in response to its cost estimates for the reporting condition.
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\136\ The NPRM at 50435, included an estimate that each
counterparty may spend 15 seconds to two minutes per swap entering a
notice of election of the exemption into the reporting system. The
hourly wage for a compliance attorney is $390, resulting in a per
transaction cost of $1.63-$13.00.
\137\ See NPRM at 50435. Affiliates may decide to report
financial obligation information and SEC Filer information on either
a swap-by-swap or annual basis, and the costs would vary depending
on the reporting frequency. Regarding the financial obligation
information, the Commission estimated in the NPRM that it may take
the reporting counterparty up to 10 minutes to collect and submit
the information for the first transaction, and one to five minutes
to collect and submit the information for subsequent transactions
with that same counterparty. The hourly wage for a compliance
attorney is $390 resulting in a cost of $65.00 for reporting the
first inter-affiliate swap, and a cost range of $6.50-$32.50 for
reporting subsequent inter-affiliate swaps.
\138\ See id. (estimating that such modifications would create a
one-time programming expense of approximately one to ten burden
hours per affiliate, which means a one-time, per entity cost ranging
from $341 and $3,410).
\139\ See id. (noting that costs would likely vary substantially
depending on how frequently the affiliate enters into swaps, whether
the affiliate undertakes an annual filing, and the due diligence
that the reporting counterparty chooses to conduct, but estimating
that a non-reporting affiliate would incur annually between five
minutes and ten hours of compliance attorney time to communicate
information to the reporting counterparty, translating to an
aggregate annual cost for communicating information to the reporting
counterparty of between $33 to $3,900). See also, id. (noting that
an annual filing option may be less costly than swap-by-swap
reporting and estimating that such an option would take an average
of 30 to 90 minutes, translating to an aggregate annual cost for
submitting the annual report of between $195 to $585).
\140\ See generally, Swap Data Recordkeeping and Reporting
Requirements, 77 FR 2176-2193 (for costs and benefits incurred by
SDRs). To the extent that no SDR is available to accept this data,
the costs would fall to the Commission.
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The benefits of the reporting condition include enhancing the level
of transparency associated with inter-affiliate swaps activity, thereby
affording the Commission new insights into the practices of affiliates
that engage in inter-affiliate swaps, and helping the Commission and
other appropriate regulators identify emerging or potential risks. As
noted above, regulators must know whether swaps are cleared or
uncleared in order to use swap data to monitor emerging risks. In
short, the overall benefit of reporting would be a greater body of
information for the Commission to analyze with the goal of identifying
and reducing systemic risk.\141\
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\141\ The Commission received no comments in response to its
cost estimates for the reporting condition.
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[[Page 21777]]
5. Treatment of Outward-Facing Swaps
The final condition imposed on the inter-affiliate exemption from
required clearing relates to the treatment of outward-facing swaps
entered into by the two eligible affiliate counterparties to the inter-
affiliate swap. As proposed, the condition required that each affiliate
counterparty either: (i) Is located in the United States; (ii) is
located in a jurisdiction with a clearing requirement that is
comparable and comprehensive to the clearing requirement in the United
States; (iii) is required to clear swaps with non-affiliated parties in
compliance with U.S. law; or (iv) does not enter into swaps with non-
affiliated parties.
The Commission received a number of comments in support of and
opposed to this proposed condition, but did not receive any comments
quantifying the costs or benefits of the proposed condition. AFR
supported the proposal and stated that inter-affiliate swaps could,
without appropriate restrictions, bring risk back to the U.S. from
foreign affiliates. AFR commented that an inter-affiliate swap might be
used to move parts of the U.S. swaps market outside of U.S. regulatory
oversight by transferring risk to jurisdictions with little or no
regulatory oversight, whereby a non-U.S. affiliate of a U.S. entity
could enter into an outward-facing swap. AFR stated that an inter-
affiliate swap could contribute to financial contagion across different
groups within a complex financial institution, making it more difficult
to ``ring-fence'' risks in one part of an organization. AFR further
commented that laws and regulations of a foreign country might prevent
U.S. counterparties to swaps from having access to the financial
resources of an affiliate in the event of a bankruptcy or insolvency.
Better Markets also supported the proposed treatment of outward-facing
swaps condition.
In opposition to the proposed condition, CDEU commented that the
proposed ``comparable and comprehensive'' condition is not necessary or
appropriate to reduce risk and prevent evasion because, according to
CDEU, transactions between affiliates do not increase systemic risk,
regardless of the location of the affiliate. ISDA & SIFMA stated that
the concern that foreign inter-affiliate swaps pose risk to the U.S.
financial system is unfounded because internal swaps have no conclusive
effect on systemic risk.\142\
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\142\ Other commenters, including The Working Group and FSR also
opposed the condition regarding treatment of outward-facing swaps.
See Section II.G above.
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The Commission considered each of these comments and decided to
adopt the treatment of outward-facing swaps condition, with certain
important modifications, because the Commission believes that the risk
of evasion of the U.S. clearing requirement and the potential systemic
risk associated with uncleared inter-affiliate swaps involving foreign
affiliates and non-affiliated counterparties necessitates that the
inter-affiliate exemption include such a condition. As modified, the
final rule requires that each eligible affiliate counterparty must
clear all swaps that it enters into with third parties to the extent
that the swap is subject to the Commission's clearing requirement. In
order to satisfy this requirement, eligible affiliates may clear their
third-party swaps pursuant to the Commission's clearing requirement or
comply with the requirements for clearing the swap under a foreign
jurisdiction's clearing mandate that is comparable to, and as
comprehensive as, the clearing requirement of section 2(h) of the Act
and part 50 of the Commission's regulations, as determined by the
Commission. In addition, the Commission modified the condition to allow
for recognition of clearing exemptions and exceptions under the CEA and
an exception or exemption under a comparable foreign jurisdiction's
clearing mandate that is comparable to an exception or exemption under
section 2(h)(7) of the CEA or part 50. For entities that are not in a
jurisdiction with a clearing requirement that is comparable to, and as
comprehensive as, the clearing mandate in 2(h) of the Act, they may
comply by clearing swaps with unaffiliated counterparties through a
registered DCO or clearing organization that is subject to supervision
by appropriate government authorities in the home country of the
clearing organization and has been assessed to be in compliance with
the PFMIs.
The Commission believes that this modification will provide greater
clarity and transparency by more clearly establishing the conditions to
the exemption and alternative methods by which eligible affiliates may
satisfy the requirements. In addition, the Commission considered the
approach adopted in EMIR.\143\ To the extent there is consistency with
the international authorities, including the European Union, the
likelihood of regulatory arbitrage is reduced. Regulatory arbitrage can
impose high costs in terms of market efficiency.
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\143\ See Section II.G above.
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As AFR noted, without appropriate restrictions, inter-affiliate
swaps could transfer risk back to the United States from foreign
affiliates. The final rule takes steps to mitigate this risk insofar as
the intent of the condition on outward-facing swaps is to narrow the
exemption such that the risk of a cascading series of defaults among
unrelated entities is reduced.
For companies whose inter-affiliate swap activities are conducted
exclusively through entities in the United States and jurisdictions
with clearing mandates that are comparable to, and as comprehensive as,
the clearing requirement of section 2(h) of the CEA, all outward-facing
swaps that fall under a Sec. 50.4 class will be subject to required
clearing,\144\ which will serve as a buffer to the spread of credit
risk from one corporation to another through those swaps, thus reducing
the risk of financial contagion. Affiliates that meet the conditions of
the inter-affiliate exemption will be able to transfer risk from one
affiliate to the other without clearing those swaps, but third parties
that enter into swaps that are required to be cleared with either of
those affiliates will continue to be protected by clearing requirement.
---------------------------------------------------------------------------
\144\ In these jurisdictions, outward-facing swaps that are not
subject to required clearing may be subject to margin requirements,
which can serve to mitigate counterparty credit risk.
---------------------------------------------------------------------------
For companies whose inter-affiliate swap activities extend to
countries without clearing mandates that are comparable to, and as
comprehensive as, the clearing requirement of section 2(h) of the CEA,
the requirements of the rule mitigate counterparty risk associated with
swaps that are required to be cleared under Sec. 50.4 by requiring
those swaps to be cleared at a DCO or a clearing organization that is
subject to supervision by appropriate government authorities and that
is in compliance with the PFMIs. In this manner, swaps that the
Commission has determined must be cleared cannot be used as a means of
transferring financial risk among unaffiliated entities where one of
the counterparties is also claiming an exemption from required clearing
under this inter-affiliate exemption. However, the Commission observes
that outward-facing swaps that are not required to be cleared under
Sec. 50.4 and that are entered into between unrelated entities in a
jurisdiction without comparable margin requirements, may be a means
through which financial risk could be passed between unaffiliated
entities without the protection of required clearing, creating the
possibility of
[[Page 21778]]
financial contagion.\145\ It is possible that such contagion could then
be transferred back to the United States or other jurisdictions through
inter-affiliate swaps, creating potential costs for the public.\146\
The Commission notes, however, that this is only a concern to the
extent that affiliates in such jurisdictions enter into outward-facing
swaps that are not required to be cleared under Sec. 50.4 in order to
meet their needs.
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\145\ This risk may be mitigated if such swaps were subject to
bilateral margining.
\146\ Not only is there the possibility of risk transfer but
also a potential inability for regulators to monitor the risks that
are capable of being transferred.
---------------------------------------------------------------------------
The Commission does not agree with CDEU's assertion that
transactions between affiliates do not increase systemic risk,
regardless of the location of the affiliate, or with ISDA & SIFMA's
comment that the concern that foreign inter-affiliate swaps pose risk
to the U.S. financial system is unfounded. As noted above, in the
absence of any restrictions on outward-facing swaps, inter-affiliate
swaps could be used to transfer risk to jurisdictions without clearing
requirements or margin requirements for uncleared swaps. Risk could
then be transferred between unrelated entities without the protection
of clearing or margin requirements to mitigate the risk of financial
contagion spreading from one to the other.
In addition to the modifications to the treatment of outward-facing
swaps condition described above, the Commission also accepted
commenter's suggestions and is providing a transition period with two
alternative compliance frameworks for eligible affiliates domiciled in
certain foreign jurisdictions that have the legal authority to
implement mandatory clearing regimes. As noted above, ISDA & SIFMA and
CDEU stated that questions of timing and criteria for comparability
render the proposed treatment of outward-facing swaps condition
problematic, and that unless the condition is satisfactorily resolved,
the condition could hamper the ability of U.S.-based groups to compete
in foreign markets. ISDA & SIFMA further commented that if the
Commission retains the cross-border requirements, the Commission should
provide an appropriate transition period in order to allow foreign
jurisdictions to implement their own G-20 mandates. The Commission is
adopting two alternative compliance frameworks in response to concerns
raised by commenters pertaining to the timing and sequencing of the
implementation of the inter-affiliate exemption.
The Commission is adopting a time-limited alternative compliance
framework, available until March 11, 2014, for certain eligible
affiliates transacting swaps with affiliated counterparties located in
the European Union, Japan, or Singapore. The alternative compliance
framework will allow affiliated counterparties, or a third party that
directly or indirectly holds a majority interest in both eligible
affiliate counterparties, to pay and collect full variation margin
daily on all swaps entered into between affiliates or between an
affiliate and its unaffiliated counterparties, rather than submitting
such swaps for clearing. In addition, the Commission has determined to
provide time-limited relief for certain eligible affiliated
counterparties located in the European Union, Japan, or Singapore from
complying with the requirements of Sec. 50.52(b)(4)(i) as a condition
of electing the inter-affiliate exemption. In particular, Sec.
50.52(b)(4)(ii)(B) provides that if one of the eligible affiliate
counterparties is located in the European Union, Japan, or Singapore,
the requirements of paragraph (b)(4)(i) will not apply to such eligible
affiliate counterparty until March 11, 2014, provided that: (1) The one
counterparty that directly or indirectly holds a majority ownership
interest in the other counterparty or the third party that directly or
indirectly holds a majority ownership interest in both counterparties
is not a ``financial entity'' as defined in section 2(h)(7)(C)(i) of
the Act, and (2) neither eligible affiliate counterparty is affiliated
with an entity that is a swap dealer or major swap participant, as
defined in Sec. 1.3.
Another time-limited alternative compliance framework also will be
available for eligible affiliates transacting swaps with affiliated
counterparties located outside the European Union, Japan, and
Singapore, as long as the aggregate notional value of such swaps, which
are included in a class of swaps identified in Sec. 50.4, does not
exceed five percent of the aggregate notional value of all swaps, which
are included in a class of swaps identified in Sec. 50.4, in each
instance the notional value as measured in U.S. dollar equivalents and
calculated for each calendar quarter, entered into by the eligible
affiliate counterparty located in the United States.
These alternative compliance frameworks will mitigate the
competitive effects that ISDA & SIFMA and CDEU noted by allowing
certain entities to collect variation margin rather than clearing such
swaps until March 11, 2014. The Commission expects that collecting full
variation margin is likely to be less costly than clearing because the
latter includes initial margin in addition to variation margin, as well
as clearing fees. To the extent that the alternative compliance
approach is less costly, it will reduce the competitive effects that
foreign affiliates experience during the period of time when comparable
clearing requirements do not yet exist for competitors operating in
foreign jurisdictions.
The time-limited alternative compliance frameworks may,
nevertheless, have some temporary competitive effects in the market.
Companies with foreign affiliates that are required to pay and collect
variation margin daily on all swaps entered into between affiliates or
between an affiliate and its unaffiliated counterparties will bear some
costs that competing firms based entirely in foreign jurisdictions may
not bear because comparable clearing mandates have not yet been
implemented. In the European Union, Japan, and Singapore, these effects
are likely to largely disappear once comparable regimes are established
and companies with entities in those jurisdictions are required to
clear. In jurisdictions where comparable regimes are never implemented,
the competitive effects will be longer-standing.
The Commission, however, believes that such costs are warranted in
light of the benefits provided by mitigating the likelihood of
transferring risk back to the United States through inter-affiliate
swaps that are not cleared or margined. Requiring the payment and
collection of full variation margin will address the possibility of
foreign affiliates developing significant counterparty credit risk
exposures and then passing that risk back to affiliates in the United
States through non-cleared swaps. Variation margin is one of the tools
used by clearinghouses to mitigate counterparty credit risk. As an
independent risk management tool, it reduces counterparty credit risk
by requiring counterparties to make daily payments reflecting gains or
losses based on each swap's value. However, it is not a complete
replacement for the panoply of risk management tools that are used by
clearinghouses to manage counterparty credit risk. As a consequence,
this time-limited alternative compliance framework will mitigate
counterparty credit risk, but not to the extent that clearing would.
The Commission, however, believes that this measure will enable
affiliates in the European Union, Japan, or Singapore to take advantage
of the exemption while comparable clearing regimes are being
established in those jurisdictions, while
[[Page 21779]]
simultaneously mitigating the risk of financial risk being transferred
back to the United States through uncleared inter-affiliate swaps. In
this way it provides benefits to companies with affiliates in these
jurisdictions, and also to the American public.
Moreover, the Commission believes that providing additional time-
limited relief for certain affiliates located in the European Union,
Japan, or Singapore from the requirements of Sec. 50.52(b)(4)(i) to
clear their outward-facing swaps until March 11, 2014 under Sec.
50.52(b)(4)(ii)(B) also will mitigate the competitive effects noted
commenters by allowing such entities to continue to enter into inter-
affiliate swaps without requiring those swaps to be submitted to
clearing or variation margin, and is likely to be less costly than
requiring such entities to either clear or exchange variation margin on
their inter-affiliate or outward-facing swaps.
Lastly, the Commission received several comments regarding the
criteria for issuing comparability determinations, and expressing
concern that unless such issues are satisfactorily resolved, the
condition could hamper the ability of U.S.-based groups to compete in
foreign markets. In response, the Commission has provided in this final
release a significant amount of additional information regarding how
and when those determinations will be made.
In the NPRM, the Commission stated that the condition for the
treatment of outward-facing swaps would not impose additional
costs.\147\ Commenters stated that the proposed condition would
increase the costs of inter-affiliate swaps.\148\ In terms of the
revised rule, there may be some additional costs for entities that must
clear their outward-facing swaps. Such costs, as discussed above, would
include the cost of initial and variation margin, contributions to a
guaranty fund, and clearing fees. However, in light of the comments
discussed above, the Commission observes that, as modified, and with
the transition period provided for under the rule, costs have been
mitigated to the extent possible while preserving the goal of
preventing evasion.
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\147\ See NPRM at 50435.
\148\ See e.g., letter from CDEU.
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In terms of benefits, the Commission stated in the NPRM that the
corporate group and U.S. financial markets may bear additional risk if
the foreign affiliate is free to enter into an uncleared swap with a
third-party that would be subject to clearing were it entered into in
the United States. The Commission believes that the requirements for
outward-facing swaps will prevent foreign affiliates from taking on
significant risk through outward-facing swaps that fall under a Sec.
50.4 class, which reduces the risk that could then be transferred back
to the United States through exempt inter-affiliate swaps.
D. Costs and Benefits to Market Participants and the Public
Many commenters asserted that inter-affiliate swaps do not create
any additional risk for third parties facing those affiliates.\149\ In
addition, some commenters state that third parties may benefit from an
inter-affiliate exemption because it will allow corporate entities to
hedge their swaps more efficiently.\150\
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\149\ See, e.g., letters from EEI, The Working Group, and DLA
Piper.
\150\ See, e.g., letters from EEI, The Working Group, and ISDA &
SIFMA.
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The Commission recognizes that these claims may be true to the
extent that each affiliate, or a common parent, completely internalizes
the risks facing the other affiliate. Majority ownership facilitates
such internalization of costs among affiliated entities, and the threat
of reputational risk is another factor that may cause related entities
to act in the best interests of affiliate counterparties. However, as
discussed above, two other factors reduce the degree to which
affiliated entities may internalize each other's costs. Ownership
stakes that are less than 100% reduce the percentage of costs that one
affiliate internalizes from another, and bankruptcy laws providing
protection for the assets of one affiliate from the creditors of
another affiliate may create incentives to permit one affiliate to
fail. These factors reduce the internalization of costs among
affiliates.
As a consequence, the counterparty risk that creditors to a given
entity face may be increased by the inter-affiliate swaps into which
that the entity enters. This risk may not be ``new'' in the sense that
it is risk that was previously borne by another affiliate. But from the
perspective of counterparties to the entity that now bears the risk, it
is new. It increases the credit risk that the entity they face bears.
The Commission, however, has established conditions on the inter-
affiliate exemption that are intended to mitigate any increase in
counterparty risk that third parties might bear as the result of the
exemption. As described above, the documentation and centralized risk
management requirements help to ensure that each group of affiliates
engaging in inter-affiliate swaps has a centralized risk management
program with adequate information to value and risk manage swap
positions effectively. Moreover, the reporting requirements will help
to ensure that regulators have information that is necessary to
understand the use of inter-affiliate swaps under this exemption.
In terms of costs, some commenters assert that this exception
creates risk of contagion and systemic risk that could threaten the
U.S. financial system.\151\ As explained above, this concern is
substantiated to the extent that the inter-affiliate exemption prevents
affiliates from protecting themselves from counterparty risk they bear
with respect to one another, and to the extent that it prevents third
parties from protecting themselves from affiliates' counterparty risk.
The Commission believes that internalization of risk among affiliated
entities mitigates this concern, and that the application of required
clearing to swaps between affiliates and third parties further reduces
the probability of risk cascading through the financial system via
inter-affiliate swaps.
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\151\ See letters from AFR and Better Markets.
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AFR stated that the exemption may deprive DCOs of swaps volume and
liquidity that is necessary for risk management. In effect, the
exemption will reduce the number of swaps being cleared. All other
things being equal, this may cause DCOs to increase the margin
requirements for those swaps to compensate for having less volume,
which may increase the cost of using cleared swaps. AFR also stated
that the inter-affiliate exception will enable banks to set up joint
ventures to trade swaps without clearing them. The Commission believes
that its conditions with regard to treatment of outward-facing swaps
address AFR's concerns about evasion of the clearing requirement.
E. Costs and Benefits Compared to Alternatives
The Commission considered several alternatives to the final
rulemaking, including: (1) Alternative definitions of eligible
affiliate counterparty; (2) more prescriptive documentation
requirements; (3) alternative risk management requirements; (4)
different requirements for treatment of outward-facing swaps; and (5)
requiring variation margin for swaps between affiliated financial
entities. The first four alternatives are discussed at length above.
The fifth alternative, the imposition of variation margin on swaps
between affiliates that are financial entities, was considered by the
Commission and ultimately rejected based on comments.
[[Page 21780]]
As proposed, the inter-affiliate exemption would have required
affiliated financial entities to pay and collect variation margin
associated with their swaps unless the affiliates were 100% commonly
owned and commonly guaranteed by a 100% commonly owned guarantor. In
the final rule, the Commission has eliminated the variation margin
requirement. This change is likely to create significant savings for
eligible affiliates. Reduced margin requirements will reduce the
capital costs that entities bear when transacting inter-affiliate
swaps, and may reduce the capital requirements for financial entities
under prudential regulation. In addition, it may help entities avoid
liquidity crunches when their positions move significantly out of the
money in a short period of time.
However, eliminating the variation margin requirement also
significantly reduces the protective value of the eligibility
requirements that the Commission established in order to reduce the
likelihood of cascading defaults among affiliated entities, and the
associated risk to third parties transacting with those entities.
Without the variation margin requirements, affiliated entities may
develop large outstanding exposures toward one another, and to the
degree that affiliated entities do not internalize one another's costs,
an affiliate that is out of the money will have incentives not to
perform on its obligations. In addition if the obligations of one
entity are sufficiently large, its default may jeopardize the health of
other affiliated entities, which would also increase counterparty risk
for third parties that have uncleared outstanding positions with those
entities.
F. Consideration of CEA Section 15(a) Factors
1. Protection of Market Participants and the Public
In deciding to finalize the inter-affiliate clearing exemption, the
Commission assessed how to protect affiliated entities, third parties
in the swaps market, and the public. The Commission has sought to
ensure that in the absence of a clearing requirement the risks
presented by uncleared inter-affiliate swaps would be mitigated so that
significant losses to one affiliate counterparty or a default of one of
the affiliate counterparties is less likely to create significant
repercussions for third-parties or the American public. Toward that
end, the Commission has required that affiliates to execute swap
trading relationship documentation, maintain a centralized-risk
management process, and report specific information to an SDR, and meet
certain requirements related to outward-facing swaps in order to be
eligible for the exception. As explained in this cost-benefit section,
these conditions serve multiple objectives that ultimately protect
market participants and the public.
For instance, the documentation requirement will reduce
uncertainties where affiliates incur significant swaps-related losses
or where there is a defaulting affiliate. Because the documentation
would be in writing, the Commission expects that there will be less
contractual ambiguity should disagreements between affiliates arise.
The condition that an inter-affiliate swap be subject to a centralized
risk management program reasonably designed to monitor and manage risk
will also help mitigate the risks associated with inter-affiliate
swaps. As noted throughout this final rulemaking, inter-affiliate swap
risk could adversely impact third parties that enter into uncleared
swaps or other contracts with affiliates engaging in inter-affiliate
swaps.
The reporting condition would help the Commission and the
affiliate's leadership monitor compliance with the inter-affiliate
clearing exemption. For example, an affiliate that also is an SEC Filer
must receive a governing board's approval for electing the proposed
exemption. It cannot act independently. In the Commission's opinion,
the reporting conditions promote accountability and transparency,
offering another public safeguard by keeping the Commission and each
entity's board of directors informed.
On the other hand, the rule also creates certain costs that will be
borne by eligible entities, the counterparties to those entities, and
the public. Regarding costs for eligible entities, the qualification
requirements will create some new costs for those that do not already
have recordkeeping and risk management systems that are in compliance
with the rule. However, as noted above, the Commission believes that
some entities may already have systems in place that meet most or all
of the requirements. Moreover, entities will elect the exemption only
if they project the benefit of doing so is greater than the costs
associated with the qualifying requirements. Therefore, these costs may
decrease the value of the exemption, but they will not create new costs
for entities that choose not to elect the exemption.
2. Efficiency, Competitiveness, and Financial Integrity of Futures
Markets
Exempting swaps between majority-owned affiliates within a
corporate group from the clearing requirement will promote allocational
efficiency by reducing overall clearing costs for eligible affiliate
counterparties. The Commission also anticipates that the exemption will
increase allocational efficiency and the financial integrity of markets
because it will make it less costly for corporate groups to centralize
their hedging and market facing swap activities within a single
affiliate. As explained above, commenters stated that clearing swaps
through single affiliates enables affiliates and corporate groups to
more efficiently and effectively manage corporate risk.
Certain provisions of the proposed rule, such as the requirements
that inter-affiliate swaps be subject to centralized risk management
and that certain information be reported, also would discourage abuse
of the exemption. Together, these conditions promote the financial
integrity of swap markets and financial markets as a whole.
3. Price Discovery
Under Commission regulation 43.2, a ``publicly reportable swap
transaction,'' means, among other things, ``any executed swap that is
an arm's length transaction between two parties that results in a
corresponding change in the market risk position between the two
parties.'' \152\ The Commission does not consider non-arms-length swaps
as contributing to price discovery in the markets.\153\ Given that
inter-affiliate swaps as defined in this rulemaking are generally not
arm's length transactions, the Commission does not anticipate the
inter-affiliate clearing exemption to have any significant effect on
price discovery.\154\
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\152\ 17 CFR 43.2. See also Real-Time Public Reporting of Swap
Transaction Data, 77 FR 1182 (Jan. 9, 2012).
\153\ Transactions that fall outside the definition of
``publicly reportable swap transaction''--that is, transactions that
are not arms-length--``do not serve the price discovery objective of
CEA section 2(a)(13)(B).'' Real-Time Public Reporting of Swap
Transaction Data, 77 FR 1195. See also id. at 1187 (discussing
``Swaps Between Affiliates and Portfolio Compression Exercises'').
\154\ The definition of ``publicly reportable swap transaction''
identifies two examples of transactions that fall outside the
definition, including ``internal swaps between one-hundred percent
owned subsidiaries of the same parent entity.'' 17 CFR 43.2 (adopted
by Real-Time Public Reporting of Swap Transaction Data, 77 FR 1244).
The Commission notes that the list of examples is not exhaustive.
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4. Sound Risk Management Practices
As a general rule, the Commission believes that clearing swaps is a
sound
[[Page 21781]]
risk management practice. Exempting certain inter-affiliate swaps from
the clearing requirement creates additional counterparty exposure for
affiliates that do not completely internalize each other's risk, and
for third parties that enter into uncleared swaps or other transactions
with those affiliated entities. This increased counterparty risk among
affiliates may increase the likelihood that a default within one
affiliate could cause significant losses in other affiliated entities.
If the default causes other affiliated entities to default, then third
parties that have entered into uncleared swaps or other agreements with
those entities also could be affected. But, in finalizing the inter-
affiliate clearing exemption, the Commission has assessed the risks of
inter-affiliate swaps, and believes that the partial internalization of
costs among affiliated entities, combined with the documentation, risk
management, reporting, and treatment of outward-facing swaps
requirements for electing the exception, will mitigate some of the
risks associated with uncleared inter-affiliate swaps. However, they
are not a complete substitute for the protections that would be
provided by required clearing, or by a requirement to use some of the
same risk management tools that a clearinghouse would use to mitigate
counterparty credit risk (i.e., initial and variation margin).
Also, as noted above, without clearing to mitigate transmission of
risk among affiliates, the risk that any one affiliate takes on, and
any contagion that may be caused by that risk, may be transferred more
easily to other affiliates. This makes the risk mitigation requirements
for outward-facing swaps more important. The Commission's requirements
for outward-facing swaps mitigate the risk that swaps that the
Commission has determined are required to be cleared could transfer
risk that would then be spread among the affiliates, but does not
eliminate the possibility that swaps that are not required to be
cleared and are transacted in a regime without mandatory clearing (or
bilateral margin requirements) for uncleared swaps could result in
financial risk that impacts its affiliates and counterparties of those
affiliates.\155\
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\155\ The Commission notes that even in the absence of required
clearing or margin requirements for swaps between certain affiliated
entities, such entities may choose to use initial and variation
margin to manage risks that could otherwise be transferred from one
affiliate to another. Similarly, third parties that have entered
into swaps with affiliates may also include variation margin
requirements in their swap agreements.
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The Commission also believes that SEC Filer reporting is a prudent
practice. As detailed in this preamble and the rule text, SEC Filers
are affiliates that meet certain SEC-related qualifications, and their
governing boards or equivalent bodies are directly responsible to
shareholders for the financial condition and performance of the
affiliate. The boards also have access to information that would give
them a comprehensive picture of the company's financial condition and
risk management strategies. Therefore, any oversight they provide to
the affiliate's risk management strategies would likely encourage sound
risk management practices. In addition, the condition that affiliates
electing the inter-affiliate clearing exemption must report their
boards' knowledge of the election is a sound risk management practice.
5. Other Public Interest Considerations
Aside from those discussed in Section II.A above, the Commission
has identified no other public interest considerations.
IV. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA) requires that agencies
consider whether the rules they propose will have a significant
economic impact on a substantial number of small entities and, if so,
provide a regulatory flexibility analysis respecting the impact.\156\
As stated in the NPRM, the clearing requirement determinations and
rules proposed by the Commission will affect only ECPs because all
persons that are not ECPs are required to execute their swaps on a
designated contract market (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.\157\ 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.
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\156\ See 5 U.S.C. 601 et seq.
\157\ 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).
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The Commission has previously determined that ECPs are not small
entities for purposes of the RFA.\158\ 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.\159\ 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.'' \160\
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.'' \161\ 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.
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\158\ See 66 FR 20740, 20743 (Apr. 25, 2001).
\159\ 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).
\160\ Small Business Administration, Table of Small Business
Size Standards, Nov. 5, 2010.
\161\ 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'').
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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.
[[Page 21782]]
B. Paperwork Reduction Act
The Paperwork Reduction Act of 1995 (PRA) \162\ imposes certain
requirements on Federal agencies in connection with their conducting or
sponsoring any collection of information as defined by the PRA. An
agency may not conduct or sponsor, and a person is not required to
respond to, a collection of information unless it has been approved by
the Office of Management and Budget (OMB) and displays a currently
valid control number.\163\
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\162\ 44 U.S.C. 3501 et seq.
\163\ Id.
---------------------------------------------------------------------------
Certain provisions of this final rulemaking impose new information
collection requirements within the meaning of the PRA, for which the
Commission must obtain a valid control number. Accordingly, the
Commission requested, and OMB has assigned control number 3038-0104 for
the new collection of information. The Commission also has submitted
this final rule release, the proposed rulemaking, and all required
supporting documentation to OMB for review in accordance with 44 U.S.C.
3507(d) and 5 CFR 1320.11. The title for this new collection of
information is ``Rule 50.52 (proposed as rule 39.6(g)) Affiliate
Transaction Uncleared Swap Notification.'' Responses to this collection
of information will be mandatory.
The Commission will protect proprietary information in accordance
with the Freedom of Information Act and 17 CFR part 145, entitled
``Commission Records and Information.'' In addition, section 8(a)(1) of
the CEA strictly prohibits the Commission, unless specifically
authorized by the Act, from making public ``data and information that
would separately disclose the business transactions or market positions
of any person and trade secrets or names of customers.'' \164\ The
Commission also is required to protect certain information contained in
a government system of records according to the Privacy Act of 1974, 5
U.S.C. 552a.
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\164\ 7 U.S.C. 12(a)(1).
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1. Information Provided by Reporting Entities
The regulations being adopted in this final rule release impose
certain reporting requirements on eligible affiliates that enter into
inter-affiliate swaps and elect the inter-affiliate exemption from
clearing such swaps. As described in the NPRM and in this final
release, the reporting requirements are designed to address Commission
concerns regarding inter-affiliate swap risk and to provide the
Commission with information necessary to regulate the swaps market. In
particular, regulation 50.52(c) (proposed as Sec. 39.6(g)(4)) will
require an electing counterparty to provide, or cause to be provided,
certain information to a registered SDR or, if no registered SDR is
available to receive the information, to the Commission, in the form
and manner specified by the Commission. As further described in this
final rule release, Sec. 50.52(c)(1) requires reporting counterparties
to notify the Commission each time they elect the inter-affiliate
clearing exemption for each swap, by reporting certain information to a
registered SDR, or to the Commission, if no registered SDR is available
to receive the information. Reporting counterparties also must report
the information required by Sec. 50.52(c)(2) and (3), and have the
option to report such information each time that the eligible
counterparties elect the inter-affiliate exemption for each swap, or on
an annual basis in anticipation of electing the exemption.
To determine the total time burden and cost associated with the
proposed rule for PRA purposes, the Commission estimated the number of
affiliates that likely would seek to claim the exemption and the
average number of inter-affiliate swaps for which the affiliates would
elect to use the proposed exemption. The Commission also estimated the
time burden required for entities to comply with the reporting
requirements.
In estimating the number of affiliates and the average number of
inter-affiliate swaps that likely would claim the inter-affiliate
exemption, the Commission used data from the U.S. Bureau of Economic
Analysis (BEA) to estimate that there are approximately 22 subsidiaries
per U.S. multinational parent company (MNC), resulting in a total of
53,195 affiliates that might elect the inter-affiliate exemption.\165\
As more fully described in the NPRM, the Commission surveyed five
corporations to obtain information that allowed it to estimate that
affiliates enter into an average of 2,230 inter-affiliate swaps
annually.\166\
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\165\ NPRM at 50439-40.
\166\ Id.
---------------------------------------------------------------------------
In estimating the time burden associated with complying with the
reporting requirements of the rules, the Commission stated in the NPRM
that it expected each reporting counterparty would likely spend between
15 seconds to two minutes per transaction entering information required
by Sec. 50.52(c)(1) (proposed Sec. 39.6(g)(4)(i)) into the reporting
system.\167\ The Commission further estimated that it would take the
reporting counterparty up to 10 minutes to collect and submit the
information required under Sec. 50.52(c)(2)-(3) (proposed Sec.
39.6(g)(4)(ii)-(iii)), for the first transaction and one to five
minutes to collect and submit the information for subsequent
transactions with that same counterparty. The Commission estimated that
together these requirements would cost a reporting counterparty between
$1.63 and $13.00 to comply with Sec. 50.52(c)(1) (proposed Sec.
39.6(g)(4)(i)), $65.00 to comply with Sec. 50.52(c)(2)-(3) (proposed
Sec. 39.6(g)(4)(ii)-(iii)) for the first inter-affiliate swap, and
between $6.50 and $32.50 to comply with Sec. 50.52(c)(2)-(3) (proposed
Sec. 39.6(g)(4)(ii)-(iii)) for subsequent inter-affiliate swaps with
the same counterparty.\168\
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\167\ The NPRM noted that to comply with proposed Sec.
39.6(g)(4)(i) (now Sec. 50.52(c)(1)), each reporting counterparty
would be required to check a box indicating that both counterparties
to the swap are electing not to clear the swap.
\168\ NPRM at 50440.
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With respect to the annual reporting option described in Sec.
50.52(d), the Commission stated in the NPRM that it anticipated that at
least 90% of MNCs would choose to file an annual report in lieu of
reporting each swap separately. The Commission estimated in the NPRM
that it would take an average of 30 to 90 minutes to complete and
submit the filing, resulting in an annual aggregate cost for submitting
the annual report of approximately $195 to $585.\169\
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\169\ NPRM at 50441.
---------------------------------------------------------------------------
In addition to the specific reporting obligations described in the
rules, the NPRM also noted that reporting counterparties may need to
update established reporting systems to comply with the reporting
requirement, and non-reporting affiliate counterparties may need to
transmit information to reporting counterparties after entering into a
swap subject to the rules. In the NPRM, the Commission stated that it
anticipated that reporting counterparties may have to modify their
established reporting systems in order to accommodate the additional
data fields required by Sec. 50.52(c) (proposed Sec. 39.6(g)(4)), and
estimated that the modifications would create a one-time cost of
between $341 and $3,410 per entity.\170\ The Commission further stated
in the NPRM that it anticipated that an affiliate who is not the
reporting counterparty may need to communicate information to the
reporting counterparty after executing an inter-affiliate swap, and
estimated the cost of, among other things, providing
[[Page 21783]]
information to facilitate any due diligence that the reporting
counterparty may conduct, to be between $33 and $3,900.\171\
---------------------------------------------------------------------------
\170\ Id.
\171\ Id.
---------------------------------------------------------------------------
Using these figures, the Commission estimated that the inter-
affiliate exemption could result in an average total annual burden of
1,758,369 hours and average total annual costs of $685,309,281, or
approximately 1.8 minutes and $10.48 per inter-affiliate swap.
2. Information Collection Comments
The Commission invited public comment on the proposed PRA analysis
and estimates and on any aspect of the reporting burdens resulting from
proposed Sec. 39.6(g) (now Sec. 50.52(c)). One commenter submitted
comments in relation to the Commission's estimate of the number of
eligible affiliates seeking to claim the exemption. No commenters
submitted comments to OMB, and OMB itself did not submit any comments
to the Commission pertaining to the proposed rule.\172\
---------------------------------------------------------------------------
\172\ See 5 CFR 1320.11(f).
---------------------------------------------------------------------------
In the context of its comments pertaining to the costs and benefits
of the reporting requirements of the proposed rule, EEI claimed that
the Commission's estimation of 22 eligible affiliates per MNC was ``far
too low'' for many U.S. energy companies. Although EEI commented that
the Commission's estimate of the number of affiliates per MNC was too
low in the context of U.S. energy companies, EEI did not provide an
alternative estimate or point to any other sources of information that
might provide an alternative source for estimating the average number
of subsidiaries per MNC.
The Commission has considered EEI's comment and declines to revise
its estimate of the number of affiliates of an MNC.\173\ As described
in the NPRM, the Commission estimated that a total of 53,195 affiliates
might elect the inter-affiliate clearing exemption. The Commission's
estimation of the number of affiliates of an MNC was based on the most
recent data collected by the BEA, which indicated that there are 2,347
MNCs in the U.S. and 25,424 foreign subsidiaries that are majority
owned by such MNCs.\174\ To account for the number of majority-owned
U.S. subsidiaries of MNCs, the Commission doubled the BEA's foreign
subsidiaries, and determined that there are an estimated 50,848 U.S.
and foreign subsidiaries, or approximately 22 subsidiaries per MNC.
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\173\ The Commission further notes that EEI's comments were made
exclusively with respect to U.S. energy companies and not the
broader spectrum of potential MNCs that are included within the
estimation.
\174\ See Table I.A 2., ``Selected Data for Foreign Affiliates
and U.S. Parents in All Industries,'' located at http://www.bea.gov/international/pdf/usdia_2009p/Group%20I%20tables.pdf. The BEA
defines a U.S. Parent of a MNC as a person that is a resident in the
United States and owns or controls 10 percent or more of the voting
securities, or the equivalent, of a foreign business enterprise. A
Guide to BEA Statistics on U.S. Multinational Companies, available
at http://www.bea.gov/scb/pdf/internat/usinvest/1995/0395iid.pdf.
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The Commission further notes that the estimate of the number of
affiliates per MNC proposed in the NPRM and adopted in this release for
purposes of the PRA, is an averaged approximation based on publically
available information collected by the BEA, and acknowledges that the
number of affiliates of an MNC may be higher or lower than 22. However,
there is no basis for concluding that the use of a different source for
estimating the average number of affiliates per MNC would result in a
higher number estimate, nor did the Commission receive comments to that
effect. Accordingly, the Commission believes that its estimation is
reasonable in light of the information that is publicly available at
this time, and that its original proposed estimates remain appropriate
for purposes of the PRA.
List of Subjects in 17 CFR Part 50
Business and industry, Clearing, Swaps.
For the reasons stated in the preamble, amend 17 CFR part 50 as
follows:
PART 50--CLEARING REQUIREMENT AND RELATED RULES
0
1. The authority citation for part 50 continues 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
2. The heading for part 50 is revised to read as set forth above.
0
3. Add Sec. 50.52 to subpart C to read as follows:
Sec. 50.52 Exemption for swaps between affiliates.
(a) Eligible affiliate counterparty status. Subject to the
conditions in paragraph (b) of this section:
(1) Counterparties to a swap may elect not to clear a swap subject
to the clearing requirement of section 2(h)(1)(A) of the Act and this
part if:
(i) One counterparty, directly or indirectly, holds a majority
ownership interest in the other counterparty, and the counterparty that
holds the majority interest in the other counterparty reports its
financial statements on a consolidated basis under Generally Accepted
Accounting Principles or International Financial Reporting Standards,
and such consolidated financial statements include the financial
results of the majority-owned counterparty; or
(ii) A third party, directly or indirectly, holds a majority
ownership interest in both counterparties, and the third party reports
its financial statements on a consolidated basis under Generally
Accepted Accounting Principles or International Financial Reporting
Standards, and such consolidated financial statements include the
financial results of both of the swap counterparties.
(2) For purposes of this section:
(i) A counterparty or third party directly or indirectly holds a
majority ownership interest if it directly or indirectly holds a
majority of the equity securities of an entity, or the right to receive
upon dissolution, or the contribution of, a majority of the capital of
a partnership; and
(ii) The term ``eligible affiliate counterparty'' means an entity
that meets the requirements of this paragraph.
(b) Additional conditions. Eligible affiliate counterparties to a
swap may elect the exemption described in paragraph (a) of this section
if:
(1) Both counterparties elect not to clear the swap;
(2)(i) A swap dealer or major swap participant that is an eligible
affiliate counterparty to the swap satisfies the requirements of Sec.
23.504 of this chapter; or
(ii) If neither eligible affiliate counterparty is a swap dealer or
major swap participant, the terms of the swap are documented in a swap
trading relationship document that shall be in writing and shall
include all terms governing the trading relationship between the
eligible affiliate counterparties;
(3) The swap is subject to a centralized risk management program
that is reasonably designed to monitor and manage the risks associated
with the swap. If at least one of the eligible affiliate counterparties
is a swap dealer or major swap participant, this centralized risk
management requirement shall be satisfied by complying with the
requirements of Sec. 23.600 of this chapter; and
(4)(i) Each eligible affiliate counterparty that enters into a
swap, which is included in a class of swaps identified in Sec. 50.4,
with an unaffiliated counterparty shall:
[[Page 21784]]
(A) Comply with the requirements for clearing the swap in section
2(h) of the Act and this part;
(B) Comply with the requirements for clearing the swap under a
foreign jurisdiction's clearing mandate that is comparable, and
comprehensive but not necessarily identical, to the clearing
requirement of section 2(h) of the Act and this part, as determined by
the Commission;
(C) Comply with an exception or exemption under section 2(h)(7) of
the Act or this part;
(D) Comply with an exception or exemption under a foreign
jurisdiction's clearing mandate, provided that:
(1) The foreign jurisdiction's clearing mandate is comparable, and
comprehensive but not necessarily identical, to the clearing
requirement of section 2(h) of the Act and this part, as determined by
the Commission; and
(2) The foreign jurisdiction's exception or exemption is comparable
to an exception or exemption under section 2(h)(7) of the Act or this
part, as determined by the Commission; or
(E) Clear such swap through a registered derivatives clearing
organization or a clearing organization that is subject to supervision
by appropriate government authorities in the home country of the
clearing organization and has been assessed to be in compliance with
the Principles for Financial Market Infrastructures.
(ii)(A) Except as provided in paragraph (b)(4)(ii)(B) of this
section, if one of the eligible affiliate counterparties is located in
the European Union, Japan, or Singapore, the following may satisfy the
requirements of paragraph (b)(4)(i) of this section until March 11,
2014:
(1) Each eligible affiliate counterparty, or a third party that
directly or indirectly holds a majority interest in both eligible
affiliate counterparties, pays and collects full variation margin daily
on all swaps entered into between the eligible affiliate counterparty
located in the European Union, Japan, or Singapore and an unaffiliated
counterparty; or
(2) Each eligible affiliate counterparty, or a third party that
directly or indirectly holds a majority interest in both eligible
affiliate counterparties, pays and collects full variation margin daily
on all of the eligible affiliate counterparties' swaps with other
eligible affiliate counterparties.
(B) If one of the eligible affiliate counterparties is located in
the European Union, Japan, or Singapore, the requirements of paragraph
(b)(4)(i) of this section shall not apply to the eligible affiliate
counterparty located in the European Union, Japan, or Singapore until
March 11, 2014, provided that:
(1) The one counterparty that directly or indirectly holds a
majority ownership interest in the other counterparty or the third
party that directly or indirectly holds a majority ownership interest
in both counterparties is not a ``financial entity'' as defined in
section 2(h)(7)(C)(i) of the Act; and
(2) Neither eligible affiliate counterparty is affiliated with an
entity that is a swap dealer or major swap participant, as defined in
Sec. 1.3.
(iii) If an eligible affiliate counterparty located in the United
States enters into swaps, which are included in a class of swaps
identified in Sec. 50.4, with eligible affiliate counterparties
located in jurisdictions other than the United States, the European
Union, Japan, and Singapore, and the aggregate notional value of such
swaps, which are included in a class of swaps identified in Sec. 50.4,
does not exceed five percent of the aggregate notional value of all
swaps, which are included in a class of swaps identified in Sec. 50.4,
in each instance the notional value as measured in U.S. dollar
equivalents and calculated for each calendar quarter, entered into by
the eligible affiliate counterparty located in the United States, then
such swaps shall be deemed to satisfy the requirements of paragraph
(b)(4)(i) of this section until March 11, 2014, provided that:
(A) Each eligible affiliate counterparty, or a third party that
directly or indirectly holds a majority interest in both eligible
affiliate counterparties, pays and collects full variation margin daily
on all swaps entered into between the eligible affiliate counterparties
located in jurisdictions other than the United States, the European
Union, Japan, and Singapore and an unaffiliated counterparty; or
(B) Each eligible affiliate counterparty, or a third party that
directly or indirectly holds a majority interest in both eligible
affiliate counterparties, pays and collects full variation margin daily
on all of the eligible affiliate counterparties' swaps with other
eligible affiliate counterparties.
(c) Reporting requirements. When the exemption described in
paragraph (a) of this section is elected, the reporting counterparty,
as determined in accordance with Sec. 45.8 of this chapter, 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:
(1) Confirmation that both eligible affiliate counterparties to the
swap are electing not to clear the swap and that each of the electing
eligible affiliate counterparties satisfies the requirements in
paragraph (b) of this section applicable to it;
(2) For each electing eligible affiliate counterparty, how the
counterparty generally meets its financial obligations associated with
entering into non-cleared swaps by identifying one or more of the
following categories, as applicable:
(i) A written credit support agreement;
(ii) Pledged or segregated assets (including posting or receiving
margin pursuant to a credit support agreement or otherwise);
(iii) A written guarantee from another party;
(iv) The electing counterparty's available financial resources; or
(v) Means other than those described in paragraphs (c)(2)(i), (ii),
(iii) or (iv) of this section; and
(3) If an electing eligible affiliate 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:
(i) The relevant SEC Central Index Key number for that
counterparty; and
(ii) Acknowledgment that an appropriate committee of the board of
directors (or equivalent body) of the eligible affiliate counterparty
has reviewed and approved the decision to enter into swaps that are
exempt from the requirements of section 2(h)(1) and 2(h)(8) of the Act.
(d) Annual reporting. An eligible affiliate counterparty that
qualifies for the exemption described in paragraph (a) of this section
may report the information listed in paragraphs (c)(2) and (3) of this
section annually in anticipation of electing the exemption for one or
more swaps. Any such reporting by a reporting counterparty under this
paragraph will be effective for purposes of paragraphs (c)(2) and (3)
of this section for 365 days following the date of such reporting.
During the 365-day period, the reporting counterparty shall amend the
report as necessary to reflect any material changes to the information
reported. Each reporting counterparty shall have a reasonable basis to
believe that the eligible affiliate counterparties meet the
requirements for the exemption under this section.
[[Page 21785]]
Issued in Washington, DC, on April 1, 2013, by the Commission.
Melissa D. Jurgens,
Secretary of the Commission.
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendices to Clearing Exemption for Swaps Between Certain Affiliated
Entities--Commission Voting Summary and Statements of Commissioners
Appendix 1--Commission Voting Summary
On this matter, Chairman Gensler and Commissioners Chilton,
O'Malia, and Wetjen voted in the affirmative; Commissioner Sommers
voted in the negative.
Appendix 2--Statement of Chairman Gary Gensler
I support the final rule to exempt swaps between certain
affiliated entities within a corporate group from the clearing
requirement in the Dodd-Frank Wall Street Reform and Consumer
Protection Act.
Since the late 19th century, clearinghouses have lowered risk
for the public and fostered competition in the futures market.
Clearing also has democratized the market by fostering access for
farmers, ranchers, merchants and other participants.
The Commission approved the first clearing requirement for swaps
last November, following through on the U.S. commitment at the 2009
G-20 meeting that standardized swaps be cleared by the end of 2012.
Following Congress' direction, end-users are not required to bring
swaps into central clearing.
A key milestone was reached on March 11 with the requirement
that swap dealers and the largest hedge funds begin clearing the
vast majority of interest rate and credit default index swaps.
Compliance will continue to be phased in throughout this year. Other
financial entities begin clearing June 10. Accounts managed by third
party investment managers and ERISA pension plans have until
September 9.
The final rule allows for an exemption from clearing for swaps
between affiliates under the following limitations:
First, the exemption covers swaps between majority-
owned affiliates whose financial statements are reported on a
consolidated basis.
Second, the rule requires documentation of such
exempted swaps, centralized risk management, and reporting
requirements for such swaps.
Third, the exemption requires that each swap entered
into by the affiliated counterparties with unaffiliated
counterparties must be cleared. This approach largely aligns with
the Europeans' approach to an exemption for inter-affiliate
clearing.
In order to promote international harmonization regarding
mandatory clearing, the final rulemaking provides for two time-
limited alternative compliance frameworks for swaps entered into
with unaffiliated counterparties in jurisdictions outside of the
United States.
With regard to affiliated counterparties located in the European
Union, Japan and Singapore--jurisdictions that have adopted swap
clearing regimes and are currently in the process of
implementation--the Commission is phasing compliance with the
requirement to clear swaps with unaffiliated counterparties until
March 11, 2014. During the phase-in period affiliated counterparties
located in these jurisdictions will be able to pay and collect
variation margin in lieu of clearing. Affiliated counterparties that
are located in these jurisdictions (that are not affiliated with
swap dealers or major swap participants) will not have to pay or
collect such variation margin during the phase-in period, provided
they are not directly or indirectly majority-owned by a financial
entity.
With regard to affiliated counterparties located in other
foreign jurisdictions, the Commission is phasing compliance with the
requirement to clear swaps with unaffiliated counterparties until
March 11, 2014. Until that date, an affiliated counterparty located
outside the United States, the European Union, Japan and Singapore
does not have to clear its swaps with unaffiliated counterparties so
long as the aggregate notional value of such swaps does not exceed
five percent of the notional value of all swaps entered into by the
affiliated counterparty located in the United States.
This phasing in of the inter-affiliate exemption provides a
transition period for foreign jurisdictions to implement comparable
and comprehensive clearing regimes.
[FR Doc. 2013-07970 Filed 4-10-13; 8:45 am]
BILLING CODE 6351-01-P
Last Updated: April 11, 2013