[Federal Register: January 2, 2009 (Volume 74, Number 1)]
[Notices]
[Page 139-149]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr02ja09-58]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-59164; File No. S7-34-08]
Order Granting Temporary Exemptions Under the Securities Exchange
Act of 1934 in Connection with Request of Liffe Administration and
Management and Lch.Clearnet Ltd. Related to Central Clearing of Credit
Default Swaps, and Request for Comments
December 24, 2008.
I. Introduction
In response to the recent turmoil in the financial markets, the
Securities and Exchange Commission (``Commission'') has taken multiple
actions to protect investors and ensure the integrity of the nation's
securities markets.\1\ Today the Commission is taking further action
designed to address concerns related to the market in credit default
swaps (``CDS''). The over-the-counter (``OTC'') market for CDS has been
a source of concerns to us and other financial regulators. These
concerns include the systemic risk posed by CDS, highlighted by the
possible inability of parties to meet their obligations as
counterparties and the potential resulting adverse effects on other
markets and the financial system.\2\ Recent credit market events have
demonstrated the seriousness of these risks in a CDS market operating
without meaningful regulation, transparency,\3\ or central
counterparties (``CCPs'').\4\ These events have emphasized the need for
CCPs as mechanisms to help control such risks.\5\ A CCP for CDS could
be an important step in reducing the counterparty risks inherent in the
CDS market, and thereby help mitigate potential systemic impacts. In
November 2008, the President's Working Group on Financial Markets
stated that the implementation of a CCP for CDS was a top priority \6\
and, in furtherance of this recommendation, the Commission, the FRB and
the Commodity Futures Trading Commission (``CFTC'') signed a Memorandum
of Understanding \7\ that establishes a framework for consultation and
information sharing on issues related to CCPs for CDS. Given the
continued uncertainty in this market, taking action to help foster the
prompt development of CCPs, including granting conditional exemptions
from certain provisions of the federal securities laws, is in the
public interest.
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\1\ A nonexclusive list of the Commission's actions to stabilize
financial markets during this credit crisis includes: Adopting a
package of measures to strengthen investor protections against naked
short selling, including rules requiring a hard T+3 close-out,
eliminating the options market maker exception of Regulation SHO,
and expressly targeting fraud in short selling transactions (See
Securities Exchange Act Release No. 58572 (September 17, 2008), 73
FR 54875 (September 23, 2008)); issuing an emergency order to
enhance protections against naked short selling in the securities of
primary dealers, Federal National Mortgage Association (``Fannie
Mae''), and Federal Home Loan Mortgage Corporation (``Freddie Mac'')
(See Securities Exchange Act Release No. 58166 (July 15, 2008), 73
FR 42379 (July 21, 2008)); taking temporary emergency action to ban
short selling in financial securities (See Securities Exchange Act
Release No. 58592 (September 18, 2008), 73 FR 55169 (September 24,
2008)); approving emergency rulemaking to ensure disclosure of short
positions by hedge funds and other institutional money managers (See
Securities Exchange Act Release No. 58591A (September 21, 2008), 73
FR 55557 (September 25, 2008)); proposing rules to strengthen the
regulation of credit rating agencies and making the limits and
purposes of credit ratings clearer to investors (See Securities
Exchange Act Release No. 57967 (June 16, 2008), 73 FR 36212 (June
25, 2008); entering into a Memorandum of Understanding with the
Board of Governors of the Federal Reserve System (``FRB'') to make
sure key federal financial regulators share information and
coordinate regulatory activities in important areas of common
interest (See Memorandum of Understanding Between the U.S.
Securities and Exchange Commission and the Board of Governors of the
Federal Reserve System Regarding Coordination and Information
Sharing in Areas of Common Regulatory and Supervisory Interest (July
7, 2008), http://www.sec.gov/news/press/2008/2008-134_mou.pdf).
\2\ In addition to the potential systemic risks that CDS pose to
financial stability, we are concerned about other potential risks in
this market, including operational risks, risks relating to
manipulation and fraud, and regulatory arbitrage risks.
\3\ See Policy Objectives for the OTC Derivatives Market, The
President's Working Group on Financial Markets, November 14, 2008,
available at http://www.ustreas.gov/press/releases/reports/
policyobjectives.pdf (``Public reporting of prices, trading volumes
and aggregate open interest should be required to increase market
transparency for participants and the public.'').
\4\ See The Role of Credit Derivatives in the U.S. Economy
Before the H. Agric. Comm., 110th Cong. (2008) (Statement of Erik
Sirri, Director of the Division of Trading and Markets, Commission).
\5\ See id.
\6\ See Policy Objectives for the OTC Derivatives Market, The
President's Working Group on Financial Markets (November 14, 2008),
http://www.ustreas.gov/press/releases/reports/policyobjectives.pdf.
See also Policy Statement on Financial Market Developments, The
President's Working Group on Financial Markets (March 13, 2008),
http://www.treas.gov/press/releases/reports/
pwgpolicystatemktturmoil_03122008.pdf; Progress Update on March
Policy Statement on Financial Market Developments, The President's
Working Group on Financial Markets (October 2008), http://
www.treas.gov/press/releases/reports/q4progress%20update.pdf.
\7\ See Memorandum of Understanding Between the Board of
Governors of the Federal Reserve System, the U.S. Commodity Futures
Trading Commission and the U.S. Securities and Exchange Commission
Regarding Central Counterparties for Credit Default Swaps (November
14, 2008), http://www.treas.gov/press/releases/reports/finalmou.pdf.
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A CDS is a bilateral contract between two parties, known as
counterparties. The value of this financial contract is based on
underlying obligations of a single entity or on a particular security
or other debt obligation, or an index of several such entities,
securities, or obligations. The obligation of a seller under a CDS to
make payments under a CDS contract is triggered by a default or other
credit event as to such entity or entities or such security or
securities. Investors may use CDS for a variety of reasons, including
to offset or insure against risk in their fixed-income portfolios, to
take positions in bonds or in segments of the debt market as
represented by an index, or to capitalize on the volatility in credit
spreads during times of economic uncertainty. In recent years, CDS
market volumes have rapidly increased.\8\ This growth has coincided
with a significant rise in the types and number of entities
participating in the CDS market.\9\
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\8\ See Semiannual OTC derivatives statistics at end-December
2007, Bank for International Settlements (``BIS''), available at
http://www.bis.org/statistics/otcder/dt1920a.pdf.
\9\ CDS were initially created to meet the demand of banking
institutions looking to hedge and diversify the credit risk
attendant with their lending activities. However, financial
institutions such as insurance companies, pension funds, securities
firms, and hedge funds have entered the CDS market.
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The Commission's authority over this OTC market for CDS is limited.
Specifically, section 3A of the Securities Exchange Act of 1934
(``Exchange Act'') limits the Commission's authority over swap
agreements, as defined in section 206A of the Gramm-Leach-Bliley
Act.\10\
[[Page 140]]
For those CDS that are swap agreements, the exclusion from the
definition of security in section 3A of the Exchange Act, and related
provisions, will continue to apply. The Commission's action today does
not affect these CDS, and this Order does not apply to them. For those
CDS that are not swap agreements (``non-excluded CDS''), the
Commission's action today provides conditional exemptions from certain
requirements of the Exchange Act.
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\10\ 15 U.S.C. 78c-1. Section 3A excludes both a non-security-
based and a security-based swap agreement from the definition of
``security'' under Section 3(a)(10) of the Exchange Act, 15 U.S.C.
78c(a)(10). Section 206A of the Gramm-Leach-Bliley Act defines a
``swap agreement'' as ``any agreement, contract, or transaction
between eligible contract participants (as defined in section 1a(12)
of the Commodity Exchange Act * * *) * * * the material terms of
which (other than price and quantity) are subject to individual
negotiation.'' 15 U.S.C. 78c note.
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The Commission believes that using well-regulated CCPs to clear
transactions in CDS would help promote efficiency and reduce risk in
the CDS market and among its participants. These benefits could be
particularly significant in times of market stress, as CCPs would
mitigate the potential for a market participant's failure to
destabilize other market participants, and reduce the effects of
misinformation and rumors. CCP-maintained records of CDS transactions
would also aid the Commission's efforts to prevent and detect fraud and
other abusive market practices.
A well-regulated CCP also would address concerns about counterparty
risk by substituting the creditworthiness and liquidity of the CCP for
the creditworthiness and liquidity of the counterparties to a CDS. In
the absence of a CCP, participants in the OTC CDS market must carefully
manage their counterparty risks because the default by a counterparty
can render worthless, and payment delay can reduce the usefulness of,
the credit protection that has been bought by a CDS purchaser. CDS
participants currently attempt to manage counterparty risk by carefully
selecting and monitoring their counterparties, entering into legal
agreements that permit them to net gains and losses across contracts
with a defaulting counterparty, and often requiring counterparty
exposures to be collateralized.\11\ A CCP could allow participants to
avoid these risks specific to individual counterparties because a CCP
``novates'' bilateral trades by entering into separate contractual
arrangements with both counterparties--becoming buyer to one and seller
to the other.\12\ Through novation, it is the CCP that assumes
counterparty risks.
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\11\ See generally R. Bliss and C. Papathanassiou, ``Derivatives
clearing, central counterparties and novation: The economic
implications'' (March 8, 2006), at 6. See also ``New Developments in
Clearing and Settlement Arrangements for OTC Derivatives,''
Committee on Payment and Settlement Systems, BIS, at 25 (March
2007), available at http://www.bis.org/pub/cpss77.pdf; ``Reducing
Risks and Improving Oversight in the OTC Credit Derivatives
Market,'' Before the Sen. Subcomm. On Secs., Ins. and Investments,
110th Cong. (2008) (Statement of Patrick Parkinson, Deputy Director,
Division of Research and Statistics, FRB).
\12\ ``Novation'' is a ``process through which the original
obligation between a buyer and seller is discharged through the
substitution of the CCP as seller to buyer and buyer to seller,
creating two new contracts.'' Committee on Payment and Settlement
Systems, Technical Committee of the International Organization of
Securities Commissioners, Recommendations for Central Counterparties
(November 2004) at 66.
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For this reason, a CCP for CDS would contribute generally to the
goal of market stability. As part of its risk management, a CCP may
subject novated contracts to initial and variation margin requirements
and establish a clearing fund. The CCP also may implement a loss-
sharing arrangement among its participants to respond to a participant
insolvency or default.
A CCP would also reduce CDS risks through multilateral netting of
trades.\13\ Trades cleared through a CCP would permit market
participants to accept the best bid or offer from a dealer in the OTC
market with very brief exposure to the creditworthiness of the dealer.
In addition, by allowing netting of positions in similar instruments,
and netting of gains and losses across different instruments, a CCP
would reduce redundant notional exposures and promote the more
efficient use of resources for monitoring and managing CDS positions.
Through uniform margining and other risk controls, including controls
on market-wide concentrations that cannot be implemented effectively
when counterparty risk management is decentralized, a CCP can help
prevent a single market participant's failure from destabilizing other
market participants and, ultimately, the broader financial system.
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\13\ See ``New Developments in Clearing and Settlement
Arrangements for OTC Derivatives,'' supra note 11, at 25.
Multilateral netting of trades would permit multiple counterparties
to offset their open transaction exposure through the CCP, spreading
credit risk across all participants in the clearing system and more
effectively diffusing the risk of a counterparty's default than
could be accomplished by bilateral netting alone.
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In this context, LIFFE Administration and Management (``LIFFE
A&M'') and LCH.Clearnet Ltd. (``LCH.Clearnet'') have requested that the
Commission grant exemptions from certain requirements under the
Exchange Act with respect to their proposed activities in clearing and
settling certain index-based CDS, as well as the proposed activities of
certain other persons, as described below.\14\
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\14\ See Letter from Arthur W. Hahn, KattenMuchinRosenman LLP,
to Florence Harmon, Acting Secretary, Commission, December 24, 2008.
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Based on the facts that LIFFE A&M and LCH.Clearnet have presented
and the representations they have made,\15\ and for the reasons
discussed in this Order, the Commission temporarily is exempting,
subject to certain conditions, LCH.Clearnet from the requirement to
register as a clearing agency under section 17A of the Exchange Act
solely to perform the functions of a clearing agency for certain non-
excluded CDS transactions. The Commission also temporarily is exempting
eligible contract participants and others from certain Exchange Act
requirements with respect to non-excluded CDS cleared by LCH.Clearnet.
The Commission's exemptions are temporary and will expire on September
25, 2009. To facilitate the operation of one or more CCPs for the CDS
market, the Commission has also approved interim final temporary rules
providing exemptions under the Securities Act of 1933 and the Exchange
Act for non-excluded CDS. Finally, the Commission is providing
temporary exemptions in connection with sections 5 and 6 of the
Exchange Act for transactions in non-excluded CDS.\16\
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\15\ See id. The exemptions we are granting today are based on
representations made by LIFFE A&M and LCH.Clearnet. We recognize,
however, that there could be legal uncertainty in the event that one
or more of the underlying representations were to become inaccurate.
Accordingly, if any of these exemptions were to become unavailable
by reason of an underlying representation no longer being materially
accurate, the legal status of existing open positions in non-
excluded CDS associated with persons subject to those unavailable
exemptions would remain unchanged, but no new positions could be
established pursuant to the exemptions until all of the underlying
representations were again accurate.
\16\ See Securities Exchange Act Release No. 59165 (December 24,
2008).
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II. Discussion
A. Description of LIFFE A&M and LCH.Clearnet's Proposal
The exemptive request by LIFFE A&M and LCH.Clearnet describes how
their proposed arrangements for central clearing of CDS would operate,
and makes representations about the safeguards associated with those
arrangements, as described below:
1. LCH Central Counterparty Services for CDS
LIFFE A&M has developed and makes available to its members an OTC
derivatives processing service, called Bclear, that will provide a
mechanism for the processing and centralized
[[Page 141]]
clearing of CDS based on credit default swap indices. The Bclear
service processes OTC transactions that are submitted to it by LIFFE
A&M members or authorized customers of those members. The Bclear
service submits these transactions for clearance to LCH.Clearnet, which
stands as the central counterparty to all transactions processed
through Bclear.\17\ LIFFE A&M will begin processing index CDS through
Bclear and would like to make such services available to certain market
participants in the U.S. LIFFE A&M represents that the following
information regarding index CDS will be available on its Web site
(http://www.nyx.com): (a) Contract specifications for index CDS that
may be processed and cleared through the Bclear Service, and (b) a
description of the Bclear Service and rules applicable thereto.
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\17\ Bclear provides a means by which counterparties to an index
CDS may negotiate a transaction on a bilateral basis and then submit
the transaction for processing and clearance by LCH.Clearnet. Bclear
accepts only completed transactions and is not a matching system for
counterparties.
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LCH.Clearnet provides CCP services to the following markets and
services: London Stock Exchange, SWX Europe Ltd., LIFFE, EDX London,
London Metal Exchange, other European Multilateral Trading Facilities
(``MTF''), and RepoClear and SwapClear.\18\
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\18\ LCH.Clearnet publishes its rules and procedures for the
various markets cleared, together with information on risk
management, application costs and procedures, minimum contributions
towards and interest rates on the default fund, and transactions
tariffs.
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LIFFE A&M has been granted recognition as a Recognised Investment
Exchange under the United Kingdom (``U.K.'') Financial Services and
Markets Act 2000 (``FSMA'') by the Financial Services Authority
(``FSA''). LCH.Clearnet has been granted recognition as a Recognized
Clearing House (``RCH'') under FSMA by the FSA.\19\ Regulation and
oversight in the U.K. is carried out by the FSA and the Bank of
England. The FSA is the main regulator of LCH.Clearnet as an RCH, while
the Bank of England's oversight is confined to LCH.Clearnet's payment
system.\20\
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\19\ LCH.Clearnet has been approved as a Derivatives Clearing
Organization (``DCO'') by the CFTC. In addition, FSA and the Bank of
England performed a risk assessment of LCH in June 2006 against the
Recommendations for Central Counterparties (``RCCP''), which was
drafted by a joint task force composed of representative members of
the International Organization of Securities Commissions (``IOSCO'')
and Committee on Payment and Settlement Systems (``CPSS'') and
published in November 2004.
The Task Force consisted of securities regulators and central
bankers from 19 countries and the European Union. The U.S.
representatives on the Task Force included staff from the
Commission, FRB, and the CFTC. The complete RCCP Report is available
on the Web sites of the Bank for International Settlements and the
International Organization of Securities Commission at, http://
www.bis.org/publ/cpss64.htm, and at http://www.iosco.org,
respectively. LCH.Clearnet has assured the Commission that it is in
full compliance with the Recommendations for Central Counterparties.
The assessment can be found at http://www.fsa.gov.uk/pubs/other/
lchclearnet.pdf.
\20\ LCH.Clearnet is owned 73.3 percent by users, 10.9 percent
by exchanges, and 15.8 percent by Euroclear. Euroclear is a user-
owned, user-governed Brussels, Belgium-based financial services
company that specializes in the settlement of securities
transactions.
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The FSA has a regulatory supervision relationship with LIFFE A&M
and with LCH.Clearnet. On an annual basis, the FSA undertakes a risk
assessment of LIFFE A&M and LCH.Clearnet pursuant to which the FSA
determines whether relevant regulatory obligations continue to be met
and whether the activities of either LIFFE A&M or LCH.Clearnet pose any
risks to the FSA's statutory objectives, including maintaining market
confidence and providing customer protection. The FSA approves the
business continuity plans of LCH.Clearnet.
2. CCP Role of LCH.Clearnet in Connection with LIFFE A&M
LIFFE A&M has two categories of members, clearing members and non-
clearing members. LIFFE A&M further has two types of clearing members:
Individual Clearing Members that clear and settle business for their
own account or, in the case of broker-dealers, on behalf of their
customers; and General Clearing Members that, in addition, clear and
settle business on behalf of other LIFFE A&M members. All transactions
of non-clearing members must be cleared through a specific clearing
member. All clearing members must also be members of LCH.Clearnet and
all are subject to standards of capital adequacy (set by LCH.Clearnet
as well as by their respective regulators). Clearing members must also
satisfy LIFFE A&M and LCH.Clearnet that they have adequate systems and
controls to clear and settle transactions.
The rules of LIFFE A&M provide for members to trade for their own
account and/or for their customers, but all transactions must be in the
name of the member effecting the trade and that member will be the
counterparty for those transactions. Thus, a LIFFE A&M member will be
considered to be ``acting as principal.'' This means that a transaction
on LIFFE A&M automatically generates a sequence of matching contracts.
For example, a sequence could be between a customer and a LIFFE A&M
member, between that member and a clearing member, and between the
clearing member and LCH.Clearnet.
The purpose of the LIFFE A&M rules is to ensure that a party to a
transaction need only look to its immediate counterparty for
performance and need not concern itself with parties at other points on
the contractual chain. Thus, LCH.Clearnet need only look to its
clearing members and would have no contractual relationship with, or
knowledge of, the non-clearing members of LIFFE A&M or customers on
whose behalf the transaction was executed.
Hence, LCH.Clearnet is the CCP to clearing firms each acting as
principal in respect of index CDS. Non-clearing members and non-member
customers are not party to any contracts registered by clearing members
with LCH.Clearnet. Once an index CDS contract has been accepted by
LIFFE A&M, a chain of linked contracts is created, all having the same
terms. Specifically, the process by which the chain of linked contracts
is created is as follows:
a. When a non-member customer enters into an index CDS with or
through a non-clearing member, the non-clearing member submits the
contract to Bclear. Once LIFFE A&M has accepted the contract, an
exchange contract \21\ is created between the non-clearing member, as
principal, and its customer. If another customer was originally a
counterparty to the index CDS, an exchange contract is created between
the non-clearing member, as principal, and the second customer. The
contracts are referred to as ``customer contracts.'' The customer
contracts replace the initial index CDS, which ceases to exist at that
point.
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\21\ An ``exchange contract'' refers to a contract that is
subject to the rules of LIFFE A&M. The term does not indicate that a
central order book exists for a product.
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b. Simultaneously, a matching contract between the non-clearing
member and its clearing member, called a ``parallel contract,'' comes
into existence for each of the customer contracts.
c. If the counterparty to the trade is a customer of another non-
clearing member, a ``related contract'' is created between the
respective clearing members. The related contract is presented to
LCH.Clearnet for registration. If there is a single non-clearing member
involved in the transaction, the parallel contracts are presented to
LCH.Clearnet for registration.
d. The related contract is replaced by contracts between
LCH.Clearnet and the
[[Page 142]]
clearing member on each side of the transaction.
Through this process, the index CDS is discharged and a set of on-
exchange contracts arise imposing equivalent obligations on and
granting equivalent rights to the original parties to the index CDS,
but with LCH.Clearnet as the CCP. Because the non-member customer will
not be a party to a contract registered with LCH.Clearnet by the
clearing member, the relationship between the non-member customer and
the non-clearing member will remain intact, although such relationship
will now be based upon the exchange contract, rather than the index CDS
originally entered into by the respective parties.
3. LCH Risk Management
LCH.Clearnet requires the posting of initial margin and maintenance
(``variation'') margin for all clearing accounts. The initial margin
and maintenance margin is determined utilizing the London SPAN
(Standard Portfolio Analysis of Risk) methodology. London SPAN was
adapted from the Chicago Mercantile Exchange's margining system.
The initial margin requirement for a member's CDS portfolio is the
largest loss identified under these various market conditions that
might reasonably occur taking into account risk offsets within the CDS
portfolio. Initial margin is refunded when the margined index CDS
position is closed. This risk management methodology is designed to
protect LCH.Clearnet against the worst likely loss from one or two
days' move in the market.
Net Liquidation Value (``NLV''), the value of a member's portfolio
at closing market prices representing the income or expenditure which
would be associated with closing out an index CDS position, is added to
initial margin to give the total margin requirement.
LCH.Clearnet revalues the margin positions of its members on at
least a daily basis to account for changes or volatility in the market
price of the underlying index and in LCH.Clearnet's valuation of margin
collateral provided in the form of securities. During the day,
LCH.Clearnet monitors market prices and clearing members' positions and
may call for additional margin payments from members. LCH.Clearnet then
revalues each member's margin requirements each night.\22\
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\22\ While LCH.Clearnet's margin requirements are central to its
risk management, LCH.Clearnet also has other measures at its
disposal, including:
1. Additional financial resource requirements (buffers);
2. Additional initial margin requirements;
3. Imposition of position limits;
4. Trading for liquidation only;
5. Prior authorization of trades above a certain size; and
6. Issuing instructions to reduce positions.
LCH.Clearnet also monitors large cumulative profits or losses.
If large and unusual trading activity is detected (relative to
previous exposures), LCH.Clearnet will contact compliance officers
and seek assurances from the senior executives or boards of a member
firm or parent company.
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LCH.Clearnet's margin requirements are only applicable to clearing
members. All clearing members must provide LCH.Clearnet with enough
margin to cover the risk on their total net positions for each account
they clear. Clearing members and/or non-clearing members in turn set
the margin requirements applicable to their customers.
4. Margin Collateral
LCH.Clearnet accepts a wide variety of collateral types from
clearing members in meeting their initial and NLV margin payments.
Members may meet their margin requirements by cash payments in the
following currencies: sterling, U.S. dollars, yen, Swiss francs, and
euros. In addition, LCH.Clearnet will accept an extensive range of
collateral including approved bank guarantees, certain U.K. treasury
bills, U.K. gilts, sterling, U.S. dollar certificates of deposit,
German, Italian, and Spanish government bonds and U.K. equities.
To avoid frequent margin payments, clearing members may deposit
margin in excess of the LCH.Clearnet required minimum. In such cases,
LCH.Clearnet pays interest to clearing members on excess cash margin on
deposit currently at the overnight London Inter-Bank Bid Rate
(``LIBID'') minus twenty-five basis points.
5. Member Default
If a clearing member appears to LCH.Clearnet to be unable, or
likely to become unable, to meet its obligations to LCH.Clearnet, it
may be declared by LCH.Clearnet in default under LCH.Clearnet's default
rules in relation to the contracts registered by it with LCH.Clearnet.
Where a clearing member has been declared in default by LCH.Clearnet,
contracts between such clearing member and its non-clearing members and
clients will be dealt with under LIFFE A&M's default rules. A default
by a non-clearing member will also be dealt with under LIFFE A&M's
default rules. Where the defaulting party is an LCH.Clearnet clearing
member, LCH.Clearnet's default rules take primacy over LIFFE A&M's,
although all actions in such circumstances are typically coordinated
between LCH.Clearnet and LIFFE A&M to take advantage of statutory
protections afforded to LCH.Clearnet as an RCH.
As the legal counterparty to each clearing member, LCH.Clearnet
bears any loss arising from the default of a clearing member, beyond
the margin deposits held as security in respect of the defaulting
member's liabilities. LCH.Clearnet's supplementary resources for use in
default cases, should a member's margin deposits prove insufficient,
comprise a Default Fund, totaling approximately 600 million, which is
provided by members and held in cash by LCH. Each member's Default Fund
contribution is assessed every three months on the basis of that
member's initial margin and (in the case of exchange traded
derivatives) trading volumes over the preceding three months.
The Default Fund is ``mutualized'' in that any loss faced by
LCH.Clearnet as a result of a default which cannot be met from the
defaulter's margin on deposit at LCH.Clearnet or from its contribution
to the Default Fund will be met by the Default Fund generally.
Customers of a defaulting clearing member have no contractual
relationship with LCH.Clearnet, but are protected to the extent of
their client agreement with the defaulting member and any segregation
arrangements in place with the defaulting member.\23\
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\23\ LCH is not a counterparty to contracts that clearing
members have with their customers.
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LCH.Clearnet uses a stress testing model to ensure that its post-
default financial backing is sufficient. The stress testing model
assesses the adequacy of initial margin requirements and the Default
Fund on the basis of extreme price movement scenarios in all contracts
cleared by LCH.
The sequence of protections to be applied in the event of a default
is as follows: \24\
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\24\ The sequence does not take into account the anticipated
replenishment of the Default Fund by market members and/or national
governments between steps d. and e.
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a. Defaulting Member's Initial Margin (including excess collateral
posted).
b. Defaulting Member's Default Fund Contribution.
c. Up to [pound]20 million of LCH.Clearnet's capital and reserves.
d. Remainder of the Default Fund.
e. Remainder of LCH.Clearnet's capital and reserves.
As the counterparty to every clearing member, LCH.Clearnet reduces
the scope of counterparty risk between clearing members. LCH.Clearnet
is legally responsible for the financial performance of the contracts
that it has registered and any resulting delivery obligations.
LCH.Clearnet represents
[[Page 143]]
that its rules and procedures are available on its Web site and such
rules and procedures generally set forth the sequence of protections to
be applied in the event of a default by a clearing member.
6. Client Money Rules and Other Member Requirements
Clearing members that undertake business for clients are subject to
UK client money and client asset rules or, if they are authorized
outside the UK, similar rules of their relevant regulator. In the
European Union, the client money rules are governed by the Markets in
Financial Instruments Directive, although the UK client money rules
prescribe some extended conditions in certain cases. Clearing members
may have two accounts with LCH.Clearnet, one for segregated customer
business and one for all house and non-segregated client business, and
neither LCH.Clearnet nor the clearing member can offset liabilities on
the house margin account with credits arising on the client margin
account. Clearing members are required to segregate customer funds and
securities except in instances where the investor, if permitted to do
so, contracts out of the segregation requirement.
LIFFE A&M represents that it only considers for membership entities
located in jurisdictions with regulatory arrangements it deems
satisfactory regarding: (i) Supervision of investment activity; (ii)
information sharing and cooperation between the supervisory authority
of the jurisdiction concerned and LIFFE A&M and/or the FSA; and (iii)
capital adequacy, liquidity, and segregation of customers' funds and
securities (and related books and records provisions). LIFFE A&M
further represents that before offering Index CDS services to U.S.
persons, LIFFE A&M will adopt a requirement that will prohibit a member
from directly or indirectly submitting, or permitting an authorized
customer to submit, an Index CDS to the Bclear service when the member
receives or holds funds or securities of U.S. persons for the purpose
of purchasing, selling, clearing, settling, or holding that Index CDS
position, unless the member, in connection with such Index CDS
activities, is regulated by: (i) A signatory to the IOSCO Multilateral
Memorandum of Understanding Concerning Consultation and Cooperation and
the Exchange of Information, (ii) a signatory to a bilateral
arrangement with the Commission for enforcement cooperation, or (iii) a
financial regulatory authority in Ireland or Sweden. In that regard,
LIFFE A&M states that it intends to launch the Index CDS service for
non-U.S. persons on December 22, 2008. LIFFE A&M will notify members at
that time that the service may not be offered to U.S. persons until
LIFFE A&M issues an additional notice.
In addition, LCH.Clearnet represents that its rules require its
clearing members to: (i) Meet specific capital adequacy standards that
vary depending on the type of activities undertaken by the member; (ii)
provide copies of audited annual financial statements to LCH.Clearnet;
and (iii) notify LCH.Clearnet upon the happening of certain material
events, such as significant reductions in shareholders' funds or net
capital.
B. Temporary Conditional Exemption From Clearing Agency Registration
Requirement
Section 17A of the Exchange Act sets forth the framework for the
regulation and operation of the U.S. clearance and settlement system,
including CCPs. Specifically, Section 17A directs the Commission to use
its authority to promote enumerated Congressional objectives and to
facilitate the development of a national clearance and settlement
system for securities transactions. Absent an exemption, a CCP that
novates trades of non-excluded CDS that are securities and generates
money and settlement obligations for participants is required to
register with the Commission as a clearing agency.
Section 36 of the Exchange Act authorizes the Commission to
conditionally or unconditionally exempt any person, security, or
transaction, or any class or classes of persons, securities, or
transactions, from any provision or provisions of the Exchange Act or
any rule or regulation thereunder, by rule, regulation, or order, to
the extent that such exemption is necessary or appropriate in the
public interest, and is consistent with the protection of
investors.\25\
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\25\ 15 U.S.C. 78mm.
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Accordingly, pursuant to section 36 of the Exchange Act, the
Commission finds that it is necessary or appropriate in the public
interest and is consistent with the protection of investors to exercise
its authority to grant an exemption until September 25, 2009 to
LCH.Clearnet from section 17A of the Exchange Act, solely to perform
the functions of a clearing agency for Cleared Index CDS,\26\ subject
to the conditions discussed below.
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\26\ For purposes of this exemption, and the other exemptions
addressed in this Order, ``Cleared Index CDS'' means a credit
default swap that is submitted (or offered, purchased, or sold on
terms providing for submission) to LCH.Clearnet, that is offered
only to, purchased only by, and sold only to eligible contract
participants (as defined in Section 1a(12) of the Commodity Exchange
Act as in effect on the date of this Order (other than a person that
is an eligible contract participant under paragraph (C) of that
section)), and in which the reference index is an index in which 80
percent or more of the index's weighting is comprised of the
following entities or securities: (i) An entity reporting under the
Exchange Act, providing Securities Act Rule 144A(d)(4) information,
or about which financial information is otherwise publicly
available; (ii) a foreign private issuer whose securities are listed
outside the United States and that has its principal trading market
outside the United States; (iii) a foreign sovereign debt security;
(iv) an asset-backed security, as defined in Regulation AB, issued
in a registered transaction with publicly available distribution
reports; or (v) an asset-backed security issued or guaranteed by the
Fannie Mae, Freddie Mac, or the Government National Mortgage
Association (``Ginnie Mae''). As discussed above, the Commission's
action today does not affect CDS that are swap agreements under
Section 206A of the Gramm-Leach-Bliley Act. See text at note 10,
supra.
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Our action today balances the aim of facilitating the prompt
establishment of LCH.Clearnet as a CCP for non-excluded CDS
transactions--which should help reduce systemic risks during a period
of extreme turmoil in the U.S. and global financial markets--with
ensuring that important elements of Commission oversight are applied to
the non-excluded CDS market. In doing so, we are mindful that applying
the full scope of the Exchange Act to transactions involving non-
excluded CDS could deter the prompt establishment of LCH.Clearnet as a
CCP to settle those transactions.
While we are acting so that the prompt establishment of
LCH.Clearnet as a CCP for non-excluded CDS will not be delayed by the
need to apply the full scope of Exchange Act section 17A's requirements
that govern clearing agencies, the relief we are providing is temporary
and conditional. The limited duration of the exemptions will permit the
Commission to gain more direct experience with the non-excluded CDS
market after LCH.Clearnet becomes operational, giving the Commission
the ability to oversee the development of the centrally cleared non-
excluded CDS market as it evolves. During the exemptive period, the
Commission will closely monitor the impact of the CCPs on the CDS
market. In particular, the Commission will seek to assure itself that
the CCPs do not act in an anticompetitive manner or indirectly
facilitate anticompetitive behavior with respect to fees charged to
members, the dissemination of market data and the access to clearing
services by independent CDS exchanges or CDS trading platforms. The
Commission will take that experience into account in future actions.
[[Page 144]]
Moreover, this temporary exemption in part is based on
LCH.Clearnet's representation that it meets the standards set forth in
the RCCP.\27\ The RCCP establishes a framework that requires a CCP to
have: (i) The ability to facilitate the prompt and accurate clearance
and settlement of CDS transactions and to safeguard its users' assets;
and (ii) sound risk management, including the ability to appropriately
determine and collect clearing fund and monitor its users' trading.
This framework is generally consistent with the requirements of section
17A of the Exchange Act.
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\27\ See note 19, supra.
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In addition, this Order is designed to assure that--as LCH.Clearnet
and LIFFE A&M have represented--information will be available to market
participants about the terms of the CDS cleared by LCH.Clearnet, the
creditworthiness of LCH.Clearnet or any guarantor, and the clearing and
settlement process for the CDS. Moreover, to be within the definition
of Cleared Index CDS for purposes of this exemption (as well as the
other exemptions granted through this Order), at least 80 percent of
the weighting of the index must be comprised of reference entities or
reference securities that satisfy certain conditions relating to the
availability of information about such persons or securities. The
definition does not prescribe the type of financial information that
must be available nor the location of the particular information,
recognizing that eligible contract participants have access to
information about reference entities and reference securities through
multiple sources. The Commission believes, however, that it is
important in the CDS market, as in the market for securities generally,
that parties to transactions should have access to financial
information that would allow them to appropriately evaluate the risks
relating to a particular investment and make more informed investment
decisions.\28\ Such information availability also will assist
LCH.Clearnet and the buyers and sellers in valuing their Cleared Index
CDS and their counterparty exposures. As a result of the Commission's
actions today, the Commission believes that information should be
available for market participants to be able to make informed
investment decisions, and value and evaluate their Cleared Index CDS
and their counterparty exposures.
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\28\ The Commission notes the recommendations of the President's
Working Group on Financial Markets regarding the informational needs
and due diligence responsibilities of investors. See Policy
Statement on Financial Market Developments, The President's Working
Group on Financial Markets, March 13, 2008, available at: http://
www.treas.gov/press/releases/reports/ pwgpolicystatemktturmoil_
03122008.pdf.
_____________________________________-
This temporary exemption is subject to a number of conditions that
are designed to enable Commission staff to monitor LCH.Clearnet's
clearance and settlement of CDS transactions, coordinate and cooperate
with the FSA, and help reduce risk in the CDS market. These conditions
require that LCH.Clearnet: (i) Make available on its Web site annual
audited financial statements; (ii) preserve records related to the
conduct of its Cleared Index CDS clearance and settlement services for
at least five years (in an easily accessible place for the first two
years); (iii) supply information relating to its Cleared Index CDS
clearance and settlement services to the Commission; (iv) provide
access to the Commission to conduct on-site inspections of facilities,
records and personnel related to its Cleared Index CDS clearance and
settlement services, subject to coordination with FSA and upon terms
and conditions agreed between the FSA and the Commission; (v) notify
the Commission about material disciplinary actions taken against users
of its Cleared Index CDS clearance and settlement services, and about
the involuntary termination of the membership of an entity using those
services; (vi) provide the Commission with prior notice of changes to
its Default Rules and Default Fund Rules; (vii) provide the Commission
with reports with respect to certain automated systems used in
connection with its Cleared Index CDS clearance and settlement
services, and with annual audited financial statements; \29\ and (viii)
provide notice to the Commission regarding the suspension of services
or the inability to operate facilities in connection with its Cleared
Index CDS clearance and settlement services.
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\29\ As a condition of LCH.Clearnet's exemption, LIFFE A&M has
agreed to provide the Commission with reports with respect to
certain automated systems used in connection with LCH.Clearnet's
Cleared Index CDS clearance and settlement services. These reports
will be generated in accordance with risk assessments of the areas
set forth in the Commission's Automation Review Policy Statements
(``ARPs''). See Automated Systems of Self-Regulatory Organization,
Securities Exchange Act Release No. 27445 (November 16, 1989), 54 FR
48703 (November 24, 1989), and Automated Systems of Self-Regulatory
Organization (II), Securities Exchange Act Release No. 29185 (May 9,
1991), 56 FR 22490 (May 15, 1991).
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In addition, this relief is conditioned on LCH.Clearnet, directly
or indirectly, making available to the public on terms that are fair
and reasonable and not unreasonably discriminatory: (i) All end-of-day
settlement prices and any other prices with respect to Cleared Index
CDS that LCH.Clearnet may establish to calculate mark-to-market margin
requirements for LCH.Clearnet or LIFFE A&M participants; and (ii) any
other pricing or valuation information with respect to Cleared Index
CDS as is published or distributed by LCH.Clearnet or LIFFE A&M. The
Commission believes this is an appropriate condition for LCH.Clearnet's
exemption from registration as a clearing agency. In section 11A of the
Exchange Act, Congress included a finding that ``[i]t is in the public
interest and appropriate for the protection of investors and the
maintenance of fair and orderly markets to assure * * * the
availability to brokers, dealers, and investors of information with
respect to quotations for and transactions in securities.'' \30\ The
President's Working Group on Financial Markets has stated that
increased transparency is a policy objective for the over-the-counter
derivatives market,\31\ which includes the market for CDS. This
condition is designed to further this policy objective of both Congress
and the President's Working Group by requiring LCH.Clearnet and LIFFE
A&M to make available to the public on terms that are fair and
reasonable all end-of-day settlement prices and any other prices with
respect to Cleared Index CDS that LCH.Clearnet may establish to
calculate mark-to-market margin requirements for LCH.Clearnet or LIFFE
A&M Participants. In addition, LCH.Clearnet or LIFFE A&M must make
available to the public on terms that are fair and reasonable and not
unfairly discriminatory any other pricing or valuation information with
respect to Cleared Index CDS as is published or distributed by
LCH.Clearnet or LIFFE A&M.
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\30\ 15 U.S.C. 78k-1(a)(1)(C)(iii). See also 15 U.S.C. 78k-
1(a)(1)(D).
\31\ See President's Working Group on Financial Markets, Policy
Objectives for the OTC Derivatives Market (November 14, 2008),
http://www.ustreas.gov/press/releases/reports/policyobjectives.pdf
(``Public reporting of prices, trading volumes and aggregate open
interest should be required to increase market transparency for
participants and the public.'').
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As a CCP, LCH.Clearnet will collect and process information about
CDS transactions and positions from all of its participants. With this
information, a CCP will, among other things, calculate and disseminate
current values for open positions for the purpose of setting
appropriate margin levels, or have an agent perform these functions on
its behalf. The availability of such information can improve fairness,
efficiency, and competitiveness of the
[[Page 145]]
market--all of which enhance investor protection and facilitate capital
formation. Moreover, with pricing and valuation information relating to
Cleared Index CDS, market participants would be able to derive
information about underlying securities and indexes. This may improve
the efficiency and effectiveness of the securities markets by allowing
investors to better understand credit conditions generally.
C. Temporary General Exemption for LCH.Clearnet, LIFFE A&M and Certain
Eligible Contract Participants
Applying the full panoply of Exchange Act requirements to
participants in transactions in non-excluded CDS likely would deter
some participants from using CCPs to clear CDS transactions. At the
same time, it is important that the antifraud provisions of the
Exchange Act apply to transactions in non-excluded CDS; indeed, OTC
transactions subject to individual negotiation that qualify as
security-based swap agreements already are subject to these antifraud
provisions.\32\
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\32\ While Section 3A of the Exchange Act excludes ``swap
agreements'' from the definition of ``security,'' certain antifraud
and insider trading provisions under the Exchange Act explicitly
apply to security-based swap agreements. See (a) paragraphs (2)
through (5) of Section 9(a), 15 U.S.C. 78i(a), prohibiting the
manipulation of security prices; (b) Section 10(b), 15 U.S.C.
78j(b), and underlying rules prohibiting fraud, manipulation or
insider trading (but not prophylactic reporting or recordkeeping
requirements); (c) Section 15(c)(1), 15 U.S.C. 78o(c)(1), which
prohibits brokers and dealers from using manipulative or deceptive
devices; (d) Sections 16(a) and (b), 15 U.S.C. 78p(a) and (b), which
address disclosure by directors, officers and principal
stockholders, and short-swing trading by those persons, and rules
with respect to reporting requirements under Section 16(a); (e)
Section 20(d), 15 U.S.C. 78t(d), providing for antifraud liability
in connection with certain derivative transactions; and (f) Section
21A(a)(1), 15 U.S.C. 78u-1(a)(1), related to the Commission's
authority to impose civil penalties for insider trading violations.
``Security-based swap agreement'' is defined in Section 206B of
the Gramm-Leach-Bliley Act as a swap agreement in which a material
term is based on the price, yield, value, or volatility of any
security or any group or index of securities, or any interest
therein.
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We thus believe that it is appropriate in the public interest and
consistent with the protection of investors temporarily to apply
substantially the same framework to transactions by market participants
in non-excluded CDS that applies to transactions in security-based swap
agreements. Applying substantially the same set of requirements to
participants in transactions in non-excluded CDS as apply to
participants in OTC CDS transactions will avoid deterring market
participants from promptly using CCPs, which would detract from the
potential benefits of central clearing.
Accordingly, pursuant to section 36 of the Exchange Act, the
Commission finds that it is necessary or appropriate in the public
interest and is consistent with the protection of investors to exercise
its authority to grant an exemption until September 25, 2009 from
certain requirements under the Exchange Act. This temporary exemption
applies to LCH.Clearnet and LIFFE A&M, and also to certain eligible
contract participants \33\ other than: Eligible contract participants
that receive or hold funds or securities for the purpose of purchasing,
selling, clearing, settling or holding Cleared Index CDS positions for
other persons; \34\ eligible contract participants that are self-
regulatory organizations; or eligible contract participants that are
registered brokers or dealers.\35\
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\33\ This exemption in general applies to eligible contract
participants, as defined in Section 1a(12) of the Commodity Exchange
Act as in effect on the date of this Order, other than persons that
are eligible contract participants under paragraph (C) of that
section.
\34\ For these purposes, and for the purpose of the definition
of ``Cleared Index CDS,'' the terms ``purchasing'' and ``selling''
mean the execution, termination (prior to its scheduled maturity
date), assignment, exchange, or similar transfer or conveyance of,
or extinguishing the rights or obligations under, a Cleared Index
CDS, as the context may require. This is consistent with the meaning
of the terms ``purchase'' or ``sale'' under the Exchange Act in the
context of security-based swap agreements. See Exchange Act Section
3A(b)(4).
A separate temporary conditional exemption addresses members of
LIFFE A&M that hold funds or securities for the purpose of
purchasing, selling, clearing, settling, or holding Cleared Index
CDS positions for other persons. See Part II.D, infra.
\35\ A separate temporary exemption addresses the Cleared Index
CDS activities of registered broker-dealers. See Part II.E, infra.
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Under this temporary exemption, and solely with respect to Cleared
Index CDS, these persons generally are exempt from provisions of the
Exchange Act and the rules and regulations thereunder that do not apply
to security-based swap agreements. Those persons thus would still be
subject to those Exchange Act requirements that explicitly are
applicable in connection with security-based swap agreements.\36\ In
addition, all provisions of the Exchange Act related to the
Commission's enforcement authority in connection with violations or
potential violations of such provisions would remain applicable.\37\ In
this way, the temporary exemption would apply the same Exchange Act
requirements in connection with non-excluded CDS as apply in connection
with OTC credit default swaps.
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\36\ See note 32, supra.
\37\ Thus, for example, the Commission retains the ability to
investigate potential violations and bring enforcement actions in
the federal courts and administrative proceedings, and to seek the
full panoply of remedies available in such cases.
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This temporary exemption, however, does not extend to sections 5
and 6 of the Exchange Act. The Commission separately is issuing a
conditional exemption from these provisions to all broker-dealers and
exchanges.\38\ This temporary exemption also does not extend to section
17A of the Exchange Act; instead, LCH.Clearnet is exempt from
registration as a clearing agency under the conditions discussed above.
In addition, this exemption does not apply to Exchange Act sections 12,
13, 14, 15(d) and 16; \39\ eligible contract participants and other
persons instead should refer to the interim final temporary rules
issued today by the Commission. Finally, this temporary exemption does
not extend to the Commission's administrative proceeding authority
under sections 15(b)(4) and (b)(6),\40\ or to certain provisions
related to government securities.\41\
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\38\ See note 16, supra. A national securities exchange that
effects transactions in Cleared Index CDS would continue to be
required to comply with all requirements under the Exchange Act
applicable to such transactions. A national securities exchange
could form subsidiaries or affiliates that operate exchanges exempt
under that order. Any subsidiary or affiliate of a registered
exchange could not integrate, or otherwise link, the exempt CDS
exchange with the registered exchange including the premises or
property of such exchange for effecting or reporting a transaction
without being considered a ``facility of the exchange.'' See Section
3(a)(2), 15 U.S.C. 78c(a)(2).
\39\ 15 U.S.C. 78l, 78m, 78n, 78o(d), 78p.
\40\ Exchange Act Sections 15(b)(4) and 15(b)(6), 15 U.S.C.
78o(b)(4) and (b)(6), grant the Commission authority to take action
against broker-dealers and associated persons in certain situations.
Accordingly, while this exemption generally extends to persons that
act as inter-dealer brokers in the market for Cleared Index CDS and
do not hold funds or securities for others, such inter-dealer
brokers may be subject to actions under Sections 15(b)(4) and (b)(6)
of the Exchange Act.
In addition, such inter-dealer brokers may be subject to actions
under Exchange Act Section 15(c)(1), 15 U.S.C. 78o(c)(1), which
prohibits brokers and dealers from using manipulative or deceptive
devices. As noted above, Section 15(c)(1) explicitly applies to
security-based swap agreements. Sections 15(b)(4), 15(b)(6) and
15(c)(1), of course, would not apply to persons subject to this
exemption who do not act as broker-dealers or associated persons of
broker-dealers.
\41\ This exemption specifically does not extend to the Exchange
Act provisions applicable to government securities, as set forth in
Section 15C, 15 U.S.C. 78o-5, and its underlying rules and
regulations; nor does the exemption extend to related definitions
found at paragraphs (42) through (45) of Section 3(a), 15 U.S.C.
78c(a). The Commission does not have authority under Section 36 to
issue exemptions in connection with those provisions. See Exchange
Act Section 36(b), 15 U.S.C. 78mm(b).
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[[Page 146]]
D. Conditional Temporary General Exemption for Certain Clearing Members
of LIFFE A&M and LCH.Clearnet
Absent an exception, persons that effect transactions in non-
excluded CDS that are securities may be required to register as broker-
dealers pursuant to section 15(a)(1) of the Exchange Act.\42\ Moreover,
certain reporting and other requirements of the Exchange Act could
apply to such persons, as broker-dealers, regardless of whether they
are registered with the Commission.
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\42\ 15 U.S.C. 78o(a)(1). This section generally provides that,
absent an exception or exemption, a broker or dealer that uses the
mails or any means of interstate commerce to effect transactions in,
or to induce or attempt to induce the purchase or sale of, any
security must register with the Commission.
Section 3(a)(4) of the Exchange Act generally defines a
``broker'' as ``any person engaged in the business of effecting
transactions in securities for the account of others,'' but provides
11 exceptions for certain bank securities activities. 15 U.S.C.
78c(a)(4). Section 3(a)(5) of the Exchange Act generally defines a
``dealer'' as ``any person engaged in the business of buying and
selling securities for his own account,'' but includes exceptions
for certain bank activities. 15 U.S.C. 78c(a)(5). Exchange Act
Section 3(a)(6) defines a ``bank'' as a bank or savings association
that is directly supervised and examined by state or federal banking
authorities (with certain additional requirements for banks and
savings associations that are not chartered by a federal authority
or a member of the Federal Reserve System). 15 U.S.C. 78c(a)(6).
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It is consistent with our investor protection mandate to require
that intermediaries in securities transactions that receive or hold
funds and securities on behalf of others comply with standards that
safeguard the interests of their customers. For example, registered
broker-dealers are required to segregate assets held on behalf of
customers from proprietary assets, because segregation will assist
customers in recovering assets in the event the intermediary fails. To
the extent that funds and securities are not segregated, they could be
used by a participant to fund its own business and could be attached to
satisfy debts of the participant were the participant to fail.
Moreover, the maintenance of adequate capital and liquidity protects
customers, CCPs and other market participants. Adequate books and
records (including both transactional and position records) are
necessary to facilitate day to day operations as well as to help
resolve situations in which a participant fails and either a regulatory
authority or receiver is forced to liquidate the firm. Appropriate
records also are necessary to allow examiners to review for improper
activities, such as insider trading or fraud.
At the same time, requiring intermediaries that receive or hold
funds and securities on behalf of customers in connection with
transactions in non-excluded CDS to register as broker-dealers may
deter the use of CCPs in CDS transactions, to the detriment of the
markets and market participants generally. Also, as noted above with
regard to other eligible contract participants to non-excluded CDS
transactions, immediately applying the panoply of Exchange Act
requirements to centrally cleared transactions may deter the use of
CCPs for CDS transactions.
Those factors argue in favor of flexibility in applying the
requirements of the Exchange Act to these intermediaries. Along with
those factors, in granting an exemption here we are particularly
relying on the representation of LIFFE A&M that it only considers for
membership entities located in jurisdictions with regulatory
arrangements it deems satisfactory regarding: (i) Supervision of
investment activity; (ii) information sharing and cooperation between
the supervisory authority of the jurisdiction concerned and LIFFE A&M
and/or the FSA; and (iii) capital adequacy, liquidity, and segregation
of customers' funds and securities (and related books and records
provisions). We also are particularly relying on the representation of
LCH.Clearnet that its rules require its clearing members to: (i) Meet
specific capital adequacy standards that vary depending on the type of
activities undertaken by the member; (ii) provide copies of audited
annual financial statements to LCH.Clearnet; and (iii) notify
LCH.Clearnet upon the happening of certain material events, such as
significant reductions in shareholders' funds or net capital.
We further are relying on LIFFE A&M's representation that before
offering Index CDS services to U.S. persons,\43\ LIFFE A&M will adopt a
requirement that will prohibit a member from directly or indirectly
submitting, or permitting an authorized customer to submit, an Index
CDS to the Bclear service when the member receives or holds funds or
securities of U.S. persons for the purpose of purchasing, selling,
clearing, settling, or holding that Index CDS position, unless the
member, in connection with such Index CDS activities, is regulated by:
(i) A signatory to the IOSCO Multilateral Memorandum of Understanding
Concerning Consultation and Cooperation and the Exchange of
Information, (ii) a signatory to a bilateral arrangement with the
Commission for enforcement cooperation, or (iii) a financial regulatory
authority in Ireland or Sweden.\44\ This will help ensure that the
Commission can access trading records and other information of LIFFE
A&M members as needed to enforce the federal securities laws.
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\43\ As noted above, LIFFE A&M states that it intends to launch
the Index CDS service for non-U.S. persons on December 22, 2008.
LIFFE A&M will notify members at that time that that the service may
not be offered to U.S. persons until LIFFE A&M issues an additional
notice.
\44\ The Commission has established informal relationships with
securities authorities in Ireland and Sweden and cooperates with
them on an ad hoc basis. The Commission will explore entering into
arrangements for cooperation with these authorities and, in the near
term, will seek letters of intent to cooperate.
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Accordingly, pursuant to section 36 of the Exchange Act, the
Commission finds that it is necessary or appropriate in the public
interest and is consistent with the protection of investors to exercise
its authority to grant a conditional exemption until September 25, 2009
from certain Exchange Act requirements. In general, we are providing a
temporary exemption, subject to the conditions discussed below, to any
member of LIFFE A&M that receives or holds funds or securities for the
purpose of purchasing, selling, clearing, settling or holding Cleared
Index CDS positions for other persons. Solely with respect to Cleared
Index CDS, those members generally will be exempt from those provisions
of the Exchange Act and the underlying rules and regulations that do
not apply to security-based swap agreements.\45\
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\45\ This exemption will be available both to clearing members
and to non-clearing members of LIFFE A&M that hold funds and
securities on behalf of others in connection with transactions in
Cleared Index CDS.
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As with the exemption discussed above that is applicable to
LCH.Clearnet, LIFFE A&M and certain eligible contract participants, and
for the same reasons, this exemption for LIFFE A&M members that receive
or hold funds and securities does not extend to Exchange Act provisions
that explicitly apply in connection with security-based swap
agreements,\46\ or to related enforcement authority provisions.\47\ As
with the exemption discussed above, we also are not exempting those
members from sections 5, 6, 12(a) and (g), 13, 14, 15(b)(4), 15(b)(6),
15(d), 16 and 17A of the Exchange Act.\48\
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\46\ See note 32, supra.
\47\ See note 37, supra.
\48\ Nor are we exempting those members from provisions related
to government securities, as discussed above.
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This temporary exemption is subject to the member complying with
conditions that are important for protecting customer funds and
[[Page 147]]
securities. Particularly, the member must be in material compliance
with the rules of LIFFE A&M and, if it is a clearing member, with the
rules of LCH.Clearnet, and applicable laws and regulations, relating to
capital, liquidity, and segregation of customers' funds and securities
(and related books and records provisions) with respect to non-excluded
CDS.\49\ Also, to the extent that the member receives or holds funds or
securities of U.S. eligible contract participants for the purpose of
purchasing, selling, clearing, settling or holding non-excluded CDS
positions for those persons, this exemption is predicated on the member
satisfying the following three conditions: (i) The U.S. persons cannot
be natural persons; (ii) the member must segregate such funds and
securities of such U.S. persons from the member's own assets (i.e., the
member may not permit U.S. persons to ``opt out'' of applicable
segregation requirements for such funds and securities even if
regulations or laws would permit the person to ``opt out''); and (iii)
the member shall disclose to such U.S. persons that the member is not
regulated by the Commission and that U.S. broker-dealer segregation
requirements and protections under the Securities Investor Protection
Act will not apply to any funds or securities held by the member.
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\49\ A member would not be ``in material compliance'' if it
failed in any way to segregate customer funds and securities
consistent with these rules, laws and regulations. In that
circumstance, the member could not rely on this exemption.
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E. Temporary General Exemption for Certain Registered Broker-Dealers
The temporary exemptions addressed above--with regard (i) to
LCH.Clearnet, LIFFE A&M and certain eligible contract participants and
(ii) to LIFFE A&M members that receive or hold funds and securities of
others--are not available to persons that are registered as broker-
dealers with the Commission (other than those that are notice
registered pursuant to section 15(b)(11)).\50\ The Exchange Act and its
underlying rules and regulations require broker-dealers to comply with
a number of obligations that are important to protecting investors and
promoting market integrity. We are mindful of the need to avoid
creating disincentives to the prompt use of CCPs, and we recognize that
the factors discussed above suggest that the full panoply of Exchange
Act requirements should not immediately be applied to registered
broker-dealers that engage in transactions involving Cleared Index CDS.
At the same time, we also are sensitive to the critical importance of
certain broker-dealer requirements to promoting market integrity and
protecting customers (including those broker-dealer customers that are
not involved with CDS transactions).
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\50\ Exchange Act Section 15(b)(11) provides for notice
registration of certain persons that effect transactions in security
futures products. 15 U.S.C. 78o(b)(11).
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This calls for balancing the facilitation of the development and
prompt implementation of CCPs with the preservation of certain key
investor protections. Pursuant to section 36 of the Exchange Act, the
Commission finds that it is necessary or appropriate in the public
interest and is consistent with the protection of investors to exercise
its authority to grant an exemption until September 25, 2009 from
certain Exchange Act requirements. Consistent with the temporary
exemptions discussed above, and solely with respect to Cleared Index
CDS, we are exempting registered broker-dealers in general from
provisions of the Exchange Act and its underlying rules and regulations
that do not apply to security-based swap agreements. As above, we are
not excluding registered broker-dealers from Exchange Act provisions
that explicitly apply in connection with security-based swap agreements
or from related enforcement authority provisions.\51\ As above, and for
similar reasons, we are not exempting registered broker-dealers from:
Sections 5, 6, 12(a) and (g), 13, 14, 15(b)(4), 15(b)(6), 15(d), 16 and
17A of the Exchange Act.\52\
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\51\ See notes 32 and 37, supra. As noted above, broker-dealers
also would be subject to Section 15(c)(1) of the Exchange Act, which
prohibits brokers and dealers from using manipulative or deceptive
devices, because that provision explicitly applies in connection
with security-based swap agreements.
\52\ We also are not exempting those members from provisions
related to government securities, as discussed above.
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Further we are not exempting registered broker-dealers from the
following additional provisions under the Exchange Act: (1) Section
7(c),\53\ which addresses the unlawful extension of credit by broker-
dealers; (2) Section 15(c)(3),\54\ which addresses the use of unlawful
or manipulative devices by broker-dealers; (3) Section 17(a),\55\
regarding broker-dealer obligations to make, keep and furnish
information; (4) Section 17(b),\56\ regarding broker-dealer records
subject to examination; (5) Regulation T,\57\ a Federal Reserve Board
regulation regarding extension of credit by broker-dealers; (6)
Exchange Act Rule 15c3-1, regarding broker-dealer net capital; (7)
Exchange Act Rule 15c3-3, regarding broker-dealer reserves and custody
of securities; (8) Exchange Act Rules 17a-3 through 17a-5, regarding
records to be made and preserved by broker-dealers and reports to be
made by broker-dealers; and (9) Exchange Act Rule 17a-13, regarding
quarterly security counts to be made by certain exchange members and
broker-dealers. Registered broker-dealers should comply with these
provisions in connection with their activities involving non-excluded
CDS because these provisions are especially important to helping
protect customer funds and securities, ensure proper credit practices
and safeguard against fraud and abuse.\58\
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\53\ 15 U.S.C. 78g(c).
\54\ 15 U.S.C. 78o(c)(3).
\55\ 15 U.S.C. 78q(a).
\56\ 15 U.S.C. 78q(b).
\57\ 12 CFR 220.1 et seq.
\58\ Indeed, Congress directed the Commission to promulgate
broker-dealer financial responsibility rules, including rules
regarding custody, the use of customer securities and the use of
customers' deposits or credit balances, and regarding establishment
of minimum financial requirements.
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F. Solicitation of Comments
The Commission intends to monitor closely the development of the
CDS market and intends to determine to what extent, if any, additional
regulatory action may be necessary. For example, as circumstances
warrant, certain conditions could be added, altered, or eliminated.
Moreover, because these exemptions are temporary, the Commission will
in the future consider whether they should be extended or allowed to
expire. The Commission believes it would be prudent to solicit public
comment on its action today, and on what action it should take with
respect to the CDS market in the future. The Commission is soliciting
public comment on all aspects of these exemptions, including:
1. Whether the length of this temporary exemption (until September
25, 2009) is appropriate. If not, what should the appropriate duration
be?
2. Whether the conditions to these exemptions are appropriate. Why
or why not? Should other conditions apply? Are any of the present
conditions to the exemptions provided in this Order unnecessary? If so,
please specify and explain why such conditions are not needed.
3. Whether LCH.Clearnet ultimately should be required to register
as a clearing agency under the Exchange Act. Why or why not?
4. Whether LIFFE A&M members that receive or hold funds or
securities for the purpose of purchasing, selling, clearing, settling
or holding non-excluded CDS positions for other persons ultimately
should be required to
[[Page 148]]
register as broker-dealers. Why or why not?
Comments may be submitted by any of the following methods:
Electronic Comments
Use the Commission's Internet comment form (http://
www.sec.gov/rules/other.shtml); or
Send an e-mail to rule-comments@sec.gov. Please include
File Number S7-34-08 on the subject line; or
Use the Federal eRulemaking Portal (http://
www.regulations.gov/). Follow the instructions for submitting comments.
Paper Comments
Send paper comments in triplicate to Secretary, Securities
and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.
All submissions should refer to File Number S7-34-08. This file
number should be included on the subject line if e-mail is used. To
help us process and review your comments more efficiently, please use
only one method. We will post all comments on the Commission's Internet
Web site (http://www.sec.gov/rules/other.shtml). Comments are also
available for public inspection and copying in the Commission's Public
Reference Room, 100 F Street, NE., Washington, DC 20549, on official
business days between the hours of 10 a.m. and 3 p.m. All comments
received will be posted without change; we do not edit personal
identifying information from submissions. You should submit only
information that you wish to make available publicly.
III. Conclusion
It is hereby ordered, pursuant to section 36(a) of the Exchange
Act, that, until September 25, 2009:
(a) Exemption from section 17A of the Exchange Act.
LCH.Clearnet Ltd. (``LCH.Clearnet'') shall be exempt from section
17A of the Exchange Act solely to perform the functions of a clearing
agency for Cleared Index CDS (as defined in paragraph (e) of this
Order), subject to the following conditions:
(1) LCH.Clearnet shall make available on its Web site annual
audited financial statements.
(2) LCH.Clearnet shall keep and preserve at least one copy of all
documents, including all correspondence, memoranda, papers, books,
notices, accounts, and other such records as shall be made or received
by it relating to its Cleared Index CDS clearance and settlement
services. These records shall be kept for at least five years and for
the first two years shall be held in an easily accessible place.
(3) LCH.Clearnet shall supply such information and periodic reports
relating to its Cleared Index CDS clearance and settlement services as
may be reasonably requested by the Commission.
(4) Subject to coordination with the FSA and upon such terms and
conditions as may be agreed between the FSA and the Commission,
LCH.Clearnet shall provide access to the Commission to conduct on-site
inspections of all facilities (including automated systems and systems
environment), records, and personnel related to LCH.Clearnet's Cleared
Index CDS clearance and settlement services.
(5) LCH.Clearnet shall notify the Commission, on a monthly basis,
of any material disciplinary actions taken against any of its members
utilizing its Cleared Index CDS clearance and settlement services,
including the denial of services, fines, or penalties. LCH.Clearnet
shall notify the Commission promptly when it involuntarily terminates
the membership of an entity that is utilizing LCH.Clearnet's Cleared
Index CDS clearance and settlement services. Both notifications shall
describe the facts and circumstances that led to LCH.Clearnet's
disciplinary action.
(6) LCH.Clearnet shall provide the Commission with notice of all
changes to its Default Rules and Default Fund Rules, not less than one
day prior to effectiveness or implementation of such rule changes or,
in exigent circumstances, as promptly as reasonably practicable under
the circumstances. If LCH.Clearnet gives notice to, or seeks approval
from, the FSA regarding any other changes to its rules regarding its
Index CDS clearance and settlement services, LCH.Clearnet will also
provide notice to the Commission. All such rule changes will be posted
on LCH.Clearnet's Web site. Such notifications will not be deemed rule
filings that require Commission approval.
(7) LCH.Clearnet shall provide the Commission with reports with
respect to automated systems used in connection with Cleared Index CDS
clearance and settlement services, other than the TRS/CPS system,
prepared by independent audit personnel that are generated in
accordance with risk assessment of the areas set forth in the
Commission's Automation Review Policy Statements (``ARPs''). LIFFE A&M
shall provide the Commission with reports with respect to its TRS/CPS
system prepared by audit personnel from Risk and Audit Services, an
independent department of NYSE Euronext, that are generated in
accordance with risk assessment of the areas set forth in the ARPs.
LCH.Clearnet shall provide the Commission with annual audited financial
statements prepared by independent audit personnel.
(8) LCH.Clearnet shall provide notice to the Commission at the same
time it provides notice to the FSA in accordance with FSA REC 3.15 and
FSA REC 3.16 regarding the suspension of services or inability to
operate its facilities in connection with the clearance and settlement
of Cleared Index CDS.
(9) LCH.Clearnet, directly or indirectly, shall make available to
the public on terms that are fair and reasonable and not unreasonably
discriminatory: (a) All end-of-day settlement prices and any other
prices with respect to Cleared Index CDS that LCH.Clearnet or LIFFE A&M
may establish to calculate mark-to-market margin requirements for
LCH.Clearnet or LIFFE A&M Participants; and (b) any other pricing or
valuation information with respect to Cleared Index CDS as is published
or distributed by LCH.Clearnet or LIFFE A&M.
(b) Exemption for LCH.Clearnet, LIFFE A&M, and certain eligible
contract participants.
(1) Persons eligible. The exemption in paragraph (b)(2) is
available to:
(i) LCH.Clearnet;
(ii) LIFFE A& and
(iii) Any eligible contract participant (as defined in section
1a(12) of the Commodity Exchange Act as in effect on the date of this
Order (other than a person that is an eligible contract participant
under paragraph (C) of that section)), other than: (A) An eligible
contract participant that receives or holds funds or securities for the
purpose of purchasing, selling, clearing, settling, or holding Cleared
Index CDS positions for other persons; (B) an eligible contract
participant that is a self-regulatory organization, as that term is
defined in Section 3(a)(26) of the Exchange Act; or (C) a broker or
dealer registered under Section 15(b) of the Exchange Act (other than
paragraph (11) thereof).
(2) Scope of exemption.
(i) In general. Such persons generally shall, solely with respect
to Cleared Index CDS, be exempt from the provisions of the Exchange Act
and the rules and regulations thereunder that do not apply in
connection with security-based swap agreements. Accordingly, under this
exemption, those persons would remain subject to those Exchange Act
requirements that explicitly are
[[Page 149]]
applicable in connection with security-based swap agreements (i.e.,
paragraphs (2) through (5) of Section 9(a), Section 10(b), Section
15(c)(1), paragraphs (a) and (b) of Section 16, Section 20(d) and
Section 21A(a)(1) and the rules thereunder that explicitly are
applicable to security-based swap agreements). All provisions of the
Exchange Act related to the Commission's enforcement authority in
connection with violations or potential violations of such provisions
also remain applicable.
(ii) Exclusions from exemption. The exemption in paragraph
(b)(2)(i), however, does not extend to the following provisions under
the Exchange Act:
(A) Paragraphs (42), (43), (44), and (45) of Section 3(a);
(B) Section 5;
(C) Section 6;
(D) Section 12 and the rules and regulations thereunder;
(E) Section 13 and the rules and regulations thereunder;
(F) Section 14 and the rules and regulations thereunder;
(G) Paragraphs (4) and (6) of Section 15(b);
(H) Section 15(d) and the rules and regulations thereunder;
(I) Section 15C and the rules and regulations thereunder;
(J) Section 16 and the rules and regulations thereunder; and
(K) Section 17A (other than as provided in paragraph (a)).
(c) Exemption for certain LIFFE A&M members.
Any member of LIFFE A&M that receives or holds funds or securities
for the purpose of purchasing, selling, clearing, settling or holding
Cleared Index CDS positions for other persons shall be exempt from the
provisions of the Exchange Act and the rules and regulations thereunder
specified in paragraph (b)(2), solely with respect to Cleared Index
CDS, subject to the following conditions:
(1) The member shall be in material compliance with the rules of
LIFFE A&M and, if a clearing member, with the rules of LCH.Clearnet,
and applicable laws and regulations, relating to capital, liquidity,
and segregation of customers' funds and securities (and related books
and records provisions) with respect to Cleared Index CDS; and
(2) To the extent that the member receives or holds funds or
securities of U.S. persons for the purpose of purchasing, selling,
clearing, settling, or holding Cleared Index CDS positions:
(i) The U.S. persons shall not be natural persons;
(ii) The member shall segregate such funds and securities of such
U.S. persons from the member's own assets (i.e., the member may not
permit U.S. persons to ``opt out'' of applicable segregation
requirements for such funds and securities even if regulations or laws
would permit the person to ``opt out''); and
(iii) The member shall disclose to such U.S. persons that the
member is not regulated by the Commission and that U.S. broker-dealer
segregation requirements and protections under the Securities Investor
Protection Act will not apply to any funds or securities held by the
member.
(d) Exemption for certain registered broker-dealers.
A broker or dealer registered under section 15(b) of the Exchange
Act (other than paragraph (11) thereof) shall be exempt from the
provisions of the Exchange Act and the rules and regulations thereunder
specified in paragraph (b)(2), solely with respect to Cleared Index
CDS, except:
(1) Section 7(c);
(2) Section 15(c)(3);
(3) Section 17(a);
(4) Section 17(b);
(5) Regulation T, 12 CFR 200.1 et. seq.;
(6) Rule 15c3-1;
(7) Rule 15c3-3;
(8) Rule 17a-3;
(9) Rule 17a-4;
(10) Rule 17a-5; and
(11) Rule 17a-13.
(e) For purposes of this Order, ``Cleared Index CDS'' shall mean a
credit default swap that is submitted (or offered, purchased or sold on
terms providing for submission) to LCH.Clearnet, that is offered only
to, purchased only by, and sold only to eligible contract participants
(as defined in section 1a(12) of the Commodity Exchange Act as in
effect on the date of this Order (other than a person that is an
eligible contract participant under paragraph (C) of that section)),
and in which the reference index is an index in which 80 percent or
more of the index's weighting is comprised of the entities or
securities described below:
(1) An entity reporting under the Exchange Act, providing
Securities Act Rule 144A(d)(4) information, or about which financial
information is otherwise publicly available;
(2) A foreign private issuer whose securities are listed outside
the United States and that has its principal trading market outside the
United States;
(3) A foreign sovereign debt security;
(4) An asset-backed security, as defined in Regulation AB, issued
in a registered transaction with publicly available distribution
reports; or
(5) An asset-backed security issued or guaranteed by Fannie Mae,
Freddie Mac or Ginnie Mae.
By the Commission.
Florence E. Harmon,
Acting Secretary.
[FR Doc. E8-31193 Filed 12-31-08; 8:45 am]
BILLING CODE 8011-01-P