FR Doc 2010-26220[Federal Register: October 18, 2010 (Volume 75, Number 200)]

[Proposed Rules]

[Page 63732-63753]

From the Federal Register Online via GPO Access [wais.access.gpo.gov]

[DOCID:fr18oc10-22]

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 1, 37, 38, 39, and 40

RIN 3038-AD01

Requirements for Derivatives Clearing Organizations, Designated

Contract Markets, and Swap Execution Facilities Regarding the

Mitigation of Conflicts of Interest

AGENCY: Commodity Futures Trading Commission.

ACTION: Notice of proposed rulemaking.

———————————————————————–

SUMMARY: The Commodity Futures Trading Commission (the “Commission”)

hereby proposes rules to implement new statutory provisions enacted by

Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection

Act (the “Dodd-Frank Act”). Specifically, the proposed rules

contained herein impose new requirements on derivatives clearing

organizations (“DCOs”), designated contract markets (“DCMs”), and

swap execution facilities (“SEFs”) with respect to mitigation of

conflicts of interest.

DATES: Submit comments on or before November 17, 2010.

ADDRESSES: You may submit comments, identified by RIN number, by any of

the following methods:

Federal eRulemaking Portal: http://www.regulations.gov.

Follow the instructions for submitting comments.

Agency Web Site: http://www.cftc.gov. Follow the

instructions for submitting comments on the Web site.

E-mail: [email protected].

Fax: 202-418-5521.

Mail: David A. Stawick, Secretary of the Commission,

Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st

Street, NW., Washington, DC 20581.

Hand Delivery/Courier: Same as mail above.

FOR FURTHER INFORMATION CONTACT: Nancy Liao Schnabel, Special Counsel,

Division of Clearing and Intermediary Oversight (DCIO), at 202-418-5344

or [email protected]; Lois Gregory, Assistant Deputy Director for

Market Review, the Division of Market Oversight (DMO), at 202-418-5569

or [email protected]; Andrea Musalem, Special Counsel, DCIO, at 202-

418-5167 or [email protected]; Jordan O’Regan, Attorney-Advisor, DCIO,

at 202-418-5984 or [email protected]; Cody Alvarez, Attorney-Advisor,

DMO, at 202-418-5404 or [email protected]; Dana Brown, Law Clerk, DMO,

at 202-418-5093 or [email protected]; Jolanta Sterbenz, Counsel, Office

of the General Counsel, at 202-418-6639 or [email protected]; David

Reiffen, Senior Economist, Office of the Chief Economist, at 202-418-

5602 or [email protected]; or Alicia Lewis, Attorney-Advisor, DCIO, at

202-418-5862 or [email protected]; in each case, also at the Commodity

Futures Trading Commission, Three Lafayette Centre, 1155 21st Street,

NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

I. Background

On July 21, 2010, President Obama signed the Dodd-Frank Act.1

Title VII of the Dodd-Frank Act 2 amended the Commodity Exchange Act

(“CEA”) 3 to establish a comprehensive new regulatory framework for

swaps and certain security-based swaps. The legislation was enacted to

reduce risk, increase transparency, and promote market integrity within

the financial system by, among other things: (i) Providing for the

registration and comprehensive regulation of swap dealers and major

swap participants; 4 (ii) imposing mandatory clearing and trade

execution requirements on clearable swap contracts; (iii) creating

robust recordkeeping and real-time reporting regimes; and (iv)

enhancing the rulemaking and enforcement authorities of the Commission

with respect to, among others, all registered entities and

intermediaries subject to the oversight of the Commission.

—————————————————————————

1 See Dodd-Frank Act, Pub. L. 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.

4 In this release, the terms “swap dealer” and “major swap

participant” shall have the meanings set forth in Section 721(a) of

the Dodd-Frank Act, which added Sections 1a(49) and (33) of the CEA.

However, Section 721(c) of the Dodd-Frank Act directs the Commission

to promulgate rules to further define, among other terms, “swap

dealer” and “major swap participant.” The Commission is in the

process of this rulemaking. See, e.g., http://www.cftc.gov/

LawRegulation/OTCDerivatives/OTC_2_Definitions.html. The

Commission anticipates that such rulemaking will be completed by the

statutory deadline of July 15, 2011.

—————————————————————————

In order to ensure the proper implementation of the comprehensive

new regulatory framework, especially with respect to (ii) above, the

Dodd-Frank Act requires 5 the Commission to promulgate rules to

mitigate conflicts of interest in the operation of certain DCOs, DCMs,

and SEFs. First, Section 726(a) of the Dodd-Frank Act specifically

empowers the Commission to adopt “numerical limits * * * on control”

or “voting rights” that enumerated entities 6 may hold with respect

to such DCOs, DCMs, and SEFs. Second, Section 726(b) of the Dodd-Frank

Act directs the Commission to determine the manner in which its rules

may be deemed necessary or

[[Page 63733]]

appropriate to improve the governance of certain DCOs, DCMs, or SEFs or

to mitigate systemic risk, promote competition, or mitigate conflicts

of interest in connection with the interaction between swap dealers and

major swap participants, on the one hand, and such DCOs, DCMs, and

SEFs. Finally, Section 726(c) of the Dodd-Frank Act directs the

Commission to consider the manner in which its rules address conflicts

of interest in the abovementioned interaction arising from equity

ownership, voting structure, or other governance arrangements of the

relevant DCOs, DCMs, and SEFs. The Commission must complete a

rulemaking under Section 726 of the Dodd-Frank Act within 180 days

after enactment–i.e., by January 14, 2011.7

—————————————————————————

5 See the following colloquy between Representative Stephen

Lynch and Representative Barney Frank on the language that became

Section 726 of the Dodd-Frank Act:

Madam Speaker, for the purpose of a colloquy, I would like to

engage with the chairman of the committee and the drafter of this

legislation. I congratulate him on the great work he has done on

this reform bill.

Mr. Chairman, I want to call your attention to sections 726 and

765 of the bill. These two provisions require the CFTC and the SEC

to conduct rulemakings to eliminate the conflicts of interest

arising from the control of clearing and trading facilities by

entities such as swap dealers and major swap participants.

This problem arises because, right now, 95 percent of all of the

clearinghouses in this country are owned by just five banks. So,

while we are relying on the clearinghouses to reduce systemic risk,

we have the banks now owning the clearinghouses.

The question I have is regarding the intent of the conferees in

retaining subsection B of these provisions. It could be loosely

construed to leave it up to the agencies whether or not to adopt

rules.

Mr. Chairman, do you agree that my reading of sections 726 and

765 affirmatively require these agencies to adopt strong conflict of

interest rules on control and governance of clearing and trading

facilities?

Mr. FRANK of Massachusetts. If the gentleman would yield to me,

he has been a leader in this important area, and he is a careful

lawyer and understands that just saving a principle isn’t enough.

You’ve got to make sure it is carried out. Dealing with a conflict

of interest that he has been a leader in identifying is essential if

this is going to work. So I completely agree with him. Yes, we mean

both of those subsections, and it is a mandatory rulemaking.

I will say to my neighbor from Massachusetts that we will be

monitoring this carefully. They can expect oversight hearings

because, yes, this is definitely a mandate to them to adopt rules to

deal with what would be a blatant conflict of interest in the

efficacy rules, and we intend to follow that closely.

156 Cong. Rec. H5217 (2010).

6 The “enumerated entities” include: (i) Bank holding

companies with over $50,000,000,000 in total consolidated assets;

(ii) a nonbank financial company supervised by the Board of

Governors of the Federal Reserve System; (iii) an affiliate of (i)

or (ii); (iv) a swap dealer; (v) a major swap participant; or (vi)

an associated person of (iv) or (v).

7 In adopting rules to implement Section 726 of the Dodd-Frank

Act, the Commission is also implementing Section 725(d) of the Dodd-

Frank Act. The latter states: “[t]he Commodity Futures Trading

Commission shall adopt rules mitigating conflicts of interest in

connection with the conduct of business by a swap dealer or a major

swap participant with a derivatives clearing organization, board of

trade, or a swap execution facility that clears or trades swaps in

which the swap dealer or major swap participant has a material debt

or material equity investment.”

—————————————————————————

In carrying out Section 726 of the Dodd-Frank Act,8 the

Commission identifies in Section II below the following potential

conflicts of interest:

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8 Although the Commission is proposing the rules contained

herein to specifically carry out Section 726 of the Dodd-Frank Act

(as well as Section 725(d) of the Dodd-Frank Act), the Commission

notes that it has additional authority to propose such rules under

Sections 735(b), 735(c), and 733 of the Dodd-Frank Act. See infra

note 17 for a more extensive description of Sections 735(b), 735(c),

and 733 of the Dodd-Frank Act.

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Conflicts of interest that a DCO may confront when

determining (i) whether a swap contract is capable of being cleared,

(ii) the minimum criteria that an entity must meet in order to become a

swap clearing member, and (iii) whether a particular entity satisfies

such criteria; 9 and

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9 The Commission requests comment as to whether DCOs, like

DCMs and SEFs, have (or potentially may have) other conflicts of

interest that implicate the balance between advancement of

commercial interests and fulfillment of self-regulatory

responsibilities.

—————————————————————————

Conflicts of interest that a DCM or SEF may confront in

balancing advancement of commercial interests and fulfillment of self-

regulatory responsibilities.

The Commission proposes in Section III below (i) structural governance

requirements and (ii) limits on the ownership of voting equity and the

exercise of voting power, and describes, in each case, the manner in

which such proposals may mitigate conflicts of interest in the

operation of a DCO, DCM, or SEF.10

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10 Commission regulations (the “Regulations”) referred to

herein are found at 17 CFR Ch. 1.

—————————————————————————

In general, the proposed rules include strengthened versions of the

acceptable practices that the Commission previously adopted for the DCM

core principle on conflicts of interest.11 The proposed rules impose

structural governance requirements and limits on the ownership of

voting equity and the exercise of voting power. They impose specific

composition requirements on DCO, DCM, or SEF Boards of Directors and

require each DCO, DCM, or SEF to have a nominating committee and one or

more disciplinary panels. Each DCO must have a risk management

committee and each DCM or SEF must have a regulatory oversight

committee and a membership or participation committee, subject to

specific composition requirements.

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11 See, generally, “Conflicts of Interest in Self-Regulation

and Self-Regulatory Organizations,” 74 FR 18982 (April 27, 2009)

(which defined “public director”); 72 FR 6936 (Feb. 14, 2007)

(which adopted final acceptable practices for the DCM core

principle) (the “DCM Conflicts of Interest Release”); 71 FR 38740

(July 7, 2006) (which proposed acceptable practices for the DCM core

principle).

Currently, DCM core principle 15 addresses conflicts of

interest. See 7 U.S.C. 7(d)(15). The Dodd-Frank Act has redesignated

DCM core principle 15 as DCM core principle 16, but has left the

actual language of the principle substantively unchanged.

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The proposed rules limit DCM or SEF members (and related persons)

from beneficially owning more than twenty (20) percent of any class of

voting equity in the registered entity or from directly or indirectly

voting an interest exceeding twenty (20) percent of the voting power of

any class of equity interest in the registered entity. With respect to

a DCO only, the proposed rules require a DCO to choose one of two

alternative limits on the ownership of voting equity or the exercise of

voting power. Under the first alternative, no individual member may

beneficially own more than twenty (20) percent of any class of voting

equity in the DCO or directly or indirectly vote an interest exceeding

twenty (20) percent of the voting power of any class of equity interest

in the DCO. In addition, the enumerated entities, whether or not they

are DCO members, may not collectively own on a beneficial basis more

than forty (40) percent of any class of voting equity in a DCO, or

directly or indirectly vote an interest exceeding forty (40) percent of

the voting power of any class of equity interest in the DCO.

Under the second alternative, no DCO member or enumerated entity,

regardless of whether it is a DCO member, may own more than five (5)

percent of any class of voting equity in the DCO or directly or

indirectly vote an interest exceeding five (5) percent of the voting

power of any class of equity interest in the DCO.

Notwithstanding the foregoing, the proposed rules recognize that

circumstances may exist where neither alternative would be appropriate

for a DCO. Consequently, the proposed rules provide a procedure for the

DCO to apply for, and the Commission to grant, a waiver of the limits

specified in the first and second alternative.

The proposed rules reflect consultation with staff of the following

agencies: (i) The Securities and Exchange Commission (the “SEC”);

12 (ii) the Board of Governors of the Federal Reserve, (iii) the

Office of the Comptroller of the Currency; (iv) the Federal Deposit

Insurance Corporation; and (v) the Treasury Department. Staff from each

of these agencies has provided verbal and/or written comments, and the

proposed rules incorporate elements of the comments provided. The

proposed rules have been further informed by (i) the joint roundtable

that Commission and SEC staff conducted on August 20, 2010 (the

“Roundtable”) 13 and (ii) public comments posted to the Web site of

the Commission.14 Finally, mindful of the importance of international

harmonization,15 the proposed rules incorporate certain elements of:

(i) The Proposal for a Regulation of the European Parliament and of the

Council on OTC Derivatives, Central Counterparties, and Trade

Depositories (the “European Commission Proposal”); 16 and (ii) the

latest draft of the Principles for Financial Market Infrastructures,

which would ultimately be reviewed by the Committee on Payment and

Settlement Systems of the Bank for International Settlements and the

Technical Committee of the

[[Page 63734]]

International Organization of Securities Commissions.

—————————————————————————

12 Section 765 of the Dodd-Frank Act requires the SEC to

promulgate rules to mitigate conflicts of interest in the operation

of (i) a clearing agency that clears security-based swaps, (ii) a

security-based swap execution facility, or (iii) a national

securities exchange that posts or makes available for trading

security-based swaps.

13 The transcript from the roundtable (the “Roundtable Tr.”)

is available at: http://www.cftc.gov/idc/groups/public/@newsroom/

documents/file/derivative9sub082010.pdf.

14 Such comments are available at: http://www.cftc.gov/

LawRegulation/DoddFrankAct/OTC_9_DCOGovernance.html.

15 Currently, the Commission regulates certain entities based

outside of the United States (e.g., LCH.Clearnet Limited and ICE

Clear Europe Limited (“ICE Clear Europe”), each of which is based

in the United Kingdom).

16 COM(2010) 484/5.

—————————————————————————

The Commission anticipates conducting at least one other rulemaking

that may impose requirements on DCOs, DCMs, and SEFs with respect to

governance and mitigation of conflicts of interest.17 The Commission

expects to finish such rulemaking by the statutory deadline of July 15,

2011.

—————————————————————————

17 Such rulemaking would implement Sections 735(b) and 725(c)

of the Dodd-Frank Act, which amends Sections 5(d) and 5b(c) of the

CEA to add new core principles, or to supplement existing core

principles, regarding the governance of DCMs and DCOs, and the

mitigation of conflicts of interest in the operation of such

entities. Such core principles would apply to all DCMs and DCOs,

regardless of whether they clear or list swap contracts or only

commodity futures or options. Such rulemaking would also implement

Section 733 of the Dodd-Frank Act, which inserts new Section 5h of

the CEA to create a registration category for SEFs, and to impose

core principles that include the mitigation of conflicts of

interest. The Commission is considering the proposals set forth

below, among others, with respect to the second rulemaking: (1)

Requiring each DCO, DCM, or SEF to have a regulatory program to (i)

identify, on an ongoing basis, existing and potential conflicts of

interest, and (ii) to make decisions in the event of such conflict;

(2) mandating that each DCO, DCM, or SEF (i) prescribe limits on use

of non-public information, and (ii) afford transparency with respect

to governance arrangements; (3) requiring each DCO, DCM, or SEF to

report to the Commission whenever (i) the Board of Directors rejects

a recommendation or supersedes an action of the DCM or SEF

Regulatory Oversight Committee, DCM or SEF Membership or

Participation Committee, or DCO Risk Management Committee, as

applicable, or (ii) the DCO Risk Management Committee rejects or

supersedes an action of the DCO Risk Management Subcommittee, if

applicable; (4) mandating minimum governance fitness standards for

DCO and DCM members and participants; and (5) prescribing minimum

standards regarding (i) DCM consideration of market participant

views and (ii) the diversity of DCM Board of Directors, if the DCM

is publicly-listed.

—————————————————————————

The Commission requests comment on all aspects of this release.

II. Conflicts of Interest

As mentioned above, Title VII of the Dodd-Frank Act amended the CEA

to establish a comprehensive new framework for swaps and security-based

swaps. This framework imposes mandatory clearing and trade execution

requirements with respect to clearable swap contracts. Some market

participants, investor advocates, and academics have expressed a

concern that the enumerated entities have economic incentives to

minimize the number of swap contracts subject to mandatory clearing and

trading. They contend that control of a DCO by the enumerated entities,

whether through ownership or otherwise, constitutes the primary means

for keeping swap contracts out of the mandatory clearing requirement,

and therefore also out of the trading requirement. The Commission

addresses these arguments below. The Commission also examines the

contention that sustained competition between DCMs or SEFs with respect

to the same swap contracts may exacerbate certain structural conflicts

of interest, as the DCM Conflicts of Interest Release defines such

term.18

—————————————————————————

18 According to the DCM Conflicts of Interest Release, “[t]he

presence of potentially conflicting demands within a single entity–

regulatory authority coupled with commercial incentives to misuse

such authority–constitutes the new structural conflict of interest

addressed by the acceptable practices adopted herein.” 72 FR at

6937.

—————————————————————————

a. DCOs

In general, in the commodity futures and options markets, the DCM

decides which contracts to list, whereas the DCO manages the risk of

guaranteeing such contracts. Clearing members exercise significant

control over the manner in which a DCO manages risk, whether the

members own the DCO or not.19 Based on Commission experience, such

control has generally permitted the DCO to serve the purposes of the

CEA, especially with respect to “ensur[ing] the financial integrity of

all transactions subject to [the CEA] and the avoidance of systemic

risk.” 20 Clearing members contribute substantial financial

resources to the DCO default or guarantee fund. If a clearing member

defaults, and the DCO holds insufficient performance bond from such

member to cover its losses, then the DCO would access the default or

guarantee fund. Thus, the DCO spreads its losses across all clearing

members. This mechanism creates an incentive for each clearing member

to ensure that (i) other clearing members meet certain financial

requirements and (ii) the DCO adopt a conservative approach towards

risk management, especially in determining whether a particular

contract would be acceptable for clearing.

—————————————————————————

19 The CME Group, Inc. (the “CME Group”), a publicly-listed

corporation, wholly owns the Chicago Mercantile Exchange, Inc.

(“CME”). However, CME Clearing House, a division of CME, has a

Risk Committee that is composed of: (i) Two members of the CME Board

of Directors; (ii) five clearing member representatives; and (iii)

two additional individuals, one of whom cannot be a clearing member

representative. See CME Rule 403.A, available at: http://

www.cmegroup.com/rulebook/CME/I/4/03.html.

20 See Section 3(b) of the CEA, 7 U.S.C. 5(b).

—————————————————————————

This same mechanism also creates a disincentive for clearing

members to act collectively (i) to exclude other entities from becoming

clearing members or (ii) to bar a DCO from accepting new commodity

futures or options contracts. After all, each new clearing member must

contribute to the default or guarantee fund. Such contribution would

result in a pro rata decrease in the potential exposure of each other

clearing member to a default. Moreover, clearing members generally had

little incentive to prevent the DCO from accepting a particular

contract, absent a risk-based objection. In fact, the more different

types of contracts that a DCO accepts, the more the intermediation

services that such clearing member offers would likely be in demand.

The regulated market structure that the Dodd-Frank Act contemplates

for swap contracts is, in many ways, the mirror image of the market

structure for commodity futures and option contracts. Currently, most

swap contracts are privately negotiated between two parties, and are

generally not cleared.21 Section 723 of the Dodd-Frank Act requires:

(i) Swap contracts meeting certain criteria to be cleared with a DCO;

and (ii) such contracts to be executed on a DCM or SEF (unless no DCM

or SEF lists such contracts). Therefore, a DCO has unprecedented

influence over the manner in which a swap contract can be executed.

—————————————————————————

21 See, e.g., Darrel Duffie, Ada Li, Theo Lubke, “Policy

Perspectives on OTC Derivatives Market Infrastructure,” Federal

Reserve Bank of New York Staff Report No. 424, dated January 2010,

as revised March 2010 (the “FRBNY Staff Report”). According to

Section II of the FRBNY Staff Report, “[a]n over-the-counter trade

is privately negotiated between the buyer and seller.” According to

Section VII(A)(i) of the FRBNY Staff Report, “[o]nly some types of

OTC derivatives are now cleared. These include, for example, certain

actively traded credit derivatives, some common forms of interest-

rate swaps, and some energy derivatives. Of these `eligible’ types

of OTC derivatives, those for which clearing has been set up, not

all positions are actually cleared; the decision of which positions

to clear has to this point been left to the discretion of market

participants.”

—————————————————————————

Certain market participants and academics believe that Section 723

of the Dodd-Frank Act does not introduce any new incentives for

clearing members to act collectively (i) to exclude other entities from

becoming clearing members or (ii) to bar a DCO from accepting new

contracts. First, they argue that clearing does not make a bilateral

swap contract less profitable.22 Second, they contend that, because

clearing does not impact the profitability of a bilateral swap

contract, swap clearing members that are

[[Page 63735]]

enumerated entities have specific, risk-based justifications for (i)

setting membership criteria that exclude certain entities 23 and (ii)

determining that certain swap contracts cannot be cleared.24 Third,

they assert that such swap clearing members must have the right to

cause the DCO to act on such justifications, since ultimately, the

capital of such clearing members (i.e., their contributions to the

default or guarantee fund) may be accessed if a fellow clearing member

defaults.25

—————————————————————————

22 See, e.g., Comments from James Hill, Managing Director and

Global Credit Derivatives Officer, Morgan Stanley, representing the

Securities Industry and Financial Markets Association (“Hill”)

(“I think there’s a bit of a misconception that somehow clearing

makes trades less profitable. That’s clearly not the case. In fact,

I think most of the large systemically important participants in

this market prefer clearing. And I think that’s not just a

statement; there is significant anecdotal evidence to support that

perhaps the most important of which is LCH”), Roundtable Tr. at 21-

22.

23 See, e.g., Comments from Hill (“as a general rule, the

clearing member needs to be able to absorb losses, a default by

another clearing member, number one; and, number two, they need to

be able to absorb the economic transaction risk in the portfolio of

a defaulting member * * * And so the way these clearinghouses set up

their risk, you know, their admission or their membership criteria,

is both of those things. So, A, they have to have a capital base

sufficient to absorb losses and add in more capital to the

clearinghouse if a member defaults. And B, they have to be able to

in a situation where a clearing member has defaulted, which is

probably the time of most economic stress, you know, in the economy,

be able to take down the economic transaction risk of the swaps that

were otherwise, the defaulting member was otherwise a party to,

those trades need to be allocated among the surviving clearing

members * * * And so the way these clearinghouses developed their

criteria is they look at both of those prongs and they set

thresholds to make sure that the members who are admitted can do

those things. Because, remember, if you admit a member who can’t do

both of those things, then what happens is the clearinghouse will

have insufficient capital in a situation where a member has

defaulted, which is the time of the highest economic stress”),

Roundtable Tr. at 28 to 29.

24 See, e.g., Comments from Hill (“In evaluating what trades

should be cleared, there’s a balance that needs to be struck between

the goal of increasing clearing, obviously, but, B, you don’t want

to put trades in the clearinghouse that can’t be appropriately risk-

managed. So if you put trades in the clearinghouse that are illiquid

and can’t be valued properly, what will happen is when a clearing

member defaults, there will be insufficient collateral with respect

to that trade because it wasn’t properly valued in the

clearinghouse, and the surviving clearing members will be stressed

from an economic perspective in taking positions the value of which

cannot be readily ascertained. So it’s critical that only trades

that can be appropriately risk-managed be put into the

clearinghouse. And I think what you’ll see is that most of the

clearinghouses look to their clearing members to help them valuate

which trades are appropriate from a clearing perspective, and that

is completely consistent with the economic incentives because the

clearing members are the ones who have the overwhelming

preponderance of the capital in the clearinghouse. So it’s their

capital that’s at risk. They should certainly have a say in helping

the clearinghouse evaluate which trades are acceptable for clearing

and which trades are too risky or can’t be valued, or are too

illiquid or not standardized and, therefore, shouldn’t be

cleared”), Roundtable Tr. at 43 to 45.

25 Id. See, also, e.g., Comments from Lee Olesky, Chief

Executive Officer and Co-Founder, TradeWeb (“Olesky”) (“And I

second Mr. Hill’s comments. I think that it’s very important that

the people who bear the risk and supply the capital should have a

substantial voice in how that risk gets managed, and that includes

what contracts are accepted for clearing”), Roundtable Tr. at 46.

—————————————————————————

Others do not agree. They maintain that certain enumerated entities

are active in the over-the-counter swap markets 26 and that they earn

significant revenues from this line of business.27 Such entities may

experience substantial decreases in revenues if swap contracts were

required to be (i) cleared with a DCO and (ii) executed on a DCM or

SEF.28 Therefore, some contend that such entities may have an

incentive to represent that certain swap contracts do not meet the

mandatory clearing criteria under Section 723 of the Dodd-Frank

Act.29 Such swap contracts would also not be subject to the trading

requirement under Section 723 of the Dodd-Frank Act.

—————————————————————————

26 For example, according to the Office of the Comptroller of

the Currency (“OCC”), as of the second quarter of 2009, U.S.

commercial banks held derivatives with $203.5 trillion in notional

value. Of that $203.5 trillion, the top five commercial banks held

approximately $197 trillion. The top five commercial banks were: (i)

JPMorgan Chase Bank N.A.; (ii) Goldman Sachs Bank USA; (iii) Bank of

America N.A.; (iv) Citibank N.A.; and (v) Wells Fargo Bank N.A. The

sixth commercial bank, holding approximately $3 trillion, was HSBC

Bank USA N.A. See OCC’s Quarterly Report on Bank Trading and

Derivatives Activities, Second Quarter 2009.

27 Id. (stating that “U.S. commercial banks reported revenues

of $5.2 billion trading cash and derivative instruments in the

second quarter of 2009, compared to a record $9.8 billion in the

first quarter”).

28 According to Section VI of the FRBNY Staff Report, “[e]ven

after an OTC derivatives product has achieved relatively active

trading, and would be suitable for exchange trading, dealers have an

incentive to maintain the wider bid-ask spreads that they can obtain

in the OTC market relative to the spreads that might apply to the

same product on an exchange, where buyers and sellers can more

directly compete for the same trade. Further, exchanges are more

likely to match ultimate buyers to sellers, reducing the fraction of

trades intermediated by dealers. Thus, from the viewpoint of their

profits, dealers may prefer to reduce the migration of derivatives

trading from the OTC market to central exchanges.”

29 See, e.g., Comments of Heather Slavkin, Senior Legal and

Policy Advisor, Office of Investment, AFL-CIO (“Slavkin”) (“If

there’s an interest among the people who own the clearinghouse, or a

conflict of interest that would create incentives for them to also

favor, you know, [not] allowing certain types of swaps to clear

because they may be more profitable for the institution generally if

they remain over the counter, then that can create perverse

incentives to maintain the OTC, nontransparent, systemically risky

markets when the goal needs to be to prevent those conflicts of

interest to ensure that anything that can be cleared does, in fact,

clear”), Roundtable Tr. at 21; Comments of Darrell Duffie, Dean

Witter Distinguished Professor of Finance at the Graduate School of

Business, Stanford University (“Duffie”) (“We talked earlier

about how the members of the clearinghouse should determine what

gets traded, and we also have conflicts of interest arising from the

incentives of the dealers to profit from bid versus ask on products

that are not traded on swap execution facilities. So the interaction

effect here is effectively if one gets cleared as one gets traded on

a swap execution facility, then we want to be very careful that the

members of a central clearing counterparty that determine what gets

cleared and, therefore, have control over what gets traded on swap

execution facilities are the members that have, you know, the right

social incentives to create competition”); Comments of Michael

Greenberger, Professor, University of Maryland School of Law

(“Greenberger”) (“If you have one clearinghouse dominated by the

major swaps dealers, they have several conflicting incentives. One

is, I reject the idea that somehow they do not want to keep a large

and vibrant over-the-counter market. We’re told that clearing is

very profitable. If it was that profitable, where were these people

when we were aggressively arguing for mandatory clearing and

exchange trading? They were on the opposite side of that. The

transaction fees and the spreads still make an unregulated market

very, very profitable, probably more profitable than the profits

that would derive from clearing. So, if you have the swaps dealers

in control of a clearing facility, they have that incentive”),

Roundtable Tr. at 111.

—————————————————————————

Although Section 723 of the Dodd-Frank Act grants the Commission

ultimate authority to determine whether a swap contract must be cleared

with a DCO, it also anticipates that the Commission would consider the

risk assessment of DCOs. Currently, DCOs that clear large volumes of

swap contracts tend to have swap clearing members that consist

exclusively of enumerated entities.30 Therefore, some argue that the

risk assessment of such DCOs may be compromised.31

[[Page 63736]]

Moreover, some contend that the swap clearing members of such DCOs may

exclude non-enumerated entities from becoming clearing members, because

non-enumerated entities may influence risk assessments of DCOs in favor

of clearing more swap contracts.32 Some market participants maintain

that such practices may have systemic implications.33

—————————————————————————

30 For example, as of July 2, 2010, ICE Clear Europe cleared

approximately $3.3 trillion in European credit default swap

(“CDS”) indices and an additional $501 billion in European CDS

single-name instruments. See “ICE Surpasses $10 Trillion Milestone

in Global CDS Clearing,” available at:

http:[sol][sol]ir.theice.com/releasedetail.cfm?ReleaseID=485527.

As of September 20, 2010, all CDS clearing members of ICE Clear

Europe are banks, bank holding companies, or affiliates thereof.

Such members are: (i) Banc of America N.A.; (ii) Barclays Bank PLC;

(iii) BNP Paribas; (iv) Citigroup Global Markets Limited; (v) Credit

Suisse International; (vi) Deutsche Bank AG; (vii) Goldman Sachs

International; (viii) HSBC Bank PLC; (ix) JPMorgan Chase Bank, N.A.;

(x) Morgan Stanley Capital Services, Inc.; (xi) Nomura International

PLC; (xii) Soci[eacute]t[eacute] G[eacute]n[eacute]rale; (xiii) The

Royal Bank of Scotland PLC; (xiv) UBS AG, London Branch; and (xv)

UniCredit Bank AG. See ICE Clear Europe, Clearing Members, available

at: https:[sol][sol]www.theice.com/publicdocs/clear_europe/ICE_

Clear_Europe_Clearing_Member_List.pdf, and the release updating

such list, available at https:[sol][sol]www.theice.com/publicdocs/

clear_europe/circulars/C10080.pdf.

ICE Trust U.S. LLC (“ICE Trust”), an affiliate of ICE Clear

Europe, cleared approximately $6 billion in North American CDS

indices and $272 billion in North American single-name indices. The

CDS clearing members of ICE Clear Europe and ICE Trust generally

overlap (counting affiliated entities), except that Merrill Lynch

International is a clearing member of ICE Trust and

Soci[eacute]t[eacute] G[eacute]n[eacute]rale and UniCredit Bank AG

are not. See ICE Trust, Participant List, available at:

https:[sol][sol]www.theice.com/publicdocs/ice_trust/ICE_Trust_

Participant_List.pdf. ICE Trust is currently not a DCO.

31 See note 29 above. See, also, Comments from Slavkin (“I

think that there’s the risk that anything that could be made to

appear to be something that is a bilateral * * * contract, you could

have the spurious customization issues, if there’s the opportunity

to get additional profits within the big dealer banks, and those

same dealer banks are running and controlling the clearinghouses,

then, you know, the potential for spurious customization becomes a

real issue and becomes a possibility”), Roundtable Tr. at 40.

In addition to noting that the enumerated entities may have

incentives to influence DCO risk assessments in favor of considering

fewer contracts to be suitable for mandatory clearing, certain

academics have observed that, for those contracts that nonetheless

are cleared, the enumerated entities may have incentives to lower

risk management standards. See, e.g., Comments from Greenberger (“*

* * yes, certain products will be cleared because they are

profitable and [the enumerated entities] may over calculate and be

over enthused about clearing things that are too risky”),

Roundtable Tr. at 112. For example, the enumerated entities may not

accurately calculate the amount of performance bond and/or guarantee

or default fund contributions necessary to clear a particular swap

contract.

32 See, e.g., Comments from Jason Kastner, Vice Chairman,

Swaps and Derivatives Markets (“Kastner”) (“Let me give you a

specific example. One of the members of this SDMA currently clears

13 percent of the business at a large exchange in Chicago. That

large, independent FCM is clearly qualified to become a swap

clearing member. But because of various conflicts of interest, the

risk committee of said exchange is precluding that firm, which is

clearly qualified and has the capital, from becoming a swap clearing

member * * * this goes back to the governance point and transparency

about who’s making that decision and why, because a lot of times

what happens is people will swallow themselves in the cloak of risk

management or financial stability or whatever really to make an

anti-competitive stand. In other words, you can never say that you

don’t want to let somebody in. But you could probably find an excuse

or a reason in the interest of systematic–you know, systemic

stability and the rest of it to put an asterisk on the application

or just delay it for awhile”), Roundtable Tr. at 90-91.

See, also, infra note 67 on the potential non-availability of

arrangements whereby a non-clearing futures commission merchant may

present a customer trade to a swap clearing member for clearing with

a DCO.

33 In Lessening Systemic Risk: Removing Final Hurdles to

Clearing OTC Derivatives, the Swaps and Derivatives Market

Association states: “[r]estricted access leads to reduced clearing

which leads to systemic risk.”

—————————————————————————

The framers of the Dodd-Frank Act observe that the clearing of swap

contracts constitutes a key means for managing systemic risk, because

clearing removes the type of interconnectedness between financial

institutions that contributed to the financial crisis resulting from

the failure and bankruptcy of firms such as Bear Stearns, Lehman

Brothers, and AIG.34 Therefore, it is important to mitigate potential

conflicts of interest that may prevent clearable swap contracts from

becoming subject to mandatory clearing. At the same time, the

Commission recognizes that the safety and soundness of a DCO should not

be compromised. A DCO must not only have the ability to appropriately

manage the risk associated with each and every contract that it

guarantees, it must be able to decline accepting contracts for clearing

if they pose unacceptable risks. In addition, DCO members must have

input in setting membership criteria, because they bear the risk of

loss in the event of member default. Nevertheless, the Commission does

not believe that (i) subjecting more swap contracts to mandatory

clearing is incompatible with (ii) DCO safety and soundness.35

Rather, the Commission intends to ensure, through the proposed rules

below, that a DCO takes action to achieve both (i) and (ii), and that

the private, competitive interests of certain DCO members do not

capture DCO risk assessments.

—————————————————————————

34 See, e.g., the letter from Senators Christopher Dodd and

Blanche Lincoln, respective chairs of the Senate Banking and

Agriculture Committee, to Representatives Barney Frank and Collin

Peterson, respective chairs of the House Financial Services and

Agriculture Committees, dated June 30, 2010 (stating that “Congress

determined that clearing is at the heart of reform–bringing

transactions and counterparties into a robust, conservative and

transparent risk management framework”).

35 Certain Roundtable participants agree. See Comments from

Duffie (“I don’t think there’s a conflict between the incentives

for competition, increasing competition in this market on the one

hand and the incentives for improving financial stability on the

other, or I don’t think there’s a problem between those two. You can

* * * have both. The incentives to watch for on competition are that

we’ve got enough access by multiple market * * * participants, and

that the oligopolistic nature of the market is, to some extent,

watched carefully by regulators”), Roundtable Tr. at 104.

—————————————————————————

b. DCMs and SEFs

The main function of a DCM, as well as a SEF, is to provide a

facility for: (i) The discovery of prices; and (ii) the execution of

transactions. However, in order to obtain and maintain a license to

perform such a function, each DCM and SEF must fulfill self-regulatory

obligations under the CEA and the Dodd-Frank Act.36 Therefore,

although each DCM or SEF 37 is a commercial enterprise, the fact that

each entity has self-regulatory obligations means that each entity “is

not simply a corporation, but a corporation charged with the public

trust.” 38 Section 3(b) of the CEA confers on the Commission the

responsibility for ensuring that each DCM or SEF appropriately

prioritizes its self-regulatory obligations. Such obligations include

appropriately implementing the comprehensive new framework that the

Dodd-Frank Act sets forth, as well as meeting existing requirements

under the CEA.

—————————————————————————

36 Section 3(a) of the CEA defines the “national public

interest” that transactions in commodity futures and options and

swaps serve. It states, “[t]he transactions subject to this Act are

entered into regularly in interstate and international commerce and

are affected with a national public interest by providing a means

for managing and assuming price risks, discovering prices, or

disseminating pricing information through trading in liquid, fair

and financially secure trading facilities.” 7 U.S.C. 5(a). The

importance of transactions in commodity futures and options, as well

as swaps, forms the basis for Commission regulation of DCMs and

SEFs.

Section 3(b) of the CEA describes the system of regulation that

Congress has directed the Commission to implement to achieve the

abovementioned purposes. It states: “[i]t is the purpose of this

chapter 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.” 7 U.S.C. 5(a). The Commission has interpreted the

“self-regulation” referenced in Section 3(b) of the CEA as

encompassing both (i) the registered entity ensuring that members

meet applicable statutory requirements, and (ii) the registered

entity having systems to ensure that it continues to meet applicable

statutory requirements. For example, as the Commission previously

stated in the DCM Conflicts of Interest Release, “Core Principle 15

requires DCMs to maintain systems to minimize structural conflicts

of interest inherent in self-regulation, as well as individual

conflicts of interest faced by particular persons. The acceptable

practices are rationally related to the purposes of Core Principle

15.” 72 FR at 6937, 6940.

37 As mentioned above, the SEF is a new registration category

that the Dodd-Frank Act created. Therefore, the Commission has never

opined as to whether a SEF is a “self-regulatory organization”

within the meaning of Regulation 1.3(ee). However, a SEF has self-

regulatory obligations under the Dodd-Frank Act, as the Commission

has interpreted such obligations in the DCM Conflicts of Interest

Release. For example, to the extent that a SEF determines that it

must impose requirements on members in order to comport with a core

principle (e.g., with respect to position limits), a SEF must

monitor member compliance with such requirement, and must have the

authority and ability to enforce such requirement. See Section

5h(f)(2)(A) of the CEA, as added by Section 733 of the Dodd-Frank

Act.

38 Preamble to proposed acceptable practices on “Conflicts of

Interest in Self-Regulation and Self-Regulatory Organizations,” 71

FR 38740, 38741 (July 7, 2006).

—————————————————————————

As the DCM Conflicts of Interest Release notes, increased

competition may exacerbate conflicts of interest, causing a DCM to (i)

prioritize commercial interests over self-regulatory responsibilities;

39 and (ii) restrict access or impose burdens on access in a

discriminatory manner.40

[[Page 63737]]

The Dodd-Frank Act attempts to create conditions favorable to sustained

competition between DCMs and SEFs with respect to the same swap

contract. For example, the Dodd-Frank Act contemplates that either a

DCM or a SEF may list swap contracts.41 It also contemplates that

multiple DCMs or SEFs may list the same swap contract, and that such

swap contracts may be offset at the same DCO.42 Also, in requiring

certain swap contracts to be listed on a DCM or SEF,43 the Dodd-Frank

Act may encourage competition between standardized swap contracts and

commodity futures and options.44

—————————————————————————

39 See, generally, the DCM Conflicts of Interest Release.

40 See, infra note 67 for a specific example of DCM or SEF

restrictions or burdens on access. Also, clauses (i) and (ii) are

not mutually exclusive. As the DCM Conflicts of Interest Release

notes, “[s]elf-regulation’s traditional conflict–that members will

fail to police their peers with sufficient zeal–has been joined by

the possibility that competing DCMs could abuse their regulatory

authority to gain competitive advantage or to satisfy commercial

imperatives.” 72 FR at 6938. In its Concept Release Concerning

Self-Regulation, the SEC identified one method that national

securities exchanges have used to gain a competitive advantage:

“abus[ing] SRO status by overregulating members that operate

markets that compete with the SROs.” Release No. 34-50700 (Nov. 18,

2004), 69 FR 71256 (Dec. 8, 2004).

Also, similar to the incentives that the enumerated entities may

have with respect to the mandatory clearing requirement, if the

enumerated entities control a DCM or SEF, they may cause such DCM or

SEF to not list a swap contract for trading, if it would be more

profitable to keep such contract bilaterally negotiated. However,

the Commission notes that nothing would prevent another DCM or SEF

from listing such contract, and that Section 723 of the Dodd-Frank

Act would require that a DCO clearing such contract provide non-

discriminatory access to such DCM or SEF.

41 See Section 2(h)(8) of the CEA, as added by Section 723 of

the Dodd-Frank Act.

42 See Section 2(h)(1)(B) of the CEA, as added by Section 733

of the Dodd-Frank Act. Whereas DCMs have competed in the past, and

are currently competing, to list commodity futures and options

contracts with the same economic terms and conditions, such

contracts have not been, and currently are not, fungible. In other

words, such contracts cannot be offset in the same DCO.

43 See Section 2(h)(8) of the CEA, as added by Section 723 of

the Dodd-Frank Act.

44 For example, two DCMs (i.e., the NASDAQ OMX Futures

Exchange and CME), as well as one exempt board of trade (i.e., Eris

Exchange), offer interest rate futures products. Currently, interest

rate swap contracts constitute a large percentage of the bilateral

swaps market. See, e.g., OCC’s Quarterly Report on Bank Trading and

Derivatives Activities, First Quarter 2010, Executive Summary,

available at: http:[sol][sol]www.occ.treas.gov/ftp/release/2010-

71a.pdf. (stating that “[d]erivative contracts remain concentrated

in interest rate products, which comprise 84% of total derivative

notional values”).

—————————————————————————

Such sustained competition, if it occurs,45 would constitute an

increase to the competition that most DCMs currently face with respect

to commodity futures and options. As described below, the Commission

intends to ensure through the proposed rules that each DCM or SEF

implements appropriate systems to manage such conflicts.

—————————————————————————

45 As discussed above, whether such competition occurs depends

in part on the manner in which Section 723 of the Dodd-Frank Act is

implemented.

—————————————————————————

c. Questions on Conflicts of Interest

The Commission seeks comment on the questions set forth below on

potential conflicts of interest.

Has the release correctly identified the conflicts of

interest that a DCO, DCM, or SEF may confront?

Has the release accurately specified the possible effects

of such conflicts of interest on DCO, DCM, or SEF operations? What are

other possible effects?

What other conflicts of interest may exist? What are the

effects of such conflicts?

III. Mitigation of Conflicts of Interest

To mitigate, on a prophylactic basis, the conflicts of interest

identified above, the Commission sets forth below proposed (i)

structural governance requirements and (ii) limits on the ownership of

voting equity and the exercise of voting power. As explained in greater

detail below, the Commission views (ii) as a method of enhancing (i),

in that (ii) limits the influence that certain shareholders may exert

over the DCO, DCM, or SEF Board of Directors. The Commission believes

that such influence may affect, among other things, the independent

perspective of public directors. The Commission does not believe that

stricter structural governance requirements (e.g., a higher percentage

of public directors) justify more lenient limits on the ownership of

voting equity and the exercise of voting power, or vice versa. However,

the Commission requests comment on the proper relationship between such

requirements and limits. The Commission also requests comment on

whether both (i) structural governance requirements and (ii) limits on

the ownership of voting equity and the exercise of voting power are

necessary or appropriate to mitigate the conflicts of interest

described in Section II, or whether one or the other (or neither) would

be effective.

In applying such requirements and limits, the Commission does not

propose to distinguish between DCMs and SEFs listing swap contracts. As

mentioned above, such DCMs and SEFs may experience sustained

competition with respect to the same swap contract, and therefore would

face the same pressures on self-regulation. Additionally, the

Commission does not propose to distinguish between (i) DCMs listing

swap contracts and (ii) DCMs listing only commodity futures and

options. As mentioned above, clearable swap contracts may share

sufficiently similar characteristics with certain commodity futures and

options as to compete with respect to execution. Therefore, a DCM

listing only commodity futures and options may face competition from a

SEF with fewer self-regulatory requirements, in the same manner as a

DCM listing swap contracts. Given that the same conflicts of interest

46 may concern both types of DCM, it would appear that the same (i)

structural governance requirements and (ii) limits on the ownership of

voting equity and the exercise of voting power should apply.

—————————————————————————

46 Namely, (i) prioritizing commercial interests over self-

regulatory responsibilities and (ii) restricting access or imposing

burdens on access in a discriminatory manner, in each case, because

of increased competition.

—————————————————————————

In addition, the Commission does not propose to distinguish between

(i) DCOs clearing swap contracts and (ii) DCOs clearing only commodity

futures and options. Certain standardized swap contracts have

sufficiently similar risk profiles to commodity futures and options

that the Commission has, on occasion, permitted such products to be

commingled and margined within the segregated customer account under

Section 4d of the CEA.47 If the Commission applied differential (i)

structural governance requirements and (ii) limits on the ownership of

voting equity and the exercise of voting power, the Commission risks

creating an incentive for regulatory arbitrage between the two types of

DCO.

—————————————————————————

47 7 U.S.C. 6d.

—————————————————————————

The Commission requests comment on holding the two types of (i)

DCMs and (ii) DCOs to the same requirements regarding the mitigation of

conflicts of interest. The Commission also requests comment on holding

DCMs and SEFs listing swap contracts to the same requirements. The

Commission is specifically interested in the costs and benefits of its

approach.

a. Structural Governance Requirements

i. Independence

In general, the structural governance requirements mitigate

conflicts of interest at a DCO, DCM, or SEF by introducing a

perspective independent of competitive, commercial, or industry

considerations to the deliberations of governing bodies (i.e., the

Board of Directors and committees). Such independent perspective would

more likely encompass regulatory considerations, and to accord such

considerations proper weight. Such independent perspective also would

more likely contemplate the manner in which a decision might affect all

constituencies, as opposed to concentrating on the manner in which a

decision affects the interests of one constituency.48

—————————————————————————

48 See, e.g., the DCM Conflicts of Interest Release (stating

that “the public interest will be furthered if the boards and

executive committees of all DCMs are at least 35% public. Such

boards and committees will gain an independent perspective that is

best provided by directors with no current industry ties or other

relationships which may pose a conflict of interest. These public

directors, representing over one-third of their boards, will

approach their responsibilities without the conflicting demands

faced by industry insiders. They will be free to consider both the

needs of the DCM and of its regulatory mission, and may best

appreciate the manner in which vigorous, impartial, and effective

self-regulation will serve the interests of the DCM and the public

at large. Furthermore, boards of directors that are at least 35%

public will help to promote widespread confidence in the integrity

of U.S. futures markets and self-regulation”). 72 FR 6946.

—————————————————————————

[[Page 63738]]

In the DCM Conflicts of Interest Release, the Commission emphasized

the importance of independent decision-makers in protecting DCM self-

regulatory functions from DCM commercial interests and that of its

constituencies. However, the Commission notes that participants in the

Roundtable raised the possibility that conflicts of interest may also

be mitigated by providing for fair representation of all constituencies

in the governance of a DCO, DCM, or SEF.49 Theoretically, all

constituencies would act in their own commercial, competitive, or

industry interests, but no one interest would dominate. The Commission

specifically requests comment regarding whether fair representation

would be preferable to, or would complement, director independence in

mitigating the DCO, DCM, and SEF conflicts of interest described in

Section II. The Commission would particularly welcome factual examples.

The Commission also requests comment on how the proposed structural

governance requirements should change if the Commission adopts a fair

representation standard as either an alternative to, or a complement

of, rules emphasizing an independent perspective.

—————————————————————————

49 See, e.g., Comment from Hal Scott, Nomura Professor of

International Financial Systems and Director of Program on

International Financial Systems, Harvard Law School (“Scott”)

(“When I spoke, I was saying I opposed ownership restrictions, I

was not talking about voting restrictions which I think is a

different issue, and the way I would put it is not a voting

restriction. I would turn it around to a duty of fair

representation, which the SEC is quite familiar with, and is applied

to their regulated entities which ensures that the users, more

broadly defined of the exchange. And maybe if you translated this

into the clearinghouse, the users, but not necessarily the members

of the clearinghouse, would have representation in terms of

governance * * * Independent directors, to me, are most needed with

public companies as under SOX when there was a broad duty to

shareholders. But I think what’s needed in this context is more the

expert, and we heard before that it’s very important that people

that know what they’re doing have input into those, and clearly

major users of these clearinghouses, that is customers who clear

through a member. Major hedge funds, for instance, have a lot of

expertise, okay, in these areas, they’re big traders * * *”),

Roundtable Tr. at 130-131; Richard Prager, Managing Director, Global

Head of Fixed Income Trading, Blackrock (“as the [sole] fiduciary

on this panel * * * we would be in support of a very inclusive

participation and governance with teeth”), Roundtable Tr. at 131-

132; Lynn Martin, Chief Operating Officer, NYSE Liffe U.S. (“You

may be aware that NYSE Euronext’s U.S. Future Exchange–NYSE Life

U.S., is a semi-neutralized structure whereby we balance the views

of both the independence criteria as required by core principle 15

in the CFTC-DCM requirements, as well as the views of NYSE Euronext

and our external investor firms’ views, such that no one board

action may be enacted based on the views of any one of those

constituents * * * So, it’s our belief that a more balanced board

structure, a more balanced governance structure, is the proper way

to handle or potentially mitigate conflicts of interest”),

Roundtable Tr. at 121.

—————————————————————————

ii. Board Requirements

1. Composition

As the DCM Conflicts of Interest Release states, “the governing

board * * * is [the] ultimate decision maker and therefore the logical

place to begin to address conflicts.” 50 The Commission proposes (i)

maintaining the requirement that DCM Boards of Directors be composed of

at least 35 percent “public directors” 51 and (ii) extending this

requirement to SEF and DCO Boards of Directors. In the DCM Conflicts of

Interest Release, the Commission stated that the 35 percent requirement

struck an appropriate balance between (i) the need to minimize

conflicts of interest in DCM decision-making processes with (ii) the

need for expertise and efficiency in such processes. Such rationale

would appear to apply to SEF and DCO Boards of Directors as well.52

—————————————————————————

50 72 FR at 6940.

51 See Section III(a)(iv) of this release for more detail

regarding the definition of “public director.”

The Commission notes that such percentage harmonizes with

Article 25(2) of the European Commission Proposal, which requires a

central counterparty (“CCP”) to have “a board of which at least

one third, but no less than two, of its members are independent.”

52 72 FR at 6946.

—————————————————————————

In addition to the 35 percent composition requirement, the

Commission proposes specifying that DCO, DCM, and SEF Boards of

Directors may not have less than two public directors. Such a

requirement is also contained in the European Commission Proposal.53

As the Commission has observed that most DCO and DCM Boards of

Directors contain more than three members, the Commission does not

believe that such a requirement imposes additional burden. However, the

Commission welcomes comment on this proposal.

—————————————————————————

53 See Article 25(2) of the European Commission Proposal.

—————————————————————————

In order to prevent evasion of the abovementioned composition

requirements through corporate structuring or internal reorganization,

the Commission proposes extending the composition requirements to any

committee of the Board of Directors that may exercise delegated

authority with respect to the management of a DCO, DCM, or SEF.

Further, the Commission proposes prohibiting a DCO, DCM, or SEF from

permitting itself to be operated 54 by another entity, unless such

entity agrees to comport with such requirements in the same manner as

the DCO, DCM, or SEF.

—————————————————————————

54 The proposed rule defines “operate” as “the direct

exercise of control (including through the exercise of veto power)

over the day-to-day business operations of” a DCO, DCM, or SEF “by

the sole or majority shareholder of such registered entity, either

through the ownership of voting equity, by contract, or otherwise.

The term `operate’ shall not prohibit an entity, acting as the sole

or majority shareholder of such registered entity, from exercising

its rights as a shareholder under any contract, agreement, or other

legal obligation.”

—————————————————————————

The Commission would like to clarify that it does not intend to

extend the abovementioned composition requirements to an entity that

does not exert active and recurrent control over the operations of a

DCO, DCM, or SEF. Consequently, the Commission proposes to deem an

entity to “operate” a DCO, DCM, or SEF only if it engages in “the

direct exercise of control (including through the exercise of veto

power) over the day-to-day business operations” of the registered

entity.

In addition to the abovementioned composition requirements, the

Commission proposes prohibiting a DCO, DCM, or SEF from permitting

itself to be operated by an entity unless such entity agrees to subject

(i) its officers, directors, employees, and agents to Commission

authority, and (ii) its books and records to Commission inspection and

copying. The Commission believes that such proposals are necessary to

ensure effective audits of DCO, DCM, or SEF operations, given the

corporate structure of the DCO, DCM, or SEF.

2. Questions on Composition

The Commission seeks comment on the questions set forth below on

DCO, DCM, and SEF Boards of Directors composition requirements:

Would such composition requirements be equally valid in

mitigating conflicts of interest concerning a privately-held DCO, DCM,

and SEF, as opposed to a publicly-held DCO, DCM, and SEF?

As mentioned above, would providing for fair

representation on DCO, DCM, or SEF Boards of Directors be preferable

to, or complementary to, mandating specific percentages of

[[Page 63739]]

public directors? Also, if the main purpose of the 35 percent

composition requirement is to introduce an independent perspective into

DCO, DCM, and SEF governance, would requiring one or two public

directors be sufficient, regardless of the size of the DCO, DCM, or SEF

Board of Directors?

As mentioned above, the Commission is seeking to mitigate

potential conflicts of interest that may influence a DCO regarding (i)

whether a swap contract is capable of being cleared, (ii) the minimum

criteria that an entity must meet in order to become a swap clearing

member, and (iii) whether a particular entity satisfies such criteria.

Because the DCO Board of Directors would make ultimate decisions

implicating (i), (ii), and (iii), is the 35 percent composition

requirement sufficient to ensure that the private, competitive

interests of certain DCO members do not capture DCO risk assessments

with respect to both products and membership? Or should the Commission

increase the required percentage of public directors to 51 percent? Or

is there a number less than 51 percent but greater than 35 percent that

would be more appropriate?

As described above, the Dodd-Frank Act envisions (i) a DCM

competing with a SEF to list the same swap contract, and (ii) a DCM

listing a commodity futures or options contract that competes with a

swap contract listed on a SEF. In both cases, a DCM would be competing

against an entity with lesser self-regulatory obligations. Such

competition may place increased stress on the manner in which the DCM

aims to satisfy its self-regulatory responsibilities. In light of such

stress, is the 35 percent composition requirement still sufficient to

protect the DCM self-regulatory function?

As referenced above, the Dodd-Frank Act anticipates that a

SEF would face a more competitive environment at inception than a DCM

currently listing commodity futures and options. As the DCM Conflicts

of Interest Release notes, increased competition may be detrimental to

self-regulation. Therefore, is the 35 percent composition requirement

appropriate to ensure that a SEF discharges its self-regulatory

functions in the first instance?

3. Substantive Requirements

In addition to the abovementioned composition requirements, the

Commission proposes the substantive requirements set forth below, which

aim to enhance the accountability of the DCO, DCM, or SEF Board of

Directors to the Commission regarding the manner in which such Board of

Directors causes the DCO, DCM, or SEF to discharge all statutory,

regulatory, or self-regulatory responsibilities under the Dodd-Frank

Act and the existing CEA.

The roles and responsibilities of a DCO, DCM, or SEF Board

of Directors must be clearly articulated, especially in respect of the

manner in which such Board of Directors ensures that the DCO, DCM, or

SEF complies with all statutory, regulatory, and self-regulatory

responsibilities under the Dodd-Frank Act and the existing CEA.

A DCO, DCM, or SEF Board of Directors shall review its

performance and that of its individual members annually. It should

consider periodically using external faciliators for such reviews.

A DCO, DCM, or SEF must have procedures to remove a member

from the Board of Directors, where the conduct of such member is likely

to be prejudicial to the sound and prudent management of the DCO, DCM,

or SEF.

Because of the highly specialized nature of DCO, DCM, or SEF

operation, the Commission proposes requiring that each member of a DCO,

DCM, or SEF Board of Directors have sufficient expertise, where

applicable, in financial services, risk management, and clearing

services. Roundtable participants generally agreed that a DCO, DCM, or

SEF Board of Directors must have sufficient expertise.55

—————————————————————————

55 See, e.g., Comments from Slavkin (“I think having real

experts on the boards of directors is a very important issue. We all

saw situations in the last several years where there were boards

that were two-thirds independent and made really stupid decisions

about risk management. So, we need to make sure that there are

people on those boards of directors that really understand the risks

that exist within a clearinghouse and are prepared to perceive

potential risks that may arise in the system down the road and

address them. So they also need to have the personalities to stand

up to a board of directors that may be entrenched and have their own

interests that may differ from those that are in the best interests

of the systemic stability”), Roundtable Tr. at 77; Comments from

Johnathan Short, Senior Vice President, General Counsel and

Corporate Secretary, the IntercontinentalExchange, Inc. (“I mean,

she’s right, but I just want to point out that there really is a

tension there, because some of the people who are best qualified to

assess risk in a given market are the people that some parts of

the–you know, of the market are complaining about is controlling

clearinghouses and controlling key infrastructure”), Roundtable Tr.

at 78; Comments from William H. Navin, Executive Vice President and

General Counsel, Options Clearing Corporation (“I would second

those remarks. Our experience has been that we’ve benefited greatly

from the expertise of industry directors, and I think it would be

throwing the baby out with the bathwater if substantial restrictions

on industry governance were to be enacted”), Roundtable Tr. at 78;

Comments from Greenberger (“I do agree with what has been said,

that you need experts on the board. What I disagree with is that all

expertise comes from five swaps dealers or it all comes from people

who work for banks. There are academics, former regulators, and, you

know, other participants in the market who have talked today about

their need for open and fair access. I think that kind of diversity

on the board is important”), Roundtable Tr. at 164.

—————————————————————————

To ensure that members of a DCO, DCM, or SEF Board of Directors are

not incented to accord undue consideration to the commercial interests

of a DCO, DCM, or SEF in relation to regulatory interests, the

Commission proposes to prohibit linking the compensation of public

directors and other non-executive members of the Board of Directors to

the business performance of the DCO, DCM, or SEF.

The abovementioned substantive requirements are in accord with

certain provisions in the European Commission Proposal.56

—————————————————————————

56 See Article 25 of the European Commission Proposal.

—————————————————————————

4. Questions on Substantive Requirements

The Commission seeks comment on the questions set forth below on

the substantive requirements applicable to a DCO, DCM, or SEF Board of

Directors:

What substantive requirements, other than those identified

above, should the Commission consider imposing on a DCO, DCM, or SEF

Board of Directors to mitigate the potential conflicts of interest

described in Section II, as well as any potential conflicts of interest

not specified herein? For example, should the Commission consider any

additional requirements related to (i) the fiduciary duties that a DCO,

DCM, or SEF Board of Directors may owe or (ii) policies or charters

that the DCO, DCM, or SEF Board of Directors may adopt?

iii. Committees

1. Requirements for Each DCO, DCM, and SEF

a. Nominating Committee

As stated above, the structural governance requirements contained

herein focus on mitigating conflicts of interest through introducing a

perspective independent of competitive, commercial, or industry

considerations to the deliberations of DCO, DCM, and SEF governing

bodies. Public director composition requirements are not, in and of

themselves, sufficient to ensure the representation of such independent

perspective. The Commission also must protect the integrity of the

process by which the DCO, DCM, or SEF selects public directors.57

—————————————————————————

57 See, e.g., Comments from Rick McVey, Chief Executive

Officer, MarketAxess (“McVey”) (“I personally think that one of

the most important areas to focus on is the governance and

nominating committee. How do people get on these boards? And if

there is a requirement that that process be independent I think you

would get both qualified people that are going to look after the

best interest of the company, and you would get better independence

on these boards”), Roundtable Tr. at 150.

—————————————————————————

[[Page 63740]]

To this end, the Commission proposes requiring each DCO, DCM, or

SEF to have a Nominating Committee. The role of the Nominating

Committee would be to: (i) Identify individuals qualified to serve on

the Board of Directors, consistent with the criteria that the Board of

Directors require and any composition requirement that the Commission

promulgates; and (ii) administer a process for the nomination of

individuals to the Board of Directors. The Commission proposes that (i)

public directors comprise at least 51 percent of the Nominating

Committee, and (ii) a public director chair the Nominating Committee.

b. Disciplinary Panels

As stated above, each DCM and SEF must fulfill self-regulatory

obligations under the CEA and the Dodd-Frank Act. Also, each DCO has

certain self-regulatory obligations.58 The Commission proposes

requiring each DCO, DCM, or SEF to have one or more disciplinary

panels.59 The role of such disciplinary panels would be to conduct

hearings, render decisions, and impose sanctions with respect to

disciplinary matters.

—————————————————————————

58 For example, to the extent that a DCO determines that it

must impose requirements on members in order to comport with a core

principle or other regulatory requirement (e.g., limits on ownership

and voting power), a DCO must monitor member compliance with such

requirement, and must have the authority and ability to enforce such

requirement. See Section 5b(c)(2)(H) of the CEA, as added by Section

725(c) of the Dodd-Frank Act.

59 The Commission understands that DCOs currently may not have

disciplinary panels, but that the Risk Management Committee of a DCO

may perform the functions of such panel. Therefore, consistent with

current practice, the Commission proposes to permit the DCO Board of

Directors to delegate to the Risk Management Committee the

performance of such functions. If the Board of Directors so

delegates, (i) the DCO would no longer need to maintain a

disciplinary panel, but (ii) the composition requirements applicable

to a disciplinary panel would be extended to any committee (or

similar body) to which a decision of the Risk Management Committee

may be appealed.

—————————————————————————

The Commission believes that it is imperative for each DCO, DCM, or

SEF to exercise its disciplinary authority in an impartial manner. In

the DCM Conflicts of Interest Release, the Commission acknowledged the

value of fair representation in maintaining such impartiality.60 To

ensure that fair representation results in impartiality, the Commission

proposes (i) maintaining the requirement that each DCM adopt rules that

would preclude any group or class of participants from dominating or

exercising disproportionate influence on the disciplinary panel, and

(ii) extending such requirement to each DCO or SEF. The Commission also

proposes mandating that each DCO, DCM, or SEF adopt rules that would

prohibit any member of a disciplinary panel from participating in

deliberations or voting on any matter in which the member knowingly has

a financial interest.

—————————————————————————

60 See 72 FR at 6952 (stating that “fair disciplinary

procedures, with minimal conflicts of interest, require disciplinary

bodies that represent a diversity of perspectives and

experiences”).

—————————————————————————

In the DCM Conflicts of Interest Release, the Commission also

acknowledged the importance of an independent perspective.61 The

Commission proposes retaining and strengthening the role that such

perspective plays in DCO, DCM, or SEF disciplinary processes. First,

the Commission proposes (i) maintaining the requirement that each DCM

disciplinary panel include at least one “public participant,” 62

and (ii) extending such requirement to each DCO or SEF disciplinary

panel. Second, the Commission proposes requiring that the chair of each

disciplinary panel be a public participant.

—————————————————————————

61 Id. (stating that “[t]he presence of at least one public

person on disciplinary bodies * * * provides an outside voice and

helps to ensure that the public’s interests are represented and

protected. This approach is consistent with the Commission’s overall

objective of ensuring an appropriate level of public representation

at every level of DCM decision making, while simultaneously

calibrating the required number of public persons to the nature and

responsibility of the decision-making body in question”).

62 Id. at 6957. In the proposed rules, a “Public

Participant” is defined as an entity that meets the bright-line

materiality tests in the definition of “Public Director.”

—————————————————————————

2. Requirements for Each DCO Only

a. Risk Management Committee (and Subcommittee)

The central purpose of a DCO is to guarantee the performance of

each derivatives contract that it clears. In order to fulfill such

guarantee, each DCO must appropriately manage the risks associated with

such contract. In general, a DCO convokes a committee to oversee risk

management. The Commission proposes to require each DCO to have a Risk

Management Committee.

Swap contracts, as well as commodity futures and options, are

complex instruments. Managing the risks of such instruments requires

expertise. In general, clearing members constitute the main source of

such expertise, as they (i) routinely execute trades in such

instruments and (ii) have experience in managing risks posed by

customer trades. Because of the lack of a centralized market for swap

contracts, swap clearing members also perform the function of (i)

pricing a swap contract and (ii) participating in an auction to

liquidate the swap contract in the event of member default.

However, as discussed above, swap clearing members at DCOs that

currently clear large volumes of swap contracts are exclusively

enumerated entities. Some have argued that the enumerated entities have

an incentive to influence DCO risk assessments regarding (i) whether a

swap contract is capable of being cleared, (ii) the appropriate

membership criteria for a swap clearing member, and (iii) whether a

particular entity meets such criteria. Therefore, the Commission must

carefully consider the composition of the Risk Management Committee, in

order to achieve (i) the increased clearing of swap contracts that the

Dodd-Frank Act contemplates without compromising (ii) DCO safety and

soundness.

The Commission proposes a three-pronged approach to mitigating the

potential conflict of interest identified above, while still ensuring

that the Risk Management Committee retains sufficient expertise. First,

the Commission proposes requiring that 35 percent of the Risk

Management Committee be composed of public directors, with sufficient

expertise in, among other things, clearing services.63 Second, the

Commission proposes requiring that 10 percent of the Risk Management

Committee be composed of customers of clearing members, who also

routinely execute swap contracts (as well as commodity futures and

options) and who have experience in using pricing models for such

contracts (if only to ensure that they receive a fair price from the

enumerated entities).64 Because customers benefit from a wider pool

of swap clearing members and greater competition between such members,

customers have an incentive to ensure that the membership criteria of a

DCO are risk-based, and do not reflect the private, competitive

interests of the enumerated entities. Third, the Commission proposes to

permit a DCO Risk Management Committee to delegate to a subcommittee

(the “Risk

[[Page 63741]]

Management Subcommittee”) the responsibility to: (i) Determine the

standards and requirements for initial and continuing clearing

membership eligibility; (ii) approve or deny (or review approvals or

denials of) clearing membership applications; and (iii) determine

products eligible for clearing. If the Risk Management Committee

effects such a delegation, then it would free itself of the composition

requirements. The decisions of the Risk Management Subcommittee would

be subject to review by the Risk Management Committee. Therefore, if

the Risk Management Committee determines that a particular decision by

the Risk Management Subcommittee is overly risky, then the Risk

Management Committee may overrule that decision.65

—————————————————————————

63 See Comments from Greenberger, supra note 55, regarding the

availability of such public directors.

64 See, generally, supra note 55.

Because customers do not contribute to the DCO default fund,

customers may have less capital at stake than clearing members if a

DCO improperly measures risk. Therefore, the Commission believes

that 10 percent representation would ensure that customers have

adequate voice on the DCO Risk Management Committee, without

adversely impacting the risk assessments of such committee.

65 The Commission is contemplating requiring the DCO to report

to the Commission whenever the Risk Management Committee overrules

the Risk Management Subcommittee, or whenever the Board of Directors

overrules the Risk Management Committee. If the Commission decides

to propose such requirement, it would be included in the second

rulemaking that the Commission contemplates finishing on governance

and mitigation of conflicts of interest. See supra note 17.

—————————————————————————

In order to prevent evasion of the above-mentioned composition

requirements through internal reorganization, the Commission proposes

to prohibit:

A decision of the Risk Management Subcommittee from being

subject to the approval of, or otherwise restricted or limited by, a

body other than the DCO Board of Directors or the DCO Risk Management

Committee, including, without limitation, any advisory committee; and

Certain decisions of the Risk Management Committee 66

from being subject to the approval of, or otherwise restricted or

limited by, a body other than the DCO Board of Directors, including,

without limitation, any advisory committee.

—————————————————————————

66 I.e., any decision pertaining to (i) whether a swap

contract is capable of being cleared, (ii) the appropriate

membership criteria for a swap clearing member, and (iii) whether a

particular entity meets such criteria.

—————————————————————————

The Commission requests comment on its three-pronged approach,

including any alternatives to such approach. The Commission also

requests comment on (i) the specific percentages set forth above, and

(ii) the prohibitions on certain bodies approving of, or otherwise

restricting or limiting, the decisions of the Risk Management Committee

(or Risk Management Subcommittee, as applicable).

3. Requirements for Each DCM or SEF Only

a. Membership or Participation Committee

As mentioned above, increased competition may exacerbate conflicts

of interest, causing a DCM or SEF to (i) prioritize commercial

interests over self-regulatory responsibilities; and (ii) restrict

access or impose burdens on access in a discriminatory manner.

Roundtable participants identified a specific example of (ii), where

swap clearing members may seek to limit access to SEF execution and

pricing to customers executing through such members.67 The rationale

of such example would apply to a DCM as well. To protect decisions

regarding access from DCM or SEF commercial interests, or the interests

of the enumerated entities, the Commission proposes requiring a DCM or

SEF to have a Membership or Participation Committee, composed of

thirty-five percent public directors.68 Such committee would have the

responsibility to: (i) Determine the standards and requirements for

initial and continuing membership or participation eligibility; (ii)

review appeals of staff denials of membership or participation

applications; and (iii) approve rules that would result in different

categories or classes of members or participants receiving disparate

access. The Commission proposes prohibiting the Membership or

Participation Committee from upholding any staff denial if the relevant

application meets the standards and requirements that such committee

sets forth. Further, the Commission proposes prohibiting the Membership

or Participation Committee from restricting access or imposing burdens

on access in a discriminatory manner, within each category or class of

members or participants or between similarly situated categories or

classes of members or participants. Nothing in this preamble is meant

to prohibit the Commission from issuing substantive proposals regarding

access to a DCM or SEF in any subsequent proposed rulemaking.

—————————————————————————

67 See, e.g., Comments from Kastner (“I’ll take the ball for

a second with the SEFs. The same principles that apply to DCOs in

terms of open access–also if you carefully apply to SEFs, anybody

who is able to get a clearing account at a qualified swap clearing

member or FCM to use the, you know, futures analog, anybody that

wants to trade on a SEF, the SEF should not have any barriers to

entry.”), Roundtable Tr. at 52, (“The point is if you have a firm

who is doing customer business and wants to engage in an interest

rate swap with an end user who is not a clearing member, that they

should be able to execute that trade with the end user and then give

up to a clearing member.”), Roundtable Tr. at 84; Comments from

William DeLeon, Executive Vice President, Global Head of Portfolio

Risk Management, PIMCO (“You know, that concept of using a SEF, I

think it should be free and open access * * *. The issue is that

there needs to be a guarantee that when you access a SEF, that when

you do a trade, that there is someone who is guarantee that that is

a good trade. So whether that means that there’s a market maker * *

* or if that means that there’s a DCM or an FCM or someone who’s

going to guarantee that they’re going to stand behind * * * unknown

clients * * * ”), Roundtable Tr. at 56.

68 The Commission acknowledges that a DCM may have already

assigned the functions of a Membership or Participation Committee to

other governing bodies. Therefore, the proposed rules permit the DCM

Board of Directors to delegate the performance of the functions of

the Membership or Participation Committee to one or more other

committees, provided that each such committee meets the applicable

composition requirements. If the Board of Directors chooses to so

delegate, the registered swap execution facility would no longer

need to maintain a Membership or Participation Committee.

—————————————————————————

b. Regulatory Oversight Committee

In the DCM Conflicts of Interest Release, the Commission emphasized

the importance of a DCM Regulatory Oversight Committee (“ROC”):

Properly functioning ROCs should be robust oversight bodies

capable of firmly representing the interests of vigorous, impartial,

and effective self-regulation. ROCs should also represent the

interests and needs of regulatory officers and staff; the resource

needs of regulatory functions; and the independence of regulatory

decisions. In this manner, ROCs will insulate DCM self-regulatory

functions, decisions, and personnel from improper influence, both

internal and external.69

69 See 72 FR 6950, 6951.

The Commission also underscored the importance of the DCM ROC being

—————————————————————————

composed of 100 percent public directors:

The Commission strongly believes that new structural conflicts

of interest within self-regulation require an appropriate response

within DCMs. The Commission further believes that ROCs, consisting

exclusively of public directors, are a vital element of any such

response * * *. ROCs make no direct commercial decisions, and

therefore, have no need for industry directors as members. The

public directors serving on ROCs are a buffer between self-

regulation and those who could bring improper influence to bear upon

it.70

—————————————————————————

70 Id. at 6951.

The Commission proposes (i) maintaining the requirement that DCMs

have a ROC composed of only public directors, and (ii) extending such

requirement to SEFs, which also have self-regulatory obligations.

However, the Commission recognizes that SEFs–but not DCMs–must have a

chief compliance officer (i) to monitor SEF adherence to statutory,

regulatory, and

[[Page 63742]]

self-regulatory requirements and (ii) to resolve conflicts of interest

that may impede such adherence. The chief compliance officer must

report to the SEF Board of Directors (or similar governing body) or the

senior SEF officer.71 Since the Dodd-Frank Act charges the SEF Board

of Directors (or similar governing body) or the senior SEF officer with

the responsibility for overseeing the chief compliance officer

(including with respect to the resolution of conflicts of interest),

the Commission requests comment on whether requiring a SEF to also have

a ROC is necessary.

—————————————————————————

71 See Section 5h(f)(15) of the CEA, as added by Section 733

of the Dodd-Frank Act.

—————————————————————————

iv. Definition of Public Director

The proposed rules include a definition of “public director” that

makes several modifications to the definition of “public director”

that the Commission adopted in 2009.72 Such modifications bring

several aspects of the definition in line with the definition of

“independent director” that the SEC proposed in 2004.73 Since the

Commission is currently, or will in the future, be regulating some of

the same entities as the SEC,74 the modifications to the definition

of “public director” are intended to allow for greater harmonization

with the SEC and currently accepted practices.75

—————————————————————————

72 See, generally, 74 FR 18982 (April 27, 2009).

73 See 69 FR 71127 (December 8, 2004) (the “SEC 2004

Release”).

74 E.g., the Options Clearing Corporation, or a SEF that lists

both CDS indices and single-name CDS contracts.

75 See, e.g., the listing standards of NYSE Euronext or NASDAQ

OMX.

—————————————————————————

First, the proposed rules include a new bright-line test that

prohibits any director that is an officer of another entity, which

entity has a compensation committee, on which any officer of the

registered entity serves, from being a public director. This test is a

part of the independence tests of most listing standards and prevents a

public director from having a financial relationship that would likely

impair his independence. In light of the obvious conflicts that could

arise as a result of such a financial relationship, the Commission

proposes that this additional bright-line test be included in the

definition of “public director.”

Second, the proposed rules would preclude directors that are

employees of members of DCOs, DCMs, and SEFs from being public

directors. The proposed rules would also preclude a director, or an

entity with which the director is an employee, from being a public

director if certain payments are made to such director. In 2009, the

Commission moved the evaluation of employment relationships from the

bright-line test to an analysis under the overarching materiality

standard. The Commission is re-evaluating such move in light of current

concerns regarding further protecting regulatory functions from

directors that are conflicted due to industry ties. The Commission

notes that CBOE Futures Exchange, LLC (“CFE”) submitted a comment

letter to this effect in 2009. In particular, CFE expressed concern

that, as a result of the removal of employment relationships from the

bright-line tests, all required public directors could be member

employees.76 At the time, the Commission felt that such a situation

would be incompatible with the overarching materiality test, even if

such prohibition against employment was not included in the bright-line

test. The Commission seeks comments regarding the re-insertion of

employment relationships in the bright-line tests.

—————————————————————————

76 CFE Comment Letter at 2.

—————————————————————————

Third, the proposed “public director” definition includes an

expanded definition of “immediate family” that includes certain

family members, whether by blood, marriage or adoption, and also

includes any person residing in the home of the director or his

immediate family. Such change attempts to harmonize the “public

director” definition with the SEC 2004 Release and currently accepted

practices.

Finally, the Commission notes that the proposed rules retain the

one-year look-back period. The Commission seeks comment as to whether

such period should be increased, given (i) current concerns regarding

further protecting regulatory functions from directors that are

conflicted due to industry ties, and (ii) the goal of achieving harmony

with the SEC and currently accepted practices.

v. Questions on Committees and the Definition of Public Director

In addition to any questions that the Commission may have posed

above, the Commission seeks comment on the following questions

regarding DCO, DCM, or SEF committees, and the attendant composition

requirements, as well as the definition of public director:

Is each of the committees or panels specified above

necessary or appropriate for the mitigation of the conflicts of

interest described in Section II, or of any conflict of interest not

identified herein? If so, are the composition requirements applicable

to such committees necessary or appropriate to effect such mitigation?

What other ways should the Commission consider defining

“public director”? Are there other circumstances that the Commission

should include in the bright-line materiality tests? Are there

circumstances that the Commission should remove from such tests?

b. Ownership and Voting Limits

As mentioned above, the structural governance requirements mitigate

DCO, DCM, or SEF conflicts of interest by introducing a perspective

independent of competitive, commercial, or industry considerations to

the deliberations of governing bodies. The Commission believes that

limits on ownership of voting equity and the exercise of voting rights

would enhance the structural governance requirements.77 In general,

individuals are compensated for service on the Board of Directors (and

the committees thereof). Voting shareholders elect, directly or

indirectly, members of the Board of Directors. Such members serve as

fiduciaries to all shareholders under state law. Therefore, to ensure

that DCO, DCM, or SEF public directors maintain their independent

perspective (rather than solely representing the competitive,

commercial, or industry considerations of shareholders), the Commission

believes that limits on ownership of voting equity and the exercise of

voting rights are necessary.78

—————————————————————————

77 The Commission proposes not to limit non-voting equity. In

general, a shareholder would have direct influence over a DCO, DCM,

or SEF Board of Directors only if the shareholder has the ability to

exercise voting rights with respect to, e.g., election,

compensation, or removal of directors. However, the Commission notes

that certain Roundtable participants disagree. See, e.g., Comments

from Slavkin (“I actually disagree with what the gentleman from JP

Morgan said when he said that he doesn’t think that having an

economic stake without having a voting interest is a concern. I

think most of us can imagine a situation where someone owns 5

percent of our company and asks us to do something. I don’t think it

matters if that person gets to vote for the board of directors, that

person has real influence regardless of whether it’s formal

influence, there is going to be influence over the decision making,

there’s going to be influence over the strategy and innovation and

the trajectory of the institution in general, so I do think we need

to look at ownership restrictions related to voting interests as

well as related to economic interests even when they’re not tied to

actual voting shares”), Roundtable Tr. at 153. The Commission

requests comment on whether limits on non-voting equity would be

appropriate to the mitigation of conflicts of interest.

78 Certain Roundtable Participants agree. See, e.g., Comments

from Slavkin (“What I’m hearing from the people who support

governance as opposed to real caps on ownership is an argument in

favor of the status quo, and I think that when Congressman Brown–

I’m sorry, when Congressman Lynch proposed this amendment that was

passed in the House legislation, and when Senator Brown proposed,

you know, the Lynch Light version that was passed by the entire

Congress, their intention was to create real change in recognition

of the fact that the current system is broken. It doesn’t work.

That’s why we’re all sitting around this table today. Governance is

a valuable tool, it’s not the only tool, and I think it’s our

responsibility to try to examine other options and I think that the

ownership cap is a real valuable tool that can be used to mitigate

the problems that exist in the current system”), Roundtable Tr. at

124 to 125.

The European Commission Proposal explicitly rejects ownership

limitations. See Section 4.3.4 of the European Commission Proposal

(stating that structural governance requirements “are considered

more effective in addressing any potential conflicts of interest

that may limit the capacity of CCPs to clear, than any other form of

regulation which may have undesirable consequence on market

structures (e.g., limitation of ownership, which would need to

extend also to so-called vertical structures in which exchanges own

a CCP)”).

However, the European Commission Proposal explicitly preserves

the power of the regulator to refuse authorization of a CCP “where,

it is not satisfied as to the suitability of the shareholders or

members that have qualifying holdings in the CCP, taking into

account the need to ensure the sound and prudent management of a

CCP.” See Article 28(2) of the European Commission Proposal.

Further, the European Commission Proposal permits the regulator to

terminate authorization of a CCP where “shareholders or members,

whether direct or indirect, * * * exercise an influence which is

likely to be prejudicial to the sound and prudent management of the

CCP.” See Article 28(1) and (4) of the European Commission

Proposal.

The Commission requests comment as to whether a reservation of

power similar to that contained in the European Commission Proposal

would complement the limits on ownership of voting equity and the

exercise of voting power described above.

—————————————————————————

[[Page 63743]]

i. DCOs

According to the DCM Conflicts of Interest Release, “[t]oday’s

DCMs * * * are vibrant commercial enterprises competing globally in an

industry whose ownership structures, business models, trading

practices, and products are evolving rapidly.” 79 The same

evolution, and the diversity in ownership structures that it engenders,

may be observed in DCOs. Therefore, in acknowledgement of the different

DCO ownership structures that currently or may in the future exist, the

Commission proposes that a DCO choose between one of two alternative

limitations on ownership of voting equity and the exercise of voting

rights. However, the Commission recognizes that circumstances may exist

where neither alternative may be appropriate. Consequently, the

Commission also proposes a waiver procedure.

—————————————————————————

79 72 FR at 6938.

—————————————————————————

1. First Alternative

For the first alternative, the Commission proposes a combination of

a single-member limitation and an aggregate limitation (the “First

Alternative”).

a. Single-Member Limitation

First, the Commission proposes requiring a 20 percent limitation on

the voting equity that any single member (and related persons) 80 may

own.81 Economic research suggests that holding 20 percent voting

equity of an entity may be sufficient for exerting control over an

entity,82 especially if that entity has otherwise diffuse

ownership.83

—————————————————————————

80 The Commission requests comment on whether the definitions

of “related person” in the proposed rules are under or over-

inclusive.

81 Ruben Lee, The Governance of Financial Infrastructure,

Oxford Finance Group, at 256 (January 2010) (stating that

“[m]andatory ownership constraints may prevent a single firm from

exercising undue influence over a market institution that is also an

SRO”).

82 See, generally, e.g., Bae, K-H., J-K and J-M Kang (2002).

“Tunneling or value added? Evidence from mergers by Korean business

groups”, Journal of Finance 57, pp. 2695-2740; Barclay, M. and C.

Holderness (1989) “Private benefits from control of public

corporations”, Journal of Financial Economics 25, pp. 371-395;

Barclay, M. and C. Holderness (1991) “Negotiated block trades and

corporate control”, Journal of Finance 46, pp. 861-878; Barclay, M.

and C. Holderness and D. Sheehan (2001) “The block pricing

puzzle”, Working Paper; Cheung,Y-L, P.R. Rao and A. Stouraitis

(2006) “Tunneling, propping, and expropriation: evidence from

connected party transactions in Hong Kong”, Journal of Financial

Economics 82, pp. 343-386; Claessens, S., S. Djankov, L.H.P. Lang

(2000) “The separation of ownership and control in East Asian

corporations”, Journal of Financial Economics 58, pp. 81-112; Dyck,

A and L. Zingales (2004) “Private benefits of control: An

international comparison”, Journal of Finance 59, pp. 537-600;

Faccio, M., L.H.P Lang, and L. Young (2001) “Dividends and

expropriation”, American Economic Review 91, 54-78; and Morck, R.,

D. Wolfenzon, and B. Yeung (2005) “Corporate governance, economic

entrenchment, and growth”, Journal of Economic Literature, 43, pp.

655-72.

The 20 percent limitation also accords with the proposals in the

SEC 2004 Release. See 69 FR at 71143-44.

83 As mentioned above, CME, for example, is wholly-owned by

CME Group. However, CME Group is a publicly-listed company with

diffuse ownership.

—————————————————————————

As described above, based on Commission experience, control of a

DCO by members collectively has generally permitted the DCO to serve

the purposes of the CEA. However, such description does not necessarily

hold true if, for example, the DCO has demutualized but one member

retains sufficient voting ownership to dominate the DCO.84 Such

domination may result in the DCO relaxing risk management standards

with respect to that member, but imposing more stringent standards on

others.

—————————————————————————

84 Comments from Greenberger (“if we want governance with

teeth, governance with teeth will have ownership limitations. You

can talk about fair representation, board governance, the fact of

the matter is, and I think this will bear its way out in the

comments to you, that does not protect fair and open access * *

*”), Roundtable Tr. 135.

—————————————————————————

Given the increased importance of the DCO in managing systemic

risk, the Commission believes that limiting the amount of voting equity

that any one member may own is appropriate to ensure impartiality in

risk assessment, especially in a DCO with otherwise diffuse ownership.

To prevent evasion of the 20 percent limitation, the Commission

proposes requiring an identical limit on voting rights; and if the DCO

is a subsidiary, extending the limitation to the shareholders of its

direct or indirect parent. If any parent is publicly-listed, then that

parent would have to comply with shareholder voting requirements

promulgated by the SEC or the exchange on which the parent is listed.

b. Aggregate Limitation

Further, the Commission proposes a 40 percent limitation on the

voting equity that the enumerated entities (and their related persons)

may own in the aggregate, regardless of whether such entities are DCO

members.85 As mentioned above, some market participants, investor

advocates, and academics have argued that the enumerated entities may

have commercial incentives to influence DCO risk assessments regarding

(i) whether a swap contract is capable of being cleared, (ii) the

appropriate membership criteria for a swap clearing member, and (iii)

whether a particular entity meets such criteria. The enumerated

entities may directly influence such assessments through participation

on the Risk Management Committee as clearing members, or indirectly

influence such assessments as voting shareholders. In general, the

Commission believes that the enumerated entities would attempt to

influence such assessments as voting shareholders only if the DCO has a

mutualized structure with concentrated ownership.86 In such a

structure, the percentage necessary for control would be higher than

the abovementioned 20 percent, which is sufficient for a diffuse

ownership structure.

—————————————————————————

85 Cf. The Lynch Amendment, which prohibited certain

“restricted owners” from collectively acquiring more than 20

percent of the voting equity in a DCO.

86 See, generally, Barclay, M. and C. Holderness (1989)

“Private benefits from control of public corporations”, Journal of

Financial Economics 25, pp. 371-395. The premise of this paper is

that (i) buyers of equity blocks in a publicly-traded corporation

appear, on average, to pay a premium above market price, and (ii)

such premium reflects the value to the buyer of being able to

influence the decisions of the corporation in a way that is

privately profitable, but not profitable to other shareholders. In

general, the Commission believes that, if a DCO has diffuse

ownership, the outlay that an enumerated entity would need to make

to influence DCO risk assessments as a voting shareholder would

likely exceed the outlay necessary to obtain the same amount of

influence through other means.

—————————————————————————

In counterweight to the commercial incentives that the enumerated

entities may have to influence DCO risk assessments regarding (i),

(ii), and (iii)

[[Page 63744]]

above, the Commission acknowledges that the enumerated entities have

the capital and expertise necessary to manage the risks of clearing

swap contracts.87 Therefore, the Commission believes that a 40

percent aggregate limitation is appropriate, assuming that the DCO has

a mutualized structure with concentrated ownership, because it permits

the enumerated entities to influence, directly or indirectly, but not

control, DCO risk assessments.

—————————————————————————

87 See, e.g., Comments from Jeremy Barnum, Managing Director,

J.P. Morgan (“Barnum”) (“So, on the question of–on the question

of ownership of clearinghouses and expertise and the Lynch

amendment, the–it is very appealing in principle to imagine that

these systemically important financial players into which we are

putting much more risk, could somehow be entirely free of the

nefarious influence of the evil dealers who contributed to the

crisis to quote Mr. Greenberger. But, unfortunately, they are, in

fact, the market participants who need to use the clearinghouses”),

Roundtable Tr. at 115; Comments from Olesky (“I think it’s really

important to recognize–for all of us to recognize–that market

participants really engender many market facilities. And in my

experience in the investment of capital and the knowledge about a

particular space has led directly to innovations and advances both

with Tradeweb and another company I was with, BrokerTech; exchanges;

clearing corps. If you go back in history, those are the folks that

have the capital to support this innovation and the knowledge and

experience to move it forward. And while it’s easy to sort of be

critical of that group, I think it’s also important not to cut off

that flow of capital into innovative organizations that are really

groups of market participants that are investing in these types of

mechanisms * * * Tradeweb was started in 1997 with the internet with

a group of banks. We had four banks initially. Then we sold 100

percent of the company in 2004 and we weren’t owned by any banks for

4 years. Then we had another investment back in, and we had a

minority stake by some banks. I think we really have to separate out

the ownership argument from the governance argument, because it’s

critical to be able to access that capital for entrepreneurs and for

innovators when they’re trying to build these mechanisms”),

Roundtable Tr. at 60 to 61.

—————————————————————————

In conjunction with the 40 percent aggregate limitation, the

Commission proposes requiring a majority vote for the passage of any

shareholder resolution; and if the DCO is a subsidiary, extending the

aggregate limitation and the requirement for a majority vote to the

shareholders of its direct or indirect parent. If any parent is

publicly-listed, then that parent would have to comply with shareholder

voting requirements promulgated by the SEC or the exchange on which the

parent is listed.

2. Second Alternative

For the second alternative, the Commission proposes a 5 percent

limitation on the voting equity that any DCO member or enumerated

entity (whether or not such entity is a DCO member), and the related

persons thereof in each case, may own (the “Second Alternative”).

Such a limitation effectively ensures that neither a DCO member nor an

enumerated entity would have sufficient power, in a concentrated or

diffuse ownership structure, to exert undue influence, as a voting

shareholder, over DCO operations (including with respect to risk

assessments regarding (i), (ii), and (iii) above). Certain Roundtable

participants favor a similar approach.88

—————————————————————————

88 See, e.g., Comments of Roger Liddell, Chief Executive

Officer, LCH.Clearnet Group (“Liddell”) (“To go back to the

question, I think with established organizations, then I think the

concept of some combination of ownership limits and voting caps

actually does make sense. For example, in the [LCH] clearinghouse,

we’ve got a 5 percent voting cap and have done for many years. And

the reason for that was to take away any incentive for anyone to

build up a stake greater than that so that we would be highly

unlikely to ever have less than 20 shareholders. That works well for

us”), Roundtable Tr. at 118 to 119.

—————————————————————————

To prevent evasion of the 5 percent limitation, the Commission

proposes requiring an identical limit on voting rights; and if the DCO

is a subsidiary, extending the limitation to the shareholders of its

direct or indirect parent. If any parent is publicly-listed, then that

parent would have to comply with shareholder voting requirements

promulgated by the SEC or the exchange on which the parent is listed.

3. Waiver

As mentioned above, the Commission believes that there may be

circumstances where the imposition of rigid limitations on ownership or

voting rights may not be appropriate for certain DCO ownership

structures. To provide flexibility, a DCO may request that the

Commission waive individual and/or aggregate ownership or voting rights

limitations by any entity for a reasonable period of time.

The Commission may grant the requested waiver if it determines that

ownership or voting rights limitations are not necessary or appropriate

to:

Improve the governance of the DCO;

Mitigate systemic risk;

Promote competition;

Mitigate conflicts of interest in connection with a swap

dealer’s or major swap participant’s conduct of business with the DCO

with respect to fair and open access and participation and product

eligibility; and

Otherwise accomplish the purposes of the Act.

The Commission may, at any time, revoke the waiver. Upon such

revocation, or at the expiration of the waiver period, any such DCO

shall require divestiture of any relevant entity’s ownership or voting

rights percentages to an individual and/or aggregate level that is

consistent with the First or Second Alternative, or such other level

that the Commission deems appropriate based on the foregoing factors as

set forth in Section 726(b) of the Dodd-Frank Act.

4. Questions on the First and Second Alternatives and the Waiver

The Commission seeks comment on the questions set forth below on

the First and Second Alternatives, as well as the Waiver:

a. First and Second Alternatives

Are the First and Second Alternatives effective for

mitigating, on a prophylactic basis, conflicts of interest arising from

the control that (i) one member may exert as a dominant voting

shareholder of a DCO and (ii) the enumerated entities may collectively

exert as voting shareholders of a DCO (specifically with respect to the

DCO risk assessments referenced above)? What methods, other than the

First and Second Alternatives, should the Commission consider to

mitigate such conflicts of interest? What are the advantages and

disadvantages of such methods?

Under what circumstances would the First and Second

Alternatives not be appropriate for a DCO? For example, should the

First and Second Alternatives apply equally to established DCOs and

start-up DCOs? 89

—————————————————————————

89 See, e.g., Comments from Olesky, supra note 87; Comments

from Liddell (“However, to pick upon the point that Lee Olesky made

before, I think you have to be a little bit careful in how you treat

entrepreneurials or starter ventures because most of the successful

starter ventures have started with a relatively small number of

banks sharing an interest in creating something which then becomes a

lot bigger”), Roundtable Tr. at 119.

—————————————————————————

Are the percentages that the Commission specifies in the

First and Second Alternatives effective for mitigating conflicts of

interest arising from the control that (i) one member may exert as a

dominant voting shareholder of a DCO and (ii) the enumerated entities

may collectively exert as voting shareholders of a DCO? If not, what

alternative percentages should the Commission consider to achieve such

mitigation?

Would the First and Second Alternatives be effective to

mitigate any potential conflicts of interest not discussed herein? If

not, then what other equity ownership and voting limits should the

Commission consider?

Should the limits in the First and Second Alternatives

only apply to clearing members, and not enumerated entities that are

not clearing members? Should the limits in the First and Second

Alternatives apply only to

[[Page 63745]]

DCOs, and not to their parent companies?

b. Waiver

The Commission seeks comment on (i) the circumstances

which may require an alternative ownership structure for a DCO, (ii)

the types of alternative ownership structures of DCOs that may require

flexibility in setting ownership or voting rights levels consistent

with achieving the goal of Section 726 of the Dodd-Frank Act to

mitigate conflicts of interest, and (iii) the appropriate means to

provide such flexibility to the Commission during the DCO application

process if such an organization were to adopt an alternative structure.

ii. DCMs or SEFs

The Commission proposes a 20 percent limitation on the voting

equity that any single member (and related persons) may own in a DCM or

SEF. As mentioned above, economic research suggests that holding 20

percent voting equity of an entity would be sufficient for control,

especially if such entity has otherwise diffuse ownership. Such a

limitation would prevent any one member of a DCM or SEF from dominating

the decision-making process. The Commission also proposes an identical

limitation on voting rights; and if the DCM or SEF is a subsidiary,

extending the limitation to the shareholders of its direct or indirect

parent. If any parent is publicly-listed, then that parent would have

to comply with shareholder voting requirements promulgated by the SEC

or the exchange on which the parent is listed.

The Commission, however, does not propose imposing a limitation on

the voting equity that the enumerated entities may own in the

aggregate. As mentioned above, the Dodd-Frank Act specifically attempts

to encourage sustained competition between multiple DCMs and SEFs over

listing the same swap contract. Based on comments from Roundtable

participants, the enumerated entities would be the most likely source

of funding for a new DCM or SEF.90 In this instance, the Commission

believes that the benefits of sustained competition between new DCMs

and SEFs outweigh the incremental benefit of better governance through

limitations on the aggregate influence of the enumerated entities.91

—————————————————————————

90 See, e.g., Comments of McVey (“I think when it comes to

ownership we have to realize that we are embarking on a major

transformation of OTC markets and all of these entities are going to

need capital to provide the market efficiencies that we’re all

seeking to achieve. And rightly or wrongly, historically a

tremendous amount of the capital for clearing, e-trading, data and

affirmation hubs, has come from the dealer community, and I think it

would be very dangerous to cut off an important source of capital

that can lead to some of the market improvements that we’re all

seeking to achieve”), Roundtable Tr. at 121 to 122.

91 See, generally, Comments of Barnum (“The traditional

vertically integrated exchange model for futures works beautifully

in a whole range of respects for those products from the perspective

of liquidity and systemic risk, but it has a couple problems. It

is–it does seem to create some natural monopoly properties. You can

debate whether they’re severe enough to warrant action or not and

that’s one of the kinds of tensions that needs to be balanced. In

addition, they work very well for the types of products that

naturally attract liquidity on exchanges. The whole premise of this

is that we’re pushing a whole new set of products with different

liquidity characteristics into central counterparties. That means

that you cannot apply exactly the same framework. There are new

challenges that are being introduced. They create tensions. And

those tensions need to be looked at rationally in a continuum

framework that balances different social goods against each

other”), Roundtable Tr. at 116 to 117.

—————————————————————————

1. Questions on DCM or SEF Limits on Ownership and Voting Power

The Commission seeks comment on the questions set forth below on

the DCM or SEF limits on ownership and voting power:

Are the single-member limits on ownership and voting power

effective for mitigating, on a prophylactic basis, the conflicts of

interest that Section II identifies? What methods, other than such

limits, should the Commission consider to mitigate such conflicts of

interest? What are the advantages and disadvantages of such methods?

Should the Commission also consider instituting a waiver

procedure for DCMs and SEFs with respect to the single-member

limitation?

Should the single-member limitation be extended to the

parent company of a DCM or SEF?

IV. Effectiveness and Transition Period

As noted above, the Commission is contemplating rulemakings on

further defining certain entities implicated by the proposed rules

(e.g., swap dealers, major swap participants, and swap execution

facilities). The Commission anticipates that such rulemakings would be

completed by the statutory deadline of July 15, 2011. Therefore, the

Commission is proposing a staggered effective date for the final rules

on mitigation of conflicts of interest. Any portion of the final rules

implicating entities subject to further definition would not become

effective until sixty (60) days after July 15, 2011. Portions of the

final rules not involving such entities would become effective sixty

(60) days after the Federal Register publication of the final rules.

Although the Commission proposes that the final rules become

effective within the time periods specified above, consistent with the

DCM Conflicts of Interest Release, the Commission will permit each

existing DCO, DCM, and SEF to phase-in implementation of the final

rules over two (2) years or two regularly-scheduled Board of Directors

elections. The Commission expects, however, all new DCO, DCM, and SEF

applicants to fully comply with the final rules.

The Commission requests comment on the (i) timing of effectiveness

for the final rules, and (ii) the length of the phase-in implementation

period. The Commission further requests comment on whether new DCO,

DCM, and SEF applicants should have to demonstrate compliance with the

final rules to receive registration.

V. Numbering

As the proposed rules constitute amendments or additions to

Regulation Parts 1, 37, 38, 39, and 40, the Commission anticipates that

the numbering of such proposed rules will change upon completion of

other rulemakings concerning such parts.

VI. Related Matters

a. Regulatory Flexibility Act

The Regulatory Flexibility Act (“RFA”) requires that agencies, in

proposing rules, consider the impact of those rules on “small

entities.” 92 The term “small entity” has the same meaning as the

term “small business” under the RFA 93 and the term “small

business” generally has the same meaning as the term “small business

concern” under section 3 of the Small Business Act.94

—————————————————————————

92 5 U.S.C. 601 et seq.

93 5 U.S.C. 601(6).

94 A “small business concern” is generally defined as one

which is independently owned and operated and which is not dominant

in its field of operation. 15 U.S.C. 632.

—————————————————————————

The proposed rules detailed in this release would only affect DCOs,

DCMs, and SEFs. The Commission has previously determined that DCOs 95

and DCMs 96 are not “small entities” for purposes of the RFA. In

contrast, SEFs constitute a new category of registrant that the Dodd-

Frank Act created. Accordingly, the Commission has not addressed the

question of whether SEFs are, in fact, “small entities” for purposes

of the RFA.

—————————————————————————

95 66 FR 45604, 45609 (August 29, 2001).

96 47 FR 18618, 18619 (April 30, 1982).

—————————————————————————

The Dodd-Frank Act defines a SEF to mean a trading system or

platform in which multiple participants have the

[[Page 63746]]

ability to execute or trade swaps by accepting bids and offers made by

multiple participants in the facility or system, through any means of

interstate commerce, including any trading facility that facilitates

the execution of swaps between persons and is not a designated contract

market.97 The Commission is hereby proposing that SEFs not be

considered to be “small entities” for essentially the same reasons

that DCMs and DCOs have previously been determined not to be small

entities. These reasons include the fact that the Commission designates

a contract market or registers a derivatives clearing organization only

when it meets specific criteria including expenditure of sufficient

resources to establish and maintain adequate self-regulatory programs.

Likewise, the Commission will register an entity as a SEF only after it

has met specific criteria including the expenditure of sufficient

resources to establish and maintain an adequate self-regulatory

program.98 Accordingly, the Commission does not expect the rules, as

proposed herein, to have a significant impact on a substantial number

of small entities. Therefore, the Chairman, on behalf of the

Commission, hereby certifies, pursuant to 5 U.S.C. 605(b), that the

proposed amendments will not have a significant economic impact on a

substantial number of small entities. The Commission invites the public

to comment on whether SEFs covered by these rules should be considered

small entities for purposes of the RFA.

—————————————————————————

97 See Section 721 of the Dodd-Frank Act. The Commission

anticipates proposing regulations that would further specify those

entities that must register as a SEF. The Commission does not

believe that such proposals would alter its determination that a SEF

is not a “small entity” for purposes of the RFA.

98 See Core Principle 2 applicable to SEFs under Section 733

of the Dodd-Frank Act.

—————————————————————————

b. Paperwork Reduction Act

The Paperwork Reduction Act (“PRA”) 99 imposes certain

requirements on Federal agencies in connection with their conducting or

sponsoring any collection of information as defined by the PRA. The

proposed rules do not require a new collection of information on the

part of any entities that would be subject to the proposed rules.

Accordingly, for purposes of the PRA, the Commission certifies that the

proposed rules, if promulgated in final form, would not impose any new

reporting or recordkeeping requirements.

—————————————————————————

99 44 U.S.C. 3501 et seq.

—————————————————————————

c. Cost-Benefit Analysis

Section 15(a) of the CEA 100 requires that the Commission, before

promulgating a regulation or issuing an order, to consider the costs

and benefits of its action. By its terms, Section 15(a) of the CEA does

not require the Commission to quantify the costs and benefits of a new

regulation or to determine whether the benefits of the regulation

outweigh its costs. Rather, Section 15(a) of the CEA simply requires

the Commission to “consider the costs and benefits” of its action.

—————————————————————————

100 7 U.S.C. 19(a).

—————————————————————————

Section 15(a) of the CEA further specifies that costs and benefits

shall be evaluated in light of the following considerations: (1)

Protection of market participants and the public; (2) efficiency and

competition; (3) financial integrity of the futures markets and price

discovery; (4) sound risk management practices; and (5) other public

interest considerations. Accordingly, the Commission could, in its

discretion, give greater weight to any one of the five considerations

and could determine that, notwithstanding its costs, a particular

regulation was necessary or appropriate to protect the public interest

or to effectuate any of the provisions or to accomplish any of the

purposes of the Act.

The Commission has evaluated the costs and benefits of the proposed

rules, in light of the specific provisions of Section 15(a) of the CEA,

as follows:

1. Protection of market participants and the public. The proposed

rules concern governance and conflicts of interest and seek to improve

governance arrangements to prevent conflicts of interest that if not

addressed, would serve the interests of one group of constituents over

other groups, including other market participants and the public. The

proposed rules require governance arrangements that allow the

registered entities to better serve the public interest.

2. Efficiency and competition. The proposed rules provide for the

identification and mitigation of conflicts of interest, which improves

efficiency in decision-making and increases fair access to clearing and

markets which improves competition.

3. Financial integrity of futures markets and price discovery. The

proposed rules facilitate transparency in governance which, in turn,

facilitates transparency in matters governed including increased fair

access to clearing and trading which, in turn, facilitates price

discovery. This decreases risk which, in turn, increases financial

integrity.

4. Sound risk management practices. The proposed rules provide for

participation in decision-making by those who share in the risk

presented by the operation of the registered entity. The governance

arrangements provided by the proposed rules provide for a balance among

different interests (including the public interest) so that risks

presented by one group’s interests will not dominate decision-making in

the organization. This balance should prevent excess risk associated

with any one group’s interests from affecting operations.

5. Other public interest considerations. The proposed rules provide

for governance arrangements for DCOs, DCMs, and SEFs, as well as

methods of mitigating the presence of conflicts of interest, that

should, for the reasons, cited above, operate in the best interests of

the public.

Accordingly, after considering the five factors enumerated above,

the Commission has determined to propose the regulations set forth

below. The Commission invites public comment on its evaluation of the

costs and benefits of the proposed rules. Specifically, commenters are

invited to submit data quantifying the costs and benefits of the

proposed rules with their comment letters.

VII. Text of Proposed Rules

List of Subjects

17 CFR Part 1

Definitions, Directors, Committees.

17 CFR Part 37

Swap execution facility, Conflict of Interest, Membership, Access,

Voting, Ownership.

17 CFR Part 38

Designated contract markets, Conflict of interest, Membership,

Access, Voting, Ownership.

17 CFR Part 39

Registered clearing organization, Conflict of interest, Membership,

Access, Voting, Ownership.

17 CFR Part 40

Governance, Directors, Committees, Conflict of interest.

For the reasons stated in this release, the Commission hereby

amends 17 CFR parts 1, 37, 38, 39, and 40 as follows:

PART 1–GENERAL REGULATIONS UNDER THE COMMODITY EXCHANGE ACT

1. Revise the authority citation for part 1 to read as follows:

[[Page 63747]]

Authority: 7 U.S.C. 1a, 2, 2a, 4, 4a, 6, 6a, 6b, 6c, 6d, 6e, 6f,

6h, 6i, 6j, 6k, 6l, 6m, 6n, 60, 6p, 7, 7a, 7b, 8, 9, 12, 12c, 13a,

13a-1, 16, 16a, 19, 21, 23, and 24 and Sec. 726, Pub. L. 111-203,

124 Stat. 1376.

2. Section 1.3 is amended by adding paragraphs (zz) through (aaa)

to read as follows:

Sec. 1.3 Definitions

(zz) Board of Directors. This term means the Board of Directors or

Board of Governors of a company or organization, or equivalent

governing body.

(aaa) Disciplinary Panel. This term shall be as defined in Sec.

40.9(c)(3)(i).

(bbb) Executive Committee. This term shall mean a committee of the

Board of Directors that may exercise the authority delegated to it by

the Board of Directors with respect to the management of the company or

organization.

(ccc) Public Director. This term means a member of the Board of

Directors (each, a “director”) of a registered derivatives clearing

organization (as defined in Section 1a(15) of the Act), a board of

trade designated as a contract market pursuant to Section 5 of the Act,

or a registered swap execution facility (as defined in Section 1a(50)

of the Act), as applicable, who has been found, by the Board of

Directors of the registered entity, on the record, to have no material

relationship with such registered entity. The Board of Directors must

make such finding upon the nomination or appointment of the director

and as often as necessary in light of all circumstances relevant to

such director, but in no case less than annually.

(1) For purposes of this definition, a “material relationship” is

one that reasonably could affect the independent judgment or decision-

making of the director. In making the finding specified in paragraph

(ccc) of this section, the Board of Directors need not consider

previous service as a director of the registered entity to constitute a

“material relationship.” Circumstances in which a director shall be

considered to have a “material relationship” with the registered

entity include, but are not limited to, the following:

(i) Such director is an officer or an employee of the registered

entity, or an officer or an employee of its affiliate. In this context,

“affiliate” includes parents or subsidiaries of the registered entity

or entities that share a common parent with the registered entity;

(ii) Such director is a member of the registered entity, or a

director, an officer, or an employee of a member. In this context,

“member” is defined according to Section 1a(34) of the Act and any

regulation promulgated thereunder, including, without limitation,

Sec. Sec. 1.3(c) and (q) of this chapter and any successor provisions;

(iii) Such director is an officer of another entity, which entity

has a compensation committee (or similar body) on which any officer of

the registered entity serves;

(iv) Such director, or an entity with which the director is a

partner, an officer, an employee, or a director, receives more than

$100,000 in combined annual payments for legal, accounting, or

consulting services from the registered entity, any affiliate thereof

(as defined in paragraph (ccc)(1)(i) of this section), any member of

the registered entity (as defined in paragraph (ccc)(1)(ii) of this

section), or any affiliate of such member. Compensation for services as

a director of the registered entity or as a director of an affiliate

thereof does not count toward the $100,000 payment limit, nor does

deferred compensation for services rendered prior to becoming a

director of the registered entity, so long as such compensation is in

no way contingent, conditioned, or revocable; or

(v) Notwithstanding paragraph (ccc)(1)(iv) of this section, in the

case of a public director that is a member of the Regulatory Oversight

Committee, the Risk Management Committee (or any subcommittee thereof),

or the Membership or Participation Committee (or any committee serving

a similar function), such director (other than in the capacity of a

member of such committee, any other committee, or the Board of

Directors, in each case, of the registered entity), accepts, directly

or indirectly, any consulting, advisory, or other compensatory fee from

the registered entity, any affiliate thereof (as defined in paragraph

(ccc)(1)(i) of this section), any member of the registered entity (as

defined in paragraph (ccc)(1)(ii) of this section), or any affiliate of

such member, other than deferred compensation for service rendered

prior to becoming a member of the Regulatory Oversight Committee, the

Risk Management Committee (or any subcommittee thereof), or the

Membership or Participation Committee (or any committee serving a

similar function), provided that such compensation is in no way

contingent, conditioned, or revocable.

(vi) Any of the relationships set forth in paragraphs (ccc)(1)(i)

through (ccc)(1)(v) of this section apply to the “immediate family”

of such director, i.e., spouse, parents, children, and siblings, in

each case, whether by blood, marriage, or adoption, or any person

residing in the home of the director or that of his or her “immediate

family.”

(2) All of the disqualifying circumstances described in paragraph

(ccc)(1)(i) through (ccc)(1)(v) of this section shall be subject to a

one-year look back.

(3) A public director of any registered entity specified in

paragraph (ccc) of this section may also serve as a public director of

an affiliate of the registered entity (as defined in paragraph

(ccc)(1)(i) of this section) if he or she otherwise meets the

requirements in paragraph (ccc)(1)(i) through (ccc)(1)(v) of this

section.

(ddd) Membership or Participation Committee. This term shall be as

defined in Sec. 37.19(c)(1)(i), with respect to a registered swap

execution facility, and Sec. 38.851(c)(1)(i), with respect to a

designated contract market.

(eee) Nominating Committee. This term shall be as defined in Sec.

40.9(c)(1)(i).

(fff) Regulatory Oversight Committee. This term shall be as defined

in Sec. 37.19(b)(1), with respect to a registered swap execution

facility, and Sec. 38.851(b)(1), with respect to a designated contract

market.

(ggg) Risk Management Committee. This term shall be as defined in

Sec. 39.13(g)(1).

PART 37–SWAP EXECUTION FACILITIES

3. Revise the authority citation for part 37 to read as follows:

Authority: Sec. 726, Pub. L. 111-203, 124 Stat. 1376.

4. Revise the heading to Part 37 to read as set forth above.

5. Add Sec. 37.19 to read as follows:

Sec. 37.19 Conflicts of Interest.

(a) General. The swap execution facility shall:

(1) Establish and enforce rules to minimize conflicts of interest

in its decision-making process; and

(2) Establish a process for resolving the conflicts of interest.

Nothing in this section shall supersede any requirement applicable to

the registered swap execution facility under Sec. 40.9 of this

chapter.

(b) Regulatory Oversight Committee.

(1) General. A registered swap execution facility shall have a

regulatory oversight committee (the “Regulatory Oversight

Committee”), which shall:

(i) Monitor the regulatory program of the registered entity for

sufficiency, effectiveness, and independence;

(ii) Oversee all facets of the regulatory program, including:

(A) Trade practice and market surveillance; audits, examinations,

and

[[Page 63748]]

other regulatory responsibilities with respect to members (including

ensuring compliance with, if applicable, financial integrity, financial

reporting, sales practice, recordkeeping, and other requirements); and

the conduct of investigations;

(B) Reviewing the size and allocation of the regulatory budget and

resources, and the number, hiring, termination, and compensation of

regulatory personnel;

(C) Reviewing the performance of the Chief Compliance Officer (as

referenced in Section 5h(f)(15) of the Act) and making recommendations

with respect to such performance to the Board of Directors;

(D) Recommending changes that would ensure fair, vigorous, and

effective regulation; and

(E) Reviewing all regulatory proposals prior to implementation and

advising the Board of Directors as to whether and how such changes may

impact regulation.

(2) Reporting. The Regulatory Oversight Committee shall report to

the Board of Directors of the registered swap execution facility.

(3) Composition. The Regulatory Oversight Committee shall be

composed entirely of Public Directors.

(4) Delegation. The Regulatory Oversight Committee shall oversee

the regulatory program of the registered swap execution facility on

behalf of the Board of Directors. The Board of Directors shall delegate

sufficient authority, dedicate sufficient resources, and allow

sufficient time for the Regulatory Oversight Committee to fulfill its

mandate.

(c) Membership or Participation.

(1) Committee.

(i) General. A registered swap execution facility shall have a

membership or participation committee (the “Membership or

Participation Committee”), which shall, at a minimum, perform the

following functions:

(A) Determine the standards and requirements for initial and

continuing membership or participation eligibility;

(B) Review appeals of staff denials of membership or participation

applications; and

(C) Approve rules that would result in different categories or

classes of members or participants receiving disparate access to the

registered swap execution facility.

(ii) Reporting. The Membership or Participation Committee shall

report to the Board of Directors of the registered swap execution

facility.

(iii) Composition. The Membership or Participation Committee shall

be composed of thirty-five percent Public Directors.

(iv) Delegation. The Board of Directors may choose to delegate the

performance of the functions of the Membership or Participation

Committee to one or more other committees, provided that each such

committee meets the composition requirements set forth in paragraph

(c)(1)(iii) of this section. If the Board of Directors chooses to so

delegate, the registered swap execution facility would no longer need

to maintain a Membership or Participation Committee.

(2) Access.

(i) In reviewing appeals of staff denials of membership or

participation applications, the Membership or Participation Committee

(or entity performing the functions of such committee) shall not uphold

any staff denial if the relevant application meets the standards and

requirements that such committee sets forth.

(ii) The Membership or Participation Committee (or entity

performing the functions of such committee) shall not, and shall not

permit the registered swap execution facility to, restrict access or

impose burdens on access in a discriminatory manner, within each

category or class of members or participants or between similarly-

situated categories or classes of members or participants.

(d) Limits on Voting Equity Ownership and the Exercise of Voting

Power.

(1) Definitions. For purposes of this Sec. 37.19(d):

(i) Related Persons means, with respect to any member of a

registered swap execution facility:

(A) Any person that, directly or indirectly, is a parent or

subsidiary of, or shares a common parent with, such member;

(B) Any partner, director, officer, or other employee of such

member;

(C) Any immediate family member of such member, or any immediate

family member of such member’s spouse, in each case, who has the same

home as such member; or

(D) Any immediate family member of the persons enumerated in

paragraph (d)(1)(i)(B) of this section, or any immediate family member

of such person’s spouse, in each case, who has the same home as such

person.

(2) Limits. A registered swap execution facility shall not permit

any member, together with any Related Persons of such member, to:

(i) Beneficially own, directly or indirectly, more than twenty

percent of any class of equity interest of the registered swap

execution facility entitled to vote; or

(ii) Directly or indirectly vote, cause the vote of, give any

consent or proxy with respect to the voting of, or enter into any

shareholder agreement regarding the voting of, any interest in the

registered swap execution facility that exceeds twenty percent of the

voting power of any class of equity interest of the registered swap

execution facility.

(3) Parent Companies. If the registered swap execution facility is

a subsidiary, paragraph (d)(2) of this section shall apply to its

parent, whether direct or indirect, in the same manner as it applies to

the registered swap execution facility. If any parent is publicly-

listed on a domestic exchange, then such parent must follow the voting

requirements promulgated by the Securities and Exchange Commission or

the entity on which such parent is listed.

(4) Remediation. A registered swap execution facility must have

rules addressing the manner in which it would remediate any breach of

the limits set forth in paragraph (d)(2) of this section. Such rules

must specify, at a minimum:

(i) The manner in which the registered swap execution facility

would redeem any equity interest that a member or a Related Person

purchased in excess of the limits set forth in paragraph (d)(2) of this

section;

(ii) The manner in which the registered swap execution facility

would disregard any votes cast in excess of such limits; and

(iii) The manner in which the registered swap execution facility

would cause any breach of such limits to be reported to the Chief

Compliance Officer (as referenced in Section 5h(f)(15) of the Act).

PART 38–DESIGNATED CONTRACT MARKETS

6. Revise the authority citation for part 38 to read as follows:

Authority: 7 U.S.C. 2, 5, 6, 6c, 7, 7a-2 and 12a and Sec. 726,

Pub. L. 111-203, 124 Stat. 1376.

7. Section 38.1 is amended by adding a new sentence to the end of

the section to read as follows:

Sec. 38.1 Scope.

* * * Nothing in this Part 38 shall apply to a board of trade

designated as a contract market pursuant to Section 5f of the Act.

8. Add Sec. 38.851 to read as follows:

Sec. 38.851 Conflicts of interest.

(a) General. A designated contract market shall establish and

enforce rules

[[Page 63749]]

to minimize conflicts of interest in its decision-making process and

establish a process for resolving any conflicts of interest. Nothing in

this section shall supersede any requirement applicable to the

designated contract market under Sec. 40.9 of this chapter.

(b) Regulatory Oversight Committee.

(1) General. A designated contract market shall have a regulatory

oversight committee (“Regulatory Oversight Committee”), which shall:

(i) Monitor the regulatory program of the registered entity for

sufficiency, effectiveness, and independence;

(ii) Oversee all facets of the regulatory program, including:

(A) Trade practice and market surveillance; audits, examinations,

and other regulatory responsibilities with respect to members

(including ensuring compliance with, if applicable, financial

integrity, financial reporting, sales practice, recordkeeping, and

other requirements); and the conduct of investigations;

(B) Reviewing the size and allocation of the regulatory budget and

resources, and the number, hiring, termination, and compensation of

regulatory personnel;

(C) Supervising the chief regulatory officer of the designated

contract market, who will report directly to the Regulatory Oversight

Committee;

(D) Recommending changes that would ensure fair, vigorous, and

effective regulation; and

(E) Reviewing all regulatory proposals prior to implementation and

advising the Board of Directors as to whether and how such changes may

impact regulation.

(2) Reporting. The Regulatory Oversight Committee shall report to

the Board of Directors of the designated contract market.

(3) Composition. The Regulatory Oversight Committee shall be

composed entirely of Public Directors.

(4) Delegation. The Regulatory Oversight Committee shall oversee

the regulatory program of the designated contract market on behalf of

the Board of Directors. The Board of Directors shall delegate

sufficient authority, dedicate sufficient resources, and allow

sufficient time for the Regulatory Oversight Committee to fulfill its

mandate.

(c) Membership or Participation.

(1) Committee.

(i) General. A designated contract market shall have a membership

or participation committee (“Membership or Participation Committee”),

which shall, at a minimum, perform the following functions:

(A) Determine the standards and requirements for initial and

continuing membership or participation eligibility;

(B) Review appeals of staff denials of membership or participation

applications; and

(C) Approve rules that would result in different categories or

classes of members or participants receiving disparate access to the

designated contract market.

(ii) Reporting. The Membership or Participation Committee shall

report to the Board of Directors of the designated contract market.

(iii) Composition. The Membership or Participation Committee shall

be composed of thirty-five percent Public Directors.

(iv) Delegation. The Board of Directors may choose to delegate the

performance of the functions of the Membership or Participation

Committee to one or more other committees, provided that each such

committee meets the composition requirements set forth in paragraph

(c)(1)(iii) of this section. If the Board of Directors chooses to so

delegate, the registered swap execution facility would no longer need

to maintain a Membership or Participation Committee.

(2) Access.

(i) In reviewing appeals of staff denials of membership or

participation applications, the Membership or Participation Committee

(or entity performing the functions of such committee) shall not uphold

any staff denial if the relevant application meets the standards and

requirements that such committee sets forth.

(ii) The Membership or Participation Committee (or entity

performing the functions of such committee) shall not, and shall not

permit the registered swap execution facility to, restrict access or

impose burdens on access in a discriminatory manner, within each

category or class of members or participants or between similarly-

situated categories or classes of members or participants.

(d) Limits on Voting Equity Ownership and the Exercise of Voting

Power.

(1) Definitions. For purposes of this Sec. 38.851(d):

(i) Related Persons means, with respect to any member of a

designated contract market:

(A) Any person that, directly or indirectly, is a parent or

subsidiary of, or shares a common parent with, such member;

(B) Any partner, director, officer, or other employee of such

member;

(C) Any immediate family member of such member, or any immediate

family member of such member’s spouse, in each case, who has the same

home as such member; or

(D) Any immediate family member of the persons enumerated in

paragraph (d)(1)(i)(B) of this section, or any immediate family member

of such person’s spouse, in each case, who has the same home as such

person.

(2) Limits. A designated contract market shall not permit any

member, together with any Related Persons of such member, to:

(i) Beneficially own, directly or indirectly, more than twenty

percent of any class of equity interest of the designated contract

market entitled to vote; or

(ii) Directly or indirectly vote, cause the vote of, give any

consent or proxy with respect to the voting of, or enter into any

shareholder agreement regarding the voting of, any interest in the

designated contract market that exceeds twenty percent of the voting

power of any class of equity interest of the designated contract

market.

(3) Parent Companies. If the designated contract market is a

subsidiary, paragraph (d)(2) of this section shall apply to its parent,

whether direct or indirect, in the same manner as it applies to the

designated contract market. If any parent is publicly-listed on a

domestic exchange, then such parent must follow the voting requirements

promulgated by the Securities and Exchange Commission or the entity on

which such parent is listed.

(4) Remediation. A designated contract market must have rules

addressing the manner in which it would remediate any breach of the

limits set forth in paragraph (d)(2) of this section. Such rules must

specify, at a minimum:

(i) The manner in which the designated contract market would redeem

any equity interest that a member or a Related Person purchased in

excess of the limits set forth in paragraph (d)(2) of this section;

(ii) The manner in which the designated contract market would

disregard any votes cast in excess of such limits; and

(iii) The manner in which the designated contract market would

cause any breach of such limits to be reported to the chief regulatory

officer.

PART 39–DERIVATIVES CLEARING ORGANIZATIONS

9. Revise the authority citation for part 39 read as follows:

Authority: 7 U.S.C. 7b and Sec. 726, Pub. L. 111-203, 124 Stat.

1376.

10. Add Sec. 39.13 to read as follows:

[[Page 63750]]

Sec. 39.13 Risk Management.

(a) through (g) [Reserved]

(g) Risk Management Committee.

(1) General. A derivatives clearing organization shall have a risk

management committee (the “Risk Management Committee”), which shall,

at a minimum, perform the following functions:

(i) Advise the Board of Directors on significant changes to the

derivatives clearing organization’s risk model and default procedures;

(ii) Determine the standards and requirements for initial and

continuing clearing membership eligibility;

(iii) Approve or deny (or review approvals or denials of) clearing

membership applications;

(iv) Determine products eligible for clearing; and

(v) Review the performance of the Chief Compliance Officer (as

referenced in Section 5b(i) of the Act) and make recommendations with

respect to such performance to the Board of Directors.

(2) Reporting. The Risk Management Committee shall report to the

Board of Directors of the derivatives clearing organization.

(3) Composition.

(i) The Risk Management Committee shall be composed of at least

thirty-five percent Public Directors of a derivatives clearing

organization and at least ten percent representatives of customers. In

this context, a “customer” means any customer of a clearing member,

including, without limitation:

(A) Any “customer” or “commodity customer” within the meaning

of Sec. 1.3(k) of this chapter;

(B) Any “foreign futures or foreign options customer” within the

meaning of Sec. 30.1(c) of this chapter; and

(C) Any customer entering into a cleared swap (as defined in

Section 1a(7) of the Act).

(ii) The remaining members of such Risk Management Committee (or

subcommittee thereof as described in paragraph (g)(5) of this section)

may be, in the discretion of the derivatives clearing organization,

representatives of clearing members. No such member shall be an

employee of the derivatives clearing organization.

(iii) The Chairman of the Risk Management Committee (or

subcommittee thereof as described in paragraph (g)(5) of this section)

shall be a Public Director.

(4) Meetings. The Risk Management Committee shall hold regular

meetings. The Committee may invite employees of the derivatives

clearing organization to attend its meetings in a non-voting capacity.

(5) Delegation. The Risk Management Committee may delegate, in

writing, the performance of the functions enumerated in paragraph

(g)(1)(ii) to (iv) of this section to a subcommittee, provided that

such subcommittee meets the composition requirements set forth in

paragraph (g)(3) of this section. If the Risk Management Committee

chooses to so delegate, then it would no longer be subject to such

composition requirements.

(6) Discretion.

(i) No decision of a subcommittee with delegated authority under

paragraph (g)(5) of this section, pertaining to the functions

enumerated in paragraph (g)(1)(ii) to (iv) of this section, may be

subject to the approval of, or otherwise restricted or limited by, a

body other than the Board of Directors or the Risk Management Committee

of the derivatives clearing organization, including, without

limitation, any advisory committee.

(ii) No decision of the Risk Management Committee pertaining to the

functions enumerated in paragraph (g)(1)(ii) to (iv) of this section,

may be subject to the approval of, or otherwise restricted or limited

by, a body other than the Board of Directors of the derivatives

clearing organization, including, without limitation, any advisory

committee.

11. Add Sec. 39.25 to read as follows:

Sec. 39.25 Conflicts of interest.

(a) General. (1) A derivatives clearing organization shall

establish and enforce rules to minimize conflicts of interest in its

decision-making process and establish a process for resolving any

conflicts of interest.

(2) Governance arrangements for derivatives clearing organizations

should be clear and transparent and be designed to promote the safety

and efficiency of the derivatives clearing organization, to support the

stability of the broader financial system and other relevant public

interest considerations, and to support the objectives of relevant

stakeholders.

(3) Nothing in this section shall supersede any requirement

applicable to the derivatives clearing organization under Sec. 40.9 of

this chapter.

(b) Limits on Voting Equity Ownership and the Exercise of Voting

Power.

(1) Definitions. For purposes of this Sec. 39.25(b):

(i) Affiliate means any person that, directly or indirectly,

controls, is controlled by, or is under common control with, another

person.

(ii) Enumerated Entities means:

(A) A bank holding company (as defined in Section 2 of the Bank

Holding Company Act of 1956 (12 U.S.C. 1841)) with total consolidated

assets of $50,000,000,000 or more,

(B) A nonbank financial company (as defined in Section 102 of the

Dodd-Frank Wall Street Reform and Consumer Protection Act) supervised

by the Board of Governors of the Federal Reserve System,

(C) An Affiliate of such bank holding company or nonbank financial

company,

(D) A swap dealer (as defined in Section 1a(49) of the Act and any

regulations promulgated thereunder),

(E) A major swap participant (as defined in Section 1a(33) of the

Act and any regulations promulgated thereunder), and

(F) An associated person of a swap dealer or major swap participant

(as defined in Section 1a(3) of the Act and any regulations promulgated

thereunder).

(iii) Related Persons means, with respect to any person:

(A) An Affiliate of such person;

(B) Any partner, director, officer, or other employee of such

person;

(C) Any immediate family member of such person, or any immediate

family member of such person’s spouse, in each case, who has the same

home as such person; or

(D) Any immediate family member of the persons enumerated in

paragraph (b)(1)(iii)(B) of this section, or any immediate family

member of such person’s spouse, in each case, who has the same home as

such person.

(2) Limits. A derivatives clearing organization shall choose to

comport with either paragraph (b)(2)(i) or (b)(2)(ii) of this section:

(i)(A) The derivatives clearing organization shall not permit any

member, together with any Related Persons of such member, to:

(1) Beneficially own, directly or indirectly, more than twenty

percent of any class of equity interest of the derivatives clearing

organization entitled to vote; or

(2) Directly or indirectly vote, cause the vote of, give any

consent or proxy with respect to the voting of, or enter into any

shareholder agreement regarding the voting of, any interest in the

derivatives clearing organization that exceeds twenty percent of the

voting power of any class of equity interest of the derivatives

clearing organization.

(B) Additionally, a derivatives clearing organization shall not

permit the Enumerated Entities (whether or not they are clearing

members), together with any Related Persons of such Enumerated

Entities, to collectively:

(1) Own, on a beneficial basis, directly or indirectly, more than

forty percent of

[[Page 63751]]

any class of equity interest of the derivatives clearing organization

entitled to vote; or

(2) Directly or indirectly vote, cause the vote of, give any

consent or proxy with respect to the voting of, or enter into any

shareholder agreement regarding the voting of, any interest in the

derivatives clearing organization that exceeds forty percent of the

voting power of any class of equity interest of the derivatives

clearing organization.

(C) The derivatives clearing organization shall ensure that no

resolution or similar measure on which the Enumerated Entities are

entitled to vote shall be passed by less than a majority of all

outstanding equity interests similarly entitled to vote.

(ii) The derivatives clearing organization shall not permit any

member or any Enumerated Entity (whether or not such entity is a

member), together with any Related Persons in each case thereof, to:

(A) Beneficially own, directly or indirectly, more than five

percent of any class of equity interest of the derivatives clearing

organization entitled to vote; or

(B) Directly or indirectly vote, cause the vote of, give any

consent or proxy with respect to the voting of, or enter into any

shareholder agreement regarding the voting of, any interest in the

derivatives clearing organization that exceeds five percent of the

voting power of any class of equity interest of the derivatives

clearing organization.

(3) Waiver.

(i) A derivatives clearing organization may request that the

Commission waive the requirements set forth in paragraph (b)(2) of this

section.

(ii)(A) The Commission may grant a waiver for a period of time that

it deems reasonable if, upon a showing by a derivatives clearing

organization, the Commission determines that, with respect to the

derivatives clearing organization, the requirements set forth in

paragraph (b)(2) of this section are not necessary or appropriate to:

(1) Improve the governance of the derivatives clearing

organization;

(2) Mitigate systemic risk;

(3) Promote competition;

(4) Mitigate conflicts of interest in connection with a swap dealer

or major swap participant’s conduct of business with the derivatives

clearing organization, including with respect to Section 2(h)(1)(B) and

Section 5b(c)(2)(c) of the Act; and

(5) Otherwise accomplish the purposes of the Act.

(B) The Commission may, at any time, revoke the waiver upon its own

motion. Upon such revocation, or at the expiration of the waiver

period, the derivatives clearing organization shall require all equity

holders to comport, through divestiture or other means, with the

requirements set forth in paragraph (b)(2) of this section.

(4) Parent Companies. If the derivatives clearing organization is a

subsidiary, paragraph (b)(2) of this section shall apply to its parent,

whether direct or indirect, in the same manner as it applies to the

derivatives clearing organization. If any parent is publicly listed on

a domestic exchange, then such parent must follow the voting

requirements promulgated by the Securities and Exchange Commission or

the entity on which such parent is listed.

(5) Remediation. A derivatives clearing organization must have

rules addressing the manner in which it would remediate any breach of

the limits set forth in paragraph (b)(2) of this section. Such rules

must specify, at a minimum:

(i) The manner in which the derivatives clearing organization would

redeem any equity interest that a member, the Enumerated Entities, or a

Related Person in each case thereof, purchased in excess of the limits

set forth in paragraph (b)(2) of this section;

(ii) The manner in which the derivatives clearing organization

would disregard any votes cast in excess of such limits; and

(iii) The manner in which the derivatives clearing organization

would cause any breach of such limits to be reported to the Chief

Compliance Officer (as referenced in Section 5b(i) of the Act).

PART 40–PROVISIONS COMMON TO REGISTERED ENTITIES

1. Revise the authority citation for part 40 to read as follows:

Authority: 7 U.S.C. 1a, 2, 5, 6, 7, 7a, 8, and 12a, and Sec.

726, Pub. L. 111-203, 124 Stat. 1376.

2. Add Sec. 40.9 to read as follows:

Sec. 40.9 Governance.

(a) General. (1) Nothing in this section shall apply to a board of

trade designated as a contract market pursuant to Section 5f of the

Act.

(2) Capitalized terms not defined herein shall have the meanings

assigned to them in Sec. 1.3 of this chapter.

(3) Nothing in this section shall supersede any requirement

applicable to the registered entity under Parts 37, 38, or 39 of this

chapter.

(b) The Board of Directors.

(1) General.

(i) The Board of Directors of a registered derivatives clearing

organization, a designated contract market, or a registered swap

execution facility shall be composed of at least thirty-five percent,

but no less than two, Public Directors.

(ii) The roles and responsibilities of such Board of Directors must

be clearly articulated, especially in respect of the manner in which

the Board of Directors ensures that a registered entity referenced in

paragraph (b)(1)(i) of this section complies with all statutory,

regulatory, and self-regulatory responsibilities under the Act and the

regulations promulgated thereunder.

(2) Parent Companies.

(i) For purposes of paragraph (b)(2) of this section, “operate”

shall mean the direct exercise of control (including through the

exercise of veto power) over the day-to-day business operations of a

registered entity specified in paragraph (b)(1)(i) of this section by

the sole or majority shareholder of such registered entity, whether

through the ownership of voting equity, by contract, or otherwise. The

term “operate” shall not prohibit an entity, acting as the sole or

majority shareholder of such registered entity, from exercising its

rights as a shareholder under any contract, agreement, or other legal

obligation.

(ii) A registered entity specified in paragraph (b)(1)(i) of this

section shall not permit itself to be operated by any entity unless

such entity agrees that:

(A) Paragraph (b)(1) of this section shall apply to such entity in

the same manner as it applies to the registered entity;

(B) The officers, directors, employees, and agents of such entity

shall be deemed to be the officers, directors, employees, and agents of

the registered entity, and shall thereby be subject to the authority of

the Commission pursuant to the Act and the regulations promulgated

thereunder; and

(C) Any books and records of such entity relating to such operation

shall be deemed to be the books and records of the registered entity

for purposes of the Act and the regulations promulgated thereunder.

Such books and records shall be subject at all times to inspection and

copying by the Commission, regardless of whether such books and records

contain confidential information, as long as such entity operates the

registered entity.

(3) Expertise. The members of the Board of Directors, including

Public Directors, of each registered entity specified in paragraph

(b)(1)(i) of this section, shall be of sufficiently good repute and,

where applicable, have sufficient expertise in financial services, risk

management, and clearing services.

[[Page 63752]]

(4) Compensation. The compensation of the Public Directors and

other non-executive members of the Board of Directors of a registered

entity specified in paragraph (b)(1)(i) of this section shall not be

linked to the business performance of such registered entity.

(5) Annual Self-Review. The Board of Directors of a registered

entity specified in paragraph (b)(1)(i) of this section shall review

its performance and that of its individual members annually. It should

consider periodically using external facilitators for such reviews.

(6) Board Member Removal. A registered entity specified in

paragraph (b)(1)(i) of this section shall have procedures to remove a

member from the Board of Directors, where the conduct of such member is

likely to be prejudicial to the sound and prudent management of the

registered entity.

(c) Committees and Panels.

(1) Nominating Committee.

(i) General. Each registered derivatives clearing organization,

designated contract market, or registered swap execution facility must

have a nominating committee (“Nominating Committee”), which shall, at

a minimum:

(A) identify individuals qualified to serve on the Board of

Directors, consistent with criteria approved by the Board of Directors,

and with the composition requirements set forth in this section; and

(B) Administer a process for the nomination of individuals to the

Board of Directors.

(ii) Reporting. The Nominating Committee shall report to the Board

of Directors of the registered entity.

(iii) Composition. The Nominating Committee shall be composed of at

least fifty-one percent Public Directors. The chair of the Nominating

Committee shall be a Public Director.

(2) Executive Committee. Any Executive Committee of a registered

derivatives clearing organization, designated contract market, or

registered swap execution facility shall be composed of at least

thirty-five percent, but no less than two, Public Directors.

(3) Disciplinary Panels.

(i) General. Each registered derivatives clearing organization,

designated contract market, or registered swap execution facility must

have one or more disciplinary panels (each, a “Disciplinary Panel”),

each of which shall be responsible for conducting hearings, rendering

decisions, and imposing sanctions with respect to disciplinary matters.

(ii) Composition. Each Disciplinary Panel shall include at least

one person who would not be disqualified from serving as a Public

Director by Sec. 1.3(ccc)(1)(i)-(vi) and (2) of this chapter (a

“Public Participant”). Such Public Participant shall chair each

Disciplinary Panel. In addition, any registered entity specified in

paragraph (c)(3)(i) of this section shall adopt rules that would, at a

minimum:

(A) Further preclude any group or class of participants from

dominating or exercising disproportionate influence on a Disciplinary

Panel and

(B) Prohibit any member of a Disciplinary Panel from participating

in deliberations or voting on any matter in which the member has a

financial interest.

(iii) Appeals. If the rules of the registered entity provide that

the decision of a Disciplinary Panel may be appealed to another

committee of the Board of Directors (or similar body), then such

committee must also include at least one Public Participant, and such

Public Participant must chair the committee.

(iv) Exception. Notwithstanding the foregoing, paragraphs

(c)(3)(ii) through (c)(3)(iii) of this section do not apply to a

Disciplinary Panel convened for cases solely involving decorum or

attire.

(v) Delegation. With respect to a registered derivatives clearing

organization, the Board of Directors may delegate to the Risk

Management Committee the performance of the functions of the

Disciplinary Panel. If the Board of Directors so delegates:

(A) The registered derivatives clearing organization need no longer

maintain a Disciplinary Panel, but

(B) Paragraph (c)(3)(iii) of this section would still apply to any

committee (or similar body) to which a decision of the Risk Management

Committee may be appealed.

Issued in Washington, DC, on October 1, 2010, by the Commission.

David A. Stawick,

Secretary of the Commission.

Concurring Statement of Commissioner Scott D. O’Malia

October 1, 2010 Public Meeting

I concur in the Commission’s proposal of rules pursuant to

Section 726 of the Dodd-Frank Act (the “Act”). However, I have a

number of concerns associated with the prescriptiveness of the

proposed conflict of interest rules. I believe, given the goals of

the Act, it is appropriate to consider more flexible ownership

structures and voting rights levels as well as the availability of

waivers for derivatives clearing organizations (“DCOs”).

Ownership and Voting Limits on DCOs

A main goal of the Act is to mitigate systemic risk in the U.S.

financial system by imposing a mandatory clearing requirement on

swaps. Additionally, the business of clearing is serious and

financially complex. I am concerned that the proposed rules may not

properly consider the effect on mitigation of systemic risk,

competition, and capital formation in the DCO space, or afford the

Commission with the necessary flexibility to achieve those outcomes.

Given that the Commission has yet to consider any new DCO

applications under the Act, it is extremely unwise to conduct an

experiment with the ownership structure of DCOs.

Second, a stated goal of the Act was to provide all market

participants with fair, open, and non-discriminatory access to DCOs.

To achieve that end, Congress included Open Access and Participant

and Product Eligibility provisions in the Act.101 Each provision

addresses and attempts to eliminate the potential for clearing

entities to use ownership control to obstruct market participants

from gaining access to a DCO. Rather than utilizing the limited and

inflexible ownership caps in the proposed rules, I believe that the

open access and eligibility provisions will be more effective in

achieving the Act’s goals of fair, open, and non-discriminatory

access to DCOs.

—————————————————————————

101 Section 2(h)(1)(B) and Section 5b(c)(2)(c) of the Act.

—————————————————————————

Third, an overarching goal of the Act is the international

harmonization of financial regulation. I believe that it’s

especially important for the Commission to harmonize its rules with

those of foreign regulators in order to prevent regulatory

arbitrage. With that said, the European Commission released

(September 15, 2010) a proposal on financial reform which does not

place individual or aggregate ownership limits on DCOs under

European Union jurisdiction.

For the aforementioned reasons, I am in favor of a more flexible

approach to limitations on DCO ownership and voting rights,

including the availability of a full waiver for individual and

aggregate ownership or voting limits on swap dealers or major swap

participants that hold or desire to hold debt or equity positions in

DCOs.

Public Directors

I fully support the Commission’s decision to require a

registered entity to have its board of directors and certain other

committees composed of thirty-five percent (35%) public directors.

This standard is consistent with the Commission’s previous core

principle 15 for designated contract markets (“DCMs”). The

Commission thoroughly vetted this percentage with the public in a

recent rulemaking and it concluded that having a board of directors

for DCMs composed of thirty-five percent (35%) public directors was

neither overly burdensome nor cost prohibitive. Today’s proposed

rulemaking also raises the question as to whether it is desirable to

expand the existing rule from thirty-five percent (35%) up to fifty-

one percent (51%) for DCMs, DCOs, and swap execution facilities. I

am interested to know how this proposal would enhance the governance

of the existing board structures of certain registered entities, and

more specifically, how it would expand the clearing and risk

management expertise of a DCO.

[[Page 63753]]

I strongly encourage the public to closely analyze the language

of each proposed rule and to provide the Commission with

constructive and detailed comments on each of them. In particular, I

am interested to know (i) what effect the Commission’s proposed

rules on voting and ownership limitations will have on competition,

raising capital, and managing risk, and (ii) whether or not the open

access and eligibility provisions in Sections 2(h)(1)(B) and

5b(c)(2)(c) of the Act would be a more effective method for the

Commission to expand access to clearing, rather than placing limits

on the voting and ownership of DCOs.

Proposed Requirements for Derivatives Clearing Organizations,

Designated Contract Markets, and Swap Execution Facilities Regarding

the Mitigation of Conflicts of Interest

Commissioner Jill E. Sommers, Dissenting

The Commission is voting today on a proposal to implement two

sections of the Dodd-Frank Act regarding the governance of CFTC

regulated trading venues and clearinghouses that trade or clear

swaps and how to mitigate conflicts of interest that may arise in

connection with ownership interests that certain entities may have

in these registrants. Specifically, Section 725(d) of the Act

directs the Commission to:

Adopt rules mitigating conflicts of interest in connection with

the conduct of business by a swap dealer or a major swap participant

with at [DCO], [DCM], or a [SEF] that clears or trades swaps in

which the swap dealer or major swap participant has a material debt

or material equity investment.

Section 726 of the Act provides that the Commission shall adopt

rules which “may” include numerical limits on the degree of

control or voting rights that certain enumerated entities may

possess with respect to DCOs, DCMs and SEFs if the Commission

determines, after a review:

That such rules are necessary or appropriate to improve the

governance of, or to mitigate systemic risk, promote competition, or

mitigate conflicts of interest in connection with a swap dealer or

major swap participant’s conduct of business with, a [DCO], [DCM],

or [SEF] that clears or posts swaps or makes swaps available for

trading and in which such swap dealer or major swap participant has

a material debt or equity investment.

I recognize that these provisions direct the Commission to adopt

strong governance rules to mitigate conflicts of interest in

connection with the interaction between swap dealers and major swap

participants and DCOs, DCMs and SEFs in which they have a material

debt or equity investment. In my opinion, however, the voting equity

restrictions being proposed are not necessary or appropriate to

mitigate the perceived conflicts and in fact, may do more harm than

good to the emerging marketplace for trading and clearing swaps.

In 2009, after more than two years of study, the Commission

finalized acceptable practices to provide a safe harbor for

complying with Core Principle 15 for DCMs dealing with conflicts of

interest. I support making those acceptable practices mandatory for

DCMs, DCOs and SEFs, as augmented by some of the additional

provisions being proposed today, such as the Risk Management

Committee for DCOs. I believe that strong governance rules, coupled

with the Commission’s ultimate authority to determine which swaps

must be cleared, under Section 723 of Dodd-Frank, is sufficient to

ensure that swaps that should be listed for trading and cleared will

be listed for trading and cleared.

I have grave concerns that the proposed limitations on voting

equity, especially those proposed for enumerated entities in the

aggregate with respect to DCOs, may stifle competition by preventing

new DCMs, DCOs and SEFs that trade or clear swaps from being formed.

The Commission recognizes in the preamble to the proposal that the

enumerated entities will be the most likely source of funding for

new DCMs and SEFs and thus chose not to propose the aggregate limits

for trading venues. I believe the same logic applies with even

greater force for DCOs. I am equally concerned that a number of

recent entrants into the swaps trading and clearing space will

potentially be required to disband their operations if they are

unable to attract the required amount of non-voting equity within

the two-year/two board election cycles proposed. I also note that

the European Commission explicitly rejected ownership limitations in

its proposal for regulating OTC derivatives announced September 15th

because such limitations may have negative consequences for market

structures. I agree. And I hope that we will be mindful of global

consistency as we move forward. The marketplace for trading and

clearing swaps is in its infancy. I strongly believe that the

limitations the Commission is proposing will have the effect of

inhibiting emerging competition rather than promoting it. I

therefore cannot support today’s proposal.

[FR Doc. 2010-26220 Filed 10-15-10; 8:45 am]

BILLING CODE P

Last Updated: October 18, 2010