2011-27536
-
Federal Register, Volume 76 Issue 216 (Tuesday, November 8, 2011)[Federal Register Volume 76, Number 216 (Tuesday, November 8, 2011)]
[Rules and Regulations]
[Pages 69334-69480]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-27536]
[[Page 69333]]
Vol. 76
Tuesday,
No. 216
November 8, 2011
Part II
Commodity Futures Trading Commission
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17 CFR Parts 1, 21, 39 et al.
Derivatives Clearing Organization General Provisions and Core
Principles; Final Rule
Federal Register / Vol. 76 , No. 216 / Tuesday, November 8, 2011 /
Rules and Regulations
[[Page 69334]]
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 1, 21, 39, and 140
RIN 3038-AC98
Derivatives Clearing Organization General Provisions and Core
Principles
AGENCY: Commodity Futures Trading Commission.
ACTION: Final rule.
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SUMMARY: The Commodity Futures Trading Commission (Commission) is
adopting final regulations to implement certain provisions of Title VII
and Title VIII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank Act) governing derivatives clearing
organization (DCO) activities. More specifically, the regulations
establish the regulatory standards for compliance with DCO Core
Principles A (Compliance), B (Financial Resources), C (Participant and
Product Eligibility), D (Risk Management), E (Settlement Procedures), F
(Treatment of Funds), G (Default Rules and Procedures), H (Rule
Enforcement), I (System Safeguards), J (Reporting), K (Recordkeeping),
L (Public Information), M (Information Sharing), N (Antitrust
Considerations), and R (Legal Risk) set forth in Section 5b of the
Commodity Exchange Act (CEA). The Commission also is updating and
adding related definitions; adopting implementing rules for DCO chief
compliance officers (CCOs); revising procedures for DCO applications
including the required use of a new Form DCO; adopting procedural rules
applicable to the transfer of a DCO registration; and adding
requirements for approval of DCO rules establishing a portfolio
margining program for customer accounts carried by a futures commission
merchant (FCM) that is also registered as a securities broker-dealer
(FCM/BD). In addition, the Commission is adopting certain technical
amendments to parts 21 and 39, and is adopting certain delegation
provisions under part 140.
DATES: The rules will become effective January 9, 2012. DCOs must
comply with Sec. Sec. 39.11; 39.12; 39.13 (except for 39.13(g)(8)(i));
and 39.14 by May 7, 2012; with Sec. Sec. 39.10(c); 39.13(g)(8)(i);
39.18; 39.19; and 39.20 by November 8, 2012; and all other provisions
of these rules by January 9, 2012.
FOR FURTHER INFORMATION CONTACT: Phyllis P. Dietz, Deputy Director,
(202) 418-5449, pdietz@cftc.gov; John C. Lawton, Deputy Director, (202)
418-5480, jlawton@cftc.gov; Robert B. Wasserman, Chief Counsel, (202)
418-5092, rwasserman@cftc.gov; Eileen A. Donovan, Associate Director,
(202) 418-5096, edonovan@cftc.gov; Jonathan Lave, Special Counsel,
(202) 418-5983, jlave@cftc.gov, Division of Clearing and Risk; and
Jacob Preiserowicz, Special Counsel, (202) 418-5432,
jpreiserowicz@cftc.gov, Division of Swap Dealer and Intermediary
Oversight, Commodity Futures Trading Commission, Three Lafayette
Centre, 1155 21st Street NW., Washington, DC 20581; and Julie A. Mohr,
Deputy Director, (312) 596-0568, jmohr@cftc.gov; and Anne C. Polaski,
Special Counsel, (312) 596-0575, apolaski@cftc.gov, Division of
Clearing and Risk, Commodity Futures Trading Commission, 525 West
Monroe Street, Chicago, Illinois 60661.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background
A. Title VII of the Dodd-Frank Act
B. Title VIII of the Dodd-Frank Act
C. Regulatory Framework for DCOs
II. Part 1 Amendments--Definitions
III. Part 39 Amendments--General Provisions
A. Scope
B. Definitions
C. Procedures for Registration
D. Procedures for Implementing DCO Rules and Clearing New
Products
E. Reorganization of Part 39
F. Technical Amendments
IV. Part 39 Amendments--Core Principles
A. Compliance with Core Principles
B. Financial Resources
C. Participant and Product Eligibility
D. Risk Management
E. Settlement Procedures
F. Treatment of Funds
G. Default Rules and Procedures
H. Rule Enforcement
I. System Safeguards
J. Reporting
K. Recordkeeping
L. Public Information
M. Information Sharing
N. Antitrust Considerations
O. Legal Risk Considerations
P. Special Enforcement Authority for SIDCOs
V. Part 140 Amendments--Delegations of Authority
VI. Effective Dates
VII. Section 4(c)
VIII. Consideration of Costs and Benefits
IX. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
I. Background
A. Title VII of the Dodd-Frank Act
On July 21, 2010, President Obama signed the Dodd-Frank Act.\1\
Title VII of the Dodd-Frank Act \2\ amended the CEA \3\ to establish a
comprehensive statutory framework to reduce risk, increase
transparency, and promote market integrity within the financial system
by, among other things: (1) Providing for the registration and
comprehensive regulation of swap dealers and major swap participants;
(2) imposing clearing and trade execution requirements on standardized
derivative products; (3) creating rigorous recordkeeping and real-time
reporting regimes; and (4) enhancing the Commission's rulemaking and
enforcement authorities with respect to all registered entities and
intermediaries subject to the Commission's oversight.
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\1\ See Dodd-Frank Wall Street Reform and Consumer Protection
Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the
Dodd-Frank Act may be accessed at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.
\2\ Pursuant to Section 701 of the Dodd-Frank Act, Title VII may
be cited as the ``Wall Street Transparency and Accountability Act of
2010.''
\3\ 7 U.S.C. 1 et seq.
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Section 725(c) of the Dodd-Frank Act amended Section 5b(c)(2) of
the CEA, which sets forth core principles with which a DCO must comply
in order to be registered and to maintain registration as a DCO.
The core principles were added to the CEA by the Commodity Futures
Modernization Act of 2000 (CFMA).\4\ The Commission did not adopt
implementing rules and regulations, but instead promulgated guidance
for DCOs on compliance with the core principles.\5\ Under Section
5b(c)(2) of the CEA, as amended by the Dodd-Frank Act, Congress
expressly confirmed that the Commission may adopt implementing rules
and regulations pursuant to its rulemaking authority under Section
8a(5) of the CEA.\6\
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\4\ See Commodity Futures Modernization Act of 2000, Public Law
106-554, 114 Stat. 2763 (2000).
\5\ See 66 FR 45604 (Aug. 29, 2001) (adopting 17 CFR part 39,
app. A).
\6\ Section 8a(5) of the CEA authorizes the Commission to
promulgate such regulations ``as, in the judgment of the Commission,
are reasonably necessary to effectuate any of the provisions or to
accomplish any of the purposes of [the CEA].'' 7 U.S.C. 12a(5).
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In light of Congress's explicit affirmation of the Commission's
authority to adopt regulations to implement the core principles, the
Commission has chosen to adopt regulations (which have the force of
law) rather than guidance (which does not have the force of law). By
issuing regulations, the Commission expects to increase legal certainty
for DCOs, clearing members, and market participants, and prevent DCOs
from lowering risk management standards for competitive reasons and
taking on more risk than is prudent. The imposition of legally
enforceable standards provides
[[Page 69335]]
assurance to market participants and the public that DCOs are meeting
minimum risk management standards. This can serve to increase market
confidence which, in turn, can increase open interest and free up
resources that market participants might otherwise hold in order to
compensate for weaker DCO risk management practices. Regulatory
standards also can reduce search costs that market participants would
otherwise incur in determining that DCOs are managing risk effectively.
B. Title VIII of the Dodd-Frank Act
Section 802(b) of the Dodd-Frank Act states that the purpose of
Title VIII is to mitigate systemic risk in the financial system and
promote financial stability. Section 804 authorizes the Financial
Stability Oversight Council (FSOC) to designate entities involved in
clearing and settlement as systemically important.\7\
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\7\ See 76 FR 44763 (July 27, 2011) (FSOC authority to designate
financial market utilities as systemically important; final rule).
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Section 805(a) of the Dodd-Frank Act allows the Commission to
prescribe regulations for those DCOs that the Council has determined
are systemically important (SIDCOs). The Commission proposed heightened
requirements for SIDCO financial resources and system safeguards for
business continuity and disaster recovery.
Section 807(c) of the Dodd-Frank Act provides the Commission with
special enforcement authority over SIDCOs, which the Commission
proposed to codify in its regulations.
C. Regulatory Framework for DCOs
The Commission, now responsible for regulating swaps markets as
well as futures markets, has undertaken an unprecedented rulemaking
initiative to implement the Dodd-Frank Act. As part of this initiative,
the Commission has issued a series of eight proposed rulemakings that,
together, would establish a comprehensive regulatory framework for the
clearing and settlement activities of DCOs. Through these proposed
regulations, the Commission sought to enhance legal certainty for DCOs,
clearing members, and market participants, to strengthen the risk
management practices of DCOs, and to promote financial integrity for
swaps and futures markets.
In this notice of final rulemaking, the Commission is adopting
regulations to implement 15 DCO core principles: A (Compliance), B
(Financial Resources), C (Participant and Product Eligibility),\8\ D
(Risk Management), E (Settlement Procedures), F (Treatment of Funds), G
(Default Rules and Procedures), H (Rule Enforcement), I (System
Safeguards), J (Reporting), K (Recordkeeping), L (Public Information),
M (Information Sharing), N (Antitrust Considerations), and R (Legal
Risk).\9\ In addition, the Commission is adopting regulations to
implement the CCO provisions of Section 725 of the Dodd-Frank Act.\10\
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\8\ The Commission is reserving for a future final rulemaking
certain proposed amendments relating to participant and product
eligibility. See 76 FR 13101 (Mar. 10, 2011) (requirements for
processing, clearing, and transfer of customer positions (Straight-
Through Processing)); and 76 FR 45730 (Aug. 1, 2011) (customer
clearing documentation and timing of acceptance for clearing
(Customer Clearing)).
\9\ The Commission is reserving for a future final rulemaking
regulations to implement DCO Core Principles O (Governance Fitness
Standards) and Q (Composition of Governing Boards) (76 FR 722 (Jan.
6, 2011) (Governance)); and Core Principle P (Conflicts of Interest)
(75 FR 63732 (Oct. 18, 2010) (Conflicts of Interest)).
\10\ See Section 5b(i) of the CEA, 7 U.S.C 7a-1(i).
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The final rules adopted herein were proposed in five separate
notices of proposed rulemaking.\11\ Each proposed rulemaking was
subject to an initial 60-day public comment period and a re-opened
comment period of 30 days.\12\ After the second comment period ended,
the Commission informed the public that it would continue to accept and
consider late comments and did so until August 25, 2011. The Commission
received a total of approximately 119 comment letters directed
specifically at the proposed rules, in addition to many other comments
applicable to the Dodd-Frank Act rulemaking initiative more
generally.\13\ The Chairman and Commissioners, as well as Commission
staff, participated in numerous meetings with representatives of DCOs,
FCMs, trade associations, public interest groups, traders, and other
interested parties. In addition, the Commission has consulted with
other U.S. financial regulators including the Board of Governors of the
Federal Reserve System and Securities and Exchange Commission (SEC).
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\11\ See 76 FR 13101 (Mar. 10, 2011) (Straight-Through
Processing); 76 FR 3698 (Jan. 20, 2011) (Core Principles C, D, E, F,
G, and I (Risk Management)); 75 FR 78185 (Dec. 15, 2010) (Core
Principles J, K, L, and M (Information Management)); 75 FR 77576
(Dec. 13, 2010) (Core Principles A, H, N, and R (General
Regulations)); and 75 FR 63113 (Oct. 14, 2010) (Core Principle B
(Financial Resources)).
\12\ See 76 FR 25274 (May 4, 2011) (extending or re-opening
comment periods for multiple Dodd-Frank proposed rulemakings); see
also 76 FR 16587 (Mar. 24, 2011) (re-opening 30-day comment period
for reporting requirement with clause omitted in the notice of
proposed rulemaking).
\13\ Comment files for each proposed rulemaking can be found on
the Commission Web site, www.cftc.gov.
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The Commission is mindful of the benefits of harmonizing its
regulatory framework with that of its counterparts in foreign
countries. The Commission has therefore monitored global advisory,
legislative, and regulatory proposals, and has consulted with foreign
regulators in developing the proposed and final regulations for DCOs.
The Commission is of the view that each DCO should be afforded an
appropriate level of discretion in determining how to operate its
business within the legal framework established by the CEA, as amended
by the Dodd-Frank Act. At the same time, the Commission recognizes that
specific, bright-line regulations may be necessary to facilitate DCO
compliance with a given core principle and, ultimately, to protect the
integrity of the U.S. derivatives clearing system. Accordingly, in
developing the proposed regulations and in finalizing the regulations
adopted herein, taking into consideration public comments and views
expressed by U.S. and foreign regulators, the Commission has endeavored
to strike an appropriate balance between establishing general
prudential standards and specific requirements.
In determining the scope and content of the final rules, the
Commission has taken into account concerns raised by commenters
regarding the implications of specific rules for smaller versus larger
DCOs, DCOs that do not clear customer positions versus those with a
traditional customer model, clearinghouses that are registered as both
a DCO and a securities clearing agency, and clearinghouses that operate
in foreign jurisdictions as well as in the United States. The
Commission addresses these issues in its discussion of specific rule
provisions, below.
The Commission has carefully considered the costs and benefits
associated with each proposed rule, with particular attention to public
comments. For the reasons discussed in this notice of final rulemaking,
in the analyses of specific rule provisions as well as in the formal
cost-benefit analysis, the Commission has determined that the final
rules appropriately balance the costs and benefits associated with
oversight and supervision of DCOs pursuant to the CEA, as amended by
the Dodd-Frank Act.
The Commission is herein adopting regulations to implement the core
principles applicable to DCOs, to implement CCO requirements
established under the Dodd-Frank Act, and to update the regulatory
framework for DCOs to reflect standards and practices that have evolved
over the past decade since the enactment of the
[[Page 69336]]
CFMA. The Commission is largely adopting final rules as proposed,
although there are a number of proposed provisions that, upon further
consideration in light of comments received, the Commission has
determined to either revise or decline to adopt. In the discussion
below, the Commission highlights topics of particular interest to
commenters and discusses comment letters that are representative of the
views expressed on those topics. The discussion does not explicitly
respond to every comment submitted; rather, it addresses the most
significant issues raised by the proposed rulemakings and it analyzes
those issues in the context of specific comments.
The final rules include a number of technical revisions to the
proposed rule text, intended variously to clarify certain provisions,
standardize terminology within part 39, conform terminology to that
used in other parts of the Commission's rules, and more precisely state
regulatory standards and requirements. These are non-substantive
changes. For example, the proposed DCO rules used the terms
``contract'' and ``product'' interchangeably, and some provisions used
the statutory language ``contracts, agreements and transactions'' to
refer to the products subject to Commission regulation. In the final
rules adopted herein, the Commission has revised the terminology to
uniformly refer to ``products,'' which encompasses contracts,
agreements, and transactions, except where the language of the rule
codifies statutory language. In those cases, the rule text is
unchanged.
For easy reference and for purposes of clarification, in this
notice of final rulemaking the Commission is publishing the complete
part 39 as currently adopted. This means that certain longstanding
rules that are not being amended (e.g., Sec. 39.8 (formerly designated
as Sec. 39.7, fraud in connection with the clearing of transactions of
a DCO), and rules recently adopted (Sec. 39.5, review of swaps for
Commission determination on clearing requirement) are being re-
published along with the newly-adopted rules. Rules that have been
proposed but not yet adopted in final form are identified in part 39 as
``reserved.''
II. Part 1 Amendments--Definitions
The Commission proposed to amend the definitions of ``clearing
member,'' ``clearing organization,'' and ``customer'' found in Sec.
1.3 of its regulations to conform the definitions with the terminology
and substantive provisions of the CEA, as amended by the Dodd-Frank
Act. The Commission also proposed to add to Sec. 1.3, definitions for
``clearing initial margin,'' ``customer initial margin,'' ``initial
margin,'' ``margin call,'' ``spread margin,'' and ``variation margin.''
ISDA commented that the margin definitions are appropriate for
futures and cleared derivatives, but less readily applicable in the
uncleared OTC derivatives context. It suggested that the definitions
should expressly provide that they apply only to cleared transactions.
The Commission notes that some of the definitions by their terms
already apply only to cleared trades, e.g., ``clearing initial
margin.'' Other terms, however, have applicability to both cleared and
uncleared trades, e.g., ``initial margin.'' \14\
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\14\ See Section 4s of the CEA, 7 U.S.C. 6s.
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The Commission proposed to define ``spread margin'' as ``reduced
initial margin that takes into account correlations between certain
related positions held in a single account.'' Better Markets commented
that the definition of ``spread margin'' omits key characteristics of
netting initial margin which are needed to precisely define spread
margin. Better Markets proposed to define it as ``initial margin
relating to two positions in a single account that has been reduced
from the aggregate initial margin otherwise applicable to the two
positions by application of an algorithm that measures statistical
correlations between the historic price movements of the two
positions.'' The Commission is adopting the definition of ``spread
margin'' as proposed because it believes that Better Markets'
definition adds unnecessary details that could have the unintended
effect of imposing substantive margin methodology requirements in a
definition.
In light of proposed rulemakings issued after the Commission
proposed the definition of ``customer; commodity customer; swap
customer,'' the Commission is making certain technical
modifications.\15\ First, instead of placing the definition in Sec.
1.3, which serves as the general definition section for all of the
Commission's regulations, this definition is being moved to Sec. 39.2,
which sets forth definitions applicable only to regulations found in
part 39 or as otherwise explicitly provided. This accommodates the need
for further consideration of other proposals before a global definition
is adopted, while satisfying the need for a definition for purposes of
part 39 as adopted herein. Second, the Commission has made certain
technical changes to the rule text in connection with the definition's
redesignation in 39.2 and to conform phraseology when incorporating by
reference definitions that appear in the CEA and Sec. 1.3. These
changes include limiting the term to ``customer,'' because the terms
``commodity customer'' and ``swap customer'' are not used in Part 39.
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\15\ See 76 FR 33818 (June 9, 2011) (Protection of Cleared Swaps
Customer Contracts and Collateral; Conforming Amendments to the
Commodity Broker Bankruptcy Provisions); 76 FR 33066 (June 7, 2011)
(Adaptation of Regulations to Incorporate Swaps).
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The Commission is adopting the other definitions as proposed.
III. Part 39 Amendments--General Provisions
A. Scope--Sec. 39.1
As originally proposed, Sec. 39.1 included an updated statement of
scope and definitions applicable to other provisions in part 39. The
Commission later revised proposed Sec. 39.1 to include only the
statement of scope. The Commission did not receive any comments on the
statement of scope, which was updated to include references to the
definition of ``derivatives clearing organization'' in newly-renumbered
Section 1(a)(15) of the CEA and Sec. 1.3(d) of the Commission's
regulations. The Commission is adopting Sec. 39.1 as proposed.
B. Definitions--Sec. 39.2
The Commission proposed definitions of the terms ``back test,''
``compliance policies and procedures,'' ``customer account '' or
``customer origin,'' ``house account'' or ``house origin,'' ``key
personnel,'' ``stress test,'' and ``systemically important derivatives
clearing organization.'' The definitions set forth in proposed Sec.
39.2 would apply specifically to provisions contained in part 39 and
such other rules as may explicitly cross-reference these definitions.
The Commission is adopting the definitions as proposed, with the
exceptions discussed below.
CME Group, Inc. (CME) commented that the proposed definition of
``compliance policies and procedures'' was too broad. That definition
was proposed as an adjunct to the proposed rules for a DCO's CCO. The
Commission is not adopting a definition of ``compliance policies and
procedures,'' as it has concluded that a DCO's compliance policies and
procedures will likely encompass a limited, self-evident body of
documents, and a regulatory definition could invite more scrutiny than
is necessary or helpful to the DCO or the Commission.
The Commission proposed to define ``stress test'' as ``a test that
compares the impact of a potential price move, change
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in option volatility, or change in other inputs that affect the value
of a position, to the financial resources of a [DCO], clearing member,
or large trader to determine the adequacy of such financial
resources.'' Better Markets, Inc. (Better Markets) expressed the view
that a stress test can only be useful if it tests unprecedented
circumstances of illiquidity, and that basing the test on historic
price data would make it meaningless. In response to this comment, the
Commission is modifying the definition in one respect. The word
``extreme'' is being inserted after the word ``potential'' to make
clear that a stress test does not include typical events. The
Commission further addresses Better Markets' concerns in its discussion
of stress tests in Sec. 39.13(h)(3).\16\
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\16\ See discussion of stress tests in section IV.D.7.c, below.
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The Commission proposed to define the term ``systemically important
derivatives clearing organization'' to mean ``a financial market
utility that is a derivatives clearing organization registered under
Section 5b of the Act (7 U.S.C. 7a-1), which has been designated by the
Financial Stability Oversight Council to be systemically important.''
The Options Clearing Corporation (OCC) submitted a comment on this
definition in connection with the Commission's proposed Sec. 40.10
(special certification procedures for submission of certain risk-
related rules by SIDCOs).\17\ OCC pointed out that, under this proposed
definition, a DCO could be a SIDCO even if the Commission were not its
Supervisory Agency pursuant to Section 803(8) of the Dodd-Frank Act.
The Commission, recognizing that some DCOs like OCC may be regulated by
more than one federal agency, is adopting a revised definition to
clarify that the term ``systemically important derivatives clearing
organization'' means a ``financial market utility that is a derivatives
clearing organization registered under Section 5b of the Act, which has
been designated by the Financial Stability Oversight Council to be
systemically important and for which the Commission acts as the
Supervisory Agency pursuant to Section 803(8) of the Dodd-Frank Wall
Street Reform and Consumer Protection Act.'' \18\
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\17\ See 76 FR 44776 at 44783-84 (July 27, 2011) (Provisions
Common to Registered Entities; final rule).
\18\ See id. for further discussion of this topic.
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The Commission also is making a technical change to the definition
of ``customer account or customer origin.'' The proposed definition
would provide, in part, that ``[a] customer account is also a futures
account, as that term is defined by Sec. 1.3(vv) of this chapter.'' The
Commission is removing this reference and defining ``customer account
or customer origin'' to mean ``a clearing member account held on behalf
of customers, as that term is defined in this section, and which is
subject to section 4d(a) or section 4d(f) of the Act.'' This clarifies
that the term encompasses both customer futures accounts and customer
cleared swaps accounts, respectively.
Similarly, the Commission is making a technical revision to the
term ``house account or house origin'' to delete the proposed reference
to proprietary accounts, which are currently defined in Sec. 1.3(y)
only in terms of futures and options (not swaps). The term ``house
account or house origin'' is now defined as a ``clearing member account
which is not subject to section 4d(a) or 4d(f) of the Act.''
In connection with the proposal to adopt a definitions section
designated as Sec. 39.2, the Commission proposed to rescind the
existing Sec. 39.2, which exempted DCOs from all Commission
regulations except those explicitly enumerated in the exemption. This
action would result in clarifying the applicability of Sec. 1.49
(denomination of customer funds and location of depositories) to DCOs
and, insofar as the rule exempted DCOs from regulations relating to DCO
governance and conflicts of interest, those regulations are expected to
themselves be replaced by rules to implement DCO Core Principles O
(Governance Fitness Standards), P (Conflicts of Interest), and Q
(Composition of Governing Boards).\19\ The Commission did not receive
any comments on the proposed rescission of the exemption provided by
existing Sec. 39.2 and is herein rescinding that exemption, as
proposed.
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\19\ See 76 FR 722 (Jan. 6, 2011) (Governance); and 75 FR 63732
(Oct. 18, 2010) (Conflicts of Interest).
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C. Procedures for Registration as a DCO--Sec. 39.3
The Commission proposed several revisions to its procedures for DCO
registration, including the elimination of the 90-day expedited review
period and the required use of an application form, proposed Form DCO.
The Commission is adopting Sec. 39.3 as proposed, and is adopting the
Form DCO with the revisions discussed below.
1. Form DCO
The Commission proposed to revise appendix A to part 39,
``Application Guidance and Compliance with Core Principles,'' by
removing the existing guidance and substituting the Form DCO in its
place. An application for DCO registration would consist of the
completed Form DCO, which would include all applicable exhibits, and
any supplemental information submitted to the Commission.
CME commented that the proposed Form DCO would require the
applicant to create and submit to the Commission a large number of
documents. It questioned why certain documents were necessary and
whether Commission staff would be able to meaningfully review all of
the materials within the 180-day timeframe contemplated in the proposed
regulations.
The Commission is adopting the Form DCO as proposed, except for the
modifications discussed below. The Commission notes that the Form DCO
standardizes and clarifies the information that the Commission has
required from DCO applicants in the past and the Form DCO Exhibit
Instructions, in an effort to reduce the burden on applicants, state
that ``If any Exhibit requires information that is related to, or may
be duplicative of, information required to be included in another
Exhibit, Applicant may summarize such information and provide a cross-
reference to the Exhibit that contains the required information.''
Based on the Commission's experience with the DCO registration process
over the past decade, it believes that its staff can meaningfully
review the required information within the 180-day time frame. In
addition, the Commission believes that by standardizing informational
requirements, the Form DCO will allow the Commission to process
applications more quickly and efficiently. This will benefit applicants
as well as free Commission staff to handle other regulatory matters.
CME specifically questioned whether, as part of the Form DCO cover
sheet, applicants should be required to identify and list ``all outside
service providers and consultants, including accountants and legal
counsel.'' This comment mischaracterizes the information required by
the Form DCO, which requires contact information for enumerated outside
service providers (Certified Public Accountant, legal counsel, records
storage or management, business continuity/disaster recovery) and
``other'' outside service providers ``such as consultants, providing
services related to this application.'' Such contact information is
helpful to the Commission staff in processing the application and
making a determination as to whether the applicant has obtained the
services it needs to effectively
[[Page 69338]]
operate as a DCO.\20\ Nonetheless, in response to CME's comments and in
order to clarify the scope of requesting contact information for ``any
other outside service providers,'' the Commission has decided to revise
section 12.e. of the Form DCO cover sheet to provide for contact
information for any ``Professional consultant providing services
related to this application.''
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\20\ This requirement focuses on outside services ``related to
this application.'' Similarly, if the applicant intends to use the
services of an outside service provider (including services of its
clearing members or market participants), to enable it to comply
with any of the core principles, the applicant must submit as
exhibit A-10 all agreements entered into or to be entered into
between the applicant and the outside service provider, and
identify: (1) The services that will be provided; (2) the staff who
will provide the services; and (3) the core principles addressed by
such arrangement. This exhibit does not require that the applicant
submit information and documentation related to all outside service
providers. Rather, the requirement is directed at contractual
arrangements related to compliance with the core principles, i.e.,
the DCO's core business functions.
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CME commented that proposed exhibit A-1, which would require the
applicant to produce a chart demonstrating in detail how its rules,
procedures, and policies address each DCO core principle, is not
necessary. The Commission believes exhibit A-1 is necessary because it
will provide a clear picture of which rules, procedures, and policies
address each DCO core principle. The chart will greatly assist
Commission staff in tracking and evaluating the materials supplied by
the applicant and should reduce the need for staff to seek follow-up
clarifications from the applicant. Again, this will also reduce the
costs to the applicant.
CME commented that the Commission has not explained its reasons for
requiring an applicant to supply ``telephone numbers, mobile phone
numbers and email addresses of all officers, managers, and directors of
the DCO,'' as provided in proposed exhibit A-6. The Commission notes
that the exhibit A-6 instructions request contact and other information
for ``current officers, directors, governors, general partners, LLC
managers, and members of all standing committees.'' The exhibit is not
directed at ``all managers'' or ``all directors,'' but rather at those
persons who are in key decision-making positions (for example, key
personnel, directors serving on a board of directors and a manager or
managing member of a DCO organized in the form of a limited liability
corporation). The purpose of obtaining contact information is to enable
the Commission to start building an emergency contact database.
CME commented that proposed exhibit A-7 would require the applicant
to list all jurisdictions where the applicant and its affiliates are
doing business, and the registration status of the applicant and its
affiliates. CME questioned the Commission's need for such information
with respect to affiliates of the applicant. The Commission believes
that such information is necessary because it allows the Commission to
develop a more complete understanding of the applicant's entire
corporate organizational structure including potential financial
commitments and regulatory obligations of the applicant's affiliates
inclusive of its parent organization.
CME commented that proposed exhibit B-3, which would require the
applicant to provide proof that each of its physical locations meets
all building and fire codes, and that it has running water and a
heating, ventilation and air conditioning system, and adequate office
technology, is not necessary. The Commission believes that it is
important for an applicant to demonstrate that it has a physical
presence capable of supporting clearing and settlement services and is
not a ``shoestring'' operation. Typically, Commission staff will
conduct a site visit to an applicant's headquarters and other
facilities, and one of the purposes of such visits is to evaluate the
suitability of the applicant's physical facilities. Site visits,
however, are conducted after a DCO application is deemed to be
materially complete, and there are instances when it might not be
feasible to conduct a site visit. Accordingly, at a minimum, a
narrative statement discussing the applicant's physical facilities and
office technology must be submitted to the Commission as part of the
application package so that staff can complete its initial review for
``adequate * * * operational resources'' under Core Principle B.
In response to CME's comments, the Commission has decided to revise
exhibit B-3 to require the following:
(3) A narrative statement demonstrating the adequacy of
Applicant's physical infrastructure to carry out business
operations, which includes a principal executive office (separate
from any personal dwelling) with a U.S. street address (not merely a
post office box number). For its principal executive office and
other facilities Applicant plans to occupy in carrying out its DCO
functions, a description of the space (e.g., location and square
footage), use of the space (e.g., executive office, data center),
and the basis for Applicant's right to occupy the space (e.g.,
lease, agreement with parent company to share leased space).
(4) A narrative statement demonstrating the adequacy of the
technological systems necessary to carry out Applicant's business
operations, including a description of Applicant's information
technology and telecommunications systems and a timetable for full
operability.
CME questioned the value of proposed exhibits C-1(9) and C-2(5),
which would, respectively, require an applicant to provide a list of
current and prospective clearing members, and to forecast expected
volumes and open interest at launch date, six months, and one year
thereafter. The Commission believes that this information is important
because it would enable the Commission to understand the nature and
level of the DCO's expected start-up activities and to appropriately
evaluate whether the applicant has adequate resources to manage the
expected volume of business.
CME questioned the benefits of what it termed the ``incredibly
burdensome'' requirements of proposed exhibit D-2(b)(3), which would
require an applicant to explain why a particular margin methodology was
chosen over other potentially suitable methodologies, and to include a
comparison of margin levels that would have been generated by using
such other potential methodologies. To address CME's comment, the
Commission is revising exhibit D-2(b)(3) to require an explanation of
whether other margining methodologies were considered and, if so,
explain why they were not chosen. This information will be sufficient
in the first instance and, when evaluating an applicant's proposed
margin methodology, Commission staff can request additional information
if needed to complete its review for compliance with Core Principle D
and Sec. 39.13 (risk management).
The Commission proposed to require use of the Form DCO by a
registered DCO when requesting an amendment to its DCO registration
order. CME and Minneapolis Grain Exchange, Inc. (MGEX) suggested that
the Form DCO be modified so that a currently registered DCO would not
have to expend as much time and resources to complete an amendment
request as a new applicant for DCO registration, unless there are
extenuating circumstances. In response to this suggestion, the
Commission is revising the Form DCO General Instructions to clarify
that if the Form DCO is being filed as an amendment to a pending
application for registration or for the purpose of amending an existing
registration order, the applicant need only submit the information and
exhibits relevant to the application
[[Page 69339]]
amendment or request for an amended registration order.
CME also noted that a DCO applicant would be required to represent
that its Form DCO submission is true, correct, and complete. It
suggested that the Commission modify this language so that the
applicant is required to certify that, ``to the best of its
knowledge,'' its Form DCO submission is true, correct, and complete
``in all material respects.'' The Commission is revising the language
as suggested by CME, in recognition of the fact that some of the
information contained in the exhibits may have been provided by third
parties and there is a limit to the reach of an applicant's due
diligence with respect to such information.
In addition to the above changes, the Commission has made non-
substantive editorial changes to the Form DCO for purposes of internal
consistency and conformity with the Form SDR for swap data repositories
(SDRs) and proposed Form DCM and Form SEF for designated contract
markets (DCMs) and swap execution facilities (SEFs), respectively.\21\
The Commission also has made changes to Form DCO to remove references
to proposed regulations that remain pending.\22\
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\21\ See 76 FR 54538 (Sept. 1, 2011) (SDRs: Registration
Standards, Duties and Core Principles; final rule); 75 FR 80572
(Dec. 22, 2010) (Core Principles and Other Requirements for
Designated Contract Markets); 76 FR 1214 (Jan. 7, 2011) (Core
Principles and Other Requirements for Swap Execution Facilities).
\22\ For example, the Commission has removed the specific cross-
references located in exhibit P to Form DCO to the proposed
conflicts of interest rules, 75 FR 63732 (Oct. 18, 2010) (Conflicts
of Interest), and replaced such references with a description of the
required information. When the Commission finalizes such proposed
rules, the Commission intends to make technical changes to the Form
DCO to include cross-references to such final rules where, in the
opinion of the Commission, doing so will facilitate compliance with
the Form DCO, the CEA and/or Commission regulations.
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2. Request for Transfer of Registration and Open Interest--Sec.
39.3(h)
The Commission proposed Sec. 39.3(h) to clarify the procedures
that a DCO must follow when requesting the transfer of its DCO
registration and positions comprising open interest for clearing and
settlement, in anticipation of a corporation change.\23\ The Commission
received a comment from OCC suggesting that a request to transfer a
DCO's registration and open interest should be published in the Federal
Register for public comment.
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\23\ As a technical matter, the Commission is removing proposed
Sec. 39.3(g)(1) and adopting proposed Sec. 39.3(h) as Sec.
39.3(f); proposed Sec. 39.3(g)(1) was a typographical error which
repeats a delegation of authority already provided by Sec.
39.3(b)(2)(i).
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The Commission recognizes the value of public comment, but it has
determined not to formalize the public comment process through
publication in the Federal Register. This procedure could unnecessarily
delay the review process and completion of the transfer, and the
Commission believes that posting the request on its Web site, which it
currently does for DCO registration applications, will provide an
opportunity for public comment without potential delay.
3. Technical Amendments
The Commission proposed a set of technical amendments to Sec. 39.3
to update filing procedures, to conform various provisions to reflect
the elimination of the 90-day expedited review period for DCO
applications, and to correct terminology in the delegation provisions
of Sec. 39.3(g). The Commission did not receive any comments on the
proposed technical amendments and the Commission is adopting the
amendments as proposed.
D. Procedures for Implementing DCO Rules and Clearing New Products--
Sec. 39.4
1. Acceptance of Certain New Products for Clearing--Sec. 39.4(c)(2)
The Commission proposed a technical amendment to existing Sec.
39.4(c)(2), which would require a DCO to certify to the Commission the
terms and conditions of new over-the-counter (OTC) products that it
intended to clear. The Commission proposed removing the reference to
new products ``not traded on a designated contract market or a
registered derivatives transaction execution facility'' and inserting a
reference to new products ``not traded on a designated contract market
or a registered swap execution facility.'' The proposed provision would
retain the reference to filing the terms and conditions of the new
product ``pursuant to the procedures of Sec. 40.2 of this chapter.''
Since proposing that technical amendment, the Commission has
adopted a new Sec. 39.5 (review of swaps for Commission determination
on clearing requirement) \24\ and revisions to Sec. 40.2 (listing
products for trading by certification).\25\ As a result, a DCO seeking
to clear new products that are not traded on a designated contract
market or swap execution facility must submit to the Commission the
terms and conditions of the product pursuant to the procedures of Sec.
39.5, not Sec. 40.2. The Commission is therefore adopting a technical
revision to conform Sec. 39.4(c)(2) to the current procedural
requirements.
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\24\ See 76 FR 44464, at 44473-44474 (July 26, 2011) (Process
for Review of Swaps for Mandatory Clearing; final rule).
\25\ See 76 FR 44776 (July 27, 2011) (Provisions Common to
Registered Entities; final rule).
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2. Holding Securities in a Futures Portfolio Margining Account--Sec.
39.4(e)
The CEA, as amended by Section 713 of the Dodd-Frank Act, permits,
pursuant to an exemption, rule or regulation, futures and options on
futures to be held in a portfolio margining account that is carried as
a securities account and approved by the SEC.\26\ Reciprocally, the
Securities Exchange Act of 1934 (SEA), as amended by Section 713 of the
Dodd-Frank Act, permits, pursuant to an exemption, rule, or regulation,
cash and securities to be held in a portfolio margining account that is
carried as a futures account and approved by the Commission.\27\ Those
provisions of the CEA and SEA further require consultation between the
Commission and the SEC in drafting implementing regulations. As a first
step toward meeting this goal, proposed Sec. 39.4(e) would establish
the procedural requirements applicable to a DCO seeking approval for a
futures portfolio margining account program.
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\26\ Section 4d(h) of the CEA, 7 U.S.C. 6d(h).
\27\ Section 15(c)(3)(C) of the SEA, 15 U.S.C. 78o(c)(3).
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OCC, Newedge USA, LLC (Newedge), New York Portfolio Clearing, LLC
(NYPC), and MetLife Inc. urged the Commission to propose rules that
would permit portfolio margining, not just establish procedural
requirements. The Commission agrees that it should propose substantive
portfolio margining rules, but it must move forward on proposing
substantive rules with the SEC's participation.
Accordingly, the Commission is adopting the procedural requirements
as proposed and anticipates consulting with the SEC in the future to
determine the substantive requirements it would impose in approving a
futures portfolio margining program and, additionally, in granting an
exemption under Section 4(c) of the CEA to permit futures and options
on futures to be held in a securities portfolio margining account. The
Dodd-Frank Act does not set a deadline for these actions, and the
Commission believes that it is important to give this matter due
consideration, both in terms of consultation with the SEC and, more
broadly, in obtaining industry views on the topic before
[[Page 69340]]
proposing substantive regulations or other guidance.
E. Reorganization of Part 39
With the adoption of regulations relating to implementation of the
core principles and other provisions of the Dodd-Frank Act, the
Commission is reorganizing part 39 of its regulations into two
subparts, with a new appendix.
Subpart A, ``General Provisions Applicable to Derivatives Clearing
Organizations'' contains Sec. Sec. 39.1 through 39.8, which are
general provisions including procedural requirements for DCO
applications and other activities such as transfer of a DCO
registration, clearing of new products, and submission of swaps for a
mandatory clearing determination. Subpart A also includes pre-existing
provisions regarding enforceability and fraud in connection with
clearing transactions on a DCO.\28\ Subpart B, ``Compliance with Core
Principles,'' contains Sec. Sec. 39.9 through 39.27, which are rules
that implement the core principles under Section 5b of the CEA, as
amended by the Dodd-Frank Act.
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\28\ As part of the reorganization of Part 39, Sec. 39.6
(Enforceability) is being redesignated as Sec. 39.7 and Sec. 39.7
(Fraud in connection with the clearing of transactions on a
derivatives clearing organization) is being redesignated as Sec.
39.8.
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As discussed above, the Commission is replacing appendix A
``Application Guidance and Compliance with Core Principles,'' with a
new appendix to part 39, ``Form DCO Derivatives Clearing Organization
Application for Registration.''
F. Technical Amendments
With the objective of listing all DCO reporting requirements in a
new Sec. 39.19, the Commission proposed redesignating Sec. 39.5(a)
and (b) (information relating to DCOs) as proposed Sec. Sec.
39.19(c)(5)(i) and (ii), respectively, in substantially the same form.
The Commission also proposed removing Sec. 39.5(c) (large trader
reporting by DCOs), redesignating Sec. 39.5(d) (special calls) as
Sec. 21.04 (and current Sec. 21.04 as Sec. 21.05), and adding Sec.
21.06, which would delegate authority under Sec. 21.04 to the Director
of the Division of Clearing and Risk.
The Commission did not receive any comments on these proposals.
Therefore, the Commission is adopting these revisions as proposed,
except for non-substantive changes to Sec. Sec. 39.19(c)(5)(i) and
(c)(5)(ii) to clarify the language.\29\
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\29\ After these technical amendments were proposed, the
Commission adopted a final rule governing the process for review of
swaps for mandatory clearing. That rule was designated as Sec.
39.5, and the former Sec. 39.5 was redesignated as Sec. 39.8. See
76 FR at 44473 (July 26, 2011) (Process for Review of Swaps for
Mandatory Clearing; final rule). In connection with adoption of the
technical amendments described above, the provisions regarding fraud
in connection with the clearing of transactions on a DCO (former
Sec. 39.7) are now redesignated as Sec. 39.8.
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IV. Part 39 Amendments--Compliance With Core Principles
Proposed Sec. 39.9 would establish the scope of the rules
contained in subpart B of part 39, stating that all provisions of
subpart B apply to DCOs. The Commission did not receive any comments on
the statement of scope, and the Commission is adopting Sec. 39.9 as
proposed.
A. Core Principle A--Compliance With Core Principles--Sec. 39.10
1. Core Principle A
Core Principle A,\30\ as amended by the Dodd-Frank Act, requires a
DCO to comply with each core principle set forth in Section 5b(c)(2) of
the CEA and any requirement that the Commission may impose by rule or
regulation pursuant to Section 8a(5) of the CEA. Core Principle A also
provides a DCO with reasonable discretion to establish the manner by
which it complies with each core principle. Proposed Sec. Sec.
39.10(a) and 39.10(b) would codify these provisions, respectively. The
Commission received no comments on these proposed rules and is adopting
the rules as proposed.
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\30\ Section 5b(c)(2)(A) of the CEA, 7 U.S.C. 7a-1(c)(2)(A).
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2. Designation of a Chief Compliance Officer--Sec. 39.10(c)(1)
Section 725(b) of the Dodd-Frank Act added a new paragraph (i) to
Section 5b of the CEA to require each DCO to designate an individual as
its CCO, responsible for the DCO's compliance with the CEA and
Commission regulations and the filing of an annual compliance
report.\31\ In proposed Sec. 39.10(c), the Commission set forth
implementing requirements that would largely track the language of
Section 5b(i).
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\31\ See Section 5b(i) of the CEA; 7 U.S.C. 7a-1(b)(i).
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Under the introductory provision of proposed Sec. 39.10(c)(1),
each DCO would be required to appoint a CCO with ``the full
responsibility and authority to develop and enforce in consultation
with the board of directors or the senior officer, appropriate
compliance policies and procedures, as defined in Sec. 39.1(b), to
fulfill the duties set forth in the Act and Commission regulations.''
As previously noted, the Commission is not adopting the definition of
``compliance policies and procedures'' included in proposed Sec.
39.1(b).
CME commented that the text of the Dodd-Frank Act does not require
a CCO to ``enforce'' compliance policies and procedures and it
suggested that Sec. 39.10 should not do so. According to CME, it is
important to separate the functions of monitoring and advising on
compliance issues from what it considers ``senior management
functions'' of enforcing and supervising compliance policies.
The Commission believes that Congress intended that the CCO have
the full responsibility and authority to enforce compliance in
consultation with the board of directors or the senior officer. Given
the specified duties of the CCO set forth in Section 5b(i)(2), the
Commission finds ample support for this interpretation and is adopting
the rule as proposed.
First, one definition of the term ``enforce'' is ``to ensure
observance of laws and rules,'' \32\ and among the CCO duties set forth
by the Dodd-Frank Act is the requirement that the CCO ``ensure
compliance.'' \33\ Second, Section 5b(i)(2)(C) requires a CCO to
``resolve any conflicts of interest that may arise'' in consultation
with the board of the DCO or the senior officer of the DCO. This duty
clearly indicates that the CCO is more than just an advisor to
management and must have the ability to enforce compliance with the CEA
and Commission regulations. The authority to resolve conflicts of
interest is more an enforcement function than an audit function.
Finally, Section 5b(i)(2)(D) requires the CCO to ``be responsible for
administering each policy.''
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\32\ See http://www.websters-online-dictionary.org/definitions/enforce.
\33\ See Section 5b(i)(2)(E) of the CEA, 7 U.S.C. 7a-
1(b)(i)(2)(E), which requires the CCO to ``ensure compliance with
this Act (including regulations) relating to agreements, contracts,
or transactions, including each rule prescribed by the Commission
under this section.''
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While the CEA does not explicitly use the word ``enforce,'' the
Commission believes that the use of this word in Sec. 39.10(c)(1) is
appropriate to capture the meaning of Section 5b(i)(2)(C), i.e., that
CCOs must have the authority to fulfill their statutory and regulatory
obligations. Moreover, it is consistent with the statutory directive
for the CCO to ensure compliance with the CEA. These considerations are
particularly important given that the CCO of a DCO has unique
responsibilities in connection with the DCO's critical role in
providing financial integrity to derivatives markets. In particular, a
CCO must have the ability to effectively address rules and practices
that could compromise compliance with fair and open access requirements
(Core Principle C), risk management
[[Page 69341]]
requirements (Core Principle D), and financial resource requirements
(Core Principle B).
The Commission, however, recognizes that the term ``enforce'' could
imply that the DCO's CCO must have direct supervisory authority over
employees not otherwise in his or her direct chain of command, or that
the CCO has independent authority to discipline employees or terminate
employment to facilitate compliance with the CEA and the Commission's
regulations. To avoid confusion, the Commission herein clarifies that
the term ``enforce,'' as used in Sec. 39.10(c)(1), is not intended to
include the authority to supervise employees not in the CCO's direct
chain of command, or the authority to terminate employment or
discipline employees for conduct that results in noncompliance. The
Commission notes that a DCO is not precluded from conferring such
authority on its CCO; however, such action would be at the DCO's
discretion and is not required by Sec. 39.10(c)(1).\34\
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\34\ See further discussion of a CCO's duties in section IV.A.7,
below.
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3. Individuals Qualifying To Serve as a CCO--Sec. 39.10(c)(1)(i)
Proposed Sec. 39.10(c)(1)(i) would require a DCO to designate an
individual with the background and skills appropriate for fulfilling
the responsibilities of the CCO position. The Commission asked whether
additional qualifications should be imposed and, in particular, whether
the Commission should restrict the CCO position from being held by an
attorney who represents the DCO or its board of directors, such as an
in-house or general counsel. The Commission explained that the
rationale for such a restriction would be based on concern that the
interests of representing the DCO's board of directors or management
could be in conflict with the duties of the CCO. Related to this, the
Commission specifically sought comment on whether there is a need for a
regulation requiring the DCO to insulate a CCO from undue pressure and
coercion. It further asked if it is necessary to adopt rules to address
the potential conflict between and among compliance interests,
commercial interests, and ownership interests of a DCO and, if there is
no need for such rules, requested comment on how such potential
conflicts would be addressed.
CME, OCC, MGEX, and the Kansas City Board of Trade Clearing
Corporation (KCC) commented that additional restrictions should not be
imposed. MGEX commented that smaller DCOs will need to maximize the
utility of each employee. It also argued that there is little risk if a
CCO serves as in-house counsel because attorneys have additional
ethical duties which can complement the duties and obligations of a
CCO. According to MGEX, if a conflict arose, the attorney could step
out of one or both of the roles.
Better Markets commented that there is potential conflict between a
CCO and in-house counsel because in-house counsel is an advocate for
the DCO or its board of directors regarding any controversy that may
relate to regulatory compliance, while a CCO's duty is to ensure
compliance. It suggested that the Commission prohibit a CCO from
serving as in-house counsel.
The Commission is adopting Sec. 39.10(c)(1)(i) as proposed. The
Commission has considered prohibiting a CCO from working in the DCO's
legal department or serving as general counsel, consistent with the
Commission's approach to the CCO of an SDR.\35\ However, in response to
public comments and in light of the fact that all currently registered
DCOs have some form of compliance program already in place, with one or
more staff members assigned to carry out compliance officer functions,
the Commission has determined that the potential costs of hiring
additional staff to satisfy such requirement could result in imposing
an unnecessary burden on DCOs, particularly smaller ones. The
Commission recognizes, however, that a conflict of interest could
compromise a CCO's ability to effectively fulfill his or her
responsibilities as a CCO. The Commission therefore expects that as
soon as any conflict of interest becomes apparent, a DCO would
immediately implement a back-up plan for reassignment or other measures
to address the conflict and ensure that the CCO's duties can be
performed without compromise.
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\35\ See 76 FR 54538 (Sept. 1, 2011) (SDRs: Registration
Standards, Duties and Core Principles; final rule).
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MGEX and KCC also recommended that the Commission should permit the
Chief Regulatory Officer to function as the CCO. Presumably, the
commenters are referring to circumstances in which a DCO (which
typically would not have a Chief Regulatory Officer) is also registered
as a DCM (which typically would have a Chief Regulatory Officer). The
Commission notes that the rule does not prohibit the person serving as
CCO from also serving as the Chief Regulatory Officer.
4. CCO Reporting Structure--Sec. 39.10(c)(1)(ii)
Section 5b(i)(2)(A) of the CEA requires that a CCO report directly
to the board of directors or the senior officer of the DCO.\36\
Proposed Sec. 39.10(c)(1)(ii) would codify this requirement. The
proposed rule also would require the board of directors or the senior
officer to approve the compensation of the CCO.
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\36\ 7 U.S.C. 7a-1(i)(2)(A).
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In the notice of proposed rulemaking, the Commission sought comment
as to the degree of flexibility that should be provided in the
reporting structure of the CCO. Specifically, the Commission requested
comment on: (i) Whether it would be more appropriate for a CCO to
report to the senior officer or the board of directors; (ii) as between
the senior officer or board of directors, which generally is a stronger
advocate of compliance matters within an organization; and (iii)
whether the proposed rules allow for sufficient flexibility with regard
to a DCO's business structure.
CME, MGEX, and KCC commented that the proposed rules would provide
DCOs with the appropriate degree of flexibility. CME, however, believes
it would be ``logical'' for a CCO to report to the senior officer, and
that the board of directors should oversee implementation of compliance
policies and ensure that compliance issues are resolved effectively and
expeditiously by the senior officer with the assistance of the CCO.
MGEX noted that each DCO may have a different business and reporting
structure and believes that rigid rules may hinder the effectiveness
and independence of the CCO.
Better Markets observed that, in the past, businesses have placed
financial interests over other considerations like risk management and
have created a climate where people were unwilling to speak out against
financial considerations for fear of being fired. Better Markets
suggested that there should be a strong reporting and working
relationship between the CCO and independent directors, and suggested
that independent directors have sole responsibility to designate or
terminate the CCO and to set compensation levels for the CCO.
The Commission is adopting Sec. 39.10(c)(1)(ii) as proposed,
declining to prescribe whether the CCO can only report to the board of
directors or to the senior officer. The Commission appreciates Better
Markets' concern that a CCO who reports to the senior officer may be
swayed by financial
[[Page 69342]]
considerations. However, the Dodd-Frank Act permits alternative
reporting structures and the Commission has not been presented with a
compelling reason to conclude that the structure and operations of a
DCO require the imposition of this limitation on the ability of a DCO's
board and management to establish lines of authority appropriate to the
particular DCO.
CME asked the Commission to clarify that the term ``senior
officer'' may apply to the senior officer of a division that is engaged
in clearing activities. The Commission notes that Section 5b(i)(2)(A)
of the CEA requires a CCO to ``report directly to the board or to the
senior officer of the derivatives clearing organization.'' If the
division engaged in clearing activities is the registered DCO, then the
senior officer of that division would be the ``senior officer'' for
purposes of this provision.
Finally, Better Markets suggested that compliance should be
addressed on an entire-group basis by a senior CCO. According to Better
Markets, a single senior CCO should have overall responsibility for
each affiliated and controlled entity, even if the individual entities
within the group have CCOs. The final rules do not require a business
organization to have a ``senior'' CCO as Better Markets suggested. The
Commission believes this would be overly prescriptive and that a DCO
should have the flexibility to manage compliance functions across
divisions or affiliates to accommodate its particular organizational
structure.
5. Annual Compliance Meeting--Sec. 39.10(c)(1)(iii)
Proposed Sec. 39.10(c)(1)(iii) would require a CCO to meet with
the board of directors or the senior officer at least once a year to
discuss the effectiveness of the DCO's compliance policies and
procedures, as well as the administration of those policies and
procedures by the CCO. Better Markets suggested that a CCO meet with
the board of directors at least quarterly. No comments were received on
the proposed topics to be discussed at the annual meeting.
The Commission is adopting Sec. 39.10(c)(1)(iii) in modified form.
The final rule retains the requirement that the CCO meet with the board
of directors or senior officer annually, but eliminates the required
topics to be discussed at the meeting. As the Commission noted in the
notice of proposed rulemaking, the requirement for an annual discussion
would not preclude the board of directors or the senior officer from
meeting with the CCO more frequently. While more frequent communication
between the CCO and the DCO's board or senior officer may be desirable,
the Commission has concluded that adopting requirements to that effect
would be overly prescriptive. Similarly, upon further consideration,
the Commission has concluded that the purpose of the meeting should be
self-evident (i.e., compliance) and it is not necessary for the
Commission, by regulation, to prescribe the business that must be
conducted at that meeting.
6. Change in the Designation of the CCO--Sec. 39.10(c)(1)(iv)
Proposed Sec. 39.10(c)(1)(iv) would require that a change in the
designation of the individual serving as the CCO be reported to the
Commission, in accordance with the requirements of proposed Sec.
39.19(c)(4)(xi). The Commission received no comments on the proposed
rule and is adopting the provision as proposed.\37\
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\37\ See discussion in section IV.J.5.h. (The Commission is
adopting proposed Sec. 39.19(c)(4)(xi) as a renumbered Sec.
39.19(c)(4)(ix)).
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7. Duties of the CCO--Sec. 39.10(c)(2)
Section 5b(i)(2) of the CEA, added by Section 725(a) of the Dodd-
Frank Act, sets forth the duties of a CCO,\38\ and proposed Sec.
39.10(c)(2) would codify those enumerated duties in paragraphs
(c)(2)(i)-(vii).
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\38\ 7 U.S.C. 7a-1(i)(2).
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The Commission received comments on the CCO's duties from CME, KCC,
and OCC. In general, the commenters expressed the view that the
proposed regulations are too broad because they improperly provide the
CCO with what CME calls ``senior management functions'' like enforcing
and supervising compliance policies. Instead, the commenters believe
that the role of a CCO is only to serve as an auditor who monitors
compliance and informs senior management of noncompliance. The
Commission has carefully considered the comments and is adopting the
rule as proposed, except as discussed below.
CME acknowledged that proposed Sec. 39.10(c)(2)(ii) mirrors the
language in the Dodd-Frank Act. However, CME believes that Congress did
not intend to mean ``resolve'' in the executive or managerial sense
such that the CCO alone would examine the facts and determine and
affect the course of action. CME believes that Congress intended the
CCO to identify, advise, and escalate, as appropriate, and to assist
senior management in resolving conflicts of interest.
KCC also believes that the board of directors or senior officer
should resolve any conflict of interest in consultation with the CCO.
KCC commented that compliance policies and procedures should be
administered by DCO staff and not by the CCO. According to KCC, a DCO's
staff is most familiar with the day-to-day operations of the DCO and is
in the best position to manage the policies and procedures. KCC
believes that a CCO's role should be that of oversight of the DCO's
compliance program and filing an annual report.
The Commission disagrees with assertions that a CCO should only
assist senior management in resolving conflicts of interest or that the
board or senior management should resolve conflicts of interest in
consultation with the CCO. Section 5b(i)(2)(C) of the CEA states that a
CCO shall ``in consultation with the board of the derivatives clearing
organization, a body performing a function similar to the board of the
derivatives clearing organization, or the senior officer of the
derivatives clearing organization, resolve any conflicts of interest
that may arise.'' Given this express statutory direction, the
Commission is not revising the proposed rule.
The Commission points out that a CCO's duty to administer
compliance policies and procedures is set forth in Section 5b(i)(2)(D)
of the CEA. It requires a CCO to ``be responsible for administering
each policy and procedure that is required to be established pursuant
to this section.'' By administering compliance policies and procedures,
a CCO is not required to perform staff functions that have compliance
implications. Rather, the CCO is responsible for oversight of such
functions.
The Commission is revising Sec. 39.10(c)(2)(iii) to require a CCO
to have the duty of ``[e]stablishing and administering written policies
and procedures reasonably designed to prevent violation of the Act.''
This does not change the substance of the requirement or alter the
implementation of the statutory standard, as it is consistent with
Sec. 39.10(c)(1) which requires a CCO to ``develop * * * appropriate
policies and procedures * * * to fulfill the duties set forth in the
Act and Commission regulations.'' The Commission believes that the
revised language eliminates the possibility of ambiguity and prevents
too narrow a reading of the reference to policies and procedures that
are ``required'' under the CEA.
CME described as ``impracticable'' the proposed standard that a CCO
must ''ensure'' a DCO's compliance and
[[Page 69343]]
suggested that an appropriate and ``achievable'' standard would be to
require a CCO to put in place measures ``reasonably designed to ensure
compliance'' with the CEA and Commission regulations.
The Commission is revising Sec. 39.10(c)(2)(iv) in response to
CME's comment. Although Section 5b(i)(2)(E) of the CEA requires a CCO
to ``ensure'' compliance, the Commission agrees that a CCO cannot fully
guarantee compliance because, as a practical matter, he or she will
have to rely to some extent on information provided by other DCO
employees or representatives of the DCO's service providers.
Accordingly, Sec. 39.10(c)(2)(iv) is being modified to include as a
duty of the CCO, ``[t]aking reasonable steps to ensure compliance with
the Act and Commission regulations * * * '' (added text in italics).
The Commission believes that this revision addresses CME's concern
while retaining the emphasis on the CCO's actions rather than focusing
on the nature of measures put in place by the CCO.\39\
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\39\ See also 76 FR at 54584 (Sept. 1, 2011) (SDRs: Registration
Standards, Duties and Core Principles; final rule) (adopting Sec.
49.22(d)(4), which applies this standard to the CCO of an SDR).
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CME recommended that the Commission revise proposed Sec.
39.10(c)(2)(vi) to require a CCO to ``[e]stablish[] appropriate
procedures [for] the handling, management response, remediation,
retesting, and closing of noncompliance issues,'' and to eliminate the
requirement that a CCO ``follow[]'' such procedures. According to CME,
this is a function of senior management and Congress did not intend for
a CCO to exercise senior management functions. OCC agrees with CME.
Specifically, CME suggested that proposed Sec. 39.10(c)(2)(vi) be
modified to eliminate the requirement that a CCO ``follow'' appropriate
procedures because following procedures is a function of senior
management. However, a CCO's performance of this ``senior management''
function is explicitly set forth in Section 5b(i)(2)(G) of the CEA,
which states that ``[t]he chief compliance officer shall * * *
establish and follow appropriate procedures for the handling,
management response, remediation, retesting, and closing of
noncompliance issues.'' The Commission does not believe that CME has
provided a persuasive basis for its suggested modification of Sec.
39.10(c)(2)(vi), and the Commission is adopting the provision as
proposed.
Finally, the Commission, on its own initiative, is revising Sec.
39.10(c)(2)(vii) to eliminate the requirement that a CCO establish a
compliance manual. While having a compliance manual is a good practice,
incorporating this requirement into a regulation may be overly
prescriptive and the Commission has concluded that a DCO should have
discretion as to the vehicles through which it will carry out its
compliance program.
8. Annual Report--Sec. 39.10(c)(3)
Section 5b(i)(3) of the CEA, added by Section 725(b) of the Dodd-
Frank Act, requires a CCO to prepare an annual report that describes
the DCO's compliance with the CEA, regulations promulgated under the
CEA, and each policy and procedure of the DCO, including the code of
ethics and conflicts of interest policies.\40\ Implementation of these
statutory requirements was addressed at proposed Sec. 39.10(c)(3)(i),
(c)(3)(ii)(A), and (c)(3)(v) and (v).
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\40\ 7 U.S.C. 7a-1(i)(3).
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With respect to proposed Sec. 39.10(c)(3)(i), CME suggested that
the Commission eliminate it and KCC commented that the requirement for
a DCO to show compliance with respect to the CEA and Commission
regulations is ambiguous and overreaching. KCC also suggested that the
scope of the annual report should not go beyond reviewing the DCO core
principles and identifying the compliance policies and procedures that
are in place to satisfy the core principles.
Although paragraph (i) mirrors the language and requirements set
forth in Section 5b(i)(3)(A)(i) of the CEA, to address CME's and KCC's
comments, the Commission has decided to revise the language of
Sec. Sec. 39.10(c)(3)(i) and (ii) to avoid submission of duplicative
information and to clarify the scope of the annual report content
requirements without altering the nature of the information that must
be included in the report pursuant to the CEA. Final Sec. 39.10
(c)(3)(i) requires that the annual report ``[c]ontain a description of
the derivatives clearing organization's written policies and
procedures, including the code of ethics and conflict of interest
policies.'' Final Sec. 39.10 (c)(3)(ii) requires that the report ''
[r]eview each core principle and applicable Commission regulations, and
with respect to each: (A) Identify the compliance policies and
procedures that are designed to ensure compliance with the core
principle.'' The Commission notes that by specifying ``written''
policies and procedures, the rule more precisely establishes the scope
of Sec. 39.10(c)(3)(i).
Proposed Sec. Sec. 39.10(c)(3)(iii) and (c)(3)(iv) would require
that the annual report list any material changes to compliance policies
and procedures since the last annual report and describe the DCO's
financial, managerial, and operational resources for compliance with
the Act and Commission regulations, respectively. The Commission did
not receive any comments on these provisions and is adopting Sec. Sec.
39.10(c)(3)(iii) and (c)(3)(iv) as proposed.
Proposed Sec. 39.10(c)(3)(v) would require that the annual report
``[d]escribe any material compliance matters, including incidents of
noncompliance, since the date of the last annual report and describe
the corresponding action taken.'' CME suggested that the provision be
revised to require that the annual report identify only material
compliance issues that were not properly addressed by the DCO.
The Commission is adopting Sec. 39.10(c)(3)(v) as proposed because
receiving such information will enable the Commission to assess whether
the DCO is addressing compliance matters effectively. It also will
enable the Commission to become aware of possible future compliance
issues across DCOs and to proactively identify best practices. An
annual report that identifies only material compliance issues would not
provide sufficient information.
Finally, the Commission on its own initiative is not adopting
proposed Sec. 39.10(c)(3)(vi) because information of this nature is
not essential to the Commission's evaluation of the DCO's compliance
program and, if it is relevant to a material compliance matter, it will
be provided to the Commission pursuant to Sec. 39.10(c)(3)(v).
9. Submission of Annual Report to the Commission--Sec. 39.10(c)(4)
Proposed Sec. 39.10(c)(4) would set forth the requirements for
submitting an annual report to the Commission. Except as noted below,
the Commission is adopting the rule as proposed.
Better Markets suggested that the Commission change proposed Sec.
39.10(c)(4)(i) to require a CCO to present the finalized annual report
to the board of directors and executive management prior to its
submission to the Commission. Better Markets also suggested that the
independent directors as well as the entire board should be required to
review and approve the report in its entirety and to detail any
disagreement with any portion. In
[[Page 69344]]
addition, Better Markets commented that a CCO should be required to
file the report with the Commission, either as approved or with
statements of disagreement.
The Commission is not revising proposed Sec. 39.10(c)(4)(i) per
Better Markets' suggestion. The Commission believes that a DCO should
have the flexibility to determine whether the annual report will be
provided to the board of directors, the senior officer, or both. The
Commission also is not requiring the board of directors to approve or
submit comments on the report given that the board of directors might
not have sufficient information to approve or disagree with the report.
In addition, there is a risk that the board might try to influence the
CCO to change the report if it were required to express approval. The
Commission notes that the rules do not prohibit the board, any of its
members, or the senior officer from approving or disagreeing with
aspects of the annual report.
Proposed Sec. 39.10(c)(4)(ii) would require that the annual report
include a certification by the CCO that, to the best of his or her
knowledge and reasonable belief, and under penalty of law, the annual
report is accurate and complete. CME commented that the Commission
should require the DCO's senior officer, and not the CCO, to make the
necessary certification in the annual compliance report. According to
CME, ``the best way to achieve the goal of a robust effective
compliance program, and to close the loop on creating a culture of
compliance, is to require the registrant's senior officer--and not the
CCO--to complete the required certification.''
KCC commented that a CCO should not have to certify ``under penalty
of law'' that the annual report is accurate and complete, and a CCO
should certify instead that to the best of his or her knowledge and
belief the annual report is accurate and complete.
The Commission is adopting Sec. 39.10(c)(4)(ii) as proposed. The
CEA requires (1) the CCO to sign the annual report and (2) that the
annual report contain a certification that, under penalty of law, the
compliance report is accurate and complete.\41\ Accordingly, the
Commission believes the regulation accurately reflects Congressional
intent.
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\41\ See Section 5b(i)(3)(B)(ii) of the CEA, 7 U.S.C. 7a-
1(i)(3)(B)(ii).
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10. Annual Report Confidentiality
CME suggested that Commission regulations should expressly state
that annual reports are confidential documents that are not subject to
public disclosure by listing annual reports as a specifically exempt
item in part 145 of the Commission's regulations. The Commission has
not proposed and is not adopting CME's proposal, which would provide
blanket confidentiality to all annual reports submitted by CCOs of
DCOs, even though the Commission may determine that there is
information contained in a report that should be public. Accordingly, a
DCO must petition for confidential treatment of its annual report under
Sec. 145.9 if it wants the Commission to determine that a particular
annual report should be subject to confidentiality.
11. Insulating the CCO From Undue Influence
The notice of proposed rulemaking solicited comments as to whether
the Commission should adopt regulations that require a DCO to insulate
its CCO from undue pressure and coercion. CME commented that the
current regulations are sufficient to protect a CCO from undue
influence and it does not believe additional regulations are necessary.
The Commission agrees with CME and is not adopting such regulations.
12. Recordkeeping--Sec. 39.10(c)(5)
Proposed Sec. 39.10(c)(5) would require a DCO to maintain: (i) A
copy of the policies and procedures adopted in furtherance of
compliance with the CEA and Commission regulations; (ii) copies of
materials, including written reports provided to the board of directors
or the senior officer in connection with review of the annual report;
and (iii) any records relevant to the DCO's annual report, including
work papers and financial data. The DCO would be required to maintain
these records in accordance with Sec. 1.31 and proposed Sec. 39.20.
The Commission did not receive any comment letters discussing proposed
Sec. 39.10(c)(5). The Commission has adopted Sec. 39.10(c)(5) as
proposed, except that the Commission has modified Sec. 39.10(c)(5)(A)
to refer to ``all compliance policies and procedures'' rather than
``the compliance policies and procedures, as defined in Sec. 39.1(b)''
in light of the Commission's decision not to adopt a definition of
compliance policies and procedures, as discussed in section III.B,
above.
B. Core Principle B--Financial Resources--Sec. 39.11
Core Principle B,\42\ as amended by the Dodd-Frank Act, requires a
DCO to possess financial resources that, at a minimum, exceed the total
amount that would enable the DCO to meet its financial obligations to
its clearing members notwithstanding a default by the clearing member
creating the largest financial exposure for the DCO in extreme but
plausible market conditions and to cover its operating costs for a
period one year, as calculated on a rolling basis. Proposed Sec. 39.11
would codify these requirements. The Commission received a total of 18
comments on the proposed regulations. The Commission considered each of
these comments in formulating the final regulations discussed below.
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\42\ Section 5b(c)(2)(B) of the CEA, 7 U.S.C. 7a-1(c)(2)(B).
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1. Amount of Financial Resources Required--Sec. Sec. 39.11(a) and
39.11(b)(3)
Proposed Sec. 39.11(a)(1) would require a DCO to maintain
sufficient financial resources to meet its financial obligations to its
clearing members notwithstanding a default by the clearing member
creating the largest financial exposure for the DCO in extreme but
plausible market conditions, and proposed Sec. 39.11(a)(2) would
require a DCO to maintain sufficient financial resources to cover its
operating costs for at least one year, calculated on a rolling basis.
Proposed Sec. 39.11(b)(3) would allow a DCO to allocate a financial
resource, in whole or in part, to satisfy the requirements of either
proposed Sec. 39.11(a)(1) or proposed Sec. 39.11(a)(2), but not both,
and only to the extent that use of that financial resource is not
otherwise limited by the CEA, Commission regulations, the DCO's rules,
or any contractual arrangements to which the DCO is a party.
The Futures Industry Association (FIA) recommended that all DCOs be
required to maintain resources sufficient to withstand the default of
the two clearing members representing the largest financial exposure to
the DCO, but that the Commission give DCOs reasonable time to come into
compliance with the enhanced requirement.
The International Swaps and Derivatives Association (ISDA) also
suggested that, in the clearing of certain OTC derivatives such as
eligible credit default swaps and interest rate swaps, a DCO should
have sufficient financial resources that, at a minimum, enable it to
withstand a potential default by two of its largest clearing members,
as measured by the two clearing members with the largest obligations to
the DCO in extreme but plausible market conditions. ISDA further
suggested, however, that this heightened financial resource level may
not be appropriate for all other OTC or other derivatives products, and
offered to work with the Commission to determine the
[[Page 69345]]
appropriate standard for derivatives in other asset classes.
Similarly, Mr. Chris Barnard recommended that consideration be
given to differentiating risk, and therefore resource requirements by
broad derivative/product class, or at least by exchange-traded and OTC
derivative types.
Better Markets suggested that the default rate used in the stress
test for DCOs should be the larger of (1) the member representing the
largest exposure to the DCO, and (2) the members constituting at least
25 percent of the exposures in aggregate to the DCO. Americans for
Financial Reform (AFR) stated that the calculation in proposed Sec.
39.11(a)(1) should be based on risk exposure as well as number of
defaults.
LCH.Clearnet Group Limited (LCH) concurred with all the provisions
set forth by the Commission under proposed Sec. 39.11(a). NYPC also
expressed support for proposed Sec. Sec. 39.11(a)(1) and 39.11(a)(2).
The Commission is adopting Sec. 39.11(a) as proposed. Section
39.11(a) is consistent with Core Principle B as amended by the Dodd-
Frank Act. As the Commission noted in its notice of proposed
rulemaking, Sec. 39.11(a)(1) is also consistent with the Bank for
International Settlements' Committee on Payment and Settlement Systems
and the Technical Committee of the International Organization of
Securities Commissions (CPSS-IOSCO) Recommendations for Central
Counterparties (CCPs), issued in 2004 (2004 CPSS-IOSCO
Recommendations).\43\ The Commission recognizes that those
recommendations eventually will be replaced by the Principles for
Financial Market Infrastructures (FMIs), which are currently being
developed by CPSS and IOSCO and are expected to be finalized in
2012.\44\ For financial resources requirements for CCPs, CPSS and IOSCO
are considering three alternatives: (1) A ``cover one'' minimum
requirement for all CCPs; (2) a ``cover two'' minimum requirement for
all CCPs; and (3) either a ``cover one'' or a ``cover two'' minimum
requirement for a particular CCP, depending upon the risk and other
characteristics of the particular products it clears, the markets it
serves, and the number and type of participants it has.\45\ The
Commission may reconsider Sec. 39.11(a)(1) once CPSS and IOSCO have
finished their work.
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\43\ See Bank for International Settlements' Committee on
Payment and Settlement Systems and Technical Committee of the
International Organization of Securities Commissions,
``Recommendations for Central Counterparties,'' CPSS Publ'n No. 64
(November 2004), available at http://www.bis.org/publ/cpss64.pdf.
\44\ See Bank for International Settlements' Committee on
Payment and Settlement Systems and Technical Committee of the
International Organization of Securities Commissions, ``Principles
for financial market infrastructures: Consultative report,'' CPSS
Publ'n No. 94 (March 2011), available at http://www.bis.org/publ/cpss94.pdf (CPSS-IOSCO Consultative Report).
\45\ CPSS-IOSCO Consultative Report, Principle 4: Credit Risk,
at 30.
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MGEX noted that proposed Sec. 39.11(b)(3) would prohibit a DCO
from using a financial resource for both default and operating cost
purposes. While MGEX agreed this seems a logical approach to take to
avoid counting an asset's value for two different purposes, MGEX stated
that there are practical implications to consider. As a DCM and DCO,
MGEX keeps one basic set of financial records that are compliant with
various accounting standards. MGEX recommended that the Commission's
proposal should not be interpreted to require a DCO to formally divide
some assets and accounts. The Commission confirms that Sec.
39.11(b)(3) does not require a DCO to formally divide its assets or
accounts. The Commission is adopting Sec. 39.11(b)(3) as proposed.
2. Treatment of Affiliated Clearing Members--Sec. 39.11(a)(1)
Proposed Sec. 39.11(a) would state, in part: ``A [DCO] shall
maintain financial resources sufficient to cover its exposures with a
high degree of confidence and to enable it to perform its functions in
compliance with the core principles set out in Section 5b of the [CEA]
* * * Financial resources shall be considered sufficient if their
value, at a minimum, exceeds the total amount that would: (1) Enable
the [DCO] to meet its financial obligations to its clearing members
notwithstanding a default by the clearing member creating the largest
financial exposure for the [DCO] in extreme but plausible market
conditions; Provided that if a clearing member controls another
clearing member or is under common control with another clearing
member, the affiliated clearing members shall be deemed to be a single
clearing member for purposes of this provision * * * ''
In the notice of proposed rulemaking, the Commission stated:
``There may be some instances in which one clearing member controls
another clearing member or in which a clearing member is under common
control with another clearing member. The Commission proposes to treat
such affiliated clearing members as a single entity for purposes of
determining the largest financial exposure because the default of one
affiliate could have an impact on the ability of the other to meet its
financial obligations to the DCO. However, to the extent that each
affiliated clearing member is treated as a separate entity by the DCO,
with separate capital requirements, separate guaranty fund obligations,
and separate potential assessment liability, the Commission requests
comment on whether a different approach might be warranted.''
CME noted that it treats affiliated clearing members as separate
entities, with separate capital requirements, separate guaranty fund
obligations, and separate potential assessment liability. While CME
acknowledged that the default of one affiliate may impact the ability
of another affiliated clearing member to meet its financial obligations
to the DCO, CME suggested that circumstances may exist in which a
clearing member is sufficiently independent to continue operating
notwithstanding a default by an affiliate. CME rules allow, but do not
require, emergency action to be taken against a clearing member based
upon the financial or operational condition of an affiliate (whether or
not that affiliate is also a clearing member). CME urged the Commission
to take a similar approach by revising the language of proposed Sec.
39.11(a) to state that ``if a clearing member controls another clearing
member or is under common control with another clearing member, the
affiliated clearing members may be deemed to be a single clearing
member * * *.''
LCH agreed with the Commission's proposed requirement that the DCO
must treat any clearing member, either controlled by another clearing
member or under common control with another clearing member, as a
single clearing member for the purposes of Sec. 39.11(a)(1).
The Commission is adopting Sec. 39.11(a)(1) as proposed. The
Commission believes this treatment appropriately addresses the
potential risks of affiliates. The Commission notes that aggregating
the potential losses of affiliated clearing members for purposes of
this calculation would provide more coverage in the event of a default.
3. Operating Costs--Sec. 39.11(a)(2)
Proposed Sec. 39.11(a)(2) would require a DCO to maintain
sufficient financial resources to cover its operating costs for at
least one year, calculated on a rolling basis.
OCC commented that while the statutory requirement that a DCO have
one year of operating costs, based on a rolling period, may be a
reasonable
[[Page 69346]]
standard to ensure that a DCO is not forced out of business while there
is still open interest in the contracts it clears, the requirement
should be calculated based on essential operating expenses for the
rolling period. According to OCC, an appropriate wind-down budget would
include projected revenues during the wind-down and would not include
expenses associated with activities having value only to a DCO that
intends to remain in business (e.g., product development, technological
enhancements, lobbying activities, investor education, etc.).
ISDA stated that it is appropriate that a DCO hold equity capital
sufficient to cover its operating costs and likely exit costs during
any liquidation and this capital should be separate from any DCO equity
contribution to the required default resources.
Eurex Clearing AG (Eurex) agreed that having a requirement for
operating resources is reasonable, especially in view of the
flexibility implied in the Commission's proposed rules for types of
financial resources, but cautioned that the one-year time frame may be
unnecessarily long.
FIA supported this aspect of the Commission's proposal, including
the requirement that a DCO not be permitted to ``double-count'' its
resources to cover both this and the default resources requirement.
The Commission is adopting Sec. 39.11(a)(2) as proposed. The
Commission notes that the language in Sec. 39.11(a)(2) is virtually
identical to that of Core Principle B.
4. Types of Financial Resources--Sec. 39.11(b)
Proposed Sec. 39.11(b)(1) lists the types of financial resources
that would be available to a DCO to satisfy the requirements of
proposed Sec. 39.11(a)(1): (1) The margin of the defaulting clearing
member; (2) The DCO's own capital; (3) the guaranty fund deposits of
the defaulting clearing member and non-defaulting clearing members; (4)
default insurance; (5) if permitted by the DCO's rules, potential
assessments for additional guaranty fund contributions on non-
defaulting clearing members; and (6) any other financial resource
deemed acceptable by the Commission. Proposed Sec. 39.11(b)(2) lists
the types of financial resources that would be available to a DCO to
satisfy the requirements of proposed Sec. 39.11(a)(2): (1) The DCO's
own capital and (2) any other financial resource deemed acceptable by
the Commission.
In the notice of proposed rulemaking, the Commission noted that a
DCO would be able to request an informal interpretation from Commission
staff on whether or not a particular financial resource may be
acceptable to the Commission. The Commission also invited commenters to
recommend particular financial resources for inclusion in the final
regulation.
ISDA encouraged the Commission to give prudent consideration to the
use of standby letters of credit as an additional financial resource,
given that many letter-of-credit issuing banks will be an affiliate of
a clearing member.
Natural Gas Exchange Inc. (NGX) requested that the Commission
consider the acceptability of letters of credit as an asset of the
guaranty fund and clarify in the final rule that letters of credit are
acceptable as an asset of the guaranty fund if subject to certain
safeguards. NGX also requested that the Commission make clear in the
final regulation that it will interpret proposed Sec. Sec.
39.11(b)(1)(vi) and 39.11(b)(2)(ii) broadly so as to permit a
demonstration, on a case-by-case basis, that a DCO meets the overall
policies of the regulation through a specific mix of financial
resources.
Mr. Barnard recommended splitting the types of financial resources
permitted under proposed Sec. 39.11(b)(1) into two classes: Class A
would consist of the financial resources listed in paragraphs (b)(i)
through (b)(iii), and would be required to make up the significant part
of the total financial resources, and class B would consist of the
financial resources listed in paragraphs (b)(iv) through (b)(vi), on
which larger prudential haircuts would be required. MGEX suggested that
proposed Sec. 39.11(b)(2) should retain the ability for a DCO to
provide its explanation and methodology for including a particular
financial resource. MGEX further suggested that the list of potential
financial resources should be broad and not pruned too quickly,
particularly by initial regulation.
Eurex commented that the Commission's proposed list of financial
resources in proposed Sec. 39.11(b)(1) is appropriate.
The Commission is adopting Sec. 39.11(b) as proposed, except for a
technical amendment to clarify the scope of the use of margin as a
financial resource to cover a default. As proposed, the Commission is
not including letters of credit as an acceptable financial resource
because they are only a promise by a bank to pay and not an asset that
can be sold.\46\ However, both Sec. 39.11(b)(1) and Sec. 39.11(b)(2)
permit ``any other financial resource deemed acceptable by the
Commission,'' which means that the Commission could evaluate the use of
letters of credit on a case-by-case basis.\47\
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\46\ The Commission recognizes that assessment powers are also a
promise to pay, but as the Commission noted in the notice of
proposed rulemaking, a clearing member may have a strong financial
incentive to pay an assessment. If a clearing member failed to pay
its assessment obligation, that failure would be treated as a
default and the clearing member would be subject to liquidation of
its positions and forfeiture of the margin in its house account.
Thus, in addition to a potential general interest in maintaining the
viability of the DCO going forward, a non-defaulting clearing member
may have a specific incentive to pay an assessment, depending on the
size and profitability of its positions and the margin on deposit
relative to the size of the assessment.
\47\ See discussion of the prohibition on accepting letters of
credit as initial margin in section IV.F.5, below.
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The Commission also received inquiries from a few DCOs as to
whether the Commission would deem projected revenue an acceptable
financial resource to satisfy the requirements of Sec. 39.11(a)(2).
The Commission expects that projected revenue generally would be deemed
acceptable for established DCOs that can demonstrate a historical
record of revenue, but not for DCO applicants or relatively new DCOs
with no such record.
With respect to any financial resource that is not enumerated in
Sec. 39.11(b) and for which a DCO seeks a determination as to its
acceptability based on the DCO's particular circumstances, DCO staff
should contact Commission staff prior to submitting the DCO's quarterly
financial resources report.
The Commission is modifying Sec. 39.11(b)(1)(i) to more precisely
reflect the fact that the use of margin as a financial resource
available to satisfy the requirements of paragraph (a)(1) is subject to
limitations imposed by the Commission and a DCO, e.g., relating to the
use of customer margin to cover a default. As proposed, Sec.
39.11(b)(1)(i) would permit the use of ``[m]argin of a defaulting
clearing member.'' The provision now refers to ``[m]argin to the extent
permitted under parts 1, 22, and 190 of this chapter and under the
rules of the derivatives clearing organization.''
5. Capital Requirement
Proposed Sec. Sec. 39.11(b)(1) and (b)(2) list the DCO's own
capital as a type of financial resource that would be available to a
DCO to satisfy the requirements of proposed Sec. Sec. 39.11(a)(1) and
(a)(2), respectively. In the notice of proposed rulemaking, the
Commission noted that Commission regulations do not prescribe capital
requirements for DCOs. The Commission invited
[[Page 69347]]
comment on whether it should consider adopting such requirements and if
so, what those requirements should be.
J.P. Morgan Chase & Co. (J.P. Morgan) commented that if a DCO
enumerates its own capital as part of its waterfall, that DCO should be
required to provide sufficient assurances that the capital will be
available to meet those obligations and will not be reallocated to
serve other purposes at the DCO's discretion. In a separate comment
letter on the proposed risk management requirements for DCOs, J.P.
Morgan offered its support for regulations that would require a DCO to
retain in a segregated deposit account, on a rolling basis, 50 percent
of its earnings from the previous 4 years. In addition, J.P. Morgan
stated that it would be appropriate for at least 50 percent of the
retained earnings to have a first loss position. J.P. Morgan also
recommended that the DCO contribution be subject to a minimum floor of
$50 million.
Mr. Michael Greenberger recommended that the Commission require
DCOs to set aside a reasonable amount of capital, equal to an average
size of one contract for that DCO, so that a DCO would have sufficient
financial resources to absorb a default. In addition, Mr. Greenberger
suggested that capital requirements for DCOs must require that the
DCOs' capital be highly liquid so that a DCO can cure a default in a
timely manner.
Eurex noted that clearing organizations exhibit a variety of
organizational and capital structures and suggested the Commission
should allow DCOs to determine their own mixes of protective measures,
which might include the DCO's own capital. Nevertheless, Eurex
expressed support for an initial capital requirement of $25 million for
DCOs.
OCC commented that an equity capital requirement for DCOs is not
appropriate because DCOs rely primarily on member-supplied resources,
such as clearing fund deposits and margin, to meet their obligations.
According to OCC, most, if not all, DCOs have little capital in
relation to their obligations. OCC suggested that the critical question
from a safeness and soundness standpoint is whether DCOs have adequate
financial resources, not the form in which such resources are held.
CME stated that the financial resources requirements contained in
Core Principle B are better suited to achieve the goal of ensuring
adequate capitalization of DCOs, and that further capital requirements
would be unnecessary and essentially duplicative.
KCC commented that, with proposed Sec. 39.11(a)(1) requiring a DCO
to maintain sufficient financial resources to meets its financial
obligations, a separate capital requirement would be redundant. KCC
also stated that onerous capital requirements placed on DCOs could have
an anti-competitive effect.
NYPC cautioned that mandating that DCOs hold specific forms or
amounts of capital could have a chilling effect on competition, at odds
with the principles of the CEA by potentially shutting out various
forms of organizational structures for DCOs. NYPC noted that Core
Principle B requires that DCOs maintain sufficient financial resources
to perform their functions as central counterparties in compliance with
the CEA. NYPC suggested that whether such financial resources are
derived from a DCO's own capital or other financial resources deemed
acceptable to the Commission should be inconsequential to the extent
such statutorily prescribed functions are fulfilled.
MGEX stated that it does not support adopting specific capital
requirements for DCOs. MGEX noted that the proposed regulation already
requires a DCO to be able to withstand the default of its largest
clearing member in extreme but plausible market conditions. MGEX
further noted that a DCO's capital is only one element of the financial
resources necessary to cover that risk, and suggested that a DCO should
be able to determine how it best needs to allocate that risk among its
various financial resources.
The Commission is not adopting a capital requirement for DCOs at
this time. The Commission believes that it is appropriate to provide
flexibility to DCOs in designing their financial resources structure so
long as the aggregate amount is sufficient. The Commission notes,
however, that one of the principles in the CPSS-IOSCO Consultative
Report would require an FMI to ``hold sufficiently liquid net assets
funded by equity to cover potential general business losses so that it
can continue providing services as a going concern.'' \48\ CPSS and
IOSCO are considering, and requesting comment on, the establishment of
a specific minimum quantitative requirement for liquid net assets
funded by equity. If such a requirement is established, the Commission
may consider a similar requirement for DCOs at that time.
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\48\ See CPSS-IOSCO Consultative Report, Principle 15: General
Business Risk, at 70.
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6. Assessments--Sec. Sec. 39.11(b)(1)(v) and 39.11(d)(2)
Proposed Sec. 39.11(b)(1)(v) would list ``potential assessments
for additional guaranty fund contributions, if permitted by the [DCO]'s
rules'' as a type of financial resource that would be available to a
DCO to satisfy the requirements of proposed Sec. 39.11(a)(1). Proposed
Sec. 39.11(d)(2) would require a DCO: (i) To have rules requiring that
its clearing members have the ability to meet an assessment within the
time frame of a normal variation settlement cycle; (ii) to monitor, on
a continual basis, the financial and operational capacity of its
clearing members to meet potential assessments; (iii) to apply a 30
percent haircut to the value of potential assessments; and (iv) to only
count the value of assessments, after the haircut, to meet up to 20
percent of its default resources requirement. The Commission requested
comment on whether these limits and requirements are appropriate and,
more generally, whether assessment powers should be considered to be a
financial resource available to satisfy the requirements of proposed
Sec. 39.11(a)(1).
With regard to proposed Sec. Sec. 39.11(d)(2)(i) and (ii), OCC
commented that the requirement that clearing members be able to meet an
assessment within the time frame of a normal variation settlement cycle
is an aggressive but appropriate standard that its clearing members
would be able to meet in most circumstances, but that DCOs should have
discretion to extend this deadline on a case-by-case basis where
appropriate to avoid severe strains on clearing member liquidity in
unusual circumstances. OCC objected to the requirement that DCOs must
monitor ``on a continual basis'' a clearing member's ability to meet
potential assessments, which OCC claimed is overly burdensome and
difficult to administer. OCC suggested that a monthly review is
reasonable and adequate.
NYPC requested that the Commission clarify how the requirement of
proposed Sec. 39.11(d)(2)(i) would be imposed on DCOs that conduct
both end-of-day and intraday settlements each business day. In order to
ensure that a uniform standard is applied across clearing members of
all DCOs, whether the DCO conducts one or two settlements per business
day, NYPC recommended that the Commission clarify that a DCO's rules
should require clearing members to have the ability to meet an
assessment within one business day.
With regard to proposed Sec. 39.11(d)(2)(ii), NYPC requested that
[[Page 69348]]
the Commission provide guidance as to how it expects DCOs to determine
whether a clearing member has the capacity to meet a potential
assessment. In addition, NYPC expressed concern that the ``continual''
monitoring of clearing members' ability to meet potential assessments,
which NYPC believes implies daily or even real-time monitoring, would
be extremely difficult, if not impossible, to administer. NYPC
suggested that it would be reasonable and more practicable for the
Commission to require that monitoring of clearing members' ability to
meet potential assessments be included as a mandatory component of the
periodic financial reviews of clearing members that DCOs already
conduct in the ordinary course of business.
In response to these comments, the Commission is revising Sec.
39.11(d)(2)(i) to read as follows (added text in italics): ``The
derivatives clearing organization shall have rules requiring that its
clearing members have the ability to meet an assessment within the time
frame of a normal end-of-day variation settlement cycle.'' In response
to OCC's comment, the Commission notes that Sec. 39.11(d)(2)(i)
requires a DCO to have rules requiring that its clearing members have
the ability to meet an assessment within the time frame of a normal
end-of-day variation settlement cycle, but would permit a DCO, in its
discretion, to provide some flexibility to clearing members as to
timing.
In addition, the requirement in Sec. 39.11(d)(2)(ii) that a DCO
must monitor the financial and operational capacity of its clearing
members to meet potential assessments ``on a continual basis'' was
intended to mean only that the DCO must perform such monitoring often
enough to enable it to become aware of any potential problems in a
timely manner. To eliminate possible ambiguity, the Commission is
revising the final rule by removing the phrase ``on a continual
basis.'' Thus, Sec. 39.11(d)(2)(ii) establishes a standard whereby a
DCO must monitor its clearing members, but the DCO can meet the
standard through the exercise of its judgment in response to particular
circumstances, e.g., a DCO might have reason to evaluate certain
clearing members on a daily basis and evaluate others only as part of
routine, periodic financial reviews.
With regard to proposed Sec. Sec. 39.11(d)(2)(iii), FIA commented
that the 30 percent haircut and 20 percent cap are reasonable and
prudent safeguards, sufficient to ensure that a DCO does not unduly
rely on its assessment power. J.P. Morgan supported the proposal and
also recommended that regulators adopt a risk-based analysis to
determine the likelihood that a clearing member will be able to meet
its assessment obligations across all DCOs. Mr. Greenberger, citing
J.P. Morgan's comments, agreed that it is absolutely critical that the
Commission promulgate rules that would determine a clearing member's
risk of default and its availability of financial resources across all
clearinghouses. Similarly, ISDA suggested that the Commission evaluate
the potential impact of multiple assessments from different DCOs on the
same clearing member or affiliate group in a short time-frame.
CME suggested that a DCO should be required to completely exclude
the potential defaulting firm's assessment liability in calculating its
available assessment resources. CME also commented that, in light of
the requirements of proposed Sec. Sec. 39.11(d)(2)(i) and (ii), and
the fact that a clearing member that failed to pay an assessment would
itself be in default to the DCO, it does not believe that a further
haircut on assessments is necessary, and it is aware of no valid reason
to cap the use of assessments at 20 percent as proposed.
KCC noted that the inclusion of assessment powers as financial
resources is necessary for it to meet its obligations in the unlikely
event of a default. KCC agreed that a reasonable haircut on the value
of a DCO's assessment power may be a prudent measure, but stated that
the proposed limits are unreasonable and excessive and seem arbitrary.
KCC suggested that a better approach would be for the DCO to be allowed
the latitude to determine clearing member assessment haircuts on an
individual basis, based on each clearing member's financial
capabilities.
MGEX recommended that the Commission allow each DCO to provide its
methodology and support for why any assessment might be considered a
financial resource and how much. MGEX stated that the 30 percent
haircut and 20 percent cap seem arbitrary and prescriptive. MGEX stated
that the DCO should have the discretion to determine an appropriate
haircut based on the clearing member's liquidity.
Better Markets commented that the proposed haircuts for assessments
are inadequate. According to Better Markets, it would be far more
prudent to require funding of risk that can be anticipated in stress
tests and rely on assessments as a financial resource only for
conditions that are not anticipated in stress tests.
LCH recommended that potential assessments not be allowed to
satisfy the requirements of proposed Sec. 39.11(a)(1) because, in
LCH's view, it is of the utmost importance that a DCO's resources
following a clearing member default be immediately and unconditionally
available. LCH suggested that assessments should be allowed as part of
the DCO's ``waterfall'' of protections, but should not be taken into
account to meet the specific test outlined under proposed Sec.
39.11(a)(1).
AFR urged the Commission to prohibit DCOs from including assessment
powers in their calculation of financial resources because it is
unclear, in a time of broad market distress, whether a DCO's members
would be willing and able to pay their assessments.
The Commission is adopting Sec. 39.11(d)(2)(iii) as proposed. In
view of the wide range of comments on this issue, the Commission
believes the rule strikes an appropriate balance. The 30 percent
haircut recognizes that the defaulting firm, which by definition will
not be paying an assessment, might represent a significant segment of
the DCO's total risk. The 20 percent cap recognizes that given the
contingent nature of assessments, they should only be relied upon as a
last resort. In response to ISDA's comment, the Commission expects that
as part of the evaluation of a clearing member's risk profile, a DCO
would take into consideration the potential exposure of the clearing
member at other DCOs, to the extent that it is able to obtain such
information, including the possibility of assessments. The Commission
notes, in response to MGEX's and KCC's comments, that a DCO may
determine clearing member assessment haircuts on an individual basis
because Sec. 39.11(d)(2)(iii) only requires a 30 percent haircut on an
aggregate basis.
7. Computation of the Financial Resources Requirement--Sec.
39.11(c)(1)
Proposed Sec. 39.11(c)(1) would require a DCO to perform stress
testing on a monthly basis in order to make a reasonable calculation of
the financial resources it needs to meet the requirements of proposed
Sec. 39.11(a)(1). The DCO would have reasonable discretion in
determining the methodology used to make the calculation, but would be
required to take into account both historical data and hypothetical
situations. In the notice of proposed rulemaking, the Commission
requested comment on whether monthly tests are appropriate.
MGEX commented that monthly reporting seems reasonable as it
already
[[Page 69349]]
performs stress tests on a routine basis. MGEX further commented that
allowing DCOs discretion in selecting stress test scenarios is
appropriate.
CME suggested that annual stress testing would suffice for
operating costs because operating costs are generally static. With
regard to default coverage, CME suggested that stress testing should be
done no less than monthly.
LCH expressed concern over the requirement that the DCO perform
stress testing only on a monthly basis. In LCH's view, stress testing
should be carried out by the DCO on at least a daily basis, and LCH
strongly urged the Commission to amend its proposal accordingly. LCH
suggested that monthly stress testing is inadequate, as experience has
shown that market conditions and member positions can change rapidly
during periods of market turmoil.
ISDA suggested that reverse stress tests \49\ should be required
for determining the size of the financial resources package and that
there should be public disclosure of the stress tests and their
results.
---------------------------------------------------------------------------
\49\ Reverse stress tests are stress tests that require a firm
to assess scenarios and circumstances that would render its business
model unviable, thereby identifying potential business
vulnerabilities. Reverse stress testing starts from an outcome of
business failure and identifies circumstances where this might
occur. This is different from general stress testing, which tests
for outcomes arising from changes in circumstances. See http://www.fsa.gov.uk/pages/About/What/International/stress_testing/firm_s/reverse_stress_testing/index.shtml.
---------------------------------------------------------------------------
Mr. Barnard agreed that stress testing should be carried out at
least monthly, and suggested that back testing should be carried out
daily. Mr. Barnard also suggested that the Commission specifically
refer to reverse stress testing in proposed Sec. 39.11(c)(1) because,
in his view, it is a useful tool for managing expectations and for
helping the DCO to anticipate financial resources requirements in
extreme conditions.
FIA recommended that the Commission make clear its expectation that
the DCOs will, at a minimum: (1) Conduct a range of stress tests that
reflect the DCO's product mix; (2) include the most volatile periods
that have been experienced by the markets for which the DCO provides
clearing services; (3) take into account the distribution of cleared
positions between clearing members and their customers; and (4) test
for unanticipated levels of volatility and for breakdowns in
correlations within and across product classes.
Mr. Greenberger recommended that historical market data that led up
to the passage of the Dodd-Frank Act be taken into account in
determining market conditions that could be defined as extreme but
plausible.
Better Markets commented that the passive role of the Commission in
measuring the financial requirements for a DCO is inappropriate in
light of the importance of this function. Better Markets proposed that
the methodology, the historical data set, and the hypothetical
scenarios be: (1) Jointly developed by the DCO and the Commission and
(2) reviewed whenever ordered by the Commission, but no less frequently
than quarterly. Better Markets also recommended that the Commission
explicitly recognize the importance of illiquidity in developing
hypothetical scenarios.
AFR stated that it is critical that the Commission play a central
role in establishing the standards by which DCOs will measure their
exposure to future risks. AFR urged the Commission to define minimal
standards that will ensure that DCO stress tests are stringent and
incorporate realistic metrics of worst-case scenarios that DCOs may
experience.
The Commission is adopting Sec. 39.11(c)(1) as proposed. The
Commission believes it is appropriate to allow the DCO discretion in
designing stress tests because stress testing is an exercise that
inherently entails the exercise of judgment at various stages.
Furthermore, Sec. 39.11(c)(1) allows the Commission to evaluate the
testing and require changes as appropriate. In response to the LCH
comment, the Commission notes that there is a distinction between the
type of stress testing carried out under this rule for the purpose of
sizing the overall financial resource package and the type of stress
testing carried out under Sec. 39.13(h)(3) for the purpose of
ascertaining the risks that may be posed to the DCO by individual
traders and clearing members. The former is a comprehensive test across
all clearing members and all products with the goal of identifying the
firms posing the greatest risk to the DCO and quantifying that risk.
The regulations would require such testing to be completed monthly. The
latter is targeted testing addressing the specific risks of specific
positions at specific firms. The regulations would require such testing
to be completed on either a daily or weekly basis, as described in
Sec. 39.13(h)(3).\50\
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\50\ See discussion of Sec. 39.13(h)(3) in section IV.D.7.c,
below.
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8. Valuation of Financial Resources--Sec. 39.11(d)(1)
Proposed Sec. 39.11(d)(1) would require a DCO, no less frequently
than monthly, to calculate the current market value of each financial
resource used to meet its obligations under proposed Sec. 39.11(a).
When valuing a financial resource, a DCO would be required to reduce
the value, as appropriate, to reflect any market or credit risk
specific to that particular resource, i.e., apply a haircut. The
Commission would permit each DCO to exercise its discretion in
determining the applicable haircuts. However, the haircuts would have
to be evaluated on a monthly basis, would be subject to Commission
review, and would have to be acceptable to the Commission.
OCC suggested that the proposed regulations should be modified or
interpreted to accommodate the use of a true portfolio margining model
that values collateral based on its relationship to an overall
portfolio in lieu of applying fixed haircuts on margin collateral.
ISDA stated that it would support an appropriate haircut for
default insurance, potential assessments, and possibly other financial
resources deemed acceptable by the Commission, as determined by the
Commission upon review of the relevant DCO.
FIA expressed reservations about the ability of a DCO to be paid
promptly under the terms of a default insurance policy. FIA therefore
recommended that default insurance coverage be subjected to a 30
percent haircut and a 20 percent cap, similar to the policies that the
Commission has proposed to apply to a DCO's assessment power.
In discussions with Commission staff, Federal Reserve and Federal
Reserve Bank of New York staff suggested that the liquidity of a
financial resource should be an additional factor in determining an
appropriate haircut. Considerations should include whether it is easy
to value the financial resource (e.g., whether the pricing is
transparent) and whether the financial resource could be divested in a
short time period under normal market conditions. The Commission agrees
that liquidity is an important factor in valuing financial resources.
Accordingly, the Commission is revising Sec. 39.11(d)(1) to read
as follows (added text in italics): ``At appropriate intervals, but not
less than monthly, a derivatives clearing organization shall compute
the current market value of each financial resource used to meet its
obligations under paragraph (a) of this section. Reductions in value to
reflect
[[Page 69350]]
credit, market, and liquidity risks (haircuts) shall be applied as
appropriate and evaluated on a monthly basis.'' In response to OCC's
comments, the Commission notes that Sec. 39.11(d)(1) does not prohibit
the valuation method described by OCC in its comment letter.
The Commission believes Sec. 39.11(d)(1) takes a balanced approach
by permitting a DCO to exercise its discretion in determining
applicable haircuts for each of its financial resources but making
those haircuts subject to Commission review and approval. Section
39.11(d)(1) requires a DCO to perform such valuations no less
frequently than monthly, which means the Commission would expect a DCO
to perform such valuations more frequently when appropriate, such as
during periods of market volatility.
9. Liquidity of Financial Resources--Sec. 39.11(e)
Proposed Sec. 39.11(e)(1) would require a DCO to have financial
resources sufficiently liquid to enable the DCO to fulfill its
obligations as a central counterparty during a one-day settlement
cycle, including sufficient capital in the form of cash to meet the
average daily settlement variation pay per clearing member over the
last fiscal quarter. The DCO would be permitted to take into account a
committed line of credit or similar facility for the purpose of meeting
the remainder of the liquidity requirement. In the notice of proposed
rulemaking, the Commission requested comment on whether the liquidity
requirement should cover more than a one-day cycle. The Commission also
requested comment on what standards might be applicable to lines of
credit--e.g., should the Commission require that there be a diversified
set of providers, or that a line of credit have same-day drawing
rights?
Proposed Sec. 39.11(e)(2) would require a DCO to maintain
unencumbered liquid financial assets in the form of cash or highly
liquid securities, equal to six months' operating costs. The DCO would
be permitted to take into account a committed line of credit or similar
facility to satisfy this requirement.
Proposed Sec. 39.11(e)(3) would require that: (i) Assets in a
guaranty fund have minimal credit, market, and liquidity risks and be
readily accessible on a same-day basis, (ii) cash balances be invested
or placed in safekeeping in a manner that bears little or no principal
risk, and (iii) letters of credit not be a permissible asset for a
guaranty fund.
OCC recommended that the proposed regulations be modified or
interpreted to provide DCOs some flexibility in determining the means
of managing their ``cash'' liquidity needs by allowing DCOs to use
secured credit facilities and tri-party repo facilities in addition to
cash held in demand deposit accounts to satisfy the cash requirement.
OCC observed that permitting these alternatives would allow a DCO to
hold a significant portion of its financial resources in the form of
U.S. Treasuries, with the ability to convert the Treasuries to cash as
needed. According to OCC, cash must generally be held at banks, which
presents a credit risk.
NGX suggested that immediately accessible bank lines of credit
should be acceptable to cover the cash requirement where the underlying
commodity is itself traded in a liquid market.
CME suggested the phrase ``average daily settlement variation pay
per clearing member over the last fiscal quarter'' in proposed Sec.
39.11(e)(1) is somewhat ambiguous. CME assumed that the Commission
intended to refer to the average daily variation pay for a single
clearing member, not the average daily settlement variation pay for all
clearing members.
CME also commented that the Commission's approach is not warranted
given the potential amount of cash at issue and the reliability of
liquidity facilities for short-term cash needs. CME suggested that the
Commission revise the last sentence of proposed Sec. 39.11(e)(1) to
read as follows: ``If any portion of such financial resources is not
sufficiently liquid, the derivatives clearing organization may take
into account a committed line of credit or similar facility for
purposes of meeting these requirements.''
In response to the Commission's request for comment on what
standards might be applicable to a liquidity facility, CME stated that
reviews and evaluations by Commission staff during regular DCO audits
are a sufficient check on the adequacy and soundness of a committed
line of credit, and that the Commission should not attempt to prescribe
the terms and conditions of a DCO's liquidity facility.
KCC found the language in proposed Sec. 39.11(e) to be ambiguous.
KCC interpreted the average daily settlement variation pay per clearing
member over the last fiscal quarter to mean the cumulative average of
the pay-ins per each clearing member divided by the number of clearing
members. In KCC's view, a line of credit with same-day drawing rights
should be considered as liquid as cash and therefore should be allowed
to be used by the DCO to fulfill its financial obligations during a
one-day settlement cycle. KCC commented that the liquidity requirement
should cover no more than one day of market price movement.
LCH was unclear on what the Commission intends to mean in proposed
Sec. 39.11(e)(1) by requiring that the DCO should allocate financial
resources to meet the requirements of Sec. 39.11(a)(1) and fulfill its
arising obligations during a ``one-day settlement cycle.'' LCH
suggested that the requirement instead should be that the DCO is
obliged to fulfill its arising obligations ``as they fall due.''
Additionally, LCH suggested that the requirement that the DCO must have
``sufficient capital in the form of cash to meet the average daily
settlement variation pay per clearing member over the last fiscal
quarter'' is insufficient. LCH recommended that this requirement be
replaced by a test that the DCO can meet its liquidity requirements
``following the default of the clearing member(s) creating the largest
liquidity requirement under stressed market conditions over the
quarter.''
Mr. Greenberger suggested that the standards for a committed line
of credit or similar facility must be narrowly and strictly defined, so
that the party can easily use such highly liquid line of credit or
similar facility. Mr. Greenberger further suggested that greater
participation by clearing members in a committed line of credit or a
similar instrument at times of market distress would not provide
necessary liquidity but rather would increase systemic risk.
Eurex noted that proposed Sec. 39.11(e) requires DCOs to monitor
the liquidity of assets and agreed that low-credit risk, highly liquid
assets should comprise guaranty funds and that this rule would serve
important purposes.
FIA recommended that the Commission clarify that the cash
requirement is intended to measure the average (and not the aggregate)
clearing member variation margin requirement. FIA further recommended
that the Commission permit a DCO to satisfy this requirement through
the use of cash or cash equivalents, including U.S. government
securities and repurchase agreements involving highly liquid securities
if such repurchase agreement matures within one business day or is
reversible upon demand. FIA additionally recommended that this aspect
of the Commission's proposal be modified to clarify that DCOs are
permitted to satisfy the liquidity requirement through the
establishment of committed repo facilities. FIA supported allowing a
DCO to obtain a
[[Page 69351]]
committed line of credit or similar credit facility to cover the
remainder of its default resources requirement, but recommended that
this proposal be strengthened by the diversification of credit
providers, with concentration limits of 25 percent per provider.
MGEX commented that proposed Sec. 39.11(e)(1) requires some
clarity. MGEX interpreted it to mean that a DCO must have cash that
will cover the average of all the clearing members' average daily
settlement variation pays, which to MGEX would seem a logical and
practical application. Rather than adopting multiple liquidity
requirements (i.e., cash, clearing member default coverage, six months'
worth of operating expenses), MGEX suggested the process could be
simplified to address the most relevant, which appeared to MGEX to be
the clearing member default coverage. In addition, MGEX recommended
that proposed Sec. 39.11(e) should permit combining and then totaling
its liquidity of financial resources as a single-entity DCO/DCM.
AFR stated that DCOs should be required to have sufficient cash to
fulfill their obligations for 10 business days and that lines of credit
should not count toward liquidity requirements.
NYPC commented that, to the extent the proposed requirement is
intended to exclude cash equivalents, such as U.S. Treasury securities,
the standard is inappropriate. NYPC recommended that the Commission
allow DCOs to satisfy their liquidity needs through the use of any
combination of cash held in demand deposit accounts, bank accounts
meeting the requirements of CFTC Interpretative Letter 03-31,\51\ and
secured credit facilities and repurchase agreements that allow DCOs to
convert U.S. Treasury securities and other high quality collateral into
cash on a same-day basis.
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\51\ CFTC Interpretative Letter 03-31 concerned a bank that
requested an interpretation that a trust deposit account product it
developed would be acceptable for the deposit of customer segregated
funds in accordance with Commission Regulation 1.20. Based on an
analysis of the account, staff of the Commission's Division of
Clearing and Intermediary Oversight issued an interpretation that
the account would be acceptable as a deposit location because the
account would be properly titled and covered by appropriate
acknowledgements by the bank, and the funds in the account would at
all times be immediately available for withdrawal on demand.
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In response to the comments, the Commission is revising Sec.
39.11(e)(1) to provide greater clarity. In addition, the Commission is
modifying the ``cash'' requirement to include ``U.S. Treasury
obligations and high quality, liquid, general obligations of a
sovereign nation.'' This conforms the requirement to existing liquidity
practices and, in particular, it accommodates acceptable practices of
foreign-based DCOs. However, the Commission is not including bank lines
of credit as an acceptable financial resource for meeting the ``cash''
requirement because they are only a promise by the bank to pay and not
an asset that can be sold. The Commission is revising Sec. 39.11(e)(1)
by deleting the following language: ``The derivatives clearing
organization shall have sufficient capital in the form of cash to meet
the average daily settlement pay per clearing member over the last
fiscal quarter. If any portion of the remainder of the financial
resources is not sufficiently liquid, the derivatives clearing
organization may take into account a committed line of credit or
similar facility for the purpose of meeting this requirement.''
The Commission is replacing the deleted language with the
following: ``[(ii)] The derivatives clearing organization shall
maintain cash, U.S. Treasury obligations, or high quality, liquid,
general obligations of a sovereign nation, in an amount greater than or
equal to an amount calculated as follows: (A) Calculate the average
daily settlement pay for each clearing member over the last fiscal
quarter; (B) Calculate the sum of those average daily settlement pays;
and (C) Using that sum, calculate the average of its clearing members'
average pays. (iii) The derivatives clearing organization may take into
account a committed line of credit or similar facility for the purpose
of meeting the remainder of the requirement under paragraph (e)(1)(ii)
of this section.''
The Commission notes that, in the CPSS-IOSCO Consultative Report,
CPSS and IOSCO are considering a minimum liquidity requirement for CCPs
that would be either: (1) A ``cover one'' minimum requirement for all
CCPs; (2) a ``cover two'' minimum requirement for all CCPs; or (3) a
``cover one'' or ``cover two'' minimum requirement for an individual
CCP, depending on the particular risk and other characteristics of the
particular products that it clears, the markets it serves, and the
number and type of participants it has.\52\ The Commission might
revisit the issue after CPSS and IOSCO determine what standard they
will adopt.
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\52\ See CPSS-IOSCO Consultative Report, Principle 7: Liquidity
Risk, at 46.
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10. Reporting Requirements--Sec. 39.11(f)
Proposed Sec. 39.11(f) would require a DCO to report to the
Commission, at the end of each fiscal quarter or at any time upon
Commission request: (i) The amount of financial resources necessary to
meet the requirements set forth in the regulation; and (ii) the value
of each financial resource available to meet those requirements. The
DCO would be required to include with its report a financial statement
(including the balance sheet, income statement, and statement of cash
flows) of the DCO or its parent company. A DCO would have 17 business
days from the end of the fiscal quarter to file its report, but would
also be able to request an extension of time from the Commission.
NYPC suggested that, in light of the scope of information required
to be submitted in the quarterly report (i.e., information regarding
default risk financial resources and operating financial resources),
the Commission should require that such reports be filed not later than
30 calendar days, rather than 17 business days, following the end of
the DCO's fiscal quarter.
ISDA suggested that a DCO seeking an extension of the 17-day
reporting deadline should be required to request the extension at least
seven business days before the deadline.
KCC noted that it does not prepare a statement of cash flows on a
monthly basis, only on an annual basis as part of its audited financial
statements. KCC commented that a monthly profit/loss statement is
sufficient for determining its financial operating needs.
MGEX suggested the Commission should consider a DCO's privacy
concerns when permitting reasonable discretion in the data the DCO
provides in the monthly reports required by the proposed regulations.
MGEX stated that some detail as to projected revenue and expenses must
remain proprietary if it involves potential business opportunities or
other strategic business decisions, and that DCOs have a legitimate
concern that confidential financial information could be subject to
Freedom of Information Act requests.
The Commission is adopting Sec. 39.11(f) as proposed. The
Commission notes that the 17-business-day filing deadline is consistent
with the deadline imposed on FCMs for the filing of monthly financial
reports under Sec. 1.10(b). Moreover, a DCO may request an extension
if it is unable to meet the deadline. The Commission does not believe
it is appropriate to require a DCO to request an extension at least
seven business days before the deadline, because a DCO may not know
that far in advance that it will be unable to meet the deadline. With
regard to the confidentiality of the information contained in the
reports, the Commission notes that Core Principle L
[[Page 69352]]
and Sec. 39.21(c)(4) require a DCO to publicly disclose the size and
composition of the financial resources package available in the event
of a clearing member default. A DCO may request confidential treatment
under Sec. 145.9 for other information submitted to the Commission
under these regulations.
11. SIDCOs--Sec. 39.29
Proposed Sec. 39.29(a) would require a SIDCO to maintain
sufficient financial resources to meet its financial obligations to its
clearing members notwithstanding a default by the two clearing members
creating the largest combined financial exposure for the SIDCO in
extreme but plausible market conditions. Proposed Sec. 39.29(b) would
require that a SIDCO not count the value of assessments to meet the
obligations arising from a default by the clearing member creating the
single largest financial exposure and only count the value of
assessments, after a 30 percent haircut, to meet up to 20 percent of
the obligations arising from a default by the clearing member creating
the second largest financial exposure. The Commission believes that it
would be premature to take action regarding Sec. 39.29 at this time.
The FSOC has not yet designated any DCOs as systemically important. As
previously noted, the CPSS-IOSCO Principles for Financial Market
Infrastructures, which are expected to be finalized in 2012, will
address minimum financial resources requirements for CCPs. Similarly,
certain foreign regulators, including the European Union, are also
considering requirements in this area for the CCPs they regulate. The
Commission is concerned that SIDCOs would be put at a competitive
disadvantage if they are forced to comply with these requirements
before non-U.S. CCPs are subject to comparable standards. The
Commission is closely monitoring developments on this issue and is
prepared to revisit the issue if the European Union or other foreign
regulators move closer to implementation. Moreover, because it may be
some time before any DCO is designated a SIDCO, the Commission believes
it would be prudent to reconsider the regulation of SIDCOs in light of
developments that may occur in the interim. The Commission expects to
consider all the proposed rules relating to SIDCOs together.
C. Core Principle C--Participant and Product Eligibility--Sec. 39.12
1. Participant Eligibility
Core Principle C,\53\ as amended by the Dodd-Frank Act, requires
each DCO to establish appropriate admission and continuing eligibility
standards for members of, and participants in, the DCO,\54\ including
sufficient financial resources and operational capacity to meet the
obligations arising from participation. Core Principle C further
requires that such participation and membership requirements be
objective, be publicly disclosed, and permit fair and open access. Core
Principle C also requires that each DCO establish and implement
procedures to verify compliance with each participation and membership
requirement, on an ongoing basis. Proposed Sec. 39.12(a) would codify
these requirements and establish the minimum requirements that a DCO
would have to meet in order to comply with Core Principle C.
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\53\ Section 5b(c)(2)(C) of the CEA, 7 U.S.C. 7a-1(c)(2)(C).
\54\ Core Principle C, as well as the other core principles that
are discussed herein, refer to ``members of, and participants in'' a
DCO. The Commission interprets this phrase to mean persons with
clearing privileges, and has used the term ``clearing member'' in
describing the requirements of each core principle and in the text
of the proposed regulations described herein. The Commission is also
amending the definition of ``clearing member'' in Sec. 1.3(c),
adopted herein, to mean ``any person that has clearing privileges
such that it can process, clear and settle trades through a
derivatives clearing organization on behalf of itself or others. The
derivatives clearing organization need not be organized as a
membership organization.''
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Although there is potential tension between the goals of ``fair and
open access'' and ``sufficient financial resources and operational
capacity to meet obligations arising from participation in the
derivatives clearing organization,'' the Commission believes the rules
that it is adopting herein strike an appropriate balance. The
Commission has crafted the provisions of Sec. 39.12 and related rules,
e.g., the risk management requirements, to establish a regulatory
framework that it believes can ensure that a DCO's participation
requirements do not unreasonably restrict any entity from becoming a
clearing member while, at the same time, limiting risk to the DCO and
its clearing members. The Commission expects that more widespread
participation will reduce the concentration of clearing member
portfolios, thereby diversifying risk, increasing market liquidity, and
increasing competition among clearing members.
a. Fair and Open Access--Sec. 39.12(a)(1)
Proposed Sec. 39.12(a) would require a DCO to establish
appropriate admission and continuing participation requirements for
clearing members of the DCO, which are objective, publicly disclosed,
and risk-based. Proposed Sec. 39.12(a)(1) would require a DCO to have
participation requirements that permit fair and open access, setting
forth specific standards.
The Managed Funds Association (MFA), BlackRock, Inc. (BlackRock),
State Street Corporation (State Street), and the Committee on Capital
Markets Regulation (CCMR) supported the proposed rules. J.P. Morgan,
ISDA, and FIA expressed support for the fair and open access provisions
as long as there is prudent risk management.
According to MFA, more inclusive DCO participation requirements
would benefit DCOs and the markets by: (1) Reducing DCO concentration
risk; (2) increasing diversity of market participants involved in DCO
governance; (3) enhancing competition in the provision of clearing
services; and (4) lowering overall costs for non-clearing members.
State Street agreed that more widespread participation could increase
competition by allowing more entities to become clearing members.
Blackrock commented that the proposed rule would allow a diverse group
of entities to become clearing members, which would increase
competition, promote more inclusive DCO participation requirements, and
lower costs to customers of clearing members.
Each of the provisions of Sec. 39.12(a)(1) are discussed below.
b. Less Restrictive Standards--Sec. 39.12(a)(1)(i)
To achieve fair and open access, proposed Sec. 39.12(a)(1)(i)
would prohibit a DCO from adopting a particular restrictive
participation requirement if it could adopt a less restrictive
requirement that would not materially increase risk to the DCO or its
clearing members. BlackRock, the Swaps & Derivatives Market Association
(SDMA), CME, LCH, Citadel, and CCMR supported the proposed rule. CCMR
commented that the proposed rule would help to encourage an open
marketplace.
KCC, ICE, and MGEX did not support the proposed rule. According to
KCC, the test is highly subjective and would be difficult to implement
in practice. ICE commented that the proposal would require a DCO to
dilute current prudent risk management practices. MGEX commented that
the proposed rule
[[Page 69353]]
would require DCOs to consider only objective, hard number risk
factors, which would force DCOs to bear other risks such as financial
fraud convictions. MGEX suggested that the Commission should provide
DCOs with latitude when determining the risks to which it will expose
itself.
The Commission is adopting Sec. 39.12(a)(1)(i) as proposed, except
for the addition of clarifying language to provide that a DCO shall not
adopt restrictive clearing member standards if less restrictive
requirements ``that achieve the same objective and'' that would not
materially increase risk to the derivatives clearing organization or
clearing members could be adopted. The rule balances the dual
Congressional mandate to provide for fair and open access while
ensuring that such increased access does not materially increase risk.
Because the rule does not require a DCO to provide access that
materially increases risk to the DCO or clearing members, the
Commission does not agree with ICE that the rule will subject a DCO to
increased risk.
The Commission does not agree with KCC that the rule will be highly
subjective or difficult to implement in practice. The rule provides a
DCO with discretion to balance restrictions on participation with
legitimate risk management concerns and, in this regard, a DCO is in
the best position in the first instance to determine the optimal
balance. Only in circumstances where there is a question as to the
impact of the rule would the Commission ask a DCO to justify the
balance that the DCO has struck.
In response to MGEX's comment, the Commission notes that the rule
does not require a DCO to rely solely on objective, hard number risk
factors. The rule permits a DCO to rely on both qualitative and
quantitative analyses, providing each DCO with latitude to determine
how it can facilitate open access while determining the risks to which
it will expose itself.
Except for certain bright-line participation requirements (e.g.,
capital requirements for clearing members), the Commission has not
provided more specific guidance as to what participant eligibility
requirements are permissible under Core Principle C. Such a
clarification would only serve to limit a DCO's flexibility to
formulate participation requirements.
The Commission encourages each DCO to conduct a self-assessment to
make sure that it can provide reasoned support to justify a conclusion
that its rules do not violate the ``less restrictive'' standard
contained in Sec. 39.12(a)(1)(i). Such an analysis should take into
consideration the interaction of this provision with the other
provisions of Sec. 39.12(a).
c. Clearing Member Qualification--Sec. 39.12(a)(1)(ii)
Proposed Sec. 39.12(a)(1)(ii) would require a DCO to permit a
market participant to become a clearing member if it meets the DCO's
participation requirements. SDMA, LCH, and CCMR supported the proposed
rule. According to CCMR, the proposed rule would help to encourage an
open marketplace.
KCC commented that the proposed rule is not workable because a DCO
may not have the operational capacity to admit all applicants that
satisfy the DCO's membership requirements. KCC proposed that the
regulation clarify that a DCO may set limits on the number of market
participants that may be admitted in light of the DCO's own operational
constraints.
The Commission is adopting Sec. 39.12(a)(1)(ii) as proposed. The
Commission is concerned that permitting a DCO to set a limit on the
number of market participants that may become clearing members could
enable a DCO to evade the open access requirement imposed by Core
Principle C. If a DCO were able to demonstrate that operational
constraints prevented it from admitting additional clearing members,
the DCO could petition the Commission for an exemption.
d. Non-Discriminatory Treatment--Sec. 39.12(a)(1)(iii)
Proposed Sec. 39.12(a)(1)(iii) would prohibit participation
requirements that have the effect of excluding or limiting clearing
membership of certain types of market participants unless the DCO can
demonstrate that the restriction is necessary to address credit risk or
deficiencies in the participants' operational capabilities that would
prevent them from fulfilling their obligations as clearing members. LCH
and SDMA supported the proposed rule. CME commented that in addition to
credit risk and deficiencies in operational capabilities, legal risk
should be included in the text of this regulation as a basis upon which
a DCO may exclude or limit clearing membership of certain types of
participants.
KCC did not support the proposed rule, commenting that a DCO's
right to exclude or place limitation on certain clearing members should
not be subject to ex-post determinations as to the necessity of such
restrictions, as the DCO itself is in the best position to monitor the
risks posed by the activities of its clearing members. According to
KCC, the proposed rule would limit the risk management capabilities of
a DCO, and DCOs should be accorded flexibility in their assessments of
the operational capabilities of potential clearing members.
The Commission is adopting Sec. 39.12(a)(1)(iii) as proposed.
CME's concerns regarding heightened legal risk, such as the inability
to attach property of a foreign clearing member under foreign law, are
encompassed within the ``credit risk'' consideration. The Commission
expects that most, if not all, bases for membership exclusion or
limitation will fall within either financial or operational
considerations. In addition, the Commission does not believe the rule
would limit a DCO's risk management capabilities as KCC suggested
because it would not prevent a DCO from excluding or limiting certain
types of market participants from clearing if such participation would
introduce genuine risk that cannot be adequately managed by the DCO.
The Commission expects that DCOs will review their existing
participation requirements for compliance with this rule.
e. Prohibition of Swap Dealer Requirement--Sec. 39.12(a)(1)(iv)
Proposed Sec. 39.12(a)(1)(iv) would prohibit a DCO from requiring
that clearing members be swap dealers. LCH commented that, in the event
of default, it relies on non-defaulting clearing members to hedge the
defaulting member's swap portfolio; to provide liquidity for such
hedging; to bid on hedged portfolios; and, in extreme circumstances, to
accept a forced allocation of swaps, which could be a risky, unhedged
swaps portfolio. LCH commented that a clearing member who is not a swap
dealer may not be able to participate in a DCO's default management
process.
The Commission is adopting Sec. 39.12(a)(1)(iv) as proposed. It is
important to note that the regulation would not preclude participation
by swap dealers (on which LCH currently relies). It simply requires
that a DCO provide clearing access to other entities that could also
participate in a DCO's default management process, even if to a lesser
extent. Broader access is supported by other Commission regulations,
e.g., Sec. 39.12(a)(3), which mandates that a DCO require its clearing
members to have adequate operational capacity to participate in default
management activities; Sec. 39.12(b)(5), which requires a DCO to
select contract units for clearing purposes that maximize liquidity,
facilitate
[[Page 69354]]
transparency in pricing, promote open access, and allow for effective
risk management; and Sec. 39.16(c)(2)(iii), which permits a DCO to
require its clearing members to accept an allocation, provided that any
allocation must be proportional to the size of the clearing member's
positions at the DCO. Thus, a DCO should be able to establish
participation requirements that allow it to rely on non-defaulting
clearing members to hedge a defaulting member's swap portfolio, to
provide liquidity for such hedging, to bid on hedged portfolios, and to
accept a forced allocation of swaps.
f. Prohibition of Swap Portfolio or Swap Transaction Volume
Requirements--Sec. 39.12(a)(1)(v)
Proposed Sec. 39.12(a)(1)(v) would prohibit a DCO from requiring
clearing members to maintain a swap portfolio of any particular size,
or that clearing members meet a swap transaction volume threshold.
According to State Street, such requirements are intended to
systematically favor membership for financial institutions that are
also substantial dealers in swaps. They do not take into account the
risk management capabilities of many DCO members such as State Street,
which are able to closely monitor risk exposures and effectively
liquidate exposures through networks of interdealer relationships. The
Commission believes that such requirements would have the effect of
permitting only large swap dealers to provide clearing services. This
would be inconsistent with Core Principle C. Accordingly, the
Commission is adopting Sec. 39.12(a)(1)(v) as proposed.
g. Financial Resources--Sec. 39.12(a)(2)(i)
Core Principle C mandates that each DCO must ensure that its
clearing members have ``sufficient financial resources and operational
capacity to meet obligations arising from participation in the [DCO].''
\55\ Proposed Sec. 39.12(a)(2)(i) would require a DCO to establish
participation requirements that require clearing members to have access
to sufficient financial resources to meet obligations arising from
participation in the DCO in extreme but plausible market conditions.
The financial resources could include a clearing member's capital, a
guarantee from a clearing member's parent, or a credit facility funding
arrangement.
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\55\ Section 5b(c)(2)(C)(i)(I) of the CEA; 7 U.S.C. 7a-
1(c)(2)(C)(i)(I).
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CME commented that it supports the inclusion of parent guarantees
and credit facility funding arrangements as acceptable financial
resources for clearing members, provided that each DCO retains the
flexibility to determine the particular terms and conditions of such
arrangements. LCH, however, commented that credit facilities or funding
arrangements should not be allowed for the purposes of fulfilling
financial participation requirements. According to LCH, all clearing
members' resources should be immediately and unconditionally available.
ISDA also commented that a credit facility funding arrangement from an
unaffiliated entity should not be available to satisfy clearing member
financial resource requirements. ISDA did not believe that such funding
would be reliable.
MGEX commented that testing for extreme but plausible market
conditions would have minimal value because the test would be based on
historical records or it would be based on future assumptions that are
based on static conditions. MGEX believes that the proposed rule would
require a DCO to devise tests for clearing members to use and would
require a DCO to conduct the tests and provide the results to clearing
members. MGEX commented that this specific rule seems unnecessary
because DCOs have other methods to address risk, like increasing and
decreasing margin. It noted further that it already requires clearing
members to be in good financial standing, which includes minimum
capital requirements and a requirement to provide a parent guarantee in
certain circumstances.
The Commission is adopting Sec. 39.12(a)(2)(i) with the
modification described below. Per CME's comment, the rule provides a
DCO with the flexibility to determine what constitutes sufficient
financial resources to meet obligations arising from participation in
the DCO in extreme but plausible market conditions, and to determine
what financial resources are available to a clearing member to satisfy
this requirement.
Regarding the comments of LCH and ISDA, the rule does not require a
DCO to allow clearing members to use a credit facility funding
arrangement to meet financial resource requirements. Because such
arrangements can serve as an important source of liquidity for clearing
members, the Commission has not prohibited their possible use to
satisfy clearing member financial resource requirements. The Commission
is modifying Sec. 39.12(a)(2)(i) to clarify a DCO's discretion, by
rephrasing the second sentence to read as follows: ``A derivatives
clearing organization may permit such financial resources to include,
without limitation, a clearing member's capital, a guarantee from the
clearing member's parent, or a credit facility funding arrangement.''
To address concerns about reliability, a DCO can consider requiring
that a credit facility funding arrangement be supported by multiple
lenders.
Finally, the Commission does not believe that MGEX's comment
provides a basis for revising the proposed rule. As an initial matter,
Core Principle C requires each DCO to establish participation standards
that require a clearing member to have sufficient financial resources
to meet obligations arising from participation in the DCO. Core
Principle B requires a DCO to maintain financial resources that would
enable it to meet its financial obligations in ``extreme but
plausible'' market conditions. The Commission believes that it is
appropriate for a DCO to subject its clearing members to a comparable
financial standard to support its own compliance with statutory
requirements. A DCO would have discretion in setting the terms of any
tests to determine whether clearing members' financial resources are
sufficient to meet their obligations in extreme but plausible market
conditions.
h. Capital Requirements Must Match Capital to Risk--Sec.
39.12(a)(2)(ii)
Proposed Sec. 39.12(a)(2)(ii) would require a DCO to establish
capital requirements that are based on objective, transparent, and
commonly accepted standards, which appropriately match capital to risk.
The capital requirements also would have to be scalable so that they
are proportional to the risks posed by clearing members.
J.P. Morgan, MFA, ISDA, State Street, SDMA, Citadel LLC (Citadel),
Better Markets, and FIA supported the proposed rule. According to
Better Markets, the proposed rule is an important change of practices
that will open DCO membership to more market participants while
protecting the risk management system. FIA commented that a DCO, when
it sets capital requirements, should take into account a clearing
member's risk-derived exposures and its potential assessment
obligations at each clearing organization of which it is a member. FIA
recommended that a DCO should allow an FCM to clear positions in
proportion to its capital net of those other risk-derived exposures and
assessment obligations.
The Commission is adopting Sec. 39.12(a)(2)(ii) as proposed, with
one modification. In response to a comment from staff of the Federal
Reserve and the Federal Reserve Bank of New York, the
[[Page 69355]]
Commission is deleting the phrase ``so that they are proportional''
from the rule. This is to make clear that a DCO should take into
account nonlinear risk. In response to FIA's comment, the Commission
notes that in setting scalable requirements, a DCO should take into
consideration risks that a clearing member carries as a result of
positions cleared at other DCOs, to the extent that it is able to
obtain such information.
i. Minimum Capital Requirement--Sec. 39.12(a)(2)(iii)
Proposed Sec. 39.12(a)(2)(iii) would prohibit a DCO from setting a
minimum capital requirement of more than $50 million for any person
that seeks to become a clearing member in order to clear swaps.
Pierpont Securities LLC (Pierpont), Better Markets, SDMA, Newedge, MFA,
Citadel, and Jefferies & Company (Jefferies) supported the proposed
rule.
Jefferies commented that the proposed rule would allow it to
participate more actively in the swap market. Jefferies believes that
taken together, the provisions of proposed Sec. 39.12(a) provide a DCO
with more than sufficient authority to assure the financial integrity
and efficient operation of its swaps clearing activities.
Newedge commented that the proposed rule should not increase risk
to a DCO because a DCO can mitigate risk by, among other things,
imposing position limits, stricter margin requirements, or stricter
default deposit requirements on lesser capitalized clearing members.
Newedge proposed that the Commission prohibit DCOs from imposing a
requirement that clearing members have an internal trading desk capable
of liquidating or hedging a defaulting clearing member's positions. It
said that there is no need for such a requirement because a non-
defaulting member can handle a default event in a variety of ways,
including having a contingent default manager. Newedge noted that under
proposed Sec. 39.16(c)(2)(iii), any obligation of a clearing member to
participate in an auction, or to accept the allocation of a defaulting
clearing member's positions, would be proportionate to the size of the
clearing member's own position at the DCO. Thus, a clearing member
should be able to hedge an allocated position and carry the position
over time without having to take a substantial charge to its capital.
MFA commented that the threshold should not impose additional risk
on a DCO because a DCO could ensure the safety of itself and clearing
members by scaling each clearing member's net capital obligation in
proportion to that clearing member's risk exposure. MFA expressed
concern that a DCO could comply with the $50 million net capital
requirement but impose a non-risk-based and excessive threshold
guaranty fund contribution requirement that would unnecessarily exclude
clearing members. MFA proposed that the regulations require that such
scaling be determined by objective, risk-based methodologies that are
based on reasonable stress and default scenarios, and the tests be
consistently applied to all clearing members, without use of ``tiers''
that could have discriminatory or anti-competitive effects.
J.P. Morgan, the U.K. Financial Services Authority (FSA), CME, KCC,
ISDA, IntercontinentalExchange, Inc. (ICE), State Street, Federal Home
Loan Banks (FHLBanks), the Securities Industry and Financial Markets
Association (SIFMA), and LCH expressed the view that the proposed rule
could increase risk and the probability of default, and require DCOs to
accept members who might not be able to participate in the default
management process. FSA, KCC, and CME commented that a DCO must have
reasonable discretion to determine the appropriate capital requirements
for its clearing members based upon the DCO's analysis of the
particular characteristics of the swaps that it clears.
J.P. Morgan, however, commented that a cap on a member's minimum
capital requirement would not impact the systemic stability of a DCO as
long as: (1) Clearing members clear house and client business in
proportion to their available capital; (2) DCOs employ real-time risk
management processes to ensure compliance with this principle; (3) DCOs
hold a sufficient amount of margin and funded default guarantee funds;
and (4) the Commission monitors clearing members to ensure that they
are able to meet their financial obligations with respect to all DCOs
of which they are members.
LCH and ISDA commented that the lower threshold could increase risk
because a $50 million threshold would allow a clearing member to meet
the eligibility requirements of multiple DCOs.
LCH, CME, and FSA commented that the smaller firms may be unable to
participate in the default management process. LCH and ISDA also
commented that members should not be able to outsource default
management to third parties because they may not be sufficiently
reliable in times of stress.
In addition, according to ISDA, there could be conflict-of-interest
issues because the unaffiliated third party would not have ``skin in
the game.'' As a result, through the actions of the unaffiliated third
party, a clearing member could be assigned an unsuitable part of a
defaulting clearing member's proprietary portfolio and/or at a sub-
optimal valuation and/or wrongly accept customer positions from the
defaulting clearing member. This conflict-of-interest concern is
exacerbated where the entity to whom the default management obligations
are outsourced is a ``competing'' clearing member in the same DCO.
State Street and SDMA, however, commented that clearing members
should be permitted to enter into committed arrangements with non-
affiliated firms to perform default management functions. According to
SDMA, there is no evidence to suggest that a legal arrangement with a
third-party dealer somehow lessens the integrity to the system.
Assuming the legal and financial arrangements between such firms are
sufficiently strong to ensure performance when needed, State Street
commented that there is no appreciable difference between the default
management capacity of the traditional dealer-affiliated clearing
member and a non-dealer clearing member outsourcing certain functions
to a non-affiliate.
Finally, SIFMA commented that the appropriate minimum capital
requirement would be $300 million, while ISDA commented that if the
Commission cannot monitor risk across all DCOs, a $1 billion capital
requirement would be appropriate.
After carefully considering the comments, the Commission is
adopting Sec. 39.12(a)(2)(iii) as proposed. The Commission believes,
as noted in numerous comments, that the rule will increase the number
of firms clearing swaps, which will make markets more competitive,
increase liquidity, reduce concentration, and reduce systemic risk. The
Commission also believes that, as explained below, the $50 million
threshold will not significantly increase risk or lead to admission of
clearing members who are unable to meaningfully and responsibly
participate in the clearing process.
As an initial matter, the Commission emphasizes that the $50
million threshold is not arbitrary. That number was arrived at by
reviewing the capital of registered FCMs.\56\ This amount
[[Page 69356]]
captures firms that the Commission believes have the financial,
operational, and staffing resources to participate in clearing swaps
without posing an unacceptable level of risk to a DCO. This capital
threshold is considered to be appropriate, particularly in light of
other proposed rules (such as scaling capital and risk exposure and
breaking down large swap positions into smaller units for more
diversified allocation in the event of a clearing member default).
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\56\ See transcript of December 16, 2010 Commission meeting at
77-81 available at www.cftc.gov (discussing $50 million threshold;
Commission staff stating that of 126 FCMs, 63 currently have capital
above $50 million and most FCMs with capital below that amount are
not clearing members).
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The Commission considered whether to increase the capital threshold
to $300 million as proposed by SIFMA or $1 billion as proposed by ISDA.
The Commission analyzed the reduction in the number of firms that would
be eligible to clear at CME, ICE Clear US, KCC, MGEX, and OCC using
these thresholds. As set forth in the table below, depending on the
basis used to measure capital, a capital threshold of $300 million
would reduce the number of firms able to clear by 38-51 percent. A
capital threshold of $1 billion would reduce the number of firms able
to clear by 62-65 percent. The Commission believes that this reduction
in participation would be contrary to the Congressional mandate for
open access to clearing.\57\
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\57\ Clearing FCM and non-clearing FCM data for adjusted net
capital and excess net capital was provided by FCM registrants and
is available on the Commission Web site. The other data is non-
public. Ownership equity data was provided by FCM registrants
through the monthly financial statements that are submitted to the
Commission. The data from the monthly financial statements reside in
the Commission's RSR Express system, and all data for clearing non-
FCMs was provided by the DCOs to the Commission's Risk Surveillance
Group during the course of its routine oversight activities.
[GRAPHIC] [TIFF OMITTED] TR08NO11.000
The Commission does not believe that the rule will increase risk.
Section 39.12(a)(2)(ii) requires DCOs to impose capital requirements
that are scalable to the risks posed by clearing members. Accordingly,
a small clearing member should not be able to expose a DCO to
significant risk even if it is able to clear at multiple DCOs because
its exposure at each DCO would be limited. DCOs that participate in the
Shared Market Information System (SHAMIS) will be able to see a
clearing member's pays and collects across participating DCOs, and a
DCO also could on its own initiative require clearing members to
directly report their clearing activity at other DCOs. The Commission
also will be able to monitor clearing member exposure by means of DCO
end-of-day reporting under the reporting requirements of Sec.
39.19(c)(1)(i), which the Commission is adopting herein. It will also
be able to monitor the financial strength of clearing members that are
registrants pursuant to financial reporting requirements.
In addition, the Commission is adopting other rules that will
reinforce a DCO's oversight of its clearing members. In this regard,
Sec. 39.12(a)(4) requires a DCO to verify, on an ongoing basis, the
compliance of each clearing member with each participation requirement;
Sec. 39.12(a)(5) requires a DCO to require all clearing members to
file periodic financial statements and timely information that concerns
any financial or business developments that may materially affect the
clearing members' ability to continue to comply with participation
requirements; and Sec. 39.13(h)(5) further requires a DCO to adopt
rules that require clearing members to maintain current risk management
policies and procedures and requires a DCO to review such policies and
procedures on a periodic basis. The Commission also has proposed
requirements for clearing member risk management.\58\
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\58\ See 76 FR 45724 (Aug. 1, 2011) (Clearing Member Risk
Management).
---------------------------------------------------------------------------
The Commission does not believe that the $50 million threshold
would lead to a DCO having to admit clearing members that are unable to
participate in the default management process. As discussed above, the
regulation does not preclude highly-capitalized entities (such as swap
dealers) from participating in a DCO as clearing members. Thus, the
addition of smaller clearing members does not eliminate the role that
larger clearing members can play in default management--it merely
spreads the risk.
The Commission wishes to emphasize that it will review DCO
membership rules as a package in light of all of the provisions of
Sec. 39.12(a). Thus, a DCO may not circumvent Sec. 39.12(a)(2)(iii)
by enacting some additional financial requirement that effectively
renders the $50 million threshold meaningless for some potential
clearing members. Such an arrangement would violate Sec.
39.12(a)(1)(i) (less restrictive alternatives), or Sec.
39.12(a)(1)(iii) (exclusion of certain types of firms).
As discussed below, under Sec. 39.12(a)(3), a DCO's participation
requirements must include provisions for adequate operational capacity.
This requirement should be read in conjunction with Sec.
39.12(a)(1)(i), which prohibits restrictive clearing member standards
if less restrictive standards could be adopted; Sec. 39.12(a)(1)(iii),
which prohibits DCOs from excluding certain types of market
participants from clearing membership if they can fulfill the
obligations of clearing membership; and Sec. 39.16(c)(2)(iii), which
permits a DCO to require a clearing member to participate in an auction
or to accept allocations of a defaulting clearing member's customer or
house positions, provided the allocated positions are proportional to
the size of the clearing member's positions at the DCO and are
permitted to be outsourced to a qualified third party subject to
safeguards imposed by the DCO.
Several commenters discussed the use of outsourcing to satisfy
default management obligations. The Commission believes that open
access to clearing and effective risk management need not be viewed as
conflicting goals. Subject to appropriate safeguards, outsourcing of
certain obligations can be an effective means of harmonizing these
goals. For example, a small clearing member might have less ability to
contribute meaningfully to a DCO's
[[Page 69357]]
auction process acting on its own than if an entity with greater
expertise in the relevant markets acted in its place.
Therefore, the Commission believes that it would be inconsistent
with Sec. 39.12(a)(1)(i) and Sec. 39.12(a)(1)(iii) for a DCO to
prohibit outsourcing. Accordingly, as discussed below, the Commission
is adopting revised default procedure rules to require a DCO to permit
outsourcing to qualified third parties of obligations to participate in
auctions or in allocations, subject to appropriate safeguards imposed
by the DCO.\59\
---------------------------------------------------------------------------
\59\ See discussion of revised Sec. 39.16(c)(2)(iii) in section
IV.G.4, below.
---------------------------------------------------------------------------
Finally, the Commission has determined that it will not permit a
DCO to require members to post a minimum amount of liquid margin or
default guarantee contributions, or to participate in a liquidity
facility per J.P. Morgan's suggestion. The Commission believes that the
rules are sufficient to ensure that each member has adequate resources
to withstand another member's default and such requirements could be
used by a DCO to evade the open access to clearing intended by the
Dodd-Frank Act.
j. Operational Requirements--Sec. 39.12(a)(3)
Proposed Sec. 39.12(a)(3) would require a DCO to require its
clearing members to have adequate operational capacity to meet their
obligations arising from participation in the DCO. The requirements
would include, but not be limited to: The ability to process expected
volumes and values of transactions cleared by a clearing member within
required time frames, including at peak times and on peak days; the
ability to fulfill collateral, payment, and delivery obligations
imposed by the DCO; and the ability to participate in default
management activities under the rules of the DCO and in accordance with
proposed Sec. 39.16.
LCH, FIA, Jefferies, and SDMA commented that the Commission has
correctly identified the operational requirements. Jefferies commented
that demonstrating sufficient operational capacity is more important
than capital considerations. According to SDMA, these operational
requirements are directly related to the core business of the clearing
member and provide the services needed and relied upon by the DCO to
clear trades. SDMA also believes that DCOs should be prohibited from
imposing operational requirements that are not part of a clearing
member's core business because they create discriminatory barriers to
clearing, and it points to the following as examples of discriminatory
operational eligibility requirements: Clearing members must (1) Have
both execution and clearing capabilities; (2) provide end-of-day prices
to mark its positions; and (3) have extensive experience in clearing
swaps or ``sophistication.''
J.P. Morgan and FIA commented that a DCO must ensure that each
member has risk management resources to assist the DCO in its risk
management process, and FIA suggested that the final rules add
appropriate risk management requirements as a participant eligibility
criterion, or make clear that nothing in the proposed rules is intended
to prevent a DCO from adopting such requirements.
ISDA commented that the ability to bid for portfolios of other
clearing members of the DCO is critically important. According to ISDA,
an appropriate risk management framework for a clearing member may be
broadly categorized as follows: (1) Board and senior management
oversight; (2) organizational structure; and (3) strong systems and
procedures for controlling, monitoring and reporting risk.
Finally, State Street commented that a clearing member must be able
to demonstrate it can carry out its obligations to a DCO under a
default scenario. That demonstration could include having the capacity
to trade swaps using experienced swap traders, and the ability to
execute transactions in the market by having appropriate trading
relationships. A clearing member must also demonstrate an ability to
monitor positions, calculate potential losses and market risk, perform
stress tests, and maintain liquidity, among numerous other
requirements.
The Commission is adopting Sec. 39.12(a)(3) as proposed. The
Commission believes that the rule correctly identifies the necessary
operational requirements and is concerned that the heightened
operational requirements suggested by some commenters could allow a DCO
to evade the open access to DCO clearing intended by the Dodd-Frank
Act. The Commission emphasizes that under the rule, any operational
requirements must be necessary to meet clearing obligations. In
addition, the Commission is adopting Sec. 39.13(h)(5) herein, which
requires a DCO to adopt rules requiring clearing members to maintain
current written risk management policies and procedures.\60\ The
Commission has also proposed rules requiring clearing members that are
FCMs (proposed Sec. 1.73) and swap dealers and major swap participants
(proposed Sec. 23.609) to engage in specific risk management
activities.\61\
---------------------------------------------------------------------------
\60\ See discussion of Sec. 39.13(h)(5) in section IV.D.7.e,
below.
\61\ See 76 FR at 45729-45730 (Aug. 1, 2011) (Clearing Member
Risk Management).
---------------------------------------------------------------------------
k. Monitoring, Reporting, and Enforcement--Sec. 39.12(a)(4)
Core Principle C requires each DCO to ``establish and implement
procedures to verify, on an ongoing basis, the compliance of each
clearing member with each participation requirement of the derivatives
clearing organization.'' \62\ Proposed Sec. 39.12(a)(4) would codify
these requirements.
---------------------------------------------------------------------------
\62\ See Section 5b(c)(2)(C)(ii) of the CEA; 7 U.S.C. 7a-
1(c)(2)(C)(ii).
---------------------------------------------------------------------------
OCC supported the proposed rule ``if interpreted reasonably.'' J.P.
Morgan commented that a clearing member may have committed to
additional unfunded assessments at more than one clearinghouse and
proposes that the Commission and DCOs monitor clearing members to
ensure that they have sufficient liquid resources to support the
business they clear at each DCO. According to J.P. Morgan, a DCO should
monitor exposures against risk-based position limits on a real-time
basis.
The Commission is adopting Sec. 39.12(a)(4) as proposed. In
response to J.P. Morgan's comments, the Commission notes that in
monitoring firms, a DCO should take into consideration risks that the
firm faces outside of that DCO. The Commission further notes that it is
not prescribing the means by which DCOs should monitor compliance.
l. Reporting Requirements--Sec. 39.12(a)(5)
Proposed Sec. 39.12(a)(5)(i) would mandate that a DCO require all
clearing members, including those that are not FCMs, to file with the
DCO periodic financial reports containing any financial information
that the DCO determines is necessary to assess whether participation
requirements are met on an ongoing basis. The proposed rule also would
mandate that a DCO require clearing members that are FCMs to file the
financial reports that are specified in Sec. 1.10 of the Commission's
regulations with the DCO, and would require the DCO to review all such
financial reports for risk management purposes. Proposed Sec.
39.12(a)(5)(i) would also require a DCO to require its clearing members
that are not FCMs to make the periodic financial reports that they file
with the DCO available to the Commission upon the Commission's
[[Page 69358]]
request. Proposed Sec. 39.12(a)(5)(ii) would mandate that a DCO adopt
rules that require clearing members to provide to the DCO, in a timely
manner, information that concerns any financial or business
developments that may materially affect the clearing members' ability
to continue to comply with participation requirements.
LCH commented that a DCO based outside the U.S. may have clearing
members that are not subject to the Commission's jurisdiction and would
be regulated in their home jurisdiction. LCH proposed this provision be
revised such that only FCMs and U.S.-based members that are not FCMs
are required to provide this information to the Commission upon
request. According to LCH, all other members should be required to
submit the information to the DCO only or to their equivalent local
regulator.
LCH and MGEX commented that proposed Sec. 39.12(a)(5)(ii) would be
more appropriately imposed on clearing members themselves, rather than
on the DCO. KCC suggested that the Commission should evaluate its
statutory authority to enact the proposed rule. MGEX commented that the
proposed rules appear to require clearing members to report to each DCO
with which they clear, which would create an additional, duplicative
burden on clearing members. MGEX suggested that the Commission regulate
the clearing members directly. As an alternative, MGEX proposed a new
industry group similar to the Joint Audit Committee (JAC) in which each
DCO would be represented and participate in developing an overall risk
management program that would be used in fulfilling the new proposed
requirements.
The Commission is adopting Sec. 39.12(a)(5) with modifications to
(1) provide that the financial information provided by non-FCM clearing
members may be submitted by the clearing members to the Commission
pursuant to DCO rules or may be submitted to the Commission by the DCO,
in either case, upon the Commission's request; and (2) eliminate the
proposed requirement that the DCO must review clearing members'
financial reports for risk management purposes.
The rule is intended to address circumstances where the Commission
must obtain information in the possession of a clearing member. The
Commission anticipates such requests will be few in number. However,
when those occasions arise, the Commission must be able to obtain the
information as expeditiously as possible. The rule addresses this need
by allowing the Commission to obtain the information directly from the
source and to minimize the burden on DCOs. In response to the comments,
the Commission is revising the rule to provide that a DCO may either
provide the requested information directly to the Commission or require
clearing members to provide the information to the Commission.
The Commission is eliminating the requirement that the DCO must
review clearing members' financial reports for risk management
purposes. Upon further consideration, the Commission has concluded that
although a DCO may review such financial reports for several reasons,
including risk management and to ensure that clearing members continue
to meet participation requirements, it is not necessary to be
prescriptive in this regard.
In response to MGEX suggestion of a new industry group, Commission
staff is considering such a step.
The Commission is making certain technical revisions to Sec.
39.12(a)(5) in connection with these changes.
m. Enforcement of Participation Requirements--Sec. 39.12(a)(6)
Proposed Sec. 39.12(a)(6) would require a DCO to enforce
compliance with its participation requirements and establish procedures
for the suspension and orderly removal of clearing members that no
longer meet the requirements. MGEX commented that the proposed rule
goes beyond the language of the Dodd-Frank Act.
The Commission is adopting Sec. 39.12(a)(6) as proposed. A DCO
must have the ability to enforce compliance with its participation
requirements or its clearing members may not satisfy these
requirements. A DCO also must have procedures for the suspension and
orderly removal of clearing members that no longer meet the
requirements. Otherwise, the enforcement process may not be orderly and
could introduce additional risk to the DCO. This requirement
complements Sec. 39.17, adopted herein, which implements Core
Principle H (Rule Enforcement).\63\
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\63\ See discussion of Sec. 39.17 in section IV.H, below.
---------------------------------------------------------------------------
2. Product Eligibility
Core Principle C requires that each DCO establish appropriate
standards for determining the eligibility of agreements, contracts, or
transactions submitted to the DCO for clearing. Proposed Sec. 39.12(b)
would codify these requirements.
a. General Comments
Citadel and MFA supported the proposed rules. To ensure non-
discriminatory clearing, Citadel and MFA recommended the Commission
make explicit that a DCO must provide highly standardized mechanisms
and procedures for establishing connectivity with SEFs and any other
permitted trading venue. According to Citadel, these mechanisms and
procedures must be objective, commercially reasonable, publicly
available, and treat all applicant execution facilities in an unbiased
manner. Citadel and MFA also proposed that the rules mandate that a DCO
keep the clearing acceptance process anonymous (i.e., without the
customer's clearing member knowing the identity of the customer's
executing counterparty).
The Commission agrees that a DCO must provide mechanisms for
establishing connectivity with SEFs and DCMs, which would provide
executing counterparties with fair and open access. The Commission has
proposed rules addressing this issue.\64\ The Commission also has
proposed rules that address the anonymity issue.\65\
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\64\ See 76 FR 13101 (Mar. 10, 2011) (Straight-Through
Processing).
\65\ See 76 FR 45730 (Aug. 1, 2011) (Customer Clearing).
---------------------------------------------------------------------------
b. Products Eligible for Clearing--Sec. 39.12(b)(1)
Proposed Sec. 39.12(b)(1) would require a DCO to establish
appropriate requirements for determining the eligibility of agreements,
contracts, or transactions submitted to the DCO for clearing, taking
into account the DCO's ability to manage the risks associated with such
agreements, contracts, or transactions. Factors to be considered in
determining product eligibility would include but would not be limited
to: (1) Trading volume; (2) liquidity; (3) availability of reliable
prices; (4) ability of market participants to use portfolio compression
with respect to a particular swap product; (5) ability of the DCO and
clearing members to gain access to the relevant market for purposes of
creating and liquidating positions; (6) ability of the DCO to measure
risk for purposes of setting margin requirements; and (7) operational
capacity of the DCO and clearing members to address any unique risk
characteristics of a product.\66\
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\66\ As proposed, Sec. 39.12(b)(1)(vii) referred to addressing
any ``unique'' risk characteristics of a product. The Commission is
revising this provision in the final rule to refer to any
``unusual'' risk characteristics to clarify that such
characteristics are not limited to those that are one of a kind.
---------------------------------------------------------------------------
OCC noted that the factors to be considered are already among the
factors that a DCO would naturally consider and that OCC in fact
considers, and it suggested that the application of
[[Page 69359]]
this new rule be limited to swaps. OCC also noted that the trading
volume of new products is often unknown and unpredictable and suggested
that factor not be a barrier to accepting a product for clearing.
MGEX commented that the proposed rule considers legitimate factors,
but mandating that a DCO establish eligibility requirements is not
necessary, other than requirements for the contract size of swaps. Like
OCC, MGEX noted that DCOs already use these factors as part of their
sound business judgment in making these types of decisions. MGEX
recommended that the Commission issue suggested guidelines or core
principles and, on an as-needed basis, request that a DCO file with the
Commission the rationale supporting its conclusion that a contract
qualifies for clearing.
LCH expressed concerns with proposed Sec. 39.12(b)(1)(iv) and
commented that compression services have been developed only when swap
markets are relatively large and well-established, and the introduction
of cleared facilities has largely pre-dated the introduction of
compression services. According to LCH, making swap clearing contingent
on swap portfolio compression may have the effect of permitting fewer
swaps to be cleared. LCH proposed that the Commission encourage the use
of compression services where suitable and available, but not constrain
the ability of a DCO to clear a given swap based on the availability of
such services.
LCH also commented that it is imperative that a DCO have the
ability to ``transfer,'' ``auction,'' or ``allocate'' cleared swaps.
LCH proposed that the factor listed in proposed Sec. 39.12(b)(1)(v),
the ``[a]bility of the [DCO] and clearing members to gain access to the
relevant market for purposes of creating and liquidating positions'' be
modified to reflect these additional actions.
The Commission agrees with LCH that a DCO must have the ability to
``transfer,'' ``auction,'' or ``allocate'' cleared swaps and it is
revising Sec. 39.12(b)(1)(v) to incorporate LCH's suggestion.\67\ The
Commission is otherwise adopting Section 39.12(b)(1) as proposed. The
Commission believes that setting forth the minimum factors that all
DCOs must consider when determining contract eligibility is necessary
to prevent a DCO from seeking to clear transactions that present an
unacceptable level of risk. The Commission also believes that OCC's and
LCH's concerns are unfounded. The rule provides factors to be
considered and does not prohibit a DCO from accepting a product for
clearing if it does not satisfy one of the factors. Finally, the
Commission is declining to limit the rule to swaps because it believes
the eligibility factors are applicable to all products cleared by a
DCO. The Commission is also declining to issue suggested guidelines or
core principles, or to request that a DCO file with the Commission the
rationale for why a contract qualifies for clearing. The Commission
believes that Sec. 39.12(b)(1) is not burdensome because, as MGEX and
OCC commented, these factors are already considered by DCOs. In
contrast, filing rationales on an as-needed basis could be burdensome
to the DCO and the Commission, and would not serve to mitigate risk
more effectively.
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\67\ This is also consistent with Sec. 39.16(c)(2)(ii), adopted
herein and discussed in section IV.G.4, below, which requires a DCO
to adopt rules that set forth the actions that a DCO may take in the
event of a default, which must include the prompt transfer,
liquidation, or hedging of the defaulting clearing member's
positions, and which may include the auctioning or allocation of
such positions to other clearing members.
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c. Economic Equivalence--Sec. 39.12(b)(2)
Proposed Sec. 39.12(b)(2) would require a DCO to adopt rules
providing that all swaps with the same terms and conditions (as defined
by templates established under DCO rules) submitted to the DCO for
clearing are economically equivalent within the DCO and may be offset
with each other within the DCO.
ISDA, CME, and FIA commented that the term ``template'' is
inappropriate. According to ISDA, ``template'' has no clear meaning,
and it assumes that the term refers to the contract specifications
currently used by a variety of futures facilities. ISDA noted that the
development of specific templates for swap transactions is a mixed
business/technological project that requires significant discussion
involving each DCO and its market participants. It suggested that the
Commission's regulations guide the meaning of ``template'' to achieve
as much individual transactional variability as possible within the
transaction or range of transactions that a template may cover.
CME commented that references to ``templates'' are confusing
because swap dealers generally maintain standard templates for
documenting their trading relationships, and their counterparties
frequently negotiate changes to those templates. According to CME, a
DCO does not define the templates used by OTC participants, and DCO
rules do not function as templates from which counterparties may
negotiate. Rather, a DCO sets forth in its rulebook the product
specifications of each contract it accepts for clearing, including
swaps. CME suggested that the Commission revise Sec. 39.12(b)(2) to
state as follows (change in italics): ``A [DCO] shall adopt rules
providing that all swaps with the same terms and conditions, as defined
by product specifications established under [DCO] rules, submitted to
the [DCO] for clearing are economically equivalent within the [DCO] and
may be offset with each other within the [DCO].''
FIA requested that Commission confirm that economically equivalent
swaps must have the same cash flows, values, and liquidation dates. FIA
also suggested that terms and conditions of such templates--for
example, events of default--should also be consistent with market
practice.
Finally, KCC commented that the proposed rule is redundant because
Chapter 21 of the KCC rulebook already defines the terms and conditions
for swaps that KCC will clear.
The Commission is revising Sec. 39.12(b)(2) as suggested by CME to
substitute the phrase ``product specifications'' for the word
``templates.'' As noted above, some commenters found the use of the
word ``templates'' confusing. The Commission's intent was to ensure
that a DCO sets the specifications for cleared products. The Commission
is otherwise adopting the rule as proposed.
In response to FIA, the Commission confirms that it regards cash
flows, values, and liquidation dates as terms and conditions
encompassed by this rule. The Commission, however, declines to require
that terms and conditions be consistent with market practice. The
Commission believes that a DCO should have the flexibility to determine
whether to conform terms and conditions to market practice.
d. Non-Discriminatory Treatment of Swaps--Sec. 39.12(b)(3)
Proposed Sec. 39.12(b)(3) would require a DCO to provide for non-
discriminatory clearing of a swap executed bilaterally or on or subject
to the rules of an unaffiliated SEF or DCM. FIA and MFA commented in
support of the proposed rule.
OCC suggested that it should not be deemed a violation of Sec.
39.12(b)(3) for a DCO to require a SEF or DCM desiring to transmit
swaps to the DCO for clearing to enter into a non-exclusive clearing
agreement on non-discriminatory terms similar to those offered by the
DCO to other SEFs or DCMs for clearing of similar products. OCC
believes that such agreements are
[[Page 69360]]
necessary and appropriate for purposes of addressing matters between
the parties such as information sharing and furnishing price data by
the exchange to the DCO.
LCH suggested that the Commission clarify that ``non-
discriminatory'' includes costs, technology, and other related
considerations. LCH also suggested that the Commission impose the
reverse requirements on execution venues such as DCMs and SEFs, so that
those venues are also required to provide trade feeds to DCOs on a non-
discriminatory basis.
The Commission is adopting Sec. 39.12(b)(3) as proposed. In
response to OCC, the Commission notes that the rule does not prohibit a
DCO from requiring a SEF or DCM desiring to transmit swaps to the DCO
for clearing to enter into a non-exclusive clearing agreement on non-
discriminatory terms similar to those offered by the DCO to other SEFs
or DCMs for clearing of similar products. The Commission agrees that
such agreements are necessary and appropriate for purposes of
addressing matters between the parties such as information sharing and
furnishing price data by the exchange to the DCO. The Commission notes
that it expects DCOs to review clearing agreements for compliance with
Sec. 39.12(b)(3), the open access requirements of Core Principle C,
and any relevant requirements of other core principles.
In response to LCH's comment, the Commission notes that the
requirement applies to the factors LCH enumerated. The Commission also
notes that LCH's suggestion regarding trading venues is outside the
scope of this rulemaking
e. Prohibition on Requirement That Executing Party Is a Clearing
Member--Sec. 39.12(b)(4)
Proposed Sec. 39.12(b)(4) would prohibit a DCO from requiring one
of the original executing parties to be a clearing member in order for
a contract, agreement, or transaction to be eligible for clearing.
CME concurred with the Commission's analysis and fully supported
the proposed regulation. FIA, Citadel, and MFA also supported the
proposed regulation.
MFA suggested strengthening the proposed rule. According to MFA,
when a non-clearing member trades with another non-clearing member, the
clearing process should be identical and as prompt as when one of the
parties is a clearing member, so long as the transaction satisfies the
relevant DCO's rules, requirements, and standards otherwise applicable
to such trades. MFA believes that providing this parity would allow new
liquidity providers to efficiently and effectively enter into and
compete within the market.
MFA also suggested that the Commission revise the proposed rule to
prohibit a DCO from adopting rules or engaging in conduct that is
prejudicial to non-clearing members as compared to clearing members
with respect to eligibility or the timing of clearing or processing of
trades generally. The Commission has addressed this issue in the
recently proposed rules on clearing documentation.\68\
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\68\ See 76 FR 45730 (Aug. 1, 2011) (Customer Clearing).
---------------------------------------------------------------------------
ISDA commented that rules barring trades that don't involve a
clearing member as a party are inappropriate in established DCOs, but
new DCOs may need to roll out products and procedures in a contained
way. According to ISDA, ``initial decisions on which market
constituencies should have access to clearing must be the subject of
legitimate, reasoned decision-making by each DCO with regard to its
ability to properly serve each constituency and each constituency's
readiness to participate in a cleared market.''
Finally, NGX commented that if the proposed rule were applied to a
non-intermediated DCO such as NGX, the rule would require a fundamental
restructuring of the manner in which the DCO admits members, guarantees
trades, and provides risk management. DCOs like NGX require all
participants to become clearing participants at the DCO, and they do
not clear contracts that involve non-clearing participants.
The Commission is adopting Sec. 39.12(b)(4) as proposed. In
response to the comments of ISDA and NGX, the Commission notes that
some DCOs currently have only direct participants, i.e., participants
that do not offer client clearing. NGX, for example, provides direct
access to commercial end users who clear for themselves. The Commission
notes that, consistent with principles of open access, a DCO must have
rules in place to offer client clearing promptly if an FCM or a
customer requests access. However, from a cost-benefit perspective, the
Commission would expect that any DCO investment in building systems
would be proportionate to evidence of demand for the service.
Finally, in a separate rulemaking, the Commission has proposed
rules that address MFA's suggestion that trades between indirect
clearing members should have parity with trades between clearing
members.\69\
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\69\ See 76 FR 45730 (Aug. 1, 2011) (Customer Clearing).
---------------------------------------------------------------------------
f. Product Standardization--Sec. 39.12(b)(5)
Proposed Sec. 39.12(b)(5) would require a DCO to select contract
unit sizes and other product terms and conditions that maximize
liquidity, facilitate transparency in pricing, promote open access, and
allow for effective risk management.\70\ To the extent appropriate to
further these objectives, a DCO would be required to select contract
units for clearing purposes that were smaller than the contract units
in which trades submitted for clearing were executed. \71\
---------------------------------------------------------------------------
\70\ See 76 FR 13101 (Mar. 10, 2011) (Straight-Through
Processing).
\71\ Id.
---------------------------------------------------------------------------
ISDA supported the goals identified by the Commission; however, it
commented that ``unit size'' is not a meaningful concept in swap
transactions because contract size is not standardized. According to
ISDA, the only meaningful size limit is the smallest unit of relevant
currency or relevant underlying. ISDA suggested that the Commission
avoid focusing on ``unit size'' and instead articulate its ultimate
objectives, as it has, leaving DCOs with the discretion to set suitable
terms and conditions to further those objectives.
FIA did not support the requirement that a DCO select contract unit
sizes because FIA does not believe that the swap market has evolved to
the point where DCOs can do this. FIA also does not believe the market
is at a point where it would be appropriate for a DCO to establish
templates regarding the terms and conditions of standardized swaps
eligible for clearing. FIA believes that requiring swaps to fit within
artificial, prescribed templates would be disruptive to the market and
would not benefit customers. FIA, however, would support a requirement
that DCOs study this matter and submit a report to the Commission on
the feasibility of establishing templates regarding the terms and
conditions of standardized swaps as soon as practicable.
Finally, LCH commented that it is not appropriate to require a DCO
to select contract units for clearing purposes that are smaller than
the contract units in which trades submitted for clearing were
executed. According to LCH, a DCO clearing swaps should be able to
accept such swaps in any size, and swaps submitted for clearing should
not
[[Page 69361]]
be broken down into sub-units. LCH suggested that the Commission strike
Sec. 39.12(b)(5) and that any rules addressing average size of
exposure traded in the swap markets be addressed in rules pertaining to
trading and execution venues.
The Commission is adopting Sec. 39.12(b)(5) as proposed. The
Commission believes that standardizing products, including swaps, by
requiring a DCO to determine product terms and conditions, including
product size, will increase liquidity, lower prices, and increase
participation. In addition, standardized products should make it easier
for members to accept a forced allocation in the event of bankruptcy.
The Commission recognizes that standardized products may create
basis risk for some hedge positions. However, this circumstance has
long existed in the futures markets. The Commission believes that the
benefits of standardization, such as competitive pricing, liquid
markets, and open access, outweigh the costs of imperfect hedging.
In response to LCH, the Commission notes that the product unit size
of a particular swap executed bilaterally may reflect the immediate
circumstances of the two parties to the transaction. Once submitted for
clearing, it may be possible to split the trade into smaller units
without compromising the interests of the two original parties. Smaller
units can promote liquidity by permitting more parties to trade the
product, facilitate open access by permitting more clearing members to
clear the product, and aid risk management by enabling a DCO, in the
event of a default, to have more potential counterparties for
liquidation. The Commission notes that under the rule, DCOs retain some
discretion in determining how best to promote liquidity, facilitate
open access, and aid risk management.
g. Novation--Sec. 39.12(b)(6)
Proposed Sec. 39.12(b)(6) would require a DCO that clears swaps to
have rules providing that upon acceptance of a swap: (i) The original
swap is extinguished; (ii) the original swap is replaced by equal and
opposite swaps between clearing members and the DCO; (iii) the terms of
the cleared swaps conform to templates established under DCO rules; and
(iv) if a swap is cleared by a clearing member on behalf of a customer,
all terms of the swap, as carried in the customer account on the books
of the clearing member, must conform to the terms of the cleared swap
established under the DCO's rules.
Newedge supported this rule, in particular, the requirement for
standardization.
CME, FIA, and ICE commented that the proposed rule appears to
presume the use of a ``principal'' model for all cleared swaps, even
those swaps cleared on behalf of customers. CME noted that at CME, an
FCM clearing customer business acts as an agent for undisclosed
principals (i.e., the FCM's customers) vis-a-vis CME and guarantees its
customers' performance to CME. CME suggested that in order to preserve
the agency model for customer-cleared swaps, the Commission should
adopt a revised Sec. 39.12(b)(6)(ii) to provide that, upon acceptance
of a swap for clearing, ``the original swap is replaced by equal and
opposite swaps with the DCO.'' As previously noted, CME also commented
that the use of the term ``template'' is confusing. It suggested that
the Commission revise Sec. 39.12(b)(6)(iii) to state: ``All terms of
the cleared swaps must conform to product specifications established
under [DCO] rules.''
FIA commented that the proposed rule would conflict with the FCMs'
position that, with respect to customer positions, FCMs are acting as
agent, and not as principal, for customers in executing and clearing
swaps (and futures) on behalf of customers. FIA suggested that the
proposed rule be revised to confirm that, in clearing swaps on behalf
of customers, a clearing member shall be deemed a guarantor and agent
of a cleared swap and not a principal.
ICE noted that U.S. futures markets may clear on an open offer
basis, which allows straight-through processing. ICE commented that the
Commission should not preclude open offer clearing of swaps by
requiring the underlying swap to be novated.
Finally, LCH suggested that the Commission revise the rule so that
the obligation would fall on the clearing member rather than the DCO
because the provisions relate to the clearing member's books and
records, not the DCO's.
The Commission is adopting Sec. 39.12(b)(6) with modifications to
clarify its intended meaning. In response to the comments from CME,
FIA, and ICE, the Commission is revising Sec. 39.12(b)(6)(ii) to
provide that a DCO that clears swaps must have rules providing that,
upon acceptance of a swap by the DCO for clearing, ``[t]he original
swap is replaced by an equal and opposite swap between the derivatives
clearing organization and each clearing member acting as principal for
a house trade or acting as agent for a customer trade.''
In response to the comment from CME, the Commission is revising
Sec. 39.12(b)(6)(iii) to substitute the phrase ``product
specifications'' for the word ``templates.'' This is consistent with
the change to Sec. 39.12(b)(2), discussed above.
In response to the comment by ICE, the Commission notes that ``open
offer'' systems are acceptable under the rule. Effectively, under an
open offer system there is no ``original'' swap between executing
parties that needs to be novated; the swap that is created upon
execution is between the DCO and the clearing member, acting either as
principal or agent.
Finally, with regard to LCH's comment, the Commission believes that
it is proper for the requirement to fall on the DCO. The DCO is the
central counterparty and is responsible for the transaction going
forward.
h. Confirmation of Terms--Sec. 39.12(b)(8)
Proposed Sec. 39.12(b)(8) would require a DCO to have rules that
provide that all swaps submitted to the DCO for clearing must include
written documentation that memorializes all of the terms of the
transaction and legally supersedes any previous agreement.\72\ The
confirmation of all terms of the transaction would be required to take
place at the same time as the swap is accepted for clearing.
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\72\ This provision was originally designated as Sec.
39.12(b)(7)(v) in 76 FR 13101 (Mar. 10, 2011) (Straight-Through
Processing). It was later proposed to be renumbered as Sec.
39.12(b)(8) in 76 FR 45730 (Aug. 1, 2011) (Customer Clearing).
Section 39.12(b)(7), as currently proposed (76 FR at 13110), will be
addressed in a separate final rulemaking.
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CME suggested that the Commission revise the proposed regulation to
require a DCO to ``provide each clearing member carrying a cleared swap
with a definitive record of the terms of the agreement, which will
serve as a confirmation of the swap.''
ISDA commented that it is not clear what efficiencies the proposed
rule would achieve for the parties to the swap in confirming through a
DCO. It suggested that the Commission be less prescriptive and
recognize that the act of clearing a swap transaction through a DCO in
and of itself should produce a definitive written record, tailored to
the particular category of swap transaction by the DCO and its market
constituency, which fulfills the Commission's objective of facilitating
the timely processing and confirmation of swaps not executed on a SEF
or a DCM.
FIA requested that the Commission clarify the obligations of the
parties under this proposed rule. According to FIA, the rule appears to
place
[[Page 69362]]
responsibility on the parties to the swap to submit a written
confirmation of the terms of the transaction to the DCO, which, upon
acceptance by the DCO, will supersede any prior documents and serve as
the confirmation of the trade. However, the notice of proposed
rulemaking places responsibility on the DCO, explaining that the
proposed rule ``would require that DCOs accepting a swap for clearing
provide the counterparties with a definitive written record of the
terms of their agreement, which will serve as a confirmation of the
swap.'' Further, the proposed rule appears to apply to all swaps
submitted for clearing, but the notice of proposed rulemaking appears
to limit the requirement to swaps not executed on a SEF or DCM, noting
that swaps executed on a SEF or DCM are confirmed upon execution.\73\
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\73\ The notice of proposed rulemaking states: ``Proposed Sec.
39.12(b)(7)(v) would require that DCOs accepting a swap for clearing
provide the counterparties with a definitive written record of the
terms of their agreement, which will serve as a confirmation of the
swap.'' 76 FR at 13105-13106 (Mar. 10, 2011) (Straight-Through
Processing).
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OCC commented that the terms and conditions applicable to a cleared
swap would already be specified in the DCO rules or product
specifications, and it does not think it is necessary for a DCO to
provide a confirmation that is similar in form to detailed trade
documentation such as an ISDA Master Agreement. OCC believes that the
term ``written documentation'' should be interpreted broadly to mean
any documentation that sufficiently memorialized the agreement of the
counterparties with respect to the terms of a swap, which may consist
of a confirmation (electronic or otherwise) that confirms the values
agreed upon for terms that can be varied by the parties.
MarkitSERV noted that the proposed rule would require a
confirmation of all terms of the transaction at the time the swap is
accepted for clearing, and commented that the rule is unclear as to
whether, when a swap is to be submitted for clearing, confirmation
would ever be required of the pre-clearing initial transaction between
the original counterparties. In contrast, the Commission has elsewhere
stated that it expects a DCO to require pre-clearing transactions to be
confirmed before clearing.\74\ MarkitSERV also noted that when a
transaction is not rapidly accepted for clearing the parties will still
be responsible for confirming the transaction under Commission
regulations. It recommended that the Commission clarify that when a
transaction is not accepted for clearing within the time frame
established for mandatory confirmation the parties should be permitted
to satisfy their confirmation obligations by confirming the transaction
prior to clearing.
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\74\ See 75 FR 81519, at 81521 (Dec. 28, 2010) (Confirmation,
Portfolio Reconciliation, and Portfolio Compression Requirements for
Swap Dealers and Major Swap Participants) (``if a swap is executed
bilaterally, but subsequently submitted to a DCO for clearing, the
DCO will require a definitive written record of all terms to the
counterparties' agreement prior to novation by the DCO'').
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The Commission is adopting Sec. 39.12(b)(8) in modified form to
read as set forth in the regulatory text of this final rule.
The change to the heading is responsive to the comment by FIA that
it was unclear whether the rule applied to all cleared swaps or only to
those that are executed bilaterally. Regardless of the execution venue,
confirmation of a cleared swap is ultimately provided by the DCO. In
the case of a trading facility with a central limit order book,
execution and acceptance for clearing are simultaneous and confirmation
occurs at that time. In all other cases, there is an interim time
between execution and acceptance, or rejection, for clearing.
The Commission notes that applicable confirmation requirements may
depend on the length of time between execution and acceptance or
rejection for clearing. For example, if a trade executed on a SEF is
accepted for clearing within seconds, the DCO notification would serve
as the single confirmation. But, if a trade is executed bilaterally and
later submitted for clearing, there may need to be an initial bilateral
confirmation that is later superseded by the clearing confirmation.
The changes to the text are responsive to the comments of FIA, CME,
ISDA, OCC, and MarkitSERV. As FIA pointed out, the proposed rule text
seems to place the confirmation obligation on the submitting parties,
while the discussion in the notice of proposed rulemaking places it on
the DCO. Consistent with the language in the discussion and the
recommendations of FIA, CME, and ISDA, the revised rule clarifies that
DCOs provide confirmations of cleared trades. This interpretation was
implicit in the proposal given that the second sentence of the rule
provides that confirmation takes place when the trade ``is accepted''
for clearing.
D. Core Principle D--Risk Management--Sec. 39.13
Core Principle D, \75\ as amended by the Dodd-Frank Act, requires
each DCO to ensure that it possesses the ability to manage the risks
associated with discharging the responsibilities of the DCO through the
use of appropriate tools and procedures. It further requires each DCO
to measure its credit exposures to each clearing member not less than
once during each business day and to monitor each such exposure
periodically during the business day. Core Principle D also requires
each DCO to limit its exposure to potential losses from defaults by
clearing members, through margin requirements and other risk control
mechanisms, to ensure that its operations would not be disrupted and
that non-defaulting clearing members would not be exposed to losses
that non-defaulting clearing members cannot anticipate or control.
Finally, Core Principle D provides that a DCO must require margin from
each clearing member sufficient to cover potential exposures in normal
market conditions and that each model and parameter used in setting
such margin requirements must be risk-based and reviewed on a regular
basis. The Commission proposed to adopt Sec. 39.13 to establish
requirements that a DCO would have to meet in order to comply with Core
Principle D.
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\75\ Section 5b(c)(2)(D) of the CEA, 7 U.S.C. 7a-1(c)(2)(D).
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1. General--Sec. 39.13(a)
Proposed Sec. 39.13(a) would require a DCO to ensure that it
possesses the ability to manage the risks associated with discharging
its responsibilities through the use of appropriate tools and
procedures. The Commission did not receive any comments on proposed
Sec. 39.13(a) and is adopting Sec. 39.13(a) as proposed.
2. Risk Management Framework--Sec. 39.13(b)
Proposed Sec. 39.13(b) would require a DCO to establish and
maintain written policies, procedures, and controls, approved by its
board of directors, which establish an appropriate risk management
framework that, at a minimum, clearly identifies and documents the
range of risks to which the DCO is exposed, addresses the monitoring
and management of the entirety of those risks, and provides a mechanism
for internal audit. In addition, proposed Sec. 39.13(b) would require
a DCO to regularly review its risk management framework and update it
as necessary.
Mr. Barnard recommended that the Commission comprehensively and
explicitly address all elements that make up a risk management
framework, including organizational structure, governance, risk
functions, internal controls, compliance, internal audit,
[[Page 69363]]
and legal functions.\76\ In particular, with respect to organizational
structure, Mr. Barnard noted that reporting lines and the allocation of
responsibilities and authority within a DCO should be clear, complete,
well-defined and enforced.
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\76\ Mr. Barnard also recommended that the Commission focus more
on operational risk and the role of reporting and public
disclosures. With respect to operational risk, the Commission notes
that it is adopting Sec. 39.18 herein, which addresses system
safeguards, and which is discussed in section I, below. Reporting
and public information are addressed in Sec. Sec. 39.19 and 39.21,
respectively, also adopted herein, which are discussed in sections J
and L, respectively, below.
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The Commission believes that a DCO should adopt a comprehensive and
documented risk management framework that addresses all of the various
types of risks to which it is exposed and the manner in which they may
relate to each other. The Commission believes that a written risk
policy is important because it will help to ensure the DCO has
carefully considered its risk management framework, and it will provide
guidance to DCO management, staff, and market participants. It will
also allow the Commission to assess the DCO's risk management framework
more efficiently. The risks to be addressed may include, but are not
limited to, legal risk, credit risk, liquidity risk, custody and
investment risk, concentration risk, default risk, operational risk,
market risk, and business risk. However, the Commission does not
believe that it is necessary to explicitly list such risks in the final
rule.
MGEX commented that the documentary and procedural requirements of
proposed Sec. 39.13(b) would impose heavy costs and turn the goal of
practical risk management into one of paperwork compliance, and that
while having a framework containing all the various policies can be
beneficial for DCOs, the development and implementation of such
policies must be flexible and left to each DCO. The Commission notes
that DCOs generally already have certain written risk management
policies, procedures and controls, although the substance, level of
detail, and integration of each DCO's documentation of such policies,
procedures and controls may vary. The Commission believes that Sec.
39.13(b) provides DCOs with the appropriate amount of flexibility with
regard to the documentation of their risk management frameworks,
without imposing significant additional costs upon DCOs.
OCC noted that its risk management policies are highly complex and
are embodied in multiple separate written documents, and much of its
day-to-day operations are related to risk management. OCC stated that
the Commission should make it clear that the proposal would not require
the board to approve every document related to risk management, as it
would be burdensome and would inappropriately require the board to
micro-manage the day-to-day functions of a DCO. OCC indicated that it
does not believe that the function of the committee that is responsible
for the oversight of its risk management activities would be enhanced
by the creation of additional written policies, procedures, and
controls.
The Commission recognizes that many of the day-to-day functions of
a DCO are related to risk management, and Sec. 39.13(b) is not
intended to require that a DCO's board must approve every document at a
DCO that addresses risk management issues nor is it intended to require
that a DCO's board must approve every day-to-day decision regarding the
implementation of the DCO's risk management framework.
CME and ICE took the position that a DCO's Risk Management
Committee should have the authority to approve the written policies,
procedures, and controls that establish a DCO's risk management
framework, noting that this would be consistent with proposed Sec.
39.13(c), which would require a DCO's Chief Risk Officer to make
appropriate recommendations to the DCO's Risk Management Committee or
board of directors, as applicable, regarding the DCO's risk management
function.
The Commission believes that a DCO's risk management framework
should be subject to the approval of its board of directors. The
Commission recognizes that a DCO's Risk Management Committee may play a
crucial role in the development of the risk management policies of a
DCO. However, the board has the ultimate responsibility for the
management of the DCO's risks. Requiring board approval of a DCO's risk
management framework is also consistent with proposed international
standards.\77\
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\77\ See CPSS-IOSCO Consultative Report, Principle 2:
Governance, Key Consideration 5, at 23.
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In addition, a requirement that a DCO's board approve its risk
management framework is consistent with Sec. 39.13(c), which permits a
DCO's Chief Risk Officer to make appropriate recommendations to the
DCO's Risk Management Committee regarding the DCO's risk management
functions. Although the board would approve the framework, it could
delegate defined decision-making authority to the Risk Management
Committee in connection with the implementation of the framework. The
Commission is adopting Sec. 39.13(b) as proposed.
3. Chief Risk Officer--Sec. 39.13(c)
Proposed Sec. 39.13(c) would require a DCO to have a Chief Risk
Officer (CRO) who would be responsible for the implementation of the
risk management framework and for making appropriate recommendations
regarding the DCO's risk management functions to the DCO's Risk
Management Committee or board of directors, as applicable. In a
separate rulemaking, the Commission has proposed to adopt Sec.
39.13(d) to require DCOs to have a Risk Management Committee with
defined composition requirements and specified minimum functions.\78\
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\78\ See 75 FR at 63750 (Oct. 18, 2010) (Conflicts of Interest).
In that proposed rulemaking, the provisions relating to the Risk
Management Committee were designated as Sec. 39.13(g). In the final
rulemaking with respect to that proposal, those provisions will be
redesignated as Sec. 39.13(d).
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Better Markets commented that the proposal should provide
substantive parameters for a CRO and that the CRO rules applicable to
FCMs should be applied to DCOs. Mr. Greenberger indicated that the CRO
of a DCO should be subject to the same rules regarding reporting and
independence as the CROs of other registered entities.
The Commission does not believe that it is necessary to further
define the responsibilities of a DCO's CRO in the final rule. The
Commission notes that it has not proposed any rules regarding a CRO for
FCMs or any other registered entities, as suggested by Better Markets
and Mr. Greenberger.\79\
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\79\ However, the Commission has proposed rules regarding a CCO
for futures commission merchants, swap dealers, and major swap
participants, at 75 FR 70881 (Nov. 19, 2010) (Designation of a Chief
Compliance Officer; Required Compliance Policies; and Annual Report
of a Futures Commission Merchant, Swap Dealer, or Major Swap
Participant), with respect to which Better Markets filed a comment
letter.
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As noted in the notice of proposed rulemaking, given the importance
of the risk management function and the comprehensive nature of the
responsibilities of a DCO's CCO, which are governed by Sec. 39.10, as
adopted in this rulemaking, the Commission expects that a DCO's CRO and
its CCO would be two different individuals. The Commission is adopting
Sec. 39.13(c) as proposed.
4. Measurement of Credit Exposure--Sec. 39.13(e)
Proposed Sec. 39.13(e) would require a DCO to: (1) Measure its
credit exposure to each clearing member and mark to market such
clearing member's open positions at least once each business
[[Page 69364]]
day; and (2) monitor its credit exposure to each clearing member
periodically during each business day. Proposed Sec. 39.13(e) was a
prerequisite for proposed Sec. 39.14(b), which would address daily
settlements based on a DCO's measurement of its credit exposures to its
clearing members.
LCH commented that a DCO should be required to measure its credit
exposures ``several times each business day'' and that a DCO should be
obliged to recalculate initial and variation margin requirements more
than once each business day. By contrast, OCC requested that the
Commission clarify that the proposed requirement that a DCO monitor its
credit exposure to each clearing member periodically during each
business day would not require a DCO to update clearing member
positions on an intra-day basis for purposes of monitoring risk, which
would not be practical, and that intra-day monitoring of credit
exposures based on periodic revaluation of beginning-of-day positions
would be sufficient to comply with the proposed rule.
The Commission does not believe that a DCO should be required to
mark each clearing member's open positions to market and recalculate
initial and variation margin requirements more than once each business
day, and notes that the requirement that a DCO monitor its credit
exposure to each clearing member periodically during each business day
could be satisfied through intra-day monitoring of credit exposures
based on periodic revaluation of beginning-of-day positions as
suggested by OCC.
However, as discussed in section IV.E.2, below, Sec. 39.14(b)
requires a DCO to effect a settlement with each clearing member at
least once each business day, and to have the authority and operational
capacity to effect a settlement with each clearing member, on an
intraday basis, either routinely, when thresholds specified by the DCO
are breached, or in times of extreme market volatility. Therefore, in
order to comply with Sec. 39.14(b), a DCO would be required to have
the authority and operational capacity to mark each clearing member's
open positions to market and recalculate initial and variation margin
requirements, on an intraday basis, under the circumstances defined in
Sec. 39.14(b).
The Commission is adopting Sec. 39.13(e) as proposed, except that
the Commission is making a technical revision by replacing the phrase
``such clearing member's open positions'' with the phrase ``such
clearing member's open house and customer positions'' to eliminate
possible ambiguity and to clarify the Commission's intent to reflect
current industry practice and include both house and customer
positions, not just house positions. The Commission notes that Sec.
39.13(e) is consistent with international recommendations.\80\
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\80\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,
Key Consideration 4, at 40.
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5. Limitation of Exposure to Potential Losses From Defaults--Sec.
39.13(f)
Proposed Sec. 39.13(f) would require a DCO, through margin
requirements and other risk control mechanisms, to limit its exposure
to potential losses from defaults by its clearing members to ensure
that: (1) Its operations would not be disrupted; and (2) non-defaulting
clearing members would not be exposed to losses that nondefaulting
clearing members cannot anticipate or control. The language of proposed
Sec. 39.13(f) is virtually identical to the language in Section
5b(c)(2)(D)(iii) of the CEA, as amended by the Dodd-Frank Act.
FIA supported the proposal and MGEX stated that it appeared
reasonable if applied appropriately. FIA acknowledged that clearing
members understand and accept that they are subject to losses in the
event of a default of another clearing member but noted that these
potential losses must be measurable and subject to a reasonable cap
over a period of simultaneous or multiple defaults. MGEX suggested that
the Commission adopt an interpretation that each clearing member, by
becoming a clearing member, can reasonably anticipate that another
clearing member may potentially default and that a DCO can apply its
rules accordingly.
The Commission believes that every clearing member is aware that
another clearing member may default. The Commission also notes that the
potential losses resulting from such a default will be mitigated to the
extent that a DCO is bound to comply with the CEA, Commission
regulations, and its own rules, particularly with regard to financial
resources and default rules and procedures.
KCC commented that there would appear to be little cost/benefit
justification for duplicating the statutory language of the core
principle in the form of a rule.\81\ The Commission believes that
codifying provisions of the CEA does not impose an additional cost on a
DCO because a DCO must satisfy such requirements to comply with the
law. At the same time, the Commission believes that codifying this
statutory provision provides a DCO with a single location in which to
identify the minimum standards necessary to fulfill the requirements of
Core Principle D. The Commission is adopting Sec. 39.13(f) as
proposed.
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\81\ See Section 5b(c)(2)(D)(iii) of the CEA, 7 U.S.C. 7a-
1(c)(2)(D)(iii).
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6. Margin Requirements--Sec. 39.13(g)
a. General
Several commenters made general comments about margin requirements
that did not address specific provisions of proposed Sec. 39.13(g).
The Commission has summarized those comments, and responded to those
comments, below.
KCC expressed its belief that the Commission's detailed proposed
margin requirements are not consistent with the Dodd-Frank Act's
changes to the CEA, which simply require that a DCO's margin models and
parameters must be ``risk-based.'' The Commission notes that Section
5b(c)(2) of the CEA, as amended by the Dodd-Frank Act, requires a DCO
to comply with the statutory core principles ``and any requirement that
the Commission may impose by rule or regulation pursuant to section
8a(5).'' As noted in section I.A, above, legally enforceable standards
set forth in regulations serve to increase legal certainty, prevent
DCOs from lowering risk management standards for competitive reasons,
and increase market confidence. These goals are especially important
with respect to margin, which is one of the key tools used by DCOs in
managing risk. Therefore, the Commission believes it is appropriate to
impose more detailed margin requirements than those contained in the
statutory language of Core Principle D.
ISDA urged the Commission to adopt rules requiring DCOs to adopt
risk methodologies that would reduce the impact that customer account
risk has on the size of default fund contributions. ISDA noted that
this would enable DCOs to better guaranty the portability of client
portfolios, but would increase risk to the DCO; however, ISDA stated
that this increased risk could be addressed by increasing the risk
margin of the customer account. The Commission has not proposed and is
not adopting such rules. The Commission believes that a DCO should have
reasonable discretion to determine how it will calculate the amounts of
any default fund contributions that it may require from its clearing
members, and the extent to which customer risk will be a factor in such
calculations.
MFA and Citadel stated that it is important that a DCO's process
for setting initial margin be transparent in order to give all market
participants
[[Page 69365]]
certainty as to the margin they can expect the DCO to assess.
Therefore, MFA and Citadel urged the Commission to adopt final rules
that would require a DCO to make available to all market participants,
at no cost, a margin calculation utility, so that they would be able to
replicate the calculation of the margin that the DCO would assess.
The Commission notes that it is adopting Sec. Sec. 39.21(c)(3) and
(d) herein, which require a DCO to disclose information concerning its
margin-setting methodology on its Web site. However, the Commission is
not requiring a DCO to provide a margin calculation utility to market
participants free of cost, although the Commission notes that some DCOs
have chosen to do so.\82\ The Commission believes that whether a DCO
will provide a margin calculation utility to market participants, and
whether and how much it might charge for such a utility, is a business
decision that should be left to the discretion of a DCO.
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\82\ See e.g., http://www.cmegroup.com/clearing/cme-core-cme-clearing-online-risk-engine.html and https://www.theice.com/publicdocs/ice_trust/ICE_Margin_Simulation_Calculator_Training_Presentation.pdf.
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The FHLBanks indicated that it may be appropriate, in some
circumstances, for a DCO to waive its initial margin requirements with
respect to certain highly creditworthy customers of a clearing member.
Therefore, the FHLBanks urged the Commission to grant DCOs discretion
to waive initial margin requirements when doing so would not pose risk
to the DCO or its clearing members. In light of the fact that the Dodd-
Frank Act requires the removal of reliance on credit ratings, the
FHLBanks recommended that the Commission adopt alternative criteria by
which a DCO could exercise such discretionary waivers, or alternatively
grant DCOs discretion to establish their own criteria, subject to
Commission approval, or to guidelines established by the Commission in
the final rule.
The Commission has not proposed a rule that would permit it to
grant DCOs the discretion to waive initial margin requirements and it
is not adopting such a rule, as requested by the FHLBanks. Even if
there were an objective way to define highly creditworthy customers,
the Commission does not believe that permitting such waivers would
constitute prudent risk management.
b. Amount of Initial Margin Required--Sec. 39.13(g)(1)
Proposed Sec. 39.13(g)(1) would require that the initial margin
\83\ that a DCO requires from each clearing member must be sufficient
to cover potential exposures in normal market conditions and that each
model and parameter used in setting initial margin requirements must be
risk-based and reviewed on a regular basis. The Commission invited
comment regarding whether a definition of ``normal market conditions''
should be included in the proposed regulation and, if so, how normal
market conditions should be defined.
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\83\ The term ``initial margin'' is now defined in Sec.
1.3(lll), adopted herein.
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MFA, BlackRock, and Citadel expressed their support for the
proposal. CME and OCC commented that the Commission should not define
normal market conditions, while ISDA stated that the Commission should
define normal market conditions. The Commission noted in the notice of
proposed rulemaking that the 2004 CPSS-IOSCO Recommendations defined
``normal market conditions'' as ``price movements that produce changes
in exposures that are expected to breach margin requirements or other
risk control mechanisms only 1 percent of the time, that is, on average
on only one trading day out of 100.'' \84\ The CPSS-IOSCO Consultative
Report was published subsequent to the issuance of proposed Sec.
39.13(g)(1). The CPSS-IOSCO Consultative Report replaced the concept of
``normal market conditions'' with a proposed requirement that
``[i]nitial margin should meet an established single-tailed confidence
level of at least 99 percent for each product that is margined on a
product basis, each spread within or between products for which
portfolio margining is permitted, and for each clearing member's
portfolio losses.'' \85\ The Commission had also proposed similar
requirements for a 99 percent confidence level in proposed Sec.
39.13(g)(2)(iii), discussed below. Therefore, in adopting Sec.
39.13(g)(1), the Commission is declining to adopt the proposed explicit
requirement that initial margin must be sufficient to cover potential
exposures in normal market conditions, in order to avoid any ambiguity
over the meaning of ``normal market conditions.''
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\84\ See 2004 CPSS-IOSCO Recommendations at 21.
\85\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,
Key Consideration 3, at 40.
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FIA recommended that parameters used in setting initial margin
requirements should be reviewed monthly and models should be reviewed
annually and on an ad hoc basis if substantive changes are made,
whereas OCC took the position that the Commission should permit a DCO
to use its reasonable discretion in determining what constitutes a
``regular basis'' for reviewing margin models and parameters. The
Commission has determined not to specify the appropriate frequency of
review, as it may differ based on the characteristics of particular
products and markets, and the nature of the margin models and
parameters that apply to those products and markets. However, although
Sec. 39.13(g)(1) would permit a DCO to exercise its discretion in
determining how often it should review its margin models and
parameters, the Commission would apply a reasonableness standard in
determining whether the frequency of reviews conducted by a particular
DCO was appropriate.
Moreover, as discussed in section IV.D.6.d, below, Sec.
39.13(g)(3) requires that a DCO's systems for generating initial margin
requirements, including the DCO's theoretical models, must be reviewed
and validated by a qualified and independent party, on a regular basis.
As the Commission noted in the notice of proposed rulemaking, the
Commission would expect a DCO to obtain an independent validation prior
to implementation of a new margin model and when making any significant
change to a model that is in use by the DCO. This express expectation
would address FIA's suggestion that a DCO should be required to review
its margin models on an ad hoc basis if substantive changes are made.
For the reasons discussed, the Commission is adopting Sec. 39.13(g)(1)
with the modification described above.
c. Methodology and Coverage
(1) General--Sec. 39.13(g)(2)(i)
Proposed Sec. 39.13(g)(2)(i) would require a DCO to establish
initial margin requirements that are commensurate with the risks of
each product and portfolio, including any unique characteristics of, or
risks associated with, particular products or portfolios.\86\ In
particular, proposed Sec. 39.13(g)(2)(i) would require a DCO that
clears credit default swaps (CDS) to appropriately address jump-to-
default risk in setting initial margins.\87\ The Commission
[[Page 69366]]
invited comment regarding whether there are specific risks that should
be identified and addressed in the proposed regulation in addition to
jump-to-default risk.
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\86\ As proposed, Sec. 39.13(g)(2)(i) referred to addressing
any ``unique'' characteristics of, or risks associated with,
particular products or portfolios. The Commission is revising this
provision in the final rule to refer to any ``unusual''
characteristics of, or risks associated with, particular products or
portfolios to clarify that such characteristics or risks are not
limited to those that are one of a kind. See also n. 66, above.
\87\ In the notice of proposed rulemaking, the Commission
defined jump-to-default risk as referring to the possibility that a
CDS portfolio with large net sales of protection on an underlying
reference entity could experience significant losses over a very
short period of time following an unexpected event of default by the
reference entity.
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CME and Nadex, Inc. (Nadex) expressed the opinion that it would not
be beneficial to attempt to identify additional specific risks that a
DCO must address in determining initial margins and LCH commented that
the reference to jump-to-default risk should either be removed or
amended to cover all other products that are subject to jump-to-default
risk. The Commission agrees with CME and Nadex that it is not necessary
to identify additional specific risks in the regulation, and also
agrees with LCH that the reference to jump-to-default risk should
generally apply to any product that may be subject to such risk.
Therefore, the Commission is adopting a revised Sec. 39.13(g)(2)(i)
that eliminates the specific reference to CDS. The Commission has also
added the phrase ``or similar jump risk.'' This is intended to address
the possibility of a large payment obligation in a product accumulating
in a very short period of time following an extreme market event.
(2) Liquidation Time--Sec. 39.13(g)(2)(ii)
Proposed Sec. 39.13(g)(2)(ii) would require a DCO to use margin
models that generate initial margin requirements sufficient to cover
the DCO's potential future exposures to clearing members based on price
movements in the interval between the last collection of variation
margin \88\ and the time within which the DCO estimates that it would
be able to liquidate a defaulting clearing member's positions
(liquidation time). As proposed, a DCO would have to use a liquidation
time that is a minimum of five business days for cleared swaps that
were not executed on a DCM, and a liquidation time that is a minimum of
one business day for all other products that it clears, although it
would be required to use longer liquidation times, if appropriate,
based on the unique characteristics of particular products or
portfolios. The Commission invited comment regarding whether the
minimum liquidation times specified in proposed Sec. 39.13(g)(2)(ii)
were appropriate, or whether there were minimum liquidation times that
were more appropriate.
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\88\ The term ``variation margin'' is now defined in Sec.
1.3(ooo), adopted herein.
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LCH suggested that ``or transfer'' should be inserted after
``liquidate'' in the proposed rule and that an appropriate liquidation
period should be a period that would be sufficient to enable a DCO to
adequately hedge or close out a defaulting member's risk. The
Commission does not believe that it is appropriate to add ``or
transfer,'' or to interpret the liquidation period to include the time
that would be sufficient to hedge a defaulting clearing member's
positions. In a worst-case scenario, a DCO would need to liquidate a
defaulting clearing member's positions, and the time it would take to
do so should be the relevant consideration in setting initial margin
requirements.
ISDA commented that a DCO should continually monitor the risk
associated with concentration in participants' positions, and if a DCO
determines that a participant's cleared portfolio is so large that it
could not be liquidated within the liquidation period assumed in the
DCO's default management plan, the DCO should have the discretion to
include an extra charge for concentration risk in the initial margin
requirements of that participant. FIA made similar comments but
suggested that prudent risk management should require the imposition of
concentration margin in appropriate circumstances. FIA further noted
that when a DCO imposes concentration margin on a clearing member, the
additional margin should be included in the DCO's minimum margin
calculations for any customers of the clearing member that generate the
increased risk.
Although the regulations adopted by the Commission herein do not
specifically address concentration margin as described by ISDA and FIA,
they do not limit a DCO's discretion to impose extra charges on its
clearing members for concentration risk. It should also be noted that
Sec. 39.13(h)(6), adopted herein,\89\ requires a DCO to take
additional actions with respect to particular clearing members, when
appropriate, based on the application of objective and prudent risk
management standards, which actions may include imposing enhanced
margin requirements.
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\89\ See discussion of Sec. 39.13(h)(6)(ii) in section
IV.D.7.f, below.
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Numerous commenters objected to the proposed difference in
requirements that would subject swaps that were either executed
bilaterally or executed on a SEF to a minimum five-day liquidation
time, while permitting equivalent swaps that were executed on a DCM to
be subject to a minimum one-day liquidation time. Commenters variously
argued that the proposed one-day/five-day distinction for swap
transactions depending on the venue of execution would: (1) Be
inconsistent with the open access provisions of Section 2(h)(1)(B) of
the CEA \90\ and/or proposed Sec. 39.12(b)(2) \91\ (GFI Group Inc.
(GFI), VMAC, LCC (VMAC), BlackRock, Wholesale Markets Brokers'
Association, Americas (WMBAA), and FX Alliance Inc. (FXall)); (2) be
inconsistent with Congressional intent, expressed in Section 731 of the
Dodd-Frank Act,\92\ which recognizes a difference in risk between
cleared and uncleared swaps that could be addressed by differential
margin requirements, but does not differentiate between the risk of
swaps executed on a DCM and those executed on a SEF (Asset Management
Group of the Securities Industry and Financial Markets Association
(AMG)); (3) discriminate against trades not executed on DCMs by
requiring DCOs to impose higher margin requirements for swaps that are
executed on SEFs than for swaps that are executed on DCMs (GFI, VMAC,
MarketAxess Corporation (MarketAxess), WMBAA, Tradeweb Markets LLC
(Tradeweb), Nodal Exchange, LLC (Nodal), and FXall); (4) raise the cost
of clearing for swaps traded on a SEF (National Energy Marketers
Association (NEM), NGX, and BlackRock); \93\ (5) put SEFs at a
competitive disadvantage to DCMs (GFI, MarketAxess, and BlackRock); (6)
artificially restrict the ability of market participants, including
asset managers, to select the best means of execution for their swap
transactions (BlackRock); (7) penalize market participants that desire
to effect swap transactions on a SEF rather than a DCM (WMBAA and
Tradeweb); (8) undermine the goal of the Dodd-Frank Act to promote
trading of swaps on SEFs (Tradeweb and FXall); (9) potentially create
detrimental arbitrage between standardized swaps traded on a SEF and
futures contracts with the same terms and conditions traded on a DCM
(Nodal); (10) impose onerous and unnecessary administrative costs on
DCOs, which would likely be passed on to clearing members and their
customers (VMAC and BlackRock); (11) create a disincentive for DCOs to
practice appropriate default management ``drills'' to reduce the
[[Page 69367]]
liquidation time of portfolios of swaps (ISDA); (12) remove the
incentive for DCOs to detail, practice and leverage clearing member
expertise in default management (FIA); (13) discourage voluntary
clearing (NGX); and (14) require DCOs and clearing members to manage
margin calls and netting based on the execution platform for the
relevant swaps (VMAC and BlackRock).
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\90\ See Section 2(h)(1)(B) of the CEA, 7 U.S.C. 2(h)(1)(B).
\91\ See discussion of Sec. 39.12(b)(2) in section IV.C.2.c,
above.
\92\ Section 731 of the Dodd-Frank Act amended the CEA to insert
Section 4s. See Section 4s(e)(3)(A)(ii) of the CEA, 7 U.S.C.
6s(e)(3)(A)(ii).
\93\ NGX estimated that the impact of transitioning from its
current two-day requirement to a five-day requirement for all of the
energy products that it clears would lead to an approximate 60
percent increase in initial margins.
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In addition, a number of commenters argued that there was no basis
for concluding that swaps executed on a SEF would be less liquid than
swaps executed on a DCM (GFI, WMBAA, NGX, MarketAxess, AMG, and FXall).
BlackRock recommended that the Commission require a DCO to use a
consistent liquidation time for cleared swaps that are executed on SEFs
and DCMs.
Commenters variously contended that a liquidation time of five
business days may be excessive for some swaps (CME and Citadel \94\), a
one-day liquidation period is too short (LCH), a one-day liquidation
period is appropriate for swaps executed on a DCM or a SEF (AMG), and a
two-day liquidation period is appropriate for cleared swaps (NGX).
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\94\ Citadel further commented that excessive margin
requirements relative to risk exposure could adversely affect market
liquidity and deter clearing.
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Various commenters encouraged the Commission to permit a DCO to
determine the appropriate liquidation time for all products that it
clears based on the unique characteristics and liquidity of each
relevant product or portfolio (CME, MFA, ISDA, LCH, NYPC, NGX, FIA,\95\
Nadex, Citadel, and FXall) or to grant DCOs such discretion subject to
a one-day minimum for all products, including cleared swaps (GFI, VMAC,
MarketAxess, Nodal, WMBAA, and Tradeweb).
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\95\ FIA also commented that liquidation times should be set at
times appropriate to manage the liquidation of the vast majority of
the portfolios carried by a DCO's clearing members, and not
necessarily that of the largest clearing member.
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FIA and ISDA commented that the appropriate liquidation time should
be derived from a DCO's default management plan and the results of its
periodic testing of such plan. FIA further stated that a DCO should
adjust its minimum margin requirements if its periodic testing of its
default management plan demonstrates that a defaulting clearing
member's positions could be resolved in a shorter period of time.
Similarly, NGX stated that the Commission should permit a DCO to
demonstrate through back testing and stress testing that a particular
type of cleared transaction should be subject to a shorter liquidation
time.
MFA and Citadel recommended that if the Commission were to mandate
minimum liquidation times in the final rules, it should allow DCOs to
apply for exemptions for specific groups of swaps if market conditions
prove that such minimum liquidation times are excessive. Citadel
further recommended that the Commission make it explicit that the
Commission may re-evaluate and, if necessary, re-calibrate such minimum
liquidation times as markets evolve.
The Commission is persuaded by the views expressed by numerous
commenters that requiring different minimum liquidation times for
cleared swaps that are executed on a DCM and equivalent cleared swaps
that are executed on a SEF could have negative consequences. Therefore,
after further consideration, the Commission has determined not to
mandate different minimum liquidation times for cleared swaps based on
their venue of execution, and has further determined that the same
minimum liquidation time should be used with respect to cleared swaps
that are executed bilaterally. This approach is consistent with the
open access requirements of Section 2(h)(1)(B) of the CEA and Sec.
39.12(b)(2), adopted herein.
The Commission also acknowledges the concerns expressed by
commenters that a five-day liquidation period may be excessive for some
swaps. For example, for a number of years, CME and ICE have
successfully cleared swaps based on physical commodities using a one-
day liquidation time.\96\ By contrast, as noted in the notice of
proposed rulemaking, several DCOs currently use a five-day liquidation
time in determining margin requirements for certain swaps based on
financial instruments.\97\ These differences reflect differences in the
risk characteristics of the products.
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\96\ NYMEX, now CME, has cleared OTC swaps generally with a one
day liquidation time since 2002. CME currently offers more than
1,000 products for clearing through its ClearPort system.
\97\ In particular, ICE Clear Credit LLC and CME use a five-day
liquidation time for credit default swaps and LCH and CME use a
five-day liquidation time for interest rate swaps.
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The Commission has carefully considered whether it should prescribe
any liquidation time or, alternatively, permit each DCO to exercise its
discretion in applying liquidation times based on the risk profile of
particular products or portfolios. In this regard, the Commission notes
that even without a specified minimum liquidation time, under Sections
5b(c)(2)(D) and 8a(7)(D) of the CEA, the Commission can require a DCO
to adjust its margin methodology if it determines that the current
margin levels for a product or portfolio are inadequate based on back
testing or current market volatility.
Weighing the advantages and drawbacks of the alternatives, the
Commission believes that a bright-line requirement, with a provision
for making exceptions, will best serve the public interest. While a DCO
will still have considerable latitude in setting risk-based margin
levels, the Commission has determined that establishing a minimum
liquidation time will provide legal certainty for an evolving
marketplace, will offer a practical means for assuring that the
thousands of different swaps that are going to be cleared subject to
the Commission's oversight will have prudent minimum margin
requirements, and will prevent a potential ``race to the bottom'' by
competing DCOs. Moreover, given the large number of swaps already
cleared, this alleviates the need for the Commission, with its limited
staff resources, to evaluate immediately the liquidation time for each
swap that is cleared.\98\
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\98\ E.g., the 950,000 trades in LCH's SwapClear have an
aggregate notional principal amount of over $295 trillion. Source:
http://www.lch.com/swaps/swapclear_for_clearing_members/.
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Taking into account these considerations, and in response to the
comments, the Commission is adopting Sec. 39.13(g)(2)(ii) with a
number of modifications. First, the final rule requires a DCO to use
the same liquidation time for a product whether it is executed on a
DCM, a SEF, or bilaterally. This addresses the competitive concerns
raised by numerous commenters and recognizes that once a swap is
cleared, its risk profile is not affected by the method by which it was
executed.\99\
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\99\ See Section 2(h)(1)(B) of the CEA and Sec. 39.12(b)(2),
adopted herein (swaps submitted to a DCO with the same terms and
conditions are economically equivalent within the DCO and may be
offset with each other within the DCO).
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Second, the final rule provides that the minimum liquidation time
for swaps based on certain physical commodities, i.e., agricultural
commodities,\100\ energy, and metals, is one day. For all other swaps,
the minimum liquidation time is five days. This distinction is based on
the differing risk characteristics of these product groups and is
consistent with existing requirements that reflect the risk assessments
DCOs have made over the course of their experience clearing these types
of swaps. The longer liquidation time, currently five days for credit
default swaps at ICE Clear Credit, LLC, and CME, and for interest rate
[[Page 69368]]
swaps at LCH and CME, is based on their assessment of the higher risk
associated with these products.\101\ Contributing factors include a
concentration of positions among clearing members, the number and
variety of products listed, the complexity of the portfolios, the long-
dated expiration time for many swaps, and the challenges of the
liquidation process in the event of a default.\102\
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\100\ See 76 FR 41048 (July 13, 2011) (Agricultural Commodity
Definition; final rule).
\101\ See e.g., Cleared OTC Interest Rate Swaps at 7 (Aug.
2011), available at http://www.cmegroup.com/clearing/cme-core-cme-clearing-online-risk-engine.html; ICE Clear Credit Clearing Rules,
Schedule 401 (Jul. 16, 2011) available at https://www.theice.com/publicdocs/clear_credit/ICE_Clear_Credit_Rules.pdf.
\102\ The liquidation of the Lehman interest rate swap portfolio
in the fall of 2008 demonstrates that the actual liquidation time
for a swap portfolio could be longer than 5 days. Between September
15, 2008 (the day Lehman Bros. Holdings declared bankruptcy) and
October 3, 2008, LCH and ``OTCDerivnet,'' an interest rate
derivatives forum of major market dealers, wound down the cleared
OTC interest rate swap positions of Lehman Bros. Special Financing
Inc. (LBSFI). This portfolio had a notional value of $9 trillion and
consisted of 66,390 trades across 5 major currencies. LCH and
OTCDerivnet competitively auctioned off LBSFI's five hedge currency
portfolios to their members between September 24 and October 3,
2008. The margin held by LCH proved sufficient to cover the costs
incurred. Source: LCH Press Release of October 8, 2008, available
at: http://www.lchclearnet.com/Images/2008-10-08%20SwapClear%20default_tcm6-46506.pdf.
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Third, to provide further flexibility, the Commission is adding a
provision specifying that, by order, the Commission may provide for a
different minimum liquidation time for particular products or
portfolios. As markets evolve, it may become appropriate to ease the
requirement for certain swaps subject to the five-day minimum.
Conversely, analysis may reveal that for other products or portfolios
the five-day or one-day minimum is insufficient. The Commission
believes that in light of the novelty, complexity, and potential
magnitude of the risk posed by financial swaps, prudential
considerations dictate that this type of fine-tuning should be used in
appropriate circumstances. Such an order could be granted upon the
Commission's initiative or in response to a petition from a DCO.
In this regard, the Commission emphasizes that it is retaining the
proposed requirement that a DCO must use longer liquidation times, if
appropriate, based on the specific characteristics of particular
products or portfolios.\103\ Such longer liquidation times may be based
on a DCO's testing of its default management plan. If a DCO determines
that a longer liquidation time is appropriate for a particular swap,
the Commission would expect that the DCO would use the same longer
liquidation time for the equivalent swaps that it clears, whether the
swaps are executed on a DCM, a SEF, or bilaterally. Among the factors
that DCOs should consider in establishing minimum liquidation times
are: (i) Average daily trading volume in a product; (ii) average daily
open interest in a product; (iii) concentration of open interest; (iv)
availability of a predictable basis relationship with a highly liquid
product; and (v) availability of multiple market participants in
related markets to take on positions in the market in question. The
Commission would also consider these factors in determining whether a
particular liquidation time was appropriate.
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\103\ As proposed, Sec. 39.13(g)(2)(ii) referred to the
``unique'' characteristics of particular products or portfolios. The
Commission is revising this phrase in the final rule to refer to the
``specific'' characteristics of a particular product or portfolio to
clarify that such characteristics are not limited to those that are
one of a kind.
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The Commission is adopting Sec. 39.13(g)(2)(ii) revised to read as
set forth in the regulatory text of this final rule.\104\
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\104\ In a technical revision, the Commission has eliminated the
phrase, ``whether the swaps are carried in a customer account
subject to Section 4d(a) or 4d(f) of the Act, or carried in a house
account,'' because it is superfluous.
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(3) Confidence Level--Sec. 39.13(g)(2)(iii)
Proposed Sec. 39.13(g)(2)(iii) would require that the actual
coverage of the initial margin requirements produced by a DCO's margin
models, along with projected measures of the models' performance, would
have to meet a confidence level of at least 99 percent, based on data
from an appropriate historic time period with respect to: (A) each
product that is margined on a product basis; (B) each spread within or
between products for which there is a defined spread margin rate, as
described in proposed Sec. 39.13(g)(3); (C) each account held by a
clearing member at the DCO, by customer origin and house origin,\105\
and (D) each swap portfolio, by beneficial owner. The Commission
invited comment regarding whether a confidence level of 99 percent is
appropriate with respect to all applicable products, spreads, accounts,
and swap portfolios.
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\105\ The terms ``customer account or customer origin'' and
``house account or house origin'' are now defined in Sec. 39.2,
adopted herein.
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Alice Corporation supported the proposed 99 percent confidence
level, especially for new swaps and swaps with non-linear
characteristics. ISDA commented that the proposed 99 percent confidence
level is appropriate given current levels of mutualization in a DCO
default fund and mutualization in omnibus client accounts.\106\ MGEX
stated that it did not oppose the proposed 99 percent confidence level
for each account held by a clearing member at a DCO, by customer origin
and house origin.\107\
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\106\ ISDA contended that if there were a requirement to have
individualized client accounts, the appropriate confidence level
should be higher than 99 percent because the funds available to a
DCO to manage a client account default would be reduced.
\107\ MGEX requested that the Commission clarify that this
proposed requirement applies to the net account of each clearing
member and not the underlying accounts at each clearing member. The
Commission did not intend proposed Sec. 39.13(g)(2)(iii)(C), which
would refer to ``[e]ach account held by a clearing member at the
DCO, by customer origin and house origin * * *, '' to apply to
individual customer accounts by beneficial owner. However, the
Commission notes that Sec. 39.13(g)(2)(iii)(D), as proposed and as
adopted herein, applies the 99 percent confidence level requirement
to ``[e]ach swap portfolio, by beneficial owner.''
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FIA opposed the proposed 99 percent requirement because it sets an
artificial floor that may remove the incentive for DCOs to conduct the
rigorous analysis necessary to establish an appropriate confidence
level. FIA further stated that if a different regulatory scheme than
loss mutualization for the protection of customer funds were to be
adopted for cleared swaps, a much higher level of confidence may be
required.
CME, Nadex, KCC,\108\ and Citadel took the position that the
Commission should not prescribe a specific confidence level, but should
instead continue to give each DCO the discretion to determine the
appropriate confidence levels. CME and Nadex noted that one or more of
the following factors could be considered by a DCO in determining the
appropriate confidence levels: the particular characteristics of the
products and portfolios it clears, the depth of the underlying markets,
the existence of multiple venues trading similar products on which a
defaulting clearing member's portfolio could be liquidated or hedged,
the duration of the products, the size of the DCO and its systemic
importance, its customer base, or its other risk management tools.
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\108\ KCC also expressed its belief that ultra-high confidence
level modeling does not protect against risk as well as direct
margin intervention by the DCO in the case of significant market
movements, such as retaining the right to review recent price
movements to re-establish margins at a higher level and retaining
the right to demand special margin from certain clearing members.
The Commission believes that a DCO should retain the right to take
such actions in addition to, rather than instead of, using a 99
percent confidence level, as required by Sec. 39.13(g)(2)(iii). For
example, Sec. 39.13(h)(6)(ii), discussed below, requires a DCO to
take additional actions with respect to particular clearing members,
when appropriate, including imposing enhanced margin requirements.
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The Commission does not agree such discretion is appropriate and
has
[[Page 69369]]
determined to establish a minimum confidence level. The Commission
believes that a minimum confidence level will provide legal certainty
for an evolving marketplace, will offer a practical means for assuring
market participants that the thousands of different products that are
going to be cleared subject to the Commission's oversight will have
prudent minimum margin requirements, and will prevent a potential
``race to the bottom'' by competing DCOs. Moreover, given the large
number of products already cleared, this alleviates the need for the
Commission, with its limited staff resources, to evaluate immediately
the confidence level requirements for each product that is cleared.
The Commission is adopting the proposed minimum 99 percent
confidence level. This is consistent with proposed international
standards.\109\ Moreover, given the potential costs of default, the
Commission agrees with those commenters who stated that a 99 percent
level is appropriate. An individual DCO may determine to set a higher
confidence level, in its discretion.
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\109\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,
Key Consideration 3, at 40. In addition, on September 15, 2010, the
European Commission (EC) proposed the European Market Infrastructure
Regulation (EMIR), available at http://ec.europa.eu/internal_market/financial-markets/docs/derivatives/20100915_proposal_en.pdf, ``to ensure implementation of the G20 commitments to clear
standardized derivatives [which can be accessed at http://www.g20.org/Documents/pittsburgh_summit_leaders_statement_250909.pdf, and that Central Counterparties (CCPs) comply with high
prudential standards * * *,'' among other things, and expressed its
intent to be consistent with the Dodd-Frank Act. (EMIR, at 2-3). The
EMIR requires that margins ``* * * shall be sufficient to cover
losses that result from at least 99 per cent of the exposures
movements over an appropriate time horizon * * *.'' (EMIR, Article
39, paragraph 1, at 46).
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NASDAQ OMX Commodities Clearing Company (NOCC) supported an
approach that would allow DCOs to set margin requirements for new and
low-volume products at a lower coverage level if the potential losses
resulting from such products are minimal. According to NOCC, this would
allow DCOs to include more products and market participants by
attracting them at an early stage without materially increasing the
risk of the DCO.
VMAC suggested that the Commission add to the requirement that
initial margin levels must be based upon ``an established confidence
level of at least 99 percent,'' language that states ``or, subject to
specific authorization from the CFTC, a lower confidence level.'' In
particular, VMAC commented that although a DCO should be required to
demonstrate that the given confidence level results in an initial
margin amount which is sufficient to allow the DCO to fully discharge
its obligations upon a clearing member default, a DCO should not be
required to collect margin substantially in excess of its obligations
to clearing members in a default scenario.
The Commission is not modifying the language of Sec.
39.13(g)(2)(iii) in a manner that would permit DCOs to set margin
requirements at a lower coverage level for new and low-volume products,
as recommended by NOCC, or provide for a lower confidence level subject
to specific Commission authorization, as suggested by VMAC. In the
notice of proposed rulemaking, the Commission noted that the 2004 CPSS-
IOSCO Recommendations stated that ``[m]argin requirements for new and
low-volume products might be set at a lower coverage level [than the
major products cleared by a CCP] if the potential losses resulting from
such products are minimal.'' \110\ However, the CPSS-IOSCO Consultative
Report, which was issued subsequent to the Commission's proposed rules,
does not contain similar language. The Commission believes that it is
prudent to apply the same standard to all products.
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\110\ See 2004 CPSS-IOSCO Recommendations at 23.
---------------------------------------------------------------------------
OCC and NYPC encouraged the Commission to modify its proposal to
make clear that, when swaps are commingled in either a Section 4d(a)
futures account or a Section 4d(f) cleared swaps account, pursuant to
Sec. 39.15(b)(2),\111\ the 99 percent test need not be separately
applied to the swaps positions alone. The Commission agrees with OCC
and NYPC that if swaps and futures are held in the same customer
account pursuant to rules approved by the Commission or a 4d order
issued by the Commission, as specified in Sec. 39.15(b)(2), the 99
percent test would apply to the entire commingled account, and not just
the swap positions, under Sec. 39.13(g)(2)(iii)(D). Therefore, the
Commission is modifying Sec. 39.13(g)(2)(iii)(D) to add ``including
any portfolio containing futures and/or options and held in a
commingled account pursuant to Sec. 39.15(b)(2) of this part,'' after
``[e]ach swap portfolio.'' The Commission is making similar
modifications in Sec. 39.13(g)(7) with respect to back testing
requirements, which are discussed in section IV.D.6.g, below.
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\111\ See discussion of Sec. 39.15(b)(2), adopted herein, in
section IV.F.3, below.
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OCC also requested that the Commission clarify that, in the case of
a margin system that calculates margin for all positions in an account
on the basis of the net risk of those positions based upon historical
price correlations rather than on a product or a pre-defined spread
basis, the 99 percent confidence level would be applied only on an
account-by-account basis, and not to individual products, product
groups, or specified spread positions. NYPC made a similar request,
stating that its historical Value at Risk (VaR)-based margin model
calculates initial margin requirements at the portfolio level, rather
than on a product or spread basis.
The Commission notes that, as proposed, Sec. 39.13(g)(2)(iii)(A)
would require the application of the 99 percent confidence level to
``[e]ach product (that is margined on a product basis)'' and Sec.
39.13(g)(2)(iii)(B) would require the application of the 99 percent
confidence level to ``[e]ach spread within or between products for
which there is a defined spread margin rate * * *.'' The Commission's
intent was that Sec. Sec. 39.13(g)(2)(iii)(A) and (B) would apply to
products and pre-defined spreads under margin models that calculate
initial margin requirements on a product and pre-defined spread basis,
respectively. Further, with respect to margin models that do not
calculate margin on a product or pre-defined spread basis, the 99
percent requirement would apply with respect to each account held by a
clearing member at the DCO by house origin and by each customer origin,
and to each swap portfolio, by beneficial owner, pursuant to Sec. Sec.
39.13(g)(2)(iii)(C) and (D), respectively.\112\
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\112\ For purposes of clarification, certain references to
customer origin in Sec. Sec. 39.13 and 39.19 have been replaced
with references to ``each customer origin'' to clarify the
distinction between customer positions in futures and options
segregated pursuant to Section 4d(a) of the CEA, and customer
positions in swaps segregated pursuant to Section 4d(f) of the CEA.
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In order to clarify the Commission's intent, the Commission is
adopting Sec. 39.13(g)(2)(iii)(A) to read as follows: ``[e]ach product
for which the derivatives clearing organization uses a product-based
margin methodology,'' while striking ``(that is margined on a product
basis).'' In addition, the Commission is adopting Sec.
39.13(g)(2)(iii)(B) to read as follows: ``[e]ach spread within or
between products for which there is a defined spread margin rate,''
while striking ``as described in paragraph (g)(4) of this section.''
LCH commented that the Commission's approach to setting margin
based on products and spreads, while appropriate for futures, is not
[[Page 69370]]
suitable or sufficient for swaps. LCH proposed that the key requirement
for swaps should be for the DCO to ensure that it has enough margin and
guarantee funds to cover its exposures, and for the DCO to prove this
on an individual client and clearing member basis. The Commission did
not intend to suggest that swaps should be margined pursuant to a
product-based margin methodology, nor that they should be subject to
defined spread margin rates. The Commission recognizes that swaps are
often margined on a portfolio basis and specifically addressed swap
portfolios in Sec. 39.13(g)(2)(iii)(D). The Commission would also like
to clarify that a 99 percent confidence level, as applied to swap
portfolios, means that each portfolio is covered 99 percent of the
time, and not that a collection of portfolios is covered 99 percent of
the time on an aggregate basis.
The Commission is adopting Sec. 39.13(g)(2)(iii) with the
modifications described above.
(4) Appropriate Historic Time Period--Sec. 39.13(g)(2)(iv)
Proposed Sec. 39.13(g)(2)(iv) would require each DCO to determine
the appropriate historic time period of data that it would use for
establishing the 99 percent confidence level based on the
characteristics, including volatility patterns, as applicable, of each
product, spread, account, or portfolio.
LCH recommended that the Commission define the ``historic time
period'' as a minimum of one calendar year in order to provide for
adequate historical observations. The Commission believes that a DCO
should be permitted to exercise its discretion with respect to the
appropriate time periods that should be used, based on the
characteristics, including volatility patterns, as applicable, of the
relevant products, spreads, accounts, or portfolios. The Commission
also notes that proposed international standards do not specify a
historic time period that would be appropriate in all circumstances,
recognizing that either a shorter or a longer historic time period may
be appropriate based on the volatility patterns of a particular
product.\113\ The Commission expects that DCOs would include periods of
significant financial stress. Therefore, the Commission is adopting
Sec. 39.13(g)(2)(iv) as proposed.
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\113\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,
Explanatory Note 3.6.7, at 43.
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d. Independent Validation--Sec. 39.13(g)(3)
Proposed Sec. 39.13(g)(3) would require that a DCO's systems for
generating initial margin requirements, including the DCO's theoretical
models, must be reviewed and validated by a qualified and independent
party, on a regular basis. The Commission invited comment regarding
whether a qualified and independent party must be a third party or
whether there may be circumstances under which an employee of a DCO
could be considered to be independent.
In the notice of proposed rulemaking, the Commission explained that
a validation should include a comprehensive analysis to ensure that
such systems and models achieve their intended goals. The Commission
also noted that, although the proposed regulation did not define the
meaning of ``regular basis,'' the Commission would expect that, at a
minimum, a DCO would obtain such an independent validation prior to
implementation of a new margin model and when making any significant
change to a model that was in use by the DCO.\114\ The Commission
further stated that significant changes would be those that could
materially affect the nature or level of risks to which a DCO would be
exposed, and that the Commission would expect a DCO to obtain an
independent validation prior to any significant change that would relax
risk management standards. However, the Commission noted that if a DCO
needed to adopt a significant change in an expedited manner to enhance
risk protections, the Commission would expect the DCO to obtain an
independent validation promptly after the change was made.
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\114\ The Commission also notes that the CPSS-IOSCO Consultative
Report recommends that a CCP's initial margin models should be
independently validated at least on a yearly basis. CPSS-IOSCO
Consultative Report, Principle 6: Margin, Explanatory Note 3.6.8, at
43. The Commission is not requiring an annual validation at this
time, although it may revisit this issue in the future.
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CME, OCC, MGEX, and KCC all expressed the view that an employee of
a DCO could be independent in appropriate circumstances. CME commented
that permitting employees of a DCO to conduct the required reviews
would be consistent with proposed Sec. 39.18(j)(2), which would allow
employees of a DCO to conduct the required testing of a DCO's business
continuity and disaster recovery systems, provided that such employees
are not the persons responsible for developing or operating the systems
being tested.\115\ OCC and MGEX took the position that employees of a
DCO could be independent as long as they are not, or have not been,
involved in designing the models, and OCC further stated that internal
personnel must not otherwise be biased due to their involvement in
implementation of the models.\116\ However, FIA argued that margin
models should be required to be validated by an independent third party
with expertise in risk and the product being cleared.
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\115\ Section 39.18(j)(2), as proposed, and as adopted herein,
states that testing shall be conducted by qualified, independent
professionals. Such qualified independent professionals may be
independent contractors or employees of the derivatives clearing
organization, but shall not be persons responsible for development
or operation of the systems or capabilities being tested.
\116\ In particular, OCC noted that the Office of the
Comptroller of the Currency, the Department of the Treasury, the
Federal Reserve System and the Federal Deposit Insurance Corporation
recently proposed revisions to their risk-based capital guidelines,
which would require that, with respect to the validation of banks'
internal risk models, ``[t]he review personnel [would] not
necessarily have to be external to the bank in order to achieve the
required independence'' but that ``[a] bank should ensure that
individuals who perform the review are not biased in their
assessment due to their involvement in the development,
implementation, or operation of the models.'' See 76 FR 1890, at
1897 (Jan. 11, 2011) (Risk-Based Capital Guidelines: Market Risk).
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The Commission recognizes that a third party could be more critical
of a DCO's margin model than an employee of a DCO, even if that
employee is ``qualified and independent.'' However, the Commission also
believes that a third party could be less critical if, for example, it
seeks to provide services to the DCO or the industry in the future.
The Commission agrees with CME, OCC, MGEX, and KCC that an employee
of a DCO could be a ``qualified and independent party,'' and thus could
review and validate the DCO's systems for generating initial margin
requirements, under appropriate circumstances. It would probably be
more costly for a DCO to use a third party for this purpose rather than
an employee.
On balance, the Commission believes that it may be appropriate for
a DCO to have an employee review and validate its margin systems.
Therefore, the Commission is adopting Sec. 39.13(g)(3) with the
addition of a sentence stating that ``[s]uch qualified and independent
parties may be independent contractors or employees of the derivatives
clearing organization, but shall not be persons responsible for
development or operation of the systems and models being tested.'' This
is consistent with the language contained in Sec. 39.18(j)(2), as
adopted herein, as well as the
[[Page 69371]]
proposed approach of other financial regulators.\117\ The Commission
also notes that the reference to independent contractors as well as
employees in the added language will also prohibit a DCO from using a
particular third party to conduct the validation if that third party
was or is responsible for development or operation of the relevant
systems and models.
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\117\ Id.
---------------------------------------------------------------------------
KCC requested that the Commission clarify that the CRO or other
comparable personnel with responsibility for overall risk management at
the DCO would meet the requirements of a ``qualified and independent
party.'' The Commission does not believe that a DCO's CRO or personnel
responsible for overall risk management would categorically qualify as
an ``independent party.'' This determination would need to be made on a
case-by-case basis depending on whether the CRO or other similar person
was or is responsible for development or operation of the systems and
models being tested.
MGEX requested that the Commission clarify whether the requirement
for independent validation would apply to the primary risk-based
portfolio system such as SPAN,\118\ or each DCO's analysis program for
determining margins, noting its belief that requiring independent tests
on the latter would be excessive. It is not clear what MGEX means by
``each DCO's analysis program for determining margins.'' However, Sec.
39.13(g)(3) requires independent validation with respect to a DCO's
underlying model, e.g., SPAN or OCC's STANS model, as well as the
methodology used to compute the inputs to any such model. On the other
hand, a DCO would not be required to obtain an independent validation
of a change in SPAN parameters as described by CME.\119\
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\118\ For a description of SPAN, see CME's Web site, at http://www.cmegroup.com/clearing/risk-management/span-overview.html#works.
\119\ See id. for a description of SPAN parameters. Therefore,
Sec. 39.13(g)(1), which requires that a DCO review its margin
models and parameters, on a regular basis, requires a broader review
than would be met by compliance with Sec. 39.13(g)(3).
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OCC commented that, as described in the notice of proposed
rulemaking, the ``could materially affect'' standard is deficient in
two respects in that: (1) It fails to include any reference to the
likelihood that a change would actually materially affect the nature or
level of risk, and (2) it omits any reference to the direction of the
change in level of risk. OCC contended that a more appropriate standard
would be to provide that significant changes are those that ``are
reasonably likely to materially change the nature or increase the level
of risks to which the DCO would be exposed.''
In response to this comment, the Commission is modifying the
standard to provide that significant changes are those for which there
is a reasonable possibility that they would materially affect the
nature or level of risks to which a DCO would be exposed. While this
standard identifies the likelihood that a change would materially
affect the nature or level of such risks, the Commission believes that
it is more appropriate than identifying significant changes as only
those that are ``reasonably likely to materially change'' the nature or
level of such risks.
The Commission does not believe that significant changes should be
limited to those that are likely to increase the level of risks. As
described in the notice of proposed rulemaking, the Commission would
expect a DCO to obtain an independent validation prior to any
significant change that would relax risk management standards, but the
Commission would permit a DCO to obtain an independent validation
promptly after a significant change that would enhance risk
protections, in appropriate circumstances. A DCO should obtain such a
validation even if the change were designed to enhance risk
protections, in order to ensure that the change would be effective in
achieving its objective.
OCC also requested that the Commission clarify that the addition of
a new product or new underlying interest would not inherently be deemed
to trigger the independent evaluation requirement. The Commission
believes that whether the addition of a new product or a new underlying
interest would trigger the independent validation requirement would
need to be determined on a case-by-case basis, depending on whether
there is a reasonable possibility that such addition will materially
change the nature or level of risks to which the DCO would be exposed.
One example would be if the addition necessitates a significant change
to the margin model as it applies to the new product or new underlying
interest. Thus, the addition of a futures contract based on a new
broad-based securities index where the DCO already clears futures
contracts based on broad-based securities indexes might not require a
significant change to the applicable margin model. However, the
addition of a new category of swaps, even if the DCO already clears
swaps, might require a significantly different margin model. Another
example might be if a swap cleared by a DCO became subject to a
clearing mandate and the risk profile changed because of changes in
volume and open interest.
e. Spread and Portfolio Margins--Sec. 39.13(g)(4)(i)
Proposed Sec. 39.13(g)(4)(i) would permit a DCO to allow
reductions in initial margin requirements for related positions (spread
margins), if the price risks with respect to such positions were
significantly and reliably correlated. Under the proposed regulation,
the price risks of different positions would only be considered to be
reliably correlated if there were a theoretical basis for the
correlation in addition to an exhibited statistical correlation.
Proposed Sec. 39.13(g)(4)(i) would include a non-exclusive list of
possible theoretical bases, including the following: (A) The products
on which the positions are based are complements of, or substitutes
for, each other; (B) one product is a significant input into the other
product(s); (C) the products share a significant common input; or (D)
the prices of the products are influenced by common external factors.
The Commission requested comment regarding the appropriateness of
requiring a theoretical basis for the correlation between related
positions before reductions in initial margin requirements would be
permitted. In addition, proposed Sec. 39.13(g)(4)(ii) would require a
DCO to regularly review its spread margins and the correlations on
which they are based.\120\
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\120\ In addition to the other comments discussed herein, Alice
Corporation noted that it supported the cautious approach taken by
the Commission and that offsets across products with different
maturities and risk profiles should be avoided where possible, and
ISDA stated that spread margins should only permitted when a DCO can
demonstrate a strong correlation in stressed market conditions and
agrees to periodic public disclosure of its methodology and results.
With respect to ISDA's comment, the Commission notes that Sec.
39.13(g)(2)(iii), discussed in section IV.D.6.c.(3), above, requires
a DCO to ensure that the actual coverage of its initial margin
requirements, along with projected measures of the performance of
its margin models, must meet an established confidence level of at
least 99 percent, based on data from an appropriate historic time
period, for, among other things, spreads within or between products
for which there is a defined spread margin rate, for each account
held by a clearing member at the DCO, by customer and house origin,
and for each swap portfolio, by beneficial owner, and Sec.
39.13(g)(7), discussed in section IV.D.6.g, below, imposes related
back testing requirements. In addition, Sec. 39.21(c)(3), discussed
in section IV.L, below, requires a DCO to publicly disclose its
margin methodology.
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KCC and OCC addressed the proposed requirement that the price risks
of related positions would only be considered to be reliably
correlated, and thus be eligible for initial margin reductions, if
there were a theoretical basis for the correlation in addition to
[[Page 69372]]
an exhibited statistical correlation. KCC contended that the proposed
requirement would be difficult for the Commission to implement and
unnecessary because DCOs have no incentive to offer margin reductions
in the absence of high correlation between positions. KCC further noted
that the proposal does not detail what level of observed statistical
correlation is required, and the proposed requirement to articulate a
theoretical basis is vague.
OCC also questioned the appropriateness of the requirement that
there must be a theoretical basis for the correlation, noting that a
theoretical basis for correlation is, by definition, theoretical and
may not be directly observable or verifiable except through the
correlation. OCC stated that it is difficult to imagine a correlation
for which no theoretical basis can be constructed, and in many if not
most cases, the theoretical basis for any significant correlation is
obvious.
The Commission continues to believe that reductions in initial
margin requirements should only be allowed if a DCO is able to
articulate a reasonable theoretical explanation for an observed
statistical correlation to ensure that the positions are reliably
correlated. The Commission notes that it is a matter of basic
statistics that correlation does not equal causation. The world is
replete with examples of events or data that are highly correlated at
various points in time but for which there is no theoretical
relationship. If there is no theoretical relationship, a DCO has no
basis to believe that a statistical relationship--no matter how
strong--is stable, and a margin based on such a relationship may be
insufficient to capture price variation.
Several commenters addressed the appropriateness of applying
proposed Sec. 39.13(g)(4) to portfolio-based margin systems. LCH
commented that the spread margin measure which the Commission proposed
is unsuited and inappropriate for swaps clearing and that the Portfolio
Approach to Interest Rate Scenarios (PAIRS), the historical simulation
method that LCH uses, is more suitable to non-standardized swaps.
Therefore, LCH urged the Commission to amend proposed Sec. 39.13(g)(4)
to afford recognition to this technique. OCC requested that the
Commission acknowledge that its STANS methodology meets the
requirements of proposed Sec. 39.13(g)(4), noting that STANS currently
relies on over 20 million separate correlations. OCC stated that it
would be impractical to attempt to document or even articulate the
``theoretical basis'' for all of these correlations even though it
believes that they would be supportable on a theoretical level, and
further believes that its systems for determining and reviewing the
validity of the correlations it uses are sufficient to ensure that OCC
does not allow unjustified margin offsets. NYPC requested that the
Commission clarify that Sec. 39.13(g)(4) would not be applicable to
margin models that calculate initial margin requirements at the account
level, including NYPC's historical VaR-based margin model.
The Commission intends Sec. 39.13(g)(4) to apply to portfolio-
based margin models as well as product-based margin models. For some
products, DCOs establish defined spread margin rates, pursuant to a
product-based margin methodology. Typically, this occurs where there is
a bilateral correlation, e.g., a March-June calendar spread or a
correlation between two related products.\121\ For other products,
there may be multilateral correlations for which margin is calculated
on a portfolio basis, pursuant to a portfolio-based margin methodology.
In the latter instance, there is not a defined margin amount or margin
reduction for a defined portfolio that remains the same over time.
Instead, margin is recalculated each day for each individual portfolio.
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\121\ A defined spread margin rate may also apply to three
related products, e.g., the Chicago Board of Trade's soybean crush
spread with respect to soybeans, soybean oil and soybean meal.
---------------------------------------------------------------------------
Therefore, the Commission is adopting Sec. 39.13(g)(4), with
several modifications, in order to clarify that margin reductions
calculated on a portfolio basis are also permissible if they meet the
standards of the regulation. First, the Commission is changing the
heading of the provision from ``[s]pread margins'' to ``[s]pread and
portfolio margins.'' The Commission is also removing the parenthetical
``(spread margins)'' after the clause in Sec. 39.13(g)(4)(i) that
states ``[a] derivatives clearing organization may allow reductions in
initial margin requirements for related positions.'' Finally, the
Commission is changing the reference to ``spread margins'' in Sec.
39.13(g)(4)(ii) to ``margin reductions.'' These changes are designed to
make it clear that Sec. 39.13(g)(4) applies to reductions in initial
margin requirements for related positions, whether a DCO uses a
product-based margin model or a portfolio-based margin model.
Better Markets and Mr. Greenberger commented that Sec. 39.13(g)(4)
must require that the relationship between positions be calculated
using the same standards (with respect to volatility and liquidity
requirements) that are applied to the calculation of initial margin for
the individual positions. The Commission agrees with Better Markets and
Mr. Greenberger and, as discussed above, spread and portfolio margins
would also be subject to a 99 percent coverage standard.
f. Price Data--Sec. 39.13(g)(5)
Proposed Sec. 39.13(g)(5) would require a DCO to have a reliable
source of timely price data to measure its credit exposure accurately,
and to have written procedures and sound valuation models for
addressing circumstances where pricing data is not readily available or
reliable.
Interactive Data Corporation expressed its belief that the concept
of ``sound valuation models'' should be expanded further with
additional prescriptive guidance in four key dimensions, including: (1)
Leveraging greater trade transparency; (2) using multiple sources; (3)
mitigating conflicts of interest; and (4) sourcing of independent price
data.
The Commission does not believe that it is necessary to be more
specific or prescriptive with respect to this requirement, and is
adopting Sec. 39.13(g)(5) as proposed. As the Commission noted in the
notice of proposed rulemaking, the nature of the applicable valuation
models would necessarily depend on the particular products and the
available sources of any relevant pricing data.
g. Daily Review and Back Tests--Sec. Sec. 39.13(g)(6) and (g)(7)
Proposed Sec. 39.13(g)(6) would require a DCO to determine the
adequacy of its initial margin requirements for each product, on a
daily basis, with respect to those products that are margined on a
product basis.
Proposed Sec. 39.13(g)(7) would require a DCO to conduct certain
back tests. The Commission has defined ``back test'' in Sec. 39.2,
adopted herein, as ``a test that compares a derivatives clearing
organization's initial margin requirements with historical price
changes to determine the extent of actual margin coverage.''
For purposes of proposed Sec. 39.13(g)(7)(i) and (ii), the
introductory paragraph of proposed Sec. 39.13(g)(7) would require
that, in conducting back tests, a DCO use historical price change data
based on a time period that is equivalent in length to the historic
time period used by the applicable margin model for establishing the
minimum 99 percent confidence level or a longer time period. The
applicable time period
[[Page 69373]]
was separately specified for the back tests required by proposed Sec.
39.13(g)(7)(iii), as discussed below.
Proposed Sec. 39.13(g)(7)(i) would require a DCO, on a daily
basis, to conduct back tests with respect to products that are
experiencing significant market volatility. Specifically, a DCO would
be required to test the adequacy of its initial margin requirements and
its spread margin requirements for such products that are margined on a
product basis.
Proposed Sec. 39.13(g)(7)(ii) would require a DCO, on at least a
monthly basis, to conduct back tests to test the adequacy of its
initial margin requirements and spread margin requirements for each
product that is margined on a product basis. The Commission requested
comment regarding whether initial margin requirements for all products
should be subject to back tests on a monthly basis or whether some
other time period, such as quarterly, would be sufficient to meet
prudent risk management standards.
Proposed Sec. 39.13(g)(7)(iii) would require a DCO, on at least a
monthly basis, to conduct back tests to test the adequacy of its
initial margin requirements for each clearing member's accounts, by
customer origin and house origin, and each swap portfolio, by
beneficial owner, over at least the previous 30 days. In the notice of
proposed rulemaking, the Commission noted that, since the composition
of such accounts and swap portfolios may change on a daily basis, it
was anticipated that back tests with respect to such accounts and
portfolios would involve a review of the initial margin requirements
for each account and portfolio as it existed on each day during the 30-
day period. The Commission also requested comment regarding whether
initial margin requirements for all clearing members' accounts, by
origin, and swap portfolios, by beneficial owner, should be subject to
back tests on a monthly basis or whether some other time period, such
as quarterly (based on the previous quarter's historical data), would
be sufficient to meet prudent risk management standards.
Several commenters addressed the appropriate frequency of back
tests and/or the appropriate historic time period for the analysis of
price change data. FIA commented that initial margin requirements
should be back tested monthly. MGEX stated that it was not opposed to a
monthly back testing requirement with respect to proposed Sec.
39.13(g)(7)(iii) based on its understanding that the Commission
intended that the DCO must look at its clearing member's net account
and not each underlying customer account with the exception of
swaps.\122\
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\122\ MGEX correctly understands that the Commission's reference
to ``each account held by a clearing member at the DCO, by origin,
house and customer'' in proposed Sec. 39.13(g)(7)(iii) was not
intended to apply to individual accounts by beneficial owner,
although proposed Sec. 39.13(g)(7)(iii) would require monthly back
tests with respect to initial margin requirements for each swap
portfolio, by beneficial owner.
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LCH took the position that back tests should be conducted at least
on a daily basis for all products cleared by a DCO. However, LCH argued
that such back tests should be conducted at the portfolio level because
margining techniques appropriate for swaps, such as LCH's PAIRS
methodology, do not allow for the disaggregation of initial margin and
spread margin requirements at a product level. LCH also commented that,
for back tests to be statistically meaningful, the applicable historic
time period should be a minimum of one calendar year.
KCC stated that it may be appropriate for the Commission to further
define ``significant market volatility,'' for purposes of proposed
Sec. 39.13(g)(7)(i),\123\ but that, more generally, any back-testing
requirements should be based on a discretionary, risk-based
determination by the DCO. In addition, KCC expressed its belief that
the back testing period should be subject to the discretion of the DCO
in light of then-current market conditions, i.e., imposing a specific
back-testing period may inappropriately reflect an exaggerated or
understated level of market volatility.
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\123\ The Commission believes that each DCO should determine
what ``significant volatility'' means based upon the volatility
patterns of each individual product or swap portfolio that it
clears.
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NOCC took the position that products, customers or spread credits
should reach a specified volume or risk exposure level before being
required to be back tested with the proposed frequencies so long as the
DCO can demonstrate that it is meeting the core principle objectives
underlying proposed Sec. 39.13(f).
NYPC requested that the Commission clarify that proposed Sec. Sec.
39.13(g)(6) and (g)(7)(i)-(ii) would not be applicable to margin models
that calculate initial margin requirements at the account level,
including NYPC's historical VaR-based margin model. OCC also stated its
belief that it would not be subject to the requirement for daily review
in proposed Sec. 39.13(g)(7)(i), as it does not margin on a product
basis, but noted that it does conduct daily back testing on all
accounts, i.e., on a portfolio basis.
The Commission is adopting Sec. 39.13(g)(6), eliminating the
language stating ``for each product (that is margined on a product
basis),'' in order to correct a potential inconsistency between the
text of the rule and the notice of proposed rulemaking. In the notice
of proposed rulemaking, the Commission stated that ``[d]aily review and
periodic back testing are essential to enable a DCO to provide adequate
coverage of the DCO's risk exposures to its clearing members.'' As
proposed, Sec. 39.13(g)(6) would only require a DCO to determine the
adequacy of its initial margin requirements, on a daily basis, for
products that were margined on a product basis. The adequacy of a DCO's
initial margin requirements for futures and options on futures products
margined on a portfolio basis, and for swap portfolios, would not have
been subject to such daily review. The Commission believes that such a
result is untenable, as one of the most rudimentary steps in risk
management is to conduct daily review of margin coverage, i.e., to
determine whether any margin breaches have occurred. Moreover, the
Commission believes that the change will not impose any burden because
it believes that all DCOs currently conduct some form of daily review
of the adequacy of their initial margin requirements, whether they use
a product-based or a portfolio-based margin methodology.
The Commission is adopting Sec. 39.13(g)(7)(i) with modifications
that require a DCO to conduct back tests, on a daily basis, to test the
adequacy of its initial margin requirements with respect to products or
swap portfolios that are experiencing significant market volatility:
(a) For that product if the DCO uses a product-based margin
methodology; (b) for each spread involving that product if there is a
defined spread margin rate; (c) for each account held by a clearing
member at the DCO that contains a significant position \124\ in that
product, by house origin and by each customer origin; and (d) for each
such swap portfolio, including any portfolio containing futures and/or
options and held in a commingled account pursuant to Sec.
39.15(b)(2),\125\ by beneficial owner.
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\124\ The Commission has not defined a ``significant position,''
leaving that determination to the discretion of each DCO, as the
size of a position that would be a ``significant position'' may vary
depending on the nature of the particular product or the composition
of the particular account.
\125\ See discussion of the addition of the same language to
Sec. 39.13(g)(2)(iii)(D), in section IV.D.6.c.(3), above.
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Similarly, the Commission is adopting Sec. 39.13(g)(7)(ii) with
modifications that
[[Page 69374]]
require a DCO to conduct back tests, on at least a monthly basis: (a)
For each product for which the DCO uses a product-based margin
methodology; (b) for each spread for which there is a defined spread
margin rate; (c) for each account held by a clearing member at the DCO,
by house origin and by each customer origin; and (d) for each swap
portfolio, including any portfolio containing futures and/or options
and held in a commingled account pursuant to Sec. 39.15(b)(2),\126\ by
beneficial owner. As adopted, Sec. 39.13(g)(7) no longer contains a
paragraph (iii) as paragraph (ii) now describes all monthly back
testing requirements.
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\126\ Id.
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As originally proposed, Sec. 39.13(g)(7) would only require daily
back testing for products that were experiencing significant market
volatility if the DCO used a product-based margin methodology, and for
spreads involving that product if there was a defined spread margin
rate. It would not require daily back testing for each account, by
customer origin and house origin, that contained a significant position
in that product, whether the DCO used a product-based or a portfolio-
based margin methodology, or for each swap portfolio that was
experiencing significant market volatility. As with respect to Sec.
39.13(g)(6), there was a potential inconsistency in the treatment of
different positions. There is no reasonable basis to require daily back
tests solely with respect to products that are experiencing significant
market volatility for which the DCO uses a product-based margin
methodology and spreads involving such products if there is a defined
spread margin rate, and not to require daily back tests with respect to
accounts, by customer origin and house origin, which contain
significant positions in those products simply because the DCO uses a
portfolio-based margin methodology. Similarly, there is no
justification for requiring daily back tests with respect to products
that are experiencing significant market volatility and not requiring
daily back tests with respect to swap portfolios that are experiencing
significant market volatility. A DCO should be required to conduct
daily back tests when the instruments that it clears are subject to
significant market volatility, whether the DCO bases its initial margin
requirements on a product-based or a portfolio-based margin
methodology, and whether those instruments are futures, options on
futures, or swaps.
Although OCC stated that it currently conducts daily back tests on
all accounts on a portfolio basis, and LCH expressed its view that back
tests should be conducted on a daily basis for all products and swap
portfolios cleared by a DCO, the Commission has determined to permit a
DCO to conduct back tests on at least a monthly basis when significant
market volatility is not present. FIA and MGEX supported monthly back
testing. Apart from KCC's contention that back testing should be
subject to the discretion of the DCO, and NOCC's suggestion that DCOs
should be able to obtain an exemption from the proposed frequencies for
products, customers and spread credits that have not reached a
specified volume or risk exposure level,\127\ none of the commenters
indicated that back tests should be conducted less frequently than
monthly. Moreover, a particular DCO would be able to exercise its
discretion to conduct back tests on a more frequent basis than that
required by the Commission's regulation.
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\127\ The Commission does not believe that it is appropriate to
adopt a regulation establishing an exemption process with respect to
back testing requirements based on volume or risk exposure or
otherwise.
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The Commission has not proposed and is not adopting LCH's
suggestion that the applicable historic time period for the price
change data used for back testing should be a minimum of one calendar
year. However, the Commission is removing the proposed language from
the introductory paragraph of Sec. 39.13(g)(7) regarding the time
periods for historical price changes that must be used in the required
back tests and is revising the introductory paragraph to require a DCO
to use an appropriate time period but not less than the previous 30
days for all of the back tests required by Sec. Sec. 39.13(g)(7)(i)
and (ii).
h. Customer Margin
(1) Gross Margin for Customer Accounts --Sec. 39.13(g)(8)(i)
Proposed Sec. 39.13(g)(8)(i) would require a DCO to collect
initial margin on a gross basis for each clearing member's customer
account equal to the sum of the initial margin amounts that would be
required by the DCO for each individual customer within that account if
each individual customer were a clearing member and would prohibit a
DCO from netting positions of different customers against one another.
The proposed regulation would permit a DCO to collect initial margin
for its clearing members' house accounts on a net basis.
Better Markets and LCH (with a suggested exception described below)
supported proposed Sec. 39.13(g)(8)(i).\128\ CME, KCC, OCC, ICE, NYPC,
FIA, and the Commodity Markets Council (CMC) argued against the
adoption of proposed Sec. 39.13(g)(8)(i).
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\128\ LCH also expressed its belief that a DCO should also
collect margin from all affiliated legal entities within a house
account on a gross basis unless there is legal certainty of the
DCO's right to offset risks across the affiliates in the event of
the default of the group or one or more of its affiliated legal
entities. The Commission has not proposed and is not adopting such a
requirement. However, although Sec. 39.13(g)(8)(i) permits a DCO to
collect initial margin for its clearing members' house accounts on a
net basis, it does not require it to do so, and a DCO could
determine to collect house margin in the manner suggested by LCH.
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KCC and ICE pointed out that DCOs that perform net margining have
not had any clearing member defaults or customer losses, including
during the 2008 financial crisis.
Various commenters opposed the proposal based on the potential
extent and costs of operational and technology changes that would need
to be made by clearing members and DCOs: (1) To convert net margining
systems to gross margining systems, and (2) to permit clearing members
to provide individual customer position information to DCOs, and DCOs
to receive individual customer position information and calculate the
margin required for each individual customer account (CME, KCC, ICE,
NYPC, and CMC).
OCC stated that the only means by which it could calculate margin
requirements on a customer-by-customer basis within a clearing member's
omnibus futures customers' account would be to create subaccounts for
each customer. CME, NYPC, KCC, and FIA commented that DCOs do not
currently receive position-level information for each individual
customer of their clearing members. CME and FIA expressed concern about
the costs associated with clearing members having to provide individual
customer position information, and CME indicated that DCOs would incur
costs in processing the information received from clearing members in
order to calculate margin requirements on individual customer accounts
on a daily basis. NYPC also stated that the adoption of proposed Sec.
39.13(g)(8)(i) would require it to make significant changes to its
systems.\129\
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\129\ See further discussion of these costs in section VII,
below. NYPC also commented that given the necessary technology
builds, it would need more than three years to come into compliance
with proposed Sec. Sec. 39.13(g)(8)(i) and 39.13(h)(2). The
Commission believes that the modifications to Sec. 39.13(g)(8)(i),
discussed in this section, would minimize any technology changes
that would be necessary in order to comply with Sec.
39.13(g)(8)(i).
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KCC stated that managing gross customer margin at the DCO level
[[Page 69375]]
would require a DCO to assume the role of a back-office account
management service, requiring continuous updates from each clearing
member regarding customer positions. KCC further noted that DCOs would
be required to adjust the timing deadlines for margin payments, DCOs'
ability to track margin requirements closely with market movements
would be decreased, and DCOs may face difficulty in relaying variation
margin payment information to their settlement banks quickly.
ICE noted that converting to a gross margining system would be a
major operational change for clearing firms and DCOs that use net
margining. However, ICE also stated that most DCOs currently use gross
margining, including ICE Trust (now ICE Clear Credit LLC) and ICE Clear
U.S., although ICE Clear Europe uses net margining. In particular, ICE
stated that gross margining would require reengineering of firms' end-
of-day processing. According to ICE, changes would need to be made to
such DCOs' margining technology, data submission/input mechanism and
margin reporting specifications, and clearing firms or their service
providers would need to implement software updates. ICE noted that
changes to position reporting, reconciliation and margining methodology
are challenging technology changes for clearing members and their
third-party software vendors and typically take at least six to nine
months to complete. However, ICE indicated that an implementation
period of at least 12 months would allow DCOs that currently use net
margining, and their clearing members, to adequately test and implement
the systems necessary for gross margining.
CME, KCC, and CMC all argued that requiring clearing members to
report gross customer positions by beneficial owner to DCOs is not
necessary in order to accomplish reasonable and adequate ``modified''
gross margining. Specifically, CME and KCC urged the Commission to
permit a version of gross margining of customer accounts that would
only require clearing members to report gross customer positions to
DCOs (not by beneficial owner) and that would allow clearing firms to
submit positions as spreadable for those accounts that have recognized
calendar spreads or spreads between correlated products. However, CME
further represented that ``[t]his version of gross margining will
sometimes lead to less than aggregate gross margins as a result of
optimal spreading that occasionally occurs between accounts.
Nevertheless, it approximates aggregate gross margins without imposing
significant costs on the industry.''
In light of the various concerns raised by CME, KCC, ICE, NYPC, and
CMC regarding the operational and technology changes that would be
needed and related costs of requiring a DCO to obtain individual
customer position information from its clearing members and to use such
information to calculate the margin requirements for each individual
customer, the Commission is modifying Sec. 39.13(g)(8)(i). In
particular, the Commission is adding a provision, which states that
``[f]or purposes of calculating the gross initial margin requirement
for each clearing member's customer account(s), to the extent not
inconsistent with other Commission regulations, a derivatives clearing
organization may require its clearing members to report the gross
positions of each individual customer to the derivatives clearing
organization, or it may permit each clearing member to report the sum
of the gross positions of its customers to the derivatives clearing
organization.'' \130\
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\130\ The Commission is including the phrase ``to the extent not
inconsistent with other Commission regulations'' because, in a
separate rulemaking, the Commission has proposed regulations that
would require FCM clearing members to provide daily information
identifying the positions of individual cleared swaps customers to
the relevant DCO and that would require such DCOs to calculate the
amount of collateral required for each cleared swaps customer of
such clearing members on a daily basis. If these regulations are
adopted, they will supersede the provisions of Sec. 39.13(g)(8)(i)
to the extent that they are inconsistent with such provisions, with
respect to cleared swaps. See 76 FR 33818 (June 9, 2011) (Protection
of Cleared Swaps Customer Contracts and Collateral; Conforming
Amendments to the Commodity Broker Bankruptcy Provisions).
The Commission is also making a conforming amendment by
inserting ``and may not permit its clearing members to'' in the
sentence that now reads as follows (added text in italics): ``A
derivatives clearing organization may not, and may not permit its
clearing members to, net positions of different customers against
one another.''.
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Thus, the Commission is providing a DCO with the discretion to
either calculate customer gross margin requirements based on individual
customer position information that it obtains from its clearing members
or based on the sum of the gross positions of all of a clearing
member's customers that the clearing member provides to the DCO,
without forwarding individual customer position information to the DCO.
In either case, the customer gross margin requirement determined by a
DCO must equal ``the sum of the initial margin amounts that would be
required by the derivatives clearing organization for each individual
customer within that account if each individual customer were a
clearing member.'' The customer gross margin collected by a DCO may not
be subject to ``spreading that occasionally occurs between accounts''
that may lead to ``less than aggregate gross margins,'' as described by
CME.
CME commented that proposed Sec. 39.13(g)(8)(i) was unclear
regarding how DCOs would be expected to treat customer omnibus accounts
of non-clearing FCMs and foreign brokers for which the clearing firm
carrying the account generally does not know the identities of
individual customers within the omnibus accounts. Under current
industry practice, omnibus accounts report gross positions to their
clearing members and clearing members collect margins on a gross basis
for positions held in omnibus accounts.\131\ The Commission does not
intend to alter this current practice by adopting Sec. 39.13(g)(8)(i).
Therefore, the Commission is adding a provision, which states that
``[f]or purposes of this paragraph, a derivatives clearing organization
may rely, and may permit its clearing members to rely, upon the sum of
the gross positions reported to the clearing members by each domestic
or foreign omnibus account that they carry, without obtaining
information identifying the positions of each individual customer
underlying such omnibus accounts.''
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\131\ See, e.g., Margins Handbook, http://www.nfa.futures.org/NFA-compliance/publication-library/margins-handbook.pdf, at 34; CME
Rule 930.J.; ICE Futures U.S. Inc. Rule 5.04; and CBOE Futures
Exchange, LLC Rule 516.
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The Commission believes that giving a DCO the option of permitting
its clearing members to provide the sum of their customers' gross
positions to a DCO, without the need to provide individual customer
position information to the DCO, allows DCOs to provide their clearing
members with a much less costly alternative to requiring clearing
members to provide individual customer position information to the DCO,
and requiring the DCO to calculate the gross margin requirement for
each customer of each clearing member.
The Commission recognizes that Sec. 39.13(g)(8)(i), even as
modified, will require DCOs and their clearing members to incur certain
costs. However, the Commission continues to believe, as stated in the
notice of proposed rulemaking, that gross margining of customer
accounts will: (a) More appropriately address the risks posed to a DCO
by its clearing members' customers than net margining; (b) will
increase the financial resources available to a DCO in the event of a
[[Page 69376]]
customer default; \132\ and (c) with respect to cleared swaps, will
support the requirement in Sec. 39.13(g)(2)(iii) that a DCO must
margin each swap portfolio at a minimum 99 percent confidence level.
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\132\ ICE commented that the Commission's rationale for gross
margining, i.e., that it would increase the financial resources
available to a DCO in the event of a customer default, is based upon
the mutualization of customer risk to protect the DCO. ICE stated
its belief that this rationale conflicts with the reasoning behind
the proposal that DCOs individually segregate cleared swaps customer
funds to protect such customers from fellow customer risk. The
Commission notes, however, that gross margining is not only
consistent with, but will be instrumental in achieving, complete
legal segregation for cleared swaps accounts. See 76 FR 33818 (June
9, 2011) (Protection of Cleared Swaps Customer Contracts and
Collateral; Conforming Amendments to the Commodity Broker Bankruptcy
Provisions).
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The Commission believes that the clearing of swaps will increase
the risk that DCOs face. Gross margining will maximize the amount of
money DCOs hold. Because a DCO may not have access to customer initial
margin collected by and held at an FCM if the DCO collects initial
margin on a net basis, if the FCM defaults, the Commission believes
that holding gross initial margin at a DCO is the safest mechanism by
which DCOs can protect themselves from increased risk. If a DCO is
unable to obtain customer margin in the event of default, there is
significant risk of contagion. Consequently, if more margin is held at
the DCO, the potential risk that the failure of one clearing member
will propagate throughout the financial system to other clearing
members and other entities is decreased.\133\
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\133\ As pointed out in the CPSS-IOSCO Consultative Report,
under certain circumstances gross margining may also increase the
portability of customer positions in an FCM insolvency. That is, a
gross margining requirement would increase the likelihood that there
will be sufficient collateral on deposit in support of a customer
position to enable the DCO to transfer it to a solvent FCM. See
CPSS-IOSCO Consultative Report, Principle 14: Segregation and
Portability, Explanatory Notes 3.14.6 and 3.14.8, at 67-68.
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CME and KCC commented that proposed Sec. 39.13(g)(8)(i) would
require clearing members to ``pass-through'' the margin deposits that
they receive from their customers to the DCO, thus requiring clearing
members to apply to their customers the DCO's standards for acceptable
collateral as well as the DCO's concentration limits with respect to
collateral types. CME indicated that this would add pressure with
respect to the available collateral pool, and argued that the
Commission should not impose such additional and costly constraints on
market participants in the absence of significant and demonstrable
benefits. The Commission notes that, although as a business matter
clearing members may determine to ``pass-through'' the margin deposits
that they receive from their customers to the relevant DCO, proposed
Sec. 39.13(g)(8)(i) does not require that a clearing member only
accept from its customers those types of margin assets that are
acceptable for the clearing member to deposit with the DCO.
KCC requested that the Commission clarify whether the requirement
to collect gross customer margin imposes an obligation on the DCO to
determine the defaulting customer accounts in a customer default
situation (which would be costly and burdensome) and stated that having
the total customer gross margin available to the DCO in the event of a
customer default is a prudent risk management technique. The Commission
notes that Commission rules currently permit a DCO to commingle the
initial margin with respect to all of a clearing member's customers in
a single customer origin account at the DCO and to apply the entire
customer origin account to cover losses with respect to a customer
default, whether the DCO collects initial margin on a net basis or on a
gross basis. The Commission does not intend Sec. 39.13(g)(8)(i), by
its terms, to alter this approach.
In a separate rulemaking, however, the Commission has proposed to
require DCOs to legally segregate customer funds and assets margining
swap positions that are held by a clearing member at the DCO in a
commingled cleared swaps customer account.\134\ In addition, European
Union legislation, although not yet finalized, would require central
counterparties to provide individual customer segregation in certain
circumstances.\135\ As previously noted, gross margining will be
instrumental if individual customer segregation is adopted. OCC
requested that the Commission restrict the applicability of proposed
Sec. 39.13(g)(8)(i) to futures customer accounts at both the clearing
level and the FCM level, to make it clear that it does not intend to
impose these margin requirements on accounts that are restricted to
securities products (with respect to an entity that is both a DCO and
an SEC-regulated clearing agency). OCC is correct that Sec.
39.13(g)(8)(i) applies only to customer and house accounts, cleared by
a DCO, which contain futures, options on futures, and/or swap positions
that are subject to the jurisdiction of the Commission. It does not
apply to accounts that only contain securities products that are
subject to the jurisdiction of the SEC.
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\134\ See 76 FR 33818 (June 9, 2011) (Protection of Cleared
Swaps Customer Contracts and Collateral; Conforming Amendments to
the Commodity Broker Bankruptcy Provisions).
\135\ See Financial markets: OTC derivatives, central
counterparties and trade repositories (amend. Directive 98/26/EC),
COD/2010/0250 (June 7, 2011), available at http://www.europarl.europa.eu/oeil/FindByProcnum.do?lang=en&procnum=COD/2010/0250.
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LCH requested that the Commission allow DCOs operating from non-
U.S. jurisdictions to offer ``net omnibus'' account structures for
associated entities operating under the same group or umbrella
structure to customers outside the U.S. The treatment of customers is
outside the scope of this rulemaking. However, to the extent a DCO is
clearing products subject to the Commission's jurisdiction, this rule
would apply at the clearing level regardless of the location of the DCO
or the customer.
The Commission is adopting Sec. 39.13(g)(8)(i) with the
modifications described above. The Commission recognizes that DCOs that
currently use net margining, or that use a ``modified'' version of
gross margining, as well as their clearing members and their service
providers, will need time to make the necessary operational and
technology enhancements that will facilitate gross margining, as
described herein. Therefore, the Commission is adopting an effective
date that is 12 months after the publication of final Sec.
39.13(g)(8)(i) in the Federal Register.
(2) End-of-Day Position Reporting--Sec. 39.19(c)(1)(iv)
Proposed Sec. 39.19(c)(1)(iv) would require each DCO to report to
the Commission, on a daily basis, the end-of-day positions for each
clearing member, by customer origin and house origin; and for customer
origin, separately, the gross positions of each beneficial owner.\136\
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\136\ As originally proposed, Sec. 39.19(c)(1)(iv) would
require each DCO to report to the Commission, on a daily basis, the
end-of-day positions for each clearing member, by customer origin
and house origin. See 75 FR 78185 (Dec. 15, 2010) (Information
Management). The preamble in the notice of proposed rulemaking (76
FR 3698 (Jan. 20, 2011) (Risk Management)), described a proposed
amendment to proposed Sec. 39.19(c)(1)(iv) to add ``and for
customer origin, separately, the gross positions of each beneficial
owner.'' However, this clause was inadvertently omitted from the
language of the regulation in the notice of proposed rulemaking.
Therefore, the Commission subsequently issued a correction at 76 FR
16588 (Mar. 24, 2011) (Risk Management Requirements for Derivatives
Clearing Organizations; Correction).
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As noted by KCC and CMC, the Commission currently receives certain
information about the ownership and control of reportable positions
through its large trader reporting program, under Parts 15 through 21
of the Commission's
[[Page 69377]]
regulations. Commission staff reviews the effectiveness of this program
on a regular basis, and will continue to adopt enhancements where
appropriate.\137\ The large trader reporting system, however, does not
currently apply to many swaps that are, or may be, cleared. The
Commission may need information about large swap positions to assess
the risk profile of a DCO or a clearing FCM.
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\137\ For example, the Commission recently adopted final rules
on Large Trader Reporting for Physical Commodity Swaps at 76 FR
43851 (July 22, 2011).
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CME, KCC, MGEX, FIA, and CMC commented that clearing members do not
generally have information identifying the underlying customers in
customer omnibus accounts carried on behalf of non-clearing member
FCMs, foreign brokers, hedge funds or commodity pools, and therefore
clearing members cannot reasonably be expected to report such
information to DCOs, and DCOs cannot reasonably be expected to report
such information to the Commission. The Commission notes that a DCO may
be able to obtain such information under its own rules. For example,
CME Rule 960 requires a clearing member to immediately disclose the
identities and positions of the beneficial owners of any omnibus
account to CME upon its request.
MGEX expressed its concern that the significant costs resulting
from compliance with a requirement for the routine daily reporting of
all gross customer positions by beneficial owner could lead to further
consolidation in the industry at the FCM, clearing member, and DCO
levels.
The Commission is not adopting the proposed requirement in Sec.
39.19(c)(1)(iv) that a DCO provide daily reports to the Commission of
the gross positions of each beneficial owner within each clearing
member's customer origin account. However, the Commission is adopting
Sec. 39.19(c)(5)(iii),\138\ which requires a DCO to provide this
information to the Commission upon the Commission's request, in the
format and manner, and within the time, specified by the Commission.
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\138\ See further discussion of Sec. 39.19, adopted herein, in
section IV.J, below.
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For example, the Commission could request that a DCO provide
information about customer positions by beneficial owner, on a case-by-
case basis, with respect to a particular clearing member, customer, or
product. Moreover, the Commission could request that such information
be provided for a particular day, month, or until further notice by the
Commission. In recent years, the Commission has worked cooperatively
with several DCOs to obtain information about cleared swap positions.
The Commission notes that any potential costs should be substantially
reduced by the modified requirement that a DCO provide information to
the Commission identifying the positions of beneficial owners of
customer accounts only upon Commission request and not on a daily
basis.
(3) Customer Initial Margin Requirements--Sec. 39.13(g)(8)(ii)
Proposed Sec. 39.13(g)(8)(ii) would require a DCO to require its
clearing members to collect customer initial margin \139\ from their
customers for non-hedge positions at a level that is greater than 100
percent of the DCO's initial margin requirements \140\ with respect to
each product and swap portfolio. Proposed Sec. 39.13(g)(8)(ii) would
permit a DCO to have reasonable discretion in determining the
percentage by which customer initial margins would have to exceed the
DCO's initial margin requirements with respect to particular products
or swap portfolios. However, under the proposed regulation, the
Commission could review such percentage levels and require different
percentage levels if the Commission deemed the levels insufficient to
protect the financial integrity of the clearing members or the DCO in
accordance with Core Principle D.\141\
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\139\ The term ``customer initial margin'' is now defined in
Sec. 1.3(kkk), adopted herein.
\140\ A DCO's initial margin requirements are also referred to
herein as ``clearing initial margin'' requirements. ``Clearing
initial margin'' is defined as ``initial margin posted by a clearing
member with a [DCO]'' in Sec. 1.3(jjj), adopted herein.
\141\ Section 5b(c)(2)(D)(iii) of the CEA, 7 U.S.C. 7a-
1(c)(2)(D)(iii).
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OCC stated its view that exchanges, which have historically set
customer level margin requirements, should continue to do so, rather
than DCOs, noting that clearing organizations would ordinarily have no
means to enforce customer level margin requirements.
KCC stated that it generally supports the concept that clearing
members should collect customer initial margin at a level above that of
DCO initial margin, but requested that the Commission clarify the
circumstances in which it may deem the ratio of customer initial margin
to DCO initial margin insufficient to protect the DCO. Although the
FHLBanks opposed the proposal, they recommended that if the Commission
were to adopt it, the Commission should provide additional guidance
and/or establish criteria for DCOs with respect to setting the required
amount of excess margin. MGEX noted that although it currently
maintains a 130 percent requirement, this is a decision that should be
left to each DCO and its clearing members to determine. Because the
circumstances for each DCO or the nature of its clearing members vary,
it would be difficult to provide the general clarification or criteria
that KCC and the FHLBanks are seeking, because such a determination
would need to be made on a case-by-case basis.
MFA argued that a requirement that a DCO must require its clearing
members to collect customer initial margin at a level that is greater
than the DCO's initial margin requirements would be inappropriate
because DCOs do not have information about individual customers'
creditworthiness and such a requirement would impair market liquidity
by limiting the trading activity of certain market participants,
resulting in greater market concentration. Citadel and the FHLBanks
made similar comments.
ICE stated that FCMs are best able to determine how much to charge
above the initial margin requirement because they have complete
visibility into their customers' positions, and the Commission should
not place this requirement on a DCO, but should address this with FCMs
through another set of rules. FIA opposed the proposed rule stating
that the amount of excess margin, if any, that an FCM may require from
its customers is a credit decision that should be made by each FCM
based on its analysis of the creditworthiness of the particular
customer, including the nature of the customer's trading activity and
its record of meeting margin calls.
Currently DCMs require their FCM members to impose customer initial
margin requirements that are a specified percentage higher than the
DCO's initial margin requirements, generally in the neighborhood of 125
percent to 140 percent, as determined by the DCM. DCMs generally permit
FCM members to impose customer initial margin requirements for hedge
positions that are equal to the applicable maintenance margin
requirements (which are generally the same as the applicable clearing
initial margin requirements). This rule simply shifts the
responsibility for establishing customer initial margin requirements
from DCMs to DCOs.
DCOs have greater expertise in risk management and a direct
financial stake in whether their clearing members' customers, and
consequently their clearing members, are able to meet their margin
obligations. Moreover, it is anticipated that some DCOs will clear
fungible swaps that may be listed on multiple SEFs. SEFs may or may not
[[Page 69378]]
impose customer initial margin requirements on their members for
cleared swaps. Requirements set by DCOs may be less susceptible to
pressure to being lowered for competitive reasons. Finally, DCOs will
be the only self-regulatory organizations that will be in a position to
set customer initial margin requirements for swaps that are executed
bilaterally, and voluntarily cleared. Moreover, DCOs will have the
opportunity to review whether their clearing members are collecting
customer initial margin, as required by the DCO, during their reviews
of the risk management policies, procedures, and practices of their
clearing members, pursuant to Sec. 39.13(h)(5).\142\
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\142\ See discussion of Sec. 39.13(h)(5), adopted herein, in
section IV.D.7.e, below.
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Section 39.13(g)(8)(ii) permits a DCO to exercise its discretion in
determining the appropriate percentage by which the customer initial
margin for a particular product or swap portfolio should exceed the
clearing initial margin,\143\ as DCMs do today with respect to futures
and options. This percentage should be based on the nature and
volatility patterns of the particular product or swap portfolio, and
the DCO's related evaluation of the potential risks posed by customers
in general to their clearing members and, in turn, the potential risks
posed by such clearing members in general to the DCO, rather than the
creditworthiness of particular customers. Consequently, a DCO will
retain the flexibility to establish an appropriate percentage for
customer initial margin that applies to each product that it clears,
which will apply to all of its clearing FCMs and all of their
customers. However, as is also the case today, such clearing FCMs would
remain free to exercise their discretion to determine whether they will
collect additional margin over and above that amount either from all of
their customers, or from particular customers based on such customers'
risk profiles.\144\
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\143\ OCC commented that its STANS margin system calculates
margin based on all positions in an account and not on a position-
by-position basis; therefore it would not be able to furnish
clearing members with a number representing the initial margin on a
particular position without conducting subaccounting for each
customer. OCC also noted that since STANS requirements are data-
driven on a month-to-month, and even a day-to-day, basis they can
vary in ways that cannot be readily predicted. The Commission is
adopting Sec. 39.13(g)(8)(i) herein, which requires a DCO to
collect initial margin on a gross basis for its clearing members'
customer accounts. Therefore, a clearing member (or the DCO) will be
required to determine the initial margin that must be posted with
the DCO with respect to each customer's positions. Even if that
amount changes from day to day as a result of the application of a
portfolio-based margin system, a DCO could require that its clearing
members collect customer initial margin in an amount that is a given
percentage in excess of 100 percent of the daily clearing initial
margin requirement with respect to each customer.
\144\ See, e.g., CME Rule 8G930.E (``IRS Clearing members may
call for additional performance bond at their discretion.'')
(available at http://www.cmegroup.com/rulebook/CME/I/8G/) and
International Derivatives Clearinghouse, LLC Rule 614(g) (``A
Clearing Member may call, at any time, for [margin] above and beyond
the minimums required by the Clearinghouse.'') (available at http://www.idch.com/pdfs/idch/20100901rulebook.pdf).
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The Commission continues to believe that requiring a DCO to require
its clearing members to collect customer initial margin in a percentage
higher than 100 percent of the clearing initial margin, for non-hedge
positions, provides a valuable cushion of readily available customer
margin. Citadel stated that the market's extensive experience in a
range of cleared markets demonstrates preparedness for the regular
exchange of margin between clearing members and their customers for
cleared OTC derivatives, even where margin calls occur more frequently
than once daily, and that frequent exchange of margin is also current
market practice for uncleared trades. However, the maintenance of such
a cushion would enable clearing members to deposit additional margin
with a DCO on behalf of their customers, as necessitated by adverse
market movements, without the need for the clearing members to make
such frequent margin calls to their customers. In addition, many
clearing members choose to deposit excess margin with their DCOs to
provide their own cushion, which may in some instances obviate the need
to transfer funds to the DCO on a daily basis in order to meet
variation margin requirements.
ISDA, FIA, and the FHLBanks commented that if the Commission were
to adopt proposed Sec. 39.13(g)(8)(ii), it should clarify the meaning
of ``non-hedge positions.'' The FHLBanks also stated that the
Commission should provide guidance regarding how the determination as
to whether a position is a hedge or a non-hedge position would be made,
whether by the DCO, the clearing member, or the customer, and expressed
the belief that a clearing member's customers should be responsible for
determining and certifying, to their clearing members or DCOs, whether
their swap positions are ``hedge'' or ``non-hedge'' positions.
Several commenters have argued that there is no basis for
distinguishing between hedge positions and non-hedge positions in
determining whether such positions should be subject to customer
initial margin requirements in excess of clearing initial margin
requirements.\145\ LCH stated that it does not believe that a DCO or a
clearing member should distinguish in any way between a customer's
hedge and non-hedge positions because: (1) if the two parts of the
hedge are carried by the same clearing member within the same DCO, such
hedges would in any event implicitly be recognized by the DCO's risk
calculations and the provision would be unnecessary; and (2) if one or
the other leg of the hedge is uncleared, or is carried by a different
clearing member, or by the same or another clearing member at another
DCO, no recognition of the offsetting hedge should be allowed either by
the DCO(s) or by the clearing member(s), as neither party would have
the economic benefit of the hedged transaction. The Commission notes
that the categorization of a position as a hedge for purposes of this
regulation does not affect the margin collected by the DCO; it only
affects the additional increment that the clearing member collects from
its customer.
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\145\ MFA stated that it would be highly burdensome to
distinguish between hedge and non-hedge positions for purposes of
the application of differentiated margining, especially in a
portfolio margining context. As noted in n. 143, above, a DCO that
uses a portfolio-based margin model could require that its clearing
members collect customer initial margin in an amount that is a given
percentage in excess of 100 percent of the daily clearing initial
margin requirement with respect to each customer. If all of a
particular customer's positions were hedge positions, the DCO could
permit the clearing member to collect customer initial margin in an
amount that equals the amount of clearing initial margin with
respect to that customer's positions. It is only in those
circumstances where a hedger may also engage in speculative trading
that it may be difficult to distinguish between positions for
purposes of the application of differentiated margining in a
portfolio margining context.
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Freddie Mac indicated that the Commission should consider
eliminating the proposed requirement for increased customer initial
margin for ``non-hedge positions,'' noting that customers with non-
hedge positions are not inherently riskier or more likely to miss
margin calls than customers with ``hedge positions.''
As previously noted, DCMs have historically drawn a distinction
between hedge positions and non-hedge positions in setting customer
initial margin requirements, and the Commission believes that it is
reasonable to assume that hedgers may present less risk than
speculators, in that losses on their derivatives positions should be
offset by gains on the positions whose risks they are hedging. The
relevant consideration is the relative risks posed by hedgers versus
non-hedgers, rather than the
[[Page 69379]]
creditworthiness of particular customers.
Freddie Mac recommended that, if the Commission does not eliminate
the distinction between hedge and non-hedge positions, the Commission
should clarify that, for purposes of Sec. 39.13(g)(8)(ii): (1) ``hedge
positions'' would include all swaps that hedge or mitigate any form of
a customer's business risks; (2) such swaps may qualify as ``hedge
positions'' regardless of whether they qualify as ``bona fide hedging
transactions'' under the CEA and Sec. 1.3(z) or qualify as hedges
under applicable accounting standards; and (3) such swaps may qualify
as ``hedge positions'' regardless of the nature of the entity that
holds such positions (e.g., whether it is a financial entity or a non-
financial entity). Freddie Mac indicated that such treatment would be
consistent with Commission proposals for defining hedging for purposes
of other Dodd-Frank Act rules, including the definition of a ``major-
swap participant'' \146\ and rules relating to the availability of the
end-user exception to mandatory clearing.\147\
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\146\ See 75 FR 80174 (Dec. 21, 2010) (Further Definition of
``Swap Dealer,'' ``Security-Based Swap Dealer,'' ``Major Swap
Participant,'' ``Major Security-Based Swap Participant'' and
``Eligible Contract Participant'').
\147\ See 75 FR 80747 (Dec. 23, 2010) (End-User Exception to
Mandatory Clearing).
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The Commission intends to interpret ``hedge positions,'' for
purposes of Sec. 39.13(g)(8)(ii), as referring to those that meet
either the definition set forth in Sec. 1.3(z), or the definition set
forth in Sec. 1.3(ttt), when, and in the form in which, it is
ultimately adopted.\148\ The Commission also believes that, as is
currently the practice, it would be the customer's responsibility to
identify its positions as hedge positions to its clearing FCM.
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\148\ The Commission has proposed a definition of ``hedging or
mitigating commercial risk,'' to be codified at Sec. 1.3(ttt), for
the purposes of the definition of ``Major Swap Participant,'' 75 FR
at 80214-80215 (Further Definition of ``Swap Dealer,'' ``Security-
Based Swap Dealer,'' ``Major Swap Participant,'' ``Major Security-
Based Swap Participant'' and ``Eligible Contract Participant'').
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The Commission is adopting Sec. 39.13(g)(8)(ii) as proposed.
(4) Withdrawal of Customer Initial Margin--Sec. 39.13(g)(8)(iii)
Proposed Sec. 39.13(g)(8)(iii) would require a DCO to require its
clearing members to prohibit their customers from withdrawing funds
from their accounts with such clearing members unless the net
liquidating value plus the margin deposits remaining in the customer's
account after the withdrawal would be sufficient to meet the customer
initial margin requirements with respect to the products or swap
portfolios in the customer's account, which were cleared by the DCO.
LCH agreed with the underlying requirement, but stated that it
should be imposed in rules that directly apply to clearing members
rather than in rules applicable to DCOs. KCC also supported the concept
but noted that DCM rules already require customers to maintain minimum
margin levels and that these restrictions are generally tested by a
clearing member's risk department and the clearing member's self-
regulatory organization during examinations. KCC further noted that
DCOs do not have full access to information regarding each customer's
financial condition. MGEX took the position that the Commission \149\
or a clearing member's designated self-regulatory organization (DSRO)
should monitor compliance with such a requirement rather than the DCO,
indicating that it would not be economically feasible for the DCO to do
so.
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\149\ The Commission does not believe that it would be practical
for the Commission to review each clearing member of each DCO to
determine whether the clearing member is prohibiting its customers
from making impermissible withdrawals from their accounts.
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As noted in the notice of proposed rulemaking, the requirement
stated in Sec. 39.13(g)(8)(iii) is consistent with the definition of
``Margin Funds Available for Disbursement'' in the Margins Handbook
prepared by the JAC.\150\ Therefore, DSROs currently review FCMs to
determine whether they are appropriately prohibiting their customers
from withdrawing funds from their futures accounts unless the net
liquidating value plus the margin deposits remaining in such customers'
accounts after the withdrawal would be sufficient to meet the customer
initial margin requirements with respect to such accounts. However, it
is unclear to what extent this requirement would apply to cleared swaps
accounts when such swaps are executed on a DCM which participates in
the JAC. Moreover, clearing members which only clear swaps that are
executed on a SEF will not be subject to the requirements set forth in
the Margins Handbook or subject to review by a DSRO.
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\150\ See http://www.nfa.futures.org/NFA-compliance/publication-library/margins-handbook.pdf, at 45.
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The Commission anticipates that, at a minimum, DCOs will be able to
review whether their clearing members are ensuring that customers do
not make withdrawals from their accounts unless the specified
conditions are met, when they conduct reviews of their clearing
members' risk management policies, procedures, and practices pursuant
to Sec. 39.13(h)(5).\151\
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\151\ See discussion of Sec. 39.13(h)(5), adopted herein, in
section IV.D.7.e, below.
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The Commission is adopting Sec. 39.13(g)(8)(iii) as proposed.
i. Time Deadlines--Sec. 39.13(g)(9)
Proposed Sec. 39.13(g)(9) would require a DCO to establish and
enforce time deadlines for initial and variation margin payments.
LCH submitted a comment letter indicating that it agrees with the
proposal, but stated that it should apply only to a DCO's clearing
members since a DCO has no direct relationship with clients of its
clearing members. Consistent with its original intent, the Commission
is adopting Sec. 39.13(g)(9) with a modification to make it clear that
it only applies to time deadlines for initial and variation margin
payments to a DCO by its clearing members.
7. Other Risk Control Mechanisms
a. Risk Limits--Sec. 39.13(h)(1)(i)
Proposed Sec. 39.13(h)(1)(i) would require a DCO to impose risk
limits on each clearing member, by customer origin and house origin, in
order to prevent a clearing member from carrying positions where the
risk exposure of those positions exceeds a threshold set by the DCO
relative to the clearing member's financial resources, the DCO's
financial resources, or both. The Commission believes that an FCM
engages in excess risk-taking if it, or its customers, take on
positions that require financial resources that exceed this threshold.
The DCO would have reasonable discretion in determining: (1) the method
of computing risk exposure; (2) the applicable threshold(s); and (3)
the applicable financial resources, provided however, that the ratio of
exposure to capital would have to remain the same across all capital
levels. For example, if a DCO set limits under which margin could not
exceed 200 percent of capital, the limit for a $100 million clearing
member would be $200 million and the limit for a $200 million clearing
member would be $400 million. The Commission could review any of these
determinations and require different methods, thresholds, or financial
resources, as appropriate.
Proposed Sec. 39.13(h)(1)(ii) would allow a DCO to permit a
clearing member to exceed the threshold(s) applied pursuant to
paragraph (h)(1)(i) provided that the DCO required the clearing member
to post additional initial margin that the DCO deemed sufficient to
appropriately eliminate excessive risk
[[Page 69380]]
exposure at the clearing member. The Commission could review the amount
of additional initial margin and require a different amount, as
appropriate.
J.P. Morgan and Alice Corporation supported the proposal to require
DCOs to establish risk-based position limits for their clearing
members. J.P. Morgan indicated that in setting such position limits
applicable to any one clearing member, a DCO should consider its
overall exposure to clearing members in the aggregate. The Commission
agrees that this would be prudent and expects that DCOs would take into
consideration the aggregate exposure in establishing individual levels.
J.P. Morgan further took the position that DCOs should monitor
exposures against these limits on a real time basis. As discussed in
section IV.D.4, above, Sec. 39.13(e)(2) requires a DCO to monitor its
credit exposure to each clearing member periodically during each
business day.
FIA stated that it generally agrees with the proposed requirement
that ``the ratio of exposure to capital must remain the same across all
capital levels'' but indicated that the rule should make clear that, in
computing the ratio of exposure to capital, a clearing member's capital
should be calculated net of all risk exposures and potential assessment
obligations at other clearing organizations of which it is a clearing
member. The Commission agrees that it would be appropriate for a DCO to
consider a clearing member's exposures to other clearing organizations,
to the extent that it is able to obtain such information, in
determining a clearing member's applicable financial resources for the
purpose of setting appropriate risk limits.
CME argued that a requirement that DCOs impose risk limits for
every clearing member would be overly prescriptive and unnecessary,
provided that a DCO collects adequate margin, its stress-test results
regarding the clearing member's exposures are acceptable, and it
employs concentration margining (whereby the DCO would set a level of
risk at which it would begin to charge higher margins based on
indicative stress-test levels). In other words, CME suggested that risk
limits may be unnecessary if a DCO sets a level of risk at which it
would begin to charge higher margins based on stress test results with
respect to a clearing member. However, Sec. 39.13(h)(1)(ii) would
allow a DCO to permit a clearing member to exceed an established risk
limit provided that the DCO required the clearing member to post
additional margin. Although CME's proposed approach is worded slightly
differently, the effect would be the same as that of Sec.
39.13(h)(1)(ii), i.e., a clearing member could only exceed a defined
risk level if it posted additional margin.
MGEX indicated that the proposed rule requiring DCOs to impose risk
limits on each clearing member might not be practical, adding
additional cost with little benefit, noting that DCOs currently address
credit and default risk via margins and security deposits on a daily
basis and conduct risk reviews. Rather, according to MGEX, a DCO should
be looking for risk signs and focusing on those that are most relevant.
The Commission believes that the establishment of risk limits for
clearing members would impose little additional cost on DCOs since DCOs
are already required to monitor their clearing members' capital levels
and their own financial resources, as well as the trading activity of
their clearing members. On the other hand, the Commission believes that
the establishment of such risk limits would add significant risk
management benefits to the benefits already conferred by margins,
security deposits, and reviews of clearing members' risk management
policies and procedures.
The Commission is adopting Sec. 39.13(h)(i) as proposed, except
for a technical revision that replaces the phrase ``by customer orgin
and house origin'' with ``by house origin and by each customer
origin,'' which conforms the language with other provisions of part 39.
OCC requested that the Commission clarify that proposed Sec.
39.13(h)(i) would not apply to securities accounts of broker-dealers
that are not FCMs and do no futures business. The Commission does not
intend for Sec. 39.13(h)(i) to apply to such accounts. The Commission
is also adopting Sec. 39.13(h)(ii) as proposed.
b. Large Trader Reports--Sec. 39.13(h)(2)
Proposed Sec. 39.13(h)(2) would require a DCO to obtain from its
clearing members, copies of all reports that such clearing members are
required to file with the Commission pursuant to part 17 of the
Commission's regulations, i.e., large trader reports. Large trader
reports are necessary for stress testing to ensure that FCMs and their
customers have not taken on too much risk. A DCO would be required to
obtain such reports directly from the relevant reporting market if the
reporting market exclusively listed self-cleared contracts, and would
therefore be required to file such reports on behalf of clearing
members pursuant to Sec. 17.00(i).
Proposed Sec. 39.13(h)(2) would further require a DCO to review
the large trader reports that it receives from its clearing members, or
reporting markets, as applicable, on a daily basis to ascertain the
risk of the overall portfolio of each large trader. A DCO would be
required to review positions for each large trader, across all clearing
members carrying an account for the large trader. A DCO would also be
required to take additional actions with respect to such clearing
members in order to address any risks posed by a large trader, when
appropriate. Such actions would include those actions specified in
proposed Sec. 39.13(h)(6).\152\
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\152\ See discussion of Sec. 39.13(h)(6), adopted herein, in
section IV.D.7.f, below.
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FIA supported the proposal to require DCOs to obtain copies of all
large trader reports that are filed with the Commission. MGEX commented
that the Commission should provide large trader reports to each DCO
rather than imposing a requirement that would require clearing members
to make redundant filings. KCC argued that the proposed requirement
that DCOs obtain large trader reports from clearing members is
duplicative because a DCO receives large trader information from the
exchange.\153\
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\153\ KCC further noted that, in its case, the exchange in turn
receives the relevant large trader reports from the Commission.
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MGEX recommended that the Commission perform the review of large
trader reports itself or permit a clearing member's DSRO to perform
such review instead of DCOs.
NYPC recommended that the Commission not adopt proposed Sec.
39.13(h)(2) because the Commission has expended considerable resources
to modify its own internal programs and processes in order to glean
potentially relevant financial and risk management information from the
large trader data that it receives from clearing members and DCMs, and
even if DCOs had comparable financial and human resources that they
could deploy for such a purpose, the information that they would obtain
would frequently be fragmented and inconclusive, given that--unlike the
Commission--no single DCO will ever have access to information relating
to the futures, option and swap positions that are cleared by other
DCOs or to uncleared swaps. NYPC further argued that given the
necessary technology builds, it would need more than three years to
come into compliance with proposed Sec. Sec. 39.13(g)(8)(i) and
39.13(h)(2).
OCC indicated that it should be the role of a clearing member's
DSRO to require that an FCM submit sufficient information to permit the
DSRO to identify customer accounts that could potentially cause a
clearing member to
[[Page 69381]]
default, and that if DCOs were required to perform all tasks required
by the proposed rules alone, they would be required to build new
surveillance systems and significantly increase their surveillance
staff.
In response to suggestions that the Commission should conduct the
required review of large trader reports, the Commission notes that it
does review large trader reports for financial, market, and risk
surveillance purposes. However, the Commission believes that DCOs
should also have an obligation to review large trader reports for those
large traders whose trades they clear, for their own risk surveillance
purposes, even though as noted by NYPC, they may not have access to
information relating to positions cleared by other DCOs or to uncleared
swaps. Moreover, Sec. 39.13(h)(2) requires a DCO to review such large
trader reports with a view toward taking any necessary additional
actions with respect to such large traders' clearing members in order
to address risks posed by such large traders to the DCO.
In addition, it would not be feasible for a clearing member's DSRO
to review large trader reports. DSRO designations apply to FCMs that
are members of multiple DCMs. Therefore, clearing members that only
trade for their own accounts do not have a DSRO. Clearing members that
solely clear SEF-executed trades also will not have DSROs. Moreover,
risk management ultimately is the responsibility of each DCO. A DSRO
would not be in a position to analyze the daily risk of the overall
portfolio of each large trader at a particular DCO, nor to take any
additional actions to address such risks at a particular DCO.
KCC stated that it is the clearing member's obligation to determine
the financial fitness of large trader customers, in that clearing
members have better, more direct information regarding the credit
quality of the customer and the exposures of the customer under
positions the customer may hold outside the DCO. KCC stated its belief
that imposing a duplicative requirement on DCOs would achieve little
risk management benefit at a high cost. The Commission agrees that
clearing members must determine the financial capacity of their
customers and they may have information which a particular DCO may not
have regarding positions that they may clear for their customers on
other DCOs.\154\ However, this does not obviate the need for each
relevant DCO to ascertain the risks that the large trader poses to that
DCO based on the information which the DCO is able to obtain through
large trader reports.
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\154\ The Commission is modifying the language in proposed Sec.
39.13(h)(2), which would have referred to ``positions at all
clearing members carrying accounts for each such large trader'' by
revising it to read as follows: ``futures, options, and swaps
cleared by the [DCO] which are held by all clearing members carrying
accounts for each such large trader.'' This will make it clear that
the Commission is not attempting to require a DCO to review a large
trader's positions that were cleared by another DCO, as it would not
typically have access to information about such positions. The
technical change from ``positions'' to ``futures, options, and
swaps'' conforms the language with other provisions of part 39.
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ISDA noted that while the expansion of oversight required by
proposed Sec. Sec. 39.13(h)(2) and Sec. 39.13(h)(3) \155\ may provide
benefits, many DCOs do not currently have the systems or infrastructure
to monitor or assess non-clearing member risk.\156\
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\155\ See discussion of Sec. 39.13(h)(3), adopted herein, in
section IV.D.7.c, below.
\156\ ISDA also stated that further clarity regarding how the
Commission intends to apply the large trader definition to swaps is
needed. The Commission notes that it has begun this process by
adopting final rules for Large Trader Reporting for Physical
Commodity Swaps, in a new part 20, at 76 FR 43851 (July 22, 2011).
Since these large trader reporting rules were adopted subsequent to
the Commission's proposal of Sec. 39.13(h)(2), the Commission is
modifying Sec. 39.13(h)(2) to refer to reports required to be filed
with the Commission by, or on behalf of, clearing members pursuant
to parts 17 and 20 of this chapter.
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In response to ISDA's comment, as well as other comments that in
order to comply with Sec. 39.13(h)(2), DCOs would need technology
builds (NYPC), new surveillance systems and additional surveillance
staff (OCC), and that there would be a high cost (KCC), the Commission
notes that some DCOs already receive and review large trader reports
for risk surveillance purposes on a daily basis. In fact, KCC stated in
its comment letter that ``KCC would also remind the Commission that DCO
compliance staff review the reportable position files that they receive
on a daily basis to ascertain large trader risks that [clearing
members] face.'' In addition, at least five years ago, Commission staff
began recommending that DCOs do so, if they had not already been doing
so, in DCO reviews that Commission staff has conducted to determine
whether such DCOs were in compliance with relevant core principles
under the CEA.
The Commission is modifying Sec. 39.13(h)(2) to require a DCO to
obtain large trader reports either from its clearing members or from a
DCM or a SEF for which it clears, which are required to be filed with
the Commission by, or on behalf of, such clearing members. However, the
Commission does not believe that it is practical or appropriate for a
DCO to rely on the Commission to provide large trader reports to the
DCO.
The Commission is adopting Sec. 39.13(h)(2) with the modifications
described above.
c. Stress Tests--Sec. 39.13(h)(3)
Proposed Sec. 39.13(h)(3) would require a DCO to conduct certain
daily and weekly stress tests. The Commission has defined a ``stress
test'' in Sec. 39.2, adopted herein, as ``a test that compares the
impact of potential extreme price moves, changes in option volatility,
and/or changes in other inputs that affect the value of a position, to
the financial resources of a derivatives clearing organization,
clearing member, or large trader, to determine the adequacy of such
financial resources.'' \157\
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\157\ See further discussion of Sec. 39.2 in section III.B,
above.
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Proposed Sec. 39.13(h)(3)(i) would require a DCO to conduct daily
stress tests with respect to each large trader who poses significant
risk to a clearing member or the DCO in the event of default, including
positions at all clearing members carrying accounts for the large
trader. The DCO would have reasonable discretion in determining which
traders to test and the methodology used to conduct the stress tests.
However, the Commission could review the selection of accounts and the
methodology and require changes, as appropriate.
Proposed Sec. 39.13(h)(3)(ii) would require a DCO to conduct
stress tests at least once a week with respect to each account held by
a clearing member at the DCO, by customer origin and house origin, and
each swap portfolio, by beneficial owner, under extreme but plausible
market conditions. The DCO would have reasonable discretion in
determining the methodology used to conduct the stress tests. However,
the Commission could review the methodology and require any appropriate
changes. The Commission requested comment regarding whether all
clearing member accounts, by origin, and all swap portfolios should be
subject to such stress tests on a weekly basis or whether some other
time period, such as monthly, would be sufficient to meet prudent risk
management standards.
Several commenters addressed daily stress testing. FIA recommended
that all of the proposed stress tests should be conducted on a daily
basis. LCH stated its belief that stress testing requirements should
not be extended to cover large traders that are clients of clearing
[[Page 69382]]
members but that the proposed weekly stress tests should be conducted
daily. OCC stated that it did not see a sufficient benefit to justify
the increased DCO resources that would be required to undertake daily
stress tests on each large trader,\158\ noting that the costs would be
passed on to clearing members and their customers. MGEX indicated that
a requirement for daily stress testing of large traders seems excessive
since the data may be dated even after one day and may not be more
relevant than doing an average stress test over a weekly or monthly
period. MGEX also expressed the view that the value of stress testing
large traders is diminished if they have accounts with different
clearing members.
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\158\ As noted above, proposed Sec. 39.13(h)(3)(i) would not
require daily stress tests on each large trader, but only with
respect to those large traders who pose significant risk to a
clearing member or the DCO in the event of default.
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As stated above, proposed Sec. 39.13(h)(3)(i) would require a DCO
to include positions at all clearing members carrying accounts for the
large trader in the required stress tests. The Commission is making the
same change to Sec. 39.13(h)(3)(i) that it is making to Sec.
39.13(h)(2) by replacing the reference to ``positions at all clearing
members carrying accounts for each such large trader'' with ``futures,
options, and swaps cleared by the derivatives clearing organization,
which are held by all clearing members carrying accounts for each such
large trader.''
KCC stated its belief that the frequency of stress testing should
be left to the discretion of the DCO and should be risk-based in light
of prevailing market conditions. NOCC indicated that products,
customers or spread credits should reach a specified volume or risk
exposure level before being required to be stress tested with the
proposed frequencies so long as the DCO can demonstrate that it is
meeting the core principle objectives underlying proposed Sec.
39.13(f).\159\
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\159\ NOCC made a similar comment with respect to the frequency
of back testing, which is discussed in section IV.D.6.g,, above. The
Commission does not believe that it is appropriate to adopt a
regulation establishing an exemption process with respect to stress
testing requirements based on volume or risk exposure or otherwise.
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The Commission believes that it is appropriate to specify the
minimum frequency of stress tests as set forth in Sec. 39.13(h)(3). As
noted above, several commenters supported certain daily stress testing
requirements. With the exception of KCC's and NOCC's comments, no
commenters suggested that stress tests should be conducted less
frequently than weekly.
LCH recommended that the Commission prescribe that the stress
scenarios used by the DCO in its testing should be adapted for current
market conditions such that price or market shifts should not be
translated literally, but rather proportionally. The Commission
believes that Sec. 39.13(h)(3) should explicitly permit DCOs to
exercise reasonable discretion in determining the methodology to be
used in conducting the required stress tests. The Commission would
recognize the approach suggested by LCH to be an appropriate element of
a DCO's stress testing methodology, but does not believe that it is
necessary to adopt such a prescriptive requirement.
OCC indicated that for regulatory reasons associated with OCC's
status as a dual SEC/Commission registrant, OCC's system does not
consolidate all positions into a single ``customer origin'' and ``house
origin'' for each clearing member, but rather permits multiple account
types, including a firm (proprietary) account that incorporates both
securities and futures positions, a securities customers' account, a
regular futures customer segregated funds account subject to Section 4d
of the CEA, separate segregated funds accounts for cross-margining
arrangements as provided in various Commission orders approving such
arrangements, and others. OCC further stated that because of the
mathematical properties of the risk measures that it uses, its
unconsolidated account level stress testing is more rigorous than if
such stress testing were conducted at the level of each origin as a
whole and argued that it makes sense to aggregate positions for stress
testing in the same manner as they would be aggregated or netted for
liquidation purposes. Therefore, OCC requested that the Commission
clarify that this method of stress testing at the unconsolidated
account level based on appropriate historical data would meet the
requirements of proposed Sec. 39.13(h)(3)(ii). The Commission agrees
with OCC that it would be appropriate for a DCO to conduct the stress
tests required by Sec. 39.13(h)(3)(ii) with respect to separate house
origin and customer origin accounts such as the house account that
incorporates both securities and futures positions identified by
OCC,\160\ separate customer accounts subject to Sections 4d(a) and
4d(f) of the CEA, respectively, or cross-margining accounts.
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\160\ A DCO that is dually-registered as a securities clearing
agency would not be subject to the stress testing requirements of
Sec. 39.13(h)(3)(ii) with respect to an account that only contains
securities positions. However, such a DCO would be subject to the
requirements of Sec. 39.13(h)(3)(ii) with respect to any relevant
account that contains positions in instruments regulated by the
Commission, even if that account also contains securities positions.
In this regard, the Commission is revising Sec. 39.13(h)(3)(ii) to
refer to ``each clearing member account, by house origin and by each
customer origin, and each swap portfolio, including any portfolio
containing futures and/or options and held in a commingled account
pursuant to Sec. 39.15(b)(2) of this part, * * *''
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OCC also argued that while the requirement of conducting stress
tests under ``extreme but plausible'' market conditions may be
appropriate for determining the adequacy of a clearing organization's
resources for withstanding the default of its largest participant, it
would be inappropriate for measuring the adequacy of an individual
clearing member's margin deposits. In particular, OCC expressed its
belief that stress testing the positions, including margin assets, in
clearing member accounts on a daily basis to ensure a positive
liquidating value at more than a 99 percent confidence level is
adequate and appropriate and that DCOs should have the ability to cover
for more extreme market conditions through the use of additional
financial resources, including clearing fund deposits.
A stress test, as defined by the Commission, is not designed to
measure the adequacy of a clearing member's margin deposits or to
ensure that margin assets in clearing members' accounts meet a 99
percent confidence level. Rather, these are the functions of the daily
review and back testing required by Sec. Sec. 39.13(g)(6) and (g)(7),
adopted herein.\161\ Stress tests address the adequacy of the
applicable financial resources to cover losses resulting from potential
extreme price moves, changes in option volatility, and/or changes in
other inputs that affect the value of a position. In other words, if
margin deposits would be sufficient to cover losses 99 percent of the
time, stress tests would determine whether other financial resources
would be available and sufficient to cover losses the remaining 1
percent of the time. Such other financial resources could include the
capital of the clearing member or the DCO, or a DCO's guaranty fund.
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\161\ See discussion of Sec. Sec. 39.13(g)(6) and (g)(7) in
section IV.D.6.g, above.
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The Commission is adopting Sec. 39.13(h)(3) with the modifications
described above.
d. Portfolio Compression--Sec. 39.13(h)(4)
Proposed Sec. 39.13(h)(4)(i) would require a DCO to offer
multilateral portfolio compression exercises, on a regular basis, for
its clearing members that clear swaps, to the extent that such
[[Page 69383]]
exercises are appropriate for those swaps that it clears. The
Commission requested comment regarding whether such exercises should be
offered monthly, quarterly, or on another frequency. In addition, the
Commission requested comment regarding whether the frequency of such
exercises should vary for different categories of swaps.
Proposed Sec. 39.13(h)(4)(ii) would mandate that a DCO require its
clearing members to participate in all multilateral portfolio
compression exercises offered by the DCO, to the extent that any swap
in the applicable portfolio was eligible for inclusion in the exercise,
unless including the swap would be reasonably likely to significantly
increase the risk exposure of the clearing member.
Proposed Sec. 39.13(h)(4)(iii) would permit a DCO to allow
clearing members participating in such exercises to set risk tolerance
limits for their portfolios, provided that the clearing members could
not set such risk tolerances at an unreasonable level or use such risk
tolerances to evade the requirements of proposed Sec. 39.13(h)(4).
CME commended the Commission for recognizing the importance of
portfolio compression exercises as an important risk management tool.
CME further suggested that the Commission refrain from prescribing the
frequency of such exercises, stating its belief that each DCO is best
positioned to determine the optimal frequency of portfolio compression
exercises for the swaps that it clears, based on the unique
characteristics of the particular products and markets. On the other
hand, the FHLBanks stated that the Commission should specify how often
portfolio compression exercises are to take place. The Commission
agrees with CME and is retaining the language that simply refers to ``a
regular basis.''
ISDA requested that the Commission clarify the meaning of
``multilateral portfolio compression'' in these proposals. ISDA stated
that if the Commission is referring to position netting, then it agrees
that a DCO must offer such exercises. However, ISDA indicated that if
it refers to the provision of multilateral portfolio compression
services such as those currently provided by entities such as
TriOptima, DCOs should not be required to build such duplicative
services, which would be likely to delay their roll-out of
comprehensive clearing services. The Commission agrees that a DCO
should not be required to incur the expense of building its own
multilateral compression services. Therefore, the Commission is
modifying the requirement to make it clear that although a DCO may
develop its own portfolio compression services if it chooses, it is
only required to make such exercises available to its clearing members
if applicable portfolio compression services have been developed by a
third party for those swaps that it clears.\162\
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\162\ This also addresses the FHLBanks' comment that the
Commission should specify what types of swaps are to be included in
portfolio compression exercises.
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The FHLBanks urged the Commission to further define ``reasonably
likely to increase risk exposure to a clearing member'' to include the
risk exposures of a clearing member's customers, and also stated their
view that a clearing member's customers must have the ability to ``opt-
out'' of portfolio compression requirements to the extent that those
customers' swap positions need to be retained for hedge accounting and
other business purposes. In particular, the FHLBanks expressed their
concern that the proposal's ambiguities would cause the internal risk
management strategies of entities that are not swap dealers or major
swap participants to be adversely affected, noting that portfolio
compression could potentially jeopardize hedge accounting treatment for
customers' swap transactions and disrupt anticipated cash flows.
LCH stated that it strongly supports the use of compression
services and believes that they should be encouraged by the Commission
to the greatest extent possible, but it would not necessarily always be
appropriate for a DCO to require its clearing members to participate in
all such exercises. First, LCH noted that a DCO's clearing members may
not always be subject to the Commission's supervision and may not be
required to engage in such compression activities; therefore imposing
such a requirement on the DCO may discourage such firms from becoming
clearing members of that DCO and thereby have the perverse effect of
discouraging such firms from clearing. Second, LCH stated that a
clearing member may have legitimate reasons for not participating in
such compression exercises at all times, or for not submitting all
eligible swaps to such exercises. Therefore, LCH took the position that
the use of compression services should be encouraged but should not be
compulsory, and suggested that the Commission eliminate Sec. 39.13
(h)(4)(ii) in its entirety. For the reasons stated by LCH and the
FHLBanks, the Commission is modifying Sec. 39.13(h)(4) to provide that
participation in compression exercises by clearing members and their
customers would be voluntary.
e. Clearing Members' Risk Management Policies and Procedures--Sec.
39.13(h)(5)
Proposed Sec. 39.13(h)(5) would impose several requirements upon
DCOs relating to their clearing members' risk management policies and
procedures. Specifically, a DCO would be required to adopt rules that:
(a) require its clearing members to maintain current written risk
management policies and procedures (proposed Sec. 39.13(h)(5)(i)(A));
(b) ensure that the DCO has the authority to request and obtain
information and documents from its clearing members regarding their
risk management policies, procedures, and practices, including, but not
limited to, information and documents relating to the liquidity of
their financial resources and their settlement procedures (proposed
Sec. 39.13(h)(5)(i)(B)); and (c) require its clearing members to make
information and documents regarding their risk management policies,
procedures, and practices available to the Commission upon the
Commission's request (proposed Sec. 39.13(h)(5)(i)(C)).
In addition, proposed Sec. 39.13(h)(5)(ii) would require a DCO to
review the risk management policies, procedures, and practices of each
of its clearing members on a periodic basis and document such reviews.
The Commission invited comment regarding whether it should require that
a DCO must conduct risk reviews of its clearing members on an annual
basis or within some other time frame. The Commission also requested
comment regarding whether it should require that such reviews be
conducted in a particular manner, e.g., whether there must be an on-
site visit or whether any particular testing should be required. In
addition, the Commission invited comment regarding whether, and to what
extent, a DCO should be permitted to vary the method and depth of such
reviews based upon the nature, risk profiles, or other regulatory
supervision of particular clearing members.
ISDA and FIA supported the proposed requirement in Sec.
39.13(h)(5)(i)(A) that clearing members must have written risk
management policies and procedures. FIA also recommended that clearing
members should be required to have adequate staff and systems to
monitor customer risk on a real-time or near-real time basis and to
routinely test their risk management procedures under theoretical
stress scenarios.
NGX stated that the requirement that clearing members have and
follow risk management policies is a sensible requirement in the
context of the
[[Page 69384]]
typical, intermediated clearinghouse.However, NGX argued that such
requirements should not apply to a non-intermediated DCO such as NGX,
where clearing participants are commercial end users, trading and
clearing for their own accounts, and none of the clearing participants
are exposed to the default risk of any other clearing participant or to
that of fellow customers of a clearing participant.
The Commission believes that it is appropriate for a DCO to require
all of its clearing members to maintain written risk management
policies and procedures, regardless of whether such clearing members
have customer business or are exclusively self-clearing. As noted
above, the Commission believes that written policies are a crucial
component of any risk management framework. Moreover, Sec.
39.13(h)(5)(i)(A) does not specify the nature or extent of the required
written risk management policies and procedures, which could vary as
appropriate to a particular type of clearing member, subject to the
requirements of any other applicable Commission regulations.\163\
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\163\ For example, in a separate rulemaking, proposed Sec.
23.600 would set forth detailed requirements for the risk management
programs of swap dealers and major swap participants, and would
require such entities to maintain written procedures and policies
describing their Risk Management Programs. See 75 FR 71397 (Nov. 23,
2010) (Regulations Establishing and Governing the Duties of Swap
Dealers and Major Swap Participants). Such swap dealers and major
swap participants may or may not be clearing members.
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The Commission has not proposed and is not adopting the additional
requirements suggested by FIA, described above, as part of this
rulemaking. However, the Commission has proposed additional
requirements with respect to clearing members' risk management policies
and procedures in a separate rulemaking applicable directly to clearing
members.\164\
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\164\ See 76 FR 45724 (Aug. 1, 2011) (Clearing Member Risk
Management). In that rulemaking, the Commission has proposed to
require FCMs, swap dealers, and major swap participants, each of
which are clearing members, to adopt certain specified risk
management procedures, including written procedures to comply with
the proposed requirements.
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With respect to the proposed requirement in Sec. 39.13(h)(5)(i)(C)
that a DCO must have rules requiring its clearing members to make
information regarding their risk management policies, procedures, and
practices available to the Commission, MGEX stated that the Commission
should seek access to a clearing member's risk management policies and
processes directly and a DCO should not act as an unnecessary conduit
between the Commission and clearing members. The Commission notes that
even if it were to propose a regulation to impose such a requirement
directly on clearing members in the future, it does not preclude the
Commission from requiring DCOs to impose this requirement on their
clearing members at this time.\165\
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\165\ In another context, e.g., a DCM has adopted a rule that
requires the operator of a DCM-approved delivery facility to '' * *
* make such reports, keep such records and permit such facility
visitation as the Exchange, the Commodity Futures Trading Commission
or any other applicable government agency may require * * * .'' See
CBOT Rule 703.A.
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LCH stated that it concurs with the provisions of proposed Sec.
39.13(h)(5) but suggested that the Commission limit the requirements
under proposed paragraph (h)(5)(C) so that they would be applicable
only to those clearing members that are subject to the Commission's
oversight and not to all clearing members of a DCO regardless of the
jurisdiction in which they operate. The Commission notes that risk
management practices of clearing members of registered DCOs, to the
extent that such clearing members are clearing products subject to the
Commission's oversight, are of importance to the Commission in its
capacity as the regulator of the DCO. For purposes of risk management
oversight, there is no basis for differentiating among clearing members
because of their registration status or domicile. Although the
Commission does not directly supervise non-registrants, the Commission
has previously adopted rules that apply to clearing members, whether or
not they are Commission registrants, e.g., Sec. Sec. 1.35(b) and (c)
(recordkeeping requirements), and Part 17 of the Commission's
regulations (reporting requirements). Section 39.13(h)(5)(C) is
consistent with the Commission's approach with respect to such other
rules, and is an appropriate component of the regulatory framework for
DCO risk management.
With regard to the proposed requirement in Sec. 39.13(h)(5)(ii)
that a DCO must review the risk management policies, procedures, and
practices of each of its clearing members on a periodic basis, FIA
stated that all clearing members should be subject to on-site audits at
least annually. NGX suggested that if the Commission requires non-
intermediated DCOs to require their members to have written risk
management policies, the Commission should provide guidance that a non-
intermediated DCO would not be required to conduct on-site audits of
clearing participants and that the DCO would meet its obligations to
review the policies of such clearing participants if it does so only on
a for-cause basis.
The Commission is adopting Sec. 39.13(h)(5)(ii) as proposed,
without prescribing the specific frequency, depth, or methodology of
such reviews, and without specifying when an on-site audit may or may
not be appropriate. The Commission believes that such a review is
important to ensure that each clearing member's risk management
framework is sufficient and properly implemented. The Commission also
believes that a DCO should be permitted to exercise reasonable
discretion with respect to each of these matters, based upon the
nature, risk profiles, or other regulatory supervision of particular
clearing members. The requirement that such reviews must be conducted
on a ``periodic basis'' means that reviews must be conducted routinely
and, therefore, the requirement would not permit a DCO to only conduct
such reviews on a for-cause basis.
A number of commenters noted that many clearing members are
clearing members of multiple DCOs and thus could be subject to multiple
duplicative risk reviews. CME, OCC, MGEX, ICE, and NYPC indicated that
this would be burdensome for such clearing members. For example, MGEX
noted ``the burden a clearing member may be faced with due to
duplication of efforts and associated costs.'' KCC indicated that such
duplicative reviews would achieve little with great expenditure of
resources.
OCC and NYPC also expressed their concerns about the costs to DCOs.
In particular, OCC noted that requiring DCOs to conduct such reviews
would impose a very high cost on a DCO that is not integrated with a
DCM. NYPC noted its concern that the Commission may be underestimating
the immensity of conducting such reviews in that a clearing member's
risk management plan will not address solely the risks associated with
clearing membership, but will be integrated and cover the broad
spectrum of risks, including market, credit, liquidity, capital, and
operational risk, that are associated with the entirety of the clearing
member's securities, banking and futures business, much of which may
have nothing to do with business through the DCO.
In order to address NYPC's specific concern, the Commission is
modifying Sec. 39.13(h)(5)(i)(A) to add the qualifier ``which address
the risks that such clearing members may pose to the derivatives
clearing organization'' after ``risk management policies and
procedures'' and is adding the same qualifier in Sec. 39.13(h)(5)(ii)
after ``risk
[[Page 69385]]
management policies, procedures, and practices of each of its clearing
members.''
To reduce the potential burden of duplicative risk reviews of
clearing members that are clearing members of multiple DCOs, CME and
NYPC urged the Commission to give each DCO reasonable discretion
regarding the frequency, scope, or manner in which it conducts risk
reviews of its clearing members, taking into account various factors
including other regulatory supervision, or review by a governmental
entity or self-regulatory organization, of particular firms. Other
commenters variously suggested that risk reviews should be conducted by
the Commission (OCC and MGEX), by the clearing member's DSRO or a
similar DCO industry group (KCC, OCC, ICE, and MGEX), or by NFA (OCC).
The Commission notes that the current DSRO system is not a viable
option for reviewing clearing members' risk management policies,
procedures and practices. Because DSROs are only responsible for
conducting examinations of DCM-member FCMs' compliance with financial
requirements, clearing members that only engage in house trading do not
have a DSRO, nor will clearing members that solely clear SEF-executed
trades. Moreover, such examinations do not address all of the risk
issues which would concern a particular DCO. Furthermore, even if the
current DSRO system were expanded to include DCOs, or a similar
industry group composed of DCOs were formed, it would be impractical to
allocate the responsibility to one DCO to analyze the risk management
policies, procedures and practices of a common clearing member, on
behalf of all relevant DCOs, when each DCO may impose different risk
management requirements on its clearing members and each DCO may have
differing margin methodologies that call for different risk management
responses from clearing members.
The Commission does not believe that it should assume the sole
oversight of the risk management policies, procedures, and practices of
clearing members of DCOs. The Commission conducts risk surveillance
with respect to both DCOs and clearing members; however, this cannot
replace a DCO's obligation to ensure that its clearing members are
appropriately managing the risks that such clearing members pose to
that particular DCO. Similarly, it does not appear that NFA would be an
efficient alternative. The Commission recognizes that certain DCMs have
entered into regulatory services agreements with NFA, and that NFA has
thereby assumed certain audit responsibilities with respect to FCMs
that are members of those DCMs. However, a DCO remains in the best
position to review the risk management policies, procedures, and
practices of its clearing members in the context of their obligations
to that particular DCO.
The Commission is adopting Sec. 39.13(h)(5) with the modifications
described above.
f. Additional Authority--Sec. 39.13(h)(6)
Proposed Sec. 39.13(h)(6) would require a DCO to take additional
actions with respect to particular clearing members, when appropriate,
based on the application of objective and prudent risk management
standards. Such actions could include, but would not be limited to: (i)
Imposing enhanced capital requirements; (ii) imposing enhanced margin
requirements; (iii) imposing position limits; (iv) prohibiting an
increase in positions; (v) requiring a reduction of positions; (vi)
liquidating or transferring positions; and (vii) suspending or revoking
clearing membership.
KCC stated that it generally supports the concept that DCOs should
impose heightened risk management requirements on clearing members as
their risk profiles change and requested that the Commission clarify
whether each of the potential heightened risk management requirements
enumerated in proposed Sec. 39.13(h)(6)(i)-(vii) must be explicitly
delineated in DCO rules or in the DCO's clearing membership agreement.
The Commission believes that a DCO must have the authority and ability
to take appropriate additional actions with respect to particular
clearing members, as described in Sec. 39.13(h)(6), but how the DCO
asserts such authority, whether by rule or contractual agreement,
should be left to the discretion of the DCO.
J.P. Morgan expressed the view that higher margin multipliers
should be adopted for members who present a higher risk profile as a
result of excessive concentration of risk cleared, reduced
creditworthiness, or other factors affecting a particular member, and
that such margin multipliers should be documented in risk management
policies applicable to all members.
J.P. Morgan's concern that margin multipliers should be applied to
clearing members with a higher risk profile, is addressed in Sec.
39.13(h)(1), adopted herein and discussed in section IV.D.7.a, above,
which requires a DCO to impose risk limits on each clearing member.
The Commission is adopting Sec. 39.13(h)(6) as proposed.
E. Core Principle E--Settlement Procedures--Sec. 39.14
Core Principle E,\166\ as amended by the Dodd-Frank Act, requires a
DCO to: (1) Complete money settlements on a timely basis, but not less
frequently than once each business day; (2) employ money settlement
arrangements to eliminate or strictly limit its exposure to settlement
bank risks (including credit and liquidity risks from the use of banks
to effect money settlements); (3) ensure that money settlements are
final when effected; (4) maintain an accurate record of the flow of
funds associated with money settlements; (5) possess the ability to
comply with the terms and conditions of any permitted netting or offset
arrangement with another clearing organization; (6) establish rules
that clearly state each obligation of the DCO with respect to physical
deliveries; and (7) ensure that it identifies and manages each risk
arising from any of its obligations with respect to physical
deliveries. The Commission proposed Sec. 39.14 to establish
requirements that a DCO would have to meet in order to comply with Core
Principle E.\167\
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\166\ Section 5b(c)(2)(E) of the CEA, 7 U.S.C. 7a-1(c)(2)(E)
(Core Principle E).
\167\ Without addressing any specific aspect of proposed Sec.
39.14, LCH commented that it agrees with the Commission's proposals
for settlement procedures.
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1. Definitions--Sec. 39.14(a)
``Settlement'' was defined in proposed Sec. 39.14(a)(1) to
include: (i) Payment and receipt of variation margin for futures,
options, and swap positions; (ii) payment and receipt of option
premiums; (iii) deposit and withdrawal of initial margin for futures,
options, and swap positions; (iv) all payments due in final settlement
of futures, options, and swap positions on the final settlement date
with respect to such positions; and (v) all other cash flows collected
from or paid to each clearing member, including but not limited to,
payments related to swaps such as coupon amounts. ``Settlement bank''
was defined in proposed Sec. 39.14(a)(2) as ``a bank that maintains an
account either for the [DCO] or for any of its clearing members, which
is used for the purpose of transferring funds and receiving transfers
of funds in connection with settlements with the [DCO].''
ISDA and FIA commented that posting of variation margin on swaps
should not be viewed as ``settling'' the present value of the trade and
noted that price alignment interest would still be paid on variation
margin. ISDA stated that, similarly, initial margin is not ``paid'' by
a clearing member to a DCO
[[Page 69386]]
but is often posted with a security interest granted by the clearing
member. FIA also commented that the deposit and withdrawal of initial
margin is not properly defined as a settlement.
NGX stated that, with the exception of a relatively small power
contract, its clearing model does not require daily variation margin
payments and collections from its clearing participants; rather, it
holds collateral (initial margin) in an account at a depository bank
rather than in a settlement account, and additional collateral may be
called for as required. Therefore, NGX stated that it would be clearer
when applied to the NGX model, to use the term ``payment and receipt''
rather than the term ``deposit'' when referring to initial margin.
The Commission proposed a broad definition of ``settlement'' in
Sec. 39.14(a)(1) to encompass all cash flows between clearing members
and a DCO. The Commission recognizes that accounts that are used for
the payment and receipt of variation margin are frequently called
settlement accounts, while accounts that are used for the deposit and
withdrawal of initial margin may be called deposit accounts, or custody
accounts, if the initial margin deposited therein is in the form of
securities. The definition of ``settlement bank'' in Sec. 39.14(a)(2)
was intended to encompass any bank that a DCO uses for settlements, as
defined in Sec. 39.14(a)(1), whether the relevant accounts are called
settlement accounts, deposit accounts, or custody accounts. In order to
avoid confusion, the Commission is modifying Sec. 39.14(a)(2) to
define a settlement bank simply as ``a bank that maintains an account
either for the [DCO] or for any of its clearing members, which is used
for the purpose of any settlement described in paragraph (a)(1)
above.'' The Commission is adopting Sec. 39.14(a)(1) as proposed,
except for a non-substantive change, which replaces each reference to
``futures, options, and swap positions'' with ``futures, options, and
swaps.''
2. Daily Settlements--Sec. 39.14(b)
Proposed Sec. 39.14(b) would require a DCO to effect a settlement
with each clearing member at least once each business day, and to have
the authority and operational capacity to effect a settlement with each
clearing member, on an intraday basis, either routinely, when
thresholds specified by the DCO were breached, or in times of extreme
market volatility.
CME expressed its support for intra-day settlements. LCH suggested
that a DCO must measure its credit exposures ``several times each
business day,'' and should be obliged to recalculate initial and
variation margin requirements more than once each business day. J.P.
Morgan stated that intraday margin calls should be made with greater
frequency for clearing members who have a higher risk profile.
The Commission does not believe that it is necessary to adopt a
requirement that all DCOs recalculate initial and variation margin
requirements more than once each business day or an explicit
requirement for intraday margin calls for clearing members with a
higher risk profile. The Commission believes that it has struck the
appropriate balance in Sec. 39.14(b), by requiring a DCO to conduct
daily settlements, while permitting a DCO to exercise its discretion
regarding whether it will conduct routine intraday settlements, or
whether it will settle positions on an intraday basis only when certain
thresholds are breached \168\ or in times of extreme market volatility.
This approach is also generally consistent with proposed international
standards.\169\ A particular DCO could determine to conduct routine
intraday settlements, as some have done, or to conduct intraday
settlements for particular clearing members based on their risk
profiles.
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\168\ E.g., a DCO could establish thresholds that relate to the
extent of market volatility, or with respect to a particular
clearing member, the extent of losses that it has suffered on a
particular day or whether it has reached a risk limit established by
the DCO pursuant to Sec. 39.13(h)(1)(i), which is discussed in
section IV.D.7.a, above.
\169\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,
Key Consideration 4, at 40; EMIR, Article 39, paragraph 3, at 46.
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NEM, NGX, and NOCC all requested that the Commission afford
recognition to a clearing model that does not require daily variation
margin payments and collections but permits accrual accounting with
respect to certain energy products.
NEM noted that most Retail Energy Marketers (REMs) \170\ use an
accrual accounting practice that recognizes revenues and costs after
energy delivery to their retail customers and that clearing solutions
that require daily cash settlements would either complicate their
accounting practices or significantly impact REM cash flows.
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\170\ NEM stated that REMs ``sell electricity and natural gas to
consumers as a competitive alternative to the local utility'' and
``often purchase wholesale physical natural gas and electricity on a
spot (delivery) month (day) basis and also purchase swaps to lock in
prices for any consumers who want a long-term fixed price
contract.''
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NGX stated that its clearing model generally does not require daily
variation margin payments and collections, and that settlement on its
energy contracts \171\ occurs only on a monthly basis, after clearing
participant obligations have been netted, consistent with practices in
the cash market and with the end-user nature of the vast majority of
NGX clearing participants. NGX noted that, therefore, the type of daily
settlement risk that proposed Sec. 39.14 addresses is not present in
the NGX model and the degree of risk in the monthly settlement process
is reduced.
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\171\ NGX stated that it ``operates a trading and clearing
system for energy products that provides electronic trading, central
counterparty clearing and data services to the North American
natural gas, electricity and oil markets.''
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Although NOCC supported adoption of proposed Sec. 39.14(b) for
traditional futures and cleared swaps, it indicated that it intends to
develop a clearinghouse that will seek registration as a DCO to clear
energy products, including commercial forward contracts that it
believes will be outside the scope of regulation as futures contracts
or as swaps under the CEA, as well as financial forwards that it
believes will fall within the definition of swaps under the CEA. NOCC
stated that while gains and losses on the commercial forward contracts
and financial forwards that it intends to clear are calculated daily,
they are accrued throughout the delivery period and following the
delivery period, and are not cash settled until final payment occurs
approximately three weeks after the month in which the commodity is
delivered. NOCC proposed that the Commission adopt a rule that would
permit exemptions for alternative risk management frameworks, which
would provide NOCC with the ability to demonstrate to the Commission
that daily accrual settlement of variation margin is a sound practice
appropriately tailored to the unique characteristics of the cash energy
markets and market participants for which NOCC is seeking to provide
the benefits of clearing.
The Commission has not proposed and is not adopting a rule
permitting exemptions for alternative risk management frameworks.
However, a particular DCO may petition the Commission for an exemption
if it believes that it can demonstrate that the daily accrual of gains
and losses provides the same protection to the DCO as would daily
variation margin payments and collections. Therefore, the Commission is
adding a clause to Sec. 39.14(b) that states ``[e]xcept as otherwise
provided by Commission order'' prior to the requirement that a DCO
``shall effect a settlement with each clearing member at least once
each business day.''
[[Page 69387]]
3. Settlement Banks--Sec. 39.14(c)
The introductory paragraph of proposed Sec. 39.14(c) would require
a DCO to employ settlement arrangements that eliminate or strictly
limit its exposure to settlement bank risks, including the credit and
liquidity risks arising from the use of such banks to effect
settlements with its clearing members.
OCC commented that it would not be possible for a DCO to
``eliminate'' all exposure to settlement bank risks and that the
Commission had not provided any guidance as to what it means to
``strictly limit'' such exposure. The Commission notes that the
language in the introductory paragraph of proposed Sec. 39.14(c),
which would require a DCO to ``employ settlement arrangements that
eliminate or strictly limit its exposure to settlement bank risks,
including the credit and liquidity risks arising from the use of such
banks to effect settlements * * *,'' is virtually identical to the
statutory language in Core Principle E.\172\ The Commission is adopting
the introductory paragraph of Sec. 39.14(c) with two modifications.
First, in response to OCC's comment, the Commission is adding the words
``as follows:'' at the end of the sentence, in order to clarify that a
DCO that complies with Sec. 39.14(c)(1), (2), and (3), discussed
below, will be deemed to have ``employ[ed] settlement arrangements that
eliminate or strictly limit its exposure to settlement bank risks''
within the meaning of Sec. 39.14(c). The Commission is also inserting
parentheses around the letter ``s'' in the word ``banks'' in order to
clarify that the Commission is not intending to require that a DCO must
have more than one settlement bank in all circumstances. However, a DCO
will need to have more than one settlement bank to the extent that it
is reasonably necessary in order to eliminate or strictly limit the
DCO's exposures to settlement bank risks, pursuant to Sec.
39.14(c)(3), as further discussed below.
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\172\ See Section 5b(c)(2)(E)(ii) of the CEA, 7 U.S.C. 7a-
1(c)(2)(E)(ii).
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4. Criteria for Acceptable Settlement Banks--Sec. Sec. 39.14(c)(1) and
(c)(2)
Proposed Sec. 39.14(c)(1) would require a DCO to have documented
criteria with respect to those banks that are acceptable settlement
banks for the DCO and its clearing members, including criteria
addressing the capitalization, creditworthiness, access to liquidity,
operational reliability, and regulation or supervision of such banks.
Proposed Sec. 39.14(c)(2) would require a DCO to monitor each approved
settlement bank on an ongoing basis to ensure that such bank continues
to meet the criteria established pursuant to Sec. 39.14(c)(1).
Proposed Sec. Sec. 39.14(c)(1) and (c)(2) are consistent with
international recommendations.\173\
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\173\ See CPSS-IOSCO Consultative Report, Principle 9: Money
Settlements, Key Consideration 3, at 54.
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NYPC agreed with the proposed requirement that DCOs must articulate
the standards that they apply to the selection of settlement banks.
OCC indicated that a DCO may have to deviate from its written
policies on the selection of clearing banks during a major market
disruption, as those settlement banks that are the best options
available at the time may not meet the technical criteria set forth in
a DCO's written policies. The Commission agrees with OCC that a DCO may
have to deviate from its written policies during a major market
disruption. However, whether the Commission would permit a DCO to do so
would need to be addressed in the context of the particular major
market disruption, e.g., based on an analysis of whether all available
settlement banks no longer meet such written criteria.
MGEX commented that the Federal Reserve and other banking
authorities are in the best position to review a bank's financial
condition. NYPC recommended that the Commission modify the proposed
rule to reflect the fact that the only criteria that are likely to be
susceptible to observation by a DCO are a bank's operational
reliability, regulatory capital, and the rating of its parent bank
holding company. The Commission agrees that the Federal Reserve and
other banking authorities may be in the best position to review a
bank's financial condition and that there is certain information about
settlement banks to which a DCO will not have regular access.
Nonetheless, a DCO has a responsibility to undertake reasonable efforts
to ensure that its settlement bank(s) continue to meet the criteria
established by the DCO. A DCO may be able to obtain pertinent
information from public sources, and it should be able to request and
obtain information from an approved settlement bank, which demonstrates
whether the bank continues to meet the criteria established by the DCO.
The Commission is adopting Sec. 39.14(c)(1) with a modification
that replaces the language that states: ``with respect to those banks
that are acceptable settlement banks for the derivatives clearing
organization and its clearing members'' with ``that must be met by any
settlement bank used by the derivatives clearing organization or its
clearing members.'' In addition, the Commission is inserting
parentheses around the letter ``s'' in the word ``banks.'' Consistent
with the modification to the introductory paragraph of Sec. 39.14(c)
described above, these modifications also clarify that there may be
circumstances in which it may be appropriate for a DCO to use a single
settlement bank. The Commission is adopting Sec. 39.14(c)(2) as
proposed.
5. Monitoring and Addressing Exposure to Settlement Banks--Sec.
39.14(c)(3)
Proposed Sec. 39.14(c)(3) would require a DCO to monitor the full
range and concentration of its exposures to its own and its clearing
members' settlement banks and assess its own and its clearing members'
potential losses and liquidity pressures in the event that the
settlement bank with the largest share of settlement activity were to
fail.\174\ A DCO would be required to: (i) maintain settlement accounts
at additional settlement banks; (ii) approve additional settlement
banks for use by its clearing members; (iii) impose concentration
limits with respect to its own or its clearing members' settlement
banks; and/or (iv) take any other appropriate actions if any such
actions are reasonably necessary in order to eliminate or strictly
limit such exposures.
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\174\ Some DCOs have their own settlement accounts at each
settlement bank used by their clearing members, in which case a
clearing member's settlement bank is also the DCO's settlement bank,
and transfers between a clearing member's settlement account and a
DCO's settlement account are made internally. Other DCOs permit
their clearing members to use settlement banks at which such DCOs do
not have their own settlement accounts, and settlement transfers are
made between a clearing member's settlement bank and the DCO's
settlement bank. In either event, the settlement bank with the
largest share of settlement activity will always be a bank at which
the DCO maintains a settlement account, as all settlement activity
will involve the DCO.
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OCC commented that the requirement that a DCO monitor its clearing
members' exposure to the settlement banks used by such clearing members
could result in a massive duplication of effort and would be very
burdensome for the DCO. Therefore, OCC suggested that clearing members
or their primary regulators should be responsible for monitoring
clearing members' exposure to their settlement banks.
The Commission does not agree with OCC that proposed Sec.
39.14(c)(3) could result in a massive duplication of effort. The focus
of the monitoring required by Sec. 39.14(c)(3) is on a DCO's exposures
and its clearing members' potential losses insofar as they may create
exposures for the DCO. Therefore, each
[[Page 69388]]
DCO must conduct the required monitoring as each DCO's exposures are
unique to that DCO. In addition, this provision of Sec. 39.14(c)(3) is
consistent with proposed international standards.\175\
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\175\ See CPSS-IOSCO Consultative Report, Principle 9: Money
Settlements, Explanatory Note, 3.9.5, at 56.
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NYPC commented that since initial and variation margin requirements
fluctuate daily, proposed Sec. 39.14(c)(3) would require DCOs to
monitor their exposures to all settlement banks and not merely the
largest. The Commission agrees with NYPC. Proposed Sec. 39.14(c)(3)
would require a DCO to ``monitor the full range and concentration of
its exposures to its own and its clearing members' settlement banks,''
which means that a DCO must conduct such monitoring with respect to all
such settlement banks. The reference to ``the settlement bank with the
largest share of settlement activity'' was made in the context of
requiring a DCO to assess the potential impact of the failure of such
bank.
CME and OCC requested that the Commission clarify that a DCO would
only be required to take any of the actions specified in proposed Sec.
39.14(c)(3)(i)-(iv), if the specific action were reasonably necessary
in order to eliminate or strictly limit exposures to settlement banks,
and that a DCO would not be required to take all of the specified
actions in all cases. CME supported this interpretation and OCC stated
its belief that these requirements would be reasonable if the final
rule were expressly limited in this manner. The Commission is modifying
Sec. 39.14(c)(3)(i)-(iv) to clarify the Commission's intent to
obligate a DCO to employ any one or more of the actions specified in
(i) through (iv), only if any one or more of such actions is reasonably
necessary in order to eliminate or strictly limit such exposures.
CME, ICE, MGEX, and KCC variously commented that prescribing
concentration limits and requiring that a DCO and its clearing members
maintain multiple settlement banks would impose significant expenses on
the DCO, its clearing members, and their customers. CME, MGEX, and NYPC
stated their belief that it would be difficult to comply with this
regulation given the limited number of banks that are qualified and
willing to serve as settlement banks.\176\ CME also commented that the
meaning of ``concentration limits'' is unclear, and stated its belief
that it would be unwise to impose artificial limits on the number of
clearing members or the size of clearing member accounts at a
particular settlement bank.
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\176\ CME also expressed concern that, as drafted, the proposed
regulation appears to require a DCO to approve at least two more
settlement banks, because of the reference to ``settlement banks''
in the plural.
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ICE took the position that hard concentration limits could increase
systemic risk because a DCO would need to distribute funds across
multiple banks. ICE indicated that as settlement funds increased,
highly rated banks would eventually be consumed by the concentration
limits and DCOs may have to open accounts with lower rated banks. ICE
further commented that concentration limits could act as a constraint
on customer choice, in that if one bank had a large number of
settlement customers, there would be natural concentration of
settlement flows, and the DCO could have to direct customers not to use
their chosen bank.
NYPC also questioned whether current settlement banks would be
willing to continue to act in that role if the Commission required a
DCO and some of its clearing members to transfer their business to
other banks. NYPC stated that this would leave the existing settlement
banks with an expensive infrastructure supported by fewer client
accounts.
MGEX stated its belief that requiring a DCO to oversee clearing
members' banks and establishing credit or concentration limits would be
intrusive and suggested that the final rule should provide DCOs with
flexibility.
The Commission notes that proposed Sec. 39.14(c)(3)(iii) would
require a DCO to impose concentration limits with respect to its own or
its clearing members' settlement banks if such action were reasonably
necessary in order to eliminate or strictly limit its exposures to such
settlement banks. Section 39.14(c)(3) would provide a DCO with other
possible options for addressing such exposures. For example, a DCO
could open an account at an additional settlement bank pursuant to
Sec. 39.14(c)(3)(i), or approve an additional settlement bank for use
by its clearing members pursuant to Sec. 39.14(c)(3)(ii), without
imposing concentration limits, if doing so would mean that such limits
would not be reasonably necessary. In addition, proposed Sec.
39.14(c)(3)(iv) would allow a DCO to take other appropriate actions,
which could obviate the potential need for concentration limits.
KCC commented that identifying multiple settlement banks for use by
clearing members could increase a DCO's operational risk by fragmenting
the DCO's margin pool. KCC suggested that there is no need for multiple
settlement banks because there would be little effect on the operations
of a DCO if a non-systemically significant settlement bank failed. KCC
noted that the Federal Deposit Insurance Corporation generally
facilitates the transfer of the accounts and operations of a failed
bank to a successor institution or a bridge bank with little or no
disruption to depositors at the failed bank. KCC further stated that a
DCO's settlement account is essentially a pass-through account and DCOs
generally do not maintain large, long-term balances in the account.
According to KCC, even if a DCO held significant guaranty funds or
security deposits at a settlement bank, such assets would likely be
held in a trust or custody account, which would be unavailable to
creditors of the failed institution and would generally be available to
the DCO within a short period of time following the insolvency of the
settlement bank. KCC also noted that a requirement that DCOs identify
additional settlement banks for use by clearing members would cause a
significant rise in bank service fees for DCOs and clearing members.
NGX noted that proposed Sec. 39.14(c) generally refers to
settlement banks, in the plural, assuming that all DCOs will maintain
accounts with at least two settlement banks. NGX questioned the benefit
of requiring all DCOs, regardless of size, to use multiple settlement
banks. According to NGX, settlement risk varies across DCOs, and the
type of daily settlement risk the proposed rule addresses is not
present at a DCO like NGX, which does not engage in daily variation
margin payments and collections from its clearing participants. NGX
stated that the rule should take account of the level of settlement
activity because requiring a DCO with a relatively small need for
settlement services to divide the flow of funds may cause the DCO to be
less attractive, bear higher costs, and be less competitive with larger
DCOs, while having a negligible impact on systemic risk.\177\ NGX also
commented that the rule could result in increased operational risk at a
DCO like NGX with complex contract settlement and delivery that
requires a settlement bank to have specialized expertise and to
maintain specialized processes and operational capabilities. NGX
requested that the Commission provide the flexibility to permit a DCO
to
[[Page 69389]]
demonstrate that the use of a single settlement bank is appropriate
from both a policy and a financial perspective.
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\177\ However, NGX stated that where a DCO has daily settlements
or monthly settlements in a greater amount, requiring more than one
settlement bank may materially reduce systemic risk without adverse
effects.
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As noted above, the Commission does not intend to require a DCO to
use more than one settlement bank if the particular DCO otherwise
employs settlement arrangements that eliminate or strictly limit its
exposure to settlement bank risks. The Commission understands that the
number of banks that are willing to serve settlement functions might be
limited, particularly for smaller DCOs. The Commission further
understands that it might be costly for some DCOs that currently only
have one settlement bank to use an additional settlement bank. However,
pursuant to Sec. 39.14(c)(3), a DCO would be required to have a second
settlement bank, if it were reasonably necessary in order to eliminate
or strictly limit the DCO's exposures to settlement bank risks.
The Commission is modifying Sec. Sec. 39.14(c)(3)(i) and (ii) to
refer to ``one or more'' additional settlement banks, so that it will
be clear that a DCO would not necessarily be required to maintain
settlement accounts with more than one additional settlement bank or to
approve more than one additional settlement bank that its clearing
members could choose to use, under the specified circumstances. In
addition, the Commission is modifying Sec. 39.14(c)(3)(iii) to
similarly clarify that a DCO may only be required to impose
concentration limits with respect to ``one or more'' of its own or its
clearing members' settlement banks, under the specified circumstances.
The Commission is also modifying Sec. 39.14(c)(3)(ii) by replacing
``for use by its clearing members'' with ``that its clearing members
could choose to use'' to make it clear that the Commission is not
suggesting that a single clearing member might be required to use more
than one settlement bank.\178\
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\178\ For example, it appears that CME may have interpreted
proposed Sec. 39.14(c)(3)(ii) in this unintended manner, since it
stated that ``we do not believe the CFTC should require clearing
members to have accounts at multiple settlement banks, which may
prove to be an impossible (and/or extremely costly) requirement to
satisfy.'' It appears that KCC may also have interpreted proposed
Sec. 39.14(c)(3)(ii) in this manner, in light of its comment that a
requirement that DCOs identify additional settlement banks for use
by clearing members would cause a significant rise in bank service
fees for DCOs and clearing members. There is no reason that
providing greater choice to clearing members regarding which single
settlement bank they could elect to use would cause a rise in bank
service fees for clearing members.
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The Commission is adopting Sec. 39.14(c)(3) with the modifications
described above.
6. Settlement Finality--Sec. 39.14(d)
Proposed Sec. 39.14(d) would require a DCO to ensure that
settlement fund transfers are irrevocable and unconditional when the
DCO's accounts are debited or credited. In addition, the proposed
regulation would require that a DCO's legal agreements with its
settlement banks must state clearly when settlement fund transfers
would occur and a DCO was required to routinely confirm that its
settlement banks were effecting fund transfers as and when required by
those legal agreements.
ISDA and FIA requested that the rule allow for the correction of
errors.\179\ The Commission agrees with ISDA and FIA that settlement
finality should not preclude the correction of errors, and is adding a
clause to Sec. 39.14(d) that explicitly provides that a DCO's legal
agreements with its settlement banks may provide for the correction of
errors.
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\179\ ISDA also requested that the Commission clarify how the
proposed requirement would be compatible with the fact that title
transfer of initial margin may not occur when it is posted to a DCO.
Title transfer is not a necessary element of settlement finality.
Although in some jurisdictions a clearing member may need to
transfer title to margin collateral to a DCO in order for the DCO to
effectively exert control over such collateral, in other
jurisdictions a clearing member may transfer margin collateral to a
DCO and grant a security interest to the DCO without transfer of
title.
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In addition, the Commission is adding the modifier ``no later
than'' before ``when the derivatives clearing organization's accounts
are debited or credited'' in recognition of the fact that a DCO's legal
agreements with its settlement banks may provide for settlement
finality prior to the time when the DCO's accounts are debited or
credited, e.g., upon the bank's acceptance of a settlement instruction.
KCC commented that a DCO can never effectively ensure that
settlement payments are irrevocable, given the existence of a legal
risk that a settlement payment may be deemed to be an inappropriate
transfer pursuant to applicable bankruptcy law. Therefore, KCC urged
the Commission to eliminate the requirement or to restate the rule as a
requirement to monitor operational risks related to settlement
finality. The Commission does not believe that it is appropriate to do
so. Core Principle E requires a DCO to ``ensure that money settlements
are final when effected.'' \180\ In addition, Section 546(e) of the
U.S. Bankruptcy Code \181\ provides that a bankruptcy trustee may not
avoid a transfer that is a margin payment or a settlement payment made
to a DCO by a clearing member, or made to a clearing member by a DCO
(with the exception of fraudulent transfers). However, the Commission
is modifying Sec. 39.14(d) to state that ``[a DCO] shall ensure that
settlements are final when effected by ensuring that it has entered
into legal agreements that state that settlement fund transfers are
irrevocable and unconditional * * *'' (added text in italics).
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\180\ See Section 5b(c)(2)(E)(iii) of the CEA, 7 U.S.C. 7a-
1(c)(2)(E)(iii).
\181\ 11 U.S.C. 546(e).
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The Commission is adopting Sec. 39.14(d) with the modifications
described above.
7. Recordkeeping--Sec. 39.14(e)
Proposed Sec. 39.14(e) would require a DCO to maintain an accurate
record of the flow of funds associated with each settlement.
KCC expressed its general support of the concept of maintaining
accurate records of settlement fund flows, but stated that it may be
prudent for the Commission to further clarify the extent to which the
additional recordkeeping applies to cross-margining and netting
arrangements that a DCO may have in place with certain clearing members
and their customers. The language in Sec. 39.14(e) is virtually
identical to the Core Principle E language, which the Dodd-Frank Act
added to the CEA.\182\ Moreover, this language is similar to the
language that had been contained in Core Principle E prior to its
amendment by the Dodd-Frank Act.\183\
Therefore, proposed Sec. 39.14(e) would not impose any additional
recordkeeping requirements. The Commission believes that the
requirement that a DCO must maintain an accurate record of the flow of
funds associated with each settlement would necessarily require the
maintenance of an accurate record with respect to any cross-margining
or netting arrangements, without the need to separately address such
arrangements. The Commission is adopting Sec. 39.14(e) as proposed.
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\182\ See Section 5b(c)(2)(E)(iv) of the CEA, 7 U.S.C. 7a-
1(c)(2)(E)(iv).
\183\ Prior to amendment by the Dodd Frank Act, Core Principle E
provided, in part, that a [DCO] applicant shall have the ability to
``* * * [m]aintain an adequate record of the flow of funds
associated with each transaction that the applicant clears. * * *''
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8. Netting Arrangements--Sec. 39.14(f)
Proposed Sec. 39.14(f) would incorporate Core Principle E's
requirement that a DCO must possess the ability to comply with each
term and condition of any permitted netting or offset arrangement with
any other clearing organization.\184\
[[Page 69390]]
The Commission did not receive any comment letters discussing Sec.
39.14(f) and is adopting Sec. 39.14(f) as proposed.
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\184\ See Section 5b(c)(2)(E)(v) of the CEA, 7 U.S.C. 7a-
1(c)(2)(E)(v).
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9. Physical Delivery--Sec. 39.14(g)
Proposed Sec. 39.14(g) would require a DCO to establish rules
clearly stating each obligation that the DCO has assumed with respect
to physical deliveries, including whether it has an obligation to make
or receive delivery of a physical instrument or commodity, or whether
it indemnifies clearing members for losses incurred in the delivery
process, and to ensure that the risks of each such obligation are
identified and managed.
KCC commented that it generally supports the concept of proposed
Sec. 39.14(g), but requested that the Commission clarify that a DCO
may be deemed to have satisfied its obligation to establish rules
relating to physical deliveries if the rules of the exchange that lists
the cleared contracts clearly delineates such physical delivery
obligations. The Commission notes that the rules referenced in Sec.
39.14(g) must be enforceable by and against the DCO. If a DCO were
integrated with a DCM and the DCM's rules were enforceable by and
against the DCO, then it may be that the DCM's rules would satisfy the
requirements of Sec. 39.14(g). However, such compliance would need to
be determined on a case-by-case basis. The Commission is adopting Sec.
39.14(g) as proposed, except for a technical revision that replaces
``contracts, agreements and transactions'' with ``products'' to ensure
consistency with other provisions in part 39.
F. Core Principle F--Treatment of Funds--Sec. 39.15
Core Principle F, \185\ as amended by the Dodd-Frank Act, requires
a DCO to: (i) Establish standards and procedures that are designed to
protect and ensure the safety of its clearing members' funds and
assets; (ii) hold such funds and assets in a manner by which to
minimize the risk of loss or of delay in the DCO's access to the assets
and funds; and (iii) only invest such funds and assets in instruments
with minimal credit, market, and liquidity risks. The Commission
proposed Sec. 39.15 to establish requirements that a DCO would have to
meet in order to comply with Core Principle F.
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\185\ Section 5b(c)(2)(F) of the CEA, 7 U.S.C. 7a-1(c)(2)(F)
(Core Principle F).
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1. Required Standards and Procedures--Sec. 39.15(a)
Proposed Sec. 39.15(a) would require a DCO to establish standards
and procedures that are designed to protect and ensure the safety of
funds and assets belonging to clearing members and their
customers.\186\ The Commission did not receive any comments on proposed
Sec. 39.15(a) and is adopting the provision as proposed.
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\186\ Such ``assets'' would include any securities or property
that clearing members deposit with a DCO in order to satisfy initial
margin obligations, which are also sometimes referred to as
``collateral.'' Proposed Sec. 39.15 uses the term ``assets'' rather
than ``securities or property'' or ``collateral'' in order to be
consistent with the statutory language.
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2. Segregation--Sec. 39.15(b)(1)
Proposed Sec. 39.15(b)(1) would require a DCO to comply with the
segregation requirements of Section 4d of the CEA and Commission
regulations thereunder, or any other applicable Commission regulation
or order requiring that customer funds and assets be segregated, set
aside, or held in a separate account.
LCH suggested that the Commission clarify the meaning of
``segregated'' and limit the segregation requirement to the funds of
clearing members' clients. LCH also urged the Commission to limit these
requirements to client business cleared by the DCO under the FCM
clearing structure, noting that a DCO based outside the United States
may offer client clearing services through alternative structures and
that it did not believe it would be appropriate for clients clearing
under these non-U.S. structures to be subject to the segregation
requirements of Section 4d of the CEA, but rather to the requirements
set out by the DCO's home or other regulators.
FIA recommended that the proposed rule be revised to make clear
that a DCO should keep margin posted by clearing members to support
proprietary positions separate from the DCO's own assets, noting that
although proprietary funds held at a DCO are not subject to the
segregation provisions of the CEA, it is essential that these funds are
protected in the event of the default of the DCO. The Commission has
not proposed and is not adopting FIA's suggestion that the Commission
expand the applicability of Sec. 39.15(b)(1) in this manner.
BlackRock and FHLBanks expressed their views on specific
segregation models. The Commission has proposed rules in a separate
rulemaking regarding the segregation of cleared swaps customer
contracts and collateral, and the Commission will address BlackRock's
and FHLBanks' comments in connection with the final rulemaking for that
proposal.\187\
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\187\ See 76 FR 33818 (June 9, 2011) (Protection of Cleared
Swaps Customer Contracts and Collateral; Conforming Amendments to
the Commodity Broker Bankruptcy Provisions).
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The comments submitted by LCH, FIA, BlackRock, and FHLBanks all
address the substance or applicability of segregation requirements.
Proposed Sec. 39.15(b)(1) would not have imposed any additional
substantive segregation requirements upon a DCO. It would simply
require a DCO to comply with the substantive segregation requirements
of the CEA and other Commission regulations or orders, which are
currently applicable or which may become applicable in the future. In
particular, Sec. 39.15(b)(1) is not intended to extend the
extraterritorial reach of existing segregation requirements beyond that
which may already exist in such requirements. However, in order to
clarify the Commission's intent in this regard, the Commission has
added ``applicable'' before ``segregation requirements'' in Sec.
39.15(b)(1). In addition, the Commission wishes to clarify that its
current segregation requirements apply to a non-U.S. based DCO with
respect to clearing members that are registered as FCMs, whether they
are clearing business for U.S. based customers or non-U.S. based
customers. Such requirements do not apply with respect to clearing
members that are non-U.S. based and that are not registered as FCMs,
nor required to be registered as FCMs.
The Commission is adopting Sec. 39.15(b)(1) with the modification
described above.
3. Commingling of Futures, Options on Futures, and Swap Positions--
Sec. 39.15(b)(2)
Proposed Sec. 39.15(b)(2)(i) would permit a DCO to commingle, and
a DCO to permit clearing member FCMs to commingle, customer positions
in futures, options on futures, and swaps, and any money, securities,
or property received to margin, guarantee, or secure such positions, in
an account subject to the requirements of Section 4d(f) of the CEA
(cleared swaps account), pursuant to DCO rules that have been approved
by the Commission under Sec. 40.5 of the Commission's regulations. The
DCO's rule filing \188\ would have to include, at a minimum, the
following: (A) an identification of the futures, options on futures,
and swaps that would be commingled, including contract specifications
or the criteria that would
[[Page 69391]]
be used to define eligible futures, options on futures, and swaps; (B)
an analysis of the risk characteristics of the eligible products; (C) a
description of whether the swaps would be executed bilaterally and/or
executed on a DCM and/or a SEF; (D) an analysis of the liquidity of the
respective markets for the futures, options on futures, and swaps that
would be commingled, the ability of clearing members and the DCO to
offset or mitigate the risks of such products in a timely manner,
without compromising the financial integrity of the account, and, as
appropriate, proposed means for addressing insufficient liquidity; (E)
an analysis of the availability of reliable prices for each of the
eligible products; (F) a description of the financial, operational, and
managerial standards or requirements for clearing members that would be
permitted to commingle the eligible products; (G) a description of the
systems and procedures that would be used by the DCO to oversee such
clearing members' risk management of the commingled positions; (H) a
description of the financial resources of the DCO, including the
composition and availability of a guaranty fund with respect to the
commingled products; (I) a description and analysis of the margin
methodology that would be applied to the commingled products, including
any margin reduction applied to correlated positions, and any
applicable margin rules with respect to both clearing members and
customers; (J) an analysis of the ability of the DCO to manage a
potential default with respect to any of the commingled products; (K) a
discussion of the procedures that the DCO would follow if a clearing
member defaulted, and the procedures that a clearing member would
follow if a customer defaulted, with respect to any of the commingled
products; and (L) a description of the arrangements for obtaining daily
position data from each beneficial owner of the commingled
products.\189\
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\188\ The DCO's rule filing would also need to comply with the
procedural requirements of Sec. 40.5(a).
\189\ As noted in the Commission's notice of proposed rulemaking
regarding the protection of cleared swaps customer contracts and
collateral, 76 FR at 33818 (June 9, 2011) (Protection of Cleared
Swaps Customer Contracts and Collateral; Conforming Amendments to
the Commodity Broker Bankruptcy Provisions), if the complete legal
segregation model is adopted for cleared swaps, a DCO could more
easily justify the approval of rules or the issuance of a 4d order
allowing the commingling of futures, options, and swaps, since the
impact of any different risk from the product being brought into the
portfolio would be limited to the customer who chooses to trade that
product. In such case, the Commission may still wish to obtain and
review all of the information specified in proposed Sec.
39.15(b)(2)(i), although its specific concerns may be minimized.
However, if the complete legal segregation model is adopted for
cleared swaps, and after the Commission obtains experience with
respect to considering requests to commingle futures, options, and
swaps under Sec. 39.15(b)(2) in an environment where that margin
model applies, the Commission may revisit its ongoing need for all
of the information listed in Sec. 39.15(b)(2)(i).
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Proposed Sec. 39.15(b)(2)(ii) would address situations where
customer positions in futures, options on futures, and cleared swaps
could be carried in a futures account subject to Section 4d(a) of the
CEA. Proposed Sec. 39.15(b)(2)(ii) would incorporate the informational
requirements of proposed Sec. 39.15(b)(2)(i), but would require a DCO
to file a petition with the Commission for an order pursuant to Section
4d(a) of the CEA, permitting the DCO and its clearing members to
commingle customer positions in futures, options on futures, and swaps
in a futures account (4d order).
Proposed Sec. 39.15(b)(2)(iii)(A) would provide that the
Commission may request additional information in support of a rule
submission and that it may approve the rules in accordance with Sec.
40.5.\190\ Proposed Sec. 39.15(b)(2)(iii)(B) would provide that the
Commission could request additional information in support of a
petition and that it could issue a 4d order in its discretion.
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\190\ A rule submitted for prior approval would be approved
unless the rule is inconsistent with the CEA or the Commission's
regulations. See Section 5c(c)(5) of the CEA, 7 U.S.C. 7a-2(c)(5);
and 75 FR at 44793-44794 (Provisions Common to Registered Entities;
final rule).
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As noted in the notice of proposed rulemaking, in the case of a
rule approval under Sec. 39.15(b)(2)(i), as well as the issuance of an
order under Sec. 39.15(b)(2)(ii), the Commission would take action
pursuant to Section 4d of the CEA (permitting commingling) and Section
4(c) of the CEA (exempting the DCO and clearing members from the
requirement to hold customer positions in a 4d(a) or 4d(f) account, as
applicable).
The Commission requested comment on whether it should take the same
approach (rule submission or petition for an order) with respect to the
futures account and the cleared swap account and, if so, what that
approach should be. In addition, the Commission requested comment on
whether the enumerated informational requirements fully capture the
relevant considerations for making a determination on either rule
approval or the granting of an order, and whether the Commission's
analysis should take into consideration the type of account in which
the positions would be carried, the particular type of products that
would be involved, or the financial resources of the clearing members
that would hold such accounts. The Commission further requested comment
on what, if any, additional or heightened requirements should be
imposed to manage the increased risks introduced to a futures account
that also holds cleared swaps.
In some instances, commenters addressed topics that are more
properly considered by the Commission in connection with a separate
rulemaking,\191\ that relate to substantive requirements that the
Commission might impose as a condition of approving a rule or granting
an order under Sec. 39.15(b)(2),\192\ or that relate to other
provisions adopted herein.\193\ The Commission is not addressing those
comments in its discussion of Sec. 39.15(b)(2) because they are not
within the scope of the proposal.
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\191\ E.g., CME and FIA raised operational concerns in the event
the Commission adopts a different segregation regime for each type
of customer account. Those comments will be considered in connection
with the Commission's proposal regarding the appropriate segregation
regime for cleared swaps accounts. See 76 FR 33818 (June 9, 2011)
(Protection of Cleared Swaps Customer Contracts and Collateral;
Conforming Amendments to the Commodity Broker Bankruptcy
Provisions).
\192\ E.g., LCH suggested additional factors that the Commission
should consider before a DCO or its clearing members should be able
to commingle, and offer offsets between, futures, options on
futures, and swaps, including: (a) clients must hold their futures,
options, and swaps under the same account structure and within the
same legal entity, and (b) the DCO must margin the futures, options,
and swaps using the same margin model; and ELX expressed the view
that in order for a customer to gain the portfolio margining
benefits of commingling futures, options, and swaps executed on a
SEF, it would be necessary for a customer to clear its futures,
options, and swaps through the same DCO.
\193\ LCH stated that all offset assumptions in the DCO's margin
calculations must, at a minimum, be replicated in the DCO's stress
testing and must be recalibrated frequently. The Commission notes
that permitted spread and portfolio margins are addressed in Sec.
39.13(g)(4), discussed in section IV.D.6.e, above, and back testing
of such spread and portfolio margins is addressed in Sec.
39.13(g)(7), discussed in section IV.D.6.g, above.
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CME, FIA, and MFA expressed their general support for the adoption
of rules that would allow commingling of customer positions in futures,
options on futures, and cleared swaps. In particular, CME indicated
that such commingling could achieve important benefits with respect to
greater capital efficiency which would result from margin reductions
for correlated positions, and that adoption of a regulation permitting
such commingling would be consistent with the public interest, in
accordance with Section 4(c) of the CEA. CME further stated that
``[h]aving positions in a single account can also enhance risk
management practices and systemic risk containment by allowing the
customer's portfolio to
[[Page 69392]]
be handled in a coordinated fashion in a transfer or liquidation
scenario.''
CME stated its belief that it would be logical to apply the same
methodology (rule submission or petition for an order) with respect to
the futures account and the cleared swaps account, and that a rule
submission would be the most efficient and optimal approach. The
Commission is retaining the proposed distinction whereby the Commission
may permit futures to be commingled in a Section 4d(f) cleared swaps
account subject to a rule approval process, and may permit cleared
swaps to be commingled in a Section 4d(a) futures account subject to a
4d order. In the latter instance, the 4d petition process would provide
additional procedural protections in that: (1) Review of a 4d petition
by the Commission is not subject to the time limits that apply to a
request for rule approval under Sec. 40.5; and (2) the Commission may
impose conditions in a 4d order, as appropriate. The Commission has
determined that, at this time, it is appropriate to provide these
additional procedural protections before exposing futures customers to
the risks of swaps that may be commingled in a futures account. As also
noted in other contexts in this notice of final rulemaking, DCOs have
greater experience in clearing futures. Swaps will expose DCOs to risks
that can differ in their nature and magnitude. However, as the
Commission and the industry gain more experience with cleared swaps,
the Commission may revisit this issue in the future.
The Commission is adopting CME's suggestion that it revise Sec.
39.15(b)(2)(i)(L) to remove the reference to obtaining daily position
data ``from each beneficial owner.'' Therefore, Sec.
39.15(b)(2)(i)(L), as modified, requires a DCO to submit ``[a]
description of the arrangements for obtaining daily position data with
respect to futures, options on futures, and swaps in the account,''
without specifying the level of detail or the source of the daily
position data that the DCO must obtain. As noted by CME, the Commission
could request additional information from the DCO, in support of its
request for rule approval or petition for a 4d order, pursuant to Sec.
39.15(b)(2)(iii).
The Commission is also making conforming changes to Sec.
39.15(b)(2), to replace a reference to ``cleared swap account'' with
``cleared swaps account'' to achieve consistency with the terminology
in another Commission rulemaking; \194\ is revising the references to
``futures, options on futures, and swap positions'' and ``futures,
options on futures, and swaps'' to read ``futures, options, and
swaps;'' \195\ is replacing a reference to ``contract'' with
``product;'' and is correcting the references to Sec. 39.15(b)(2)(i)
and (ii) in Sec. 39.15(b)(iii)(A) and (B), respectively.
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\194\ See 76 FR 33818 (June 9, 2011) (Protection of Cleared
Swaps Customer Contracts and Collateral; Conforming Amendments to
the Commodity Broker Bankruptcy Provisions).
\195\ This conforming terminology, which appears elsewhere in
part 39, streamlines the rule text without changing the meaning of
the provision. The scope of part 39 covers only those products
subject to the Commission's oversight and would not include, for
example, options on securities. Refinements in the definitions of
products subject to Commission oversight will be addressed in the
future.
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The Commission is adopting Sec. 39.15(b)(2) with the modifications
described above.
4. Holding of Funds and Assets--Sec. 39.15(c)
The introductory paragraph of proposed Sec. 39.15(c) would require
that a DCO hold funds and assets belonging to clearing members and
their customers in a manner that minimizes the risk of loss or of delay
in the DCO's access to those funds and assets. The Commission did not
receive any comment letters discussing the introductory paragraph of
proposed Sec. 39.15(c) and is adopting the provision as proposed.
5. Types of Assets--Sec. 39.15(c)(1)
Proposed Sec. 39.15(c)(1) would require a DCO to limit the assets
it accepts as initial margin to those that have minimal credit, market,
and liquidity risks, and prohibit a DCO from accepting letters of
credit as initial margin.
LCH agreed with the provisions of proposed Sec. 39.15(c), but
added that the rules might more properly require that a DCO must be
able to convert any funds and assets held promptly into cash, and
should prove that it is able to do so on an ongoing basis. J.P. Morgan
stated that it is necessary for DCOs to maintain sufficient liquidity,
and that this could be achieved by requiring that clearing members post
a minimum amount of liquid (cash and qualifying government securities)
margin, among other things.\196\
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\196\ J.P. Morgan also suggested that DCOs could maintain
liquidity by requiring clearing members to make guarantee fund
contributions or by requiring clearing members to participate in a
liquidity facility. The Commission has not proposed and is not
adopting such requirements.
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The Commission believes that the standard of ``minimal credit,
market, and liquidity risks'' is sufficient and that it is not
necessary to modify the language of the regulation to include an
explicit requirement that a DCO must be able to convert funds and
assets promptly into cash or to require that clearing members must post
a minimum amount of cash and qualifying government securities.
Moreover, the requirement that a DCO shall limit the assets that it
accepts as initial margin to those that have ``minimal credit, market,
and liquidity risks'' is consistent with international
recommendations.\197\
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\197\ See CPSS-IOSCO Consultative Report, Principle 5:
Collateral, at 37.
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OCC expressed its belief that the proposal places an excessive
focus on the types of assets that may be used as margin and that the
Commission's central focus should be on whether a DCO's procedures and
risk management systems are sufficient to provide a high degree of
assurance that a portfolio, including margin assets, can be liquidated
with a positive liquidation value. OCC further noted its concern that
some of the collateral that it currently accepts as initial margin,
including less-liquid stocks and long-dated Treasury securities, would
no longer be permitted under the proposed rule. OCC explained that its
``collateral in margins'' or ``CIM'' program looks at each type of
collateral as an asset with specific risk characteristics rather than
as a fixed value, and it recognizes both positive and negative
correlations with other assets and liabilities in a particular account.
As an example, OCC stated that even though XYZ stock may be less
liquid than other stocks, it may have a greater value than a more
liquid stock when it is used as margin for a short position in XYZ call
options. Therefore, OCC urged the Commission not to impose a standard
of ``minimal credit, market, and liquidity risk,'' or not to adopt an
interpretation of such a standard in a manner that would reduce the
opportunities for diversification of collateral and use of assets that
may have specific risk-reducing properties in a particular portfolio.
In particular, OCC stated that ``[w]here a DCO is capable of reflecting
the risk of certain assets in its margin model, we see no reason why
less liquid instruments or instruments with higher than average credit
or market risks should not be acceptable for initial margin.''
The Commission agrees that a DCO should be permitted to accept
assets as initial margin if such assets have specific risk-reducing
properties in a particular portfolio and the DCO's margin model is
capable of appropriately reflecting the risk of those
[[Page 69393]]
assets. Accordingly, although the Commission is retaining the standard
of minimal credit, market, and liquidity risk, it is revising the
provision to add the following: ``A [DCO] may take into account the
specific risk-reducing properties that particular assets have in a
particular portfolio.'' As illustrated by OCC, an asset that would not
generally be acceptable could be acceptable for use in connection with
a particular portfolio.
Freddie Mac requested that the Commission clarify that DCOs may
accept collateral types beyond those specified as permitted investments
under Sec. 1.25. Section 39.15(c) does not prohibit a DCO from
accepting collateral types that are not specified as permitted
investments under Sec. 1.25. The Commission believes that it is
appropriate to permit DCOs to retain the flexibility to accept a
broader range of assets that meet the general requirement of ``minimal
credit, market, and liquidity risks'' than those which are appropriate
investments for funds received from clearing members.
Several comment letters specifically discussed the proposal to
prohibit the use of letters of credit as initial margin. The commenters
disagreed with the Commission's proposed requirement that a DCO may not
accept letters of credit for this purpose. CME stated that letters of
credit provide an absolute assurance of payment and, therefore, the
issuing bank must honor the demand even in circumstances where the DCO
(the beneficiary) breached its duty to the clearing member and even if
the clearing member is unable to reimburse the bank for its payment.
CME also stated that it was not aware of any instances in the cleared
derivatives industry in which a beneficiary of a letter of credit
posted as collateral had sought to draw upon the letter of credit and
had not been promptly paid by the issuer. CME noted that letters of
credit have been especially useful for clearing members to post as
collateral for late-day margin calls. ICE and NOCC similarly commented
that letters of credit should be permitted to serve as non-cash
collateral. NGX indicated that letters of credit are consistent with
Section 4s(e)(3)(D) of the CEA, which provides that the financial
regulators shall establish comparable capital requirements and minimum
initial and variation margin requirements, including the use of non-
cash collateral, for swap dealers.\198\
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\198\ The Commission notes that the minimum initial and
variation margin requirements referenced in Section 4s(e)(3)(D) of
the CEA, 7 U.S.C. 6s(e)(3)(D), apply to uncleared swaps.
NGX also stated its view that in a non-intermediated model, such
as that operated by NGX, the DCO is familiar with its clearing
participants, and can exercise a degree of discretion in accepting
letters of credit without the same risk management challenges that
may be faced by an intermediated DCO.
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Many commenters suggested that letters of credit should be
acceptable if they are subject to appropriate conditions. OCC
recommended that the Commission should allow letters of credit as long
as a DCO sets criteria with respect to issuers, diversifies
concentration of risk among issuers, and limits the proportion of a
clearing member's margin requirement that can be represented by letters
of credit. In addition, OCC stated that it would be appropriate for the
Commission to prohibit a DCO from accepting a letter of credit from a
clearing member if the letter of credit is issued by an institution
affiliated with the clearing member.
Similarly, FIA suggested that a DCO should be permitted to accept
letters of credit on a case-by-case basis subject to the credit quality
of the bank and appropriate limits on the percentage of a clearing
member's margin requirements that can be met by letters of credit. FIA
also indicated that DCOs should limit the aggregate value of letters of
credit that may be issued by any one bank.
FHLBanks wrote that ``a hard and fast prohibition against letters
of credit is inappropriate because it fails to take into account that a
letter of credit issued by a highly creditworthy entity could contain
terms that would make the letter of credit just as liquid as a funded
asset.'' \199\
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\199\ The FHLBanks further noted that the prohibition on letters
of credit may unnecessarily constrain certain end-users from
clearing swaps because they may be precluded from pledging other
assets, e.g., by loan covenants.
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CME stated that it only accepts letters of credit that comply with
its specified terms and conditions, including payment within one hour
of notification of a draw, from issuers that it has reviewed and
approved and that meet its criteria for issuing banks. CME further
noted that it conducts periodic reviews of approved banks and uses caps
and concentration limits in connection with letters of credit.
NGX stated that it has accepted letters of credit that comply with
its requirements regarding timing and acceptable institutions, for many
years, and has successfully drawn on such letters of credit.
Several commenters warned of the potential risks associated with
prohibiting letters of credit, including higher costs for clearing
members and their customers (OCC), the placement of U.S. DCOs at a
disadvantage to foreign clearing houses (ICE),\200\ and increased
systemic risk as a result of decreased voluntary clearing (NOCC).
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\200\ ICE noted that the CPSS-IOSCO Consultative Report did not
prohibit any type of collateral.
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The Commission acknowledges that DCOs have historically been
permitted to exercise their discretion regarding whether and to what
extent they would accept letters of credit for initial margin for
futures and options. Certain DCOs have accepted such letters of credit
without incident and continue to do so. On the other hand, as stated in
the notice of proposed rulemaking, letters of credit are unfunded
financial resources with respect to which funds might be not be
available when they are most needed by the DCO. Moreover, the initial
margin of a defaulting clearing member would typically be the first
asset tapped to cure the clearing member's default. Taking into account
both the strong track record of letters of credit in connection with
cleared futures and options on futures and the potentially greater
risks of cleared swaps, the Commission is modifying the provision to
permit DCOs to accept letters of credit as initial margin for futures
and options on futures. However, the Commission has determined to
maintain an additional safeguard for swaps at this time by prohibiting
a DCO from accepting letters of credit as initial margin for swaps. In
cases where futures and swaps are margined together, the Commission has
determined that letters of credit may not be accepted. The Commission
will monitor developments in this area and may revisit this issue in
the future.
The Commission is adopting Sec. 39.15(c)(1), redesignated as Sec.
39.13(g)(10),\201\ with the modification described above.
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\201\ Redesignation of this provision and several other
provisions proposed as part of Sec. 39.15 is a non-substantive
change that moves the provisions to the risk management rules for
margin requirements. As a risk management rule, the provision
implements Core Principle D, Section 5b(c)(2)(D)(iii) of the CEA,
which provides that ``Each [DCO], through margin requirements and
other risk control mechanisms, shall limit the exposure of the [DCO]
to potential losses from defaults by members and participants of the
[DCO].''
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6. Valuation and Haircuts--Sec. Sec. 39.15(c)(2) and 39.15(c)(3)
Proposed Sec. 39.15(c)(2) would require a DCO to use prudent
valuation practices to value assets posted as initial margin on a daily
basis. Proposed Sec. 39.15(c)(3) would require a DCO to apply
appropriate reductions in value to reflect the market and credit risk
of the assets that it accepts in satisfaction of
[[Page 69394]]
initial margin obligations and to evaluate the appropriateness of its
haircuts on at least a quarterly basis.
OCC commented that if a DCO can only accept instruments with
minimal risk, then haircuts should either not be required at all or
should be very small. The Commission notes that, as defined in Sec.
39.15(c)(3), haircuts are ``appropriate reductions in value to reflect
market and credit risk.'' This is a flexible standard that would allow
a DCO to determine the extent of the haircut based on the extent of the
risk posed by the instrument deposited as initial margin.
OCC further stated that proposed Sec. 39.15(c)(3) is ambiguous
regarding what OCC would be required to test on a quarterly basis. OCC
explained that its STANS margin methodology does not apply fixed
haircuts to securities deposited as collateral, but rather treats
collateral as part of a clearing member's overall portfolio, revisiting
each ``haircut'' or valuation on a security-by-security, account-by-
account, and day-by-day basis. Thus, OCC stated that it checks the
adequacy of its haircuts through back testing and not through a
periodic review.
The general language of Sec. 39.15(c)(3), requiring a DCO to
``apply appropriate reductions in value to reflect market and credit
risk * * * to the assets that it accepts in satisfaction of initial
margin obligations'' and to ``evaluate the appropriateness of such
haircuts on at least a quarterly basis,'' is broad enough to encompass
the method of daily valuation and back testing described by OCC.
The Commission is adopting Sec. 39.15(c)(2), redesignated as Sec.
39.13(g)(11), as proposed. The Commission is adopting a technical
revision to Sec. 39.15(c)(3), redesignated as Sec. 39.13(g)(12), by
adding a reference to ``liquidity'' risk to conform the terminology
used to describe haircuts (proposed as ``appropriate reductions in
value to reflect market and credit risk'') with the terminology used in
Sec. 39.13(g)(10), which refers to assets that have ``minimal credit,
market, and liquidity risks.'' \202\ The Commission is also making a
non-substantive revision to replace the phrase ``including in stressed
market conditions'' with ``taking into consideration stressed market
conditions.''
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\202\ Credit, market, and liquidity risks are concepts that are
not mutually exclusive, and this articulation of the types of risks
to be evaluated by a DCO appears in the CEA (Core Principle F,
Treatment of Funds (requiring that ``[f]unds and assets invested by
a [DCO] shall be held in instruments with minimal credit, market,
and liquidity risks''), and ``minimal credit, market, and liquidity
risks'' is set forth as the standard for assets acceptable for a
guaranty fund (Sec. 39.11(e)(3)(i)), and as the standard for assets
acceptable as initial margin (Sec. 39.13(g)(10)).
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7. Concentration Limits--Sec. 39.15(c)(4)
Proposed Sec. 39.15(c)(4) would require a DCO to apply appropriate
limitations on the concentration of assets posted as initial margin, as
necessary, in order to ensure the DCO's ability to liquidate those
assets quickly with minimal adverse price effects. The proposed
regulation also would require a DCO to evaluate the appropriateness of
its concentration limits, on at least a monthly basis.
OCC indicated that the proposed rule was not clear regarding
whether it would be sufficient to impose concentration charges rather
than imposing concentration limits, but argued that if the margin
system adequately penalizes concentration of risk, it does not believe
that fixed concentration limits are required. The Commission agrees
that concentration charges, rather than concentration limits, may be
appropriate in certain circumstances, and is modifying the provision to
permit a DCO to apply ``appropriate limitations or charges on the
concentration of assets posted as initial margin'' and to ``evaluate
the appropriateness of any such concentration limits or charges, on at
least a monthly basis.'' The inclusion of concentration charges as an
acceptable alternative to concentration limits is consistent with
international recommendations.\203\
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\203\ See CPSS-IOSCO Consultative Report, Principle 5:
Collateral, Explanatory Note 3.5.4, at 38.
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CME stated its view that the Commission should not prescribe the
frequency of a DCO's reviews of its concentration limits and it urged
the Commission to revise Sec. 39.15(c)(4) to replace ``on at least a
monthly basis'' with ``on a regular basis.'' The Commission believes
that it is appropriate to require a DCO to evaluate the appropriateness
of its concentration limits (or charges) on at least a monthly basis
and notes that Sec. 39.15(c)(4) provides a DCO with the discretion to
determine the nature of such evaluation.
The Commission is adopting Sec. 39.15(c)(4), redesignated as Sec.
39.13(g)(13), with the modifications described above.
8. Pledged Assets--Sec. 39.15(c)(5)
Under proposed Sec. 39.15(c)(5), if a DCO were to permit its
clearing members to pledge assets for initial margin while retaining
such assets in accounts in the names of such clearing members, the DCO
would have to ensure that the assets are unencumbered and that the
pledge has been validly created and validly perfected in the relevant
jurisdiction. The Commission did not receive any comments discussing
proposed Sec. 39.15(c)(5) and is adopting the provision, redesignated
as Sec. 39.13(g)(14), as proposed.
9. Permitted Investments--Sec. 39.15(d)
Proposed Sec. 39.15(d) would require that clearing members' funds
and assets that are invested by a DCO must be held in instruments with
minimal credit, market, and liquidity risks and that any investment of
customer funds or assets by a DCO must comply with Sec. 1.25 of the
Commission's regulations. Moreover, the proposed regulation would apply
the limitations contained in Sec. 1.25 to all customer funds and
assets, whether they are the funds and assets of futures and options
customers subject to the segregation requirements of Section 4d(a) of
the CEA, or the funds and assets of cleared swaps customers subject to
the segregation requirements of Section 4d(f) of the CEA.
The Commission did not receive any comment letters discussing
proposed Sec. 39.15(d). The Commission is adopting the provision,
redesignated as Sec. 39.15(e), as proposed.
10. Transfer of Customer Positions--Sec. 39.15(d)
The Commission proposed regulations addressing the processing,
clearing, and transfer of customer positions by swap dealers (SDs),
major swap participants (MSPs), FCMs, SEFs, DCMs, and DCOs.\204\
Proposed Sec. 39.15(d) would require a DCO to have rules providing
that, upon the request of a customer and subject to the consent of the
receiving clearing member, the DCO would promptly transfer all or a
portion of such customer's portfolio of positions and related funds
from the carrying clearing member of the DCO to another clearing member
of the DCO, without requiring the close-out and rebooking of the
positions prior to the requested transfer.
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\204\ 76 FR 13101 (March 10, 2011) (Straight-Through
Processing).
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MFA, Citadel, and FHLBanks supported the proposal. MFA and Citadel
suggested that the Commission clarify that associated margin should
transfer simultaneously with the transferred positions.
LCH also suggested that the section should be revised to require
that the transfer of positions and related funds be effected
simultaneously. LCH believes that absent such a provision, a
[[Page 69395]]
DCO could be understood to be required to transfer either the positions
or the funds, but not both, and such an obligation would expose the DCO
to risk during the customer transfer.
FIA agreed with the Commission that a customer should not be
required to close-out and re-book positions as a condition of
transferring such positions, and that a clearing member should not
unnecessarily interfere with a customer's request to transfer
positions. However, FIA noted that a DCO will not have the immediate
ability to determine which positions carried in a clearing member's
omnibus account belong to a particular customer. FIA suggested that a
DCO's rules provide that the customer submit its request to transfer
its positions to the clearing member carrying the positions, not to the
DCO. FIA also suggested that the Commission revise the proposed rule to
confirm that a clearing member is required to transfer a customer's
positions only after that customer has met all contractual obligations,
including outstanding margin calls and any additional margin required
to support any remaining positions.
OCC also noted that a customer will not ask a DCO directly to
transfer a customer position. Like FIA, OCC believes that any such
transfer must be subject to all legitimate conditions or restrictions
established by the DCO in connection with its clearing of swaps.
CME stated that it fully supports the concept of applying the same
standards to transfer of customer cleared swaps as have historically
been applied to transfer of customer futures. It noted that a customer
request to transfer its account is made not to a DCO but to the FCM
that carries the customer's account.
ISDA commented that any transfer rule must provide that a party
seeking transfer not be in default to its existing clearing member.
ISDA believes that the transfer rule must take into account any cross-
cleared or cross-margined transactions and in the case where only a
portion of a customer's portfolio is transferred, clearing members must
have the ability to condition the transfer on the posting of additional
margin by the customer.
KCC commented that this rule is not necessary because KCC has never
required a futures position to be closed out and re-booked prior to
transfer from the carrying clearing member to another clearing member,
nor would KCC require a wheat calendar swap to be closed out and re-
booked prior to transfer. The Commission notes that such a requirement
has been imposed by other clearinghouses in connection with swaps.
In response to concerns raised by commenters, the Commission is
revising Sec. 39.15(d) to read as set forth in the regulatory text of
this final rule.
The language making it explicit that positions and margin be
transferred at the same time is responsive to the comments of MFA,
Citadel, and LCH and consistent with prudent risk management
procedures. The language clarifying that a customer transfer
instruction would go to a clearing member and not directly to the DCO
is responsive to the comments of FIA, OCC, and CME. The requirement
that a customer may not be in default is responsive to the comments of
FIA and ISDA and consistent with the statement in the notice of
proposed rulemaking that transfers should be subject to contractual
requirements. The requirement that positions at both clearing members
will have appropriate margin is responsive to the comments of MFA,
Citadel, and ISDA and consistent with the statement in the notice of
proposed rulemaking that transfers should be subject to contractual
requirements.
G. Core Principle G--Default Rules and Procedures--Sec. 39.16
Core Principle G,\205\ as amended by the Dodd-Frank Act, requires
each DCO to have rules and procedures designed to allow for the
efficient, fair, and safe management of events during which clearing
members become insolvent or otherwise default on their obligations to
the DCO. In addition, Core Principle G requires each DCO to clearly
state its default procedures, make its default rules publicly
available, and ensure that it may take timely action to contain losses
and liquidity pressures and to continue meeting its obligations. The
Commission proposed Sec. 39.16 to establish requirements that a DCO
would have to meet in order to comply with Core Principle G.
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\205\ Section 5b(c)(2)(G) of the CEA, 7 U.S.C. 7a-1(c)(2)(G)
(Core Principle G).
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1. General--Sec. 39.16(a)
Proposed Sec. 39.16(a) would require a DCO to adopt rules and
procedures designed to allow for the efficient, fair, and safe
management of events during which clearing members become insolvent or
default on the obligations of such clearing members to the DCO.
The Commission did not receive any comment letters discussing
proposed Sec. 39.16(a), although LCH stated that it concurs with all
the provisions set out under proposed Sec. 39.16. The Commission is
adopting Sec. 39.16(a) as proposed.
2. Default Management Plan--Sec. 39.16(b)
Proposed Sec. 39.16(b) would require a DCO to maintain a current
written default management plan that delineates the roles and
responsibilities of its board of directors, its Risk Management
Committee, any other committee that has responsibilities for default
management, and the DCO's management, in addressing a default,
including any necessary coordination with, or notification of, other
entities and regulators. The proposed regulation also would require the
default management plan to address any differences in procedures with
respect to highly liquid contracts (such as certain futures) and less
liquid contracts (such as certain swaps). In addition, proposed Sec.
39.16(b) would require a DCO to conduct and document a test of its
default management plan on at least an annual basis.
OCC agreed with the proposal for annual testing of a DCO's default
management plan, while ISDA stated that such tests should be conducted
at least on a semi-annual basis. FIA indicated that the default
management plan should be subject to frequent, periodic testing. The
Commission believes that it is appropriate and sufficient to require at
least annual testing of a DCO's default management plan. A particular
DCO could determine to test its plan on a semi-annual or other periodic
basis, in its discretion.
ISDA expressed its view that regulators should review and sign off
on the default management plans of DCOs. KCC requested that the
Commission clarify that the default management plan concepts in
proposed Sec. 39.16(b) may be satisfied by annual testing of the DCO's
existing set of default rules and procedures. The Commission does not
believe that it is necessary to adopt an explicit requirement that the
Commission review and approve a DCO's default management plan. However,
Commission staff will review a DCO's default management plan in the
context of the Commission's ongoing DCO review program, including a
determination of whether a DCO's ``existing set of default rules and
procedures'' meet the requirements of Sec. 39.16(b).
The Commission is making a technical revision to Sec. 39.16(b),
removing the parentheticals and substituting the word ``products'' for
the word ``contracts.'' The sentence now reads: ``Such plan shall
address any differences in procedures with respect
[[Page 69396]]
to highly liquid products and less liquid products.''
3. Default Procedures--Sec. 39.16(c)(1)
Proposed Sec. 39.16(c)(1) would require a DCO to adopt procedures
that would permit the DCO to take timely action to contain losses and
liquidity pressures and to continue meeting its obligations in the
event of a default on the obligations of a clearing member to the DCO.
The Commission did not receive any comment letters discussing
proposed Sec. 39.16(c)(1) and is adopting Sec. 39.16(c)(1) as
proposed.
4. Default Rules--Sec. 39.16(c)(2)
Proposed Sec. 39.16(c)(2) would require a DCO to include certain
identified procedures in its default rules. In particular, proposed
Sec. 39.16(c)(2)(i) would require a DCO to set forth its definition of
a default. Proposed Sec. 39.16(c)(2)(ii) would require a DCO to set
forth the actions that it is able to take upon a default, which must
include the prompt transfer, liquidation, or hedging of the customer or
proprietary positions of the defaulting clearing member, as applicable.
Proposed Sec. 39.16(c)(2)(ii) would further state that such procedures
could also include, in the DCO's discretion, the auctioning or
allocation of such positions to other clearing members. Proposed Sec.
39.16(c)(2)(iii) would require a DCO to include in its default rules
any obligations that the DCO imposed on its clearing members to
participate in auctions, or to accept allocations, of a defaulting
clearing member's positions, and would specifically provide that any
allocation would have to be proportional to the size of the
participating or accepting clearing member's positions at the DCO.
Proposed Sec. 39.16(c)(2)(iv) would require that a DCO's default
rules address the sequence in which the funds and assets of the
defaulting clearing member and the financial resources maintained by
the DCO would be applied in the event of a default. Proposed Sec.
39.16(c)(2)(v) would require that a DCO's default rules contain a
provision that customer margin posted by a defaulting clearing member
could not be applied in the event of a proprietary default.\206\
Proposed Sec. 39.16(c)(2)(vi) would require that a DCO's default rules
contain a provision that proprietary margins posted by a defaulting
clearing member would have to be applied in the event of a customer
default, if the relevant customer margin were insufficient to cover the
shortfall.
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\206\ This is consistent with the segregation requirements of
Section 4d of the CEA and Sec. 1.20 of the Commission's
regulations.
---------------------------------------------------------------------------
The Commission did not receive any comment letters discussing
proposed Sec. 39.16(c)(2)(i), (ii) or (iii). The Commission is
adopting Sec. 39.16(c)(2)(i) as proposed. The Commission is making
technical revisions to Sec. Sec. 39.16(c)(2)(ii), (iii), (v) and (vi),
as well as Sec. 39.16(d)(3), by replacing each use of the word
``proprietary'' with ``house.''
As discussed above in connection with participant eligibility
requirements under Sec. 39.12,\207\ the Commission is revising Sec.
39.16(c)(2)(iii) to require a DCO that imposes obligations on its
clearing members to participate in auctions or to accept allocations of
a defaulting clearing member's positions, to permit its clearing
members to outsource these obligations to qualified third parties,
subject to appropriate safeguards imposed by the DCO. The Commission
believes that it is important to permit outsourcing, while recognizing
that it is essential to limit participation only to qualified third
parties. Accordingly, a DCO's rules may impose appropriate terms and
conditions on outsourcing arrangements, addressing, for example, the
necessary qualifications to be eligible to act in the clearing member's
place and conflicts of interest issues. Thus, for example, a clearing
member could hire a qualified third party to act as its agent in an
auction. The Commission cautions, however, that any DCO imposing terms
and conditions that could indirectly deny fair and open access and
therefore are not ``appropriate,'' i.e., not supported by sound risk
management policies, may run afoul of Core Principle C and Sec. 39.12.
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\207\ See discussion in section IV.C.1.i, above.
---------------------------------------------------------------------------
The Commission is also making two additional technical revisions to
Sec. 39.16(c)(2)(iii). First, the Commission is replacing ``a
defaulting clearing member's positions'' with ``the customer or house
positions of the defaulting clearing member,'' to correct an oversight
in the proposed language. Second, the Commission is revising Sec.
39.16(c)(2)(iii)(A) to provide that any allocation shall be
``[p]roportional to the size of the participating or accepting clearing
member's positions in the same product class at the derivatives
clearing organization'' (added text in italics) to clarify the
Commission's intent.
With respect to proposed Sec. 39.16(c)(2)(iv), OCC agreed that it
would be appropriate to require DCOs to adopt rules that would define
the sequence in which the funds and assets of a defaulting clearing
member and the financial resources maintained by the DCO would be
applied in the event of a default.
Freddie Mac expressed concern with the broad discretion that would
be given to DCOs to determine the sequence in which financial resources
would be applied in the event of a clearing member default, and
recommended that DCOs should be required to place non-customer
resources (e.g., clearing member guaranty funds and their own capital)
ahead of non-defaulting customer collateral in the risk waterfall. In
particular, Freddie Mac indicated that if the Commission does not
require individual segregation of customer collateral, it should
require DCOs to place non-defaulting customers at the bottom of the
risk waterfall. Freddie Mac stated that the Commission should defer
adoption of proposed Sec. 39.16(c) until after adoption of rules
relating to customer segregation.
The Commission is adopting Sec. 39.16(c)(2)(iv) to require that a
DCO adopt rules that identify the sequence of its default waterfall, as
proposed, without imposing any substantive requirements with respect to
such sequence, as suggested by Freddie Mac. The Commission is
addressing the issue of the application of the collateral of non-
defaulting swaps customers in a separate pending rulemaking,\208\ but
does not believe that it is appropriate to defer the adoption of
proposed Sec. 39.16(c) until that rulemaking is complete.
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\208\ See 76 FR 33818 (June 9, 2011) (Protection of Cleared
Swaps Customer Contracts and Collateral; Conforming Amendments to
the Commodity Broker Bankruptcy Provisions).
---------------------------------------------------------------------------
The Commission is making a technical revision to Sec.
39.16(c)(2)(iv) by inserting ``and its customers'' after ``the funds
and assets of the defaulting clearing member'' to correct an oversight
in the proposed language.
ISDA commented that proposed Sec. 39.16(c)(2)(v), which would
require a DCO to adopt ``[a] provision that customer margin posted by a
defaulting clearing member shall not be applied in the event of a
proprietary default'' should be revised to replace the words ``in the
event of'' with ``to cover losses in respect of''; otherwise, ISDA
believed that customer margin would not be able to be applied even to
cover customer losses. The Commission agrees with ISDA and is modifying
Sec. 39.16(c)(2)(v) by replacing ``in the event of'' with ``to cover
losses with respect to'' and has made a similar modification to Sec.
39.16(c)(2)(vi).
CME recommended that the Commission replace ``proprietary
[[Page 69397]]
margins posted by a defaulting clearing member'' in Sec.
39.16(c)(2)(vi) with ``proprietary margins, positions and any other
assets in the account of the defaulting clearing member.'' CME argued
that the Commission's proposed reference to ``proprietary margins
posted by a defaulting clearing member'' is too narrow in scope, since
in the event of a clearing member default (whether originating in the
customer origin or the house origin), a DCO would likely liquidate
positions in the defaulting clearing member's house account and then
apply excess funds and not just proprietary margins to cure the
default. The Commission agrees that ``proprietary margins posted by a
defaulting clearing member'' is too narrow and is replacing the phrase
in Sec. 39.16(c)(2)(vi) with ``house funds and assets of a defaulting
clearing member.'' The Commission believes that ``house funds and
assets'' is broad enough to include ``proprietary margins, positions
and any other assets,'' as suggested by CME, and is consistent with the
language in Sec. 39.16(c)(2)(iv) and Sec. 39.15. The Commission is
similarly replacing ``customer margin posted by a defaulting clearing
member'' in Sec. 39.16(c)(2)(v) with ``the funds and assets of a
defaulting clearing member's customers'' and is replacing ``customer
margin'' in Sec. 39.16(c)(2)(vi) with ``customer funds and assets.''
ISDA commented that proposed Sec. 39.16(c)(2)(vi) should be
revised to insert the word ``excess'' immediately before the words
``proprietary margins'' to make it clear that proprietary margin is to
be applied first to cover proprietary losses, noting that the use of
proprietary margin to cover customer losses ahead of proprietary losses
would hasten the mutualization of losses among clearing members, which
would likely result in higher margin levels being imposed with respect
to customer positions in order to avoid that outcome. The Commission
agrees with ISDA and is modifying Sec. 39.16(c)(2)(vi) by inserting
``excess'' before ``house funds and assets of a defaulting clearing
member,'' as suggested by ISDA.
The Commission is adopting Sec. 39.16(c)(2) with the modifications
described above.
5. Publication of Default Rules--Sec. 39.16(c)(3)
Proposed Sec. 39.16(c)(3) would require that a DCO must make its
default rules publicly available, and would cross-reference Sec.
39.21, adopted herein, which also addresses this requirement.\209\
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\209\ See discussion of Sec. 39.21 in section IV.L, below.
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The Commission did not receive any comment letters discussing
proposed Sec. 39.16(c)(3) and is adopting Sec. 39.16(c)(3) as
proposed.
6. Insolvency of a Clearing Member--Sec. 39.16(d)
Proposed Sec. 39.16(d)(1) would require a DCO to adopt rules that
require a clearing member to provide prompt notice to the DCO if the
clearing member becomes the subject of a bankruptcy petition, a
receivership proceeding, or an equivalent proceeding, e.g., a foreign
liquidation proceeding. Proposed Sec. 39.13(d)(2) would require a DCO
to review the clearing member's continuing eligibility for clearing
membership, upon receipt of such notice. Proposed Sec. 39.16(d)(3)
would require a DCO to take any appropriate action, in its discretion,
with respect to the clearing member or its positions, including but not
limited to liquidation or transfer of positions, and suspension or
revocation of clearing membership, upon receipt of such notice.
CME recommended that, in order to preserve a DCO's right to take
appropriate steps before a clearing member files for, or is placed
into, bankruptcy, the Commission should amend proposed Sec. Sec.
39.16(d)(2) and (3) to require DCOs to take appropriate actions ``no
later than upon receipt'' of notice that the clearing member is the
subject of a bankruptcy petition or similar proceeding. The Commission
is adopting Sec. 39.16(d) with the modifications to Sec. Sec.
39.16(d)(2) and (3) suggested by CME. In addition, the Commission is
making a technical revision to Sec. 39.16(d)(3) by replacing the
phrase ``with respect to such clearing member or its positions'' with
the phrase ``with respect to such clearing member or its house or
customer positions.'' This revision eliminates possible ambiguity in
the reference to ``its positions,'' which was intended to reflect
current industry practice and include both house and customer
positions, not just house positions.
H. Core Principle H--Rule Enforcement--Sec. 39.17
Core Principle H,\210\ as amended by the Dodd-Frank Act, requires a
DCO to maintain adequate arrangements and resources for the effective
monitoring and enforcement of compliance with its rules and resolution
of disputes. It also requires a DCO to have the authority and ability
to discipline, limit, suspend, or terminate the activities of a member
or participant due to a violation by the member or participant of any
rule of the DCO. It further requires that a DCO report to the
Commission regarding rule enforcement activities and sanctions imposed
against clearing members.
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\210\ Section 5b(c)(2)(H) of the CEA, 7 U.S.C. 7a-1(c)(2)(H).
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Proposed Sec. 39.17 would codify these requirements, adding a
provision that would require a DCO to report to the Commission in
accordance with proposed Sec. 39.19(c)(4)(xiii). As proposed, Sec.
39.19(c)(4)(xiii) would require a DCO to report the initiation of a
rule enforcement action against a clearing member or the imposition of
sanctions against a clearing member, no later than two business days
after the DCO takes such action. As discussed in connection with rules
implementing Core Principle J (Reporting), the Commission is adopting
that reporting requirement with a modification that only requires a DCO
to report sanctions imposed against a clearing member.\211\
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\211\ See discussion of rule enforcement reporting in section
IV.J.5.j, below.
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The Commission received no comments on proposed Sec. 39.17. The
Commission is adopting Sec. 39.17 as proposed, but with a change to
the cross-reference to Sec. 39.19(c)(4)(xiii) in Sec. 39.17(a)(3) to
reflect the redesignation of that provision as Sec.
39.19(c)(4)(xi).\212\
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\212\ See id. (The Commission is adopting Sec.
39.19(c)(4)(xiii) as a renumbered Sec. 39.19(c)(4)(xi)).
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I. Core Principle I--System Safeguards--Sec. 39.18
Core Principle I,\213\ as amended by the Dodd-Frank Act, requires a
DCO to establish and maintain a program of risk analysis and oversight
that identifies and minimizes sources of operational risk through the
development of appropriate controls and procedures, and automated
systems that are reliable, secure and have adequate scalable capacity.
Core Principle I also requires that the emergency procedures, back-up
facilities, and disaster recovery plans that a DCO is obligated to
establish and maintain specifically allow for the timely recovery and
resumption of the DCO's operations and the fulfillment of each
obligation and responsibility of the DCO. Finally, Core Principle I
requires that a DCO periodically conduct tests to verify that the DCO's
back-up resources are sufficient to ensure daily processing, clearing,
and settlement.
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\213\ Section 5b(c)(2)(I) of the CEA, 7 U.S.C. 7a-1(c)(2)(I).
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Proposed Sec. 39.18 would codify the obligations contained in Core
Principle I and delineate the minimum requirements that a DCO would be
required to satisfy in order to comply with Core Principle I. Proposed
Sec. 39.18 also would define the terms ``relevant
[[Page 69398]]
area,'' ``recovery time objective,'' and ``wide-scale disruption'' for
purposes of that section.
The Commission received one general comment from LCH. LCH generally
``concurred with all the provisions set out under proposed rule
39.18,'' but urged the Commission to align these provisions with the
CPSS-IOSCO standards, and to phase in such standards.
As discussed below, the Commission received comments on proposed
Sec. Sec. 39.18 (h), (j), and (k), and proposed Sec. 39.30(a).
The Commission did not receive any comments specifically related to
the definitions contained in proposed Sec. 39.18(a); proposed
Sec. Sec. 39.18(b),(c) and (d), which would address the required
program of risk analysis and oversight; proposed Sec. 39.18(e), which
would require a DCO to have a business continuity and disaster recovery
(BC-DR) plan and resources sufficient to enable the DCO to resume daily
processing, clearing and settlement no later than the next business day
following a disruption; proposed Sec. 39.18(f), which would address
outsourcing by a DCO of resources required to meet its responsibilities
with respect to business continuity and disaster recovery plans;
proposed Sec. 39.18(g), which would delineate certain exceptional
events upon the occurrence of which a DCO would be obligated to notify
promptly the Commission's Division of Clearing and Risk; proposed Sec.
39.18(h)(1), which would require a DCO to provide timely advance notice
to the Division of Clearing and Risk of certain planned changes to
automated systems; or proposed Sec. 39.18(i), which would set forth
certain records that a DCO would be required to maintain. The
Commission is adopting each of these provisions as proposed, except
that the Commission is replacing ``contracts'' with ``products'' in
Sec. 39.18(a) and is adding ``of the derivatives clearing
organization's'' before ``own and outsourced resources'' in Sec.
39.18(f)(2)(ii) for clarification.
1. Notice of Changes to Program of Risk Analysis and Oversight--Sec.
39.18(h)(2)
Proposed Sec. 39.18(h)(2) would require a DCO to give Division of
Clearing and Risk staff ``timely advance notice'' of ``planned changes
to the DCO's program of risk analysis and oversight.'' CME commented
that this is an ``extraordinarily broad requirement'' and urged the
Commission to ``appropriately consider[] context and relative risks.''
The Commission is adopting Sec. 39.18(h)(2) as proposed. The
provision merely requires that DCOs submit such notice as part of their
planning process. The Commission expects that staff will evaluate
compliance with this provision, as with all other provisions, giving
appropriate consideration to context and relative risks.
2. Testing--Sec. 39.18(j)
Proposed Sec. 39.18(j) would set forth the requirements for the
testing that a DCO must conduct of its automated systems and BC-DR
plans. Proposed Sec. 39.18(j)(1) would require that DCOs conduct
regular, periodic, and objective testing and review of (i) their
automated systems, to ensure that such systems are reliable, secure,
and have adequate scalable capacity, and (ii) their BC-DR capabilities,
to ensure that the DCO's backup resources meet the standards set forth
in proposed Sec. 39.18(e). Proposed Sec. 39.18(j)(2) would require
that these tests ``be conducted by qualified, independent professionals
* * * [who] may be independent contractors or employees [of the DCO]
but shall not be persons responsible for development or operation of
the capabilities being tested.'' Proposed Sec. 39.18(j)(3) would
require that reports setting forth the protocols for, and the results
of, such tests ``be communicated to, and reviewed by, senior management
of the [DCO]'' and that ``[p]rotocols of tests which result in few or
no exceptions shall be subject to more searching review.''
ICE, OCC, and MGEX objected to the obligation that the testing
required by Sec. 39.18(j) be performed by ``qualified, independent
professionals.'' ICE contended that the proper standard should be to
have qualified, independent professionals review, rather than conduct
testing of, systems or capabilities. Similarly, OCC suggested that the
testing could be overseen, rather than conducted, by an independent
professional. MGEX objected more generally to the requirement that
tests of its BC-DR capabilities be performed by ``independent
professionals'' and expressly objected to the proposal's prohibition on
the use of any employees who participated in the development or the
operation of the systems or capabilities being tested to fulfill this
role. MGEX argued that such persons are the most qualified persons to
run the tests. KCC requested that a DCO's CRO or other similar official
qualify as an `independent professional' for purposes of the testing
rule.
The Commission is adopting Sec. 39.18(j) as proposed. The
Commission notes that the obligation that the required testing of
automated systems and BC-DR capabilities be performed by qualified,
independent professionals is consistent with the Commission's
historical practice of requiring independent testing of systems where
appropriate.\214\
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\214\ For example, paragraph (a)(2) of the application guidance
to Core Principle 9 (prior to amendment by the Dodd-Frank Act) for
contract markets noted that ``Any program of independent testing and
review of [an automated] system should be performed by a qualified,
independent professional.'' 17 CFR part 38, appendix B at Core
Principle 9, paragraph (a)(2).
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The Commission recognizes that persons charged with developing or
operating a system are frequently called upon to test that system. The
Commission believes, however, that the active involvement and direction
of qualified, independent professionals in the testing process is
needed to ensure objective and accurate results.
MGEX's requested approach would result in tests being conducted
only by persons with an inherent conflict of interest (because negative
results of the tests might call into question the work of those who
developed or operate the systems) and, separately, would deny the DCO
the benefit of an independent analysis of the workings of the system.
Accordingly, while some testing of a DCO's automated systems and BC-DR
capabilities may be conducted by persons who design or operate such
system or capabilities, the Commission has decided to retain the
requirement that the objective testing performed to satisfy Sec.
39.18(j) must be conducted by qualified, independent persons, as
defined therein. While a DCO's CRO may appropriately serve this
function if he or she has the appropriate training and experience to be
``qualified'' in this context, and the appropriate role in the
organization to be ``independent,'' the Commission does not believe it
would be advisable to determine that the person serving in such a role
is necessarily qualified and independent.
3. Coordination of BC-DR Plans With Members and Providers of Essential
Services--Sec. 39.18(k)
Proposed Sec. 39.18(k) would require that a DCO to the extent
practicable: (1) Coordinate its BC-DR plan with those of its clearing
members, in a manner adequate to enable effective resumption of daily
processing, clearing, and settlement following a disruption; (2)
initiate and coordinate periodic, synchronized testing of its BC-DR
plans and the plans of its clearing members; and (3) ensure that its
BC-DR plan takes into account the plans of its providers
[[Page 69399]]
of essential services, including telecommunications, power, and water.
MGEX proposed that industry-sponsored events should suffice to
satisfy the requirement that a DCO must coordinate its BC-DR plan with
those of its members. Similarly, KCC requested that the Commission
clarify that coordination would be deemed to be satisfied if the DCO
reviews the BC-DR plans of its clearing members and essential service
providers and subsequently provides to such parties the DCO's own BC-DR
plan. KCC stated that it does not believe that coordination should
involve extensive efforts at achieving specific consistency between the
procedures of each party, as each has a distinct business model that
faces varying operational risks.
NYPC objected to the requirement contained in proposed Sec.
39.18(k)(3). NYPC noted that its business continuity plan (BCP) would
be invoked any time a service provider ceases to provide an essential
service, regardless of whether that service provider has invoked its
own BCP, and thus such information would not necessarily give DCOs any
additional insight into their own BCP. Similarly, CME noted that, while
it obtains representations that its major vendors have disaster
recovery plans, CME does not control, or generally have access to, the
details of the proprietary plans of those service providers.
The Commission is adopting Sec. 39.18(k) as proposed. With respect
to the requirements of Sec. Sec. 39.18(k)(1) and (2), the Commission
recognizes that participation in industry-sponsored events, such as the
annual testing conducted by FIA, serves as an important assessment of
the connectivity between the systems of DCOs and their members
(including backup sites), but such participation would not, in and of
itself, satisfy the requirements of these regulations. The level of
participation of a particular DCO in a particular industry test is left
to the discretion of the DCO, and different DCOs may participate in
such tests to different extents. Moreover, while such industry-
sponsored events may be helpful, it is the responsibility of each DCO--
not that of an industry organization--to ensure that the functionality
of clearing will be maintained between the DCO and its members. The
Commission believes that a DCO will best be able to meet its
responsibilities reliably in a wide-area disaster that affects a DCO
and its clearing members if the DCO has actively worked together with
those clearing members to coordinate their plans and has obtained some
evidence that such plans will appropriately mesh when implemented.
While it is true that a DCO should have backup arrangements that
promptly can be engaged to address a failure of essential services, it
is likely that most DCOs will prepare for a temporary, rather than an
indefinite, loss of such services. Among the benefits provided by
coordination of a DCO's BCP with that of providers of essential
services is an insight into the period of time for which the DCO should
be prepared to provide such services itself.
The Commission recognizes that a service provider may reasonably be
reluctant to provide sensitive details of its own BCP, such as the
precise location of backup facilities, and notes that the proposed
requirement is prefaced with the limitation that a DCO is required to
obtain this information only ``to the extent practicable.''
Nonetheless, merely obtaining a representation that states that a
service provider has a backup plan--with no detail as to the Recovery
Time Objective (RTO) of that service provider, and no insight into how
that service provider's BCP might affect the BCP of the DCO--would
likely be insufficient.
4. Recovery Time Objective--Sec. 39.18(a)
Proposed Sec. 39.18(a) would define an RTO as the period within
which an entity should be able to achieve recovery and resumption of
clearing and settlement of existing and new contracts after those
capabilities become temporarily inoperable for any reason up to a wide-
scale disruption, and defines a wide-scale disruption as an event that
causes a severe disruption or destruction of transportation,
telecommunications, power, water or other critical infrastructure
components in a relevant area, or an event that results in an
evacuation or unavailability of the population in a relevant area.
Proposed Sec. 39.18(e)(3) would require that a DCO have an RTO of the
next business day, while proposed Sec. 39.30(a) would require that a
SIDCO have an RTO of two hours.
ICE noted that proposed Sec. 39.18(a) does not specify a minimum
time that a wide-scale disruption must be accommodated, and that costs
would be higher if the unavailability of staff in the relevant area
that must be accommodated is the total loss of personnel. ICE suggested
that one week would allow relocation of personnel outside the affected
area.
The Commission is adopting Sec. Sec. 39.18(a) and 39.18(e)(3) as
proposed. However, as discussed above in connection with the financial
resources requirements, the Commission believes that it would be
premature to take action regarding Sec. 39.30 at this time. The
Commission will consider the proposals relating to SIDCOs together in
the future.
J. Core Principle J--Reporting Requirements--Sec. 39.19
Core Principle J,\215\ as amended by the Dodd-Frank Act, requires a
DCO to provide the Commission with all information that the Commission
determines to be necessary to conduct oversight of the DCO. The
Commission proposed Sec. 39.19 to establish requirements that a DCO
would have to meet in order to comply with Core Principle J. Under
proposed Sec. 39.19, certain reports would have to be made by a DCO to
the Commission: (1) On a periodic basis (daily, quarterly, or
annually), (2) where the reporting requirement is triggered by the
occurrence of a significant event; and (3) upon request by the
Commission. Section 39.19(a) states the general requirement of Core
Principle J. The Commission did not receive any comment letters
discussing Sec. 39.19(a) and is adopting the provision as proposed.
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\215\ Section 5b(c)(2)(J) of the CEA, 7 U.S.C. 7a-1(c)(2)(J).
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1. Submission of Reports--Sec. 39.19(b)
The Commission proposed Sec. 39.19(b) to establish procedural
requirements for electronic submission of reports and determination of
time zones applicable to filing deadlines. The Commission received no
comments and is adopting Sec. Sec. 39.19(b)(1) and (2) as proposed.
For purposes of clarification, the Commission is also adopting Sec.
39.19(b)(3) to provide a definition of ``business day'' as ``the
intraday period of time starting at the business hour of 8:15 a.m. and
ending at the business hour of 4:45 p.m., on all days except Saturdays,
Sundays, and Federal holidays.'' This is consistent with the definition
of ``business day'' set forth in Sec. 40.1(a).\216\
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\216\ See 76 FR at 44790 (July 27, 2011) (Provisions Common to
Registered Entities; final rule).
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2. Daily Reporting--Sec. 39.19(c)(1)
Proposed Sec. 39.19(c)(1) would require a DCO to submit daily
reports with certain initial margin and variation margin data as well
as other cash flows for each clearing member. More specifically, Sec.
39.19(c)(1)(i) would require a DCO to report both the initial margin
requirement for each clearing member, by customer origin and house
origin, and the initial margin on deposit for each clearing member, by
origin.
[[Page 69400]]
Proposed Sec. 39.19(c)(1)(ii) would require a DCO to report the daily
variation margin collected and paid by the DCO, listing the mark-to-
market amount collected from or paid to each clearing member, by
origin.\217\
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\217\ This requirement would apply to options transactions only
to the extent a DCO uses futures-style margining for options.
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Proposed Sec. 39.19(c)(1)(iii) would require a DCO to report all
other cash flows relating to clearing and settlement including, but not
limited to, option premiums and payments related to swaps such as
coupon amounts, collected from or paid to each clearing member, by
origin. Proposed Sec. 39.19(c)(1)(iv) would require a DCO to report
the end-of-day positions for each clearing member, by customer origin
and house origin.
In addition, as discussed in section IV.D.6.h.(2), above, in
connection with the Commission's proposal to require DCOs to collect
initial margin for customer accounts on a gross basis under proposed
Sec. 39.13(g)(8)(i), the Commission further proposed an addition to
proposed Sec. 39.19(c)(1)(iv) that would also require DCOs to report,
for each clearing member's customer account, the end-of-day positions
of each beneficial owner. The Commission is adopting Sec. 39.19(c)(1)
with two modifications. First, the Commission is not requiring
reporting of customer positions by beneficial owner, except upon
Commission request.\218\ Second, as discussed below, the Commission is
renumbering the paragraphs in Sec. 39.19(c)(1) and adding a new
paragraph (ii) to clarify the applicability of the daily reporting
requirements to FCM/BDs. In addition, the Commission is replacing ``by
customer origin and house origin'' with ``by house origin and by each
customer origin''; and is replacing ``options on futures positions''
with ``options positions.''
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\218\ See further discussion of reports of beneficial ownership
in section IV.D.6.h.(2), above.
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MGEX and KCC commented that while such information is available to
them,\219\ they are concerned that if the Commission mandates a
specific form of delivery, the cost to DCOs will be significantly
higher than expected. MGEX referred to its recent experience with the
Trade Capture Reporting initiative conversion to the Commission's new
FIXML standards, which was more costly and time consuming than
expected. KCC commented that all of the data proposed to be reported to
the Commission is already made readily available to the Commission in
varying degrees, and there is little need for the Commission to require
the increasing level of detailed information in specified formats. In
addition, MGEX expressed concern with the Commission's potential data
storage capacity limitations. MGEX concluded that the combination of
these two factors suggest that the burden of the daily reporting
requirements on DCOs and the Commission outweigh the value of these
reports.
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\219\ MGEX noted that it is already ``internally performing
these tasks'' in reference to the several daily reporting
requirements. KCC has also noted that it already submits trading
activity and positions by each clearing member by origin on a daily
basis in file formats prescribed by the Commission.
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MGEX suggested that requiring such data on an as-needed, rather
than a daily, basis would limit the burden on DCOs and the Commission
while ensuring relevancy as to the data being requested. KCC asked that
the Commission reconsider the amount and detail of information
necessary for its oversight role. While CME supported the proposed
reporting requirement, it suggested that the Commission work with DCOs
to determine the form and manner of delivery.
As mentioned in the notice of proposed rulemaking, many DCOs
already provide the Commission with much of the data required under
this provision. The Commission recognizes that the daily reporting
requirements may place an additional burden on a DCO, particularly if
the DCO must employ a specific form of delivery that it does not
already have in place. However, establishment of an automated reporting
system is a one-time cost, and a uniform reporting format for all DCOs
is necessary to facilitate the Commission's ability to receive data
promptly and quickly disseminate it within the agency.\220\
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\220\ The Commission notes that its staff is in the process of
developing a plan for uniform submission of DCO reports.
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The overall purpose of receiving the daily data is to enable
Commission staff to analyze the data on a regular basis so that it can
detect certain trends or unusual activity on a timely basis. Receiving
such data less frequently would significantly reduce its usefulness.
While there may be initial costs for DCOs to set up the reporting
systems, there should be little cost to DCOs on a continuing
basis.\221\ Finally, MGEX's suggestion to require such data on an as-
needed basis does not further the objective of enhanced risk
surveillance, given that the purpose of gathering the data is to
identify and address potential problems at the earliest possible time.
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\221\ See further discussion of the costs and benefits of the
reporting requirements in section VII.J, below.
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OCC expressed concern that the reporting requirements make no
accommodation for clearing members that are FCM/BDs, with respect to
their securities positions. In response to OCC's comment, the
Commission is adding a new paragraph (ii) to Sec. 39.19(c)(1) to
clarify the limited applicability of the daily reporting requirements
to securities positions. The final rule provides that ``The report
shall contain the information required by paragraph (c)(1)(i) of this
section for (A) all futures positions, and options on futures
positions, as applicable; (B) all swaps positions; and (C) all
securities positions that are held in a customer account subject to
Section 4d of the Act or are subject to a cross-margining agreement.''
3. Quarterly Reporting--Sec. 39.19(c)(2)
The Commission is adopting Sec. 39.19(c)(2), requirements for
quarterly reporting of financial resources, as proposed.\222\
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\222\ See further discussion of the quarterly reporting
requirement under Sec. 39.11(f) in section IV.B.10, above.
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4. Annual Reporting--Sec. 39.19(c)(3)
Proposed Sec. 39.19(c)(3) would require a DCO to submit a report
of the CCO and an audited financial statement annually, as required by
Sec. 39.10(c). The Commission received no comments on proposed Sec.
39.19(c)(3), and the Commission is adopting Sec. 39.19(c)(3) as
proposed.
The Commission notes that in a separate proposed rulemaking
implementing Core Principle O (Governance Fitness Standards), it
proposed a new Sec. 39.24(b)(4) which would require annual
verification that directors, members of the disciplinary panel and
disciplinary committee, clearing members, persons with direct access,
and certain affiliates of a DCO, satisfy applicable fitness
standards.\223\ In connection with this, the Commission subsequently
proposed to cross-reference this annual reporting obligation as a
renumbered Sec. 39.19(c)(3)(iii). At such time as the Commission may
adopt the verification requirement as a final rule, Sec. 39.19(c)(3)
will be amended accordingly.
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\223\ See 76 FR at 736 (Jan. 6, 2011) (Governance).
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5. Event-Specific Reporting--Sec. 39.19(c)(4)
a. Decrease in Financial Resources--Sec. 39.19(c)(4)(i)
Under proposed Sec. 39.19(c)(4)(i), a DCO would be required to
report to the
[[Page 69401]]
Commission a 10 percent decrease in the total value of the financial
resources required to be maintained by the DCO under Sec. 39.11(a),
either from the last quarterly report. or from the value as of the
close of the previous business day. Such notification would alert the
Commission of potential strain on the DCO's financial resources, either
gradual or precipitous.
The Commission invited comments regarding possible alternatives as
to what would be considered a significant drop in the value of
financial resources. Although many commenters opposed using the 10
percent threshold as a barometer for a ``significant'' decrease, no
commenter questioned the Commission's objective in obtaining this type
of information in a timely manner.
MGEX commented that 10 percent is an arbitrary threshold and it is
not uncommon for financial resources to fluctuate by 10 percent even in
a stable market. Similarly, OCC and KCC stated that the threshold is
arbitrary and would most likely be crossed on a frequent basis during
the ordinary course of business.\224\ In addition, KCC suggested that
this requirement is duplicative, as a material drop in financial
resources would already be required to be reported by the proposed
requirement to report all material adverse changes (Material Adverse
Change Reporting Requirement).\225\
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\224\ KCC mentioned that changes in the level of excess
permanent margin deposited by clearing members, changes in the
minimum margin requirements on contracts or in the level of the
guarantee pool requirements, and changes in the level of assessments
that can be levied against clearing members in the event of a
default, could cause financial resources to drop more than 10
percent within the ordinary course of business. OCC stated it would
cross the 10 percent threshold on an almost monthly basis, i.e., the
day after monthly expirations occur.
\225\ See discussion of proposed Sec. 39.19(c)(4)(xiv)
(finalized as Sec. 39.19(c)(4)(xii)) in section IV.J.5.k, below.
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OCC, Better Markets, and Mr. Barnard were also concerned about the
types of financial resources to consider when calculating a decrease.
OCC suggested it is counterproductive to report a decrease in financial
resources as a result of a decrease in margin requirements, which is a
sign of risk reduction. Similarly, Better Markets suggested that
coincidental increases in margin-based financial resources, which could
fluctuate substantially, could offset decreases by more important
financial resources. In addition, Mr. Barnard raised concerns
regarding: (1) Grouping all types of financial resources together for
purposes of calculating decreases, and (2) whether only requiring a
report of a decrease in financial resources is sufficient.
Several commenters proposed using a different threshold: (1) OCC
suggested 25 percent; (2) MGEX suggested allowing a DCO to determine
what constitutes a material decrease or, as an alternative, adopting a
threshold of 30 percent over a five-day period and 25 percent when
compared to the previous quarter; and (3) Better Markets suggested
adopting a threshold of 5 percent of non-margin-based financial
resources. NYPC recommended taking an approach similar to the FCM
``early warning'' reporting requirement.\226\
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\226\ Section 1.12(b)(2) requires an FCM to give 24 hours notice
to the Commission if it ``knows or should have known'' that its
adjusted net capital is at any time less than 110 percent of the
amount required by the Commission's net capital rule.
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To compensate for an upwards adjustment of the financial resources
requirement, Better Markets suggested also requiring a report if the
ratio of financial resources to minimum required levels decreases to 1
to 1. Mr. Barnard suggested splitting financial resources into two
groups: (1) The more ``robust'' financial resources (a DCO's own
capital and guaranty fund), and (2) market or risk-related items
(margins); and requiring a report for a decrease in either amount or a
decrease in the total of both amounts. Mr. Barnard also suggested
requiring a DCO to report a calculation of its ``solvency ratio''
(available financial resources/financial resources requirements) and a
5 percent or more drop in such ratio.
In response to commenters' objections to setting the level at 10
percent, the Commission is setting the reporting threshold at a level
of 25 percent for both the daily and quarterly financial resources
decreases. As noted, OCC suggested 25 percent while MGEX suggested 25
percent for the quarterly and 30 percent for a report covering any 5-
day period. MGEX did not explain why there should be a distinction
between the percentage decrease triggering the quarterly and shorter-
term reports. The Commission believes that a 25 percent level addresses
the commenters' concerns about ``noise'' while providing the Commission
with notification of material decreases.
The Commission is not excluding certain financial resources from
the decrease calculation as suggested by several commenters. Although
there are certain financial resources that may fluctuate in the
ordinary course of business, the Commission believes that setting the
reporting threshold level higher should resolve many of these issues
because fewer fluctuations that occur in the ordinary course of
business would trigger the higher 25 percent threshold. Additionally,
the purpose of the financial resources requirement in Core Principle B
and as codified in the Commission's regulations is to ensure that a DCO
has adequate resources to cover the default of the clearing member with
the largest exposure. Financial resources are looked at in the
aggregate. Thus, fluctuations during the ordinary course of business,
even coincidental decreases in financial resources, all reflect the
financial health of the DCO at that time.
The Commission is not replacing the financial resources percentage
decrease reporting requirement with a requirement similar to the FCM
``early warning'' reporting requirement, as suggested by NYPC. While
FCMs do have an ``early warning'' reporting requirement, this is only
in addition to an FCM's requirement to also report decreases of 20
percent pursuant to Sec. 1.12(g)(1).\227\ In fact, even with the new
financial resources reporting requirement for DCOs, DCOs still have a
lesser reporting requirement than FCMs in this regard: DCOs are only
required to report 25 percent decreases, while FCMs are required to
report 20 percent decreases in addition to reporting decreases below
certain thresholds (the ``early warning'' requirement).
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\227\ Section 1.12(g)(1) requires an FCM to provide written
notice within two business days of a substantial reduction in
capital as compared to that last reported in a financial report if
there is a reduction in net capital of 20 percent or more.
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The Commission is adopting the modified Sec. 39.19(c)(4)(i)
reporting requirement described herein. The Commission does not
consider it to be duplicative of the Material Adverse Change Reporting
Requirement, or the quarterly financial resource reporting requirement
under Sec. 39.11(f), as suggested by KCC. Each reporting requirement,
including the financial resources reporting requirement, relates to
specific circumstances that the Commission has determined to be
material and which, based on its experience in conducting financial
risk surveillance, the Commission believes warrants notification. The
Material Adverse Change Reporting Requirement is intended to cover more
unusual changes that are not readily identifiable in advance but would
nonetheless be of interest to Commission staff in conducting its
oversight of a DCO. The Commission is also not requiring the solvency
ratio decrease reporting requirement suggested by Mr. Barnard. The
Commission believes that receiving reports regarding financial
resources decreases will serve the purpose of alerting the Commission
to possible financial distress at a DCO, without
[[Page 69402]]
unnecessarily burdening a DCO with additional reporting requirements.
NYPC pointed out that the proposed rule language referring to a
decrease in the ``total value of financial resources'' could be read to
refer to the total combined default and operating resources. It also
raised a question as to whether the reference to financial resources
``required to be maintained * * * under Sec. 39.11(a)'' referred to
the minimum amount ``required'' or if it was intended to encompass all
financial resources ``available to satisfy'' the requirements.
The Commission intends the reporting requirement in Sec.
39.19(c)(4)(i) to refer only to financial resources available to cover
a default in accordance with Sec. 39.11(a)(1). A significant change in
the amount of financial resources available to meet operating expenses
is addressed by Sec. 39.19(c)(4)(iv).\228\ In response to the
interpretive issues raised by NYPC, the Commission is revising the
language in Sec. 39.19(c)(4)(i) to clarify that the decrease in
financial resources refers to a decrease in resources ``available to
satisfy the requirements under Sec. 39.11(a)(1)'' so it is clear that
the reporting requirement applies only to default resources and refers
to those resources available to the DCO to satisfy the default resource
requirements, even if the amount of those resources exceeds the minimum
amount that is required by Sec. 39.11(a)(1).\229\
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\228\ See discussion of Sec. 39.19(c)(4)(iv) in section
IV.J.5.d, below.
\229\ As a technical matter, ICE Clear sought clarification in
the rule text regarding the reference to Sec. 39.11(a), pointing
out that Sec. 39.11(a) sets the standard for financial resources
and Sec. 39.11(b) lists the financial resources available to
satisfy those standards. ICE Clear recommended that Sec.
39.19(c)(4)(i) be revised to refer to both Sec. Sec. 39.11(a) and
(b). The Commission declines to include a reference to Sec.
39.11(b) as the purpose of the cross-reference is to incorporate by
reference the standard, not the means for satisfying the standard.
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The Commission notes that it should be apprised when a DCO
experiences a 25 percent decrease in the value of its default resources
from the value as of the close of the previous business day, even if
their value has increased substantially since the last quarterly
report. Such a change could signal a significant change in a DCO's risk
profile and early reporting will enable the Commission to take
appropriate measures to facilitate proper risk management at the DCO.
b. Decrease in Ownership Equity--Sec. 39.19(c)(4)(ii)
Proposed Sec. 39.19(c)(4)(ii) would require a DCO to report an
expected 20 percent decrease in ownership equity two business days
prior to the event (or two business days following the event, if the
DCO does not and reasonably should not have known prior to the event).
Such report must include pro forma financial statements (or current
financial statements) reflecting the anticipated condition of the DCO
following the decrease (or current condition). The report is intended
to alert the Commission of major planned events that would
significantly affect ownership equity, most of which are events of
which the DCO would have advance knowledge, such as a reinvestment of
capital, dividend payment, or a major acquisition.
Better Markets commented that a decrease in ownership equity is an
extraordinary event which would warrant notification for even a 5
percent decrease, the threshold the SEC uses for triggering reporting
of acquisition of beneficial ownership of a class of shares. While a
decrease in ownership equity can have a significant effect on the
financial resources of a DCO, the Commission determined that 20 percent
is a level that would represent a significant decrease and yet would
not occur on a frequent basis. The Commission believes that setting the
threshold lower than 20 percent would unnecessarily increase the
potential burden on DCOs as well as on the Commission, which could then
be responsible for reviewing a larger number of reports.
Better Markets also suggested that five business days advance
notice is more appropriate and would not pose a significant burden for
DCOs. While changing the requirement to five business days does not
itself pose an additional burden on a DCO, the Commission is adopting
the two-day notification requirement, as proposed. The Commission has
determined that requiring the report two days prior to such an event is
sufficient for its purposes in reviewing the transaction, particularly
given the confidential nature of such a transaction.
OCC expressed concern that it would be problematic to provide the
necessary financial statements within the time frame required; OCC
stated that it runs financial statements on a monthly basis, thus it
would not have them readily available within two days. Rather, OCC
suggested keeping the notification time frame at two days, but allowing
up to 30 days, or when the financial statements are ready, whichever
occurs first, to provide the financial statements. The Commission is
adopting the two-day requirement, as proposed. A 20 percent decrease in
ownership equity is generally a major, planned event and the Commission
believes it would be highly unusual for a DCO not to have financial
statements prepared in connection with such a transaction.
The Commission is adopting Sec. 39.19(c)(4)(ii) as proposed.
c. Six-Month Liquid Asset Test--Sec. 39.19(c)(4)(iii)
Proposed Sec. 39.19(c)(4)(iii) would require immediate notice of a
deficit in the six months of liquid assets required by Sec.
39.11(e)(2). CME expressed concern with other ``immediate notice''
events,\230\ stating that this would require a DCO to immediately
notify the Commission, in the specific form and manner requested, even
before the DCO attends to the situation and gathers all the relevant
information. CME recommended only requiring ``prompt'' notice, which
would require the DCO to notify the Commission ``quickly and
expeditiously,'' while allowing the DCO to first attend to the
situation at hand and ensure that the information reported to the
Commission is correct and accurate. CME also suggested ``prompt''
notice for the Material Adverse Change Reporting Requirement.
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\230\ CME referred to the immediate notice required under
proposed Sec. Sec. 39.19(c)(4)(v)-(ix).
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The Commission is adopting the rule as proposed and retaining the
``immediate'' reporting requirement for both Sec. 39.19(c)(4)(iii) and
the Material Adverse Change Reporting Requirement.\231\ While the
Commission appreciates that in such situations a DCO would be busy
attending to the matter at hand, the burden to contact the Commission
is minimal. The Commission does not specify a particular form or manner
of delivery, so as to minimize the burden on the DCO. Moreover, the
Commission is concerned that using a time frame of ``prompt'' would
leave too much open to interpretation by the DCO and could lead to
untimely notices.
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\231\ See further discussion of the Material Adverse Change
Reporting Requirement in section IV.J.5.k, below.
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d. Change in Working Capital (Current Assets)--Sec. 39.19(c)(4)(iv)
Proposed Sec. 39.19(c)(4)(iv) would require a DCO to report to the
Commission no later than two business days after working capital is
negative. The report must include a current balance sheet of the DCO.
Better Markets commented that allowing a DCO two days to report
negative working capital is too much time, given the potential gravity
of the situation, and that anything less than a requirement of
immediate notification is ``simply indefensible.''
[[Page 69403]]
As with the ownership equity decrease reporting requirement, OCC
commented that it is problematic to submit a balance sheet in two
business days. OCC suggested keeping the notification requirement at
two days, but allowing up to 30 days (or sooner if ready) to provide a
balance sheet.
The Commission is adopting Sec. 39.19(c)(4)(iv) as proposed,
except that it is revising certain terminology to clarify the intended
meaning of the term ``working capital.'' While the Commission agrees
that negative working capital is a serious matter, immediate reporting
is not necessary to further the Commission's purpose in obtaining this
information. The Commission is allowing up to two days for notification
because immediate notification would require a DCO to put in place a
potentially expensive system to allow for real-time tracking of working
capital. Nonetheless, a DCO is expected to have a general knowledge of
the level of its working capital at all times. By allowing two days for
notification, a DCO will have time to compute whether working capital
is negative if it has reason to believe that this may be the case,
without being required to implement a real-time notification system.
Thus, the purpose of the two business days is actually to give a DCO
time to become aware of its obligation to report, not to allow the DCO
to wait two days after it becomes aware of the situation.
The Commission is also requiring the DCO to submit a balance sheet
within two business days of the DCO experiencing negative working
capital. Given that a DCO would be expected to update its balance sheet
upon realizing that it has negative working capital, the Commission
does not believe this requirement imposes an additional burden on the
DCO.
As ``working capital'' is not a defined term, the Commission is
substituting the term ``current assets'' for ``working capital'' for
purposes of clarification. Thus, ``negative working capital'' now
refers to a situation when current liabilities exceed current assets.
Section 39.19(c)(4)(iv) now reads as follows: ``Change in current
assets. No later than two business days after current liabilities
exceed current assets; the notice shall include a balance sheet that
reflects the derivatives clearing organization's current assets and
current liabilities and an explanation as to the reason for the
negative balance.''
e. Intraday Initial Margin Calls--Sec. 39.19(c)(4)(v)
Proposed Sec. 39.19(c)(4)(v) would require a DCO to report to the
Commission any intraday margin call to a clearing member, no later than
one hour following the margin call. Several commenters stated that the
requirement is unnecessary and a burden on DCOs, while other commenters
requested certain modifications to the proposal.
The Commission is not adopting the intraday margin call reporting
requirement in proposed Sec. 39.19(c)(4)(v). While such information
could provide early notice of potential problems at a DCO, the
Commission has concluded that the requirement would be overly
burdensome to DCOs given the amount of work commenters indicated it
would entail. In addition, the Commission will still receive much of
the same information as part of each DCO's daily reporting under Sec.
39.19(c)(1), and unusual intraday initial margin calls that reflect a
material adverse change will still be reported under the Material
Adverse Change Reporting Requirement.
f. Issues Related to Clearing Members--Sec. Sec. 39.19(c)(4)(vi)-(ix)
Proposed Sec. Sec. 39.19(c)(4)(vi)-(ix) would require a DCO to
report the following issues related to clearing members: (1) A delay in
collection of initial margin; (2) a request to clearing members to
reduce positions; (3) a determination by the DCO to transfer or
liquidate a clearing member position; and (4) a default of a clearing
member. The Commission received comments suggesting that these
reporting requirements are unnecessary or, at the very least, require
some modification. KCC suggested not adopting these requirements
altogether, because notification of these events would still be
required under the Material Adverse Change Reporting Requirement.
The Commission has concluded that delays in the collection of
initial margin are not necessarily signs of a financial problem at
either the DCO or its clearing members. The Commission therefore is not
adopting the requirement to report such delays under proposed Sec.
39.19(c)(4)(vi). Nonetheless, if a delay is evidence of a material
adverse change in the financial condition of a clearing member, it
would still have to be reported under the Material Adverse Change
Reporting Requirement.
The Commission is adopting the remainder of these reporting
requirements as proposed. However, it is redesignating proposed
Sec. Sec. 39.19(c)(4)(vii)-(ix) as Sec. Sec. 39.19(c)(4)(v)-(vii).
These reporting requirements relate to events that occur infrequently
but can be of significance to the Commission's risk surveillance
program even if they do not rise to the level of having ``a material
adverse financial impact'' on the DCO or represent ``a material adverse
change in the financial condition of any clearing member'' under the
Material Adverse Change Reporting Requirement. Thus, with respect to
these reports, the Commission is not relying on the Material Adverse
Change Reporting Requirement as suggested by KCC.
In connection with these proposed requirements, the Commission also
proposed removing Sec. 1.12(f)(1) in light of the fact that its
requirements were substantially similar to those being proposed as
Sec. 39.19(c)(4)(viii). The Commission did not receive any comments on
this proposal and is removing Sec. 1.12(f)(1) as proposed.
g. Change in Ownership or Corporate or Organizational Structure--Sec.
39.19(c)(4)(x)
Proposed Sec. 39.19(c)(4)(x) would require a DCO to report certain
changes in ownership or corporate or organizational structure. In
general, such reports must be submitted to the Commission three months
in advance of the anticipated change. With the exception of the change
discussed below, the Commission is adopting Sec. 39.19(c)(4)(x) as
proposed, redesignated as Sec. 39.19(c)(4)(viii).
Proposed Sec. 39.19(c)(4)(x)(A)(2) (redesignated as Sec.
39.19(c)(4)(viii)(A)(2)) would require a DCO to report the creation of
a new subsidiary, or the elimination of a current subsidiary, of the
DCO or its parent company. CME commented that the creation or
elimination of a separate subsidiary of the DCO's parent company would
not serve the Commission's purpose of conducting effective oversight of
the DCO or enhance the Commission's ability to conduct timely analysis
of a DCO's activities. CME added that the plans of a DCO's parent
company to create (or eliminate) a subsidiary may be highly
confidential.\232\ CME urged the Commission to eliminate such reporting
requirement, asserting that ``the value of this information to the
[Commission] is questionable, and the burdens associated with providing
it may be substantial.'' CME did not provide any explanation as to why
the burden of reporting might be substantial.
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\232\ MGEX also commented on the highly confidential nature of
changes in ownership, corporate or organizational structure. The
Commission believes MGEX's concerns are addressed by the
Commission's procedures for nonpublic records and confidential
treatment requests set forth in Part 145 of the Commission's
regulations.
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While information about corporate changes that potentially impact a
DCO's
[[Page 69404]]
financial standing or operations is helpful to the Commission in its
oversight of a DCO, to avoid creating an unintended burden on DCOs and
Commission staff, particularly where a DCO is part of a complex
corporate structure, the Commission is modifying Sec.
39.19(c)(4)(viii)(A)(2) to eliminate the requirement to report a change
in subsidiaries of the DCO's parent company. Thus, Sec.
39.19(c)(4)(viii)(A) now requires only that a DCO report ``[a]ny
anticipated change in the ownership or corporate or organizational
structure of the [DCO] or its parent(s) that would: * * * (2) Create a
new subsidiary or eliminate a current subsidiary of the [DCO]. * * *
\233\
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\233\ As proposed, the provision referred to the DCO's ``parent
company.'' The Commission is adopting a technical amendment to refer
to the ``parent(s)'' to clarify that there could be more than one
parent, such as in the case of a DCO owned by a joint venture, and
the parent need not have any particular corporate form. For purposes
of these reporting requirements, a ``parent'' is a direct parent,
not an entity further up the chain of ownership.
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h. Change in Key Personnel--Sec. 39.19(c)(4)(xi)
Proposed Sec. 39.19(c)(4)(xi) would require a DCO to report the
departure or addition of any person who qualifies as ``key personnel,''
as defined in Sec. 39.2, no later than two business days following the
change. KCC suggested requiring a report ``within a reasonable period
of time.'' The Commission notes that key personnel are not likely to
change often, and KCC did not provide any explanation as to why the two
business day notification period is inappropriate. The Commission is
adopting Sec. 39.19(c)(4)(xi) as proposed, but redesignated as Sec.
39.19(c)(4)(ix).
i. Change in Credit Facility Funding Arrangement--Sec.
39.19(c)(4)(xii)
Proposed Sec. 39.19(c)(4)(xii) would require a DCO to report no
later than one business day after a DCO changes an existing credit
facility funding arrangement, is notified that such arrangement has
changed, or knows or reasonably should have known that the arrangement
will change. KCC commented that this requirement is duplicative: such
reports would already be required by the Material Adverse Change
Reporting Requirement. CME had no objection to the requirement to
report such changes, but opposed the requirement to notify the
Commission when it knows that the arrangement will change in the
future, stating that it serves little purpose to notify the Commission
without knowing what will change. CME suggested that the requirement
should be to report to the Commission after the terms have changed.
Conversely, Better Markets opposed several components of the proposed
rule, asserting that it is ``too narrow and too loose,'' allowing one
business day is too long, and the standard of reporting when the DCO
``knows or reasonably should have known'' is insufficient. Better
Markets suggested expanding the reporting requirement to cover
alternative sources of liquidity such as access to commercial paper and
repurchase agreement markets. It also suggested requiring such a report
(i) immediately, and (ii) when ``there is a reasonable likelihood that
the arrangement may change.''
The Commission is modifying the rule as suggested by CME by
removing the following: ``or knows or reasonably should have known that
the arrangement will change.'' Thus, a DCO is required to report a
change in a credit facility funding arrangement no later than one
business day after it changes the arrangement or is notified that such
arrangement has changed. The provision is also being redesignated as
Sec. 39.19(c)(4)(x). The Commission is not adopting KCC's suggestion
to rely on the Material Adverse Change Reporting Requirement because a
change in a credit facility funding arrangement would be of specific
interest to the Commission in its conduct of DCO oversight, but such a
change is not likely to rise to the level of being a material adverse
change. The Commission also is declining to adopt Better Markets'
recommendations because they would result in the filing of multiple
reports, many of limited usefulness, which, on balance, would place an
unnecessary burden on DCOs and Commission staff. Nonetheless, the
Commission notes that unusual market conditions such as those that
might limit a DCO's access to commercial paper or ability to enter into
repurchase agreements, thereby adversely affecting the DCO's liquidity,
could constitute a material adverse change that would have to be
reported under the Material Adverse Change Reporting Requirement.
j. Rule Enforcement--Sec. 39.19(c)(4)(xiii)
Proposed Sec. 39.19(c)(4)(xiii) would require a DCO to report the
initiation of a rule enforcement action against a clearing member or
the imposition of sanctions against a clearing member, no later than
two business days after the DCO takes such action. Several commenters
observed that this would result in multiple reports with little useful
information. They further noted that the DCO would otherwise inform the
Commission about serious financial issues, as a matter of current
practice and pursuant to the Material Adverse Change Reporting
Requirement. MGEX recommended that the Commission not adopt the rule
enforcement reporting requirement. OCC and CME recommended that the
Commission not adopt the enforcement reporting requirement as proposed.
MGEX commented that requiring notification of the initiation of
rule enforcement is unnecessary and premature, noting that many
investigations are unrelated to financial risk and many are routine.
OCC made a similar comment. MGEX expressed concern about the harm such
a report could cause to a clearing member's reputation by notifying the
Commission before there has been any determination of any guilt. MGEX
also noted that the Commission is already routinely informed or is
aware of ongoing or potential actions.
OCC stated that the proposed enforcement reports would serve no
purpose because if there were serious financial issues, the DCO would
already have been in regular contact with the Commission long before
the DCO reached the stage of initiating a rule enforcement action.
Thus, OCC believes these reports would not serve as an effective early
warning sign. OCC further opposed this reporting requirement because a
clearing member could appeal a decision after a sanction is imposed.
OCC recommended notification to the Commission within 30 days after a
final decision on a disciplinary matter.
CME believes it is unclear when the notification requirement would
be triggered, and that there are situations when it is unclear when an
enforcement action is considered to be initiated.
The Commission is adopting the rule with modifications. While the
Commission considers information about enforcement actions to be useful
in its oversight of a DCO's rule enforcement program under Core
Principle H, and more broadly in its oversight of a DCO's overall risk
management program, the Commission has concluded that the requirement,
as proposed, could result in the reporting of many events that are not
material to the Commission's oversight of a DCO.\234\ The Commission
recognizes that many enforcement actions may be based on relatively
minor offenses and are
[[Page 69405]]
unlikely to have a significant impact on a DCO's ability to manage risk
related to the provision of clearing and settlement services.
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\234\ Core Principle H provides in relevant part that ``each
derivatives clearing organization shall * * * (iii) report to the
Commission regarding rule enforcement activities and sanctions
imposed against members and participants. * * * '' See also
discussion of Sec. 39.17 in section IV.H, above.
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Therefore, the Commission is adopting the regulation with a
modification such that it would only require the reporting of sanctions
against clearing members, no later than two business days after the DCO
takes such action, and would not require the reporting of the
initiation of rule enforcement actions. The Commission is also
redesignating the provision as Sec. 39.19(c)(4)(xi). The Commission
notes that events or circumstances that rise to the level of having a
material adverse impact on a DCO's ability to comply with the
requirements of Part 39, or relate to a material adverse change in the
financial condition of any clearing member, whether or not they form
the basis of an enforcement action, will have to be formally reported
under Sec. 39.19(c)(4)(xii)(B) or (C), respectively.
Last, OCC requested clarification as to whether the rule
enforcement reporting requirement applies to DCO enforcement activities
involving a clearing member that is only registered as a BD. The
Commission confirms that the requirement to report the imposition of
sanctions against clearing members does not apply to a DCO's clearing
members that are registered as BDs only and engaged solely in
securities-based transactions. However, insofar as such a clearing
member's actions might have a material adverse impact on the DCO's
ability to comply with the requirements of Part 39 or would constitute
a material adverse change in the financial condition of a clearing
member, the DCO would be required to submit a Material Adverse Change
Report, as discussed below.
k. Financial Condition and Events (Material Adverse Change Reporting
Requirement)--Sec. 39.19(c)(4)(xiv)
Proposed Sec. 39.19(c)(4)(xiv) would require a DCO to immediately
notify the Commission after the DCO knows or reasonably should have
known of certain material adverse changes, i.e., the institution of any
legal proceedings which may have a material adverse financial impact on
the DCO; any event, circumstance or situation that materially impedes
the DCO's ability to comply with part 39 of the Commission's
regulations and is not otherwise required to be reported; or a material
adverse change in the financial condition of any clearing member that
is not otherwise required to be reported.\235\ CME and OCC are opposed
to this ``catch-all'' requirement. In particular, CME is concerned that
the requirement is too broad and thus would include a reporting
requirement for anything that is technically in violation of Part 39,
e.g., even if the DCO's email or Web site goes down temporarily. OCC
also commented that the requirement is unnecessary because the
Commission will be receiving adequate reporting as a result of other
reporting requirements in Part 39 and the reporting requirements for
FCMs. Alternatively, CME suggested requiring ``prompt'' notice, rather
than ``immediate'' notice.
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\235\ Because of the potential impact on a DCO of an adverse
change in the financial condition of a clearing member, this
reporting requirement would apply to ``any'' clearing member,
including one that is solely a BD engaging in securities activities.
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The Commission is adopting Sec. 39.19(c)(4)(xiv) as proposed, but
redesignated as Sec. 39.19(c)(4)(xii). CME's concerns are unwarranted
as the reporting requirement would only require reporting incidents
that could have a material adverse effect on the DCO. A Web site
temporarily going down would not necessarily be expected to have a
``material'' adverse effect on the DCO. However, if it did have a
material adverse impact, the Commission would expect it to be reported.
The Commission recognizes that it is requiring a DCO to exercise its
discretion in the first instance to determine what events trigger this
reporting requirement, but the Commission considers this to be an
appropriate responsibility for a DCO.
Moreover, while the Commission will be getting information as a
result of other Part 39 and FCM reporting requirements, there may be
certain conditions or events that could materially impact a DCO that
the Commission could not anticipate, yet about which it would still be
important for the Commission to be notified. This is especially
important in light of the Commission's decision not to adopt certain
proposed reporting requirements, as discussed above.
The Commission is also keeping the timing of the reporting
requirement as ``immediate'' rather than ``prompt,'' as these are
material changes for which immediate notification is essential and for
which the more ambiguous ``prompt'' is not appropriate.\236\
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\236\ See discussion of timing requirements in section IV.J.5.c,
above.
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l. Financial Statements Material Inadequacies--Sec. 39.19(c)(4)(xv)
Proposed Sec. 39.19(c)(4)(xv) would require a DCO to report
material inadequacies in its financial statements. The Commission
received no comments on this requirement, and the Commission is
adopting Sec. 39.19(c)(4)(xv) as proposed (redesignated as Sec.
39.19(c)(4)(xiii)), with the exception of a technical revision to add a
reference to ``in a financial statement'' so that the language now
reads ``If a derivatives clearing organization discovers or is notified
by an independent public accountant of the existence of any material
inadequacy in a financial statement, such derivatives clearing
organization shall give notice. * * *'' \237\
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\237\ The Commission is also making a technical non-substantive
change by substituting the word ``shall'' for the word ``must'' to
conform this provision with other provisions in Sec. 39.19.
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m. Action of Board of Directors or Risk Management Committee--Sec.
39.19(c)(4)(xvi)
In a separate proposed rulemaking that would implement Core
Principle P (Conflicts of Interest), the Commission proposed Sec.
39.25(b), which would require a DCO to report when the board of
directors of a DCO rejects a recommendation or supersedes an action of
the DCO's Risk Management Committee, or when the Risk Management
Committee rejects a recommendation or supersedes an action of its
subcommittee.\238\ In connection with this, the Commission subsequently
proposed to cross reference this reporting obligation in proposed Sec.
39.19(c)(4)(xvi). At such time as the Commission may adopt the
reporting requirement in Sec. 39.25(b) as a final rule, Sec.
39.19(c)(4) will be amended accordingly.
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\238\ See 76 FR at 736 (Jan. 6, 2011) (Governance).
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n. Election of Board of Directors--Sec. 39.19(c)(4)(xvii)
In a separate proposed rulemaking that would implement Core
Principles P (Conflicts of Interest) and Q (Composition of Governing
Boards), the Commission proposed Sec. 40.9(b)(1)(iii), which would
require a DCO to report certain information to the Commission after
each election of its board of directors.\239\ In connection with this,
the Commission subsequently proposed to cross-reference this reporting
obligation in proposed Sec. 39.19(c)(4)(xvii). At such time as the
Commission may adopt the reporting requirement in Sec. 40.9(b)(1)(iii)
as a final rule, Sec. 39.19(c)(4) will be amended accordingly.
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\239\ Id.
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o. System Safeguards--Sec. 39.19(c)(4)(xviii)
Proposed Sec. 39.19(c)(4)(xviii) would require a DCO to report
certain exceptional events and planned changes as required by Sec.
39.18(g) and Sec. 39.18(h),
[[Page 69406]]
respectively. The Commission received no comments on this reporting
requirement, and the Commission is adopting Sec. 39.19(c)(4)(xviii),
redesignated as Sec. 39.19(c)(4)(xvi), as proposed.\240\
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\240\ See discussion of system safeguards reporting in section
IV.I, above.
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K. Core Principle K--Recordkeeping--Sec. 39.20
Core Principle K,\241\ as amended by the Dodd-Frank Act, requires a
DCO to maintain records of all activities related to the business of
the DCO as a DCO, in a form and manner that is acceptable to the
Commission and for a period of not less than 5 years. The Commission
proposed Sec. 39.20 to establish requirements that a DCO would have to
meet in order to comply with Core Principle K.
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\241\ Section 5b(c)(2)(K) of the CEA, 7 U.S.C. 7a-1(c)(2)(K).
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Under proposed Sec. 39.20(b), a DCO would have to maintain records
of all activities related to its business as a DCO ``for a period of
not less than 5 years,'' except for swap data that must be maintained
in accordance with the SDR rules in part 45 of the Commission's
regulations. Mr. Barnard expressed the view that limiting record
retention to five years is insufficient and records should be required
to be kept indefinitely.
The Commission is adopting Sec. 39.20 as proposed. The Commission
believes that codifying the statutory minimum requirement of five years
is appropriate, noting that a five-year minimum is consistent with
other Commission recordkeeping requirements.\242\ In addition, the
exception for swap data recordkeeping addresses situations where the
Commission has previously determined that a five-year minimum may not
be sufficient.\243\
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\242\ See, e.g., Sec. 1.31 of the Commission's regulations.
\243\ See 75 FR 76574 (Dec. 8, 2010) (Swap Data Recordkeeping
and Reporting Requirements).
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L. Core Principle L--Public Information--Sec. 39.21
Core Principle L,\244\ as amended by the Dodd-Frank Act, requires a
DCO to provide market participants sufficient information to enable the
market participants to identify and evaluate accurately the risks and
costs associated with using the DCO's services. More specifically, a
DCO is required to make available to market participants information
concerning the rules and operating and default procedures governing its
clearing and settlement systems and also to disclose publicly and to
the Commission the terms and conditions of each contract, agreement,
and transaction cleared and settled by the DCO, each clearing and other
fee charged to members,\245\ the DCO's margin-setting methodology,
daily settlement prices, and other matters relevant to participation in
the DCO's clearing and settlement activities.
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\244\ Section 5b(c)(2)(L) of the CEA, 7 U.S.C. 7a-1(c)(2)(L).
\245\ The statutory language refers to fees charged to ``members
and participants,'' and the Commission interprets this phrase to
mean fees charged to ``clearing members.''
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Proposed Sec. 39.21 would require a DCO to provide market
participants with sufficient information to enable the market
participants to identify and evaluate accurately the risks and costs
associated with using the services of the DCO. In particular, proposed
Sec. Sec. 39.21(c)(2), (3) and (4) would require a DCO to disclose
publicly and to the Commission information concerning its margin-
setting methodology and the size and composition of the financial
resource package available in the event of a clearing member default.
KCC, MGEX, and NGX variously commented that DCO fees and charges,
margin methodology and financial resource information are confidential
and should not be required to be publicly disclosed for the following
reasons: (1) It is intellectual property, (2) there is no correlation
between the availability of such information and the decision whether
to invest in or trade with a DCO, and (3) privately held companies (or
non-intermediated DCOs in the case of NGX) should not have to disclose
such information. MGEX also suggested that making margin methodology
information available to the public could lead to market manipulation
by those who might attempt to influence the margin level. MGEX
suggested that the rule should only require making the financial
resource package information available upon request by a clearing
member that has signed the DCO's confidentiality agreement. Conversely,
Better Markets believes that Sec. 39.21 does not go far enough and
that many of the DCO reports required by Sec. 39.19 should also be
required to be disclosed to the public, as the Dodd-Frank Act requires
that market participants and the public be informed of the risks and
other potential consequences of transacting with a DCO.\246\ Similarly,
Mr. Barnard suggested requiring public disclosure of all items of
public interest, including event-specific reports under Sec.
39.19(c)(4), except for those that would expose business-specific
confidential issues.
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\246\ In particular, Better Markets stated that, at a minimum, a
DCO should be required to publicly disclose (i) the adequacy of its
financial resources, measured by the required level of financial
resources under Commission rules, and (ii) to the extent they must
be reported to the Commission, a reduction in financial resources,
decrease in ownership equity, or change in ownership or corporate
structure.
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The Commission is adopting Sec. 39.21 as proposed, except for
proposed Sec. 39.21(c)(7), which would require the public disclosure
of information related to governance and conflicts of interest in
accordance with provisions that were proposed in a separate rulemaking.
At such time as the Commission adopts those provisions, Sec. 39.21
will be amended accordingly. The requirement to publicly disclose
clearing and other fees charged by the DCO, margin methodology and
financial resources information comes directly from Core Principle L.
Moreover, the Commission believes that concerns regarding the
confidential nature of this information are unfounded because such
information would seem to be fundamental to a clearing member or
potential clearing member's assessment of the strengths and weaknesses
of a DCO. This does not necessarily require disclosure of proprietary
information; certain DCOs, e.g., CME, already disclose this type of
information on their Web sites.
The Commission is not revising the rule to incorporate Better
Markets' or Mr. Barnard's proposals. From a practical standpoint, some
of the information Better Markets and Mr. Barnard have requested to be
publicly disclosed is otherwise going to be public information,
particularly if the DCO is a public company, and thus subject to SEC
filing requirements. Regardless, the Commission does not interpret Core
Principle L as requiring disclosure of all of the financial workings of
a DCO.
M. Core Principle M--Information Sharing--Sec. 39.22
Core Principle M,\247\ as amended by the Dodd-Frank Act, requires a
DCO to enter into and abide by the terms of each appropriate and
applicable domestic and international information-sharing agreement and
to use relevant information obtained under such agreements in carrying
out its risk management program. The Commission proposed Sec. 39.22 to
codify the statutory requirement.
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\247\ Section 5b(c)(2)(M) of the CEA, 7 U.S.C. 7a-1(c)(2)(M).
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Proposed Sec. 39.22 would require a DCO to enter into certain
information-sharing agreements and use relevant information obtained
from those
[[Page 69407]]
agreements in carrying out the risk management program of the DCO. MGEX
is opposed to sharing confidential information such as proprietary
intellectual property. MGEX also asked for further clarity to be able
to comment further on this requirement.
The Commission is adopting Sec. 39.22 as proposed. The provision
purposely lacks specific details to allow each DCO the discretion to
make its own determination as to which information-sharing agreements
are necessary and appropriate, including taking into account
confidentiality concerns. DCOs may seek further guidance from
Commission staff if they have specific questions about existing or
potential information-sharing arrangements.
N. Core Principle N--Antitrust Considerations--Sec. 39.23
Core Principle N,\248\ as amended by the Dodd-Frank Act, conforms
the standard for DCOs with the standard applied to DCMs under Core
Principle 19.\249\ Proposed Sec. 39.23 would codify Core Principle N.
CME commented that the proposed regulation is adequate, and the
Commission is adopting the rule as proposed.
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\248\ Section 5b(c)(2)(N) of the CEA, 7 U.S.C. 7a-1(c)(2)(N).
\249\ See Section 5(d)(19) of the CEA, 7 U.S.C. 7(d)(19) (DCM
Core Principle 19).
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O. Core Principle R--Legal Risk--Sec. 39.27
Section 725(c) of the Dodd-Frank Act sets forth a new Core
Principle R (Legal Risk).\250\ Core Principle R requires a DCO to have
a well-founded, transparent, and enforceable legal framework for each
aspect of the DCO's activities. Proposed Sec. 39.27 would set forth
the required elements of such a legal framework. The Commission
solicited comment as to the legal risks addressed in proposed Sec.
39.27 and whether the rule should address additional legal risks.
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\250\ Section 5b(c)(2)(R) of the CEA, 7 U.S.C. 7a-1(c)(2)(R).
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CME commented that proposed Sec. 39.27(c)(1), which would require
a DCO that provides clearing services outside the United States to
identify and address all conflict of law issues, should only require a
DCO to identify and address any ``material'' conflict of law issues.
The Commission agrees with CME that a DCO should not be burdened to
identify non-material conflict of law issues and has revised Sec.
39.27(c)(1) to provide that such a DCO must identify and address ``any
material conflict of law issues.'' The Commission is otherwise adopting
the rule as proposed.
P. Special Enforcement Authority for SIDCOs
Under Section 807(c) of the Dodd-Frank Act, for purposes of
enforcing the provisions of Title VIII, a SIDCO is subject to, and the
Commission has authority under the provisions of subsections (b)
through (n) of Section 8 of, the Federal Deposit Insurance Act \251\ in
the same manner and to the same extent as if the SIDCO were an insured
depository institution and the Commission were the appropriate Federal
banking agency for such insured depository institution. Proposed Sec.
39.31 would codify this special authority. The Commission did not
receive any comments on this provision. Nevertheless, as discussed
above in connection with the proposals relating to SIDCO financial
resources and system safeguards for SIDCOs, the Commission is not
finalizing the rules relating to SIDCOs at this time. The Commission
expects to consider all the proposals relating to SIDCOs together in
the future.
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\251\ 12 U.S.C. 1818.
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V. Part 140 Amendments--Delegations of Authority
Under Sec. 140.94, the Commission delegates the authority to
perform certain functions that are reserved to the Commission to the
Director of the Division of Clearing and Risk. In connection with the
regulations the Commission is adopting herein, as well as previously
adopted Sec. 39.5, the Commission is amending Sec. 140.94 to delegate
authority to perform certain functions to the Director of the Division
of Clearing and Risk, as discussed below.
With respect to DCO applications, under Sec. 140.94(a)(6), the
Commission is delegating authority to determine whether a DCO
application is materially complete under Sec. 39.3(a)(2), and to
request that an applicant submit supplemental information in order for
the Commission to process a DCO application under Sec. 39.3(a)(3).
In addition to the authority delegated to the Director of the
Division of Clearing and Risk in connection with the Commission's final
rulemaking for Sec. 39.5,\252\ Sec. 140.94(a)(7) delegates authority
to request specific additional information as part of a DCO's swap
submission under Sec. 39.5(b)(3)(ix).
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\252\ The Commission has already delegated authority to the
Director of the Division of Clearing and Risk to: (1) consolidate
multiple swap submissions from one DCO or subdivide a submission as
appropriate for review under Sec. 39.5(b)(2); and request
information from a DCO to assist the Commission's review of a
clearing requirement that has been stayed under Sec. 39.5(d)(3).
See 76 FR at 44474 (July 26, 2011) (Process for Review of Swaps for
Mandatory Clearing; final rule).
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Section 140.94(a)(8) delegates authority to grant an extension of
time for a DCO to file its annual compliance report under Sec.
39.10(c)(4)(iv).
With respect to financial resources requirements for DCOs, Sec.
140.94(a)(9) delegates authority to: (1) determine whether a particular
financial resource may be used to satisfy the requirements of Sec.
39.11(a)(1) under Sec. 39.11(b)(1)(vi); (2) determine whether a
particular financial resource may be used to satisfy the requirements
of Sec. 39.11(a)(2) under Sec. 39.11(b)(2)(ii); (3) review the
methodology used to compute the requirements of Sec. 39.11(a)(1) and
require changes as appropriate under Sec. 39.11(c)(1); (4) review the
methodology used to compute the requirements of Sec. 39.11(a)(2) and
require changes as appropriate under Sec. 39.11(c)(2); (5) request
financial reporting from a DCO (in addition to the quarterly reports)
under Sec. 39.11(f)(1); and (6) grant an extension of time for a DCO
to file its quarterly financial report under Sec. 39.11(f)(4).
Section 140.94(a)(10) delegates authority to request the periodic
financial reports of a DCO's clearing members that are not FCMs under
Sec. 39.12(a)(5)(i)(B).
With respect to risk management requirements, Sec. 140.94(a)(11)
delegates authority to: (1) Review percentage levels for customer
initial margin requirements and require different percentage levels if
levels are deemed insufficient under Sec. 39.13(g)(8)(ii); (2) review
methods, thresholds, and financial resources and require the
application of different methods, thresholds, and financial resources
as appropriate (relating to risk limits on clearing members) under
Sec. 39.13(h)(1)(i)(C); (3) review the amount of additional initial
margin required of a clearing member permitted to exceed its risk
threshold and require a different amount as appropriate under Sec.
39.13(h)(1)(ii); (4) review the selection of accounts and methodology
used in daily stress testing of large trader positions and require
changes as appropriate under Sec. 39.13(h)(3)(i); (5) review
methodology for weekly stress testing of clearing member accounts and
swap portfolios and require changes as appropriate under Sec.
39.13(h)(3)(ii); and (6) request clearing member information and
documents regarding their risk management policies, procedures, and
practices under Sec. 39.13(h)(5)(i)(A).
With respect to rule submissions and 4d petitions relating to the
commingling of futures, options on futures, and cleared swaps in a
cleared swaps
[[Page 69408]]
account or futures account, respectively, Sec. 140.94(a)(12) delegates
authority to request additional information in support of a rule
submission, under Sec. 39.15(b)(2)(iii)(A), and to request additional
information in support of a 4d petition, under Sec.
39.15(b)(2)(iii)(B).
With respect to DCO reporting requirements, Sec. 140.94(a)(13)
delegates authority to: (1) Grant an extension of time for filing of
reports required to be filed annually under Sec. 39.19(c)(3)(iv); (2)
request that a DCO file information related to its business as a
clearing organization, including information relating to trade and
clearing details, under Sec. 39.19(c)(5)(i); (3) request that a DCO
file a written demonstration that the DCO is in compliance with one or
more core principles and relevant rule provisions under Sec.
39.19(c)(5)(ii); and (4) request that a DCO file, for each clearing
member, by customer origin, the end-of day positions for each
beneficial owner under Sec. 39.19(c)(5)(iii).
Finally, Sec. 140.94(a)(14) delegates authority to permit a DCO to
refrain from publishing on its Web site information that is otherwise
required to be published under Sec. 39.21(d).
VI. Effective Dates
For purposes of publication in the Code of Federal Regulations, all
of the rules adopted herein will have an effective date of 60 days
after publication in the Federal Register. The Commission received a
number of comments, however, that discussed a DCO's need for time to
develop appropriate systems and procedures to come into compliance with
some of the rules. The Commission is extending the date by which DCOs
must come into compliance for certain rules as follows:
DCOs must comply with the following rules 180 days after
publication in the Federal Register: Financial resources--Sec. 39.11;
participant and product eligibility--Sec. 39.12; risk management--
Sec. 39.13 (except gross margin--Sec. 39.13(g)(8)(i)); and settlement
procedures--Sec. 39.14.
DCOs must comply with the following rules 1 year after publication
in the Federal Register: chief compliance officer--Sec. 39.10(c);
gross margin--Sec. 39.13(g)(8)(i); system safeguards--Sec. 39.18;
reporting--Sec. 39.19; and recordkeeping--Sec. 39.20.
VII. Section 4(c)
Proposed Sec. Sec. 39.15(b)(2)(i) and 39.15(b)(2)(ii) would
establish procedures for permitting futures and options on futures to
be carried in a cleared swaps account (subject to Section 4d(f) of the
CEA), and for cleared swaps to be carried in a futures account (subject
to Section 4d(a) of the CEA), respectively. In connection with
proposing those rules, the Commission proposed to grant an exemption
under Section 4(c) of the CEA and requested comment on its proposed
exemption.\253\
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\253\ See 76 FR at 3715-3716 (Jan. 20, 2011) (Risk Management).
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Section 4(c) of the CEA provides that, in order to promote
responsible economic or financial innovation and fair competition, the
Commission, by rule, regulation or order, after notice and opportunity
for hearing, may exempt any agreement, contract, or transaction, or
class thereof, including any person or class of persons offering,
entering into, rendering advice or rendering other services with
respect to, the agreement, contract, or transaction, from the contract
market designation requirement of Section 4(a) of the CEA, or any other
provision of the CEA other than certain enumerated provisions, if the
Commission determines that the exemption would be consistent with the
public interest.\254\
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\254\ 7 U.S.C. 6(c).
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Proper treatment of customer funds requires, among other things,
segregation of customer money, securities and property received to
margin, guarantee, or secure positions in futures or options on
futures, in an account subject to Section 4d(a) of the CEA (i.e., a
futures account), and segregation of customer money, securities and
property received to margin, guarantee, or secure positions in cleared
swaps, in an account subject to Section 4d(f) of the CEA (i.e., a
cleared swaps account). Customer funds required to be held in a futures
account cannot be commingled with non-customer funds and cannot be held
in an account other than an account subject to Section 4d(a), absent
Commission approval in the form of a rule, regulation or order. Section
4d(f) of the CEA mirrors these limitations as applied to customer
positions in cleared swaps.
Under the proposed exemption, a DCO and its clearing members would
be exempt from complying with the segregation requirements of Section
4d(a) when holding customer segregated funds in a cleared swaps account
subject to Section 4d(f) of the CEA, instead of a futures account; and
similarly, a DCO and its clearing members would be exempt from
complying with the segregation requirements of Section 4d(f) when
holding customer funds related to cleared swap positions in a futures
account subject to Section 4d(a) of the CEA, instead of a cleared swaps
account. For the reasons discussed below, the Commission has determined
to grant the exemption under Section 4(c) of the CEA.
In the notice of proposed rulemaking, the Commission expressed its
view that the adoption of proposed Sec. Sec. 39.15(b)(2)(i) and
39.15(b)(2)(ii) would promote responsible economic and financial
innovation and fair competition, and would be consistent with the
``public interest,'' as that term is used in Section 4(c) of the CEA.
However, the Commission solicited public comment on whether the
proposed regulations would satisfy the requirements for exemption under
Section 4(c) of the CEA.
The Commission received one comment. CME supported the Commission's
conclusion, agreeing that in appropriate circumstances, the commingling
of customer positions in futures, options on futures, and cleared swaps
could achieve important benefits with respect to greater capital
efficiency resulting from margin reductions for correlated positions.
CME believes that adoption of a regulation permitting such commingling
would be consistent with the public interest, adding that ``[h]aving
positions in a single account can also enhance risk management
practices and systemic risk containment by allowing the customer's
portfolio to be handled in a coordinated fashion in a transfer or
liquidation scenario.''
In light of the foregoing, the Commission finds that permitting the
commingling of positions pursuant to Sec. Sec. 39.15(b)(2)(i) and
39.15(b)(2)(ii) will promote responsible economic and financial
innovation and fair competition, and is consistent with the ``public
interest,'' as that term is used in Section 4(c) of the CEA.
VIII. Considerations of Costs and Benefits
Section 15(a) of the CEA requires the Commission to ``consider the
costs and benefits'' of its actions before promulgating a
regulation.\255\ In particular, these costs and benefits must 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. In conducting its evaluation, the Commission
may, in its discretion, give greater weight to any one of the five
enumerated areas and it may determine that, notwithstanding
[[Page 69409]]
costs, a particular rule is necessary to protect the public interest or
to effectuate any of the provisions or to accomplish any of the
purposes of the CEA.\256\
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\255\ 7 U.S.C. 19(a).
\256\ See, e.g., Fisherman's Doc Co-op., Inc v. Brown, 75 F.3d
164 (4th Cir. 1996); Center for Auto Safety v. Peck, 751 F.2d 1336
(D.C. Cir. 1985) (noting that an agency has discretion to weigh
factors in undertaking cost-benefit analysis). Section 3 of the CEA
states the purposes of the Act:
It is the purpose of this Act to serve the public interests
described in subsection (a) through a system of effective self-
regulation of trading facilities, clearing systems, market
participants and market professionals under the oversight of the
Commission. To foster these public interests, it is further the
purpose of this Act to deter and prevent price manipulation or any
other disruptions to market integrity; to ensure the financial
integrity of all transactions subject to this Act and the avoidance
of systemic risk; to protect all market participants from fraudulent
or other abusive sales practices and misuses of customer assets; and
to promote responsible innovation and fair competition among boards
of trade, other markets and market participants.
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In the following discussion, the Commission presents its
considerations of the costs and benefits of the final rulemaking in
light of the comments it received, other relevant data and information,
and the five broad areas of market and public concern as required by
section 15(a) of the CEA.
A. Background
A derivatives clearing organization (DCO) is an entity registered
with the Commission through which derivatives transactions are cleared
and settled. A DCO acts as a central counterparty, serving principally
to ensure performance of the contractual obligations of the original
counterparties to derivatives transactions and to manage and mitigate
counterparty risk and systemic risk in the markets they serve. This is
accomplished by interposing the DCO between the counterparties so that
the DCO becomes the buyer to every seller and the seller to every
buyer. Upon novation by the original parties to a transaction, the
contractual obligations of the original parties to one another are
extinguished and replaced by a pair of equal and opposite transactions
between the DCO and the counterparties or their agents.
The DCO's role as central counterparty potentially exposes the DCO
itself to risk from every user whose transactions are cleared through
the DCO. Conversely, if a DCO itself fails or suffers a risk of
failure, the consequences for the market at large are likely to be
serious and widespread. Effective risk management, therefore, is
critical to the functioning of a marketplace in which swaps are cleared
through DCOs.
Clearing members are the entities that deal directly with DCOs.
They may be acting on their own behalf or as agents. DCOs establish
rules and risk management requirements for their clearing members,
which typically include specified levels of financial resources,
operational capacity, and risk management capability; deposit of risk-
based initial margin and payment of daily variation margin sized to
cover current and potential losses of the member; and contribution to a
guaranty fund that can be used in the event of a clearing member
default. These requirements lower systemic risk by reducing the
likelihood of a clearing member default and, in the event a clearing
member default does occur, reducing the likelihood that it will result
in the default of other market participants.
Additionally, unlike bilateral derivatives transactions where
parties do not know the exposures their counterparties have to other
market participants, as a result of the multilateral nature of
centralized clearing, DCOs have a real-time, more complete picture of
each clearing member's risk exposure to multiple parties. Thus the DCO
can more effectively and quickly identify developing risk exposures for
individual clearing members and better manage these risks if clearing
members become distressed.
B. General Comments and Considerations
The Dodd-Frank Act is intended to facilitate stability in the
financial system of the United States by reducing risk, increasing
transparency, and promoting market integrity. To accomplish these
objectives, among other things, the Dodd-Frank Act provides for the
mandatory clearing of certain swaps by DCOs and explicitly authorizes
the Commission to promulgate rules to establish appropriate standards
for DCOs in carrying out their risk mitigation function. Regulatory
standards for DCOs will serve to assure market participants that credit
and other risks associated with cleared swap transactions are being
appropriately managed by DCOs. This, in turn, can promote the use of
cleared swaps. Regulatory standards also can foster market confidence
in the integrity of the derivatives clearing system.
In this final rulemaking, the Commission is adopting regulations to
implement 15 DCO core principles: A (Compliance), B (Financial
Resources), C (Participant and Product Eligibility), D (Risk
Management), E (Settlement Procedures), F (Treatment of Funds), G
(Default Rules and Procedures), H (Rule Enforcement), I (System
Safeguards), J (Reporting), K (Recordkeeping), L (Public Information),
M (Information Sharing), N (Antitrust Considerations), and R (Legal
Risk). In addition, the Commission is adopting regulations to implement
the Chief Compliance Officer provisions of Section 725 of the Dodd-
Frank Act, and to update the regulatory framework for DCOs to reflect
standards and practices that have evolved over the past decade since
the enactment of the CFMA.
This rulemaking process has generated an extensive record, which is
discussed at length throughout this notice as it relates to the
substantive provisions in the final rules. A number of commenters
expressed the view that there would be significant costs associated
with implementing and complying with proposed rules. The Commission
also received comments from KCC, CME, and OCC who stated generally that
the cost-benefit analysis presented in the proposed rulemakings was
insufficient. The Commission has carefully considered alternatives
suggested by commenters, and in a number of instances, for reasons
discussed in detail above, has adopted such alternatives or
modifications to the proposed rules where, in the Commission's
judgment, the alternative or modified standard accomplishes the same
regulatory objective in a more cost-effective manner.
The Commission invited comments on the comprehensive or
``systemic'' costs and benefits of the proposed rules. MFA and Better
Markets addressed this issue stating that the Commission's cost-benefit
analyses presented in the notices of proposed rulemaking may have
understated the benefits of the proposed rules.\257\ MFA commented that
the costs to market participants would be substantial if the Commission
does not adopt the proposed regulations. Better Markets commented that
the only reasonable way to consider costs and benefits of any of the
Commission's rule proposals under Dodd-Frank is to view them as a
whole. According to Better Markets:
\257\ See Letter from Better Markets dated June 3, 2011; Letter
from MFA dated March 21, 2011 (comment file for 76 FR 3698 (Risk
Management)).
It is undeniable that the Proposed Rules are intended and
designed to work as a system. Costing-out individual components of
the Proposed Rules inevitably double counts costs which are
applicable to multiple individual rules. It also prevents the
consideration of the full range of benefits that arise from the
system as a whole that provides for greater stability, reduces
[[Page 69410]]
systemic risk and protects taxpayers and the public treasury from
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future bailouts.
Better Markets believes that the benefits must include the avoided
risk of a new financial crisis and the best measure of this benefit is
the cost of the 2008 financial crisis, which is still accumulating. It
cited Andrew G. Haldane, Executive Director, Financial Stability of the
Bank of England, who estimated that the worldwide cost of the crisis in
terms of lost output was between $60 trillion and $200 trillion,
depending primarily on the long term persistence of the effects.
The Commission agrees with Better Markets that the DCO rules
operate in an integrated, systemic manner to ensure that the risks
associated with cleared swap transactions are being appropriately
managed or addressed by DCOs. When implemented in their entirety, these
rules have the potential to significantly change not only the aggregate
risk profile of the entire derivatives clearing industry, but also the
allocation of risks among DCOs, clearing firms, and market
participants. The final rules require DCOs to admit firms as clearing
members that may differ substantially from existing members with
respect to size, risk profiles, specializations, and risk management
abilities. The rules also help create an environment in which DCOs will
compete for the business of clearing trades of different sizes, and of
many different derivatives products--both futures and swaps. In a
potentially much more diverse range of both participants and products,
these final rules will allow, and in some cases require, DCOs to make
use of a number of risk management tools, including, among others,
periodic valuation of financial resources; a potentially more rigorous
design for margins; stress testing and back testing for financial
resources and margin, respectively; and additional rules and procedures
designed to allow for management of events associated with a clearing
member defaulting on its obligations to the DCO. These rules help
reduce the potential for DCO default, and the potential follow-on
effects on financial markets as a whole. In addition, the daily,
quarterly, annual, and event-specific reporting requirements for DCOs
enhance the tools available to the Commission in conducting its
financial risk surveillance in connection with derivatives clearing by
DCOs.
Certain of the regulations promulgated in this final rulemaking
merely codify the requirements of the CEA, as amended by the Dodd-Frank
Act, e.g., Sec. Sec. 39.10(a) and (b) (compliance with core
principles); 39.17 (rule enforcement); 39.22 (information sharing); and
39.23 (antitrust considerations). For such provisions, the Commission
has not considered alternatives to the statute's prescribed
requirements, even though a DCO may incur costs to comply with these
provisions. As these requirements are imposed by the Dodd-Frank Act,
any associated costs and benefits are the result of statutory
directives, as previously determined by the Congress, that govern DCO
activities independent of the Commission's regulations. By its terms,
CEA Section 15(a) requires the Commission to consider and evaluate the
prospective costs and benefits of regulations and orders of the
Commission prior to their issuance; it does not require the Commission
to evaluate the costs and benefits of the actions or mandates of the
Congress.
In its notice of proposed rulemaking, the Commission requested data
or other information in connection with its cost-benefit
considerations. The Commission received only a few comments providing
quantitative information on the costs of the proposed rules. It
received two comments on the benefits of the proposed rules.
The Commission invited but did not receive public comments specific
to, or related to, its consideration of costs and benefits for proposed
Sec. Sec. 1.3, 39.1, 39.2, 39.4, 39.9, 39.16, 39.18, 39.20, 39.21, and
39.27. However, the Commission received comments on substantive
provisions of those proposed rules and such comments are addressed
above.
The following discussion summarizes the Commission's consideration
of the costs and benefits of the final rules pursuant to CEA Section
15(a).
C. Form DCO--Sec. 39.3(a)(2)
Section 5b(c)(1) of the CEA provides that ``[a] person desiring to
register as a derivatives clearing organization shall submit to the
Commission an application in such form and containing such information
as the Commission may require for the purpose of making the
determinations required for approval under paragraph (2).'' Paragraph
(2), which sets forth the 18 core principles applicable to DCOs,
further provides in paragraph (i) that ``[t]o be registered and to
maintain registration as a derivatives clearing organization, a
derivatives clearing organization shall comply with each core principle
described in this paragraph and any requirement that the Commission may
impose by rule or regulation pursuant to section 8a(5) [of the CEA].''
Accordingly, the standard for approval of DCO registration is the
applicant's ability to satisfy the DCO core principles.
Proposed Sec. 39.3(a)(2) would require that any person seeking to
register as a DCO submit a completed Form DCO, which would be provided
as an appendix to part 39 of the Commission's regulations. The Form
DCO, composed of a cover sheet and list of exhibits, would replace the
general guidance contained in Appendix A to Part 39, ``Application
Guidance and Compliance With Core Principles'' (Guidance), which was
adopted by the Commission in 2001. In accordance with Section 5b(c) of
the Act, the Form DCO is designed to elicit a demonstration that an
applicant can satisfy each of the DCO core principles. Toward this end,
the Form DCO requires submission of extensive information about an
applicant's intended operations. This information has been required of
applicants under the previous Guidance, and the use of the Form DCO
does not represent a departure in substance from the Commission's
practices over the past decade.
Rather, as explained in the proposed rulemaking, the Form DCO was
designed to standardize and clarify the information that the Commission
has required from DCO applicants in the past, in an effort to
facilitate a more streamlined and efficient application process. The
Commission has learned from experience that the general guidance
contained in the previous Appendix A did not provide sufficiently
specific instructions to applicants. As a result, the registration
process has been prolonged in some cases because of the need for
Commission staff to provide applicants with additional guidance about
the nature of the information that the Commission requires to conclude
that the applicant has demonstrated its ability to comply with the core
principles.
The Commission did not receive comments specifically with respect
to its cost-benefit analysis of proposed Sec. 39.3(a)(2) or to its
Paperwork Reduction Act estimate that the cost of preparing a completed
application would be $100,000. The Commission notes that applicants for
DCO registration will incur direct costs associated with the
preparation of the completed Form DCO. However, because the Form DCO to
a large extent captures information that has already been required by
the Commission under the Guidance or, with respect to new core
principles, captures information that tracks the statutory
[[Page 69411]]
requirements,\258\ the use of the Form DCO will not impose greater
costs than have been imposed in the past. In fact, by providing greater
clarity as to what is expected from an applicant and by reducing the
need for Commission staff to request, and the applicant to provide,
supplementary information, the Form DCO should reduce costs for
applicants.
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\258\ Exhibits O, P, and Q, relating to the requirements of Core
Principles O (Governance Fitness Standards), P (Conflicts of
Interest), and Q (Composition of Governing Boards), respectively.
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As discussed in more detail in this notice of final rulemaking, the
Commission received two comment letters that addressed the proposed
Form DCO.\259\ The comments did not oppose the concept of the Form DCO.
The comments were directed at the large amount of information required
and the necessity of submitting certain specific information. One of
the comment letters focused on the use of the Form DCO for amending an
existing DCO registration, and the Commission has provided a
clarification to address that commenter's concerns. The Commission has
determined to adopt the final Form DCO largely as proposed, but it has
modified several of the exhibits in response to specific comments.
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\259\ See discussion in Section III.C.1, above.
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The Commission has evaluated the costs and benefits of the required
use of Form DCO, under Sec. 39.3(a)(2), in light of the specific
considerations identified in Section 15(a) of the CEA as follows:
1. Protection of Market Participants and the Public
Costs
Applicants currently incur costs in demonstrating compliance with
the core principles. As described above, based on the staff's
experience in processing DCO applications over the last ten years, the
Commission believes that use of the Form DCO will not increase, and
often may decrease, the time and expense associated with applying for
registration as a DCO for future applicants.
Benefits
The Commission expects that use of the Form DCO will promote the
protection of market participants and the public. Given the critical
role that DCOs play in providing financial integrity to the markets for
which they clear--which now include swaps as well as futures markets--
it is essential that the Commission conduct a comprehensive and
thorough review of all DCO applications. Such review is essential for
the protection of market participants and the public insofar as it
serves to limit the performance of DCO functions to only those entities
that have provided adequate demonstration that they are capable of
satisfying the core principles.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
As noted, the Commission believes that use of the Form DCO will not
increase, and often may decrease, the time and expense associated with
applying for registration as a DCO for future applicants.
Benefits
The Commission expects that use of the Form DCO will promote
efficiency, competitiveness, and financial integrity. As discussed
above, the CEA requires that prospective DCO registrants submit an
application and comply with the core principles. In connection with
these requirements, in 2001, the Commission adopted the Guidance to
assist applicants in preparing application materials. However, the
Commission's experience with protracted reviews of draft applications
and materially incomplete final submissions has indicated a need for
streamlining the application process.
By requiring the use of Form DCO, the Commission is promoting
increased efficiency by providing greater clarity to applicants before
they undertake the application process, thereby facilitating the
submission of a materially complete final application in the first
instance. This will also reduce the need for submission of supplemental
materials and consultation between applicants and the Commission staff.
The result will be more cost effective and expeditious review and
approval of applications. This will benefit applicants as well as free
Commission staff to handle other regulatory matters.
In addition, use of the Form DCO makes available to the public the
Commission's informational requirements so that all prospective
applicants have a heightened understanding of what is involved in the
preparation and processing of an application. It promotes greater
transparency in the process and will enhance competition among DCOs by
making it easier for qualified applicants to undertake and navigate the
application process in a timely manner.
The Form DCO is designed to address an applicant's ability to
comply with the core principles. Compliance with the core principles is
essential to ensure the financial integrity of the derivatives clearing
process and of derivatives markets, generally. In particular, the
required information in Form DCO Exhibits B (financial resources), D
(risk management), E (settlement procedures), F (treatment of funds), G
(default rules and procedures) and I (system safeguards) elicits
important information supporting the applicant's ability to operate a
financially sound clearing organization that can provide reliable
clearing and settlement services and appropriately manage the risks
associated with its role as a central counterparty.
3. Price Discovery
The Commission does not anticipate that use of the Form DCO will
impact the price discovery process.
4. Sound Risk Management Practices
Costs
As noted, the Commission believes that use of the Form DCO will not
increase, and often may decrease, the time and expense associated with
applying for registration as a DCO for future applicants.
Benefits
The Commission expects that use of the Form DCO will promote sound
risk management practices. Use of the Form DCO will reinforce sound
risk management by requiring an applicant to examine its proposed risk
management program through the preparation of a series of detailed
exhibits. The submission of exhibits relating to risk management also
make it easier for Commission staff to analyze and evaluate an
applicant's ability to comply with Core Principle D (risk management,
which includes monitoring and addressing credit exposure through margin
requirements and other risk control mechanisms). Sound risk management
practices are required by the CEA and Commission regulations, and are
essential to the effective functioning of a DCO.
5. Other Public Interest Considerations
Costs
As noted, the Commission believes that use of the Form DCO will not
increase, and often may decrease, the time and expense associated with
applying for registration as a DCO for future applicants.
Benefits
There are considerable benefits to the public in standardizing and
streamlining the DCO application process in terms of more efficient use
of Commission resources and more cost-effective and transparent
requirements for applicants. DCOs play a key role in
[[Page 69412]]
supporting the financial integrity of derivatives markets, and this
role takes on even greater significance with the Dodd-Frank
requirements for swaps clearing. A coherent and comprehensive approach
to DCO registration is needed to ensure that only qualified applicants
will be approved and that they are capable of satisfying the
requirements of the core principles and Commission regulations.
D. Chief Compliance Officer--Sec. 39.10(c)
Section 725(b) of the Dodd-Frank Act added a new paragraph (i) to
Section 5b of the CEA to require each DCO to designate an individual as
its CCO, responsible for the DCO's compliance with the CEA and
Commission regulations and the filing of an annual compliance report.
The provisions regarding the CCO in proposed Sec. 39.10(c) would
largely codify Section 5b(i) of the CEA. There are certain provisions,
however, that effectuate or implement the statutory requirements. For
example, the proposed rules would require that the CCO have the
appropriate background and skills for the position and not be
disqualified from registration under Sections 8a(2) or 8a(3) of the
CEA; meet with the board of directors or the senior officer at least
once a year to discuss the DCO's compliance program; and perform duties
including establishing a code of ethics. In addition, with respect to
the annual report, the proposed rules would set forth certain content
requirements (e.g., discussing areas for compliance program improvement
and listing any material changes to compliance policies and procedures
since the last annual report) and procedural requirements (e.g.,
submitting the annual report to the board of directors or senior
officer prior to submitting the report to the Commission, and
submitting the annual report not more than 90 days after the end of the
DCO's fiscal year unless the Commission grants an extension of time.)
As discussed in detail above, the Commission received a number of
comments that supported the proposed rules for CCOs and the annual
compliance report, and other comments that suggested alternatives or
refinements to the Commission's proposed rules. Commenters did not
provide any quantitative data regarding the costs to either DCOs or
market participants and the public. The Commission addressed those
comments above and, where appropriate, the final rules reflect
commenters' suggestions.
One commenter, MGEX, expressed concerns that relate to the
Commission's implementation of the compliance framework established by
Congress. MGEX stated that the regulations regarding organizational
structure and reporting lines seem ``excessive and beyond what was
contemplated by the passage of the Dodd-Frank Act.'' It also believes
that the regulations do not ``guarantee improved market protection,
which is one of the main goals of the Dodd-Frank Act.''
The Commission does not agree with MGEX that the rules exceed what
was contemplated by Congress. To a great extent the rules codify the
relevant provisions of the CEA, as amended, and it was Congress, not
the Commission, that specified the compliance framework that the
Commission is now implementing. The additional requirements set forth
by the rules are designed to increase the CCO's effectiveness and
ensure that the annual report is a useful compliance and oversight
tool.
MGEX also commented that ``the rules will impose a cost and burden
on the market that will be passed along to the market participants
which decreases the overall efficiency and risk mitigation.'' MGEX did
not provide any details to support its conclusion.
The Commission disagrees with MGEX that the Commission's rules will
impose such a significant burden on the market and market participants.
The principal costs of the CCO requirement result from the statutory
provisions of the CEA which, as amended by the Dodd-Frank Act, requires
each DCO to designate a CCO and submit an annual compliance report.
Although the Commission's rules would impose certain additional costs
in order to implement this statutory requirement, these additional
costs are not expected to significantly increase costs to the DCO or
market participants. For example, a DCO may incur higher costs to the
extent that it needs to pay a higher salary to a person who has the
qualifications set forth in the rule to perform the statutory and
regulatory duties of the CCO.\260\ The Commission believes that such
costs are appropriate because it has determined that a CCO should have
these qualifications to be effective, and notes that the standards are
general enough to provide reasonable discretion to the DCO in its
designation of a CCO.\261\ Similarly, a DCO may have to incur higher
costs in terms of staff time to prepare an annual report that contains
the information required by Sec. 39.10(c)(3), as opposed to a less
comprehensive annual report. However, the Commission believes that the
annual report must contain adequate information if it is to be useful
to the DCO and the Commission. The Commission does not anticipate that
these costs of hiring a qualified CCO, or of preparing a more detailed
annual report, will be significantly higher than the costs to the DCO
imposed by the basic statutory requirements for the CCO.\262\
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\260\ The Commission believes that even in the absence of this
specific rule many DCOs would employ well-qualified persons to
perform the responsibilities of the statutorily-required CCO. In
such circumstances this rule would not result in any additional
costs for a DCO.
\261\ As noted in section IV.A.3, above, the rules do not
require that the person designated as the CCO hold that position,
exclusively. A CCO may have dual responsibilities so long as the CCO
can effectively carry out his or her duties as the CCO. Accordingly,
depending on the skills and background of the personnel within a
particular DCO, a DCO may be able to use an existing staff member to
perform the duties of the CCO.
\262\ In light of the variations that exist today among DCO
compliance programs, including the qualifications of DCO compliance
personnel, the Commission does not believe it is feasible to
quantify the incremental costs associated with Sec. 39.10(c).
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For purposes of the Paperwork Reduction Act, the notice of proposed
rulemaking estimated the cost of preparing the annual report to be
$8000 to $9000 per year. The Commission received no comments on this
estimate. The Commission received comments that the annual report
should be more limited than proposed. The Commission notes that those
comments did not suggest limiting the annual report to achieve a more
favorable cost-benefit ratio, and the Commission addressed those
comments above.
The Commission has evaluated the costs and benefits of Sec.
39.10(c) in light of the specific considerations identified in Section
15(a) of the CEA as follows:
1. Protection of Market Participants and the Public
Costs
As discussed above, there are likely to be direct costs to DCOs in
connection with designating a qualified CCO and annually preparing a
comprehensive compliance report. To the extent that the Commission's
regulations impose more specific or supplemental requirements when
compared to those requirements explicitly imposed by Section 5b(i) of
the CEA, those incremental costs are not likely to be significant.
While it is possible that those incremental costs will be passed along
to clearing members and market participants in the form of increased
clearing fees, the size of those incremental costs, when spread across
recipients of clearing services, are likely to be negligible.
[[Page 69413]]
Benefits
The Commission believes that the CCO rules will protect market
participants and the public by promoting compliance with the core
principles and Commission regulations through the designation and
effective functioning of the CCO, and the establishment of a framework
for preparation of a meaningful annual review of a DCO's compliance
program. While there may be incremental costs associated with
imposition of the Commission's regulatory standards, those costs may be
mitigated by the countervailing benefits of an effective compliance
program that fosters financial integrity of the clearing process and
responsible risk management practices to protect the public from the
adverse consequences that would result from a DCO failure.
The annual compliance report, in particular, will help the DCO and
the Commission to assess whether the DCO has mechanisms in place to
adequately address compliance issues and whether the DCO remains in
compliance with the core principles and the Commission's regulations.
Such compliance will protect market participants and the public.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
The Commission believes that designation of a qualified CCO who
will effectively perform required duties, including the preparation of
an annual compliance report, will not increase costs and is likely to
lead to reduction of costs, in terms of the efficiency,
competitiveness, and financial integrity of the derivatives markets.
Benefits
Clearing is a critical component of the efficient, competitive, and
financially sound functioning of derivatives markets. The financial
integrity of these markets, in particular, is achieved through layers
of protection. Requirements for an effective DCO compliance program
will add a new layer of protection to ensure that the DCO remains
compliant with the CEA and Commission regulations, especially relating
to Core Principles B (financial resources), D (risk management), E
(settlement procedures), F (treatment of funds), G (default rules and
procedures), I (system safeguards), and N (antitrust considerations).
An effective CCO will provide benefits to DCOs and the markets they
serve by implementing measures that enhance the safety and efficiency
of DCOs and reduce systemic risk. Reliable and financially sound DCOs
are essential for the stability of the derivatives markets they serve,
and for the greater public which benefits from a sound financial
system.
3. Price Discovery
The Commission does not anticipate that Sec. 39.10(c) will impact
the price discovery process.
4. Sound Risk Management Practices
Costs
The Commission does not believe that the CCO provisions will impose
costs in terms of sound risk management practices. To the contrary, the
Commission perceives there to be benefits that will result from its CCO
implementing regulations.
Benefits
The regulatory provisions that interpret or implement the statutory
requirements for the CCO and annual report serve to enhance the
standards for a DCO's compliance program which will necessarily
emphasize risk management compliance because of its significance to the
overall purpose and functioning of the DCO. Compliance with Core
Principle D (risk management) and related regulations encompasses,
among other things, measurement and monitoring of credit exposures to
clearing members, implementation of effective risk-based margin
methodologies, and appropriate calculation and back testing of margin
levels. It is the responsibility of the CCO to ensure that the DCO is
compliant with Core Principle D and the regulations thereunder, and is
otherwise engaged in appropriate risk management activities in
accordance with the DCO's own rules, policies and procedures.
5. Other Public Interest Considerations
The Commission does not believe that the rule will have a material
effect on public interest considerations other than those identified
above.
E. Financial Resources--Sec. 39.11
Section 5b(c)(2)(B) of the CEA, Core Principle B, as amended by the
Dodd-Frank Act, requires a DCO to possess financial resources that, at
a minimum, exceed the total amount that would enable the DCO to meet
its financial obligations to its clearing members notwithstanding a
default by the clearing member creating the largest financial exposure
for the DCO in extreme but plausible market conditions, and to cover
its operating costs for a period of one year, calculated on a rolling
basis.
Proposed Sec. 39.11 would codify these requirements and set forth
additional standards for the types of financial resources that are
acceptable (Sec. 39.11(b)); computation of the amount of financial
resources required to satisfy the statutory default and operational
resources requirements (Sec. 39.11(c)); valuation of financial
resources (Sec. 39.11(d)); liquidity of financial resources (Sec.
39.11(e)); and quarterly reporting of financial resources (Sec.
39.11(f)).\263\
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\263\ The Commission also proposed Sec. 39.29 which would apply
certain stricter requirements to SIDCOs. As discussed above, the
Commission is not taking action on those proposed rules as part of
this final rulemaking.
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As discussed in more detail above, the Commission received comment
letters requesting further clarity as to the proposed requirements. The
Commission also received comment letters that discussed how the
proposed rules might impose costs or burdens on DCOs.\264\ Two
commenters objected to the requirement that DCOs must monitor ``on a
continual basis'' a clearing member's ability to meet potential
assessments, which one of the commenters characterized as ``overly
burdensome and difficult to administer.'' Regarding the proposed
restrictions on the use of assessment powers, another commenter stated
that the inclusion of assessment powers as a financial resource is
necessary for it to meet its obligations in the event of a default. Two
commenters recommended that the Commission permit letters of credit to
be considered in the financial resources computation. Finally, several
DCOs urged the Commission to allow U.S. Treasuries, in addition to
cash, as a financial resource sufficient to meet the proposed financial
resource liquidity requirement.
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\264\ See discussion in Section IV.B, above.
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As discussed above, in proposing that a DCO ``monitor, on a
continual basis, the financial and operational capacity of its clearing
members to meet potential assessments,'' the Commission did not intend
to require real-time monitoring of clearing members. Rather, the
purpose of the provision was to require a DCO to monitor often enough
to enable it to become aware of any potential problems in a timely
manner. The Commission has modified Sec. 39.11(d)(2)(ii) to remove the
``continual basis'' standard, leaving the DCO to exercise its
discretion in determining the appropriate frequency of periodic reviews
or more frequent reviews as circumstances warrant in connection with
particular clearing members.
The Commission is permitting DCOs to include potential clearing
member
[[Page 69414]]
assessments in calculating default financial resources, as proposed,
subject to the limitations of Sec. 39.11(d)(2)(iii) (30 percent
haircut) and Sec. 39.11(d)(2)(iv) (DCO may count the value of
assessments, after the haircut, to meet up to 20 percent of its default
resources requirement). The comments on this proposal were varied. Some
commenters stated that the Commission had proposed an appropriate,
balanced approach; others stated that the limitations on assessments
were too strict; and still others stated that the Commission should not
permit assessments to count at all.
It is the Commission's view that, in light of recent market events
and as a general matter, it is not prudent to permit a DCO to rely on
letters of credit. However, for the reasons discussed above, the
Commission would consider permitting letters of credit to be included
as a DCO financial resource on a very limited case-by-case basis.
Finally, the Commission is revising Sec. 39.11(e)(1) so that, in
addition to cash, a DCO may use U.S. Treasury obligations and high
quality, liquid, general obligations of a sovereign nation to satisfy
financial resource liquidity requirements. This revised standard
reflects the current practices of U.S. and foreign-based DCOs.
The Commission has evaluated the costs and benefits of Sec. 39.11
in light of the specific considerations identified in Section 15(a) of
the CEA as follows:
1. Protection of Market Participants and the Public
Costs
The regulations require DCOs to take specific actions to ensure
that they are able to meet the statutory requirements for covering
default and operating expenses. These actions include monthly stress
testing to calculate what those financial obligations are, and
quarterly reporting to the Commission to demonstrate the adequacy of
financial resources in terms of dollar amount and liquidity. DCOs will
incur direct costs related to staffing and technology programming to
calculate, monitor, and report financial resources.
Existing DCOs will have already implemented certain practices and
systems for tracking and managing financial resources in order to
comply with Core Principle B, as originally enacted in 2000. Given the
staffing and operational differences among DCOs, the Commission is
unable to accurately estimate or quantify the additional costs DCOs may
incur to comply with the new financial resource rules.\265\ Moreover,
the cost-effects of new cleared products and new market participants
clearing those products are too speculative and uncertain for the
Commission to be able to quantify or estimate at this time. Such costs
or benefits will depend upon a number of variables that are not
estimable or quantifiable at this time, such as the nature and number
of the new products that become subject to clearing, the nature and
number of market participants that enter into transactions involving
such products, and the resulting costs or benefits to such market
participants from the clearing of such products.
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\265\ Commenters did not provide the Commission with
quantitative data regarding such costs.
---------------------------------------------------------------------------
As to costs associated with restrictions the Commission is imposing
on the types and valuation of financial resources that may be counted
as financial resources for purposes of satisfying Core Principle B,
those too will vary among DCOs. For example, for DCOs that do not
include potential clearing member assessments in their calculations of
financial resources, the limitations on assessments will not result in
increased costs. For DCOs that to any extent rely on potential
assessments, the new limitations might require revisions to their
default management plans, an increase in guaranty fund requirements, or
an infusion of additional capital. The same would apply to letters of
credit that cannot be considered to be financial resources for purposes
of complying with Core Principle B, absent relief. Again, because of
the range of circumstances of different DCOs, it is not feasible to
estimate or quantify the costs of the safeguards imposed by the
Commission's financial resource rules.
Benefits
The financial resource rules establish uniform standards that
further the goals of avoiding market disruptions and financial losses
to market participants and the general public, and avoiding systemic
problems that could arise from a DCO's failure to maintain adequate
default or operating resources. While it is not possible to estimate or
quantify the benefits to market participants and the public in
facilitating the financial soundness of a DCO, the Commission believes
that a DCO failure, regardless of the size of the DCO, could adversely
affect the financial markets, market participants, and the public.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
As discussed in connection with factor 1 above, quantification or
estimation of these costs and benefits is not readily feasible. For
some DCOs, the financial resource rules will have little or no direct
or indirect impact. For others, the impact may be more substantial.
Although there may be disparate impact among DCOs, overall the rules
are not expected to impose significant costs in terms of efficiency,
competitiveness, or financial integrity of derivatives markets.
Benefits
The regulations promote financial strength and stability, thereby
fostering efficiency and a greater ability to compete in the broader
financial markets. The regulations promote competition by preventing
DCOs that lack adequate financial safeguards from expanding in ways
that may ultimately harm the broader financial market. The regulations
promote efficiency insofar as DCOs that operate with adequate financial
resources are less likely to fail. The regulations are designed to
ensure that DCOs can meet their financial obligations to market
participants, thus contributing to the financial integrity of the
derivatives markets as a whole.
As highlighted by recent events in the global financial markets,
maintaining sufficient financial resources is a critical aspect of any
financial entity's risk management system, and ultimately contributes
to the goal of stability in the broader financial markets. Therefore,
the Commission believes it is prudent to include financial resources
requirements for entities applying to become or operating as DCOs.
Finally, Congress has determined that a DCO must comply with Core
Principle B to achieve the purposes of the CEA and the Commission has
determined that Sec. 39.11 sets forth the minimum standards for a DCO
to do so.
3. Price Discovery
The Commission does not believe that this rule will have a material
effect on price discovery.
4. Sound Risk Management Practices
Costs
Adequate financial resources are a corollary to strong risk
management. To the extent that the financial resource rules result in
additional costs, these costs are associated with implementing the
practices and procedures that are necessary to ensure a DCO has
adequate financial resources.
[[Page 69415]]
Benefits
The regulations, by setting specific standards with respect to how
DCOs should assess, monitor, and report the adequacy of their financial
resources, contribute to DCOs' maintenance of sound risk management
practices and further the goal of minimizing systemic risk. The
reporting requirements, in particular, will enable the Commission to
conduct more thorough and meaningful oversight of DCOs that will
contribute to improved risk management by DCOs overall.
5. Other Public Interest Considerations
Costs
The Commission has not identified any public interest
considerations that would be negatively affected by the provisions of
the financial resource rules that effectuate or implement the statutory
requirements of Core Principle B (financial resources).
Benefits
The benefits to the public of a DCO maintaining adequate financial
resources are discussed above.
F. Participant and Product Eligibility--Sec. 39.12
Participant Eligibility
Section 5b(c)(2)(C) of the CEA, Core Principle C, as amended by the
Dodd-Frank Act, requires each DCO to establish appropriate admission
and continuing eligibility standards for members of, and participants
in, the DCO, including sufficient financial resources and operational
capacity to meet the obligations arising from participation. Core
Principle C further requires that such participation and membership
requirements be objective, be publicly disclosed, and permit fair and
open access. Core Principle C also requires that each DCO establish and
implement procedures to verify compliance with each participation and
membership requirement, on an ongoing basis.
As discussed above, the Commission crafted the provisions of
proposed Sec. 39.12(a) and related rules to establish a regulatory
framework that accomplishes two goals: (1) to provide for fair and open
access, while (2) limiting risk to the DCO and its clearing members.
The provisions in Sec. 39.12(a)(1) provide for fair and open access in
a number of ways. A DCO is prohibited from adopting restrictive
clearing member standards if less restrictive requirements that would
not materially increase risk to the DCO or clearing members could be
adopted (Sec. 39.12(a)(1)(i)); a DCO must allow all market
participants who satisfy participation requirements to become clearing
members (Sec. 39.12(a)(1)(ii)); the standards must be non-
discriminatory (Sec. 39.12(a)(1)(iii)); and they may not require
clearing members to be swap dealers (Sec. 39.12(a)(1)(iv)), or
clearing members to maintain a swap portfolio of any particular size or
meet a swap transaction volume threshold (Sec. 39.12(a)(1)(v)).
Section 39.12(a)(2) facilitates greater participation by requiring
that capital requirements for clearing members be based on objective,
transparent, and commonly accepted standards that appropriately match
capital to risk (Sec. 39.12(a)(2)(i)); and by setting the minimum
capital requirement at not more than $50 million (Sec.
39.12(a)(2)(ii)).
A number of commenters supported the proposed rules. They asserted
that increased access to clearing would stimulate competition and
diversify risk. A number of other commenters opposed aspects of the
proposed rules, particularly the $50 million capital standard. They
argued that these provisions could increase risk by providing access to
firms with insufficient financial resources or operational capacity.
The Commission did not receive any comments that quantified the
costs associated with the proposed participation rules. Instead,
commenters focused on qualitative considerations, including how the
proposed rules would affect market participants, market risk,
efficiency, competitiveness, the financial integrity of futures
markets, and price discovery.
The Commission is adopting these provisions essentially as
proposed.
The Commission has evaluated the costs and benefits of the proposed
regulations in light of the specific considerations identified in
Section 15(a) of the CEA, as follows:
1. Protection of Market Participants and the Public
Costs
The participant eligibility rules may result in costs beyond those
incurred in the normal course of operating a DCO or clearing firm, but
such potential costs are, at this time, speculative in nature and
impossible to estimate or quantify. By providing access to clearing to
additional firms, the rules could impose costs on DCOs, other clearing
members, or customers if a firm admitted to clearing membership in a
DCO pursuant to these rules failed to meet its obligations. Any such
costs depend upon a number of factors that are not presently knowable,
quantifiable, or estimable.
It is not possible to estimate or quantify these costs in a
reliable way for a number of reasons. The historical record prior to
the enactment of the Dodd-Frank Act with respect to the operation of
clearing organizations provides little guidance as to the costs that
may be incurred in the future in the unlikely event of a default at a
DCO. Defaults at DCOs are very rare and the circumstances of each one
are unique. Moreover, the Dodd-Frank Act and implementing regulations
will alter the landscape significantly. Existing DCOs and FCMs will be
clearing new products. New DCOs and FCMs will enter the market.
Mandatory clearing will bring new products and participants to DCOs and
FCMs. The interaction of all these factors creates a wide range of
uncertainty as to the nature of the potential consequences of a default
under the new regulatory regime. In sum, the Commission believes that
the possible future circumstances leading to and potential resulting
consequences of a DCO default are too speculative and uncertain to be
able to quantify or estimate the resulting costs to DCOs, clearing
members, or market participants with any precision or degree of
magnitude.
Whatever these potential costs, the Commission believes that the
participant eligibility rules will reduce the risk that clearing
members will in fact incur such costs. First, increased access to
clearing membership should reduce concentration at any one clearing
member and diversify risk. Second, the rules contain risk management
provisions specifically designed to minimize the likelihood and extent
of defaults. The provisions in Sec. 39.12(a)(2) set forth requirements
that mandate DCOs: Require that all clearing members have sufficient
financial resources to meet obligations arising from participation in
the DCO (Sec. 39.12(a)(2)(i)); establish capital requirements that are
scalable so that they are proportional to the risks posed by clearing
members (Sec. 39.12(a)(2)(ii)); require that clearing members have
adequate operational capacity to meet obligations arising from
participation in the DCO (Sec. 39.12(a)(3)); verify the compliance of
each clearing member with the requirements of the DCO (Sec.
39.12(a)(4)); satisfy certain reporting requirements (Sec.
39.12(a)(5)); and have the ability to enforce participation
requirements (Sec. 39.12(a)(6)).
For reasons similar to those described above, it is also not
feasible to quantify or estimate this reduction in costs with any
confidence. Based on its judgment and experience with the regulation
and operation of clearing organizations, the
[[Page 69416]]
Commission believes that these rules will lower the risk that clearing
members will in fact incur such costs. However, the possible future
circumstances leading to and potential resulting consequences of a
future default are too speculative and uncertain to quantify or
estimate, either under the current regulatory regime or under the rules
being adopted by the Commission.
Benefits
Greater access to clearing should benefit market participants by
increasing competition among clearing members. Allowing more firms to
clear should increase competition among clearing firms on both price
and service which should, in turn, reduce costs to market participants.
Further, the safeguards in Sec. 39.12(a)(2) will benefit DCOs,
clearing members, and market participants by reducing risk. Reductions
in risk also benefit the general public by decreasing the probability
of a systemic failure.
For the reasons described above in connection with costs, it is
also impractical to quantify or estimate these benefits associated with
reductions in risk to clearing members, market participants, and the
public.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
The considerations under this factor are very similar to the
considerations under the previous factor with respect to participant
eligibility requirements. Quantification or estimation of these costs
and benefits is not feasible for the reasons set forth under the first
factor. The potential increase in risk of default resulting from open
access is mitigated by the decrease in risk resulting from
diversification of risk, increased competition, and the safeguards set
forth in Sec. 39.12(a)(2).
Benefits
By opening access the rules should increase competition among
clearing members thereby resulting in increased efficiency in the
provision of clearing services. The safeguards in the rules such as the
requirement that DCOs impose risk limits on clearing members will
enhance the financial integrity of the DCO and its clearing members.
3. Price Discovery
Costs
The Commission has not identified any way in which the rules will
impair price discovery.
Benefits
Increased competition among clearing members could bring more
participants into the markets which could result in more competitive
pricing and enhanced price discovery.
4. Sound Risk Management Practices
Costs
According to some commenters, the open access rules could hinder
sound risk management practices by admitting clearing members unable to
participate in the default management process. Other commenters assert
that the rules provide appropriate protections and will facilitate
sound risk management practices. The Commission believes that the open
access rules, when coupled with the default management rules discussed
below, will not impair sound risk management practices. Under the
rules, clearing members will be required to demonstrate that they have
operational capacity to carry out their responsibilities as well as
sufficient financial resources to meet their obligations.
Benefits
As explained above, the provisions in Sec. 39.12(a)(2) require
that DCOs establish a risk management framework with respect to their
members. In addition, open access should lead to diversification of
risk at DCOs and allow additional firms to assist in the resolution of
any defaults.
5. Other Public Interest Considerations
Costs
The Commission has not identified any other public interest
considerations that would be negatively affected by the potential costs
of the eligibility requirements.
Benefits
The CEA, as amended by the Dodd-Frank Act, requires DCOs to allow
for open access and, therefore, broader participation. The Commission
believes that greater participation in clearing could increase
liquidity in the markets. This could help prevent price manipulation or
other anti-competitive practices because it will be harder to organize
concerted efforts to achieve such ends. Finally, Congress has
determined that a DCO must comply with Core Principle C to achieve the
purposes of the CEA and the Commission has determined that Sec.
39.12(a) sets forth the minimum standards for a DCO to comply with the
CEA's participation requirements.
Product Eligibility
Core Principle C also requires a DCO to establish ``appropriate
standards for determining the eligibility of agreements, contracts, or
transactions submitted to the [DCO] for clearing.'' Section 39.12(b)
implements this provision.
Proposed Sec. 39.12(b)(1) would require a DCO to establish
requirements for determining product eligibility taking into account
the DCO's ability to manage risks associated with the product. Proposed
Sec. Sec. 39.12(b)(2) and (b)(3) would codify section 2(h)(1)(B) of
the CEA. Proposed Sec. 39.12(b)(4) would prohibit a DCO from requiring
an executing party to be a clearing member in order for the product to
be eligible for clearing. Proposed Sec. 39.12(b)(5) would require a
DCO to select contract units for clearing purposes that maximize
liquidity, facilitate transparency, promote open access, and allow for
effective risk management. Proposed Sec. 39.12(b)(6) would require
novation upon acceptance of a swap. Finally, proposed Sec. 39.12(b)(8)
would require a DCO to confirm the terms of a swap at the time the swap
is accepted for clearing.\266\
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\266\ Proposed Sec. 39.12(b)(7) will be addressed in a separate
rulemaking.
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The Commission did not receive any comments directly addressing
cost-benefit considerations. The Commission did receive several
comments on substantive provisions that bear on those considerations.
One commenter suggested that Sec. 39.12(b)(4) may be an impediment to
the development of new DCOs. Several commenters suggested that it would
be impractical or inappropriate for a DCO to establish unit sizes for
clearing that differ from the unit size at execution (Sec.
39.12(b)(5)).
The Commission also received several comments requesting
clarification of certain provisions. As discussed above, the Commission
has made changes to these rules that are responsive to the comments.
The Commission is adopting Sec. 39.12(b) largely as proposed with
several clarifying amendments as discussed above.
The Commission has evaluated the costs and benefits of Sec.
39.12(b) in light of the specific considerations identified in Section
15(a) of the CEA, as follows:
1. Protection of Market Participants and the Public
Costs
The Commission has not identified any new costs arising out of
Sec. Sec. 39.12(b)(1), 39.12(b)(6), or
[[Page 69417]]
39.12(b)(8). DCOs currently perform risk analysis before accepting new
products for clearing, currently novate trades upon acceptance, and
currently issue confirmations to clearing members.
As noted, one commenter suggested that prohibiting a DCO from
requiring one of the original executing parties to be a clearing member
in order for a contract to be eligible for clearing may be an
impediment to the development of new DCOs. The Commission believes
that, to the contrary, such restrictions on product eligibility for
clearing increase overall costs for market participants, and that
prohibiting such restrictions will lead to lower overall costs. Such
restrictions deny the availability and benefits of clearing to non-
clearing members. Open access will enable non-clearing members to
obtain the benefits of clearing and increase competition in clearing
and trading, thereby increasing liquidity, and reducing costs.
The commenters who questioned the unit size provision did not
elaborate on the costs. It is not feasible to quantify these costs for
a number of reasons. The rule provides DCOs with significant
flexibility in selecting unit sizes. Different DCOs may select
different sizes for the same or similar products. Numerous SEFs will
also be making judgments concerning unit size which will influence the
decisions of DCOs and traders. Some products will be subject to
mandatory clearing and others to voluntary clearing. The unpredictable
interaction of these variables creates a wide range of uncertainty as
to the nature of the consequences of the selection of unit sizes by
DCOs. Similar considerations apply to the other provisions of Sec.
39.12(b). In sum, the Commission believes that the possible future
circumstances leading to, and the potential resulting consequences of,
the implementation of Sec. 39.12(b) are too speculative and uncertain
to be able to quantify or estimate resulting costs with any precision
or degree of magnitude.
Benefits
The Commission believes that Sec. 39.12(b) will protect market
participants and the public in many ways. First, these provisions are
likely to facilitate the standardization of swaps, thereby eliminating
differences between the terms of a swap as cleared at the DCO level and
as carried at the customer level. Any such outstanding differences
would raise both customer protection and systemic risk concerns. From a
customer protection standpoint, if the terms of the swap at the
customer level differ from those at the clearing level, then the
customer still has a bilateral position opposite its counterparty. The
customer is still exposed to the credit risk of the counterparty and
the position would not be able to be offset against other positions at
the DCO. Similarly, from a systemic perspective, any differences in
terms between the trades would eliminate the possibility of
multilateral offset and thereby diminish liquidity.
Second, Sec. 39.12(b) can promote liquidity by permitting more
parties to trade the product and by permitting more clearing members to
clear the product. Third, it can enhance risk management by enabling a
DCO, in the event of a default, to have more potential counterparties
for liquidation.
Fourth, these provisions will support the requirement in section
2(h)(1)(B) of the CEA and proposed Sec. 39.12(b)(2) that a DCO must
adopt rules providing that all swaps with the same terms and conditions
submitted to the DCO are economically equivalent within the DCO and may
be offset with each other.
Fifth, clearing will eliminate the need for a counterparty to
ascertain the credit-worthiness of each of its counterparties. This
will promote liquidity, competition, and financial integrity to the
benefit of all market participants.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
The Commission has not identified any ways in which the proposals
would reduce efficiency, competitiveness, or financial integrity.
Benefits
The rules should increase participation by clearing members, which
should increase competition among clearing members to provide services
to customers. In addition, the rules will lead to standardization of
products. Finally, the rules will allow for more clearing through
novation, which should result in increased open interest and liquidity.
In turn, this should lead to more competitive and efficient markets. As
noted above, smaller units can promote liquidity and encourage
prospective clearing members to bid on positions and enable them to
accept a forced allocation in the event of a clearing member's default.
This facilitates open access, and at same time promotes risk management
by enabling a DCO, in the event of a default, to be able to rely on
more potential counterparties for liquidation.
3. Price Discovery
Costs
The Commission has not identified any ways in which the rules would
reduce price discovery.
Benefits
As discussed above, the rules will increase competition, which
should enhance price discovery by bringing more participants into the
markets. In addition, standardization means that prices observed on
different trades are more directly comparable, which can improve price
discovery.
4. Sound Risk Management Practices
Costs
The Commission has not identified any ways in which the rules would
impair sound risk management practices.
Benefits
The rules require DCOs to establish appropriate standards for
determining the eligibility of contracts submitted to the DCO for
clearing taking into account the DCO's ability to manage risks
associated with the product. Such standards are a sound risk management
practice.
5. Other Public Interest Considerations
Costs
The Commission has not identified any ways in which the rules would
harm any other public interest considerations.
Benefits
As discussed above, open access, increased competition, greater
liquidity, improved price discovery, and greater financial integrity
are all benefits of the rules. All these factors will benefit the
general public, which may not participate in these markets directly but
may feel their impact on the larger economy.
G. Risk Management--Sec. 39.13
In General
Core Principle D,\267\ as amended by the Dodd-Frank Act, requires
each DCO to ensure that it possesses the ability to manage the risks
associated with discharging the responsibilities of the DCO through the
use of appropriate tools and procedures. It further requires each DCO
to measure its credit exposures to each clearing member not less than
once during each business day and to monitor each such exposure
[[Page 69418]]
periodically during the business day. Core Principle D also requires
each DCO to limit its exposure to potential losses from defaults by
clearing members, through margin requirements and other risk control
mechanisms, to ensure that its operations would not be disrupted and
that non-defaulting clearing members would not be exposed to losses
that non-defaulting clearing members cannot anticipate or control.
Finally, Core Principle D provides that a DCO must require margin from
each clearing member sufficient to cover potential exposures in normal
market conditions and that each model and parameter used in setting
such margin requirements must be risk-based and reviewed on a regular
basis.
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\267\ Section 5b(c)(2)(D) of the CEA; 7 U.S.C. 7a-1(c)(2)(D).
---------------------------------------------------------------------------
The Commission proposed Sec. 39.13 to establish requirements that
a DCO would have to meet in order to comply with Core Principle D. For
a number of provisions of proposed Sec. 39.13, the Commission did not
receive any comments on the associated costs or on cost-benefit
analysis. The Commission discussed in the notice of proposed rulemaking
and above why it believes a DCO must satisfy each of those provisions
to be in compliance with the Core Principle D and why it is appropriate
for market participants to incur any costs associated with implementing
each of those provisions. The Commission also addressed comments that
suggested alternative standards, frameworks, or procedures. Where
appropriate, the Commission revised the proposed rules. To avoid
repetition, the Commission incorporates by reference the above
discussion of Sec. 39.13.
Commenters raised concerns about the costs of Sec. Sec.
39.13(g)(2)(ii) (minimum liquidation time), 39.13(g)(2)(iii) (margin
confidence level), 39.13(g)(8)(i) (gross margin), 39.13(h)(1)(i) (risk
limits), 39.13(h)(2) (large trader reports), and 39.13(h)(5)(ii)
(clearing member risk review) or the Commission's cost-benefit analysis
relating to these rules. The Commission's consideration of the costs
and benefits associated with these rules is discussed in greater detail
below.
Minimum Liquidation Time
As proposed, Sec. 39.13(g)(2)(ii) would require a DCO to use a
liquidation time that is a minimum of five business days for cleared
swaps that are not executed on a DCM, and a liquidation time that is a
minimum of one business day for all other products that it clears,
although it would be required to use longer liquidation times, if
appropriate, based on the unique characteristics of particular products
or portfolios.
Numerous commenters objected to the proposed difference in
requirements that would subject swaps that were either executed
bilaterally or executed on a SEF to a minimum five-day liquidation
time, while permitting equivalent swaps that were executed on a DCM to
be subject to a minimum one-day liquidation time. The Commission did
not receive any comments that quantified the costs of this rule.
As to the actual periods proposed, commenters variously contended
that a liquidation time of five business days may be excessive for some
swaps, a one-day liquidation period is too short, a one-day liquidation
period is appropriate for swaps executed on a DCM or a SEF, and a two-
day liquidation period is appropriate for cleared swaps.
Some commenters encouraged the Commission to permit a DCO to
determine the appropriate liquidation time for all products that it
clears based on the unique characteristics and liquidity of each
relevant product or portfolio. Two commenters recommended that if the
Commission were to mandate minimum liquidation times in the final
rules, it should allow DCOs to apply for exemptions for specific groups
of swaps if market conditions prove that such minimum liquidation times
are excessive.
Upon consideration of the comments, the Commission is adopting
Sec. 39.13(g)(2)(ii) with a number of modifications. First, the final
rule requires a DCO to use the same liquidation time for a product
whether it is executed on a DCM, a SEF, or bilaterally. Second, the
final rule provides that the minimum liquidation time for swaps based
on certain physical commodities, i.e., agricultural commodities,
energy, and metals, as well as futures and options, is one day. For all
other swaps, the minimum liquidation time is five days. Third, to
provide further flexibility, the Commission is adding a provision
specifying that, by order, the Commission may provide for a different
minimum liquidation time for particular products or portfolios.
The Commission has evaluated the costs and benefits of the proposed
regulations in light of the specific considerations identified in
Section 15(a) of the CEA, as follows:
1. Protection of Market Participants and the Public
Costs
The Commission anticipates that using only one criterion--i.e., the
characteristic of the commodity underlying a swap--to determine
liquidation time could result in less-than-optimal margin calculations.
For some products, a five-day minimum may prove to be excessive and tie
up more funds than are strictly necessary for risk management purposes.
For other products, a one-day or even a five-day period may be
insufficient and expose a DCO and market participants to additional
risk.
The Commission believes that it is not feasible to estimate or
quantify these costs reliably. In addition to the liquidation time
frame, the margin requirements for a particular instrument depend upon
a variety of characteristics of the instrument and the markets in which
it is traded, including the risk characteristics of the instrument, its
historical price volatility, and liquidity in the relevant market.
Determining such margin requirements does not solely depend upon such
quantitative factors, but also requires expert judgment as to the
extent to which such characteristics and data may be an accurate
predictor of future market behavior with respect to such instruments,
and applying such judgment to the quantitative results. Thousands of
different swap products may be subject to clearing. Determining the
risk characteristics, price volatility, and market liquidity of even a
sample for purposes of determining a liquidation time specifically for
such instrument would be a formidable task for the Commission to
undertake and any results would be subject to a range of uncertainty.
Reliable data is not readily available for many swaps that prior to the
Dodd-Frank Act were executed in unregulated markets.
Given the amount of uncertainty in estimating margin requirements
using either a five-day liquidation time or a one-day liquidation time,
the amount of uncertainty in estimating the cost of using one rather
than the other is compounded. For all the reasons stated in the
previous paragraph, the possible range within which the size of the
difference would fall is very large. In sum, in the absence of a
reasonably feasible and reliable methodology at the present time for
the Commission to use in calculating the appropriate margin
requirements for swaps with either five-day or one-day liquidation
times,\268\ the
[[Page 69419]]
Commission believes that possible future circumstances surrounding
margin levels are too speculative and uncertain to be able to quantify
or estimate the resulting costs to DCOs, clearing members, or the
public from the rule with any precision or degree of magnitude.
---------------------------------------------------------------------------
\268\ The Commission notes that ``[t]he existence of significant
outstanding notional exposures, trading liquidity, and adequate
pricing data'' is one of the factors the Commission must consider in
reviewing whether a swap or group or class of swaps is subject to
the mandatory clearing requirement in CEA Section 2(h)(1). See
Section 2(h)(2)(D) of the CEA. To enable the Commission to make this
determination, the Commission requires DCOs that submit swaps to the
Commission for a mandatory clearing determination to submit data and
other information that would enable the Commission to effectively
consider this factor. See Sec. 39.5(b)(3)(ii)(A), 76 FR at 44473
(July 26, 2011) (Process for Review of Swaps for Mandatory Clearing;
final rule). Not only is this type of information needed for the
Commission to consider the statutory factors and make the
determinations as to which swaps should be subject to mandatory
clearing, but it also would be needed to calculate appropriate
margin amounts for such swaps, were the Commission to attempt such
calculations.
---------------------------------------------------------------------------
Moreover, any potential costs of this rule may be mitigated by the
provision that allows DCOs to request, or the Commission on its own
initiative to make, a determination that the liquidation time for a
particular contract is too long or too short. As markets evolve, it may
become appropriate to ease the requirement for certain swaps subject to
the five-day minimum. Conversely, analysis may reveal that for other
products or portfolios the five-day or one-day minimum is insufficient.
This procedure could serve to reduce costs that may arise from
application of the rule.
Benefits
A minimum liquidation time is a standard input in value-at-risk
models used by DCOs to compute a confidence interval to estimate their
risk. The value-at-risk confidence interval protects DCOs, their
clearing members, market participants, and the public by fixing the
probability that a default will occur and the position cannot be
liquidated in time.
The five-day/one-day distinction for different types of swaps is
based on the ease of liquidation of different product groups and is
consistent with existing requirements that reflect the risk assessments
DCOs have made over the course of their experience clearing these types
of swaps. Several DCOs have determined that these are the appropriate
standards for these instruments and apply it to their margin
requirements. The Commission believes that this is a reasonable and
prudent judgment.
A minimum standard is designed to prevent DCOs from competing by
offering lower margin requirements than other DCOs and, as a result,
taking on more risk than is prudent. In addition, the Commission is
concerned that a DCO may misjudge the appropriate liquidation time
frame because of limited experience with clearing and managing the
risks of financial swaps. A minimum liquidation time frame should
prevent DCOs from taking on too much risk.
While it is not possible to estimate or quantify the benefits to
market participants and the public in facilitating the financial
soundness of DCOs, the Commission believes that a DCO failure,
regardless of the size of the DCO, could adversely affect the financial
markets, market participants, and the public. This rule will diminish
the chances that such a failure will occur.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
The considerations under this factor are similar to the
considerations under the first factor.
Benefits
The rule will promote efficiency, competitiveness and financial
integrity by establishing a minimum standard for all DCOs. While a DCO
will still have considerable latitude in setting risk-based margin
levels, the Commission has determined that establishing a minimum
liquidation time will provide legal certainty for an evolving
marketplace, will offer a practical means for assuring that the
thousands of different swaps that are going to be cleared subject to
the Commission's oversight will have prudent minimum margin
requirements, and will help prevent a potential ``race to the bottom''
by competing DCOs. Competition among DCOs will be channeled to other
areas such as level of service.
The Commission believes that default by a clearing member could
have a significant, adverse effect on market participants or the
public. Market participants may have to incur the costs of making up
any shortfall in margin through guaranty fund deposits and/or
assessments, and any costs associated with participation in an auction
or allocation of the positions of a defaulting clearing member. In a
worst case scenario, a default by a clearing member may undermine the
financial integrity of the DCO, which could have serious and widespread
consequences for the U.S. financial markets. This rule protects market
participants and the public from bearing these costs by requiring a DCO
to follow certain minimum standards in establishing margin
requirements.
3. Price Discovery
The Commission does not believe that this rule will have a material
effect on price discovery.
4. Sound Risk Management Practices
Costs
Because the rule simply establishes minimums, it will not hinder
the exercise of sound risk management practices. The rule specifically
requires DCOs to use longer liquidation times if appropriate for
particular products.
Benefits
As discussed under the first two factors, the rule will foster
sound risk management practices.
5. Other Public Interest Considerations
The Commission has not identified any costs or benefits beyond
those discussed under the first factor.
Margin Confidence Level
As proposed, Sec. 39.13(g)(2)(iii) would require a DCO's initial
margin models to meet an established confidence level of at least 99%
based on data from an appropriate historical period.
A number of commenters stated that each DCO should have discretion
to establish confidence levels based on the particular characteristics
of the products and portfolios it clears and their underlying markets.
However, a number of other commenters stated that a 99% confidence
level was the proper minimum.
The Commission is adopting the rule as proposed.
The Commission has evaluated the costs and benefits of the proposed
regulation in light of the specific considerations identified in
Section 15(a) of the CEA, as follows:
1. Protection of Market Participants and the Public
Costs
A 99% confidence level will require that more money be held as
margin as compared to a lower confidence level. There is an opportunity
cost to clearing members holding this money as margin.
The Commission believes that it is not feasible to estimate or
quantify this cost reliably. In addition to the confidence level, the
margin requirements for a particular instrument depend upon a variety
of characteristics of the instrument and the markets in which it is
traded, including the risk characteristics of the instrument, its
historical price volatility, and liquidity in the relevant market.
Determining such margin requirements does not solely depend upon such
quantitative
[[Page 69420]]
factors, but also requires expert judgment as to the extent to which
such characteristics and data may be an accurate predictor of future
market behavior with respect to such instruments, and applying such
judgment to the quantitative results. Thousands of different swap
products may be subject to clearing. Determining the risk
characteristics, price volatility, and market liquidity of even a
sample for purposes of determining a confidence level specifically for
such instrument would be a formidable task for the Commission to
undertake and any results would be subject to a range of uncertainty.
Reliable data is not readily available for many swaps that prior to the
Dodd-Frank Act were executed in unregulated markets. In sum, in the
absence of a reasonably feasible and reliable methodology at the
present time for the Commission to use in calculating the margin
requirements for swaps,\269\ the Commission believes that possible
future circumstances surrounding margin levels are too speculative and
uncertain to be able to quantify or estimate the resulting costs to
DCOs, clearing members, or the public from the rule with any precision
or degree of magnitude.
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\269\ Id.
---------------------------------------------------------------------------
Benefits
A minimum confidence level is essential to protect market
participants and the public. A minimum confidence level will prevent
DCOs from competing with respect to how much risk they are willing to
take on or from misjudging the amount of risk they would take on if
they operated under lower standards. In addition, it will provide
assurance to market participants that every DCO has sufficient margin
to effectively manage a default.
Some DCOs currently apply the 99 percent standard. Others use 95-99
percent for some contracts depending on facts and circumstances.
International standards currently recommend 99 percent.\270\ In view of
the increased risk that DCOs will face as a result of clearing swaps,
the Commission believes that protection of market participants and the
public dictates that the minimum standard on this key risk management
element should be set in accordance with current best practices among
DCOs and international standards.
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\270\ See CPSS-IOSCO Consultative Report, Principle 6: Margin,
Key Consideration 3, at 40; EMIR, Article 39, paragraph 1, at 46.
---------------------------------------------------------------------------
2. Efficiency, Competitiveness, and Financial Integrity
Costs
The considerations under this factor are very similar to the
considerations under the first factor.
Benefits
The rule will promote efficiency, competitiveness and financial
integrity by establishing a minimum standard for all DCOs. While a DCO
will still have considerable latitude in setting risk-based margin
levels, the Commission has determined that establishing a minimum
confidence level will provide legal certainty for an evolving
marketplace, will offer a practical means for assuring that the
thousands of different swaps that are going to be cleared subject to
the Commission's oversight will have prudent minimum margin
requirements, and will prevent a potential ``race to the bottom'' by
competing DCOs. As noted above, the Commission is adopting a 99%
standard in order to conform to current best practices among DCOs as
well as international standards. Competition among DCOs will be
channeled to other areas such as level of service.
The Commission believes that default by a clearing member could
have a significant, adverse effect on market participants and the
public. Market participants may have to incur the costs of making up
any shortfall in margin through guaranty fund deposits and/or
assessments, and any costs associated with participation in an auction
or allocation of the positions of a defaulting clearing member. In a
worst case scenario, a default by a clearing member may undermine the
financial integrity of the DCO, which could have significant negative
consequences for the financial stability of U.S. financial markets. As
highlighted by recent events in the global financial markets, the
ability to manage the risks associated with clearing is critical to the
goal of stability in the broader financial markets. This rule protects
market participants and the public from bearing these costs by
requiring a DCO to follow certain minimum standards in establishing
margin requirements.
3. Price Discovery
The Commission does not believe that this rule will have a material
effect on price discovery.
4. Sound Risk Management Practices
Costs
Because the rule simply establishes minimums, it will not hinder
the exercise of sound risk management practices. The rule specifically
requires DCOs to use higher confidence levels if appropriate for
particular products.
Benefits
As discussed under the first two factors, the rule will foster
sound risk management practices.
5. Other Public Interest Considerations
The Commission does not believe that the rule will have a material
effect on public interest considerations other than those identified
above.
Gross Margin
As proposed, Sec. 39.13(g)(8)(i) would require a DCO to collect
initial margin on a gross basis for customer accounts.
Two commenters supported the proposal. Several commenters stated
that the provision of individual customer position information to DCOs
may entail significant, costly, and time-consuming changes to systems
infrastructure at the clearing member level and the DCO level.
In light of the various concerns regarding the operational and
technology changes that would be needed and related costs of requiring
a DCO to obtain individual customer position information from its
clearing members and to use such information to calculate the margin
requirements for each individual customer, the Commission is modifying
Sec. 39.13(g)(8)(i). As amended, the rule provides a DCO with the
discretion to either calculate customer gross margin requirements based
on individual customer position information that it obtains from its
clearing members or based on the sum of the gross positions of all of a
clearing member's customers that the clearing member provides to the
DCO, without forwarding individual customer position information to the
DCO.
The Commission has evaluated the costs and benefits of the proposed
regulation in light of the specific considerations identified in
Section 15(a) of the CEA, as follows:
1. Protection of Market Participants and the Public
Costs
Three kinds of costs could result from a change from net to gross
margining, for those DCOs that currently use net margining.\271\ First,
gross margining could change the loss that customers of a clearing
member may face in the event
[[Page 69421]]
of default by a fellow customer of that clearing member. Under net
margining, a greater portion of customer margin is held at the clearing
member and thereby insulated from the DCO, so that non-defaulting
customers face lower risk of losing their margin deposits to the DCO if
a fellow customer defaults. Gross margining gives a DCO access to the
margin deposits of non-defaulting customers of a defaulting FCM.\272\
In this sense, gross margining could shift a portion of the default
risk from the DCO to fellow customers.\273\
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\271\ As discussed in section IV.D.6.h.(1), above, certain DCOs
already use a version of gross margining, in which case the costs of
complying with Sec. 39.13(g)(8)(i) would be considerably less.
\272\ Offsetting this effect is the potential for a failing FCM
to misappropriate customer funds. That potential is greater under
net margining.
\273\ The Commission has proposed rules that would not permit
this in the case of swaps. See 76 FR 33818 (June 9, 2011)
(Protection of Cleared Swaps Customer Contracts and Collateral;
Conforming Amendments to the Commodity Broker Bankruptcy
Provisions).
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It is not possible to estimate or quantify these costs--which would
only arise in the event of a default of a customer--in a reliable way
for a number of reasons. The historical record prior to the enactment
of the Dodd-Frank Act with respect to the operation of clearing
organizations provides little guidance as to the costs that may be
incurred in the future in the unlikely event of a default at a DCO.
Defaults at DCOs are very rare and the circumstances of each one are
unique. Moreover, the Dodd-Frank Act and implementing regulations will
alter the landscape significantly. Existing DCOs and FCMs will be
clearing new products. New DCOs and FCMs will enter the market.
Mandatory clearing will bring new products and participants to DCOs and
FCMs. The interaction of all these factors creates a wide range of
uncertainty as to the nature of the potential consequences of a default
under the new regulatory regime. In sum, the Commission believes that
the possible future circumstances leading to and potential resulting
consequences of a future default are too speculative and uncertain to
be able to quantify or estimate the resulting costs to clearing members
with any precision or degree of magnitude.
Second, because gross margining means that more customer margin is
held at the DCO, rather than the FCM, gross margining also means that
any return on this margin (e.g., interest earned) is earned by the DCO,
rather than the FCM. This is largely a transfer between those parties.
If there is no offsetting change in other terms of the relationship
between customers, FCMs and DCOs, gross margining leads to a cost for
FCMs and a benefit to DCOs from this change.
Third, gross margining could result in changes in operating costs
for DCOs and clearing members. Gross margining could require the DCO to
possess more detailed information about customer positions. The
provision of individual customer position information to DCOs may
entail significant, costly, and time-consuming changes to systems
infrastructure at the clearing firm level and the DCO level. For
example, NYPC stated that its preliminary cost estimate for compliance
with the customer gross margin and large trader report requirements
contained in proposed Sec. Sec. 39.13(g)(8)(i) and 39.13(h)(2) was
approximately 128,650 hours and $14.5 million.
In order to reduce the potential costs, the Commission has revised
Sec. 39.13(g)(8)(i) to allow a DCO to permit an FCM to provide the DCO
with the sum of the gross positions of all of its customers so that the
DCO may calculate the applicable gross margin requirement based on that
sum. Under this scenario, a DCO will not have to establish a framework
to receive each customer's position information and calculate the
initial margin requirement applicable to each customer's positions. The
Commission believes this alternative framework will be significantly
less expensive for market participants. Whether a DCO chooses to make
the calculation based on individual customer position information or
the sum of customers' gross positions submitted by the clearing member,
the clearing member's customer gross margin requirement will be the
same.
NYPC also commented that such implementation costs could
significantly deter new clearinghouses like NYPC from launching.
However, NYPC did not provide an estimate for the costs of a new
clearinghouse system capable of gross margining in relation to the cost
of retrofitting an existing net margin system. The Commission believes
that retrofitting an existing system may be more expensive than
implementing a new system from scratch, and that it is unclear whether
additional implementation costs would deter any new clearinghouses.
Benefits
The Commission believes that the clearing of swaps will increase
the risk that DCOs face. Gross margining will increase the amount of
money that DCOs hold. Under gross margining, the amount of margin at
the DCO more accurately approximates the risks posed to a DCO by its
clearing members' customers than net margining and increases the
financial resources available to a DCO in the event of a customer
default.
A DCO may not be able to collect initial customer margin from an
FCM if the FCM defaults. This could have a serious adverse impact on
the financial stability of a DCO, non-defaulting customers, and
potentially wider markets. In this regard, a significant customer
default leading to an FCM default could strain a DCO's financial
resources, causing it to exhaust the initial margin available to cover
the default and forcing other clearing members and/or the DCO to incur
related costs. In the worst case, an FCM default resulting from a large
customer default could cause a DCO to fail if its financial resources
are inadequate to cover the losses it incurs as a result of the
default. Gross margining provides the DCO with a larger financial
cushion that can be tapped in the event of a default. Initial margin is
the DCO's first ``line of defense'' in managing a default, and a larger
initial margin held at the DCO will help compensate for the DCO's
inability to collect additional margin from a defaulting clearing
member. This rule protects market participants and the public from
bearing these costs by requiring a DCO to hold additional margin.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
The considerations under this factor are very similar to the
considerations under the first factor.
Benefits
The rule promotes efficiency, competitiveness, and financial
integrity by providing that the amount of margin at the DCO more
accurately approximates the risks posed to a DCO by its clearing
members' customers and by increasing the financial resources available
to a DCO in the event of a customer default.
3. Price Discovery
The Commission does not believe that this rule will have a material
effect on price discovery.
4. Sound Risk Management Practices
The considerations relating to sound risk management practices are
very similar to the considerations under the first factor.
5. Other Public Interest Considerations
The Commission does not believe that the rule will have a material
effect on
[[Page 69422]]
public interest considerations other than those identified above.
Risk Limits
As proposed, Sec. 39.13(h)(1)(i) would require a DCO to impose
risk limits on each clearing member, by customer origin and house
origin, in order to prevent a clearing member from carrying positions
where the risk exposure of those positions exceeds a threshold set by
the DCO relative to the clearing member's financial resources, the
DCO's financial resources, or both.
Several commenters supported the rule as an appropriate risk
management procedure. Two commenters suggested that the rule is overly
prescriptive. The Commission did not receive any comments that
quantified the costs of this rule.
The Commission is adopting Sec. 39.13(h)(i) as proposed.
The Commission has evaluated the costs and benefits of the proposed
regulation in light of the specific considerations identified in
Section 15(a) of the CEA, as follows:
1. Protection of Market Participants and the Public
Costs
Some DCOs already set limits and will not incur any costs. Others
will incur the costs of calculating limits for each clearing member.
Such costs will be incremental because all DCOs currently have
procedures for monitoring clearing member risk and may already have
informal triggers or alerts in place. For clearing members, the rule
would impose opportunity costs to the extent the limits constrain their
activities.
Under the rule each DCO would have discretion to set limits for
each clearing member. It would be pure conjecture for the Commission to
estimate what levels DCOs would set for their clearing members and how
much that would constrain such clearing members. Each DCO would rely on
the informed judgment of its risk management committee and/or risk
management staff to assess the risks and resources of each clearing
member and arrive at the applicable limits for each one. Estimating the
extent to which this would constrain clearing members is even more
speculative. That would entail a guess as to the risk appetite of each
clearing member. In sum, the Commission believes that possible future
circumstances surrounding risk limits are too speculative and uncertain
to be able to quantify or estimate the resulting costs to DCOs,
clearing members, or the public with any precision or degree of
magnitude.
Benefits
The rule will benefit market participants by reducing the ability
of clearing members and their customers to assume excessive risks. This
will diminish the chances of default with all the attendant
consequences previously discussed.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
The considerations under this factor are very similar to the
considerations under the first factor.
Benefits
Because the rule provides DCOs the discretion to tailor the limits
for each clearing member in accordance with the DCO's assessment of the
risk that the clearing member poses, it will foster efficiency and
competitiveness in the markets. Because it will decrease the chance of
default it will foster financial integrity.
The Commission believes that default by a clearing member could
have a significant, adverse effect on market participants or the
public. Market participants may have to incur the costs of making up
any shortfall in margin through guaranty fund deposits and/or
assessments, and any costs associated with participation in an auction
or allocation of the positions of a defaulting clearing member. In a
worst case scenario, a default by a clearing member may undermine the
financial integrity of the DCO, which could have serious and widespread
consequences for the stability of U.S. financial markets. This rule
protects market participants and the public from bearing these costs by
requiring a DCO to analyze the risk posed by each clearing member and
impose appropriate limits.
3. Price Discovery
The Commission does not believe that this rule will have a material
effect on price discovery.
4. Sound Risk Management Practices
Costs
The considerations under this factor are very similar to the
considerations under the first factor.
Benefits
Risk limits are a sound risk management practice currently employed
by several DCOs. The rule will extend the practice across all DCOs.
5. Other Public Interest Considerations
The Commission does not believe that the rule will have a material
effect on public interest considerations other than those identified
above.
Large Trader Reports
As proposed, Sec. 39.13(h)(2) would require a DCO to obtain from
its clearing members, copies of all reports that such clearing members
are required to file with the Commission pursuant to part 17 of the
Commission's regulations, i.e., large trader reports. Proposed Sec.
39.13(h)(2) would further require a DCO to review the large trader
reports that it receives from its clearing members on a daily basis to
ascertain the risk of the overall portfolio of each large trader.
One commenter supported the proposal. One commenter argued that the
proposed requirement that DCOs obtain large trader reports from
clearing members is duplicative because a DCO receives large trader
information from the exchange. One commenter stated that a DCO would
need new technology to implement the rule. One commenter stated that a
DCO would need additional surveillance staff.
The Commission is modifying Sec. 39.13(h)(2) to require a DCO to
obtain large trader reports either from its clearing members or from a
DCM or a SEF for which it clears.
The Commission has evaluated the costs and benefits of the proposed
regulations in light of the specific considerations identified in
Section 15(a) of the CEA, as follows:
1. Protection of Market Participants and the Public
Costs
The Commission notes that some DCOs already receive large trader
reports from DCMs and review large trader reports for risk surveillance
purposes on a daily basis. For them, this rule imposes no additional
cost. For other DCOs, the receipt and analysis of large trader
information may entail significant, costly, and time-consuming changes
to systems infrastructure. Clearing members could also incur costs to
provide large trader reports to DCOs. For example, NYPC stated that its
preliminary cost estimate for compliance with the customer gross margin
and large trader report requirements contained in proposed Sec. Sec.
39.13(g)(8)(i) and 39.13(h)(2) was approximately 128,650 hours and
$14.5 million.
In order to reduce costs, the Commission modified Sec. 39.13(h)(2)
to permit a DCO to obtain large trader reports either from its clearing
members or from a DCM or a SEF for which it clears. The latter approach
would
[[Page 69423]]
eliminate duplicative reporting for clearing members and would
significantly reduce costs for DCOs by enabling them to obtain the data
from a single source.
Benefits
Currently, at some DCOs, the receipt and analysis of large trader
reports is an integral part of their risk management programs.
Extension of this practice to all DCOs would benefit market
participants and the public. Proactive analysis of this information
allows DCOs to identify and to address incipient problems in customer
accounts before they get out of hand. In particular, large trader
reports are an essential part of a rigorous risk management system
because they provide information that is required for stress testing.
A default by a clearing member could have a significant, adverse
effect on market participants or the public. Market participants may
have to incur the costs of making up any shortfall in margin through
guaranty fund deposits and/or assessments, and any costs associated
with participation in an auction or allocation of the positions of a
defaulting clearing member. In a worst case scenario, a default by a
clearing member may undermine the financial integrity of the DCO, which
could have serious and widespread consequences for the stability of
U.S. financial markets. This rule protects market participants and the
public by requiring a DCO to analyze the potential risks at an earlier
stage.
2. Efficiency, Competitiveness, and Financial Integrity
The considerations under this factor are very similar to the
considerations under the first factor.
3. Price Discovery
The Commission does not believe that this rule will have a material
effect on price discovery.
4. Sound Risk Management Practices
The considerations under this factor are very similar to the
considerations under the first factor.
5. Other Public Interest Considerations
The Commission does not believe that the rule will have a material
effect on public interest considerations other than those identified
above.
Clearing Member Risk Review
As proposed, Sec. 39.13(h)(5)(ii) would require each DCO to review
the risk management policies, procedures, and practices of each of its
clearing members on a periodic basis.
Several commenters asserted that the review would be burdensome for
such clearing members. The Commission did not receive any comments that
quantified the costs of this rule.
The Commission is adopting the rule with two modifications. These
changes clarify that a DCO's review need only cover those procedures of
a clearing member which address the risks that such clearing member may
pose to the DCO.
The Commission has evaluated the costs and benefits of Sec.
39.13(h)(5)(ii) in light of the specific considerations identified in
Section 15(a) of the CEA, as follows:
1. Protection of Market Participants and the Public
Costs
Those DCOs that currently conduct risk reviews of their clearing
members are not likely to incur any additional costs as a result of the
rule.\274\ Those DCOs that do not currently have such a program will
incur costs to build on existing procedures for reviewing applicants
for clearing membership in order to develop programs for ongoing review
of clearing members. Clearing members will incur costs in working with
the DCOs that review them. Commission staff intends to work with the
DCOs to develop arrangements designed to avoid duplicative efforts
without compromising the requirement that each DCO maintain an
understanding of the risks of each of its clearing members.
---------------------------------------------------------------------------
\274\ To the extent that some DCOs would conduct risk reviews in
the absence of a rule, the incremental benefits of the rule are
reduced. Even for these DCOs, however, a rule provides the market
with the benefit of greater certainty that risk reviews of members
will be continued in the future.
---------------------------------------------------------------------------
In recognition that each DCO has a unique product mix and set of
rules, the rule does not prescribe the specific frequency, depth, or
methodology of such reviews, nor does it specify when an on-site audit
may or may not be appropriate. Nevertheless, based on the Commission's
experience overseeing DCOs that currently conduct risk reviews of
clearing members, the Commission estimates the approximate costs of
this rule as follows.\275\
---------------------------------------------------------------------------
\275\ Figures used in the estimate are based on the judgment of
Commission staff with experience overseeing DCO reviews of clearing
member risk.
---------------------------------------------------------------------------
The Commission estimates that a risk review by a large DCO
typically would require on the order of 100 person-hours of work by a
supervisor and several risk analysts. This includes preparation, an on-
site visit, and drafting the report. The Commission also estimates that
a large DCO would perform, on average, 40 risk reviews a year, although
the number would vary depending on the number of clearing members a
particular DCO has, and other circumstances. The Commission estimates
compensation costs on the order of $150 an hour for risk analysts, and
$250 an hour for a supervisor. Based on these estimates, the Commission
estimates that the annual cost to a large DCO would be roughly on the
order of $700,000.\276\ Costs for particular DCOs are likely to vary
from this amount based on the size of the DCO, the DCO's management and
compensation practices, and the DCO's exercise of the flexibility
allowed by the rule provision. In light of the potential consequences
of risk management failures by clearing members discussed below, and of
the Commission's judgment that DCOs are the market participants in the
best position to review clearing member risk management programs, the
Commission believes that the benefits of this provision would justify
the costs even if costs proved to be substantially larger than the
Commission's estimate.
---------------------------------------------------------------------------
\276\ For example, 20 hours supervisor time per review x $250/hr
plus 80 hours analyst time per review x $150/hr = $17,000 x 40
reviews = $680,000.
---------------------------------------------------------------------------
Benefits
Rigorous risk management programs at clearing members benefit
market participants by providing safeguards to prevent default.
Clearing members are at the front line of risk management. The
Commission believes that risk reviews are important to ensure that each
clearing member's risk management framework is sufficient and properly
implemented. The Commission believes that a clearing member's DCO
should undertake the review because that DCO is in the best position to
review the risk management policies, procedures, and practices of its
clearing members in the context of the clearing members' obligations
under the DCO's rules.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
The considerations under this factor are very similar to the
considerations under the first factor.
Benefits
Ensuring that each clearing member has proper risk management
procedures for each DCO at which it clears will promote efficiency and
competitiveness in the clearing process by ensuring that the clearing
member is in compliance
[[Page 69424]]
with each such DCO's rules and encouraging the exercise of best
practices. The rule will foster financial integrity for the reasons set
forth under the first factor.
The Commission believes that default by a clearing member could
have a significant, adverse effect on market participants and the
public. Market participants may have to incur the costs of making up
any shortfall in margin through guaranty fund deposits and/or
assessments, and any costs associated with participation in an auction
or allocation of the positions of a defaulting clearing member. In a
worst case scenario, a default by an FCM may undermine the financial
integrity of the DCO, which could have serious and widespread
consequences for the stability of U.S. financial markets. This rule
protects market participants and the public from bearing these costs by
requiring a DCO to periodically review the risk management procedures
of each of its clearing members.
3. Price Discovery
The Commission does not believe that this rule will have a material
effect on price discovery.
4. Sound Risk Management Practices
The considerations under this factor are similar to the
considerations under the first factor.
5. Other Public Interest Considerations
The Commission does not believe that the rule will have a material
effect on public interest considerations other than those identified
above.
H. Settlement Procedures--Sec. 39.14(c)(3)
Section 5b(c)(2)(E) of the CEA, Core Principle E, as amended by the
Dodd-Frank Act, requires a DCO to: (1) complete money settlements on a
timely basis, but not less frequently than once each business day; (2)
employ money settlement arrangements to eliminate or strictly limit its
exposure to settlement bank risks (including credit and liquidity risks
from the use of banks to effect money settlements); (3) ensure that
money settlements are final when effected; (4) maintain an accurate
record of the flow of funds associated with money settlements; (5)
possess the ability to comply with the terms and conditions of any
permitted netting or offset arrangement with another clearing
organization; (6) establish rules that clearly state each obligation of
the DCO with respect to physical deliveries; and (7) ensure that it
identifies and manages each risk arising from any of its obligations
with respect to physical deliveries.
The Commission proposed Sec. 39.14 to implement Core Principle E.
With the exception of proposed Sec. 39.14(c), the commenters did not
address the costs of the proposed rule or the Commission's
consideration of costs and benefits.
Proposed Sec. 39.14(c)(3) would require a DCO to ``monitor the
full range and concentration of its exposures to its own and its
clearing members' settlement banks and assess its own and its clearing
members' potential losses and liquidity pressures in the event that the
settlement bank with the largest share of settlement activity were to
fail.'' It would further require that a DCO (i) maintain settlement
accounts at additional settlement banks; (ii) approve additional
settlement banks for use by its clearing members; (iii) impose
concentration limits with respect to its own or its clearing members'
settlement banks; and/or (iv) take any other appropriate actions
reasonably necessary in order to eliminate or strictly limit such
exposures.
As discussed above, several commenters expressed concern that these
provisions would impose costly requirements that are unnecessary or
could have unintended adverse consequences. In this regard, one
commenter claimed that the requirement to monitor clearing members'
exposure to their settlement banks could result in a duplication of
effort that would be burdensome for a DCO. Commenters also stated that
there are a limited number of banks that are qualified and willing to
serve as settlement banks; as such, it may be difficult for smaller
DCOs to maintain more than one settlement bank given the associated
costs. Further, commenters stated that imposing concentration limits
could increase systemic risk because a DCO would need to distribute
funds across multiple banks and as settlement funds increased, highly
rated banks would eventually reach the applicable concentration limit,
potentially forcing DCOs to open accounts with lower rated banks.
None of the commenters provided quantitative data or information to
support their assertions as to the potential costs and burdens of
compliance with Sec. 39.14(c)(3), and none addressed the benefits of
the rule.
As discussed above, the Commission believes that there are risks
associated with a DCO concentrating all its funds in a single
settlement bank. Bank failure in such a circumstance could have adverse
consequences for the DCO, its clearing members, and their customers.
However, the Commission also acknowledges the concerns expressed by
commenters, particularly given the settlement practices and procedures
that DCOs currently maintain in the absence of such a regulation.
Accordingly, the Commission is modifying Sec. 39.14(c)(3) to
eliminate any implied requirement that all DCOs must maintain
settlement accounts at more than one bank, and is retaining the
requirement that a DCO monitor exposure to its settlement bank(s) and
those of its clearing members, including an ongoing assessment of the
effect to the DCO of a failure of the settlement bank that has the
largest share of settlement activity. It is also clarifying its intent
to qualify the need to take actions set forth in Sec. 39.14(c)(3)(i)-
(iv) (such as imposing concentration limits) ``to the extent that any
such action or actions are reasonably necessary in order to eliminate
or strictly limit such exposures.'' Thus, the Commission is providing
DCOs with more flexibility than would have been provided under the
proposed rule which, in turn, should reduce the costs associated with
compliance.
The Commission has evaluated the costs and benefits of Sec.
39.14(c)(3) in light of the specific considerations identified in
Section 15(a) of the CEA, as follows:
1. Protection of Market Participants and the Public
Costs
A DCO's monitoring of its exposure to its settlement bank(s) and
those of its clearing members is a sound business practice in which a
DCO should be engaged notwithstanding the rule. Nevertheless, the
Commission believes the rule will require commitment of DCO staff
resources, the costs of which could be passed along to clearing members
and market participants as part of the DCO's clearing fees. Such costs
could vary significantly across DCOs given differences in operational
and risk management procedures, settlement arrangements, and fee
pricing practices. Given these circumstances, the Commission is unable
to quantify the costs attributable to the Commission's rule, and no
commenter provided an estimate. As a general matter, however, the
Commission is mindful that the measures set forth in Sec.
39.14(c)(3)(i)-(iv), specifically the requirement that DCOs take
actions that are ``reasonably necessary in order to eliminate or
strictly limit'' exposure to settlement banks, could cause DCOs to
incur costs. Such costs could include, for example, the costs of
establishing an account at an additional settlement bank, which would
entail evaluating the bank to ensure that it meets the DCO's
[[Page 69425]]
criteria for a settlement bank, reviewing account agreements, and
establishing connectivity to the bank. There may also be fees charged
by a bank for standby services if the bank is not used as the primary
settlement bank, or there may be other account-related fees. The
Commission is unable to ascertain the specific amount of any such costs
for DCOs because of the varying nature of settlement bank arrangements
across DCOs.
Benefits
Use of multiple settlement banks by DCOs, as well as imposition of
concentration limits and other safeguards provided for in Sec.
39.14(c)(3)(i)-(iv), when reasonably necessary, could help insulate the
DCO and its members from the risk of default by a settlement bank. This
in turn could provide market participants and the public with greater
protection from disruption of markets, as well as the clearing and
settlement system.
Affording a DCO flexibility in managing its settlement bank
arrangements and, to a lesser degree, those of its clearing members,
benefits market participants and the public by reducing the costs and
potential inefficiencies associated with maintaining settlement
arrangements with multiple settlement banks when that might not yield a
concomitant benefit in the form of risk reduction. The rule sets forth
general standards while permitting each DCO to tailor its settlement
bank arrangements to its unique circumstances and risk tolerances.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
Quantification or estimation of costs to efficiency,
competitiveness, and financial integrity of markets are not readily
ascertainable, and no commenter provided an estimate.
Benefits
The rule permits DCOs to obtain settlement services from a single
bank if the size and needs of the DCO, as well as the availability of
suitable settlement bank services, makes the use of more than one
settlement bank cost-prohibitive and it is not reasonably necessary to
have more than one settlement bank in order to eliminate or strictly
limit the DCO's exposures. More efficient use of DCO resources can
result in enhanced efficiency and financial integrity of the markets
for which the DCO clears. Particularly for smaller DCOs, it may not be
practical to obtain settlement services from more than one settlement
bank because of the costs of evaluating a bank's suitability to perform
settlement functions, reviewing account agreements, and establishing
connectivity to the bank. There also may be account-related fees
charged by a bank, including fees for standby services, if the bank is
used as a back-up settlement bank and not the primary settlement bank.
3. Price Discovery
The Commission has not identified any ways in which Sec.
39.14(c)(3) could affect price discovery.
4. Sound Risk Management Practices
Costs
The Commission has not identified any ways in which Sec.
39.14(c)(3) could impair sound risk management practices.
Benefits
The Commission regards an effective settlement framework as a sound
risk management practice because it reduces the risks associated with a
bank's potential failure to make timely settlement. The requirements
that a DCO monitor risk exposures to settlement banks and address
diversification concerns, as reasonably necessary, are important
adjuncts to a DCO's overall risk management practices.
5. Other Public Interest Considerations.
The Commission has not identified any other costs or benefits that
should be taken into account.
I. Treatment of Funds--Sec. 39.15
Core Principle F, as amended by the Dodd-Frank Act, requires a DCO
to: (i) Establish standards and procedures that are designed to protect
and ensure the safety of its clearing members' funds and assets; (ii)
hold such funds and assets in a manner by which to minimize the risk of
loss or of delay in the DCO's access to the assets and funds; and (iii)
only invest such funds and assets in instruments with minimal credit,
market, and liquidity risks.\277\
---------------------------------------------------------------------------
\277\ Section 5b(c)(2)(F) of the CEA; 7 U.S.C. 7a-1(c)(2)(F)
(Core Principle F).
---------------------------------------------------------------------------
Proposed Sec. 39.15 would establish minimum standards for DCO
compliance with Core Principle F. Among other things, it would set
forth standards for the types of assets that could be accepted as
initial margin. In this regard, proposed Sec. 39.15(c)(1) would
require a DCO to limit the assets it accepts as initial margin to those
that have minimal credit, market, and liquidity risk. It would further
specify that a DCO may not accept letters of credit as initial margin.
The Commission received comments on substantive aspects of the
proposed rules, and it has addressed those comments above. The
Commission also received several comments on potential costs associated
with the proposed Sec. 39.15(c)(1) prohibition on the acceptance of
letters of credit as initial margin.\278\ CME asserted that the
prohibition is unnecessary because letters of credit provide an
absolute assurance of payment and, therefore, the issuing bank must
honor the demand even in circumstances where the beneficiary is unable
to reimburse the bank for its payment. Other commenters suggested that
letters of credit should be acceptable if they are subject to
appropriate conditions. Finally, several commenters warned of the
potential risks associated with prohibiting letters of credit,
including higher costs for clearing members and their customers, the
potential placement of U.S. DCOs at a disadvantage as compared to
foreign clearing houses, and increased systemic risk as a result of
decreased voluntary clearing.
---------------------------------------------------------------------------
\278\ The Commission notes that proposed 39.15(c)(1) regarding
types of assets that can be accepted as initial margin has been
redesignated as Sec. 39.13(g)(10) under the risk management rules.
---------------------------------------------------------------------------
Taking into account both the strong track record of letters of
credit in connection with cleared futures and options on futures and
the potentially greater risks of cleared swaps, the Commission has
determined to modify the rule to permit letters of credit in connection
with cleared futures and options on futures but to retain the
prohibition on letters of credit as initial margin for swaps. Certain
DCOs have accepted letters of credit as initial margin for futures and
options on futures for a number of years without incident and continue
to do so. On the other hand, letters of credit are only a promise by a
bank to pay, not an asset that can be sold. The Commission is concerned
that the potential losses that swap market participants could incur may
be of a greater magnitude than potential losses with respect to futures
and options. Initial margin is the first financial resource that a DCO
will apply in the event of a clearing member default. If a DCO were to
need to draw on a letter of credit posted by a clearing member whose
customers had suffered such losses, the larger the amount that it would
need to draw, the greater the risk that the issuing bank may be unable
to pay under the terms of the letter of credit. Accordingly, the
Commission is modifying the proposal as described.
[[Page 69426]]
The Commission has evaluated the costs and benefits of Sec.
39.13(g)(10) in light of the specific considerations identified in
Section 15(a) of the CEA, as follows:
1. Protection of Market Participants and the Public
Costs
The prohibition on accepting letters of credit as initial margin
for swaps may impose higher costs for clearing members because they
will have to deposit cash or other assets that have minimal credit,
market, and liquidity risk for those products. This could increase
costs for market participants and decrease capital efficiency. It may
also place U.S. DCOs at a disadvantage to those foreign clearing houses
that permit letters of credit to be used as initial margin for swaps.
The Commission notes, however, that in response to the comments it has
modified the rule to permit letters of credit for futures. Therefore,
futures market participants will not incur any costs as a result of
this provision.
It is not possible to estimate or quantify these costs for a number
of reasons. The Dodd-Frank Act and implementing regulations will
significantly affect the manner in which swaps are developed, traded,
executed, and cleared. Existing DCOs and FCMs will be clearing new
products. New DCOs and FCMs will enter the market. Mandatory clearing
will bring new products and participants to DCOs and FCMs. The
interaction of all these factors creates a wide range of uncertainty as
to which products will be cleared, what their margin requirements will
be, and the extent to which clearing members would post letters of
credit as margin if permitted. Under these circumstances, the potential
opportunity costs that may arise from the deposit of cash or other
assets rather than letters of credit depends on a variety of future
circumstances and actions of market participants that cannot be known
or predicted at the present time. In sum, the Commission believes that
the possible future circumstances involving the posting of letters of
credit as margin is too speculative and uncertain to be able to
quantify or estimate the resulting costs to clearing members with any
precision or degree of magnitude.
Benefits
One of the primary functions of a DCO is to guarantee financial
performance, which includes performing daily variation settlement.
Daily pays are made in cash, and to the extent a DCO relies on margin
deposits to meet its end-of-day obligations, it must have access to
sufficient cash or highly liquid assets. Similarly, initial margin may
be tapped by a DCO in the event of a clearing member default. By
limiting the use of letters of credit, the DCO will avoid the
possibility that a letter of credit would be dishonored when presented
to the issuing bank.
Thus, requiring initial margin in the form of assets that can be
immediately sold provides greater financial protection to the DCO,
clearing members, and market participants.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
As noted above, there could be competitive disadvantages to DCOs if
foreign competitors do not impose similar restrictions on initial
margin deposits. In addition, the prospect of increased costs may
reduce voluntary clearing of swaps, which would be inconsistent with
the goals of the Dodd-Frank Act and could potentially lead to systemic
risk.
Benefits
A DCO can be more efficient in facilitating payments if it has
readily available liquid assets as opposed to a conditional obligation
that must be presented for payment. Holding actual assets provides
greater assurance of financial integrity to the clearing process, as
the DCO will not have to bear the costs of possible default on the part
of the issuing bank. Even an irrevocable letter of credit can be
dishonored, with the DCO's only recourse being a lawsuit.
3. Price Discovery
The Commission does not believe this rule will have a material
effect on price discovery.
4. Sound Risk Management Practices
Costs
The Commission does not believe this rule will have a material
adverse impact on sound risk management practices.
Benefits
The Commission expects that prohibiting the use of letters of
credit as initial margin for swaps could serve to strengthen a DCO's
risk management program. It eliminates the risk of funds not being
available if a letter of credit were to be dishonored, which could have
a significant impact because initial margin is the first financial
resource to be tapped in the event of a clearing member default.
5. Other Public Considerations
The Commission does not believe this rule will have a material
impact on public interest considerations other than those discussed
above.
J. Reporting--Sec. 39.19
Core Principle J,\279\ as amended by the Dodd-Frank Act, requires a
DCO to provide the Commission with all information that the Commission
determines to be necessary to conduct oversight of the DCO.
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\279\ Section 5b(c)(2)(J) of the CEA, 7 U.S.C. 7a-1(c)(2)(J).
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The Commission proposed Sec. 39.19 to establish minimum
requirements that a DCO would have to meet in order to comply with Core
Principle J. Under proposed Sec. 39.19, certain reports would have to
be made by a DCO to the Commission (1) On a periodic basis (daily,
quarterly, or annually); (2) where the reporting requirement is
triggered by the occurrence of a significant event; and (3) upon
request by the Commission.
The rules would require DCOs to provide information that the
Commission has determined is necessary to conduct oversight of DCOs.
The proposed reporting regime would assist the Commission in monitoring
the financial strength and operational capabilities of a DCO and in
evaluating whether a DCO's risk management practices are effective. The
required reports also would assist the Commission in taking prompt
action as necessary to identify incipient problems and address them at
an early stage. A self-reporting program of this type enhances the
Commission's ability to conduct oversight given its limited resources
which do not permit routine on-site surveillance of DCOs.
The proposed rules would require submission of information
electronically and in a form and manner prescribed by the Commission.
These general procedural standards would provide flexibility to the
Commission in establishing and updating uniform format and delivery
protocols that would assist the Commission in conducting timely review
of submissions. In this regard, the transmission of information using a
uniform format would enable Commission staff to sort and interpret data
without the need to convert the data into a format that provides the
necessary functionality, e.g., it would be designed to provide the
Commission with the ability to compare data across DCOs when necessary.
A number of commenters discussed costs associated with proposed
Sec. 39.19
[[Page 69427]]
in the form of comments on the substantive provisions of the proposed
rule. For example, a number of commenters discussed whether alternative
reporting requirements might better inform the Commission of potential
risks. Some commenters questioned the need for certain information and
some commenters questioned the feasibility of the reporting
requirements. The Commission has addressed those comments above.
The Commission also received comments that directly addressed two
areas of the Commission's cost-benefit analysis of proposed Sec.
39.19: (1) The cost of preparing and submitting daily and annual
audited financial reports; and (2) the cost of reporting a 10 percent
decrease in financial resources. Those comments are discussed in detail
below.
a. Cost of Preparing and Submitting Daily and Annual Reports
Proposed Sec. 39.19(c) would require a DCO to submit various
periodic reports for the purposes of risk surveillance and oversight of
the DCO's compliance with the core principles and Commission
regulations. In the notice of proposed rulemaking, the Commission
observed that the information that would be reported was information
readily available to a DCO and which, in certain instances, was already
being reported to the Commission. The Commission requested data or
other information that could quantify or qualify costs.
Only NYPC provided an estimate of the fixed cost of implementing an
automated system for daily reporting. In a comment letter submitted by
NYPC, the cost was estimated at $582,000.
In a follow-up phone conversation with representatives of NYPC,
Commission staff discussed the basis for NYPC's estimate that
implementing an automated system for daily reporting would cost
$582,000. Staff was told that NYPC already provides certain daily
reports to the Commission, but that the additional data that it would
have to report under the proposal (not including the proposed gross
margin data or large trader data) would necessitate implementing an
automated system. NYPC representatives confirmed that the estimate was
for a one-time cost, not the cost of generating and transmitting the
actual daily reports. NYPC also confirmed that the cost of generating
and transmitting the actual daily reports would be minimal.
The Commission was able to estimate the costs of providing reports
and presented this information in the Paperwork Reduction Act
discussion. It estimated that daily reporting could require a DCO to
expend up to $8,280 per year, and an annual report could require a DCO
to expend up to $482,110 per year.
KCC and MGEX commented that the variable cost for daily reporting
could be significantly more than the Commission's estimates if the
Commission were to require a costly format and method of delivery. MGEX
also commented that the Commission may have underestimated the cost of
providing the annual report (audited financial report under Sec.
39.19(c)(3)(ii)), and that the Commission's estimate is ``extremely
excessive, particularly when most of [the annual reporting requirements
do] not appear to be required by the Dodd-Frank Act.'' Finally, MGEX
believes that the proposed rules will not guarantee increased market
participation or improve legitimate risk management and hedging
activity, and the additional costs will create barriers to entry and
decrease DCO competition.
Although KCC and MGEX commented that the costs of preparing the
reports may be greater than the Commission's estimates, neither DCO
provided an alternative estimate. Nor did they suggest alternative
reporting requirements that would achieve the purposes of the CEA with
a more favorable cost-benefit ratio. As to the estimated costs of the
required format and method of delivery, the Commission notes that it
based its estimate on the cost of using the SHAMIS system. The
Commission has no basis for concluding that the cost of using an
alternative system would be less substantial and it received no
comments on this.
The Commission believes that the costs that DCOs will incur to
implement a system to provide such information to the Commission are
necessary and justified. As explained above, the Commission has
determined that the information required in the reports is necessary
for the Commission to conduct adequate oversight of DCOs, particularly
given its limited ability to conduct on-site reviews.
b. Reporting a 10 Percent Decrease in Financial Resources
Under proposed Sec. 39.19(c)(4)(i), a DCO would be required to
report a decrease of 10 percent in the total value of its financial
resources either from (1) the value reported in the DCO's last
quarterly report or (2) from the value as of the close of the previous
business day. This would allow the Commission to more quickly identify
and address financial problems at the DCO. As discussed above, the
Commission raised the reporting threshold from 10 percent to 25 percent
in response to comments that a higher percentage might yield more
meaningful results. In addition, the higher threshold is likely to
reduce the number of reports that might be submitted under this
requirement.
NYPC commented that compliance with the proposed reporting
requirement would necessitate an expenditure of approximately 15,000
hours and $1.7 million. NYPC explained that this estimate reflects
implementing a system that would track default resources and working
capital, combined. After talking with Commission staff, NYPC submitted
a comment letter that provided a preliminary estimate of approximately
4,600 hours and $566,000 for designing, building, and testing a
reporting system for a decline in default resources only.
Based on NYPC's initial comment letter, the Commission believes
that the material costs associated with Sec. 39.19(c)(4)(i) are the
initial investments made by a DCO to develop and implement a system
(automated or not) to alert the DCO that the valuation threshold has
been met. As discussed above, it is important for the Commission to be
apprised of a 25% reduction in default resources because it could
indicate that the DCO's financial resources are strained and corrective
action may be needed.
The Commission has evaluated the costs and benefits of Sec. 39.19
in light of the specific considerations identified in Section 15(a) of
the CEA as follows:
1. Protection of Market Participants and the Public
Costs
Section 39.19 requires DCOs to provide information that the
Commission has determined is necessary for oversight of DCOs and to
provide that information in a time frame, format, and delivery method
that will enable effective use of the information. To the extent that
DCOs do not already have an infrastructure for preparing and
transmitting reports, they will incur one-time costs to put such a
framework in place.
Benefits
The comprehensive regulatory reporting program will enhance
protection of market participants and the public by promoting more in-
depth and effective oversight by the Commission. The reports will
assist the Commission's Risk Surveillance staff in monitoring clearing
house risk and evaluating DCOs' management and mitigation of that risk.
In addition, the
[[Page 69428]]
information will assist the Commission to identify incipient problems
and address them at an early stage.
2. Efficiency, Competitiveness, and Financial Integrity
Costs
The Commission does not believe that the reporting requirements
will adversely impact efficiency, competitiveness, or the financial
integrity of derivatives markets.
Benefits
The reporting requirements will protect the financial integrity of
derivatives markets because they will support effective and timely
oversight of DCOs. This will help to minimize the risk of default and
the impact default would have on the markets.
3. Price Discovery
The Commission does not believe that Sec. 39.19 will have a
material impact on price discovery.
4. Sound Risk Management Practices
Costs
The Commission does not believe that the reporting requirements
will adversely impact sound risk management practices.
Benefits
The reporting requirements are expected to enhance sound risk
management practices because the Commission will be able to more
effectively evaluate a DCO's risk management practices on an on-going
basis. The Commission staff can build a knowledge base that will
support prompt action if there are adverse changes in trends or
financial profiles.
5. Other Public Interest Considerations
The Commission does not believe this rule will have a material
impact on public interest considerations other than those discussed
above. Effective oversight of DCOs will enhance the safety and
efficiency of DCOs and reduce systemic risk. Safe and reliable DCOs are
essential not only for the stability of the derivatives markets they
serve but also the public which relies on the prices formed in these
markets for all manner of commerce.
IX. 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.\280\
The rules adopted herein will affect only DCOs). The Commission has
previously established certain definitions of ``small entities'' to be
used by the Commission in evaluating the impact of its regulations on
small entities in accordance with the RFA.\281\ The Commission has
previously determined that DCOs are not small entities for the purpose
of the RFA.\282\ Accordingly, the Chairman, on behalf of the
Commission, hereby certifies pursuant to 5 U.S.C. 605(b) that these
rules will not have a significant economic impact on a substantial
number of small entities. The Chairman made the same certification in
the proposed rulemakings, and the Commission did not receive any
comments on the RFA in relation to any of those rulemakings.
---------------------------------------------------------------------------
\280\ 5 U.S.C. 601 et seq.
\281\ 47 FR 18618 (Apr. 30, 1982).
\282\ See 66 FR 45604, at 45609 (Aug. 29, 2001) (New Regulatory
Framework for Clearing Organizations).
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B. Paperwork Reduction Act
The Commission may not conduct or sponsor, and a registered entity
is not required to respond to, a collection of information unless it
displays a currently valid Office of Management and Budget (OMB)
control number. The Commission's adoption of Sec. Sec. 39.3 (DCO
registration application requirements), 39.10 (annual compliance report
and recordkeeping), 39.11 (financial resources quarterly report), 39.14
(settlement recordkeeping), 39.18 (system safeguards reporting and
recordkeeping), 39.19 (periodic and event-specific reporting), and
39.20 (general recordkeeping), imposes new information collection
requirements on registered entities within the meaning of the Paperwork
Reduction Act.\283\
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\283\ 44 U.S.C. 3501 et seq.
---------------------------------------------------------------------------
Accordingly, the Commission requested and OMB assigned control
numbers for the required collections of information. The Commission has
submitted this notice of final rulemaking along with supporting
documentation for OMB's review in accordance with 44 U.S.C. 3507(d) and
5 CFR 1320.11. The titles for these collections of information are
``Financial Resources Requirements for Derivatives Clearing
Organizations, OMB control number 3038-0066,'' ``Information Management
Requirements for Derivatives Clearing Organizations, OMB control number
3038-0069,'' ``General Regulations and Derivatives Clearing
Organizations, OMB control number 3038-0081,'' and ``Risk Management
Requirements for Derivatives Clearing Organizations, OMB control number
3038-0076.'' Many of the responses to this new collection of
information are mandatory.
The Commission protects proprietary information according to the
Freedom of Information Act and 17 CFR part 145, ``Commission Records
and Information.'' In addition, Section 8(a)(1) of the CEA strictly
prohibits the Commission, unless specifically authorized by the Act,
from making public ``data and information that would separately
disclose the business transactions or market positions of any person
and trade secrets or names of customers.'' The Commission also is
required to protect certain information contained in a government
system of records according to the Privacy Act of 1974, 5 U.S.C. 552a.
The regulations require each respondent to file certain information
with the Commission and to maintain certain records.\284\ The
Commission received comments from NYPC and MGEX regarding the estimated
costs of preparing and submitting daily reports. It also received
comments from MGEX regarding costs associated with annual reports and
the proposed rules in general.
---------------------------------------------------------------------------
\284\ See 75 FR at 63119 (Oct. 14, 2010) (Financial Resources)
(requirement to file quarterly reports); see also discussion of the
financial resources reporting requirements in section IV.B.10,
above.
See 75 FR at 77583-77584 (Dec. 13, 2010) (General Regulations)
(proposed requirements: (i) For the CCO to submit an annual report
to the Commission; (ii) to retain a copy of the policies and
procedures adopted in furtherance of compliance with the CEA; (iii)
to retain copies of materials, including written reports provided to
the board of directors in connection with the board's review of the
annual report; and (iv) to retain any records relevant to the annual
report, including, but not limited to, work papers and other
documents that form the basis of the report, and memoranda,
correspondence, other documents, and records that are (a) created,
sent or received in connection with the annual report and (b)
contain conclusions, opinions, analyses, or financial data related
to the annual report); see also discussion of Sec. 39.10 in section
IV.A, above.
See 75 FR at 78193 (Dec. 15, 2010) (Information Management)
(proposed requirements to file specified information with the
Commission (i) periodically, on a daily, quarterly, and annual
basis; (ii) as specified events occur; and (iii) upon Commission
request); see also discussion of reporting requirements in section
IV.J, above.
See 75 FR at 78196 (Dec. 15, 2010) (Information Management)
(proposed requirement to maintain records of all activities related
to its business as a DCO, including all information required to be
created, generated, or reported under part 39, including but not
limited to the results of and methodology used for all tests,
reviews, and calculations); see also discussion of recordkeeping
requirements in section IV.K, above.
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NYPC and MGEX commented that the costs associated with the rules in
the Information Management proposed rulemaking would be higher than the
[[Page 69429]]
Commission estimated.\285\ With respect to daily reporting, NYPC
commented that designing, building, and testing the application
necessary to automate the process of producing daily reports would
require approximately 5,200 hours and cost $582,000.\286\ MGEX
commented that the cost to a DCO could be significantly more than the
estimated cost if the Commission were to require a costly format and
method of delivery.
---------------------------------------------------------------------------
\285\ See 75 FR at 78193 (Dec. 15, 2010) (Information
Management). In the Paperwork Reduction Act discussion, the
Commission estimated that daily reporting would result in an
aggregated cost of $8,280 initially (12 respondents x $690) and
$16,800 per annum (12 respondents x $1,400). Annual reporting would
result in an aggregated cost of $5,785,320 per annum (12 respondents
x $482,110).
\286\ In a follow-up phone conversation with representatives of
NYPC, Commission staff discussed the basis for NYPC's estimate that
implementing an automated system for daily reporting would cost
$582,000. Commission staff was told that NYPC already provides
certain daily reports to the Commission's Risk Surveillance Group,
but that the additional data that it would have to report under the
Information Management NPRM (not including the gross margin data or
large trader data) would necessitate implementing an automated
system. NYPC representatives confirmed that the estimate was for a
one-time cost, not the cost of generating and transmitting the
actual daily reports. NYPC also confirmed that the cost of
generating and transmitting the actual daily reports would be
minimal.
---------------------------------------------------------------------------
With respect to annual reporting, MGEX commented that the
Commission may have underestimated the associated costs because the
Commission did not address the costs of building reporting methods,
forms, programs, or the allocation of labor resources. In addition,
MGEX believes that the estimated costs associated with the annual
report are ``extremely excessive, particularly when most of [the annual
report requirements do] not appear to be required by the Dodd-Frank
Act.'' MGEX further commented that the proposed rules will not
guarantee increased market participation or improve legitimate risk
management and hedging activity, and the additional costs would create
barriers to entry and decreased DCO competition.
Finally, with respect to the estimated costs identified in the Risk
Management notice of proposed rulemaking,\287\ MGEX noted that the
Commission had estimated the total hours for the proposed collection of
information to be 50 hours per year per respondent for the additional
reporting requirements at an annual cost of $500 per respondent (50
hours x $10). MGEX stated its belief that these estimates, both in
hours and cost, are extremely low, and that it did not appear that the
Commission had accounted for the costs to implement a system; collect,
forward and format data; monitor and enforce compliance; and document
compliance with the proposed rulemaking. MGEX noted that the costs are
not limited to reporting to the Commission for many of the proposed
rules, and that reporting may be the least expensive facet. MGEX
specifically identified reporting the gross position of each beneficial
owner as a requirement for which the Commission did not provide any
cost estimates.
---------------------------------------------------------------------------
\287\ See 76 FR at 3716-3717 (Jan. 20, 2011) (Risk Management).
---------------------------------------------------------------------------
Although MGEX commented that the costs of the proposed requirements
may be greater than the costs the Commission set forth in the
Information Management and Risk Management proposed rulemakings, and
that the Commission did not estimate the costs of building reporting
methods, forms, programs, or the allocation of labor resources, MGEX
did not provide an estimate of these costs. Nor did MGEX suggest
alternative reporting requirements that would achieve the purposes of
the CEA with a more favorable cost-benefit ratio.
As to the estimated costs of the required format and method of
delivery, the Commission notes that the estimates of these costs were
based on the cost of using the SHAMIS system. There was no basis for
concluding that the cost of using an alternative system would be more
substantial and the Commission received no comment to that effect.
Moreover, Core Principle J requires a DCO to provide reports to the
Commission, and all DCOs will have to bear these costs in order to
comply with Core Principle J. Core Principle J requires each DCO ``to
provide to the Commission all information that the Commission
determines to be necessary to conduct oversight of the [DCO].'' As
discussed above and in the Information Management proposed rulemaking,
the Commission believes that the daily and annual reporting
requirements provide the Commission with information that is important
to its oversight of a DCO to ensure the DCO is in compliance with the
core principles. This can lead to increased market participation and
improve legitimate risk management and hedging activity. Accordingly,
the Commission believes the collection of information related to the
reporting rules is necessary to achieve the purposes of the CEA,
particularly in light of the Dodd-Frank Act clearing mandate for
swaps.\288\
---------------------------------------------------------------------------
\288\ See further discussion of the costs and benefits
associated with the reporting requirements in section VII.J, above.
---------------------------------------------------------------------------
The Commission has considered the comments of NYPC and MGEX but is
declining to revise the estimated costs. The Commission believes that
its original estimates remain appropriate for PRA purposes.
List of Subjects
17 CFR Part 1
Brokers, Commodity futures, Consumer protection, Definitions,
Swaps.
17 CFR Part 21
Brokers, Commodity futures, Reporting and recordkeeping
requirements.
17 CFR Part 39
Definitions, Commodity futures, Reporting and recordkeeping
requirements, Swaps, Business and industry, Participant and product
eligibility, Risk management, Settlement procedures, Treatment of
funds, Default rules and procedures, System safeguards, Enforcement
authority, Application form.
17 CFR Part 140
Authority delegations (Government agencies), Conflict of interests,
Organization and functions (Government agencies).
For the reasons stated in the preamble, amend 17 CFR parts 1, 21,
39, and 140 as follows:
PART 1--GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT
0
1. The authority citation for part 1 is revised to read as follows:
Authority: 7 U.S.C. 1a, 2, 5, 6, 6a, 6b, 6c, 6d, 6e, 6f, 6g, 6h,
6i, 6j, 6k, 6l, 6m, 6n, 6o, 6p, 7, 7a, 7b, 8, 9, 12, 12a, 12c, 13a,
13a-1, 16, 16a, 19, 21, 23, and 24, as amended by Pub. L. 111-203,
124 Stat. 1376.
0
2. Amend Sec. 1.3 to revise paragraphs (c) and (d), remove and reserve
paragraph (k), and add paragraphs (aaa), (bbb), (ccc), (ddd), (eee),
and (fff) to read as follows:
Sec. 1.3 Definitions.
* * * * *
(c) Clearing member. This term means any person that has clearing
privileges such that it can process, clear and settle trades through a
derivatives clearing organization on behalf of itself or others. The
derivatives clearing organization need not be organized as a membership
organization.
(d) Clearing organization or derivatives clearing organization.
This term means a clearinghouse, clearing association, clearing
corporation, or similar entity, facility, system, or
[[Page 69430]]
organization that, with respect to an agreement, contract, or
transaction--
(1) Enables each party to the agreement, contract, or transaction
to substitute, through novation or otherwise, the credit of the
derivatives clearing organization for the credit of the parties;
(2) Arranges or provides, on a multilateral basis, for the
settlement or netting of obligations resulting from such agreements,
contracts, or transactions executed by participants in the derivatives
clearing organization; or
(3) Otherwise provides clearing services or arrangements that
mutualize or transfer among participants in the derivatives clearing
organization the credit risk arising from such agreements, contracts,
or transactions executed by the participants.
(4) Exclusions. The terms clearing organization and derivatives
clearing organization do not include an entity, facility, system, or
organization solely because it arranges or provides for--
(i) Settlement, netting, or novation of obligations resulting from
agreements, contracts or transactions, on a bilateral basis and without
a central counterparty;
(ii) Settlement or netting of cash payments through an interbank
payment system; or
(iii) Settlement, netting, or novation of obligations resulting
from a sale of a commodity in a transaction in the spot market for the
commodity.
* * * * *
(k) [Reserved]
* * * * *
(aaa) Clearing initial margin. This term means initial margin
posted by a clearing member with a derivatives clearing organization.
(bbb) Customer initial margin. This term means initial margin
posted by a customer with a futures commission merchant, or by a non-
clearing member futures commission merchant with a clearing member.
(ccc) Initial margin. This term means money, securities, or
property posted by a party to a futures, option, or swap as performance
bond to cover potential future exposures arising from changes in the
market value of the position.
(ddd) Margin call. This term means a request from a futures
commission merchant to a customer to post customer initial margin; or a
request by a derivatives clearing organization to a clearing member to
post clearing initial margin or variation margin.
(eee) Spread margin. This term means reduced initial margin that
takes into account correlations between certain related positions held
in a single account.
(fff) Variation margin. This term means a payment made by a party
to a futures, option, or swap to cover the current exposure arising
from changes in the market value of the position since the trade was
executed or the previous time the position was marked to market.
0
3. Amend Sec. 1.12 to remove and reserve paragraph (f)(1).
PART 21--SPECIAL CALLS
0
4. The authority citation for part 21 is revised to read as follows:
Authority: 7 U.S.C. 1a, 2, 2a, 4, 6a, 6c, 6f, 6g, 6i, 6k, 6m,
6n, 7, 7a, 12a, 19 and 21, as amended by Pub. L. 111-203, 124 Stat.
1376; 5 U.S.C. 552 and 552(b), unless otherwise noted.
0
5. Redesignate Sec. 21.04 as Sec. 21.05.
0
6. Add a new Sec. 21.04 to read as follows:
Sec. 21.04 Special calls for information on customer accounts or
related cleared positions.
Upon special call by the Commission, each futures commission
merchant, clearing member or foreign broker shall provide information
to the Commission concerning customer accounts or related positions
cleared on a derivatives clearing organization in the format and manner
and within the time provided by the Commission in the special call.
0
7. Add Sec. 21.06 to read as follows:
Sec. 21.06 Delegation of authority to the Director of the Division of
Clearing and Risk.
The Commission hereby delegates, until the Commission orders
otherwise, the special call authority set forth in Sec. 21.04 to the
Director of the Division of Clearing and Risk to be exercised by such
Director or by such other employee or employees of such Director as
designated from time to time by the Director. The Director of the
Division of Clearing and Risk may submit to the Commission for its
consideration any matter which has been delegated in this section.
Nothing in this section shall be deemed to prohibit the Commission, at
its election, from exercising the authority delegated in this section
to the Director.
PART 39--DERIVATIVES CLEARING ORGANIZATIONS
0
8. Revise part 39 to read as follows:
Subpart A--General Provisions Applicable to Derivatives Clearing
Organizations
Sec.
39.1 Scope.
39.2 Definitions.
39.3 Procedures for registration.
39.4 Procedures for implementing derivatives clearing organization
rules and clearing new products.
39.5 Submission of swaps for Commission determination regarding
clearing requirements.
39.6 [Reserved]
39.7 Enforceability.
39.8 Fraud in connection with the clearing of transactions on a
derivatives clearing organization.
Subpart B--Compliance With Core Principles
39.9 Scope.
39.10 Compliance with core principles.
39.11 Financial resources.
39.12 Participant and product eligibility.
39.13 Risk management.
39.14 Settlement procedures.
39.15 Treatment of funds.
39.16 Default rules and procedures.
39.17 Rule enforcement.
39.18 System safeguards.
39.19 Reporting.
39.20 Recordkeeping.
39.21 Public information.
39.22 Information sharing.
39.23 Antitrust considerations.
39.24 [Reserved]
39.25 [Reserved]
39.26 [Reserved]
39.27 Legal risk considerations.
Appendix A to Part 39--Form DCO Derivatives Clearing Organization
Application for Registrations
Authority: 7 U.S.C. 7a-1 as amended by Pub. L. 111-203, 124
Stat. 1376.
Subpart A--General Provisions Applicable to Derivatives Clearing
Organizations
Sec. 39.1 Scope.
The provisions of this subpart A apply to any derivatives clearing
organization as defined under section 1a(15) of the Act and Sec.
1.3(d) of this chapter which is registered or deemed to be registered
with the Commission as a derivatives clearing organization, is required
to register as such with the Commission pursuant to section 5b(a) of
the Act, or which voluntarily applies to register as such with the
Commission pursuant to section 5b(b) or otherwise.
Sec. 39.2 Definitions.
For the purposes of this part,
Back test means a test that compares a derivatives clearing
organization's initial margin requirements with historical price
changes to determine the extent of actual margin coverage.
Customer means a person trading in any commodity named in the
definition of commodity in section 1a(9) of the Act or in Sec. 1.3 of
this chapter, or in any swap as defined in section 1a(47) of the Act or
in Sec. 1.3 of this chapter; Provided, however, an owner or holder of
a house
[[Page 69431]]
account as defined in this section shall not be deemed to be a customer
within the meaning of section 4d of the Act, the regulations that
implement sections 4d and 4f of the Act and Sec. 1.35, and such an
owner or holder of such a house account shall otherwise be deemed to be
a customer within the meaning of the Act and Sec. Sec. 1.37 and 1.46
of this chapter and all other sections of these rules, regulations, and
orders which do not implement sections 4d and 4f of the Act.
Customer account or customer origin means a clearing member account
held on behalf of customers, as that term is defined in this section,
and which is subject to section 4d(a) or section 4d(f) of the Act.
House account or house origin means a clearing member account which
is not subject to section 4d(a) or 4d(f) of the Act.
Key personnel means derivatives clearing organization personnel who
play a significant role in the operations of the derivatives clearing
organization, the provision of clearing and settlement services, risk
management, or oversight of compliance with the Act and Commission
regulations and orders. Key personnel include, but are not limited to,
those persons who are or perform the functions of any of the following:
chief executive officer; president; chief compliance officer; chief
operating officer; chief risk officer; chief financial officer; chief
technology officer; and emergency contacts or persons who are
responsible for business continuity or disaster recovery planning or
program execution.
Stress test means a test that compares the impact of potential
extreme price moves, changes in option volatility, and/or changes in
other inputs that affect the value of a position, to the financial
resources of a derivatives clearing organization, clearing member, or
large trader, to determine the adequacy of such financial resources.
Systemically important derivatives clearing organization means a
financial market utility that is a derivatives clearing organization
registered under section 5b of the Act, which has been designated by
the Financial Stability Oversight Council to be systemically important
and for which the Commission acts as the Supervisory Agency pursuant to
section 803(8) of the Dodd-Frank Wall Street Reform and Consumer
Protection Act.
Sec. 39.3 Procedures for registration.
(a) Application procedures. (1) An organization desiring to be
registered as a derivatives clearing organization shall file
electronically an application for registration with the Secretary of
the Commission in the format and manner specified by the Commission.
The Commission will review the application for registration as a
derivatives clearing organization pursuant to the 180-day timeframe and
procedures specified in section 6(a) of the Act. The Commission may
approve or deny the application or, if deemed appropriate, register the
applicant as a derivatives clearing organization subject to conditions.
(2) Application. Any person seeking to register as a derivatives
clearing organization, any applicant amending its pending application,
or any registered derivatives clearing organization seeking to amend
its order of registration (applicant), shall submit to the Commission a
completed Form DCO, which shall include a cover sheet, all applicable
exhibits, and any supplemental materials, including amendments thereto,
as provided in the appendix to this part 39 (application). An
applicant, when filing a Form DCO for purposes of amending its pending
application or requesting an amendment to an existing registration, is
only required to submit exhibits and updated information that are
relevant to the requested amendment and are necessary to demonstrate
compliance with the core principles affected by the requested
amendment. The Commission will not commence processing an application
unless the applicant has filed the application as required by this
section. Failure to file a completed application will preclude the
Commission from determining that an application is materially complete,
as provided in section 6(a) of the Act. Upon its own initiative, an
applicant may file with its completed application additional
information that may be necessary or helpful to the Commission in
processing the application.
(3) Submission of supplemental information. The filing of a
completed application is a minimum requirement and does not create a
presumption that the application is materially complete or that
supplemental information will not be required. At any time during the
application review process, the Commission may request that the
applicant submit supplemental information in order for the Commission
to process the application. The applicant shall file electronically
such supplemental information with the Secretary of the Commission in
the format and manner specified by the Commission.
(4) Application amendments. An applicant shall promptly amend its
application if it discovers a material omission or error, or if there
is a material change in the information provided to the Commission in
the application or other information provided in connection with the
application.
(5) Public information. The following sections of all applications
to become a registered derivatives clearing organization will be
public: first page of the Form DCO cover sheet, proposed rules,
regulatory compliance chart, narrative summary of proposed clearing
activities, documents establishing the applicant's legal status,
documents setting forth the applicant's corporate and governance
structure, and any other part of the application not covered by a
request for confidential treatment, subject to Sec. 145.9 of this
chapter.
(b) Stay of application review. (1) The Commission may stay the
running of the 180-day review period if an application is materially
incomplete, in accordance with section 6(a) of the Act.
(2) Delegation of authority. (i) The Commission hereby delegates,
until it orders otherwise, to the Director of the Division of Clearing
and Risk or the Director's designee, with the concurrence of the
General Counsel or the General Counsel's designee, the authority to
notify an applicant seeking designation under section 6(a) of the Act
that the application is materially incomplete and the running of the
180-day period is stayed.
(ii) The Director of the Division of Clearing and Risk may submit
to the Commission for its consideration any matter which has been
delegated in this paragraph.
(iii) Nothing in this paragraph prohibits the Commission, at its
election, from exercising the authority delegated in paragraph
(b)(2)(i) of this section.
(c) Withdrawal of application for registration. An applicant for
registration may withdraw its application submitted pursuant to
paragraph (a) of this section by filing electronically such a request
with the Secretary of the Commission in the format and manner specified
by the Commission. Withdrawal of an application for registration shall
not affect any action taken or to be taken by the Commission based upon
actions, activities, or events occurring during the time that the
application for registration was pending with the Commission.
(d) Reinstatement of dormant registration. Before listing or
relisting products for clearing, a dormant registered derivatives
clearing organization as defined in Sec. 40.1 of this chapter must
reinstate its registration under the procedures of paragraph (a) of
this section; provided, however, that an application for reinstatement
may rely
[[Page 69432]]
upon previously submitted materials that still pertain to, and
accurately describe, current conditions.
(e) Request for vacation of registration. A registered derivatives
clearing organization may vacate its registration under section 7 of
the Act by filing electronically such a request with the Secretary of
the Commission in the format and manner specified by the Commission.
Vacation of registration shall not affect any action taken or to be
taken by the Commission based upon actions, activities or events
occurring during the time that the entity was registered by the
Commission.
(f) Request for transfer of registration and open interest. (1) In
anticipation of a corporate change that will result in the transfer of
all or substantially all of a derivatives clearing organization's
assets to another legal entity, the derivatives clearing organization
shall submit a request for approval to transfer the derivatives
clearing organization's registration and positions comprising open
interest for clearing and settlement.
(2) Timing of submission and other procedural requirements. (i) The
request shall be submitted no later than three months prior to the
anticipated corporate change, or as otherwise permitted under Sec.
39.19(c)(4)(viii)(C) of this part.
(ii) The derivatives clearing organization shall submit a request
for transfer by filing electronically such a request with the Secretary
of the Commission in the format and manner specified by the Commission.
(iii) The derivatives clearing organization shall submit a
confirmation of change report pursuant to Sec. 39.19(c)(4)(viii)(D) of
this part.
(3) Required information. The request shall include the following:
(i) The underlying agreement that governs the corporate change;
(ii) A narrative description of the corporate change, including the
reason for the change and its impact on the derivatives clearing
organization's financial resources, governance, and operations, and its
impact on the rights and obligations of clearing members and market
participants holding the positions that comprise the derivatives
clearing organization's open interest;
(iii) A discussion of the transferee's ability to comply with the
Act, including the core principles applicable to derivatives clearing
organizations, and the Commission's regulations thereunder;
(iv) The governing documents of the transferee, including but not
limited to articles of incorporation and bylaws;
(v) The transferee's rules marked to show changes from the current
rules of the derivatives clearing organization;
(vi) A list of products for which the derivatives clearing
organization requests transfer of open interest;
(vii) A representation by the derivatives clearing organization
that it is in compliance with the Act, including the core principles
applicable to derivatives clearing organizations, and the Commission's
regulations thereunder; and
(viii) A representation by the transferee that it understands that
the derivatives clearing organization is a regulated entity that must
comply with the Act, including the core principles applicable to
derivatives clearing organizations, and the Commission's regulations
thereunder, in order to maintain its registration as a derivatives
clearing organization; and further, that the transferee will continue
to comply with all self-regulatory requirements applicable to a
derivatives clearing organization under the Act and the Commission's
regulations thereunder.
(4) Commission determination. The Commission will review a request
as soon as practicable, and based on the Commission's determination as
to the transferee's ability to continue to operate the derivatives
clearing organization in compliance with the Act and the Commission's
regulations thereunder, such request will be approved or denied
pursuant to a Commission order.
Sec. 39.4 Procedures for implementing derivatives clearing
organization rules and clearing new products.
(a) Request for approval of rules. An applicant for registration,
or a registered derivatives clearing organization, may request,
pursuant to the procedures of Sec. 40.5 of this chapter, that the
Commission approve any or all of its rules and subsequent amendments
thereto, including operational rules, prior to their implementation or,
notwithstanding the provisions of section 5c(c)(2) of the Act, at any
time thereafter, under the procedures of Sec. 40.5 of this chapter. A
derivatives clearing organization may label as, ``Approved by the
Commission,'' only those rules that have been so approved.
(b) Self-certification of rules. Proposed new or amended rules of a
derivatives clearing organization not voluntarily submitted for prior
Commission approval pursuant to paragraph (a) of this section must be
submitted to the Commission with a certification that the proposed new
rule or rule amendment complies with the Act and rules thereunder
pursuant to the procedures of Sec. 40.6 of this chapter.
(c) Acceptance of new products for clearing. (1) A dormant
derivatives clearing organization within the meaning of Sec. 40.1 of
this chapter may not accept for clearing a new product until its
registration as a derivatives clearing organization is reinstated under
the procedures of Sec. 39.3 of this part; provided however, that an
application for reinstatement may rely upon previously submitted
materials that still pertain to, and accurately describe, current
conditions.
(2) A derivatives clearing organization that accepts for clearing a
new product that is a swap shall comply with the requirements of Sec.
39.5 of this part.
(d) Orders regarding competition. An applicant for registration or
a registered derivatives clearing organization may request that the
Commission issue an order concerning whether a rule or practice of the
organization is the least anticompetitive means of achieving the
objectives, purposes, and policies of the Act.
(e) Holding securities in a futures portfolio margining account. A
derivatives clearing organization seeking to provide a portfolio
margining program under which securities would be held in a futures
account as defined in Sec. 1.3(vv) of this chapter, shall submit rules
to implement such portfolio margining program for Commission approval
in accordance with Sec. 40.5 of this chapter. Concurrent with the
submission of such rules for Commission approval, the derivatives
clearing organization shall petition the Commission for an order under
section 4d of the Act.
Sec. 39.5 Review of swaps for Commission determination on clearing
requirement.
(a) Eligibility to clear swaps. (1) A derivatives clearing
organization shall be presumed eligible to accept for clearing any swap
that is within a group, category, type, or class of swaps that the
derivatives clearing organization already clears. Such presumption of
eligibility, however, is subject to review by the Commission.
(2) A derivatives clearing organization that wishes to accept for
clearing any swap that is not within a group, category, type, or class
of swaps that the derivatives clearing organization already clears
shall request a determination by the Commission of the derivatives
clearing organization's eligibility to clear such a swap before
accepting the swap for clearing. The request, which shall be filed
electronically with the Secretary of the Commission, shall address the
derivatives clearing
[[Page 69433]]
organization's ability, if it accepts the swap for clearing, to
maintain compliance with section 5b(c)(2) of the Act, specifically:
(i) The sufficiency of the derivatives clearing organization's
financial resources; and
(ii) The derivative clearing organization's ability to manage the
risks associated with clearing the swap, especially if the Commission
determines that the swap is required to be cleared.
(b) Swap submissions. (1) A derivatives clearing organization shall
submit to the Commission each swap, or any group, category, type, or
class of swaps that it plans to accept for clearing. The derivatives
clearing organization making the submission must be eligible under
paragraph (a) of this section to accept for clearing the submitted
swap, or group, category, type, or class of swaps.
(2) A derivatives clearing organization shall submit swaps to the
Commission, to the extent reasonable and practicable to do so, by
group, category, type, or class of swaps. The Commission may in its
reasonable discretion consolidate multiple submissions from one
derivatives clearing organization or subdivide a derivatives clearing
organization's submission as appropriate for review.
(3) The submission shall be filed electronically with the Secretary
of the Commission and shall include:
(i) A statement that the derivatives clearing organization is
eligible to accept the swap, or group, category, type, or class of
swaps for clearing and describes the extent to which, if the Commission
were to determine that the swap, or group, category, type, or class of
swaps is required to be cleared, the derivatives clearing organization
will be able to maintain compliance with section 5b(c)(2) of the Act;
(ii) A statement that includes, but is not limited to, information
that will assist the Commission in making a quantitative and
qualitative assessment of the following factors:
(A) The existence of significant outstanding notional exposures,
trading liquidity, and adequate pricing data;
(B) The availability of rule framework, capacity, operational
expertise and resources, and credit support infrastructure to clear the
contract on terms that are consistent with the material terms and
trading conventions on which the contract is then traded;
(C) The effect on the mitigation of systemic risk, taking into
account the size of the market for such contract and the resources of
the derivatives clearing organization available to clear the contract;
(D) The effect on competition, including appropriate fees and
charges applied to clearing; and
(E) The existence of reasonable legal certainty in the event of the
insolvency of the relevant derivatives clearing organization or one or
more of its clearing members with regard to the treatment of customer
and swap counterparty positions, funds, and property;
(iii) Product specifications, including copies of any standardized
legal documentation, generally accepted contract terms, standard
practices for managing any life cycle events associated with the swap,
and the extent to which the swap is electronically confirmable;
(iv) Participant eligibility standards, if different from the
derivatives clearing organization's general participant eligibility
standards;
(v) Pricing sources, models, and procedures, demonstrating an
ability to obtain sufficient price data to measure credit exposures in
a timely and accurate manner, including any agreements with clearing
members to provide price data and copies of executed agreements with
third-party price vendors, and information about any price reference
index used, such as the name of the index, the source that calculates
it, the methodology used to calculate the price reference index and how
often it is calculated, and when and where it is published publicly;
(vi) Risk management procedures, including measurement and
monitoring of credit exposures, initial and variation margin
methodology, methodologies for stress testing and back testing,
settlement procedures, and default management procedures;
(vii) Applicable rules, manuals, policies, or procedures;
(viii) A description of the manner in which the derivatives
clearing organization has provided notice of the submission to its
members and a summary of any views on the submission expressed by the
members (a copy of the notice to members shall be included with the
submission); and
(ix) Any additional information specifically requested by the
Commission.
(4) The Commission must have received the submission by the open of
business on the business day preceding the acceptance of the swap, or
group, category, type, or class of swaps for clearing.
(5) The submission will be made available to the public and posted
on the Commission Web site for a 30-day public comment period. A
derivatives clearing organization that wishes to request confidential
treatment for portions of its submission may do so in accordance with
the procedures set out in Sec. 145.9(d) of this chapter.
(6) The Commission will review the submission and determine whether
the swap, or group, category, type, or class of swaps described in the
submission is required to be cleared. The Commission will make its
determination not later than 90 days after a complete submission has
been received, unless the submitting derivatives clearing organization
agrees to an extension. The determination of when such submission is
complete shall be at the sole discretion of the Commission. In making a
determination that a clearing requirement shall apply, the Commission
may impose such terms and conditions to the clearing requirement as the
Commission determines to be appropriate.
(c) Commission-initiated reviews. (1) The Commission, on an ongoing
basis, will review swaps that have not been accepted for clearing by a
derivatives clearing organization to make a determination as to whether
the swaps should be required to be cleared. In undertaking such
reviews, the Commission will use information obtained pursuant to
Commission regulations from swap data repositories, swap dealers, and
major swap participants, and any other available information.
(2) Notice regarding any determination made under paragraph (c)(1)
of this section will be made available to the public and posted on the
Commission Web site for a 30-day public comment period.
(3) If no derivatives clearing organization has accepted for
clearing a particular swap, group, category, type, or class of swaps
that the Commission finds would otherwise be subject to a clearing
requirement, the Commission will:
(i) Investigate the relevant facts and circumstances;
(ii) Within 30 days of the completion of its investigation, issue a
public report containing the results of the investigation; and
(iii) Take such actions as the Commission determines to be
necessary and in the public interest, which may include requiring the
retaining of adequate margin or capital by parties to the swap, group,
category, type, or class of swaps.
(d) Stay of clearing requirement. (1) After making a determination
that a swap, or group, category, type, or class of swaps is required to
be cleared, the Commission, on application of a counterparty to a swap
or on its own
[[Page 69434]]
initiative, may stay the clearing requirement until the Commission
completes a review of the terms of the swap, or group, category, type,
or class of swaps and the clearing arrangement.
(2) A counterparty to a swap that wishes to apply for a stay of the
clearing requirement for that swap shall submit a written request to
the Secretary of the Commission that includes:
(i) The identity and contact information of the counterparty to the
swap;
(ii) The terms of the swap subject to the clearing requirement;
(iii) The name of the derivatives clearing organization clearing
the swap;
(iv) A description of the clearing arrangement; and
(v) A statement explaining why the swap should not be subject to a
clearing requirement.
(3) A derivatives clearing organization that has accepted for
clearing a swap, or group, category, type, or class of swaps that is
subject to a stay of the clearing requirement shall provide any
information requested by the Commission in the course of its review.
(4) The Commission will complete its review not later than 90 days
after issuance of the stay, unless the derivatives clearing
organization that clears the swap, or group, category, type, or class
of swaps agrees to an extension.
(5) Upon completion of its review, the Commission may:
(i) Determine, subject to any terms and conditions as the
Commission determines to be appropriate, that the swap, or group,
category, type, or class of swaps must be cleared; or
(ii) Determine that the clearing requirement will not apply to the
swap, or group, category, type, or class of swaps, but clearing may
continue on a non-mandatory basis.
Sec. 39.6 [Reserved]
Sec. 39.7 Enforceability.
An agreement, contract or transaction submitted to a derivatives
clearing organization for clearing shall not be void, voidable, subject
to rescission, or otherwise invalidated or rendered unenforceable as a
result of:
(a) A violation by the derivatives clearing organization of the
provisions of the Act or of Commission regulations; or
(b) Any Commission proceeding to alter or supplement a rule under
section 8a(7) of the Act, to declare an emergency under section 8a(9)
of the Act, or any other proceeding the effect of which is to alter,
supplement, or require a derivatives clearing organization to adopt a
specific rule or procedure, or to take or refrain from taking a
specific action.
Sec. 39.8 Fraud in connection with the clearing of transactions on a
derivatives clearing organization.
It shall be unlawful for any person, directly or indirectly, in or
in connection with the clearing of transactions by a derivatives
clearing organization:
(a) To cheat or defraud or attempt to cheat or defraud any person;
(b) Willfully to make or cause to be made to any person any false
report or statement or cause to be entered for any person any false
record; or
(c) Willfully to deceive or attempt to deceive any person by any
means whatsoever.
Subpart B--Compliance with Core Principles
Sec. 39.9 Scope.
The provisions of this subpart B apply to any derivatives clearing
organization, as defined under section 1a(15) of the Act and Sec.
1.3(d) of this chapter, which is registered or deemed to be registered
with the Commission as a derivatives clearing organization, is required
to register as such with the Commission pursuant to section 5b(a) of
the Act, or which voluntarily registers as such with the Commission
pursuant to section 5b(b) or otherwise.
Sec. 39.10 Compliance with core principles.
(a) To be registered and to maintain registration as a derivatives
clearing organization, a derivatives clearing organization shall comply
with each core principle set forth in section 5b(c)(2) of the Act and
any requirement that the Commission may impose by rule or regulation
pursuant to section 8a(5) of the Act; and
(b) Subject to any rule or regulation prescribed by the Commission,
a registered derivatives clearing organization shall have reasonable
discretion in establishing the manner by which it complies with each
core principle.
(c) Chief compliance officer--(1) Designation. Each derivatives
clearing organization shall establish the position of chief compliance
officer, designate an individual to serve as the chief compliance
officer, and provide the chief compliance officer with the full
responsibility and authority to develop and enforce, in consultation
with the board of directors or the senior officer, appropriate
compliance policies and procedures, to fulfill the duties set forth in
the Act and Commission regulations.
(i) The individual designated to serve as chief compliance officer
shall have the background and skills appropriate for fulfilling the
responsibilities of the position. No individual who would be
disqualified from registration under sections 8a(2) or 8a(3) of the Act
may serve as a chief compliance officer.
(ii) The chief compliance officer shall report to the board of
directors or the senior officer of the derivatives clearing
organization. The board of directors or the senior officer shall
approve the compensation of the chief compliance officer.
(iii) The chief compliance officer shall meet with the board of
directors or the senior officer at least once a year.
(iv) A change in the designation of the individual serving as the
chief compliance officer of the derivatives clearing organization shall
be reported to the Commission in accordance with the requirements of
Sec. 39.19(c)(4)(ix) of this part.
(2) Chief compliance officer duties. The chief compliance officer's
duties shall include, but are not limited to:
(i) Reviewing the derivatives clearing organization's compliance
with the core principles set forth in section 5b of the Act, and the
Commission's regulations thereunder;
(ii) In consultation with the board of directors or the senior
officer, resolving any conflicts of interest that may arise;
(iii) Establishing and administering written policies and
procedures reasonably designed to prevent violation of the Act;
(iv) Taking reasonable steps to ensure compliance with the Act and
Commission regulations relating to agreements, contracts, or
transactions, and with Commission regulations prescribed under section
5b of the Act;
(v) Establishing procedures for the remediation of noncompliance
issues identified by the chief compliance officer through any
compliance office review, look-back, internal or external audit
finding, self-reported error, or validated complaint; and
(vi) Establishing and following appropriate procedures for the
handling, management response, remediation, retesting, and closing of
noncompliance issues.
(3) Annual report. The chief compliance officer shall, not less
than annually, prepare and sign a written report that covers the most
recently completed fiscal year of the derivatives clearing
organization, and provide the annual report to the board of directors
or the senior officer. The annual report shall, at a minimum:
(i) Contain a description of the derivatives clearing
organization's
[[Page 69435]]
written policies and procedures, including the code of ethics and
conflict of interest policies;
(ii) Review each core principle and applicable Commission
regulation, and with respect to each:
(A) Identify the compliance policies and procedures that are
designed to ensure compliance with the core principle;
(B) Provide an assessment as to the effectiveness of these policies
and procedures;
(C) Discuss areas for improvement, and recommend potential or
prospective changes or improvements to the derivatives clearing
organization's compliance program and resources allocated to
compliance;
(iii) List any material changes to compliance policies and
procedures since the last annual report;
(iv) Describe the financial, managerial, and operational resources
set aside for compliance with the Act and Commission regulations; and
(v) Describe any material compliance matters, including incidents
of noncompliance, since the date of the last annual report and describe
the corresponding action taken.
(4) Submission of annual report to the Commission. (i) Prior to
submitting the annual report to the Commission, the chief compliance
officer shall provide the annual report to the board of directors or
the senior officer of the derivatives clearing organization for review.
Submission of the report to the board of directors or the senior
officer shall be recorded in the board minutes or otherwise, as
evidence of compliance with this requirement.
(ii) The annual report shall be submitted electronically to the
Secretary of the Commission in the format and manner specified by the
Commission not more than 90 days after the end of the derivatives
clearing organization's fiscal year, concurrently with submission of
the fiscal year-end audited financial statement that is required to be
furnished to the Commission pursuant to Sec. 39.19(c)(3)(ii) of this
part. The report shall include a certification by the chief compliance
officer that, to the best of his or her knowledge and reasonable
belief, and under penalty of law, the annual report is accurate and
complete.
(iii) The derivatives clearing organization shall promptly submit
an amended annual report if material errors or omissions in the report
are identified after submission. An amendment must contain the
certification required under paragraph (c)(4)(ii) of this section.
(iv) A derivatives clearing organization may request from the
Commission an extension of time to submit its annual report in
accordance with Sec. 39.19(c)(3) of this part.
(5) Recordkeeping. (i) The derivatives clearing organization shall
maintain:
(A) A copy of all compliance policies and procedures and all other
policies and procedures adopted in furtherance of compliance with the
Act and Commission regulations;
(B) Copies of materials, including written reports provided to the
board of directors or the senior officer in connection with the review
of the annual report under paragraph (c)(4)(i) of this section; and
(C) Any records relevant to the annual report, including, but not
limited to, work papers and other documents that form the basis of the
report, and memoranda, correspondence, other documents, and records
that are created, sent, or received in connection with the annual
report and contain conclusions, opinions, analyses, or financial data
related to the annual report.
(ii) The derivatives clearing organization shall maintain records
in accordance with Sec. 1.31 of this chapter and Sec. 39.20 of this
part.
Sec. 39.11 Financial resources.
(a) General. A derivatives clearing organization shall maintain
financial resources sufficient to cover its exposures with a high
degree of confidence and to enable it to perform its functions in
compliance with the core principles set out in section 5b of the Act. A
derivatives clearing organization shall identify and adequately manage
its general business risks and hold sufficient liquid resources to
cover potential business losses that are not related to clearing
members' defaults, so that the derivatives clearing organization can
continue to provide services as an ongoing concern. Financial resources
shall be considered sufficient if their value, at a minimum, exceeds
the total amount that would:
(1) Enable the derivatives clearing organization to meet its
financial obligations to its clearing members notwithstanding a default
by the clearing member creating the largest financial exposure for the
derivatives clearing organization in extreme but plausible market
conditions; Provided that if a clearing member controls another
clearing member or is under common control with another clearing
member, the affiliated clearing members shall be deemed to be a single
clearing member for purposes of this provision; and
(2) Enable the derivatives clearing organization to cover its
operating costs for a period of at least one year, calculated on a
rolling basis.
(b) Types of financial resources. (1) Financial resources available
to satisfy the requirements of paragraph (a)(1) of this section may
include:
(i) Margin to the extent permitted under parts 1, 22, and 190 of
this chapter and under the rules of the derivatives clearing
organization;
(ii) The derivatives clearing organization's own capital;
(iii) Guaranty fund deposits;
(iv) Default insurance;
(v) Potential assessments for additional guaranty fund
contributions, if permitted by the derivatives clearing organization's
rules; and
(vi) Any other financial resource deemed acceptable by the
Commission.
(2) Financial resources available to satisfy the requirements of
paragraph (a)(2) of this section may include:
(i) The derivatives clearing organization's own capital; and
(ii) Any other financial resource deemed acceptable by the
Commission.
(3) A financial resource may be allocated, in whole or in part, to
satisfy the requirements of either paragraph (a)(1) or paragraph (a)(2)
of this section, but not both paragraphs, and only to the extent the
use of such financial resource is not otherwise limited by the Act,
Commission regulations, the derivatives clearing organization's rules,
or any contractual arrangements to which the derivatives clearing
organization is a party.
(c) Computation of financial resources requirement. (1) A
derivatives clearing organization shall, on a monthly basis, perform
stress testing that will allow it to make a reasonable calculation of
the financial resources needed to meet the requirements of paragraph
(a)(1) of this section. The derivatives clearing organization shall
have reasonable discretion in determining the methodology used to
compute such requirements, provided that the methodology must take into
account both historical data and hypothetical scenarios. The Commission
may review the methodology and require changes as appropriate.
(2) A derivatives clearing organization shall, on a monthly basis,
make a reasonable calculation of its projected operating costs over a
12-month period in order to determine the amount needed to meet the
requirements of paragraph (a)(2) of this section. The derivatives
clearing organization shall have reasonable discretion in determining
the methodology used to compute such projected operating costs. The
Commission may review the
[[Page 69436]]
methodology and require changes as appropriate.
(d) Valuation of financial resources. (1) At appropriate intervals,
but not less than monthly, a derivatives clearing organization shall
compute the current market value of each financial resource used to
meet its obligations under paragraph (a) of this section. Reductions in
value to reflect credit, market, and liquidity risks (haircuts) shall
be applied as appropriate and evaluated on a monthly basis.
(2) If assessments for additional guaranty fund contributions are
permitted by the derivatives clearing organization's rules, in
calculating the financial resources available to meet its obligations
under paragraph (a)(1) of this section:
(i) The derivatives clearing organization shall have rules
requiring that its clearing members have the ability to meet an
assessment within the time frame of a normal end-of-day variation
settlement cycle;
(ii) The derivatives clearing organization shall monitor the
financial and operational capacity of its clearing members to meet
potential assessments;
(iii) The derivatives clearing organization shall apply a 30
percent haircut to the value of potential assessments, and
(iv) The derivatives clearing organization shall only count the
value of assessments, after the haircut, to meet up to 20 percent of
those obligations.
(e) Liquidity of financial resources. (1) (i) The derivatives
clearing organization shall effectively measure, monitor, and manage
its liquidity risks, maintaining sufficient liquid resources such that
it can, at a minimum, fulfill its cash obligations when due. The
derivatives clearing organization shall hold assets in a manner where
the risk of loss or of delay in its access to them is minimized.
(ii) The financial resources allocated by the derivatives clearing
organization to meet the requirements of paragraph (a)(1) of this
section shall be sufficiently liquid to enable the derivatives clearing
organization to fulfill its obligations as a central counterparty
during a one-day settlement cycle. The derivatives clearing
organization shall maintain cash, U.S. Treasury obligations, or high
quality, liquid, general obligations of a sovereign nation, in an
amount greater than or equal to an amount calculated as follows:
(A) Calculate the average daily settlement pay for each clearing
member over the last fiscal quarter;
(B) Calculate the sum of those average daily settlement pays; and
(C) Using that sum, calculate the average of its clearing members'
average pays.
(iii) The derivatives clearing organization may take into account a
committed line of credit or similar facility for the purpose of meeting
the remainder of the requirement under paragraph (e)(1)(ii) of this
section.
(2) The financial resources allocated by the derivatives clearing
organization to meet the requirements of paragraph (a)(2) of this
section must include unencumbered, liquid financial assets (i.e., cash
and/or highly liquid securities) equal to at least six months'
operating costs. If any portion of such financial resources is not
sufficiently liquid, the derivatives clearing organization may take
into account a committed line of credit or similar facility for the
purpose of meeting this requirement.
(3)(i) Assets in a guaranty fund shall have minimal credit, market,
and liquidity risks and shall be readily accessible on a same-day
basis;
(ii) Cash balances shall be invested or placed in safekeeping in a
manner that bears little or no principal risk; and
(iii) Letters of credit shall not be a permissible asset for a
guaranty fund.
(f) Reporting requirements.
(1) Each fiscal quarter, or at any time upon Commission request, a
derivatives clearing organization shall:
(i) Report to the Commission;
(A) The amount of financial resources necessary to meet the
requirements of paragraph (a);
(B) The value of each financial resource available, computed in
accordance with the requirements of paragraph (d) of this section; and
(C) The manner in which the derivatives clearing organization meets
the liquidity requirements of paragraph (e) of this section;
(ii) Provide the Commission with a financial statement, including
the balance sheet, income statement, and statement of cash flows, of
the derivatives clearing organization or of its parent company; and
(iii) Report to the Commission the value of each individual
clearing member's guaranty fund deposit, if the derivatives clearing
organization reports having guaranty funds deposits as a financial
resource available to satisfy the requirements of paragraph (a)(1) of
this section.
(2) The calculations required by this paragraph shall be made as of
the last business day of the derivatives clearing organization's fiscal
quarter.
(3) The derivatives clearing organization shall provide the
Commission with:
(i) Sufficient documentation explaining the methodology used to
compute its financial resources requirements under paragraph (a) of
this section,
(ii) Sufficient documentation explaining the basis for its
determinations regarding the valuation and liquidity requirements set
forth in paragraphs (d) and (e) of this section, and
(iii) Copies of any agreements establishing or amending a credit
facility, insurance coverage, or other arrangement evidencing or
otherwise supporting the derivatives clearing organization's
conclusions.
(4) The report shall be filed not later than 17 business days after
the end of the derivatives clearing organization's fiscal quarter, or
at such later time as the Commission may permit, in its discretion,
upon request by the derivatives clearing organization.
Sec. 39.12 Participant and product eligibility.
(a) Participant eligibility. A derivatives clearing organization
shall establish appropriate admission and continuing participation
requirements for clearing members of the derivatives clearing
organization that are objective, publicly disclosed, and risk-based.
(1) Fair and open access for participation. The participation
requirements shall permit fair and open access;
(i) A derivatives clearing organization shall not adopt restrictive
clearing member standards if less restrictive requirements that achieve
the same objective and that would not materially increase risk to the
derivatives clearing organization or clearing members could be adopted;
(ii) A derivatives clearing organization shall allow all market
participants who satisfy participation requirements to become clearing
members;
(iii) A derivatives clearing organization shall not exclude or
limit clearing membership of certain types of market participants
unless the derivatives clearing organization can demonstrate that the
restriction is necessary to address credit risk or deficiencies in the
participants' operational capabilities that would prevent them from
fulfilling their obligations as clearing members.
(iv) A derivatives clearing organization shall not require that
clearing members be swap dealers.
(v) A derivatives clearing organization shall not require that
clearing members maintain a swap portfolio of any particular size, or
that clearing members meet a swap transaction volume threshold.
[[Page 69437]]
(2) Financial resources. (i) The participation requirements shall
require clearing members to have access to sufficient financial
resources to meet obligations arising from participation in the
derivatives clearing organization in extreme but plausible market
conditions. A derivatives clearing organization may permit such
financial resources to include, without limitation, a clearing member's
capital, a guarantee from the clearing member's parent, or a credit
facility funding arrangement. For purposes of this paragraph,
``capital'' means adjusted net capital as defined in Sec. 1.17 of this
chapter, for futures commission merchants, and net capital as defined
in Sec. 240.15c3-1of this title, for broker-dealers, or any similar
risk adjusted capital calculation for all other clearing members.
(ii) The participation requirements shall set forth capital
requirements that are based on objective, transparent, and commonly
accepted standards that appropriately match capital to risk. Capital
requirements shall be scalable to the risks posed by clearing members.
(iii) A derivatives clearing organization shall not set a minimum
capital requirement of more than $50 million for any person that seeks
to become a clearing member in order to clear swaps.
(3) Operational requirements. The participation requirements shall
require clearing members to have adequate operational capacity to meet
obligations arising from participation in the derivatives clearing
organization. The requirements shall include, but are not limited to:
the ability to process expected volumes and values of transactions
cleared by a clearing member within required time frames, including at
peak times and on peak days; the ability to fulfill collateral,
payment, and delivery obligations imposed by the derivatives clearing
organization; and the ability to participate in default management
activities under the rules of the derivatives clearing organization and
in accordance with Sec. 39.16 of this part.
(4) Monitoring. A derivatives clearing organization shall establish
and implement procedures to verify, on an ongoing basis, the compliance
of each clearing member with each participation requirement of the
derivatives clearing organization.
(5) Reporting. (i) A derivatives clearing organization shall
require all clearing members, including non-futures commission
merchants, to provide to the derivatives clearing organization periodic
financial reports that contain any financial information that the
derivatives clearing organization determines is necessary to assess
whether participation requirements are being met on an ongoing basis.
(A) A derivatives clearing organization shall require clearing
members that are futures commission merchants to provide the financial
reports that are specified in Sec. 1.10 of this chapter to the
derivatives clearing organization.
(B) A derivatives clearing organization shall require clearing
members that are not futures commission merchants to make the periodic
financial reports provided pursuant to paragraph (a)(5)(i) of this
section available to the Commission upon the Commission's request or,
in lieu of imposing this requirement, a derivatives clearing
organization may provide such financial reports directly to the
Commission upon the Commission's request.
(ii) A derivatives clearing organization shall adopt rules that
require clearing members to provide to the derivatives clearing
organization, in a timely manner, information that concerns any
financial or business developments that may materially affect the
clearing members' ability to continue to comply with participation
requirements.
(6) Enforcement. A derivatives clearing organization shall have the
ability to enforce compliance with its participation requirements and
shall establish procedures for the suspension and orderly removal of
clearing members that no longer meet the requirements.
(b) Product eligibility. (1) A derivatives clearing organization
shall establish appropriate requirements for determining the
eligibility of agreements, contracts, or transactions submitted to the
derivatives clearing organization for clearing, taking into account the
derivatives clearing organization's ability to manage the risks
associated with such agreements, contracts, or transactions. Factors to
be considered in determining product eligibility include, but are not
limited to:
(i) Trading volume;
(ii) Liquidity;
(iii) Availability of reliable prices;
(iv) Ability of market participants to use portfolio compression
with respect to a particular swap product;
(v) Ability of the derivatives clearing organization and clearing
members to gain access to the relevant market for purposes of creating,
liquidating, transferring, auctioning, and/or allocating positions;
(vi) Ability of the derivatives clearing organization to measure
risk for purposes of setting margin requirements; and
(vii) Operational capacity of the derivatives clearing organization
and clearing members to address any unusual risk characteristics of a
product.
(2) A derivatives clearing organization shall adopt rules providing
that all swaps with the same terms and conditions, as defined by
product specifications established under derivatives clearing
organization rules, submitted to the derivatives clearing organization
for clearing are economically equivalent within the derivatives
clearing organization and may be offset with each other within the
derivatives clearing organization.
(3) A derivatives clearing organization shall provide for non-
discriminatory clearing of a swap executed bilaterally or on or subject
to the rules of an unaffiliated swap execution facility or designated
contract market.
(4) A derivatives clearing organization shall not require that one
of the original executing parties be a clearing member in order for a
product to be eligible for clearing.
(5) A derivatives clearing organization shall select product unit
sizes and other terms and conditions that maximize liquidity,
facilitate transparency in pricing, promote open access, and allow for
effective risk management. To the extent appropriate to further these
objectives, a derivatives clearing organization shall select product
units for clearing purposes that are smaller than the product units in
which trades submitted for clearing were executed.
(6) A derivatives clearing organization that clears swaps shall
have rules providing that, upon acceptance of a swap by the derivatives
clearing organization for clearing:
(i) The original swap is extinguished;
(ii) The original swap is replaced by an equal and opposite swap
between the derivatives clearing organization and each clearing member
acting as principal for a house trade or acting as agent for a customer
trade;
(iii) All terms of a cleared swap must conform to product
specifications established under derivatives clearing organization
rules; and
(iv) If a swap is cleared by a clearing member on behalf of a
customer, all terms of the swap, as carried in the customer account on
the books of the clearing member, must conform to the terms of the
cleared swap established under the derivatives clearing organization's
rules.
(7) [Reserved]
(8) Confirmation. A derivatives clearing organization shall provide
each
[[Page 69438]]
clearing member carrying a cleared swap with a definitive written
record of the terms of the transaction which shall legally supersede
any previous agreement and serve as a confirmation of the swap. The
confirmation of all terms of the transaction shall take place at the
same time as the swap is accepted for clearing.
Sec. 39.13 Risk management.
(a) General. A derivatives clearing organization shall ensure that
it possesses the ability to manage the risks associated with
discharging the responsibilities of the derivatives clearing
organization through the use of appropriate tools and procedures.
(b) Documentation requirement. A derivatives clearing organization
shall establish and maintain written policies, procedures, and
controls, approved by its board of directors, which establish an
appropriate risk management framework that, at a minimum, clearly
identifies and documents the range of risks to which the derivatives
clearing organization is exposed, addresses the monitoring and
management of the entirety of those risks, and provides a mechanism for
internal audit. The risk management framework shall be regularly
reviewed and updated as necessary.
(c) Chief risk officer. A derivatives clearing organization shall
have a chief risk officer who shall be responsible for implementing the
risk management framework, including the procedures, policies and
controls described in paragraph (b) of this section, and for making
appropriate recommendations to the derivatives clearing organization's
risk management committee or board of directors, as applicable,
regarding the derivatives clearing organization's risk management
functions.
(d) [Reserved]
(e) Measurement of credit exposure. A derivatives clearing
organization shall:
(1) Measure its credit exposure to each clearing member and mark to
market such clearing member's open house and customer positions at
least once each business day; and
(2) Monitor its credit exposure to each clearing member
periodically during each business day.
(f) Limitation of exposure to potential losses from defaults. A
derivatives clearing organization, through margin requirements and
other risk control mechanisms, shall limit its exposure to potential
losses from defaults by its clearing members to ensure that:
(1) The operations of the derivatives clearing organization would
not be disrupted; and
(2) Non-defaulting clearing members would not be exposed to losses
that non-defaulting clearing members cannot anticipate or control.
(g) Margin requirements. (1) General. Each model and parameter used
in setting initial margin requirements shall be risk-based and reviewed
on a regular basis.
(2) Methodology and coverage. (i) A derivatives clearing
organization shall establish initial margin requirements that are
commensurate with the risks of each product and portfolio, including
any unusual characteristics of, or risks associated with, particular
products or portfolios, including but not limited to jump-to-default
risk or similar jump risk.
(ii) A derivatives clearing organization shall use models that
generate initial margin requirements sufficient to cover the
derivatives clearing organization's potential future exposures to
clearing members based on price movements in the interval between the
last collection of variation margin and the time within which the
derivatives clearing organization estimates that it would be able to
liquidate a defaulting clearing member's positions (liquidation time);
provided, however, that a derivatives clearing organization shall use:
(A) A minimum liquidation time that is one day for futures and
options;
(B) A minimum liquidation time that is one day for swaps on
agricultural commodities, energy commodities, and metals;
(C) A minimum liquidation time that is five days for all other
swaps; or
(D) Such longer liquidation time as is appropriate based on the
specific characteristics of a particular product or portfolio; provided
further that the Commission, by order, may establish shorter or longer
liquidation times for particular products or portfolios.
(iii) The actual coverage of the initial margin requirements
produced by such models, along with projected measures of the models'
performance, shall meet an established confidence level of at least 99
percent, based on data from an appropriate historic time period, for:
(A) Each product for which the derivatives clearing organization
uses a product-based margin methodology;
(B) Each spread within or between products for which there is a
defined spread margin rate;
(C) Each account held by a clearing member at the derivatives
clearing organization, by house origin and by each customer origin; and
(D) Each swap portfolio, including any portfolio containing futures
and/or options and held in a commingled account pursuant to Sec.
39.15(b)(2) of this part, by beneficial owner.
(iv) A derivatives clearing organization shall determine the
appropriate historic time period based on the characteristics,
including volatility patterns, as applicable, of each product, spread,
account, or portfolio.
(3) Independent validation. A derivatives clearing organization's
systems for generating initial margin requirements, including its
theoretical models, must be reviewed and validated by a qualified and
independent party, on a regular basis. Such qualified and independent
parties may be independent contractors or employees of the derivatives
clearing organization, but shall not be persons responsible for
development or operation of the systems and models being tested.
(4) Spread and portfolio margins. (i) A derivatives clearing
organization may allow reductions in initial margin requirements for
related positions if the price risks with respect to such positions are
significantly and reliably correlated. The price risks of different
positions will only be considered to be reliably correlated if there is
a theoretical basis for the correlation in addition to an exhibited
statistical correlation. That theoretical basis may include, but is not
limited to, the following:
(A) The products on which the positions are based are complements
of, or substitutes for, each other;
(B) One product is a significant input into the other product(s);
(C) The products share a significant common input; or
(D) The prices of the products are influenced by common external
factors.
(ii) A derivatives clearing organization shall regularly review its
margin reductions and the correlations on which they are based.
(5) Price data. A derivatives clearing organization shall have a
reliable source of timely price data in order to measure the
derivatives clearing organization's credit exposure accurately. A
derivatives clearing organization shall also have written procedures
and sound valuation models for addressing circumstances where pricing
data is not readily available or reliable.
(6) Daily review. On a daily basis, a derivatives clearing
organization shall determine the adequacy of its initial margin
requirements.
(7) Back tests. A derivatives clearing organization shall conduct
back tests, as defined in Sec. 39.2 of this part, using an appropriate
time period but not less than the previous 30 days, as follows:
(i) On a daily basis, a derivatives clearing organization shall
conduct back
[[Page 69439]]
tests with respect to products or swap portfolios that are experiencing
significant market volatility, to test the adequacy of its initial
margin requirements, as follows:
(A) For that product if the derivatives clearing organization uses
a product-based margin methodology;
(B) For each spread involving that product if there is a defined
spread margin rate;
(C) For each account held by a clearing member at the derivatives
clearing organization that contains a significant position in that
product, by house origin and by each customer origin; and
(D) For each such swap portfolio, including any portfolio
containing futures and/or options and held in a commingled account
pursuant to Sec. 39.15(b)(2) of this part, by beneficial owner.
(ii) On at least a monthly basis, a derivatives clearing
organization shall conduct back tests to test the adequacy of its
initial margin requirements, as follows:
(A) For each product for which the derivatives clearing
organization uses a product-based margin methodology;
(B) For each spread for which there is a defined spread margin
rate;
(C) For each account held by a clearing member at the derivatives
clearing organization, by house origin and by each customer origin; and
(D) For each swap portfolio, including any portfolio containing
futures and/or options and held in a commingled account pursuant to
Sec. 39.15(b)(2) of this part, by beneficial owner.
(8) Customer margin. (i) Gross margin. (A) A derivatives clearing
organization shall collect initial margin on a gross basis for each
clearing member's customer account(s) equal to the sum of the initial
margin amounts that would be required by the derivatives clearing
organization for each individual customer within that account if each
individual customer were a clearing member.
(B) For purposes of calculating the gross initial margin
requirement for each clearing member's customer account(s), to the
extent not inconsistent with other Commission regulations, a
derivatives clearing organization may require its clearing members to
report the gross positions of each individual customer to the
derivatives clearing organization, or it may permit each clearing
member to report the sum of the gross positions of its customers to the
derivatives clearing organization.
(C) For purposes of this paragraph (g)(8), a derivatives clearing
organization may rely, and may permit its clearing members to rely,
upon the sum of the gross positions reported to the clearing members by
each domestic or foreign omnibus account that they carry, without
obtaining information identifying the positions of each individual
customer underlying such omnibus accounts.
(D) A derivatives clearing organization may not, and may not permit
its clearing members to, net positions of different customers against
one another.
(E) A derivatives clearing organization may collect initial margin
for its clearing members' house accounts on a net basis.
(ii) Customer initial margin requirements. A derivatives clearing
organization shall require its clearing members to collect customer
initial margin, as defined in Sec. 1.3 of this chapter, from their
customers, for non-hedge positions, at a level that is greater than 100
percent of the derivatives clearing organization's initial margin
requirements with respect to each product and swap portfolio. The
derivatives clearing organization shall have reasonable discretion in
determining the percentage by which customer initial margins must
exceed the derivatives clearing organization's initial margin
requirements with respect to particular products or swap portfolios.
The Commission may review such percentage levels and require different
percentage levels if the Commission deems the levels insufficient to
protect the financial integrity of the clearing members or the
derivatives clearing organization.
(iii) Withdrawal of customer initial margin. A derivatives clearing
organization shall require its clearing members to ensure that their
customers do not withdraw funds from their accounts with such clearing
members unless the net liquidating value plus the margin deposits
remaining in a customer's account after such withdrawal are sufficient
to meet the customer initial margin requirements with respect to all
products and swap portfolios held in such customer's account which are
cleared by the derivatives clearing organization.
(9) Time deadlines. A derivatives clearing organization shall
establish and enforce time deadlines for initial and variation margin
payments to the derivatives clearing organization by its clearing
members.
(10) Types of assets. A derivatives clearing organization shall
limit the assets it accepts as initial margin to those that have
minimal credit, market, and liquidity risks. A derivatives clearing
organization may take into account the specific risk-reducing
properties that particular assets have in a particular portfolio. A
derivatives clearing organization may accept letters of credit as
initial margin for futures and options on futures but shall not accept
letters of credit as initial margin for swaps.
(11) Valuation. A derivatives clearing organization shall use
prudent valuation practices to value assets posted as initial margin on
a daily basis.
(12) Haircuts. A derivatives clearing organization shall apply
appropriate reductions in value to reflect credit, market, and
liquidity risks (haircuts), to the assets that it accepts in
satisfaction of initial margin obligations, taking into consideration
stressed market conditions, and shall evaluate the appropriateness of
such haircuts on at least a quarterly basis.
(13) Concentration limits or charges. A derivatives clearing
organization shall apply appropriate limitations or charges on the
concentration of assets posted as initial margin, as necessary, in
order to ensure its ability to liquidate such assets quickly with
minimal adverse price effects, and shall evaluate the appropriateness
of any such concentration limits or charges, on at least a monthly
basis.
(14) Pledged assets. If a derivatives clearing organization permits
its clearing members to pledge assets for initial margin while
retaining such assets in accounts in the names of such clearing
members, the derivatives clearing organization shall ensure that such
assets are unencumbered and that such a pledge has been validly created
and validly perfected in the relevant jurisdiction.
(h) Other risk control mechanisms-- (1) Risk limits. (i) A
derivatives clearing organization shall impose risk limits on each
clearing member, by house origin and by each customer origin, in order
to prevent a clearing member from carrying positions for which the risk
exposure exceeds a specified threshold relative to the clearing
member's and/or the derivatives clearing organization's financial
resources. The derivatives clearing organization shall have reasonable
discretion in determining:
(A) The method of computing risk exposure;
(B) The applicable threshold(s); and
(C) The applicable financial resources under this provision;
provided however, that the ratio of exposure to capital must remain the
same across all capital levels. The Commission may review such methods,
thresholds, and financial resources and require the application of
different methods, thresholds, or financial resources, as appropriate.
[[Page 69440]]
(ii) A derivatives clearing organization may permit a clearing
member to exceed the threshold(s) applied pursuant to paragraph
(h)(1)(i) of this section provided that the derivatives clearing
organization requires the clearing member to post additional initial
margin that the derivatives clearing organization deems sufficient to
appropriately eliminate excessive risk exposure at the clearing member.
The Commission may review the amount of additional initial margin and
require a different amount of additional initial margin, as
appropriate.
(2) Large trader reports. A derivatives clearing organization shall
obtain from its clearing members or from a relevant designated contract
market or swap execution facility, copies of all reports that are
required to be filed with the Commission by, or on behalf of, such
clearing members pursuant to parts 17 and 20 of this chapter. A
derivatives clearing organization shall review such reports on a daily
basis to ascertain the risk of the overall portfolio of each large
trader, including futures, options, and swaps cleared by the
derivatives clearing organization, which are held by all clearing
members carrying accounts for each such large trader, and shall take
additional actions with respect to such clearing members, when
appropriate, as specified in paragraph (h)(6) of this section, in order
to address any risks posed by any such large trader.
(3) Stress tests. A derivatives clearing organization shall conduct
stress tests, as defined in Sec. 39.2 of this part, as follows:
(i) On a daily basis, a derivatives clearing organization shall
conduct stress tests with respect to each large trader who poses
significant risk to a clearing member or the derivatives clearing
organization, including futures, options, and swaps cleared by the
derivatives clearing organization, which are held by all clearing
members carrying accounts for each such large trader. The derivatives
clearing organization shall have reasonable discretion in determining
which traders to test and the methodology used to conduct such stress
tests. The Commission may review the selection of accounts and the
methodology and require changes, as appropriate.
(ii) On at least a weekly basis, a derivatives clearing
organization shall conduct stress tests with respect to each clearing
member account, by house origin and by each customer origin, and each
swap portfolio, including any portfolio containing futures and/or
options and held in a commingled account pursuant to Sec. 39.15(b)(2)
of this part, by beneficial owner, under extreme but plausible market
conditions. The derivatives clearing organization shall have reasonable
discretion in determining the methodology used to conduct such stress
tests. The Commission may review the methodology and require changes,
as appropriate.
(4) Portfolio compression. A derivatives clearing organization
shall make portfolio compression exercises available, on a regular and
voluntary basis, for its clearing members that clear swaps, to the
extent that such exercises are appropriate for those swaps that it
clears; provided, however, a derivatives clearing organization is not
required to develop its own portfolio compression services, and is only
required to make such portfolio compression exercises available, if
applicable portfolio compression services have been developed by a
third party.
(5) Clearing members' risk management policies and procedures. (i)
A derivatives clearing organization shall adopt rules that:
(A) Require its clearing members to maintain current written risk
management policies and procedures, which address the risks that such
clearing members may pose to the derivatives clearing organization;
(B) Ensure that it has the authority to request and obtain
information and documents from its clearing members regarding their
risk management policies, procedures, and practices, including, but not
limited to, information and documents relating to the liquidity of
their financial resources and their settlement procedures; and
(C) Require its clearing members to make information and documents
regarding their risk management policies, procedures, and practices
available to the Commission upon the Commission's request.
(ii) A derivatives clearing organization shall review the risk
management policies, procedures, and practices of each of its clearing
members, which address the risks that such clearing members may pose to
the derivatives clearing organization, on a periodic basis and document
such reviews.
(6) Additional authority. A derivatives clearing organization shall
take additional actions with respect to particular clearing members,
when appropriate, based on the application of objective and prudent
risk management standards including, but not limited to:
(i) Imposing enhanced capital requirements;
(ii) Imposing enhanced margin requirements;
(iii) Imposing position limits;
(iv) Prohibiting an increase in positions;
(v) Requiring a reduction of positions;
(vi) Liquidating or transferring positions; and
(vii) Suspending or revoking clearing membership.
Sec. 39.14 Settlement procedures.
(a) Definitions--(1) Settlement. For purposes of this section,
``settlement'' means:
(i) Payment and receipt of variation margin for futures, options,
and swaps;
(ii) Payment and receipt of option premiums;
(iii) Deposit and withdrawal of initial margin for futures,
options, and swaps;
(iv) All payments due in final settlement of futures, options, and
swaps on the final settlement date with respect to such positions; and
(v) All other cash flows collected from or paid to each clearing
member, including but not limited to, payments related to swaps such as
coupon amounts.
(2) Settlement bank. For purposes of this section, ``settlement
bank'' means a bank that maintains an account either for the
derivatives clearing organization or for any of its clearing members,
which is used for the purpose of any settlement described in paragraph
(a)(1) above.
(b) Daily settlements. Except as otherwise provided by Commission
order, a derivatives clearing organization shall effect a settlement
with each clearing member at least once each business day, and shall
have the authority and operational capacity to effect a settlement with
each clearing member, on an intraday basis, either routinely, when
thresholds specified by the derivatives clearing organization are
breached, or in times of extreme market volatility.
(c) Settlement banks. A derivatives clearing organization shall
employ settlement arrangements that eliminate or strictly limit its
exposure to settlement bank risks, including the credit and liquidity
risks arising from the use of such bank(s) to effect settlements with
its clearing members, as follows:
(1) A derivatives clearing organization shall have documented
criteria that must be met by any settlement bank used by the
derivatives clearing organization or its clearing members, including
criteria addressing the capitalization, creditworthiness, access to
liquidity, operational reliability, and regulation or supervision of
such bank(s).
(2) A derivatives clearing organization shall monitor each approved
settlement
[[Page 69441]]
bank on an ongoing basis to ensure that such bank continues to meet the
criteria established pursuant to paragraph (c)(1) of this section.
(3) A derivatives clearing organization shall monitor the full
range and concentration of its exposures to its own and its clearing
members' settlement bank(s) and assess its own and its clearing
members' potential losses and liquidity pressures in the event that the
settlement bank with the largest share of settlement activity were to
fail. A derivatives clearing organization shall take any one or more of
the following actions, to the extent that any such action or actions
are reasonably necessary in order to eliminate or strictly limit such
exposures:
(i) Maintain settlement accounts at one or more additional
settlement banks; and/or
(ii) Approve one or more additional settlement banks that its
clearing members could choose to use; and/or
(iii) Impose concentration limits with respect to one or more of
its own or its clearing members' settlement banks; and/or
(iv) Take any other appropriate actions.
(d) Settlement finality. A derivatives clearing organization shall
ensure that settlements are final when effected by ensuring that it has
entered into legal agreements that state that settlement fund transfers
are irrevocable and unconditional no later than when the derivatives
clearing organization's accounts are debited or credited; provided,
however, a derivatives clearing organization's legal agreements with
its settlement banks may provide for the correction of errors. A
derivatives clearing organization's legal agreements with its
settlement banks shall state clearly when settlement fund transfers
will occur and a derivatives clearing organization shall routinely
confirm that its settlement banks are effecting fund transfers as and
when required by such legal agreements.
(e) Recordkeeping. A derivatives clearing organization shall
maintain an accurate record of the flow of funds associated with each
settlement.
(f) Netting arrangements. A derivatives clearing organization shall
possess the ability to comply with each term and condition of any
permitted netting or offset arrangement with any other clearing
organization.
(g) Physical delivery. With respect to products that are settled by
physical transfers of the underlying instruments or commodities, a
derivatives clearing organization shall:
(1) Establish rules that clearly state each obligation that the
derivatives clearing organization has assumed with respect to physical
deliveries, including whether it has an obligation to make or receive
delivery of a physical instrument or commodity, or whether it
indemnifies clearing members for losses incurred in the delivery
process; and
(2) Ensure that the risks of each such obligation are identified
and managed.
Sec. 39.15 Treatment of funds.
(a) Required standards and procedures. A derivatives clearing
organization shall establish standards and procedures that are designed
to protect and ensure the safety of funds and assets belonging to
clearing members and their customers.
(b) Segregation of funds and assets. (1) Segregation. A derivatives
clearing organization shall comply with the applicable segregation
requirements of section 4d of the Act and Commission regulations
thereunder, or any other applicable Commission regulation or order
requiring that customer funds and assets be segregated, set aside, or
held in a separate account.
(2) Commingling of futures, options, and swaps. (i) Cleared swaps
account. In order for a derivatives clearing organization and its
clearing members to commingle customer positions in futures, options,
and swaps, and any money, securities, or property received to margin,
guarantee or secure such positions, in an account subject to the
requirements of section 4d(f) of the Act, the derivatives clearing
organization shall file rules for Commission approval pursuant to Sec.
40.5 of this chapter. Such rule submission shall include, at a minimum,
the following:
(A) Identification of the futures, options, and swaps that would be
commingled, including product specifications or the criteria that would
be used to define eligible futures, options, and swaps;
(B) Analysis of the risk characteristics of the eligible products;
(C) Identification of whether the swaps would be executed
bilaterally and/or executed on a designated contract market and/or a
swap execution facility;
(D) Analysis of the liquidity of the respective markets for the
futures, options, and swaps that would be commingled, the ability of
clearing members and the derivatives clearing organization to offset or
mitigate the risk of such futures, options, and swaps in a timely
manner, without compromising the financial integrity of the account,
and, as appropriate, proposed means for addressing insufficient
liquidity;
(E) Analysis of the availability of reliable prices for each of the
eligible products;
(F) A description of the financial, operational, and managerial
standards or requirements for clearing members that would be permitted
to commingle such futures, options, and swaps;
(G) A description of the systems and procedures that would be used
by the derivatives clearing organization to oversee such clearing
members' risk management of any such commingled positions;
(H) A description of the financial resources of the derivatives
clearing organization, including the composition and availability of a
guaranty fund with respect to the futures, options, and swaps that
would be commingled;
(I) A description and analysis of the margin methodology that would
be applied to the commingled futures, options, and swaps, including any
margin reduction applied to correlated positions, and any applicable
margin rules with respect to both clearing members and customers;
(J) An analysis of the ability of the derivatives clearing
organization to manage a potential default with respect to any of the
futures, options, or swaps that would be commingled;
(K) A discussion of the procedures that the derivatives clearing
organization would follow if a clearing member defaulted, and the
procedures that a clearing member would follow if a customer defaulted,
with respect to any of the commingled futures, options, or swaps in the
account; and
(L) A description of the arrangements for obtaining daily position
data with respect to futures, options, and swaps in the account.
(ii) Futures account. In order for a derivatives clearing
organization and its clearing members to commingle customer positions
in futures, options, and swaps, and any money, securities, or property
received to margin, guarantee or secure such positions, in an account
subject to the requirements of section 4d(a) of the Act, the
derivatives clearing organization shall file with the Commission a
petition for an order pursuant to section 4d(a) of the Act. Such
petition shall include, at a minimum, the information required under
paragraph (b)(2)(i) of this section.
(iii) Commission action. (A) The Commission may request additional
information in support of a rule submission filed under paragraph
(b)(2)(i) of this section, and may grant approval of such rules in
accordance with Sec. 40.5 of this chapter.
(B) The Commission may request additional information in support of
a
[[Page 69442]]
petition filed under paragraph (b)(2)(ii) of this section, and may
issue an order under section 4d of the Act in its discretion.
(c) Holding of funds and assets. A derivatives clearing
organization shall hold funds and assets belonging to clearing members
and their customers in a manner which minimizes the risk of loss or of
delay in the access by the derivatives clearing organization to such
funds and assets.
(d) Transfer of customer positions. A derivatives clearing
organization shall have rules providing that the derivatives clearing
organization will promptly transfer all or a portion of a customer's
portfolio of positions and related funds at the same time from the
carrying clearing member of the derivatives clearing organization to
another clearing member of the derivatives clearing organization,
without requiring the close-out and re-booking of the positions prior
to the requested transfer, subject to the following conditions:
(1) The customer has instructed the carrying clearing member to
make the transfer;
(2) The customer is not currently in default to the carrying
clearing member;
(3) The transferred positions will have appropriate margin at the
receiving clearing member;
(4) Any remaining positions will have appropriate margin at the
carrying clearing member; and
(5) The receiving clearing member has consented to the transfer.
(e) Permitted investments. Funds and assets belonging to clearing
members and their customers that are invested by a derivatives clearing
organization shall be held in instruments with minimal credit, market,
and liquidity risks. Any investment of customer funds or assets by a
derivatives clearing organization shall comply with Sec. 1.25 of this
chapter, as if all such funds and assets comprise customer funds
subject to segregation pursuant to section 4d(a) of the Act and
Commission regulations thereunder.
Sec. 39.16 Default rules and procedures.
(a) General. A derivatives clearing organization shall adopt rules
and procedures designed to allow for the efficient, fair, and safe
management of events during which clearing members become insolvent or
default on the obligations of such clearing members to the derivatives
clearing organization.
(b) Default management plan. A derivatives clearing organization
shall maintain a current written default management plan that
delineates the roles and responsibilities of its board of directors,
its risk management committee, any other committee that a derivatives
clearing organization may have that has responsibilities for default
management, and the derivatives clearing organization's management, in
addressing a default, including any necessary coordination with, or
notification of, other entities and regulators. Such plan shall address
any differences in procedures with respect to highly liquid products
and less liquid products. A derivatives clearing organization shall
conduct and document a test of its default management plan at least on
an annual basis.
(c) Default procedures. (1) A derivatives clearing organization
shall adopt procedures that would permit the derivatives clearing
organization to take timely action to contain losses and liquidity
pressures and to continue meeting its obligations in the event of a
default on the obligations of a clearing member to the derivatives
clearing organization.
(2) A derivatives clearing organization shall adopt rules that set
forth its default procedures, including:
(i) The derivatives clearing organization's definition of a
default;
(ii) The actions that the derivatives clearing organization may
take upon a default, which shall include the prompt transfer,
liquidation, or hedging of the customer or house positions of the
defaulting clearing member, as applicable, and which may include, in
the discretion of the derivatives clearing organization, the auctioning
or allocation of such positions to other clearing members;
(iii) Any obligations that the derivatives clearing organization
imposes on its clearing members to participate in auctions, or to
accept allocations, of the customer or house positions of the
defaulting clearing member, provided that:
(A) The derivatives clearing organization shall permit a clearing
member to outsource to a qualified third party, authority to act in the
clearing member's place in any auction, subject to appropriate
safeguards imposed by the derivatives clearing organization;
(B) The derivatives clearing organization shall permit a clearing
member to outsource to a qualified third party, authority to act in the
clearing member's place in any allocations, subject to appropriate
safeguards imposed by the derivatives clearing organization; and
(C) Any allocation shall be proportional to the size of the
participating or accepting clearing member's positions in the same
product class at the derivatives clearing organization;
(iv) The sequence in which the funds and assets of the defaulting
clearing member and its customers and the financial resources
maintained by the derivatives clearing organization would be applied in
the event of a default;
(v) A provision that the funds and assets of a defaulting clearing
member's customers shall not be applied to cover losses with respect to
a house default;
(vi) A provision that the excess house funds and assets of a
defaulting clearing member shall be applied to cover losses with
respect to a customer default, if the relevant customer funds and
assets are insufficient to cover the shortfall; and
(3) A derivatives clearing organization shall make its default
rules publicly available as provided in Sec. 39.21 of this part.
(d) Insolvency of a clearing member.
(1) A derivatives clearing organization shall adopt rules that
require a clearing member to provide prompt notice to the derivatives
clearing organization if it becomes the subject of a bankruptcy
petition, receivership proceeding, or the equivalent;
(2) No later than upon receipt of such notice, a derivatives
clearing organization shall review the continuing eligibility of the
clearing member for clearing membership; and
(3) No later than upon receipt of such notice, a derivatives
clearing organization shall take any appropriate action, in its
discretion, with respect to such clearing member or its house or
customer positions, including but not limited to liquidation or
transfer of positions, suspension, or revocation of clearing
membership.
Sec. 39.17 Rule enforcement.
(a) General. Each derivatives clearing organization shall:
(1) Maintain adequate arrangements and resources for the effective
monitoring and enforcement of compliance with the rules of the
derivatives clearing organization and the resolution of disputes;
(2) Have the authority and ability to discipline, limit, suspend,
or terminate the activities of a clearing member due to a violation by
the clearing member of any rule of the derivatives clearing
organization; and
(3) Report to the Commission regarding rule enforcement activities
and sanctions imposed against clearing members as provided in paragraph
(a) (2) of this section, in accordance with Sec. 39.19(c)(4)(xi) of
this part.
(b) Authority to enforce rules. The board of directors of the
derivatives clearing organization may delegate responsibility for
compliance with the requirements of paragraph (a) of this
[[Page 69443]]
section to the risk management committee, unless the responsibilities
are otherwise required to be carried out by the chief compliance
officer pursuant to the Act or this part.
Sec. 39.18 System safeguards.
(a) Definitions. For purposes of this section:
Recovery time objective means the time period within which an
entity should be able to achieve recovery and resumption of clearing
and settlement of existing and new products, after those capabilities
become temporarily inoperable for any reason up to or including a wide-
scale disruption.
Relevant area means the metropolitan or other geographic area
within which a derivatives clearing organization has physical
infrastructure or personnel necessary for it to conduct activities
necessary to the clearing and settlement of existing and new products.
The term ``relevant area'' also includes communities economically
integrated with, adjacent to, or within normal commuting distance of
that metropolitan or other geographic area.
Wide-scale disruption means an event that causes a severe
disruption or destruction of transportation, telecommunications, power,
water, or other critical infrastructure components in a relevant area,
or an event that results in an evacuation or unavailability of the
population in a relevant area.
(b) General--(1) Program of risk analysis. Each derivatives
clearing organization shall establish and maintain a program of risk
analysis and oversight with respect to its operations and automated
systems to identify and minimize sources of operational risk through:
(i) The development of appropriate controls and procedures; and
(ii) The development of automated systems that are reliable,
secure, and have adequate scalable capacity.
(2) Resources. Each derivatives clearing organization shall
establish and maintain resources that allow for the fulfillment of each
obligation and responsibility of the derivatives clearing organization
in light of the risks identified pursuant to paragraph (b)(1) of this
section.
(3) Verification of adequacy. Each derivatives clearing
organization shall periodically verify that resources described in
paragraph (b)(2) of this section are adequate to ensure daily
processing, clearing, and settlement.
(c) Elements of program. A derivatives clearing organization's
program of risk analysis and oversight with respect to its operations
and automated systems, as described in paragraph (b) of this section,
shall address each of the following categories of risk analysis and
oversight:
(1) Information security;
(2) Business continuity and disaster recovery planning and
resources;
(3) Capacity and performance planning;
(4) Systems operations;
(5) Systems development and quality assurance; and
(6) Physical security and environmental controls.
(d) Standards for program. In addressing the categories of risk
analysis and oversight required under paragraph (c) of this section, a
derivatives clearing organization shall follow generally accepted
standards and industry best practices with respect to the development,
operation, reliability, security, and capacity of automated systems.
(e) Business continuity and disaster recovery. (1) Plan and
resources. A derivatives clearing organization shall maintain a
business continuity and disaster recovery plan, emergency procedures,
and physical, technological, and personnel resources sufficient to
enable the timely recovery and resumption of operations and the
fulfillment of each obligation and responsibility of the derivatives
clearing organization following any disruption of its operations.
(2) Responsibilities and obligations. The responsibilities and
obligations described in paragraph (e)(1) of this section shall
include, without limitation, daily processing, clearing, and settlement
of transactions cleared.
(3) Recovery time objective. The derivatives clearing
organization's business continuity and disaster recovery plan described
in paragraph (e)(1) of this section, shall have the objective of, and
the physical, technological, and personnel resources described therein
shall be sufficient to, enable the derivatives clearing organization to
resume daily processing, clearing, and settlement no later than the
next business day following the disruption.
(f) Location of resources; outsourcing. A derivatives clearing
organization may maintain the resources required under paragraph (e)(1)
of this section either:
(1) Using its own employees as personnel, and property that it
owns, licenses, or leases (own resources); or
(2) Through written contractual arrangements with another
derivatives clearing organization or other service provider
(outsourcing).
(i) Retention of responsibility. A derivatives clearing
organization that enters into such a contractual arrangement shall
retain complete liability for any failure to meet the responsibilities
specified in paragraph (e) of this section, although it is free to seek
indemnification from the service provider. The outsourcing derivatives
clearing organization must employ personnel with the expertise
necessary to enable it to supervise the service provider's delivery of
the services.
(ii) Testing. The testing referred to in paragraph (j) of this
section shall include all of the derivatives clearing organization's
own and outsourced resources, and shall verify that all such resources
will work effectively together.
(g) Notice of exceptional events. A derivatives clearing
organization shall notify staff of the Division of Clearing and Risk
promptly of:
(1) Any hardware or software malfunction, cyber security incident,
or targeted threat that materially impairs, or creates a significant
likelihood of material impairment, of automated system operation,
reliability, security, or capacity; or
(2) Any activation of the derivatives clearing organization's
business continuity and disaster recovery plan.
(h) Notice of planned changes. A derivatives clearing organization
shall give staff of the Division of Clearing and Risk timely advance
notice of all:
(1) Planned changes to automated systems that are likely to have a
significant impact on the reliability, security, or adequate scalable
capacity of such systems; and
(2) Planned changes to the derivatives clearing organization's
program of risk analysis and oversight.
(i) Recordkeeping. A derivatives clearing organization shall
maintain, and provide to Commission staff promptly upon request,
pursuant to Sec. 1.31 of this chapter, current copies of its business
continuity plan and other emergency procedures, its assessments of its
operational risks, and records of testing protocols and results, and
shall provide any other documents requested by Commission staff for the
purpose of maintaining a current profile of the derivatives clearing
organization's automated systems.
(j) Testing.--(1) Purpose of testing. A derivatives clearing
organization shall conduct regular, periodic, and objective testing and
review of:
(i) Its automated systems to ensure that they are reliable, secure,
and have adequate scalable capacity; and
(ii) Its business continuity and disaster recovery capabilities,
using testing protocols adequate to ensure that the derivatives
clearing organization's backup resources are sufficient to meet
[[Page 69444]]
the requirements of paragraph (e) of this section.
(2) Conduct of testing. Testing shall be conducted by qualified,
independent professionals. Such qualified, independent professionals
may be independent contractors or employees of the derivatives clearing
organization, but shall not be persons responsible for development or
operation of the systems or capabilities being tested.
(3) Reporting and review. Reports setting forth the protocols for,
and results of, such tests shall be communicated to, and reviewed by,
senior management of the derivatives clearing organization. Protocols
of tests which result in few or no exceptions shall be subject to more
searching review.
(k) Coordination of business continuity and disaster recovery
plans. A derivatives clearing organization shall, to the extent
practicable:
(1) Coordinate its business continuity and disaster recovery plan
with those of its clearing members, in a manner adequate to enable
effective resumption of daily processing, clearing, and settlement
following a disruption;
(2) Initiate and coordinate periodic, synchronized testing of its
business continuity and disaster recovery plan and the plans of its
clearing members; and
(3) Ensure that its business continuity and disaster recovery plan
takes into account the plans of its providers of essential services,
including telecommunications, power, and water.
Sec. 39.19 Reporting.
(a) General. Each derivatives clearing organization shall provide
to the Commission the information specified in this section and any
other information that the Commission deems necessary to conduct its
oversight of a derivatives clearing organization.
(b) Submission of reports. (1) Unless otherwise specified by the
Commission or its designee, each derivatives clearing organization
shall submit the information required by this section to the Commission
electronically and in a format and manner specified by the Commission.
(2) Time zones. Unless otherwise specified by the Commission or its
designee, any stated time in this section is Central time for
information concerning derivatives clearing organizations located in
that time zone, and Eastern time for information concerning all other
derivatives clearing organizations.
(3) Unless otherwise specified by the Commission or its designee,
business day means the intraday period of time starting at the business
hour of 8:15 a.m. and ending at the business hour of 4:45 p.m., on all
days except Saturdays, Sundays, and Federal holidays.
(c) Reporting requirements. Each registered derivatives clearing
organization shall provide to the Commission or other person as may be
required or permitted by this paragraph the information specified
below:
(1) Daily reporting. (i) A report containing the information
specified by this paragraph (c)(1), which shall be compiled as of the
end of each trading day and shall be submitted to the Commission by 10
a.m. on the following business day:
(A) Initial margin requirements and initial margin on deposit for
each clearing member, by house origin and by each customer origin;
(B) Daily variation margin, separately listing the mark-to-market
amount collected from or paid to each clearing member, by house origin
and by each customer origin;
(C) All other daily cash flows relating to clearing and settlement
including, but not limited to, option premiums and payments related to
swaps such as coupon amounts, collected from or paid to each clearing
member, by house origin and by each customer origin; and
(D) End-of-day positions for each clearing member, by house origin
and by each customer origin.
(ii) The report shall contain the information required by paragraph
(c)(1)(i) of this section for:
(A) All futures positions, and options positions, as applicable;
(B) All swaps positions; and
(C) All securities positions that are held in a customer account
subject to section 4d of the Act or are subject to a cross-margining
agreement.
(2) Quarterly reporting. A report of the derivatives clearing
organization's financial resources as required by Sec. 39.11(f) of
this part; provided that, additional reports may be required by
paragraph (c)(4)(i) of this section or Sec. 39.11(f) of this part.
(3) Annual reporting--(i) Annual report of chief compliance
officer. The annual report of the chief compliance officer required by
Sec. 39.10 of this part.
(ii) Audited financial statements. Audited year-end financial
statements of the derivatives clearing organization or, if there are no
financial statements available for the derivatives clearing
organization itself, the consolidated audited year-end financial
statements of the derivatives clearing organization's parent company.
(iii) [Reserved]
(iv) Time of report. The reports required by this paragraph (c)(3)
shall be submitted concurrently to the Commission not more than 90 days
after the end of the derivatives clearing organization's fiscal year;
provided that, a derivatives clearing organization may request from the
Commission an extension of time to submit a report, provided the
derivatives clearing organization's failure to submit the report in a
timely manner could not be avoided without unreasonable effort or
expense. Extensions of the deadline will be granted at the discretion
of the Commission.
(4) Event-specific reporting--(i) Decrease in financial resources.
If there is a decrease of 25 percent in the total value of the
financial resources available to satisfy the requirements under Sec.
39.11(a)(1) of this part, either from the last quarterly report
submitted under Sec. 39.11(f) of this part or from the value as of the
close of the previous business day, the derivatives clearing
organization shall report such decrease to the Commission no later than
one business day following the day the 25 percent threshold was
reached. The report shall include:
(A) The total value of the financial resources:
(1) As of the close of business the day the 25 percent threshold
was reached, and
(2) If reporting a decrease in value from the previous business
day, the total value of the financial resources immediately prior to
the 25 percent decline;
(B) A breakdown of the value of each financial resource reported in
each of paragraphs (c)(4)(i)(A)(1) and (2) of this section, calculated
in accordance with the requirements of Sec. 39.11(d) of this part,
including the value of each individual clearing member's guaranty fund
deposit if the derivatives clearing organization reports guaranty fund
deposits as a financial resource; and
(C) A detailed explanation for the decrease.
(ii) Decrease in ownership equity. No later than two business days
prior to an event which the derivatives clearing organization knows or
reasonably should know will cause a decrease of 20 percent or more in
ownership equity from the last reported ownership equity balance as
reported on a quarterly or audited financial statement required to be
submitted by paragraph (c)(2) or (c)(3)(ii), respectively, of this
section; but in any event no later than two business days after such
decrease in ownership equity for events that caused the decrease about
which the derivatives clearing organization did not know and reasonably
could not have
[[Page 69445]]
known prior to the event. The report shall include:
(A) Pro forma financial statements reflecting the derivatives
clearing organization's estimated future financial condition following
the anticipated decrease for reports submitted prior to the anticipated
decrease and current financial statements for reports submitted after
such a decrease; and
(B) Details describing the reason for the anticipated decrease or
decrease in the balance.
(iii) Six-month liquid asset requirement. Immediate notice when a
derivatives clearing organization knows or reasonably should know of a
deficit in the six-month liquid asset requirement of Sec. 39.11(e)(2).
(iv) Change in current assets. No later than two business days
after current liabilities exceed current assets; the notice shall
include a balance sheet that reflects the derivatives clearing
organization's current assets and current liabilities and an
explanation as to the reason for the negative balance.
(v) Request to clearing member to reduce its positions. Immediate
notice, of a derivatives clearing organization's request to a clearing
member to reduce its positions because the derivatives clearing
organization has determined that the clearing member has exceeded its
exposure limit, has failed to meet an initial or variation margin call,
or has failed to fulfill any other financial obligation to the
derivatives clearing organization. The notice shall include:
(A) The name of the clearing member;
(B) The time the clearing member was contacted;
(C) The number of positions by which the derivatives clearing
organization requested the reduction;
(D) All products that are the subject of the request; and
(E) The reason for the request.
(vi) Determination to transfer or liquidate positions. Immediate
notice, of a determination that any position a derivatives clearing
organization carries for one of its clearing members must be liquidated
immediately or transferred immediately, or that the trading of any
account of a clearing member shall be only for the purpose of
liquidation because that clearing member has failed to meet an initial
or variation margin call or has failed to fulfill any other financial
obligation to the derivatives clearing organization. The notice shall
include:
(A) The name of the clearing member;
(B) The time the clearing member was contacted;
(C) The products that are subject to the determination;
(D) The number of positions that are subject to the determination;
and
(E) The reason for the determination.
(vii) Default of a clearing member. Immediate notice, upon the
default of a clearing member. An event of default shall be determined
in accordance with the rules of the derivatives clearing organization.
The notice of default shall include:
(A) The name of the clearing member;
(B) The products the clearing member defaulted upon;
(C) The number of positions the clearing member defaulted upon; and
(D) The amount of the financial obligation.
(viii) Change in ownership or corporate or organizational
structure. (A) Reporting requirement. Any anticipated change in the
ownership or corporate or organizational structure of the derivatives
clearing organization or its parent(s) that would:
(1) Result in at least a 10 percent change of ownership of the
derivatives clearing organization,
(2) Create a new subsidiary or eliminate a current subsidiary of
the derivatives clearing organization, or
(3) Result in the transfer of all or substantially all of the
assets of the derivatives clearing organization, including its
registration as a derivatives clearing organization to another legal
entity.
(B) Required information. The report shall include: a chart
outlining the new ownership or corporate or organizational structure; a
brief description of the purpose and impact of the change; and any
relevant agreements effecting the change and corporate documents such
as articles of incorporation and bylaws. With respect to a corporate
change for which a derivatives clearing organization submits a request
for approval to transfer its derivatives clearing organization
registration and open interest under Sec. 39.3(f) of this part, the
informational requirements of this paragraph (c)(4)(viii)(B) shall be
satisfied by the derivatives clearing organization's compliance with
Sec. 39.3(f)(3).
(C) Time of report. The report shall be submitted to the Commission
no later than three months prior to the anticipated change; provided
that the derivatives clearing organization may report the anticipated
change to the Commission later than three months prior to the
anticipated change if the derivatives clearing organization does not
know and reasonably could not have known of the anticipated change
three months prior to the anticipated change. In such event, the
derivatives clearing organization shall immediately report such change
to the Commission as soon as it knows of such change.
(D) Confirmation of change report. The derivatives clearing
organization shall report to the Commission the consummation of the
change no later than two business days following the effective date of
the change.
(ix) Change in key personnel. No later than two business days
following the departure, or addition of persons who are key personnel
as defined in Sec. 39.1(b), a report that includes, as applicable, the
name of the person who will assume the duties of the position on a
temporary basis until a permanent replacement fills the position.
(x) Change in credit facility funding arrangement. No later than
one business day after a derivatives clearing organization changes an
existing credit facility funding arrangement it may have in place, or
is notified that such arrangement has changed, including but not
limited to a change in lender, change in the size of the facility,
change in expiration date, or any other material changes or conditions.
(xi) Sanctions. Notice of action taken, no later than two business
days after the derivatives clearing organization imposes sanctions
against a clearing member.
(xii) Financial condition and events. Immediate notice after the
derivatives clearing organization knows or reasonably should have known
of:
(A) The institution of any legal proceedings which may have a
material adverse financial impact on the derivatives clearing
organization;
(B) Any event, circumstance or situation that materially impedes
the derivatives clearing organization's ability to comply with this
part and is not otherwise required to be reported under this section;
or
(C) A material adverse change in the financial condition of any
clearing member that is not otherwise required to be reported under
this section.
(xiii) Financial statements material inadequacies. If a derivatives
clearing organization discovers or is notified by an independent public
accountant of the existence of any material inadequacy in a financial
statement, such derivatives clearing organization shall give notice of
such material inadequacy within 24 hours, and within 48 hours after
giving such notice file a written report stating what steps have been
and are being taken to correct the material inadequacy.
(xiv) [Reserved]
(xv) [Reserved]
(xvi) System safeguards. A report of:
[[Page 69446]]
(A) Exceptional events as required by Sec. 39.18(g) of this part;
or
(B) Planned changes as required by Sec. 39.18(h) of this part.
(5) Requested reporting. (i) Upon request by the Commission, a
derivatives clearing organization shall file with the Commission such
information related to its business as a clearing organization,
including information relating to trade and clearing details, in the
format and manner specified, and within the time provided, by the
Commission in the request.
(ii) Upon request by the Commission, a derivatives clearing
organization shall file with the Commission a written demonstration,
containing such supporting data, information and documents, that the
derivatives clearing organization is in compliance with one or more
core principles and relevant provisions of this part, in the format and
manner specified, and within the time provided, by the Commission in
the request.
(iii) Upon request by the Commission, a derivatives clearing
organization shall file with the Commission, for each customer origin
of each clearing member, the end-of-day gross positions of each
beneficial owner, in the format and manner specified, and within the
time provided, by the Commission in the request. Nothing in this
paragraph shall affect the obligation of a derivatives clearing
organization to comply with the daily reporting requirements of
paragraph (c)(1) of this section.
Sec. 39.20 Recordkeeping.
(a) Requirement to maintain information. Each derivatives clearing
organization shall maintain records of all activities related to its
business as a derivatives clearing organization. Such records shall
include, but are not limited to, records of:
(1) All cleared transactions, including swaps;
(2) All information necessary to record allocation of bunched
orders for cleared swaps;
(3) All information required to be created, generated, or reported
under this part 39, including but not limited to the results of and
methodology used for all tests, reviews, and calculations in connection
with setting and evaluating margin levels, determining the value and
adequacy of financial resources, and establishing settlement prices;
(4) All rules and procedures required to be submitted pursuant to
this part 39 and part 40 of this chapter, including all proposed
changes in rules, procedures or operations subject to Sec. 40.10 of
this chapter; and
(5) Any data or documentation required by the Commission or by the
derivatives clearing organization to be submitted to the derivatives
clearing organization by its clearing members, or by any other person
in connection with the derivatives clearing organization's clearing and
settlement activities.
(b) Form and manner of maintaining information. (1) General. The
records required to be maintained by this chapter shall be maintained
in accordance with the provisions of Sec. 1.31 of this chapter, for a
period of not less than 5 years, except as provided in paragraph (b)(2)
of this section.
(2) Exception for swap data. Each derivatives clearing organization
that clears swaps must maintain swap data in accordance with the
requirements of part 45 of this chapter.
Sec. 39.21 Public information.
(a) General. Each derivatives clearing organization shall provide
to market participants sufficient information to enable the market
participants to identify and evaluate accurately the risks and costs
associated with using the services of the derivatives clearing
organization. In furtherance of this objective, each derivatives
clearing organization shall have clear and comprehensive rules and
procedures.
(b) Availability of information. Each derivatives clearing
organization shall make information concerning the rules and the
operating and default procedures governing the clearing and settlement
systems of the derivatives clearing organization available to market
participants.
(c) Public disclosure. Each derivatives clearing organization shall
disclose publicly and to the Commission information concerning:
(1) The terms and conditions of each contract, agreement, and
transaction cleared and settled by the derivatives clearing
organization;
(2) Each clearing and other fee that the derivatives clearing
organization charges its clearing members;
(3) The margin-setting methodology;
(4) The size and composition of the financial resource package
available in the event of a clearing member default;
(5) Daily settlement prices, volume, and open interest for each
contract, agreement, or transaction cleared or settled by the
derivatives clearing organization;
(6) The derivatives clearing organization's rules and procedures
for defaults in accordance with Sec. 39.16 of this part; and
(7) Any other matter that is relevant to participation in the
clearing and settlement activities of the derivatives clearing
organization.
(d) Publication of information. The derivatives clearing
organization shall make its rulebook, a list of all current clearing
members, and the information listed in paragraph (c) of this section
readily available to the general public, in a timely manner, by posting
such information on the derivatives clearing organization's Web site,
unless otherwise permitted by the Commission. The information required
in paragraph (c)(5) of this section shall be made available to the
public no later than the business day following the day to which the
information pertains.
Sec. 39.22 Information sharing.
Each derivatives clearing organization shall enter into, and abide
by the terms of, each appropriate and applicable domestic and
international information-sharing agreement, and shall use relevant
information obtained from each such agreement in carrying out the risk
management program of the derivatives clearing organization.
Sec. 39.23 Antitrust considerations.
Unless necessary or appropriate to achieve the purposes of the Act,
a derivatives clearing organization shall not adopt any rule or take
any action that results in any unreasonable restraint of trade, or
impose any material anticompetitive burden.
Sec. 39.24 [Reserved]
Sec. 39.25 [Reserved]
Sec. 39.26 [Reserved]
Sec. 39.27 Legal risk considerations.
(a) Legal authorization. A derivatives clearing organization shall
be duly organized, legally authorized to conduct business, and remain
in good standing at all times in the relevant jurisdictions. If the
derivatives clearing organization provides clearing services outside
the United States, it shall be duly organized to conduct business and
remain in good standing at all times in the relevant jurisdictions, and
be authorized by the appropriate foreign licensing authority.
(b) Legal framework. A derivatives clearing organization shall
operate pursuant to a well-founded, transparent, and enforceable legal
framework that addresses each aspect of the activities of the
derivatives clearing organization. As applicable, the framework shall
provide for:
(1) The derivatives clearing organization to act as a counterparty,
including novation;
(2) Netting arrangements;
(3) The derivatives clearing organization's interest in collateral;
[[Page 69447]]
(4) The steps that a derivatives clearing organization would take
to address a default of a clearing member, including but not limited
to, the unimpeded ability to liquidate collateral and close out or
transfer positions in a timely manner;
(5) Finality of settlement and funds transfers that are irrevocable
and unconditional when effected (no later than when a derivatives
clearing organization's accounts are debited and credited); and
(6) Other significant aspects of the derivatives clearing
organization's operations, risk management procedures, and related
requirements.
(c) Conflict of laws. If a derivatives clearing organization
provides clearing services outside the United States:
(1) The derivatives clearing organization shall identify and
address any material conflict of law issues. The derivatives clearing
organization's contractual agreements shall specify a choice of law.
(2) The derivatives clearing organization shall be able to
demonstrate the enforceability of its choice of law in relevant
jurisdictions and that its rules, procedures, and contracts are
enforceable in all relevant jurisdictions.
Appendix to Part 39--Form DCO Derivatives Clearing Organization
Application for Registrations
BILLING CODE 6351-01-P
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BILLING CODE 6351-01-C
PART 140--ORGANIZATION, FUNCTIONS, AND PROCEDURES OF THE COMMISSION
0
9. The authority citation for part 140 continues to read as follows:
Authority: 7 U.S.C. 2 and 12a.
0
10. Amend Sec. 140.94 by revising the section heading and paragraph
(a)(5), redesignating paragraph (a)(6) as paragraph (a)(7), revise
newly redesignated paragraph (a)(7), and add new paragraphs (a)(6) and
(a)(8) through (a)(14) to read as follows:
Sec. 140.94 Delegation of authority to the Director of the Division
of Clearing and Risk.
(a) * * *
(5) All functions reserved to the Commission in Sec. 5.14 of this
chapter;
(6) All functions reserved to the Commission in Sec. Sec.
39.3(a)(2) and (a)(3) of this chapter;
(7) All functions reserved to the Commission in Sec. Sec.
39.5(b)(2), (b)(3)(ix), and (d)(3) of this chapter;
(8) All functions reserved to the Commission in Sec.
39.10(c)(4)(iv) of this chapter;
(9) All functions reserved to the Commission in Sec. Sec.
39.11(b)(1)(vi), (b)(2)(ii), (c)(1), (c)(2), (f)(1) and (f)(4) of this
chapter;
(10) All functions reserved to the Commission in Sec.
39.12(a)(5)(i)(B) of this chapter;
(11) All functions reserved to the Commission in Sec. Sec.
39.13(g)(8)(ii), (h)(1)(i)(C), (h)(1)(ii), (h)(3)(i), (h)(3)(ii), and
(h)(5)(i)(A) of this chapter;
(12) The authority to request additional information in support of
a rule submission under Sec. 39.15(b)(2)(iii)(A) of this chapter and
in support of a petition pursuant to section 4d of the Act under Sec.
39.15(b)(2)(iii)(B) of this chapter;
(13) All functions reserved to the Commission in Sec. Sec.
39.19(c)(3)(iv), (c)(5)(i), (c)(5)(ii), and (c)(5)(iii) of this
chapter; and
(14) All functions reserved to the Commission in Sec. 39.21(d) of
this chapter.
Issued in Washington, DC, on October 18, 2011, by the
Commission.
David A. Stawick,
Secretary of the Commission.
Appendices to Derivatives Clearing Organization General Provisions and
Core Principles--Commission Voting Summary and Statements of
Commissioners
Note: The following appendices will not appear in the Code of
Federal Regulations
[[Page 69473]]
Appendix 1--Commission Voting Summary
On this matter, Chairman Gensler and Commissioners Dunn and Chilton
voted in the affirmative; Commissioners Sommers and O'Malia voted in
the negative.
Appendix 2--Statement of Chairman Gary Gensler
I support the final rulemaking on core principles for derivatives
clearing organizations (DCOs). Centralized clearing has been a feature
of the U.S. futures markets since the late-19th century. Clearinghouses
have functioned both in clear skies and during stormy times--through
the Great Depression, numerous bank failures, two world wars, and the
2008 financial crisis--to lower risk to the economy. Importantly,
centralized clearing protects banks and their customers from the risk
of either party failing.
When customers don't clear their transactions, they take on their
dealer's credit risk. We have seen over many decades, however, that
banks do fail. Centralized clearing protects all market participants by
requiring daily mark to market valuations and requiring collateral to
be posted by both parties so that both the swap dealer and its
customers are protected if either fails. It lowers the
interconnectedness between financial entities that helped spread risk
throughout the economy when banks began to fail in 2008.
Today's rulemaking will establish certain regulatory requirements
for DCOs to implement important core principles that were revised by
the Dodd-Frank Act. We recognize the need for very robust risk
management standards, particularly as more swaps are moved into central
clearinghouses. We have incorporated the newest draft Committee on
Payment and Settlement Systems (CPSS)-International Organization of
Securities Commissions (IOSCO) standards for central counterparties
into our final rules.
First, the financial resources and risk management requirements
will strengthen financial integrity and enhance legal certainty for
clearinghouses. We're adopting a requirement that DCOs collect initial
margin on a gross basis for its clearing member's customer accounts For
interest rates and financial index swaps, such as credit default swaps,
we are maintaining, as proposed, a minimum margin for a five-day
liquidation period. This is consistent with current market practice,
and many commenters recommended this as a minimum. For the clearing of
physical commodity swaps, such as on energy, metals and agricultural
products, we are requiring margin that is risk-based but consistent
with current market practice--a minimum of one day. Maintaining a
minimum five day liquidation period for interest rates and credit
default swaps is appropriate not only as it is consistent with current
market practice, but also as these markets are the most systemically
relevant for the interconnected financial system. History shows that,
in 2008, it took five days after the failure of Lehman Brothers for the
clearinghouse to transfer Lehman's interest rate swaps positions to
other clearing members. These financial resource requirements, and
particularly the margin requirements, are critical for safety and
soundness as more swaps are moved into central clearing.
Second, the rulemaking implements the Dodd-Frank Act's requirement
for open access to DCOs. The participant eligibility requirements
promote fair and open access to clearing. Importantly, the rule
addresses how a futures commission merchant can become a member of a
DCO. The rule promotes more inclusiveness while allowing DCO to scale a
member's participation and risk based upon its capital. This improves
competition that will benefit end-users of swaps, while protecting
DCOs' ability manage risk.
Third, the reporting requirements will ensure that the Commission
has the information it needs to monitor DCO compliance with the
Commodity Exchange Act and Commission regulations.
Fourth, the rules formalize the DCO application procedures to bring
about greater uniformity and transparency in the application process
and facilitate greater efficiency and consistency in processing
applications.
These reforms will both lower risk in the financial system and
strengthen the market by making many of the processes more efficient
and consistent.
Appendix 3--Statement of Commissioner Jill Sommers
The final rules adopted by the Commission today for derivatives
clearing organizations (DCOs) will implement a key component of the
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank)
to facilitate centralized clearing of both exchange-traded and over-
the-counter swaps. While I fully support the centralized clearing of
swaps, I reluctantly cannot support the final DCO rules.
In my opinion, the rules are needlessly prescriptive, internally
inconsistent, and depart from the Commission's time-tested principles-
based oversight regime, with little to no explanation of the costs and
benefits of doing so, or even a rationale other than an overarching
belief that prescriptive rules will increase legal certainty and
prevent a race to the bottom by competing clearinghouses. A few
examples will illustrate my point.
Rule 39.11(a)(1) requires a DCO to maintain sufficient financial
resources to cover a default by its largest clearing member. Rule
39.11(a)(2) requires a DCO to maintain sufficient financial resources
to cover its operating costs for a period of at least one year. Rules
39.11(b)(1) and (b)(2) list the types of financial resources deemed
sufficiently liquid to meet the requirements of Rules 39.11(a)(1) and
(a)(2). The preamble to the rules states that letters of credit are not
an acceptable financial resource for purposes of Rules 39.11(a)(1) or
(a)(2), but may be allowed on a case-by-case basis. Letters of credit
are also banned for purposes of Rule 39.11(e)(1) (cash obligations),
and Rule 39.11(e)(3) (guaranty fund obligations), neither of which
allow for a case-by-case determination. When it comes to initial
margin, letters of credit are allowed for futures and options without
qualification, but banned for swaps.
These distinctions, in my opinion, are not legally or factually
justifiable. The ability to draw on safe, liquid assets is critical in
all of the situations described above. We should treat letters of
credit the same way unless there is a compelling reason not to. This is
especially true given the fact that banning their use as initial margin
for swaps will have the perverse, unintended consequence of
disincentivizing voluntary clearing by commercial end-users who support
their swaps positions using letters of credit--a result that is
directly at odds with the goals of Dodd-Frank.
Another example can be found in Rule 39.13(g)(2)(ii), which
establishes a one-day minimum liquidation time for calculating initial
margin for futures and options, a one-day minimum liquidation time for
swaps on agricultural, metal, and energy commodities, and a five-day
minimum liquidation time for all other swaps. In the cost-benefit
analysis, the Commission states that ``using only one criterion--i.e.,
the characteristic of the commodity underlying a swap--to determine
liquidation time could result in less-than-optimal margin
calculations.'' The Commission goes on to describe the complex nature
of calculating appropriate margin levels, which includes the ability to
assess quantitative factors such as the risk characteristics of the
instrument traded,
[[Page 69474]]
its historical price volatility and liquidity in the relevant market,
as well as ``expert judgment as to the extent to which such
characteristics and data may be an accurate predictor of future market
behavior with respect to such instruments, and [the application of]
such judgment to the quantitative results.'' We then explain that the
Commission is not capable of determining the risk characteristics,
price volatility and market liquidity of even a sample of swaps for
purposes of determining an appropriate liquidation time for specific
swaps.
In the face of our admitted inability to determine appropriate
liquidation times for particular swaps, we are picking a one-day time
for some, based on the underlying commodity, and a five-day time for
all others, even though this ``could result in less-than-optimal margin
calculations.'' This defies common sense.
The only reason we give for eliminating the long-standing
discretion of the acknowledged experts, i.e., the DCOs, to determine
the appropriate liquidation times for the transactions they clear is to
prevent a feared race to the bottom by DCOs who will compete to clear
swaps in the future. We acknowledge, however, that DCOs have used
reasonable and prudent judgment in establishing liquidation times in
the past, including DCOs that currently compete in the swaps clearing
space. The Commission gives no reason for its belief that there may be
a race to the bottom if we do not establish this less than ideal
methodology. Nor does the Commission acknowledge the existence of other
safeguards in the rules that give us strong tools for policing a
potential race to the bottom.
With the passage of Dodd-Frank, Congress gave the Commission broad
authority to regulate swap transactions, swap markets and swap market
participants. I do not believe, however, that Congress intended for the
Commission to strip DCOs of the flexibility to determine the manner in
which they comply with core principles, as we have done with these
rules. Our registered DCOs have a strong track record of prudent risk
management, including during the financial crisis, and there is no
reason to believe they will not continue to use their expert judgment
in a responsible fashion. Moreover, unnecessary and inflexible rules,
such as these, will prevent DCOs from quickly adapting to changing
market conditions for no apparent benefit. I therefore dissent.
Appendix 4--Statement of Commissioner Scott O'Malia
Today, the Commission approved a final rulemaking on the operation
of derivatives clearing organizations (each, a ``DCO'').\289\ Of the
Dodd-Frank rulemakings that the Commission has so far undertaken, this
rulemaking is among the most important. I have been a strong proponent
of clearing. In the aftermath of the Enron crisis, I witnessed first-
hand how the creation of ClearPort ameliorated counterparty credit
fears in the energy merchant markets and restored liquidity to those
markets. I am certain that clearing will similarly benefit the swaps
market,\290\ particularly by significantly expanding execution on
electronic platforms, thereby increasing price transparency and
discovery. Moreover, as we have seen in the 2008 financial crisis,
clearing has the potential to mitigate systemic risk, by ensuring that
swap counterparties--not hardworking American taxpayers--post
collateral to support their exposures.
---------------------------------------------------------------------------
\289\ Derivatives Clearing Organizations (to be codified at 17
CFR pts. 1, 21, 39, and 140), available at: http://www.cftc.gov/PressRoom/Events/opaevent_cftcdoddfrank101811 (the ``DCO Final
Rule'').
\290\ See Kathryn Chen et al., An Analysis of CDS Transactions:
Implications for Public Reporting, Federal Reserve Bank of New York
Staff Report no. 517 (September 2011), available at: http://www.newyorkfed.org/research/staff_reports/sr517.pdf (stating that
``[c]learing-eligible products within our sample traded on more days
and had more intraday transactions than non-clearing eligible
products'').
---------------------------------------------------------------------------
The main goal of this final rulemaking is to ensure that clearing
contributes to the integrity of the United States financial system by,
among other things, allowing entities other than the largest dealer
banks to offer clearing services to commercial and financial end-users.
I fully support this goal. However, in an attempt to achieve this goal,
this rulemaking abandons the principles-based regulatory regime which
permitted DCOs to perform so admirably in the 2008 financial crisis.
Instead, the final rulemaking sets forth a series of prescriptive
requirements. I disagree with this approach. DCO risk management poses
complex and multidimensional challenges. One DCO may have a
significantly different risk profile than another. Consequently, each
DCO must have sufficient discretion to match requirements to risks. The
role of the Commission is to oversee the exercise of such discretion,
not to prevent such exercise.\291\
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\291\ See section 3(b) of the Commodity Exchange Act (CEA), 7
U.S.C. 5(b) (stating that ``[i]t is the purpose of this Act to serve
the public interests * * * through a system of effective self-
regulation of trading facilities, clearing systems, market
participants and market professionals under the oversight of the
Commission.'').
---------------------------------------------------------------------------
Additionally, I am mindful of the cost of clearing and want to
ensure that such cost does not constitute a barrier to entry. Certain
provisions in this final rulemaking may impose substantial costs
without corresponding benefits. Such provisions may discourage market
participants from executing transactions subject to mandatory clearing,
even if they need such transactions to prudently hedge risks, or from
clearing on a voluntary basis. By creating perverse incentives to keep
risk outside of the regulatory framework, and to leave it within our
commercial and financial enterprises, the DCO rules undermine a
fundamental purpose of the Dodd-Frank Act--namely, the expansion of
clearing.
I will elaborate on each concern in turn.
Participant Eligibility: One-Size Does Not Fit All
This final rulemaking prohibits a DCO from requiring more than $50
million in capital from any entity seeking to become a swaps clearing
member. This number makes a great headline, mainly because it is so
low. It also sends an unequivocal message to DCOs that have clearing
members that are primarily dealer banks. However, in adopting and
interpreting this requirement, the Commission may unwisely limit the
range of legitimate actions that DCOs can take to manage their
counterparty risks. By imposing such limitations, the Commission is
introducing costs to clearing that it fails to detail and explore.
Let me be plain. I oppose anticompetitive behavior. However, an
entity with $50 million in capitalization may not be an appropriate
clearing member for every DCO. The $50 million threshold prevents DCOs
from engaging in anticompetitive behavior but also prohibits DCOs from
taking legitimate, risk-reducing actions. Instead of adopting this
prescriptive requirement, the Commission should have provided
principles-based guidance to DCOs on the other components of fair and
open access, such as the standard for less restrictive participation
requirements.\292\ By taking a more principles-based approach, the
Commission could have been in greater accord with international
regulators, one of which explicitly cautioned against the $50 million
threshold.\293\
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\292\ The DCO Final Rule, supra note 289, at 387-388 (to be
codified at 17 CFR 39.12(a)(1)).
\293\ See letter, dated March 21, 2011, from the United Kingdom
Financial Services Authority (``FSA''), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=957 (stating
that ``whilst capital thresholds or other participation eligibility
threshold limitations may be a potential tool to help ensure fair
and open access to [central counterparties (``CCPs'')], to impose
them on clearing arrangements for products that have complex or
unique characteristics could lead to increased risk to the system in
the short to medium term.'')
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[[Page 69475]]
Basis for the $50 Million?
How did the Commission determine that the $50 million threshold is
appropriate? It is not really evident from the notice of proposed
rulemaking.\294\ In the final rulemaking, the Commission states that
the $50 million threshold was derived from the fact that most
registered futures commission merchants (``FCMs'') that are currently
DCO clearing members have at least $50 million in capital.\295\
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\294\ See Risk Management Requirements for Derivatives Clearing
Organizations, 76 FR 3698, 3791 (Jan. 20, 2011).
\295\ See the DCO Final Rule, supra note 289, at 83 to 84
(further stating that ``of 126 FCMs, 63 currently have capital above
$50 million and most FCMs with capital below that amount are not
clearing members.'').
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The final rulemaking, however, does not answer a number of
questions that are crucial to determining whether the $50 million
threshold is appropriate for all swap transactions. These questions
include, without limitation: What types of products do the referenced
FCMs currently clear? Are there differences between the capital
distributions of FCMs that clear different products? If so, what are
such differences?
The answers to these questions are important because FCMs may need
different amounts of capital to support their exposures to different
products. Assume, for example, that the average capitalization of FCMs
clearing agricultural futures is $50 million. Further assume that an
FCM has $50 million in capital, and is seeking to become a clearing
member. The Commission may reasonably conclude that such FCM would have
the resources to clear agricultural futures. It may also reasonably
conclude that such FCM would have the resources to clear agricultural
swaps that have the same terms and conditions as agricultural futures.
The Commission cannot reasonably conclude, however, that such FCM would
have the resources to clear credit default swaps.
By not setting forth the answers to questions such as these, the
final rulemaking creates the impression that the $50 million threshold
is arbitrary, and renders vulnerable its conclusion that the threshold
``captures firms that the Commission believes have the financial,
operational, and staffing resources to participate in clearing swaps
without posing an unacceptable level of risk to a DCO.'' \296\
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\296\ Id. at 83.
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Anticompetitive behavior? Or legitimate, risk-reducing action?
The final rulemaking recognizes that DCOs may increase capital
requirements for legitimate, risk-reducing reasons. In fact, the final
rulemaking requires a DCO to ``set forth capital requirements that * *
* appropriately match capital to risk.'' \297\ Further, the final
rulemaking mandates DCOs to ``require clearing members to have access
to sufficient financial resources to meet obligations arising from
participation in the [DCO] in extreme but plausible market
conditions.'' \298\ The final rulemaking states that a DCO ``may permit
such financial resources to include, without limitation, a clearing
member's capital.'' \299\
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\297\ Id. at 388 (to be codified at 17 CFR 39.12(a)(2)(ii))
(further stating that ``[c]apital requirements shall be scalable to
risks posed by clearing members''.).
\298\ Id. (to be codified at 17 CFR 39.12(a)(2)(i)).
\299\ Id. Additionally, the notice of proposed rulemaking
states: ``Proposed Sec. Sec. 39.12(a)(2)(ii) and 39.12(a)(2)(iii),
considered together, would require a DCO to admit any person to
clearing membership for the purpose of clearing swaps, if the person
had $50 million in capital, but would permit a DCO to require each
clearing member to hold capital proportional to its risk exposure.
Thus, if a clearing member's risk exposure were to increase in a
non-linear manner, the DCO could increase the clearing member's
corresponding scalable capital requirement in a non-linear manner.''
76 FR at 3701.
---------------------------------------------------------------------------
The final rulemaking, however, provides little insight on how the
Commission intends to differentiate between (i) a required risk-based
increase in capital requirements and (ii) an illegitimate attempt to
circumvent the $50 million threshold to squash competition. To use an
example grounded in reality--ICE Clear Credit recently lowered its
minimum capital requirement for clearing members to $100 million.
However, it added a requirement that clearing members hold excess net
capital equal to 5 percent of their segregated customer funds. Upon
learning about the additional requirement, at least two existing FCMs
complained that it violates fair and open access.\300\ The final
rulemaking gives very little guidance on the criteria that the
Commission will apply in adjudicating a dispute such as this. The
preamble to the final rulemaking simply states: ``A DCO may not * * *
[enact] some additional financial requirement that effectively renders
the $50 million threshold meaningless for some potential clearing
members.'' It further states that such a requirement would violate the
other components of fair and open access, such as ``Sec.
39.12(a)(1)(i) (less restrictive alternatives), or Sec.
39.12(a)(1)(iii) (exclusion of certain types of firms).'' \301\ This
vague statement provides no legal certainty or bright lines for DCOs
and potential clearing members to follow.
---------------------------------------------------------------------------
\300\ See Matthew Leising, ``ICE Clear Credit's Member Rules Too
Exclusive, Small Firms Say,'' Bloomberg, Aug. 9, 2011, available at:
http://www.bloomberg.com/news/2011-08-09/ice-clear-credit-s-member-rules-too-exclusive-small-firms-say.html.
\301\ The DCO Final Rule, supra note 289, at 85-86.
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If I were running a DCO, I would be extremely confused. On the one
hand, the final rulemaking requires me to match capital requirements to
risk. On the other hand, the preamble suggests that I cannot increase
capital requirements (or any other financial requirement), if that
would prohibit some entities with $50 million in capitalization from
becoming clearing members. How should I resolve this conundrum?
Hidden Costs
If a DCO took a narrow interpretation of the reference to financial
requirements in the preamble, then it has only one alternative: (i)
Admit any entity with $50 million in capital as a clearing member and
(ii) impose strict risk limits.\302\ How strict could such limits be?
To lend some context to this $50 million threshold, a recent report
from the staff of the Federal Reserve Bank of New York observed that
$50 million tended to be the notional value of one single transaction
in a credit default swap index with relatively high liquidity.\303\
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\302\ The final rulemaking requires DCOs to impose risk limits
on clearing members. See id. at 399 to 400 (to be codified at 17 CFR
39.13(h)(1)).
\303\ See supra note.
---------------------------------------------------------------------------
Assuming that the Commission does not require the DCO to increase
its risk limits,\304\ where does this situation leave the DCO? The DCO
would need to incur the cost of (i) evaluating applications from all
entities with $50 million in capital, (ii) operationally connecting to
such entities, and (iii) potentially defending itself against claims
from such entities that the risk limits or financial requirements are
too stringent. The DCO may pass on such costs to clearing members,
which may pass on such costs to commercial and financial end-users. In
the meantime, such entities, when admitted, may be unable to clear any
significant volume
[[Page 69476]]
of transactions, for themselves or for customers, especially in asset
classes such as credit default swaps. Under this scenario, rather than
leading to fair and open access, the $50 million threshold may actually
impede access to clearing by commercial and financial end-users,
because the threshold would increase their costs without introducing
meaningful competition among FCMs offering clearing services.
---------------------------------------------------------------------------
\304\ See the DCO Final Rule, supra note 289, at 399 to 400 (to
be codified at 17 CFR 39.13(h)(1)(i)(C)) (stating that ``[t]he
Commission may review such methods, thresholds, and financial
resources and require the application of different methods,
thresholds, or financial resources, as appropriate.'').
---------------------------------------------------------------------------
If, on the other hand, a DCO took a more aggressive interpretation
of the reference to financial requirements in the preamble, then it may
have other alternatives to mitigate risks that admitting an entity with
$50 million in capital may introduce. For example, it may increase
margin requirements. It may also increase guaranty fund contributions
for all clearing members, in proportion to their clearing activity. In
other words, a DCO may increase the overall cost of clearing in order
to compensate for the risks of having lesser capitalized new clearing
members.
What are the potential effects of such increases? It is difficult
to determine from our cost-benefit analysis. The analysis does not
identify increases in margin or guaranty fund contributions as
potential costs, much less attempt to quantify such costs.\305\
However, if the increases in costs are significant, and if such
increases apply to a wide range of clearing members (because the DCO
fears being accused of unjustified discrimination),\306\ then such
increases would most definitely influence whether commercial and
financial entities voluntarily clear or even enter into hedges in the
first place.
---------------------------------------------------------------------------
\305\ Interestingly, the preamble notes that at least two
commenters agreed that a DCO may legitimately use such increases to
moderate the risk of a member with only $50 million in capital.
Specifically, the preamble states: ``Newedge commented that the
proposed rule should not increase risk to a DCO because a DCO can
mitigate risk by, among other things, imposing position limits,
stricter margin requirements, or stricter default deposit
requirements on lesser capitalized clearing members.'' The preamble
also states: ``J.P. Morgan, however, commented that a cap on a
member's minimum capital requirement would not impact the systemic
stability of a DCO as long as * * * DCOs hold a sufficient amount of
margin and funded default guarantee funds.'' Id. at 80 to 82. It is
therefore unclear why the cost-benefit analysis did not address the
potential for such increases.
\306\ See id. at 387 (to be codified at 17 CFR 39.12(a)(1)(iii))
(stating that ``[a] derivatives clearing organization shall not
exclude or limit clearing membership of certain types of market
participants unless the derivatives clearing organization can
demonstrate that the restriction is necessary to address credit risk
or deficiencies in the participants' operational capabilities that
would prevent them from fulfilling their obligations as clearing
members.'' The regulation contains no further detail regarding what
type of demonstration would be sufficient.).
---------------------------------------------------------------------------
Principles-Based Regulation Is a Better Solution
I propose a simple solution that would have addressed the confusion
and hidden costs resulting from the $50 million threshold. The
Commission should have eliminated the threshold. The threshold adds no
value to the other components of fair and open access.\307\ Given that
the final rulemaking rightfully requires a DCO to properly manage its
risks, one or more DCOs would inevitably impose some sort of financial
requirement that would prevent entities with $50 million (or more) in
capital from directly participating in clearing. At that point, the
Commission would not be able to opine on such a requirement without
looking to the other components of fair and open access. As a result,
it would have served the Commission well to have focused in the first
instance on setting forth principles-based guidance on such
components.\308\ Moreover, principles-based guidance would have brought
the Commission into greater accord with certain international
regulators,\309\ current international standards on CCP
regulation,\310\ as well as the proposed revisions to such
standards.\311\
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\307\ In legal parlance, the $50 million threshold is neither
necessary nor sufficient to determining whether a DCO has violated
fair and open access. The threshold is not necessary because a DCO
can set an even lower minimum capital requirement and still violate
fair and open access if another requirement ``excludes or limits
clearing membership of certain types of market participants.'' Id.
(to be codified at 17 CFR 39.12(a)(1)(iii)). The threshold is not
sufficient because, even if the DCO accepts all entities with $50
million in capital as clearing members, the Commission may still
hold that DCO violated fair and open access if it imposes ``some
additional financial requirement that effectively renders the $50
million threshold meaningless.'' Id. at 85-86.
\308\ In such guidance, the Commission could have detailed the
information that a DCO would need to provide in order to demonstrate
that it could not adopt a less restrictive participation requirement
without materially increasing its own risk. The Commission could
have also discussed the weight that DCOs should accord to a
particular level of capitalization, depending on whether the
relevant clearing member (i) engages in businesses other than the
intermediation of futures or swaps, or (ii) participates at multiple
DCOs rather than one DCO.
\309\ See supra note. I note that the Commission and FSA share
jurisdiction over three DCOs clearing swaps--namely, LCH.Clearnet
Limited, ICE Clear Europe Limited, and CME Clearing Europe. How the
Commission and FSA will resolve conflicting regulation remains to be
seen.
\310\ See Bank for International Settlements' Committee on
Payment and Settlement Systems and Technical Committee of the
International Organization of Securities Commissions (``CPSS-
IOSCO''), ``Recommendations for Central Counterparties,'' CPSS
Publ'n No. 64 (November 2004), available at: http://www.bis.org/publ/cpss64.pdf (the ``CPSS-IOSCO Recommendations''). Section 4.2.2
of the CPSS-IOSCO Recommendations state: ``To reduce the likelihood
of a participant's default and to ensure timely performance by the
participant, a CCP should establish rigorous financial requirements
for participation. Participants are typically required to meet
minimum capital standards. Some CCPs impose more stringent capital
requirements if exposures of or carried by a participant are large
or if the participant is a clearing participant. Capital
requirements for participation may also take account of the types of
products cleared by a CCP. In addition to capital requirements, some
CCPs impose standards such as a minimum credit rating or parental
guarantees.''
\311\ See CPSS-IOSCO, ``Principles for financial market
infrastructures: Consultative report,'' CPSS Publ'n No. 94 (March
2011), available at: http://www.bis.org/publ/cpss94.pdf (the ``CPSS-
IOSCO Consultation''). The CPSS-IOSCO Consultation, which CPSS-IOSCO
has not adopted as final, does not set forth any requirement or
suggestion that resembles the $50 million threshold. Instead, the
Consultation, like the Recommendations, emphasizes the importance of
``risk-based'' CCP participation criteria that are not unduly
discriminatory. Specifically, Section 3.16.6 of the CPSS-IOSCO
Consultation states: ``Participation requirements based solely on a
participant's size are typically insufficiently related to risk and
deserve careful scrutiny.'' Whereas the Consultation may have
intended to comment on restrictively high CCP participation
requirements, the same logic applies to restrictively low CCP
participation requirements. Neither are risk-based.
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Costs Without Benefits: Minimum Liquidation Time Requirements
I have consistently highlighted that our rulemakings are
interconnected and that the Commission has an obligation to analyze the
cost impact across rulemakings. In this instance, I am concerned about
the relationship between this final rulemaking and our proposal
interpreting core principle 9 for designated contract markets (DCMs),
which may be finalized in the future.\312\ Although this relationship
may result in significant costs for the market, this final rulemaking
fails to disclose such costs.
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\312\ See Core Principles and Other Requirements for Designated
Contract Markets, 75 FR 80572 (Dec. 22, 2010).
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Specifically, this final rulemaking requires a DCO to calculate
margin using different minimum liquidation times for different
products. A DCO must calculate margin for (i) futures based on a one-
day minimum liquidation time, (ii) agricultural, energy, and metals
swaps based on a one-day minimum liquidation time, and (iii) all other
swaps based on a five-day minimum liquidation time.\313\
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\313\ See the DCO Core Principles, supra note 289, at 393-394
(to be codified at 17 CFR 39.13(g)(2)(ii)).
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No Policy Basis for Minimum Liquidation Times
As a preliminary matter, this final rulemaking creates the
impression that these requirements are arbitrary, like the $50 million
threshold. Although the final rulemaking characterizes these
requirements as ``prudent,'' it sets forth
[[Page 69477]]
no justification for this characterization.\314\ According to the final
rulemaking, DCOs should consider at least five factors in establishing
minimum liquidation times for its products, including trading volume,
open interest, and predictable relationships with highly liquid
products.\315\ In setting forth such factors, the Commission is holding
DCOs to a higher standard than it holds itself. The final rulemaking
presents no evidence that the Commission considered any of the five
factors in determining minimum liquidation times.\316\
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\314\ See id. at 126-127.
\315\ According to the final rulemaking, such factors are: ``(i)
Average daily trading volume in a product; (ii) average daily open
interest in a product; (iii) concentration of open interest; (iv)
availability of a predictable basis relationship with a highly
liquid product; and (v) availability of multiple market participants
in related markets to take on positions in the market in question.''
Id. at 129.
\316\ Instead of considering the five factors, the Commission
appears to have simply codified the minimum liquidations times that
certain DCOs currently use for swaps. For example, the Commission
justifies setting a minimum liquidation time of five days for swaps
referencing non-physical commodities as follows: ``The longer
liquidation time, currently five days for credit default swaps at
ICE Clear Credit LLC and CME, and for interest rate swaps at LCH and
CME, is based on their assessment of the higher risk associated with
these products.'' Id. at 127-128. Given that this justification
appears to focus on credit default swaps and interest rate swaps, it
is unclear how the Commission concluded that a five-day minimum
liquidation time is appropriate for swaps that reference financial
commodities but are neither credit default swaps nor interest rate
swaps.
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Negative Implications for Competition
More importantly, when these requirements are juxtaposed against
our proposal interpreting DCM core principle 9, the potential of these
requirements to disrupt already established futures markets becomes
apparent. In the proposal, which is entitled Core Principles and Other
Requirements for Designated Contract Markets, the Commission proposed,
in a departure from previous interpretations of DCM core principle 9,
to prohibit a DCM from listing any contract for trading unless an
average of 85 percent or greater of the total volume of such contract
is traded on the centralized market, as calculated over a twelve (12)
month period.\317\ If the Commission finalizes such proposal, then DCMs
may need to delist hundreds of futures contracts.\318\ Financial
contracts may be affected, along with contracts in agricultural
commodities, energy commodities, and metals.
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\317\ 75 FR at 80616.
\318\ According to information that I have received from one
DCM, the proposal would force conversion of 628 futures and options
contracts to swap contracts. Moreover, according to the Off-Market
Volume Study (May-2010 through July-2010) prepared by Commission
staff, the proposal would force conversion of approximately 493
futures and options contracts. See Off-Market Volume Study,
available at: http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_12_DCMRules/index.htm.
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According to the proposal, DCMs may convert delisted futures
contracts to swap contracts.\319\ However, if the futures contracts
reference financial commodities, then this final rulemaking would
require that a DCO margin such swap contracts using a minimum
liquidation time of five days instead of one day for futures. If
nothing substantive about the contracts change other than their
characterization (i.e., futures to swaps), then how can the Commission
justify such a substantial increase in minimum liquidation time and
margin? An increase of this magnitude may well result in a chilling of
activity in the affected contracts. Such chilling would be an example
of the type of market disruption that the CEA was intended to avoid.
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\319\ See 75 FR at 80589-90.
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I believe this has severe implications for competition. As
commenters to the DCM proposal noted, market participants generally
execute new futures contracts outside the DCM centralized market until
the contracts attract sufficient liquidity. Attracting such liquidity
may take years.\320\ Let us assume that an established DCM already
lists a commercially viable futures contract on a financial commodity
that meets the 85 percent threshold. Even without the DCM proposal and
this final rulemaking, a DCM seeking to compete by listing a futures
contract with the same terms and conditions already faces an uphill
battle. Now with the DCM proposal, the competitor DCM would have to
also face the constant threat of being required to convert the futures
contract into a swap contract.
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\320\ See letter, dated February 22, 2011, from NYSE Liffe U.S.,
available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27910&SearchText=. See also letter, dated
February 22, 2011, from ELX Futures, L.P., available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27873&SearchText=. See further letter, dated
February 22, 2011, from Eris Exchange, LLC, available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=27853&SearchText=.
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With this final rulemaking, the competitor DCM (or a competitor
swap execution facility (SEF)) faces the additional threat that, by
virtue of such conversion, the contract would be margined using a five-
day minimum liquidation time. In contrast, the incumbent futures
contract--which may have the same terms and conditions as the new
``swap'' contract--would still be margined using a one-day minimum
liquidation time. It is difficult to imagine a DCM (or a competitor
SEF) willing to compete given the twin Swords of Damocles that it would
need to confront. By dissuading such competition, this final rulemaking
and the DCM proposal undermine the ``responsible innovation and fair
competition among boards of trade'' that the CEA was intended to
promote.\321\
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\321\ See section 3(b) of the CEA, 7 U.S.C. 5(b).
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Some may argue that this final rulemaking would not have the
negative effects that I articulated because it explicitly permits the
Commission to establish, either sua sponte or upon DCO petition, longer
or shorter liquidation times for particular products or
portfolios.\322\ I would argue that requiring market participants,
during the pendency of such a petition, to pay margin calculated using
a five-day minimum liquidation time would likely cause a substantial
number of market participants to withdraw from the market, thereby
chilling activity--perhaps irrevocably--in the contract. I would
further argue that the additional cost that (i) a DCM would incur to
persuade a DCO to file a petition with the Commission and (ii) a DCM or
DCO would incur to prepare such a petition, when coupled with the
possibility that the Commission may deny such petition, would likely
deter a DCM from seeking to compete with an incumbent futures contract.
After all, the Commission may take a long time to consider any DCO
petition. For example, the Commission took approximately two years to
approve a petition to reduce the minimum liquidation time for certain
contracts on the Dubai Mercantile Exchange from two days to one
day.\323\ Thus, this power to petition the Commission for relief may be
of little value to offset the likely stifling of competition.
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\322\ See the DCO Final Rule, supra note 289, at 394 (to be
codified at 17 CFR 39.13(g)(2)(ii)(D)).
\323\ The petition is available at: http://www.cftc.gov/PressRoom/PressReleases/pr5724-09. The petition was filed on July
28, 2009. The Commission issued an order granting the petition on
September 16, 2011. The order does not appear on the Commission Web
site.
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Return to Principles-Based Regulation
What should the Commission have done to avoid market disruption and
a curtailment in competition? Again, the Commission should have
retained a principles-based regime, and should have permitted each DCO
to determine the appropriate minimum liquidation time for its products,
using the five factors articulated above. Determining
[[Page 69478]]
appropriate margin requirements involves quantitative and qualitative
expertise. Such expertise resides in the DCOs and not in the
Commission. In its cost-benefit analysis, the final rulemaking admits
as much.\324\ Returning to a principles-based regime would have also
better aligned with current international standards on CCP
regulation,\325\ as well as the revisions to such standards.\326\
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\324\ See the DCO Final Rule, supra note 289, at 315-316
(stating that ``[i]n addition to the liquidation time frame, the
margin requirements for a particular instrument depend upon a
variety of characteristics of the instrument and the markets in
which it is traded, including the risk characteristics of the
instrument, its historical price volatility, and liquidity in the
relevant market. Determining such margin requirements does not
solely depend upon such quantitative factors, but also requires
expert judgment as to the extent to which such characteristics and
data may be an accurate predictor of future market behavior with
respect to such instruments, and applying such judgment to the
quantitative results * * * Determining the risk characteristics,
price volatility, and market liquidity of even a sample for purposes
of determining a liquidation time specifically for such instrument
would be a formidable task for the Commission to undertake and any
results would be subject to a range of uncertainty.'').
\325\ See supra note 310. With respect to minimum liquidation
times, Section 4.4.3 of the CPSS-IOSCO Recommendations simply state:
``Margin requirements impose opportunity costs on CCP participants.
So, a CCP needs to strike a balance between greater protection for
itself and higher opportunity costs for its participants. For this
reason, margin requirements are not designed to cover price risk in
all market conditions. Nonetheless, a CCP should estimate the
interval between the last margin collection before default and the
liquidation of positions in a particular product, and hold
sufficient margin to cover potential losses over that interval in
normal market conditions.''
\326\ See also supra note 311. Like the CPSS-IOSCO
Recommendations, the CPSS-IOSCO Consultation also advocates a
principles-based model for estimating minimum liquidation times.
Section 3.6.7 of the CPSS-IOSCO Consultation states: ``A CCP should
select an appropriate close-out period for each product cleared by
the CCP, and document the close-out periods and related analysis for
each product type. A CCP should base its close-out period upon
historical price and liquidity data when developing its initial
margin methodology. Historical data should include the worst events
that occurred in the selected time period for the product cleared as
well as simulated data projections that would capture potential
events outside of the historical data. In certain instances, a CCP
may need to determine margin levels using a shorter historical
period to reflect better new or current volatility in the market.
Conversely, a CCP may need to determine margin levels based on a
longer period in order to reflect past volatility. The close-out
period should be set based on anticipated close-out times in
stressed market conditions. Close-out periods should be set on a
product-specific basis, as less-liquid products might require
significantly longer close-out periods. A CCP should also consider
and address position concentrations, which can lengthen close-out
timeframes and add to price volatility during close outs.''
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The ``Race to the Bottom'' Argument Simply Cannot Withstand Scrutiny
Some may argue that, by not imposing minimum liquidation times, the
Commission may enable a ``race to the bottom,'' where DCOs would
compete by offering the lowest margin. As a conceptual matter, given
that the Commission has not demonstrated that the minimum liquidation
times that it has decided to mandate are ``prudent,'' it cannot
demonstrate that the one-day or five-day period would prevent a ``race
to the bottom.'' \327\ As an empirical matter, the Commission must have
decided that DCOs currently competing to clear interest rate swaps and
credit default swaps have not entered into a ``race to the bottom,''
because the final rulemaking codifies the existing five-day minimum
liquidation time that such competing DCOs voluntarily adopted.\328\
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\327\ The Commission acknowledged as much in its cost-benefit
analysis. The analysis states: ``The Commission anticipates that
using only one criterion--i.e., the characteristic of the commodity
underlying a swap--to determine liquidation time could result in
less-than-optimal margin calculations. For some products, a five-day
minimum may prove to be excessive and tie up more funds than are
strictly necessary for risk management purposes. For other products,
a one-day or even a five-day period may be insufficient and expose a
DCO and market participants to additional risk.'' The DCO Final
Rule, supra note 289, at 315.
\328\ Id. at 127 to 128 (stating `` * * * the final rule
provides that the minimum liquidation time for swaps based on
certain physical commodities, i.e., agricultural commodities,
energy, and metals, is one day. For all other swaps, the minimum
liquidation time is five days. This distinction is based on the
differing risk characteristics of these product groups and is
consistent with existing requirements that reflect the risk
assessments DCOs have made over the course of their experience
clearing these types of swaps. The longer liquidation time,
currently five days for credit default swaps at ICE Clear Credit,
LLC, and CME, and for interest rate swaps at LCH and CME, is based
on their assessment of the higher risk associated with these
products.'').
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Finally, the Commission has more effective tools to prevent any
``race to the bottom.'' First, this final rulemaking requires a DCO to
determine the adequacy of its initial margin requirements on a daily
basis.\329\ Second, this final rulemaking requires a DCO to conduct
back testing of its initial margin requirements on a daily or monthly
basis.\330\ Third, this final rulemaking requires a DCO to stress test
its default resources at least once a month, and to report to the
Commission the results of such stress testing at least once every
fiscal quarter.\331\ Fourth, the Commission has the ability to
independently back test and stress test DCO initial margin
requirements.\332\ Consequently, the Commission would be able to detect
any ``race to the bottom'' that would cause any DCO to have
insufficient initial margin to cover its risks.
---------------------------------------------------------------------------
\329\ Id. at 396 (to be codified at 17 CFR 39.13(g)(6)).
\330\ Id. at 396-397 (to be codified at 17 CFR 39.13(g)(7)).
\331\ Id. at 383-387 (to be codified at 17 CFR 39.11(c)(1) and
(f)).
\332\ See United States Commodity Futures Trading Commission,
International Monetary Fund--Financial Sector Assessment Program:
Self-Assessment of IOSCO Objectives and Principles of Securities
Regulation, August 2009, available at: http://www.treasury.gov/resource-center/international/standards-codes/Documents/Securities%20CFTC%20Self%20Assessment%208-28-09.pdf (the ``FSAP
Assessment'') (describing the capabilities of the Risk Surveillance
Group within the Division of Clearing and Risk (formerly known as
the Division of Clearing and Intermediary Oversight): ``After
identifying traders or FCMs at risk, the RSG estimates the magnitude
of the risk. The SRM system enables RSG staff to calculate the
current performance bond requirement for any trader or FCM. This
amount is generally designed to cover approximately 99% of potential
one-day moves * * * SRM also enables RSG staff to conduct stress
tests. RSG staff can determine how much a position would lose in a
variety of circumstances such as extreme market moves. This is a
particularly important tool with respect to option positions. As
noted, the non-linear nature of options means that the loss
resulting from a given price change may be many multiples greater
for an option position than for a futures position in the same
market. Moreover, the complexity of option positions can result in
situations where the greatest loss does not correspond to the most
extreme price move.'').
The FSAP Assessment also describes the ability of the RSG to
check DCO stress testing of its default resources: ``The RSG
compares the risk posed by the largest clearing member to a DCO's
financial resource package. The RSG analyzes not only the size of
the DCO package but also its composition. In the event of a default,
a DCO must have access to sufficient liquidity to meet its
obligations as a central counterparty on very short notice.''
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Cost-Benefit Analysis: We Can Do Better
I have always emphasized that the Commission must engage in more
rigorous cost-benefit analyses of its rulemakings. At various points in
my speeches and writings, I have urged the Commission to (i) focus on
the economic effects of its rulemakings, both cumulative and
incremental, (ii) quantify the costs and benefits of its rulemakings,
both cumulative and incremental, and (iii) better justify the choice of
a prescriptive requirement when a less-costly and equally effective
principles-based alternative is available. Only by engaging in more
rigorous cost-benefit analyses would the Commission fulfill the
mandates of two Executive Orders \333\ and render our rulemakings less
vulnerable to legal challenge.\334\
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\333\ See Exec. Order No. 13,563, 76 Fed. Reg. 3821 (Jan. 21,
2011); Exec. Order No. 13,579, 76 Fed. Reg. 41,587 (July 14, 2011).
\334\ See, e.g., Business Roundtable and the United States
Chamber of Commerce vs. SEC, No. 10-1305, 2011 U.S. App. LEXIS 14988
(July 22, 2011).
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I have read the cost-benefit analysis in this final rulemaking with
great interest. I can confirm that such analysis is longer than
previous analyses. Unfortunately, increased length does not ensure an
improvement in analysis and content.
[[Page 69479]]
Although I have numerous concerns with the cost-benefit analysis,
my primary concern relates to its failure to attempt meaningful
quantification. In multiple places in the cost-benefit analysis, the
Commission concludes that the costs of a particular requirement are
difficult or impossible to estimate. In certain instances, the
statement may be accurate. If the Commission truly cannot quantify the
costs in those instances, then that fact alone should cause the
Commission to proceed with caution if it is going to abandon the
existing principles-based regime. In other instances, however, I find
the statement to be puzzling, given the capabilities and expertise of
the Risk Surveillance Group (``RSG'') and the DCO Review Group
(``DRG'') in our Division of Clearing and Risk (formerly known as the
Division of Clearing and Intermediary Oversight).
I would like to highlight two such instances where the Commission
has not utilized its own data to quantify the costs associated with its
policy decisions. First, with respect to the minimum liquidation time
requirements, the Commission states that ``it is not feasible to
estimate or quantify these costs reliably.'' The Commission justifies
such conclusion by stating that (i) ``reliable data is not available
for many swaps that prior to the Dodd-Frank Act were executed in
unregulated markets,'' and (ii) it would be too difficult for the
Commission to estimate margin using either a one-day or five-day
minimum liquidation time for any particular product.\335\ Whereas these
statements may be accurate for certain swaps, they are not accurate for
futures contracts currently listed on a DCM that will be converted to
swap contracts under the pending DCM proposal. However potentially
incomplete, the Off-Market Volume Study (May 2010 through July 2010)
accompanying the DCM proposal entitled Core Principles and Other
Requirements for Designated Contract Markets \336\ demonstrates that
the Commission has the ability to identify at least a sample of the
futures contracts that may be potentially converted to swap contracts.
It is true that the DCO usually impounds the minimum liquidation time
in the risk arrays that it uses to calculate margin, and the RSG cannot
change such risk arrays easily. However, the RSG can ask the DCO to
provide the assumptions underlying the risk arrays, including the
minimum liquidation time (usually one day). Then the RSG can modify
such assumptions to estimate margin calculations using a five-day
minimum liquidation time.\337\ Would these calculations be imperfect?
Yes. However, any attempt, even an imperfect one, undertaken by the
Commission to understand the cost of our rulemakings or to justify our
policy decisions is better than no attempt at all.
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\335\ See the DCO Final Rule, supra note 289, at 315-316.
\336\ See supra note 318. The Off-Market Volume Survey does not
include contracts listed on new DCMs, such as NYSE Liffe U.S., ELX
Futures, L.P., or Eris Exchange, LLC. However, the existence of such
survey is proof that the Commission has the ability to identify
contracts that DCM core principle 9 may affect.
\337\ See supra note 332. See pages 252 to 268 of the FSAP
Assessment for a full description of the capabilities of the RSG.
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Another instance that I would like to highlight pertains to letters
of credit. This final rulemaking prohibits DCOs from accepting letters
of credit as (i) initial margin for swaps contracts (but not futures
contracts) or (ii) as guarantee fund contributions. In the cost-benefit
analysis, the Commission states that, ``it is not possible to estimate
or quantify [the] cost'' of the prohibition.\338\ In response to
questions from me and certain of my colleagues, however, the DRG
prepared a memorandum on the use of letters of credit as initial
margin. Although this memorandum is non-public, it is part of the
administrative record for this final rulemaking. This memorandum
details, among other things: (i) the number and identity of certain
DCOs accepting and/or holding letters of credit as initial margin; (ii)
the percentage of total initial margin on deposit across all DCOs that
letters of credit constitute; and (iii) the potential disproportionate
impact on energy and agricultural end-users of disallowing letters of
credit. Whereas the memorandum may focus on the use of letters of
credit as initial margin for futures contracts, the Commission proposal
for DCM core principle 9 may force conversion of numerous energy and
agricultural futures contracts into swaps contracts. Yet, the cost-
benefit analysis contains none of the information in the memorandum,
even in aggregate and anonymous form. In the interests of transparency,
the Commission should have found a way to share this information with
the public.
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\338\ The DCO Final Rule, supra note 289, at 344.
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The Commission (or its predecessor) has regulated the futures
markets since the 1930s. The Commission has overseen DCOs clearing
swaps since at least 2001. We can do better than this. If the
Commission needs to re-propose a rulemaking to provide quantitative
estimates of its costs and benefits, so be it. Given the foundational
nature of this rulemaking, as well as other rulemakings that are
forthcoming, it is more important for the Commission to achieve the
most reasonable balance between costs and benefits, rather than to
finish the rulemaking fast.
International Coordination: We Must Do Better.
In closing, I would mention my strong desire for the Commission to
ensure that its policies do not create disadvantages for United States
businesses and that our rules comport with international standards. It
is becoming increasingly clear that the schedule for financial reform
is converging among the G-20 nations. It is less clear that the
substantive policies underlying financial reform are experiencing the
same convergence. We must be more cognizant of the effects of such lack
of convergence on dually-registered entities, and the incentives
created by such divergence for regulatory arbitrage.
This final rulemaking illustrates the inconsistent approach that
the Commission has taken towards international coordination to date.
First, although the final rulemaking notes that the CPSS-IOSCO
Recommendations embody the current international standards on CCP
regulation, the final rulemaking does not attempt to comport with the
CPSS-IOSCO Recommendations.\339\ Instead, the final rulemaking attempts
to comport with the CPSS-IOSCO Consultation, which has not been
finalized.\340\ In general, both the CPSS-IOSCO Recommendations and the
CPSS-IOSCO Consultation are less prescriptive than the final
rulemaking.
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\339\ See supra note 310.
\340\ See supra note 311.
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Second, while the final rulemaking does note the rare instance
where its prescriptive requirements comport with the CPSS-IOSCO
Consultation,\341\ it does not reveal where its prescriptive
requirements depart from the CPSS-IOSCO Consultation. For example, as I
stated above, the CPSS-IOSCO Consultation actually sets forth
principles-based considerations for participant eligibility and margin
calculation.
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\341\ See, e.g., id. at 132 (stating that requiring DCOs to
calibrate margin to cover price movements at a 99 percent confidence
interval accords with Principle 6 of the CPSS-IOSCO Consultation).
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Finally, the final rulemaking states that the Commission will
review a number of its provisions after CPSS and IOSCO finish their
work, which is likely to occur in 2012. Whereas I support such a
review, the statement begs the following questions: What legal
certainty are these regulations offering
[[Page 69480]]
DCOs, clearing members, and market participants if the Commission
changes such regulations in 2012? Also, what are the implications of
requiring DCOs to incur costs to comport with prescriptive requirements
now when the Commission might change such requirements next year? If
changes are foreseeable, shouldn't the Commission adopt a phasing or
delayed implementation plan to allow the international coordination
process to reach completion before our rules and their costs become
effective? If, in the alternative, the Commission will not be
influenced by international standards, what are the costs of such non-
convergence?
As we are finalizing foundational rulemakings, we can no longer
rely on an inconsistent approach. We need to produce a more coherent
plan for international coordination.
Conclusion
Due to the above concerns, I respectfully dissent from the decision
of the Commission to approve this final rulemaking for publication in
the Federal Register.
[FR Doc. 2011-27536 Filed 11-7-11; 8:45 am]
BILLING CODE 6351-01-P
Last Updated: November 8, 2011
See Also:
