2012-18383
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Federal Register, Volume 77 Issue 146 (Monday, July 30, 2012)[Federal Register Volume 77, Number 146 (Monday, July 30, 2012)]
[Rules and Regulations]
[Pages 44441-44456]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-18383]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 50
RIN 3038-AD60
Swap Transaction Compliance and Implementation Schedule: Clearing
Requirement Under Section 2(h) of the CEA
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rule.
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SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)
is adopting regulations to establish a schedule to phase in compliance
with the clearing requirement under new section 2(h)(1)(A) of the
Commodity Exchange Act (CEA or Act), enacted under Title VII of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank
Act). The schedule will provide additional time for compliance with
this requirement. This additional time is intended to facilitate the
transition to the new regulatory regime established by the Dodd-Frank
Act in an orderly manner that does not unduly disrupt markets and
transactions.
DATES: The rules will become effective September 28, 2012.
FOR FURTHER INFORMATION CONTACT: Sarah E. Josephson, Deputy Director,
202-418-5684, sjosephson@cftc.gov; Brian O'Keefe, Associate Director,
202-418-5658. bokeefe@cftc.gov; or Peter Kals, Attorney-Advisor, 202-
418-5466, pkals@cftc.gov, Division of Clearing and Risk, 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 Notices of Proposed Rulemaking
A. Comment Period
B. Harmonization
C. Cross-Border and Affiliate Transactions
D. Comprehensive Implementation Schedule
E. Prerequisite Rules
F. Definitions
1. Active Fund
2. Third-Party Subaccount
3. Category 1 and Category 2 Entities
G. Compliance Schedule for the Clearing Requirement
4. Application to All Swap Types
5. Timing of Implementation Schedules
III. Cost-Benefit Considerations
IV. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
I. Background
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 (the Clearing
Requirement).\1\ Section 2(h)(2) charges the Commission with the
responsibility for determining whether a swap is required to be cleared
(a Clearing Requirement determination), through one of two avenues: (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.'' \2\ The
Commission is proposing its first Clearing Requirement determination
concurrently with its adoption of this compliance schedule rule. The
finalization of that proposal will trigger the compliance schedule
provided for under this adopting release.
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\1\ 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.
\2\ Under section 2(h)(2)(B)(ii), the Commission must consider
swaps listed for clearing by a DCO as of the date of enactment of
the Dodd-Frank Act.
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On September 20, 2011, the Commission published proposed Sec.
39.5(e) \3\ to phase in compliance of the Clearing Requirement upon the
Commission's issuance of a Clearing Requirement determination pursuant
to Sec. 39.5(b) or (c).\4\ That notice of proposed rulemaking (NPRM)
also included an implementation schedule for the requirement pursuant
to amended section 2(h)(8)(A), which requires a swap subject to the
Clearing
[[Page 44442]]
Requirement to be executed on a designated contract market (DCM) or
swap execution facility (SEF), unless no SEF or DCM makes the swap
available to trade (the Trade Execution Requirement). The Commission is
hereby adopting proposed Sec. 39.5(e), as newly designated Sec.
50.25, to establish a schedule for compliance only for the Clearing
Requirement. A separate rulemaking will promulgate the final
implementation schedule for the Trade Execution Requirement.\5\
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\3\ Commission regulations referred to herein are found at 17
CFR Ch. 1.
\4\ See 76 FR 58186 (Sept. 20, 2011).
\5\ The Commission will address the proposed compliance
schedules for trading documentation and margining under section 4s
of the CEA, 76 FR 58176 (Sept. 20, 2011), at the same time that it
finalizes the underlying documentation and margin rules.
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The compliance schedule for the Clearing Requirement is based on
the type of market participants entering into a swap subject to the
Clearing Requirement. The compliance schedule balances several goals.
First, the Commission believes that some market participants, such as
certain managed accounts, referred to under Sec. 50.25 as ``Third-
Party Subaccounts,'' may require additional time to bring their swaps
into compliance with the Clearing Requirement. Pursuant to Sec.
39.5(e) (finalized as Sec. 50.25), these market participants would be
afforded additional time to clear their swaps so that they will be able
to document new client clearing arrangements, connect to market
infrastructure such as DCOs, and prepare themselves and their customers
for the new regulatory requirements.
Another goal of the compliance schedule is to have adequate
representation of market participants involved at the outset of
implementing a new regime for requiring certain swaps to be cleared.
The Commission believes that having a cross-section of market
participants involved at the outset of formulating and designing the
rules and infrastructure under which the Clearing Requirement is
implemented will best meet the needs of all market participants.
The compliance schedule set forth in Sec. 50.25 defines three
categories of market participants: Category 1 Entities,\6\ Category 2
Entities,\7\ and all other market participants. As described in Sec.
50.25(b), a swap between two Category 1 Entities must comply with the
Clearing Requirement no later than 90 days after the publication of the
Clearing Requirement determination in the Federal Register.\8\ A swap
between a Category 2 Entity and a Category 1 Entity or another Category
2 Entity must comply within 180 days, and all other swaps must be
submitted for clearing no later than 270 days after the Clearing
Requirement determination is published in the Federal Register. To
clarify, the swap is subject to the latest compliance date for one of
the counterparties. In other words, if a Category 1 Entity enters into
a swap with a Category 2 Entity, both parties have 180 days to submit
the swap for clearing. However, the counterparty entitled to the later
compliance date may elect to clear the swap earlier, and in that event,
its counterparty is required to oblige.
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\6\ A Category 1 Entity is defined under Sec. 50.25(a) to
include a swap dealer; security-based swap dealer; major swap
participant; major security-based swap participant; or active fund
(also defined by Sec. 50.25(a)).
\7\ A Category 2 Entity is defined under Sec. 50.25(a) to
include a commodity pool; a private fund as defined in section
202(a) of the Investment Advisers Act of 1940 other than an active
fund; or a person 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, provided that, in each case, the entity is not a Third-Party
Subaccount. As proposed, this category contained employee benefit
plans under the Employee Retirement Income and Security Act of 1974,
but under the final rule, these plans will not be included in
Category 2. See below for further discussion.
\8\ As proposed, the rule required compliance within 90, 180, or
270 days after the effective date set by the Commission for a
Clearing Requirement determination. In order to clarify precisely
when the compliance period will commence, the Commission has
modified the rule to indicate that the compliance periods begin as
of the date of publication of final Clearing Requirement
determination rules in the Federal Register. From this point, market
participants have either 90, 180, or 270 days to come into
compliance.
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II. Comments on the Notices of Proposed Rulemaking
The Commission received 26 comments during the six-week public
comment period following publication of the NPRM. The Commission
considered each of these comments in formulating the final regulation,
Sec. 39.5(e) (finalized as Sec. 50.25).
A. Comment Period
The Commission published the NPRM in the Federal Register on
September 20, 2011, and the public comment period closed on November 4,
2011.
Financial Services Roundtable (FSR) comments that the public should
be able to comment on an implementation schedule for each swap subject
to the Clearing Requirement because the characteristics of one
particular swap may necessitate a very different schedule from another.
Pursuant to Sec. 39.5(b)(5) in the case of swap submissions and
Sec. 39.5(c)(2) in the case of Commission-initiated reviews, the
public will have an opportunity to comment on each of the Commission's
proposed Clearing Requirement determinations, and to comment on whether
the Commission should employ the compliance schedule for that
determination. In this manner, the public will have an opportunity to
comment on whether use of the compliance schedule is appropriate for a
given Clearing Requirement determination covering particular swaps.
B. Harmonization
The NPRM reflects consultation with the staff of the Securities and
Exchange Commission (SEC), prudential regulators, and international
regulatory authorities. With respect to the latter, the Commission is
mindful of the benefits of harmonizing its regulatory framework with
that of its counterparts in foreign countries. The Commission therefore
has monitored global advisory, legislative, and regulatory proposals,
and has consulted with foreign regulators in developing the final
regulations.
Vanguard, the Federal Home Loan Banks (FHLBs), and the Investment
Company Institute (ICI) each recommend that the Commission coordinate
the compliance schedule for the Clearing Requirement, as well as
implementation schedules concerning other Dodd-Frank Act requirements,
with the SEC, the prudential regulators, and international regulators
to avoid market disruption and avoid regulatory arbitrage. The American
Council of Life Insurers (ACLI) urges the Commission to coordinate with
the SEC and international regulators to achieve reductions in
compliance costs. A joint letter by the Futures Industry Association,
the International Swaps and Derivatives Association, and the Securities
Industry and Financial Markets Association (FIA/ISDA/SIFMA) urges the
Commission to coordinate implementation schedules with those introduced
by the SEC, the National Futures Association, self-regulatory
organizations, and market infrastructure providers.
In addition to the regulators referenced above, the Commission has
consulted with other U.S. financial regulators including: (1) The Board
of Governors of the Federal Reserve System; (2) the Office of the
Comptroller of the Currency; and (3) the Federal Deposit Insurance
Corporation. Staff from each of these agencies has had the opportunity
to provide oral and/or written comments to this adopting release, as
well as to the proposal.
[[Page 44443]]
C. Cross-Border and Affiliate Transactions
The NPRM did not differentiate between domestic and foreign swap
dealers (SDs), major swap participants (MSPs) or their counterparties,
and did not address affiliate transactions.
MarkitSERV and the Alternative Investment Management Association
(AIMA) each comment that the NPRM, as well as other proposals setting
forth implementation schedules for complying with Dodd-Frank Act
requirements, should clarify the status of cross-border transactions.
Better Markets states that trading relationships between an SD or MSP
and its affiliate or an international counterparty should not be
treated any differently than any other trading relationship. FIA/ISDA/
SIFMA comments that the Commission should publish guidance concerning
the extraterritorial application of Title VII prior to the commencement
of any implementation schedule.
The Commission separately has issued guidance on the cross-border
application of Title VII, including the Clearing Requirement.\9\ With
regard to inter-affiliate transactions, the Commission will be
considering this issue in an upcoming proposal.
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\9\ See Cross-Border Application of Certain Swaps Provisions of
the Commodity Exchange Act, 77 FR 41213 (July 12, 2012).
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D. Comprehensive Implementation Schedule
This adopting release pertains exclusively to the implementation of
the Clearing Requirement.
The Coalition for Derivatives End-Users (CDE), a joint letter by
the Edison Electric Institute, the National Rural Electric Cooperative
Association, and the Electric Power Supply Association (Joint
Associations); ICI; and MarkitSERV each argue that the Commission
should create an implementation plan addressing all of its final Dodd-
Frank rules and that the Clearing Requirement compliance schedule
should be part of that comprehensive schedule. CDE comments further
that a comprehensive schedule is important to end-users, particularly
in the areas of recordkeeping and reporting. The Joint Associations
also comment that a comprehensive schedule should detail compliance
dates, both specific and market-wide, for each registered entity and
that the Commission should request further comment on this subject as
more final rules are published.
Vanguard comments that in implementing Title VII, the Commission
should focus first on systemic risk issues and then issues relating to
transparency and trade practices. Implementation schedules should be
organized by type of participant and asset class. The schedules should
also allow for voluntary compliance.
ACLI argues that the Commission has not provided sufficient
guidance concerning new rules and effective dates in order for market
participants to conduct a prudent review of resource planning. ACLI
maintains that complying with only some rules creates a risk that
documents will have to be renegotiated when other rules are phased in.
In this adopting release, the Commission is focused on providing
additional time to market participants that may require more time to
comply with one of the key elements of the Dodd-Frank Act--the Clearing
Requirement. The compliance schedule that is the subject of this
adopting release was proposed at the same time as three other
compliance schedules--schedules for the Trade Execution Requirement and
two important requirements under section 4s of the CEA, documentation
and margin for uncleared swaps. Each of these proposed compliance
schedules responded to particular concerns from market participants,
especially those that are not required to register with the Commission.
The Commission also has published compliance dates for phasing in
implementation in nearly all of its final rules.\10\ In addition, the
Commission has twice published on its Web site general schedules
regarding the sequence and timing for its own consideration of final
rules.\11\
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\10\ See, e.g., Swap Data Recordkeeping and Reporting
Requirements, 77 FR 2136, 2195-2196 (Jan. 13, 2012); Business
Conduct Standards for Swap Dealers and Major Swap Participants with
Counterparties, 77 FR 9734, 9803 (Feb. 17, 2012); and Derivatives
Clearing Organization General Provisions and Core Principles, 76 FR
69334, 69408 (Nov. 8, 2011).
\11\ See http://www.cftc.gov/LawRegulation/DoddFrankAct/index.htm.
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In response to ACLI, as discussed further below, the Commission has
finalized all the documentation requirements necessary for compliance
with the Clearing Requirement.\12\ With regard to Vanguard's comment,
the Commission intends to implement the Clearing Requirement based on
specific classes of swaps, beginning with those asset classes that are
currently being cleared. The Commission believes that implementation of
the Clearing Requirement will serve to reduce systemic risk by
mitigating counterparty credit risk through the use of the marking-to-
market, margining, and risk mutualization provided by central
counterparties. The adoption of this compliance schedule is an
important step toward implementing that requirement. In addition, the
compliance schedule expressly allows for voluntary clearing prior to
the required compliance date, and market participants currently are
free to clear all swaps offered for clearing by DCOs on a voluntary
basis.
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\12\ See Customer Clearing Documentation, Timing of Acceptance
for Clearing, and Clearing Member Risk Management, 77 FR 21278
(April 9, 2012).
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E. Prerequisite Rules
The preamble to the NPRM stated that prior to requiring compliance
with any Clearing Requirement determination, the Commission must
publish the following final rules: Definitions of swap, SD, and MSP;
End-User Exception to Mandatory Clearing of Swaps; and Protection of
Cleared Swaps Customer Collateral.
The FHLBs comment that the rule text of an implementation rule
should state that the compliance schedule will not take effect until
the Commission has published applicable final rules. The FHLBs believe
that it is insufficient for the preamble to make this point.
The Joint Associations state that they cannot comment on the
adequacy of either the compliance schedule for the Clearing Requirement
or other implementation schedules until various final rules have been
published, including the definitions of swap, SD, and MSP. The Joint
Associations want to see how many of their comments to these rules have
been adopted because this will affect how long it will take their
members to comply with Title VII requirements. ICI comments that
parties cannot prepare for centralized clearing until the Commission
publishes the final rule concerning the definition of swap.
Citadel, FHLBs, and FIA/ISDA/SIFMA each recommend that the
Commission publish final rules related to clearing, such as customer
clearing documentation, timing of acceptance for clearing, and clearing
member risk management, prior to phasing in the Clearing Requirement.
FHLBs state that the prior publication of the Customer Clearing
Documentation, Timing of Acceptance for Clearing, and Clearing Member
Risk Management rules is important so that market participants can
fully appreciate risks and not have to renegotiate documentation.
The Committee on Investment of Employee Benefit Assets (CIEBA)
recommends that the Commission not impose the Clearing Requirement
until full physical segregation is available for margin of cleared
swaps. CIEBA also
[[Page 44444]]
comments that if the Commission publishes final segregation rules for
cleared swaps customer collateral at the same time that it phases in
the Clearing Requirement, then market participants' limited resources
would be overwhelmed. ICI comments that parties cannot prepare for
centralized clearing until the Commission publishes the final rule
concerning the Protection of Cleared Swaps Customer Collateral. ICI
also argues that the documentation requirements under section 4s(i) of
the CEA must be finalized before market participants are required to
comply with mandatory clearing.
CME recommends that the Commission finalize the DCO Conflicts of
Interest rules prior to requiring compliance with the Clearing
Requirement.
The American Bankers Association (ABA) believes that end-user banks
not be required to comply with the Clearing Requirement until 180 days
after the Commission determines whether end-user banks will be exempt
from the Clearing Requirement.
AIMA believes the Commission should publish final rules concerning
the Margin Requirement, as well as customer collateral protection
rules, prior to phasing in the Clearing Requirement.
The Commission has finalized all four of the rules identified in
the NPRM that it needed to be completed prior to requiring compliance
with the Clearing Requirement (namely, the End-User Exception to
Mandatory Clearing of Swaps; \13\ Protection of Cleared Swaps Customer
Collateral; \14\ the Further Definition of ``Swap Dealer,'' ``Security-
Based Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-Based
Swap Participant'' and ``Eligible Contract Participant''; \15\ and the
Further Definition of ``Swap,'' ``Security-Based Swap,'' and
``Security-Based Swap Agreement''; Mixed Swaps; Security-Based Swap
Agreement Recordkeeping).\16\ In addition, the Commission has finalized
rules related to Customer Clearing Documentation, Timing of Acceptance
for Clearing, and Clearing Member Risk Management.\17\ Finalizing these
rules addresses the FHLBs' concerns about having to revise
documentation more than once and provides certainty as to swap
processing requirements and expectations regarding risk management for
clearing members. On the other hand, in response to CME's comment, the
Commission does not believe it is necessary for final DCO Conflicts of
Interest rules to be in effect before requiring compliance with the
Clearing Requirement because these rules do not relate directly to the
clearing process, customer connectivity, clearinghouse risk management,
or other matters that would affect the implementation of the Clearing
Requirement.
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\13\ End-User Exception to the Clearing Requirement for Swaps,
adopted by the Commission on July 10, 2012, available at
www.cftc.gov.
\14\ Protection of Cleared Swaps Customer Contracts and
Collateral; Conforming Amendments to the Commodity Broker Bankruptcy
Provisions, 77 FR 6336 (Feb. 7, 2012).
\15\ Further Definition of ``Swap Dealer,'' ``Security-Based
Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-Based
Swap Participant'' and ``Eligible Contract Participant,'' 77 FR
30596 (May 23, 2012).
\16\ Further Definition of ``Swap,'' ``Security-Based Swap,''
and ``Security-Based Swap Agreement''; Mixed Swaps; Security-Based
Swap Agreement Recordkeeping, Section VII, adopted by the Commission
on July 10, 2012, available at www.cftc.gov.
\17\ Customer Clearing Documentation, Timing of Acceptance for
Clearing, and Clearing Member Risk Management, 77 FR 21278, (April.
9, 2012).
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In response to the FHLBs' request that the implementation rule text
include a provision that the rule is not effective until the
definitions of SD, MSP, and swap are finalized, the Commission
reiterates that all of the pre-requisite rules for the Clearing
Requirement have been adopted. With regard to CIEBA's comment about
full physical segregation, the Commission published its final rule
concerning Protection of Cleared Swaps Customer Collateral on February
7, 2012.\18\ In that rulemaking, the Commission indicated that it may
address issues related to collateral held in third-party safekeeping
accounts at some point in the future. However, given that a fully
operational segregation regime is required to be in place by November
8, 2012, the Commission does not believe that it is necessary for this
additional matter to be resolved prior to requiring compliance with the
Clearing Requirement.
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\18\ 77 FR 6336 (Feb. 7, 2012).
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In response to ICI's comment, the Commission clarifies that
finalization of the swap trading relationship documentation
requirements for SDs and MSPs under section 4s(i) of the CEA is not
required for compliance with the Clearing Requirement because the
documentation that is the subject of those rules relates primarily to
bilaterally-executed, uncleared swap transactions, and none of the
provisions in proposed Sec. 23.504 pertain directly to the Clearing
Requirement. Similarly, in response to AIMA's comment, final margin
rules for uncleared swaps are not required to be finalized prior to
requiring compliance with the Clearing Requirement as these are
related, but distinct, provisions under the Dodd-Frank Act.
F. Definitions
Under Sec. 39.5(e)(1), the Commission proposed definitions of the
terms ``Category 1 Entity,'' ``Category 2 Entity,'' ``Active Fund,''
and ``Third-Party Subaccount.'' The definitions set forth in proposed
Sec. 39.5(e) (now Sec. 50.25) would apply specifically to provisions
contained in part 39 (now part 50) and only those other rules that
explicitly cross-reference these definitions. The Commission is
adopting the definitions as proposed, with the exceptions discussed
below.
1. Active Fund
As proposed under Sec. 39.5(e)(1), ``any private fund as defined
in section 202(a) of the Investment Advisers Act of 1940, that is not a
third-party subaccount and that executes 20 or more swaps per month''
would be defined as an ``Active Fund'' and subject to the shortest
implementation schedule for compliance with the Clearing Requirement.
Numerous commenters, such as Better Markets, Chris Barnard, and
AIMA, agree with the Commission that using a market participant's
average monthly trading volume would be an appropriate proxy for
determining an entity's ability to comply with the Clearing Requirement
and would be better than a proxy based on notional volume or open
interest. AIMA agrees with the NPRM's proposal that Active Funds be
subject to the 90-day deadline.
Other commenters express concerns about solely relying on monthly
volumes as a proxy, especially without further defining the types of
swaps that would be included in the calculation. ACLI states that the
frequency of trading is not an appropriate indicator of a market
participant's experience or resources. The Association of Institutional
Investors (AII) states that the definition should specify the type of
swaps that count towards the threshold. CDE recommends a minimum
average monthly notional threshold to avoid capturing smaller end-
users. CDE also states that hedges and inter-affiliate swaps should be
excluded from this monthly average threshold. Managed Funds Association
(MFA) similarly requests clarification regarding those swaps that would
be included in the monthly swap calculation. Specifically, MFA requests
clarification as to whether novations, amendments, or partial tear-ups
would be included.
Commenters also focus on the average monthly threshold of 20 swaps
per
[[Page 44445]]
month for the preceding 12 months. FIA/ISDA/SIFMA proposes that the
threshold be an average of 200 trades per month. Vanguard proposes a
similar threshold. Both AII and MFA think the proposed threshold was
overly inclusive. MFA also highlights its belief that the proposed
definition would be difficult to administer, while unnecessarily
creating another tier of market participants for the purposes of the
implementation schedules.
In response to these comments, the Commission is increasing the
average monthly threshold to 200 swap trades per month for the
preceding 12 months. The Commission believes that monthly trading
volume is a suitable proxy for determining the appropriate
implementation schedule for a swap counterparty. By increasing the
threshold to 200, as recommended by FIA/ISDA/SIFMA, as well as
Vanguard, the risk of capturing smaller, less experienced swap
counterparties should be substantially diminished. The market
participants engaging in this level of swap activity should be able to
access the resources necessary to meet the 90-day implementation
schedule. In light of the number of transactions currently being
cleared on a voluntary basis by funds, the Commission does not believe
that an increase in the threshold of monthly swap trades will
negatively impact the goal of broad market participation in the
implementation of the Clearing Requirement. The Commission believes
this increase in the average monthly threshold also addresses CDE's
concerns about smaller market participants using swaps only to hedge
risk.
Further, by maintaining the concept of Active Fund, the Commission
believes that it will continue to ensure adequate representation across
the spectrum of market participants during the first phase of the
implementation of the Clearing Requirement. As a result of this
participation, processes and infrastructure will be established to
serve all segments of the market, not just SDs and MSPs, which are
included in the initial phase of the compliance schedule for the
Clearing Requirement.
In response to AII and MFA, the Commission clarifies that the
average monthly threshold of swaps applies to new swaps that the entity
enters into, and it does not apply to novations, amendments, or partial
tear-ups. In addition, the Commission clarifies that the 200 swap
threshold includes any swap, as defined under the CEA and Sec. 1.3,
and not just those swaps that would be subject to the relevant Clearing
Requirement determination and attendant compliance schedule.
2. Third-Party Subaccount
Under Sec. 39.5(e) (finalized herein as Sec. 50.25), Third-Party
Subaccounts are excluded from the definitions of Category 1 Entity and
Category 2 Entity, with the effect that such subaccounts will have 270
days, the longest period, in which to comply with the Clearing
Requirement. The NPRM defined Third-Party Subaccounts as ``a managed
account that requires the specific approval by the beneficial owner of
the account to execute documentation necessary for executing,
confirming, margining, or clearing swaps.'' The purpose of excluding
Third-Party Subaccounts from the defined categories was to ensure that
investment managers, who may be faced with bringing numerous accounts
into compliance, would have adequate time to do so.
Commenters question whether the definition was broad enough to
provide sufficient time for Third-Party Subaccounts to comply with the
Clearing Requirement. ICI noted that Third-Party Subaccounts, whether
subject to the specific execution authority of the beneficiary or not,
require managers to work closely with clients when entering into
trading agreements on the customer's behalf. As such, ICI feels that no
distinction should be made based on specific execution authority or
lack thereof. ICI comments that all Third-Party Accounts should be
uniformly classified and be given 270 days to comply. AII similarly
states that the definition is too narrow given the administrative work
required to manage an account, regardless of the execution authority.
Further, AII states that execution authority is not an industry
standard. The term, as proposed, therefore divides the universe of
managed accounts inappropriately. FIA/ISDA/SIFMA recommends that all
accounts managed by third parties, regardless of the execution
authority, should be given the most time to comply with the Clearing
Requirement.
Based on the comments received, the Commission is revising the
definition of Third-Party Subaccount to mean ``an account that is
managed by an investment manager that (1) is independent of and
unaffiliated with the account's beneficial owner or sponsor, and (2) is
responsible for the documentation necessary for the account's
beneficial owner to clear swaps.'' In modifying this definition, the
Commission is taking into account the point made by AII, FIA/ISDA/
SIFMA, and ICI that all investment managers will need additional time
to comply with a Clearing Requirement regardless of whether they have
explicit execution authority. However, the definition retains the nexus
between the investment manager and the documentation needed for
clearing swaps. In other words, if the investment manager has no
responsibility for documenting the clearing arrangements, then that
account would be required to clear its swaps subject to required
clearing within 180 days. For those accounts under the revised
definition, however, the Commission believes that the 270-day deadline
is more appropriate. Given the general notice investment managers have
had about the Dodd-Frank Act's Clearing Requirement since the enactment
of the statute in July, 2010, managers should have been able to
consider and plan the infrastructure and resources that are necessary
for all of their accounts, including Third-Party Subaccounts, to comply
with the Clearing Requirement. Thus, the 180- and 270-day deadlines
should provide adequate time to accommodate all managed accounts.
3. Category 1 and Category 2 Entities
The compliance schedule is organized according to the type of
market participant. To the extent that the Commission determines that a
compliance schedule is warranted in connection with a Clearing
Requirement determination (i.e. to comply with the Clearing
Requirement) a market participant defined as a Category 1 Entity will
have 90 days to comply, a Category 2 Entity will have 180 days, and all
others will have 270 days. According to the proposed definitions, a
Category 1 Entity includes an SD, a security-based swap dealer, an MSP,
a major security-based swap participant, or an Active Fund. A Category
2 Entity includes a commodity pool, a private fund, as defined by the
Investment Advisers Act of 1940, an ERISA plan, or a person
predominantly engaged in banking or other financial activities, as
defined by section 4(k) of the Bank Holding Company Act. A Category 2
Entity would not include an Active Fund or a Third-Party Subaccount.
Encana Marketing (USA) Inc. (Encana) and the Joint Associations
comment that non-financial end users should be expressly included in
the category with the longest timeframe. CDE argues that financial end-
users should be treated identically to non-financial end-users because
they do not pose systemic risk, and, therefore, should be given the
most time to comply with the Clearing Requirement, and not included in
Category 2. ICI seeks clarification that a market participant can
determine whether it is an MSP for purposes of the compliance schedule
for the Clearing
[[Page 44446]]
Requirement at the same time that it is required to review its status
as an MSP under other Commission and SEC rules.
CIEBA states that in-house ERISA funds should be in the group with
the longest compliance time, and not Category 2 Entities. CIEBA notes
that such funds do not pose systemic risk, and they typically rely upon
third-party managers for some portion of their fund management.
Splitting in-house and external accounts (i.e. those accounts meeting
definition of Third-Party Subaccount and permitted 270 days) of the
same ERISA plan will impact risk management given different
implementation schedules. CIEBA also states that this distinction will
cause pension funds to bear the costs of compliance because they will
need to comply prior to their third-party managers, who would be better
positioned to provide insight and service in this regard.
The Commission believes that the definitions of Category 1 Entity
should be finalized as proposed, but that the definition of Category 2
Entity should be modified by removing the reference to ERISA plans. In
response to Encana and the Joint Associations, non-financial end users
are adequately addressed in Sec. 39.5(e)(2)(iii) (now Sec.
50.25(b)(3))--unless the swap transactions are eligible to claim the
exception from the Clearing Requirement under section 2(h)(7) of the
CEA, the parties are given 270 days to comply with the Clearing
Requirement. With respect to issues raised by CDE regarding those
financial entities included in Category 2, based on numerous meetings
with participants in the swap market, the Commission believes that
financial entities are capable of complying with the Clearing
Requirement 90 days sooner than non-financial entities. Accordingly,
the compliance schedule has correctly situated Category 2 Entities
based upon their ability to meet the requirements of the underlying
regulations. Moreover, the distinction between financial and non-
financial entities has a statutory basis in section 2(h)(7) of the CEA.
The Commission recognizes the concerns raised by CIEBA regarding
splitting in-house and external accounts (i.e., those accounts meeting
the definition of Third-Party Subaccount and permitted 270 days) of the
same ERISA plan. In response to these concerns, the Commission is
removing the reference to employee benefit plans as defined in
paragraphs (3) and (32) of section 3 of the Employee Retirement Income
and Security Act of 1974. As a result, these ERISA plans will be
afforded the longest compliance period (270 days).
With regard to ICI's comment, a potential MSP can review its
obligation to register as an MSP at the same time it is reviewing where
it fits under the Clearing Requirement compliance schedule. In many
instances, MSPs will have to review their registration obligations
ahead of complying with the Clearing Requirement. However, if an entity
discovers that it has crossed the threshold established under the MSP
rules and is required to register during the 90-day period for Category
1 Entities, the Commission would consider allowing that entity to
petition for additional time to come into compliance with the Clearing
Requirement.\19\
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\19\ Similarly, the Commission would consider allowing entities
to petition for additional time to comply to the extent that they
discover that they have exceeded the de minimis threshold under the
swap dealer definition and are required to register during the 90-
day period for Category 1.
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G. Compliance Schedule for the Clearing Requirement
As mentioned above, Sec. 39.5(e)(2) provides that when the
Commission determines that an implementation schedule is appropriate in
connection with a given Clearing Requirement determination, market
participants within the definition of Category 1 will have 90 days to
comply, those within the definition of Category 2 will have 180 days,
and all others 270 days to implement the Clearing Requirement.
4. Application to All Swap Types
The Clearing Requirement compliance schedule is based upon the
nature of a given swap market participant, considering the
participant's risk profile, compliance burden, resources, and
expertise. The schedule does not contemplate different implementation
timeframes based upon the characteristics of particular swaps.
AIMA states that it does not believe further implementation
schedules are necessary based on the nature of the swap itself. Better
Markets, Citadel, and MFA comment that the compliance schedule should
apply, however, to all swaps within a ``group'' or ``class,'' as
defined by the Commission's Clearing Requirement determination.
Commenters such as CDE state that the Commission should publish an
implementation schedule specific to the characteristics of a particular
type of swap. CDE comments that because it is unlikely that end-users,
and other entities relied upon by end-users, will be able to meet the
requirements necessary to comply with clearing determinations for all
swap products at the same time, the Commission should phase in
implementation deadlines by swap type, according to the amount of
systemic risk posed by a particular swap.
MarkitSERV asserts that all Dodd-Frank Act requirements should be
phased-in by asset class, taking into account that different asset
classes have various levels of product standardization,
electronification, volumes, and types of counterparties. FIA/ISDA/SIFMA
also states that there should be a separate compliance schedule for
each asset class. FIA/ISDA/SIFMA also states that the Commission should
require credit default swaps and interest rate swaps to be cleared
first because those products are already being cleared. Commodity and
equity swaps, according to FIA/ISDA/SIFMA, should be required to be
cleared later because the marketplace is currently clearing fewer of
those products.
AIMA, CDE, ICI, and MarkitSERV state that the compliance schedule
should require the Commission to phase in each Clearing Requirement
determination as set forth in Sec. 39.5(e). FHLB and ICI comment that
the Commission should have the flexibility to extend clearing
implementation dates, but not shorten them. Citadel counters that the
compliance schedule should only be triggered when a determination is
issued for a new category of swaps.
This rule affords the Commission discretion to determine whether to
apply the compliance schedule in connection with a particular Clearing
Requirement determination. The Commission agrees that while the
schedule may be necessary in connection with some Clearing Requirement
determinations, especially those covering new classes of swaps, there
also may be determinations that are sufficiently similar to prior ones
that no compliance schedule is necessary. As such, the Commission will
determine whether or not to apply the Sec. 39.5(e) (now Sec. 50.25)
compliance schedule as part of its analysis in connection with each
Clearing Requirement determination.
Further, it remains the Commission's intention that those swaps
currently being cleared will be subject to the first Clearing
Requirement determinations. As a result, market participants initially
will comply with the Clearing Requirement using established platforms
and technology. This should limit a market participant's burden in
transitioning to clearing, as the use of existing infrastructure will
mean less time and expense necessary to develop independent programs,
technology, or platforms to clear such transactions.
[[Page 44447]]
5. Timing of Implementation Schedules
Citadel and Better Markets comment that they agree with the
proposed compliance schedule because market participants have had
notice of the movement towards clearing for one to three years, and the
clearing infrastructure already exists with regard to interest rate and
credit default swap products. Citadel and Tradeweb believe the proposed
schedule correctly staggers compliance according to category of market
participant. Citadel does not support extending the 270-day timeframe
because 270 days would grant sufficient time to market participants
without providing so much time as to engender a material, competitive
advantage or regulatory arbitrage. AIMA believes the proposed schedule
grants sufficient time to each category of market participant so that
they will be able to comply with the Clearing Requirement. Similarly,
the Joint Associations and The Westpac Group (Westpac) generally agree
with phasing in implementation with the Clearing Requirement according
to category of participant.
CIEBA states that because SDs, MSPs, and Active Funds will be the
first focus for all third party vendors, ERISA plans will be competing
for these resources only after the first implementation deadline has
passed, leaving only 90 days for a crowded market place to comply. With
limited resources, such a tight timeframe may lead to inadequate
agreements and/or increased risk exposure. Further, inadequate
agreements caused by lack of resources and rushed documentation will
create even further cost disparity for clearing between U.S. pension
plans and European ones that will not be required to clear swaps. As
such, CIEBA recommends that Category 2 Entities have more than 180 days
to comply. Likewise, FIA/ISDA/SIFMA note that the compliance schedule
should be lengthened and that buy-side entities, which may currently be
categorized as Category 1 Entities, should not be required to commence
clearing until the second quarter of 2013 at the earliest.
CDE argues that SDs and MSPs should comply before establishing
other end-user deadlines. CDE believes that if Category 1 Entities
cannot comply, then that will compound problems for Category 2 and 3
Entities. If an implementation schedule must be set, the CDE recommends
one year for end-users, in light of their limited internal resources
and the competition for external resources.
ACLI comments that complex issues will surface as market
participants try to combine the agency framework presently existing in
the futures markets (i.e., customer-futures commission merchant) with
the principal-to-principal framework that has existed in the over-the-
counter swaps market. In addition to executing the necessary
agreements, insurers will want to ensure they enter into agreements
with parties that serve them best. The combination of these factors
means that timeframes are too short and may result in smaller firms
accepting unfavorable agreements with fewer counterparties, possibly
concentrating risk. ACLI also highlights that insurers face an
additional burden in ensuring that compliance with the Clearing
Requirement is consistent with their state regulatory obligations.
Vanguard argues that additional time will be required to enter into
the new agreements necessitated by the move to a cleared derivatives
market. Vanguard highlights the large volume of such agreements and the
lack of market standards. ICI also finds the compliance schedule to be
too short in light of the needs to build and test new systems, adapt to
new regulatory requirements, and educate customers about these changes.
Mastercard Worldwide urges the Commission to give non-bank firms at
least 270 days to comply with the Clearing Requirement in respect of
their foreign currency hedging activities, even if the firm is covered
by section 4(k) of the Bank Holding Company Act. Westpac comments that
Category 1 Entities should have at least 180 days to comply with the
Clearing Requirement, noting that not all SDs, particularly smaller
ones, are currently DCO members. Regional Banks also request that small
SDs have at least 180 days to comply with the Clearing Requirement in
light of their relative lack of resources and experience, as compared
to larger SDs.
ACLI and FSR believe that the compliance schedule for the
respective entity categories should run consecutively rather than
concurrently. For example, the 180 days given to Category 2 Entities to
comply with the Clearing Requirement should begin only after the
expiration of the 90 days given to Category 1 Entities.
FSR does not believe there are sufficient resources, either
internally, at market participants, or externally, at third party
vendors, for the compliance schedule to run concurrently. If the
schedule were to run concurrently, then resources would be allocated
sequentially to the detriment of entities in the later implementation
groups. ACLI, Joint Associations, and the Coalition of Physical Energy
Companies (COPE) each express concern that the proposed compliance
schedule does not provide sufficient time for the software companies
and other vendors, upon which many smaller market participants rely, to
develop, test, and debug the software and other technology that will be
needed to ensure compliance with the Clearing Requirement. The Joint
Associations and COPE each suggests the Commission take affirmative
steps to solicit feedback from these software makers, particularly from
vendors that provide ``position and trade capture software,'' in order
to determine the amount of time market participants will need to
implement software necessary to comply with the Clearing Requirement.
The Commission is finalizing the compliance schedule for the
Clearing Requirement as proposed, except for the changes described
above for ERISA plans and Third-Party Subaccounts. The Commission
believes that the 90-, 180-, and 270-day implementation periods will
give market participants sufficient time to comply with the Clearing
Requirement. The Commission agrees with commenters such as Citadel and
Better Markets that the move to required clearing has been proceeding
for two years under the Dodd-Frank Act. This period should have allowed
parties to contemplate and design implementation plans and to identify
the resources needed to execute those plans. With the Commission's
decision to focus on those swaps that are currently cleared when
considering its initial Clearing Requirement determinations, market
participants will be working with clearing offerings that are seasoned
and established, justifying the timeframes provided for in the
compliance schedule. For these reasons, the Commission also declines to
change the concurrent nature of the compliance schedule.
Given the final rules for the definitions of swap dealers, and the
threshold used in terms of annual notional volume of swaps for such
swap dealers, the Commission does not believe it necessary to further
distinguish between larger swap dealers and smaller ones for purposes
of the implementation periods related to Clearing Requirements.\20\
Similarly, the Commission does not believe it practicable to make
distinctions between entities covered by section 4(k) of the Bank
Holding Company Act for the purpose of establishing a 180-day
[[Page 44448]]
implementation period as compared to a 270-day period.
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\20\ Further Definition of ``Swap Dealer,'' ``Security-Based
Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-Based
Swap Participant'' and ``Eligible Contract Participant,'' 77 FR
30596 (May 23, 2012).
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In response to CDE, the Commission also notes that certain swaps
would not be subject to the Clearing Requirement under section 2(h)(7)
of the CEA 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. If a market participant can claim an exemption, the
Clearing Requirement will not be applicable. In all other cases, the
implementation schedule for a Clearing Requirement would provide for up
to 180 or 270 days for such market participants.
In response to concerns that state regulatory obligations for
insurance companies might create obstacles to compliance with
implementation schedules as suggested by ACLI, the Commission observes
that those insurers would have a minimum of six months to work with
their state regulators to address the matter. If no solution could be
found within that time period, an affected insurer would be able to
petition the Commission for specific relief.
The Commission also has taken affirmative steps to ensure that
external providers of services to derivative market participants, such
as derivatives software providers, have been included in the dialogue
concerning implementation scheduling. At the May 2011 Implementation
Roundtable, these vendors voiced their opinions with respect to how an
implementation schedule could provide sufficient time for market
participants relying on ``off-the-shelf'' derivatives tracking software
to deploy such software such that they could comply with the Clearing
Requirement. The Commission will continue to develop its understanding
of technology issues and will solicit comment on this issue in
forthcoming proposed Clearing Requirement determinations.
III. Cost-Benefit Considerations
A. Pre-Dodd-Frank Context
Prior to the enactment of the Dodd-Frank Act,\21\ swaps were not
subject to required clearing. However, the limited market data that is
available suggests that over-the-counter (OTC) swap markets have been
migrating into clearing over the last few years in response to natural
market incentives as well as in anticipation of the Dodd-Frank Act's
clearing requirement. LCH.Clearnet data, for example, shows that the
outstanding volume of interest rate swaps cleared by LCH has grown
steadily since at least November 2007, as has the monthly registration
of new trade sides. Together, those facts indicate increased demand for
LCH clearing services related to interest rate swaps, a portion of
which preceded the Dodd-Frank Act.\22\ Data available through CME and
TriOptima indicate similar patterns of growing demand for interest rate
swap clearing services, though their publicly available data does not
provide a picture of demand prior to the passage of the Dodd-Frank Act
in July 2010.\23\ The trend toward increased clearing of swaps is
likely to continue as the Commission begins determining that certain
swaps are required to be cleared (Clearing Requirement determination).
In fact, the Tabb Group estimates that 60-80% of the swaps market
measured by notional amount will be cleared within five years of the
time that the Dodd-Frank Act is implemented.\24\
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\21\ Dodd-Frank Wall Street Reform and Consumer Protection Act,
Pub. L. No. 111-203, 124 Stat. 1376 (2010).
\22\ See http://www.lchclearnet.com/swaps/volumes/.
\23\ See http://www.cmegroup.com/trading/interest-rates/cleared-otc/index.html#data and http://www.trioptima.com/repository/historical-reports.html.
\24\ See Tabb Group, ``Technology and Financial Reform: Data,
Derivatives and Decision Making.''
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B. Dodd-Frank Act Section 723(a)(3)
In the wake of the financial crisis of 2008, Congress determined,
among other things, that swaps shall be cleared upon Commission
determination. Specifically, section 723(a)(3) of the Dodd-Frank Act
amended section 2(h)(1)(A) of the CEA to make it ``unlawful for any
person to engage in a swap unless that person submits such swap for
clearing to a derivatives clearing organization that is registered
under this Act or a derivatives clearing organization that is exempt
from registration under this Act if the swap is required to be
cleared.'' \25\ The statutory swap clearing requirement is designed to
standardize and reduce counterparty risk associated with swaps, and, in
turn, mitigate the potential systemic impact of such risks and reduce
the likelihood for swaps to cause or exacerbate instability in the
financial system.\26\ It reflects a fundamental premise of the Dodd-
Frank Act: The use of properly functioning central clearing can reduce
systemic risk.
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\25\ Section 2(h)(2) of the CEA charges the Commission with
responsibility for determining whether a swap is required to be
cleared (a Clearing Requirement determination).
\26\ 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.
This is because a clearinghouse benefits from netting with
counterparties and may compel counterparties to post additional
initial margin as collateral or force them to reduce their
outstanding positions when markets move against them. 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.
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C. Final Rule
The rule contained in this adopting release addresses one aspect of
required swap clearing under section 2(h) of the CEA: Implementation
scheduling following a Commission determination that a class of swaps
is required to be cleared. In other words, is immediate clearing
required or is implementation subject to some delay. On September 20,
2011, the Commission published a NPRM.\27\ The Commission proposed a
phased-in compliance schedule for swaps subject to Clearing Requirement
determinations that distinguishes among Category 1 Entities, Category 2
Entities, and all other entities (referred to for purposes of this
section III as ``Category 3 Entities''); those entities, respectively,
would have 90 days, 180 days, and 270 days, from the date of the
Clearing Requirement determination to comply with the Clearing
Requirement.\28\ The NPRM also requested comment with respect to the
costs and benefits of the proposed schedule, including, specifically,
data, assumptions, calculations, or other information to quantify its
costs and benefits, as well as alternatives to it. The Commission
received 26 comment letters in response, none of which provided
quantitative analysis regarding the costs or benefits of the proposed
compliance schedule.\29\
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\27\ See 76 FR 58186.
\28\ The schedule contained in the NPRM, like the one contained
in this adopting release, can be used at the option of the
Commission when issuing Clearing Requirement determinations.
\29\ ACLI provides an estimate for one member's information
technology and legal costs to comply with all Title VII
requirements. The estimate does not include any calculations and
does not separate out any costs they believe are directly
attributable to this rule.
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These comments touch upon a variety of issues, and include a number
that supported the Commission's approach as proposed. Others note
certain areas of concern about costs or benefits under
[[Page 44449]]
the rule as proposed, and either expressly propose alternatives or
raise issues that have caused the Commission to consider alternatives
to it. Among other things, commenters responded to the phased approach,
the entities included in Category 1, Category 2, and Category 3, the
amount of time that the schedule provides for entities in each
category, and the optionality of the schedule.
In the absence of this rule, market participants would be required
to comply with the Clearing Requirement immediately upon issuance of a
Clearing Requirement determination by the Commission. Pursuant to the
rule, however, when the Commission deems it appropriate, market
participants will be provided additional time as prescribed in the
rule's schedule to comply with Clearing Requirement determinations.
Category 1 entities, which include, among others, SDs, MSPs, and Active
Funds,\30\ will have 90 days from the date that a Clearing Requirement
determination is published in the Federal Register to comply. Category
2 Entities, which include commodity pools; private funds as defined by
the Investment Advisers Act of 1940, other than Active Funds; and
banks; but not Third-Party Subaccounts, will have 180 days to comply
with a new Clearing Requirement determination. Category 3 Entities are
those with Third-Party Subaccounts, as well as any other entity not
eligible to claim an exception under section 2(h)(7) of the CEA,
including ERISA plans, and they will have 270 days to comply with a
Clearing Requirement determination once it is published in the Federal
Register.
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\30\ An ``Active Fund'' is any private fund as defined in
section 202(a) of the Investment Advisers Act of 1940, that is not a
third-party subaccount and that executes 200 or more swaps per
month. The Commission does not intend to use the designation for any
purpose beyond this rule.
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The discussion that follows considers the costs and benefits of,
and alternatives to, the rule in this adopting release.
D. Statutory Mandate To Consider the Costs and Benefits of the
Commission's Action: CEA Section 15(a)
Section 15(a) of the CEA \31\ 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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\31\ 7 U.S.C. 19(a).
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In this rulemaking the Commission is not imposing clearing
requirements, but is exercising its discretion to stagger required
clearing implementation according to a particular schedule and subject
to the conditions specified in these rules. For purposes of this
analysis, the Commission considers the costs and benefits attributable
to its choices in this rulemaking--e.g., to stagger the implementation
of clearing requirements and to do so in the manner prescribed--against
those that would arise absent this Commission action--i.e., if
implementation of the Dodd-Frank Act's Clearing Requirement for those
swaps that the Commission separately determines to be subject to
clearing was not staggered according to the rule's schedule.
For reasons discussed in more detail below, the cost and benefits
associated with requiring clearing immediately upon the Clearing
Requirement determination for a swap class, or after some longer versus
shorter period of delay, are not susceptible to meaningful
quantification. As described above, these are not the costs and
benefits of implementing Clearing Requirement determinations, but
rather the costs and benefits of implementing them more slowly than
would be required in the absence of this rule. The Commission is not
aware of any analog to either an immediate or delayed requirement to
establish the capability to clear that would produce data that the
Commission could use to estimate the difference in costs and benefits
between the two. Moreover, any data that might be gleaned from the
experiences of an individual market participant establishing a
relationship with a futures commission merchant (FCM) during normal
market conditions would not reflect the influence of a number of
effects that are likely to result from the simultaneous implementation
of many market participants in a series of three waves. This
coordinated movement creates both costs and benefits that cannot be
quantified using data drawn from current market conditions.
Notwithstanding these limitations, the Commission identifies and
considers the costs and benefits of this rule in qualitative terms.
E. Costs and Benefits of This Rule
Determining whether to implement required clearing immediately upon
Commission determination or after some period of delay necessarily
involves cost and benefit tradeoffs. On the one hand, delaying required
clearing implementation also delays the benefits of clearing of certain
swaps, including reduced counterparty risk and increased stability in
the financial system. These benefits are substantial, and any delay in
their realization represents a cost to the market and the public. On
the other hand, requiring implementation immediately or within a very
compressed timeframe creates certain costs for industry participants.
Reducing these costs--enumerated below--by extending the implementation
schedule represents a benefit.
First, to meet pressing timelines, some firms will need to contract
additional staff or hire vendors to handle some necessary tasks or
projects. Additional staff hired or vendors contracted in order to meet
more pressing timelines represent an additional cost for market
participants. Moreover, a tightly compressed timeframe raises the
likelihood that more firms will be competing to procure services at the
same time; this could put firms that conduct fewer swaps at a
competitive disadvantage in obtaining those services, making it more
difficult for them to meet required timelines.\32\ In addition, it
could enable service providers to command a pricing premium when
compared to times of ``normal'' or lesser competition for similar
services. That premium represents an additional cost when compared to a
longer implementation timeline.
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\32\ See letter from CIEBA.
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Second, if entities are not able to comply with Clearing
Requirement determinations by the required date, they may avoid
transacting swaps that are required to be cleared until such a time as
they are able to comply. In this event, liquidity that otherwise would
result from those foregone swaps would be reduced, making the swaps
more expensive for market participants taking the other side. Moreover,
firms compelled to withdraw from the market pending implementation of
required clearing measures will either leave certain positions un-
hedged--potentially increasing the firm's own default risk, and
therefore the risk to their counterparties and the public.
Alternatively, firms compelled to withdraw from the market for a period
of time could attempt to approximate
[[Page 44450]]
their foregone swap hedges using other, likely more expensive,
instruments. And to the extent the withdrawing entities are market
makers, they will forsake the revenue potential that otherwise would
exist for the period of their market absence.
Third, firms may have to implement technological solutions, sign
contracts, and establish new operational procedures before industry
standards have emerged that address new problems effectively. To the
extent that this occurs, it is likely to create costs. Firms may have
to incur additional costs later to modify their technology platforms
and operational procedures further, and to renegotiate contracts--
direct costs that a more protracted implementation schedule would have
avoided.\33\ Moreover, costs created by the adoption of standards that
fail to address certain problems, or attributable to undesired
competitive dynamics resulting from such standards, may be
longstanding.
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\33\ See e.g., ACLI letter.
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Given the factors identified above, this rulemaking aims to strike
the optimal cost-balance tradeoff amidst the competing concerns.
Shorter timelines will tend to push greater numbers of swaps into
clearing more quickly, reducing the counterparty and systemic exposures
in ways that were intended by the Dodd-Frank Act--a benefit. But,
shorter timelines also increase the costs as discussed above. Longer
timelines have the opposite effect, decreasing the costs described
above, but increasing the amount of time during which counterparty and
systemic exposures that would otherwise be mitigated by required
clearing persist.
In theory, the optimal tradeoff between the two is the point at
which the marginal cost of an additional one-day delay in
implementation equals the marginal benefits of the same incremental
delay. But it is not possible, at this stage, to determine the marginal
costs or benefits of each day of delay. To estimate such values
reliably requires data that does not yet exist--i.e., data gleaned in
the midst of the transition process. Therefore, neither the Commission
nor commenters are able to assert conclusively that any particular
schedule is more or less advantageous relative to all others that the
Commission might have considered. Thus, in the face of these practical
limitations, the Commission has relied on qualitative considerations,
informed by commenters, to guide the necessary tradeoff determinations.
The Commission, informed by its consideration of comments and
alternatives, discussed in the sections above and below, believes that
the approach contained in this adopting release is reasonable and
appropriate in light of the tradeoffs described above. The schedule
established here gives the Commission the opportunity to provide
additional time to entities in ways that generally align with: (1)
Their resources and expertise, and therefore their ability to comply
more quickly; and (2) their level of activity in the swap markets, and
therefore the possible impact of their swap activities on the stability
of the financial system. Entities with the most expertise in, and
systems capable to transact, swaps also are likely to be those whose
swaps represent a significant portion of all transactions in the swap
markets. They are more likely to be able to comply quickly, and the
benefits of requiring them to do so are greater than would be the case
for less active entities. On the other hand, entities with less system
capability and in-house swap expertise may need more time to comply
with Clearing Requirement determinations, but it is also likely that
their activities represent a smaller proportion of the overall market,
and therefore are less likely to create or exacerbate shocks to the
financial system.\34\ The Commission believes that Category 1
encompasses entities likely possessing more advanced systems and
expertise, and whose swap activities constitute a significant portion
of overall swap market transactions, while Categories 2 and 3 encompass
those likely to have relatively less developed infrastructure and whose
swap activities constitute a less significant proportion of the market.
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\34\ OCC data demonstrates that among insured U.S. commercial
banks, ``the five banks with the most derivatives activity hold 96
percent of all derivatives, while the largest 25 banks account for
nearly 100% of all contracts.'' The report is limited to insured
U.S. commercial banks, and also includes derivatives that are not
swaps. However, swap contracts are included among the derivatives in
the report, constituting approximately 63 percent of the total
notional value of all derivatives. These statistics suggest that a
relatively small number of banks hold the majority of swap positions
that could create or contribute to distress in the financial system.
Data is insufficient, however, to generalize the conclusions to non-
banking institutions. See ``OCC's Quarterly Report on Bank Trading
and Derivatives Activities: Fourth Quarter 2011'' at 11. http://www.occ.treas.gov/topics/capital-markets/financial-markets/trading/derivatives/dq411.pdf.
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The Commission notes that clearing of certain swaps, and in
particular interest rate and credit default swaps, has been occurring
for some time; by implication, this indicates that the requisite
technology, contractual terms, and operational standards among
clearinghouses, clearing members, and some clients exist.\35\ The
Commission also notes that it is likely that the degree to which firms
have already implemented such technology, contracts, and operational
patterns varies considerably, particularly among potential customers of
FCMs, and that the legal, technological, and operational changes that
are necessary for less frequent swap market participants may be more
substantial. However, given the availability of FCMs (through which
market participants may clear swaps) as well as the technology and
contractual standards necessary to clear swaps, the Commission believes
that a number of firms can reduce the costs associated with meeting
compliance timelines by forming necessary FCM relationships and
contracts, and implementing the necessary technology, before the
Commission begins issuing Clearing Requirement determinations.\36\
Nonetheless, the Commission considered these concerns, among other
issues, when determining to grant Category 2 and Category 3 Entities an
extended 180 and 270 days, respectively, rather than requiring them to
comply at the same time as Category 1 Entities.
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\35\ For example, CME and ICE both began clearing credit default
swaps (CDS) in 2009. As of March 2012, ICE had cleared more than $11
trillion notional in CDS, and had 26 clearing members in CDS. CME
began clearing interest rate swaps in 2010 and currently has open
interest of $210 billion notional and 15 clearing members in
interest rate swaps. Moreover, by March of 2010, 26 of the largest
market makers were clearing interest rate derivatives. At that time,
ISDA asserted that ``In excess of 90% of new dealer-to-dealer volume
in Eligible Trades of Interest Rate Derivative products, and total
dealer-to-dealer volume in Eligible Trades of Credit Derivative
products is now cleared through CCPs.'' See http://www.newyorkfed.org/newsevents/news/markets/2010/100301_letter.pdf.
\36\ The Commission understands approximately 2.5 months is
sufficient for some market participants to enter into a clearing
arrangement with an FCM for purposes of clearing swaps. See External
Meeting with Blackrock, 4/2/2012. http://www.cftc.gov/LawRegulation/DoddFrankAct/ExternalMeetings/dfmeeting_040212_1463.
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Moreover, use of the schedule contained in this release is at the
Commission's discretion; in situations where the Commission determines
that the benefits of delayed implementation do not justify the
additional costs of such a delay, the Commission may require immediate
compliance with Clearing Requirement determinations. Therefore, in
situations where the Commission determines that a swap must be cleared,
and further believes that clearing the swap will not necessitate
significant changes to market participants' technology, legal
arrangements, or operational patterns, the Commission is likely to
determine that immediate compliance is
[[Page 44451]]
warranted. In these cases, the benefits of required clearing will be
realized immediately.
The discretionary nature of the schedule contained in the adopting
release, however, may create some uncertainty for market participants,
and consequently may create some costs as market participants take
steps to protect themselves from the impact of such uncertainty. For
example, if a market participant believes that the Commission may issue
a determination that a particular swap must be cleared, but is not
certain whether clearing will be required immediately or according to
the schedule contained in this release, that entity may begin
developing the capacity to clear such a swap prior to a determination
by the Commission in order to reduce the risk that it would be forced
to stop trading the swap while it comes into compliance. If that
participant's belief that the Commission will require the swap to be
cleared is incorrect, the participant will have unnecessarily borne the
cost of preparing for such a possibility. The Commission considered
this cost, but believes that the notice and comment approach that the
Commission will use when issuing Clearing Requirement determinations
mitigates it. Each proposed Clearing Requirement determination will be
published in the Federal Register and will be available for public
comment for a period of at least 30 days; the Commission anticipates
clarifying in each proposed Clearing Requirement determination whether
compliance will be required immediately upon the final determination or
according to the schedule contained in this rule. This approach will
provide market participants with notice regarding the expected timeline
for compliance, which will mitigate costs associated with uncertainty
about compliance timelines.
F. Consideration of Comments and the Costs and Benefits of Alternatives
Commenters propose or otherwise highlight points that suggest
alternatives with respect to various aspects of the NPRM.\37\ These
aspects, as categorized for discussion below, are: (1) Phased approach;
(2) entity categorization; (3) schedule increments; and (4) schedule
discretion.
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\37\ Other commenters raise issues beyond the scope of this
rule--i.e., implementation timing of required clearing--that,
consequently, are beyond, and not appropriate for Commission
consideration in, this rulemaking. Specifically, some commenters
request that the Commission establish a comprehensive schedule for
implementation of all rules and requirements pursuant to the Dodd-
Frank Act. (See Barnard, MFA.) Others request a comprehensive
schedule of clearing requirement determinations (See, e.g., CDEU),
an issue already addressed by the Dodd-Frank Act and the rule
regarding the Process for Review of Swaps for Mandatory Clearing.
See section 2(h)(2)(B)(ii) of the CEA; 76 FR 44473.
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Phased Approach
A number of commenters express support generally for additional
time to comply with Clearing Requirement determinations and for a
phased approach that distinguishes between various types of
entities.\38\ Commenters note that the additional clarity provided by
the schedule will encourage industry participants to commit resources
to overcoming structural and economic barriers that prevent widespread
clearing.\39\ Some commenters, however, maintain that the phased
approach used to implement clearing requirement determinations should
not be applied to exchange trade requirements.\40\ The AIMA believes
that effective required clearing will enable execution of swaps on SEFs
and DCMs and that linking the trading and clearing compliance schedules
could delay the transition into central clearing. In response to these
comments, the Commission has decided to limit the scope of this rule to
Clearing Requirement determinations, to retain the phased approach to
required clearing, and to address implementation of trade execution in
a separate rule.
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\38\ See letters from Encana, Vanguard, ICI, FSR, MFA, FIA/ISDA/
SIFMA, AII, MarkitSERV, and AIMA.
\39\ See MFA letter.
\40\ See letters from AIMA and MFA.
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Some commenters note that a phased approach could complicate
implementation for large investor advisor firms that may have multiple
funds in separate categories. Specifically, AII expresses concern that
it may be difficult for institutional advisers to execute block trades
for multiple clients during the implementation period because they will
have to consider whether each client must comply with the Clearing
Requirement. Nevertheless, AII recommends retaining the phased approach
with at least 18 months for entities to comply. The Commission
recognizes that such complexities exist and could introduce certain
costs for large investor adviser firms. However, it is not clear that
delaying the implementation period would alleviate this concern,
although prolonging the implementation period likely would exacerbate
the issue by extending the time during which such concerns are
relevant. Moreover, the Commission notes that the benefits of required
clearing are substantial and that further delays create costs borne by
market participants and the public. In these circumstances, the
Commission considers the latter consideration most compelling and,
accordingly, has determined not to delay implementation beyond what is
set forth in the schedule in the adopting release.
Finally, relative to the alternative of immediate implementation
following a Commission Clearing Requirement determination--the result
in the absence of this rule--the Commission believes that the phased
approach reflected in this adopting release is superior. The immediate
implementation alternative would not mitigate the costs, enumerated
above, to market participants and the public. In contrast, while
delaying implementation also entails a different set of costs, also
discussed above, the Commission has carefully tailored the rule's
phased approach to contain and dampen them.
Entity Categorization
Commenters generally agree that some buy-side representation in
Category 1 is valuable in order to ensure that buy-side interests are
represented as technological and legal standards begin to form,\41\
though commenters express varied views about whether Active Funds
should play that role, and what entities should be included in that
group. Some commenters state their belief that transaction volume is an
appropriate proxy for a firm's level of expertise in conducting swaps
and, therefore, is a useful criterion for identifying the buy-side
entities that are best equipped to make the transition as part of
Category 1.\42\ Some express concern, however, that as defined in the
NPRM, the term ``Active Fund'' could be over-inclusive and recommend
raising the threshold number of swaps or excluding swaps that are
hedges or have a notional value below $10 million.\43\
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\41\ See AIMA letter.
\42\ See letters from Barnard and AIMA.
\43\ See letters from AII and CDEU.
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The Commission's intent in selecting Active Funds to participate in
Category 1 is to identify those market participants that are larger and
have significant experience in the swap markets. To ensure that the
rule effectively selects for these entities, and in response to
commenters, the Commission has raised the threshold number of swaps
from a trailing average of 20 swaps per month over the previous twelve
months, to a trailing average of 200 swaps per month over the previous
twelve months. The Commission, however, believes that
[[Page 44452]]
further criteria restricting the swaps that are included against that
count would create incremental administrative and operational costs
that do not justify the resulting benefit, and therefore has not placed
further restrictions on the types of swaps that count against the
threshold. However, per commenters' request for clarification, the
Commission is clarifying that the average monthly threshold of swaps
applies to new swaps that the entity enters into, and it does not apply
to novations, amendments, or partial tear-ups.
ACLI maintains that there is diversity among buy-side participants
in their use of swaps, and expresses concern that Active Funds may not
be able to effectively represent diverse buy-side interests, and those
of insurance companies in particular. ACLI, however, does not describe
or quantify specific costs that it believes would result from this
circumstance.\44\ The Commission acknowledges that buy-side market
participants are diverse and may have specific needs reflecting
concerns or interests unique to individual industries or even
individual entities. However, the Commission also notes that the fact
of certain differences among firms does not exclude the possibility of
remaining similarities. Further, it believes that realizing the
benefits provided by some buy-side representation in Category 1 is
preferable to a scenario in which these benefits are foregone by
removing Active Funds from Category 1 for required clearing
implementation. Moreover, in the absence of any input as to how
dissimilarities may specifically impact the compliance implementation
process, the apparent solution to ACLI's concern would be to include
insurance companies in Category 1 to assure representation of their
interests earlier in the implementation process. While any Category 2
Entity or any other entity may elect to comply sooner than the schedule
requires (and are encouraged by the Commission to do so), the
Commission finds no basis to believe that the benefits of requiring all
insurance companies to participate in Category 1 warrant the additional
costs that such an approach would create for them.
---------------------------------------------------------------------------
\44\ See ACLI letter.
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MFA expresses concern that questions related to the term ``Active
Fund'' could create an additional burden for fund operations and
Commission staff, and proposed that all private funds be placed in
Category 2 in order to eliminate this burden.\45\ MFA, however, does
not specify what these questions are, nor the cost to funds associated
with addressing them. In the absence of more specific information about
the nature of the potential questions and their associated costs, the
Commission has insufficient basis to conclude that costs to clarify
Active Fund issues--either for fund operators or itself--are likely to
be significant. Accordingly, it believes that the benefits of early-
stage, buy-side representation warrant retention of the Category 1
Active-Fund component.
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\45\ See MFA letter.
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Some commenters express concern about the definition of the term
Third-Party Subaccounts. They maintain that the Third-Party Subaccount
category should include any managed accounts, regardless of the level
of authority granted in the advisory agreement to enter into trading
agreements, on grounds that the operational and contractual challenges
for moving swaps related to these accounts into clearing will be much
the same regardless of whether the accounts' investment management
agreements have ``specific approval'' requirements.\46\ Similarly, some
commenters advocate in favor of including all ERISA plans in Category 3
given their expectations that (1) Category 2 entities will bear more
``start-up'' costs related to required clearing than those in Category
3, and (2) putting some ERISA plans in Category 2 and others in
Category 3 will make overlays more difficult and costly.\47\
Conversely, AIMA specifically states that making all funds Category 3
Entities is not a suitable approach because it would eliminate buy-side
representation during the early stages of implementation, and,
consequently, urges the Commission not to adopt this approach.\48\
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\46\ See e.g., letters from ICI and AII.
\47\ See CIEBA letter.
\48\ See AIMA letter.
---------------------------------------------------------------------------
Furthermore, AIMA and FSR asserted that some Third-Party
Subaccounts may be ``private funds'' as defined in the Investment
Advisers Act of 1940 that would otherwise qualify as Active Funds; AIMA
expresses concern that allowing such funds 270 days to comply with
clearing requirements could provide them a competitive advantage
relative to other Active Funds that are not Third-Party Subaccounts for
the period of time between the compliance dates for Categories 1 and 3.
To level this playing field, AIMA proposes placing all Active Funds in
Category 1, regardless of whether the funds also meet the criteria for
a Third-Party Subaccount. In support of this proposition, AIMA opines
that large institutional managers of large numbers of Third-Party
Subaccounts are likely to have sufficient resources to make the
transition within the 90 days required of Category 1 Entities.
The Commission recognizes that some managed funds that do not
require third party sign-off for clearing agreements, nevertheless, may
choose to involve their clients in negotiation of relevant documents,
and that some costs may result from placing some managed funds and
ERISA plans in Category 2 and others in Category 3. After considering
the alternatives posed by commenters, the Commission has modified the
definition of Third-Party Subaccount to include managed accounts for
which the investment manager is responsible for clearing documentation,
regardless of whether the investment manager has explicit execution
authority. In addition, the Commission has determined not to include
ERISA plans in Category 2. The Commission has made these changes
despite the fact that commenters do not attempt to quantify the costs
associated with these provisions, nor do they recognize that such costs
must be considered against the costs of further delaying required
clearing implementation by a number of managed funds and ERISA plans. A
fundamental premise of the Dodd-Frank Act is that central clearing
minimizes risk to counterparties and the financial system as a whole;
therefore, further delaying implementation of one or more groups of
market participants creates costs associated with prolonged exposure of
the financial system to a greater number of un-cleared swaps.
Nonetheless, the Commission believes it appropriate to permit certain
market participants an additional 90 days to come into compliance with
the clearing requirement based on the comments received.
Schedule Increments
Some commenters express the opinion that 90, 180, and 270 days is
sufficient for Category 1, 2, and 3 Entities, respectively, to comply
with Clearing Requirement determinations.\49\ Several other commenters,
however, expressed concern that the additional time provided in this
rule may not be sufficient for some entities to comply.\50\ In that
vein, commenters state that the
[[Page 44453]]
schedules may not be sufficient for contract negotiations to be
completed,\51\ that pressing timelines could undermine the ability of
some entities to negotiate effectively,\52\ and that rapid compliance
may lead to the creation of industry standards that are not fair or
prudent.\53\ Some commenters also express concern that entities in
Categories 2 and 3 may not be able to find vendors able to provide
sufficient support to meet the deadlines effectively.\54\
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\49\ See e.g., letters from Better Markets and MFA. MFA
qualifies its support, stating that certain additional rules should
be adopted prior to the schedule becoming effective, and also
requests changes to the entities included in each category, but
still generally supports the 90-, 180-, and 270-day implementation
schedule.
\50\ See e.g., letters from AII, CIEBA, ICI, FIA/ISDA/SIFMA, and
FSR.
\51\ See e.g., ACLI letter.
\52\ See letters from ACLI, AII, and CIEBA.
\53\ See letters from ACLI and ICI.
\54\ See letters from ACLI, CDEU, CIEBA, COPE, and EEI. COPE and
EEI specifically requested that the Commission determine whether
``off the shelf'' software is available to meet the needs of
entities that do not yet have necessary technology. Further
conversation clarified that both were concerned about technologies
that extend beyond those directly related to Clearing Requirements
established by the Act.
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It is impossible to quantify the costs and benefits of one
particular schedule phase-in increment relative to another--e.g., 90
days to comply versus 110--and the permutations of such an exercise
would be endless, even if possible. Similarly, as discussed above,
whether the schedule included in this adopting release mitigates costs
to a greater degree than other increments the Commission might have
adopted as an alternative to immediate implementation of required
clearing (the result in the absence of this rule) is also a question
that cannot be resolved with precision. In light of these limitations,
however, the Commission has drawn upon its historical experience
monitoring clearing, as well as its consideration of the qualitative
feedback offered by market participants, in determining to incorporate
the 90-, 180-, and 270-day benchmark features within the schedule
adopted in this release. In so doing, the Commission believes that it
has selected a reasonable schedule that is appropriate and well-suited
to mitigate compliance pressures for market participants, and fairly
accommodate the various competing interests involved.
As is stated above, the Commission recognizes that extending the
compliance schedule for one or more entities will reduce compliance
costs for market participants in a number of different ways, but will
also increase the amount of time during which market participants and
the public do not benefit from the protections provided by mandatory
clearing.
Scheduling Discretion
Some commenters support the Commission's retention of discretion to
override the schedule in this release to require immediate clearing
when it believes that the benefits do not justify the associated
costs.\55\ These commenters note that over time market participants
will gain experience to enable swifter compliance with later Clearing
Requirement determinations, and maintain that, over time, the
compliance schedules will not be warranted for Clearing Requirement
determinations for new types, groups, or categories of swaps within an
asset class that are already subject to a prior Clearing
Requirement.\56\ Other commenters, however, support application of the
schedule to all Clearing Requirement determinations in order to reduce
uncertainty and facilitate orderly transitions to compliance.\57\
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\55\ See letters from Barnard and MFA.
\56\ See letters from Barnard and MFA.
\57\ See letters from FHLB and ICI.
---------------------------------------------------------------------------
As discussed below, the Commission believes that the challenges of
compliance are likely to vary depending on whether previous Clearing
Requirement determinations have been made for other swaps in the same
class, how long previous Clearing Requirement determinations for swaps
in that class have been in place, the similarities between the swaps
addressed by a determination and swaps subject to previous
determinations, and a number of other factors. Therefore, the
Commission believes that the tradeoff between the costs and benefits of
more rapid compliance will vary as well. Where Clearing Requirement
determinations pertain to swaps that have important points of
similarity with swaps already required to be cleared, it is likely that
the costs associated with more rapid compliance will be significantly
less, and therefore the balance will shift in favor of a shorter
compliance deadline than would be allowed under the schedule contained
in this rule. Also, by including the applicable compliance schedule
within its public notifications of a proposed Clearing Requirement
determination, the Commission will mitigate uncertainty costs that
could result.
G. Consideration of Section 15(a) Factors
(1) Protection of Market Participants and the Public
Category 1 includes, among others, SDs as well as MSPs and Active
Funds. If SDs were not able to comply immediately with a Clearing
Requirement determination, and were not given additional time to
comply, they could choose to withdraw from the market as they work
toward compliance. Such withdrawal would create lost opportunities for
them as they fail to capture business that they would have otherwise
conducted during that period. If MSPs or Active Funds choose to
withdraw from the market while they work to come into compliance, it
could become more costly for them to either effectively create or hedge
certain exposures, which could also prompt them to leave certain risks
un-hedged that they would otherwise mitigate through the use of swaps.
By giving Category 1 Entities an additional 90 days to comply with
Clearing Requirement determinations, the schedule contained in this
adopting release reduces the likelihood of these entities withdrawing
from the swap markets while they work toward compliance; this, in turn,
reduces the probability that these Category 1 Entities will bear the
potential costs of un-hedged risk exposure.
Moreover, the Commission believes that SDs are an important source
of liquidity for swap market participants. If SDs withdraw from the
market while they work toward compliance, it could negatively impact
swap liquidity, increasing costs for market participants forced to
hedge certain risks through less efficient means (or not at all) for a
period of time. The costs of not hedging certain risks would be borne
not only by the firms that choose such an approach, but by the public
in the form of increased counterparty risk throughout the financial
system. Again, by providing additional time for SDs to comply with
Clearing Requirement determinations, the schedule in the adopting
release facilitates an orderly transition and reduces the likelihood
that the costs associated with SDs withdrawing from the market for a
period of time would materialize. The Commission considered this
benefit in light of the cost associated with delayed compliance among
Category 1 Entities and believes that an appropriate balance has been
struck.
The Commission also anticipates that the staggered compliance
schedule contained in this rule will, to some extent, enable Category 2
and 3 Entities to adopt technological, legal, and operational standards
developed by Category 1 Entities. To the extent that this occurs, it
will reduce the number of entities that are working in parallel to
develop solutions to the same problems by allowing Category 2 and 3
Entities some time to wait for Category 1 Entities and vendors to
develop viable solutions to technological, legal, and operational
challenges. Some of those solutions are likely to be proprietary, while
others
[[Page 44454]]
will likely relate to non-proprietary standards that must be shared in
order to be effective. Both types of advances can reduce costs for
Category 2 and 3 Entities. In the case of non-proprietary standards,
Category 2 and 3 entities will benefit from the opportunity to adopt
them without having to invest in their development. In the case of
proprietary solutions, some of them are likely to be owned by vendors
marketing them to multiple market participants, thereby spreading the
development costs among their clients. Each of these consequences is
likely to reduce overall development costs for the industry, and
development costs for Category 2 and 3 Entities, in particular.\58\
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\58\ As indicated in the NPRM, to the extent that Category 1
Entities bear a larger portion of the industry wide ``start-up'' or
development costs, the Commission believes this is appropriate since
they are likely to be among the most active participants in these
markets.
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In weighing the tradeoff between shorter versus longer compliance
timelines, the Commission believes Category 2 Entities are likely to be
less well-resourced and less active in these markets. Therefore the
dynamic between more or less rapid compliance tips in favor of
providing additional time for these entities. As stated above, by
providing 180 days, it becomes more likely that Category 2 Entities
will be able to draw from lessons learned and standards established by
Category 1 Entities. It also increases the likelihood that where
Category 2 Entities will depend on vendors for help developing and
implementing necessary technology, legal agreements, and operational
patterns, they will not have to compete as directly with Category 1
Entities for those resources.
The Commission believes that entities with Third-Party Subaccounts
have an additional challenge of transitioning hundreds (or in some
cases, thousands) of subaccounts into compliance with Clearing
Requirement determinations, which may require formalizing new
agreements with each of their customers, and educating their customers
about how the Clearing Requirement will impact costs and operations. In
the Commission's view, this additional challenge justifies additional
time for compliance beyond what is allowed for Category 2 Entities.\59\
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\59\ As stated in the NPRM, Category 2 and 3 Entities that want
to come into compliance sooner than the 180- and 270-day deadlines
are allowed, and encouraged, to do so.
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As described above, the Commission recognizes that delaying
implementation creates some additional costs in the form of delayed
protections that central clearing of swaps would otherwise provide--
standardized and reduced counterparty risk for swaps that are required
to be cleared, and associated reductions in the overall level of
systemic risk. However, the Commission believes that this approach
appropriately balances the tradeoff by requiring firms that are likely
to be the most active in these markets to comply first and allowing
additional time for those whose positions are less likely to pose
significant risk to the financial system as a whole.
(2) Efficiency, Competitiveness, and Financial Integrity of Futures
Markets
As suggested above, Category 1 Entities are likely to establish
technological, legal, and operational standards that will influence or
be adopted by Category 2 and 3 Entities. This will (1) serve to reduce
development costs that Category 2 and 3 Entities otherwise would face,
(2) focus responsibility for shaping new platforms and standards on
those firms that possess greater cleared swap experience, and (3)
support the likelihood that new platforms and standards will reflect
current best practices. Each of these elements promotes the efficiency
and integrity of the markets. Moreover, by reducing the number of
entities necessarily working in parallel to develop such standards, and
allowing Category 2 and 3 Entities to learn from and build on the
solutions developed by Category 1 Entities, the phased schedule
contained in this adopting release holds the potential to foster
compatibility and interoperability, which reduces the cost and
complexity of interconnectedness.
The phased schedule as adopted also will promote an implementation
plan in which similar entities (i.e., those that usually compete with
one another) generally have the same compliance timelines, thereby
protecting competition during the transition period. One commenter
states, ``A phased approach to compliance will allow the Commission to
balance its goal of obtaining adequate representation at each stage of
the regulatory roll-out with the goal of avoiding anti-competitive
concerns.'' \60\
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\60\ See ICI letter.
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That said, however, the Commission also has to balance the goal of
maintaining a level playing field with other priorities. In particular,
the Commission deems it important to ensure representation of both buy
and sell side firms in the earliest stages of compliance. Moreover, the
Commission believes that, in certain circumstances, variance in
compliance burden among competitors warrants placing them in different
implementation categories. Some competitive consequences may result
from the need to balance these various priorities. The Commission
believes, however, that it has built sufficient flexibility into the
phased schedule to mitigate such consequences; specifically, the
schedule preserves entities' ability to respond to competitive
incentives to move into clearing voluntarily prior to the date required
by the compliance schedule. The Commission believes that providing
flexibility to allow expression of competitive market incentives is
preferable to the alternative of imposing a more compressed compliance
schedule for purposes of maintaining a level playing field. As
discussed above, a shorter schedule could also increase the likelihood
that industry standards established during the implementation period
could create and perpetuate undesirable competitive dynamics. In sum,
the Commission anticipates that any temporary impacts on competitive
dynamics created by the phased implementation approach it is adopting
are likely to be less costly than an approach that increases the
likelihood of sustained competitive disparities, and therefore has
chosen not to shorten the compliance schedule as a remedy to address
the risk of competitive advantages that may be conferred on market
participants that have later compliance dates.
As discussed above, for the 90-, 180-, and 270-day periods that
Clearing Requirements are delayed, the markets are exposed to the risks
that the Clearing Requirements would mitigate. However, the Commission
has considered this cost for the limited delay durations prescribed in
light of the benefits--reduced implementation costs, greater degrees of
compatibility and interoperability, and lessened risk of market
disturbances from the withdrawal of entities that are not able to
comply immediately--and considers the tradeoff reflected in the rules
warranted.
(3) Price Discovery
Neither the Commission nor commenters have identified consequences
for price discovery that are expected to result from this rule.
(4) Sound Risk Management Practices
An orderly transition for swaps subject to a Clearing Requirement
determination promotes sounder risk management practices, particularly
during the transition period. As mentioned above, in the absence of the
[[Page 44455]]
schedule provided in this rule, some entities might exit swap markets
while taking steps to come into compliance. This result could reduce
liquidity, particularly if the withdrawing entities are SDs. Reduced
liquidity likely would increase the cost of using swaps to manage risk
by increasing spreads, and make it more difficult for entities to enter
and exit positions in a timely manner. It could also prompt some
entities to maintain exposures that they would otherwise use swaps to
mitigate, which would elevate the risk profile of those entities and
the level of risk that their counterparties bear as a consequence. By
providing a timetable for orderly transition, this rule encourages
continued participation in the swap markets and use of swaps for risk
mitigation purposes during the transition.
Clearing Requirement delay does prolong existing costs associated
with not having counterparty credit risk monitored and managed
effectively by a DCO. More prompt implementation of Clearing
Requirements would have the benefit of preventing losses from
accumulating over time through the settlement of variation margin
between a DCO's clearing members each day. The settlement of variation
margin each day (and in some cases, multiple times per day) reduces the
size of exposures a clearinghouse faces should one of its
counterparties default, and the mechanisms that a clearinghouse has to
ensure its own solvency reduce the probability that it would default on
obligations to clearing members. Moreover, more prompt implementation
also promotes the use of initial margin as a performance bond against
potential future losses such that if a party fails to meet its
obligation to pay variation margin, resulting in a default, the DCO may
use the defaulting party's initial margin to cover most or all of any
loss based on the need to replace the open position. The Commission
believes, however, that (1) it has tailored the rule to limit the
degree, and thereby these costs attributable to, clearing
implementation delay and (2) the benefits afforded by the schedule's
operation when the Commission elects to use it warrant the costs of the
tailored implementation delay.
(5) Other Public Interest Considerations
The schedule allows market participants to comply with the
requirements of the Dodd-Frank Act and provides a sound basis for
achieving the overarching Dodd-Frank Act goals of reducing counterparty
risk and promoting stability of the financial system.
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.\61\ As
stated in the NPRM, the subject of this rulemaking provides a
compliance schedule for a new statutory requirement, section 2(h)(1)(A)
of the CEA, and does not itself impose significant new regulatory
requirements.\62\ Accordingly, the Chairman, on behalf of the
Commission, certified pursuant to 5 U.S.C. 605(b) that the proposed
rule would not have a significant economic impact on a substantial
number of small entities. The Commission then invited public comment on
this determination.
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\61\ 5 U.S.C. 601 et seq.
\62\ 76 FR 58192-58193 (Sept. 20, 2011).
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FSR comments that the NPRM failed to evaluate the impact of the
proposed compliance schedule for the Clearing Requirement on a
substantial number of small entities. FSR argued that small entities
may have to bear a more significant burden than larger entities in
establishing clearing arrangements with FCMs because larger entities
will be able to enter into such arrangements first.
In response, the Commission points out that the compliance schedule
for the Clearing Requirement will affect only eligible contract
participants (ECPs). Pursuant to section 2(e) of the CEA, only ECPs may
enter into swaps, unless the swap is listed on a DCM. The Clearing
Requirement will affect only ECPs because all persons that are not ECPs
are required to execute their swaps on a DCM, and all contracts
executed on a DCM must be cleared by a DCO, as required by statute and
regulation; not by operation of any Clearing Requirement.
The Commission has previously determined that ECPs are not small
entities for purposes of the RFA.\63\ However, in their comment letter,
the Joint Associations assert that certain members of the National
Rural Electric Cooperative Association (NRECA) may both be ECPs under
the CEA and small businesses under the RFA. 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.'' \64\
Although the Joint Associations do not provide details on whether or
how the NRECA members that have been determined to be small entities
use the types of swaps that will be subject to the Clearing
Requirement, the Joint Associations do state that NRECA members
``engage in swaps to hedge commercial risk.'' \65\ 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 the
Clearing Requirement.
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\63\ See 66 FR 20740, 20743 (Apr. 25, 2001).
\64\ Small Business Administration, Table of Small Business Size
Standards, Nov. 5, 2010.
\65\ See Joint Associations' comment letter, at 2. The letter
also suggests that NRECA 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
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 Commission, hereby certifies pursuant to 5 U.S.C. 605(b) that the
rule herein creating the compliance schedule for the Clearing
Requirement will not have a significant economic impact on a
substantial number of small entities.
B. Paperwork Reduction Act
The Paperwork Reduction Act (PRA) \66\ imposes certain requirements
on federal agencies (including the Commission) in connection with
conducting or sponsoring any collection of information as defined by
the PRA. As stated in the NPRM, this rulemaking will not require a new
collection of information from any persons or entities.\67\
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\66\ 44 U.S.C. 3507(d).
\67\ 76 FR 58186, 58193 (Sept. 20, 2011).
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V. List of Subjects
List of Subjects in 17 CFR Part 50
Business and industry, Clearing, Swaps.
In consideration of the foregoing, and pursuant to the authority in
the Commodity Exchange Act, as amended, and in particular section 2(h)
of the Act, the Commission hereby adopts an amendment to Chapter I of
Title 17 of the Code of Federal Regulation by adding a new part 50 as
follows:
[[Page 44456]]
PART 50--CLEARING REQUIREMENT
Authority: 7 U.S.C. 2 as amended by Pub. L. 111-203, 124 Stat.
1376.
Sec. 50.25 Clearing requirement compliance schedule.
(a) Definitions. For the purposes of this paragraph:
Active Fund means any private fund as defined in section 202(a) of
the Investment Advisers Act of 1940, that is not a third-party
subaccount and that executes 200 or more swaps per month based on a
monthly average over the 12 months preceding the Commission issuing a
clearing requirement determination under section 2(h)(2) of the Act.
Category 1 Entity means a swap dealer, a security-based swap
dealer; a major swap participant; a major security-based swap
participant; or an active fund.
Category 2 Entity means a commodity pool; a private fund as defined
in section 202(a) of the Investment Advisers Act of 1940 other than an
active fund; or a person 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, provided that, in each case, the entity is not a third-party
subaccount.
Third-party Subaccount means an account that is managed by an
investment manager that is independent of and unaffiliated with the
account's beneficial owner or sponsor, and is responsible for the
documentation necessary for the account's beneficial owner to clear
swaps.
(b) Upon issuing a clearing requirement determination under section
2(h)(2) of the Act, the Commission may determine, based on the group,
category, type, or class of swaps subject to such determination, that
the following schedule for compliance with the requirements of section
2(h)(1)(A) of the Act shall apply:
(1) A swap between a Category 1 Entity and another Category 1
Entity, or any other entity that desires to clear the transaction, must
comply with the requirements of section 2(h)(1)(A) of the Act no later
than ninety (90) days from the date of publication of such clearing
requirement determination in the Federal Register.
(2) A swap between a Category 2 Entity and a Category 1 Entity,
another Category 2 Entity, or any other entity that desires to clear
the transaction, must comply with the requirements of section
2(h)(1)(A) of the Act no later than one hundred and eighty (180) days
from the date of publication of such clearing requirement determination
in the Federal Register.
(3) All other swaps for which neither of the parties to the swap is
eligible to claim the exception from the clearing requirement set forth
in section 2(h)(7) of the Act and Sec. 39.6, must comply with the
requirements of section 2(h)(1)(A) of the Act no later than two hundred
and seventy (270) days from the date of publication of such clearing
requirement determination in the Federal Register.
(c) Nothing in this rule shall be construed to prohibit any person
from voluntarily complying with the requirements of section 2(h)(1)(A)
of the Act sooner than the implementation schedule provided under
paragraph (b).
Issued in Washington, DC, on July 24, 2012, by the Commission.
Sauntia Warfield,
Assistant Secretary of the Commission.
Appendices to Swap Transaction Compliance and Implementation
Schedule: Clearing Requirement under Section 2(h) of the CEA--
Commission Voting Summary and Statements of Commissioners
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendix 1--Commission Voting Summary
On this matter, Chairman Gensler and Commissioners Sommers,
Chilton, O'Malia and Wetjen voted in the affirmative; no
Commissioner voted in the negative.
Appendix 1--Statement of Chairman Gary Gensler
I support the final rule to establish a schedule to phase in
compliance with the clearing requirement provisions in the Dodd-
Frank Wall Street Reform and Consumer Protection Act.
The rule gives market participants an adequate amount of time to
comply and helps facilitate an orderly transition to the new
clearing requirements for the swaps market. The rule provides
greater clarity to market participants regarding the timeframe for
bringing their swaps into compliance with the clearing requirement.
[FR Doc. 2012-18383 Filed 7-27-12; 8:45 am]
BILLING CODE 6351-01-P
Last Updated: July 30, 2012
See Also:
