[ad_1]
Federal Register, Volume 77 Issue 152 (Tuesday, August 7, 2012)[Federal Register Volume 77, Number 152 (Tuesday, August 7, 2012)]
[Proposed Rules]
[Pages 47169-47222]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2012-18382]
[[Page 47169]]
Vol. 77
Tuesday,
No. 152
August 7, 2012
Part II
Commodity Futures Trading Commission
———————————————————————–
17 CFR Part 50
Clearing Requirement Determination Under Section 2(h) of the CEA;
Proposed Rule
Federal Register / Vol. 77 , No. 152 / Tuesday, August 7, 2012 /
Proposed Rules
[[Page 47170]]
———————————————————————–
COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 50
RIN 3038-AD86
Clearing Requirement Determination Under Section 2(h) of the CEA
AGENCY: Commodity Futures Trading Commission.
ACTION: Notice of proposed rulemaking.
———————————————————————–
SUMMARY: The Commodity Futures Trading Commission (Commission or CFTC)
is proposing regulations to establish a clearing requirement under new
section 2(h)(1)(A) of the Commodity Exchange Act (CEA or Act), enacted
under Title VII of the Dodd-Frank Wall Street Reform and Consumer
Protection Act (Dodd-Frank Act). The regulations would require that
certain classes of credit default swaps (CDS) and interest rate swaps
(IRS), described herein, be cleared by a derivatives clearing
organization (DCO) registered with the Commission. The Commission also
is proposing regulations to prevent evasion of the clearing requirement
and related provisions.
DATES: Comments must be received on or before September 6, 2012.
ADDRESSES: You may submit comments, identified by RIN number 3038-AD86,
by any of the following methods:
The agency’s Web site, at http://comments.cftc.gov. Follow
the instructions for submitting comments through the Web site.
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.
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.
Please submit your comments using only one method.
All comments must be submitted in English, or if not, accompanied
by an English translation. Comments will be posted as received to
http://www.cftc.gov. You should submit only information that you wish
to make available publicly. If you wish the Commission to consider
information that you believe is exempt from disclosure under the
Freedom of Information Act, a petition for confidential treatment of
the exempt information may be submitted according to the procedures
established in Sec. 145.9 of the Commission’s regulations.1
—————————————————————————
1 17 CFR 145.9. Commission regulations referred to herein are
found on the Commission’s Web site.
—————————————————————————
The Commission reserves the right, but shall have no obligation, to
review, pre-screen, filter, redact, refuse or remove any or all of your
submission from http://www.cftc.gov that it may deem to be
inappropriate for publication, such as obscene language. All
submissions that have been redacted or removed that contain comments on
the merits of the rulemaking will be retained in the public comment
file and will be considered as required under the Administrative
Procedure Act and other applicable laws, and may be accessible under
the Freedom of Information Act.
FOR FURTHER INFORMATION CONTACT: Sarah E. Josephson, Deputy Director,
202-418-5684, [email protected]; Brian O’Keefe, Associate Director,
202-418-5658, [email protected]; or Erik Remmler, Associate Director,
202-418-7630, [email protected], Division of Clearing and Risk,
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st
Street NW., Washington, DC 20581.
SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background
A. Financial Crisis
B. Central Role of Clearing in the Dodd-Frank Act
C. G-20 and International Commitments on Clearing
D. Overview of Section 2(h) and Sec. 39.5
E. Submissions From DCOs
II. Review of Swap Submissions
A. General Description of Information Considered
B. Commission Processes for Review and Surveillance of DCOs
C. Credit Default Swaps
D. Proposed Determination Analysis for Credit Default Swaps
E. Interest Rate Swaps
F. Proposed Determination Analysis for Interest Rate Swaps
III. Proposed Rule
A. Proposed Sec. 50.1 Definitions
B. Proposed Sec. 50.2 Treatment of Swaps Subject to a Clearing
Requirement
C. Proposed Sec. 50.3 Notice to the Public
D. Proposed Sec. 50.4 Classes of Swaps Required To Be Cleared
E. Proposed Sec. 50.5 Clearing Transition Rules
F. Proposed Sec. 50.6 Delegation of Authority
G. Proposed Sec. 50.10 Prevention of Evasion of the Clearing
Requirement and Abuse of an Exception or Exemption to the Clearing
Requirement
IV. Implementation
V. Cost Benefit Considerations
A. Statutory and Regulatory Background
B. Overview of Swap Clearing
C. Consideration of the Costs and Benefits of the Commission’s
Action
D. Costs and Benefits of the Rule as Compared to Alternatives
E. Section 15(a) Factors
VI. Related Matters
A. Regulatory Flexibility Act
B. Paperwork Reduction Act
I. Background
A. Financial Crisis
In the fall of 2008, a series of large financial institution
failures triggered a financial and economic crisis that threatened to
freeze U.S. and global credit markets. As a result of these failures,
unprecedented governmental intervention was required to ensure the
stability of the U.S. financial system.2 These failures revealed the
vulnerability of the U.S. financial system and economy to wide-spread
systemic risk resulting from, among other things, poor risk management
practices of financial firms and the lack of supervisory oversight for
a financial institution as a whole.3
—————————————————————————
2 On October 3, 2008, President Bush signed the Emergency
Economic Stabilization Act of 2008, which was principally designed
to allow the U.S. Department of the Treasury and other government
agencies to take action to restore liquidity and stability to the
U.S. financial system (e.g., the Troubled Asset Relief Program–also
known as TARP–under which the U.S. Department of the Treasury was
authorized to purchase up to $700 billion of troubled assets that
weighed down the balance sheets of U.S. financial institutions). See
Public Law 110-343, 122 Stat. 3765 (2008).
3 See Financial Crisis Inquiry Commission, “The Financial
Crisis Inquiry Report: Final Report of the National Commission on
the Causes of the Financial and Economic Crisis in the United
States,” Jan. 2011, at xxviii, available at http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.
—————————————————————————
The financial crisis also illustrated the significant risks that an
uncleared, over-the-counter (OTC) derivatives market can pose to the
financial system. As the Financial Crisis Inquiry Commission explained:
The scale and nature of the [OTC] derivatives market created
significant systemic risk throughout the financial system and helped
fuel the panic in the fall of 2008: millions of contracts in this
opaque and deregulated market created interconnections among a vast
web of financial institutions through counterparty credit risk, thus
exposing the system to a contagion of spreading losses and
defaults.4
—————————————————————————
4 See id. at 386.
Certain OTC derivatives, such as CDS, played a prominent role
during the crisis. According to a white paper by the U.S. Department of
the Treasury, “the sheer volume of these [CDS] contracts overwhelmed
some firms that had promised to provide payment of the CDS and left
institutions with losses that they believed they had been
[[Page 47171]]
protected against.” 5 In particular, AIG reportedly issued uncleared
CDS transactions covering more than $440 billion in bonds, leaving it
with obligations that it could not cover as a result of changed market
conditions.6 As a result of AIG’s CDS exposure, the Federal
government bailed out the firm with over $180 billion of taxpayer money
in order to prevent AIG’s failure and a possible contagion event in the
broader economy.7
—————————————————————————
5 Financial Regulatory Reform: A New Foundation, June 2009,
available at: http://www.treasury.gov/initiatives/Documents/FinalReport_web.pdf and cited in S. Rep. 111-176 at 29-30 (Apr. 30,
2010).
6 Adam Davidson, “How AIG fell apart,” Reuters, Sept. 18,
2008, available at http://www.reuters.com/article/2008/09/18/us-how-aig-fell-apart-idUSMAR85972720080918.
7 Hugh Son, “AIG’s Trustees Shun `Shadow Board,’ Seek
Directors,” Bloomberg, May 13, 2009, available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aaog3i4yUopo&refer=us.
—————————————————————————
More broadly, the President’s Working Group (PWG) on Financial
Policy noted shortcomings in the OTC derivative markets as a whole
during the crisis. The PWG identified the need for an improved
integrated operational structure supporting OTC derivatives,
specifically highlighting the need for an enhanced ability to manage
counterparty risk through “netting and collateral agreements by
promoting portfolio reconciliation and accurate valuation of trades.”
8 These issues were exposed in part by the surge in collateral
required between counterparties during 2008, when the International
Swaps and Derivatives Association (ISDA) reported an 86% increase in
the collateral in use for OTC derivatives, indicating not only the
increase in risk, but also circumstances in which positions may not
have been collateralized.9
—————————————————————————
8 The President’s Working Group on Financial Markets, “Policy
Statements on Financial Market Developments,” Mar. 2008, available
at http://www.treasury.gov/resource-center/fin-mkts/Documents/pwgpolicystatemktturmoil_03122008.pdf.
9 ISDA, ISDA Margin Survey, 2009, available at http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2009.pdf.
—————————————————————————
With only limited checks on the amount of risk that a market
participant could incur, great uncertainty was created among market
participants. A market participant did not know the extent of its
counterparty’s exposure, whether its counterparty was appropriately
hedged, or if its counterparty was dangerously exposed to adverse
market movements. Without central clearing, a market participant bore
the risk that its counterparty would not fulfill its payment
obligations pursuant to a swap’s terms (counterparty credit risk). As
the financial crisis deepened, this risk made market participants wary
of trading with each other. As a result, markets quickly became
illiquid and trading volumes plummeted. The dramatic increase in “TED
spreads” evidenced this mistrust.10 These spreads increased from a
long-term average of approximately 30 basis points to 464 basis
points.11
—————————————————————————
10 The TED spread measures the difference in yield between
three-month Eurodollars as represented by London Interbank Offered
Rate (LIBOR), and three-month Treasury Bills. LIBOR contains credit
risk while T-bills do not. As the spread got larger, it meant that
lenders demanded more return to compensate for credit risk then they
would need if they loaned the money to the U.S. Department of the
Treasury without any credit risk.
11 The U.S. Financial Crisis: Credit Crunch and Yield Spreads,
by James R. Barth et al., page 5, available at: http://apeaweb.org/confer/bei08/papers/blp.pdf.
—————————————————————————
The failure to adequately collateralize the risk exposures posed by
OTC derivatives, along with the contagion effects of the vast web of
counterparty credit risk, led many to conclude that OTC derivatives
should be centrally cleared. For instance, in 2008, the Federal Reserve
Bank of New York (FRBNY) began encouraging market participants to
establish a central counterparty to clear CDS.12 For several years
prior, the FRBNY had led a targeted effort to enhance operational
efficiency and performance in the OTC derivatives market by increasing
automation in processing and by promoting sound back office practices,
such as timely confirmation of trades and portfolio reconciliation.
Beginning with CDS in 2008, the FRBNY and other primary supervisors of
OTC derivatives dealers increasingly focused on central clearing as a
means of mitigating counterparty credit risk and lowering systemic risk
to the markets as a whole. Both regulators and market participants
alike recognized that risk exposures would have been monitored,
measured, and collateralized through the process of central clearing.
—————————————————————————
12 See Federal Reserve Bank of New York, Press Release, “New
York Fed Welcomes Further Industry Commitments on Over-the-Counter
Derivatives,” Oct. 31, 2008, available at http://www.newyorkfed.org/newsevents/news/markets/2008/an081031.html, which
references documents prepared by market participants describing the
importance of clearing. See also Ciara Linnane and Karen Brettell,
“NY Federal Reserve pushes for central CDS counterparty,” Reuters,
Oct. 6, 2008, available at http://www.reuters.com/article/2008/10/06/cds-regulation-idUSN0655208920081006.
—————————————————————————
B. Central Role of Clearing in the Dodd-Frank Act
Recognizing the peril that the U.S. financial system faced during
the financial crisis, Congress and the President came together to pass
the Dodd-Frank Act in 2010. Title VII of the Dodd-Frank Act establishes
a comprehensive new regulatory framework for swaps, and the requirement
that swaps be cleared by DCOs is one of the cornerstones of that
reform. The CEA, as amended by Title VII, now requires a swap: (1) To
be cleared through a DCO if the Commission has determined that the
swap, or group, category, type, or class of swap, is required to be
cleared, unless an exception to the clearing requirement applies; (2)
to be reported to a swap data repository (SDR) or the Commission; and
(3) if the swap is subject to a clearing requirement, to be executed on
a designated contract market (DCM) or swap execution facility (SEF),
unless no DCM or SEF has made the swap available to trade.13
—————————————————————————
13 The Commission has proposed rules that would establish a
separate process for determining whether a swap has been made
“available to trade” by a DCM or SEF. Those rules, and any
determinations made under those rules, will be finalized separately
from the proposed clearing requirements discussed herein. See
Process for a Designated Contract Market or Swap Execution Facility
to Make a Swap Available to Trade Under Section 2(h)(8) of the
Commodity Exchange Act, 76 FR 77728 (Dec. 14, 2011).
—————————————————————————
Clearing is at the heart of the Dodd-Frank financial reform.
According to the Senate Report:14
—————————————————————————
14 S. Rep. 111-176, at 32 (April 30, 2010). See also Letter
from Senators Christopher Dodd and Blanche Lincoln to Congressmen
Barney Frank and Collin Peterson (June 30, 2010) (“Congress
determined that clearing is at the heart of reform–bringing
transactions and counterparties into a robust, conservative, and
transparent risk management framework.”).
As a key element of reducing systemic risk and protecting
taxpayers in the future, protections must include comprehensive
regulation and rules for how the OTC derivatives market operates.
Increasing the use of central clearinghouses, exchanges, appropriate
margining, capital requirements, and reporting will provide
safeguards for American taxpayers and the financial system as a
—————————————————————————
whole.
The Commission believes that a clearing requirement will reduce
counterparty credit risk and provide an organized mechanism for
collateralizing the risk exposures posed by swaps. According to the
Senate Report:15
—————————————————————————
15 S. Rep. 111-176, at 33.
With appropriate collateral and margin requirements, a central
clearing organization can substantially reduce counterparty risk and
provide an organized mechanism for clearing transactions. * * *
While large losses are to be expected in derivatives trading, if
those positions are fully margined there will be no loss to
counterparties and the overall financial system and none of the
uncertainty about potential exposures that contributed to the panic
—————————————————————————
in 2008.
[[Page 47172]]
Notably, Congress did not focus on just one asset class, such as CDS;
rather, Congress determined that all swaps that a DCO plans to accept
for clearing must be submitted to the Commission for a determination as
to whether or not those swaps are required to be cleared pursuant to
section 2(h)(2)(D) of the CEA.
C. G-20 and International Commitments on Clearing
The financial crisis generated international consensus on the need
to strengthen financial regulation by improving transparency,
mitigating systemic risk, and protecting against market abuse. As a
result of the widespread recognition that transactions in the OTC
derivatives market increased risk and uncertainty in the economy and
became a significant contributor to the financial crisis, a series of
policy initiatives were undertaken to better regulate the financial
markets.
In September 2009, leaders of the Group of 20 (G-20)–whose
membership includes the United States, the European Union, and 18 other
countries–agreed that: (1) OTC derivatives contracts should be
reported to trade repositories; (2) all standardized OTC derivatives
contracts should be cleared through central counterparties and traded
on exchanges or electronic trading platforms, where appropriate, by the
end of 2012; and (3) non-centrally cleared contracts should be subject
to higher capital requirements.
In June 2010, the G-20 leaders reaffirmed their commitment to
achieve these goals. In its October 2010 report on Implementing OTC
Derivatives Market Reforms (the October 2010 Report), the Financial
Stability Board (FSB) made twenty-one recommendations addressing
practical issues that authorities may encounter in implementing the G-
20 leaders’ commitments.16 The G-20 leaders again reaffirmed their
commitments at the November 2011 Summit, including the end-2012
deadline. The FSB has issued three implementation progress reports. The
most recent report urged jurisdictions to push forward aggressively to
meet the G-20 end-2012 deadline in as many reform areas as possible. On
mandatory clearing, the report observed that “[j]urisdictions now have
much of the information they requested in order to make informed
decisions on the appropriate legislation and regulations to achieve the
end-2012 commitment to centrally clear all standardised OTC
derivatives.” 17
—————————————————————————
16 See “Implementing OTC Derivatives Market Reforms,”
Financial Stability Board, Oct. 25, 2010, available at http://www.financialstabilityboard.org/publications/r_101025.pdf.
17 OTC Derivatives Working Group, “OTC Derivatives Market
Reforms: Third Progress Report on Implementation,” Financial
Stability Board, June 15, 2012, available at http://www.financialstabilityboard.org/publications/r_120615.pdf.
—————————————————————————
Specifically with regard to required clearing, the Technical
Committee of the International Organization of Securities Commissions
(IOSCO) has published a final report, Requirements for Mandatory
Clearing, outlining recommendations that regulators should follow to
carry out the G-20’s goal of requiring standardized swaps to be
cleared.18
—————————————————————————
18 IOSCO’s report, published in February 2012, is available at
https://www.iosco.org/library/pubdocs/pdf/IOSCOPD374.pdf.
—————————————————————————
D. Overview of Section 2(h) and Sec. 39.5
The Commission has promulgated Sec. 39.5 of its regulations to
implement procedural aspects section 2(h) of the CEA.19 Regulation
39.5 establishes procedures for: (1) Determining the eligibility of a
DCO to clear swaps; (2) the submission of swaps by a DCO to the
Commission for a clearing requirement determination; (3) Commission
initiated reviews of swaps; and (4) the staying of a clearing
requirement.
—————————————————————————
19 See 76 FR 44464 (July 26, 2011); 17 CFR 39.5.
—————————————————————————
This determination and rule proposed today would require that
certain swaps submitted by Commission-registered DCOs are required to
be cleared under section 2(h) of the CEA. Under section 2(h)(1)(A),
“it shall be unlawful for any person to engage in a swap unless that
person submits such swap for clearing to a [DCO] that is registered
under [the CEA] or a [DCO] that is exempt from registration under [the
CEA] if the swap is required to be cleared.” 20
—————————————————————————
20 See section 2(h) of the CEA. A clearing requirement
determination also may be initiated by the Commission. Section
2(h)(2)(A)(i) of the CEA requires the Commission on an ongoing basis
to “review each swap, or any group, category, type, or class of
swaps to make a determination as to whether the swap, category, type
or class of swaps should be required to be cleared.” As previously
noted, the Commission intends to consider swaps submitted by DCOs
prior to undertaking any Commission-initiated reviews.
—————————————————————————
A clearing requirement determination may be initiated by a swap
submission. Section 2(h)(2)(B)(i) of the CEA requires a DCO to “submit
to the Commission each swap, or any group, category, type or class of
swaps that it plans to accept for clearing, and provide notice to its
members of the submission.” In addition under section 2(h)(2)(B)(ii)
of the CEA, “[a]ny swap or group, category, type, or class of swaps
listed for clearing by a [DCO] as of the date of enactment shall be
considered submitted to the Commission.”
E. Submissions From DCOs
On February 1, 2012, Commission staff sent a letter requesting that
DCOs submit all swaps that they were accepting for clearing as of that
date, pursuant to Sec. 39.5.21 The Commission received submissions
relating to CDS and IRS clearing from: the International Derivatives
Clearinghouse Group (IDCH) on February 17, 2012; the CME Group (CME),
ICE Clear Credit, ICE Clear Europe, each dated February 22, 2012, and a
submission from LCH.Clearnet Limited (LCH) on February 24, 2012.22
—————————————————————————
21 The letter made it clear that DCOs should submit both pre-
enactment swaps and swaps for which DCOs have initiated clearing
since enactment of the Dodd-Frank Act. Pre-enactment swaps refer to
those swaps that DCOs were accepting for clearing as of July 21,
2010, the date of enactment of the Dodd-Frank Act.
22 Other swaps submissions were received from Kansas City
Board of Trade (KCBT) and the Natural Gas Exchange (NGX). KCBT and
NGX do not accept any CDS or IRS for clearing.
—————————————————————————
This proposal’s clearing requirement determination would cover
certain CDS and IRS currently being cleared by a DCO. The Commission
intends subsequently to consider other swaps submitted by DCOs, such as
agricultural, energy, and equity indices.
The decision to focus on CDS and IRS in the initial clearing
requirement determination is a function of both the market importance
of these swaps and the fact that they already are widely cleared. In
order to move the largest number of swaps to required clearing in its
initial determination, the Commission believes that it is prudent to
focus on those swaps that have the highest market shares and market
impact. Further, for these swaps there is already a blueprint for
clearing and appropriate risk management. CDS and IRS fit these
considerations and therefore are well suited for required clearing
consideration.23
—————————————————————————
23 The Commission will consider all other swaps submitted
under Sec. 39.5(b) as soon as possible after this proposal is
published. These other swaps include certain CDS that were submitted
to the Commission subsequent to the initial February 2012
submissions discussed above. If the Commission determines that
additional swaps should be required to be cleared such determination
likely will be proposed as a new class under proposed Sec. 50.4, as
discussed below.
—————————————————————————
Significantly, market participants have recommended that the
Commission take this approach. In their joint comment letter to the
Commission’s proposed Compliance and Implementation Schedule for the
clearing requirement, the Futures Industry Association (FIA), ISDA, and
the Securities Industry and Financial Markets Association (SIFMA)
opined
[[Page 47173]]
that CDS and IRS should be required to be cleared first because they
are already being cleared.24 FIA, ISDA, and SIFMA commented further
that it would make sense for the Commission to require commodity and
equity swaps to be cleared later because fewer of these swaps are
currently being cleared. Similarly, the letter sent by the Alternative
Investment Management Association (AIMA) in response to Commissioner
O’Malia’s request for comment concerning the implementation of the
clearing requirement 25 argues that the Commission should first
review those swaps currently being cleared and then swaps that
currently trade in large numbers.
—————————————————————————
24 FIA/ISDA/SIFMA comment letter to the Notice of Proposed
Rulemaking, Swap Transaction Compliance and Implementation Schedule:
Clearing and Trade Execution Requirements under Section 2(h) of the
CEA, 76 FR 58186 (Sept. 20, 2011). This comment letter is available
on the Commission’s Web site at: http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1093&ctl00–ctl00–
cphContentMain–MainContent–gvCommentListChangePage=2.
25 On July 28, 2011, Commissioner O’Malia released a letter
seeking public comment on the manner in which the Commission should
determine (i) which swaps would be subject to the clearing
requirement and (ii) whether to grant a stay of a clearing
requirement. Commissioner O’Malia’s letter, as well as AIMA’s
letter, are available on the Commission’s Web site at: http://www.cftc.gov/About/Commissioners/ScottDOMalia/reviewofswaps.
—————————————————————————
IRS accounts for about $500 trillion of the $650 trillion global
OTC swaps market, in notional dollars–the highest market share of any
class of swaps.26 LCH claims to clear about $302 trillion of those–
meaning that, in notional terms, LCH clears approximately 60% of the
IRS market.27 While CDS indices do not have as prominent a market
share as IRS, CDS indices are capable of having a sizeable market
impact, as they did during the 2008 financial crisis. Overall, the CDS
marketplace has almost $29 trillion in notional outstanding across both
single and multi-name products.28 CDS on standardized indices
accounts for about $10 trillion of the global OTC market in notional
dollar amount outstanding.29 Since March 2009, the ICE Clear Credit
and ICE Clear Europe have combined to clear over $30 trillion in gross
notional for all CDS.30 Because of the market shares and market
impacts of these swaps, and because these swaps are currently being
cleared, the Commission decided to review CDS and IRS in its initial
clearing requirement determination. The Commission recognizes that
while this is an appropriate basis for this initial proposal, swap
clearing is likely to evolve and clearing requirement determinations
made at later times may be based on a variety of other factors beyond
the extent to which the swaps in question are already being cleared.
—————————————————————————
26 Bank of International Settlements (BIS) data, December
2011, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.
27 Id.; LCH data.
28 BIS data, December 2011, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.
29 Id.
30 ICE Clear Credit data, as of the April 26, 2012 clearing
cycle.
—————————————————————————
II. Review of Swap Submissions
A. General Description of Information Considered
The Commission reviewed each of the submissions in detail. Based on
these submissions, the Commission was able to consider the ability of
an individual DCO to clear a given swap, as well as to consider the
information supplied cumulatively across all submissions for a given
swap. The analysis included reviews of the DCOs’ existing rule
frameworks and their risk management policies. The Commission relied on
industry data as available, such as publicly available Depository Trust
and Clearing Corporation (DTCC) data from the Trade Information
Warehouse (TIW) on CDS transactions. Other publicly available data
sources, such as data from the Bank of International Settlements (BIS)
on the OTC derivatives markets are analyzed and cited throughout this
notice of proposed rulemaking. The Commission also was able to review
letters from market participants directly related to the clearing
requirement.31 Other market input on the clearing requirement could
be taken from comments received with regard to rules relating to the
proposed Swap Transaction Compliance and Implementation Schedule:
Clearing and Trade Execution Requirements under Section 2(h) of the CEA
32 and the Process for Review of Swaps for Mandatory Clearing.33
This notice of proposed rulemaking also reflects consultation with the
staff of the Securities and Exchange Commission (SEC), prudential
regulators, and international regulatory authorities. As Sec. 39.5
provides for a 30-day comment period for any clearing determination,
the final clearing requirement will be informed by public feedback.
—————————————————————————
31 See responses to Commissioner O’Malia’s letter of June 28,
2011 requesting input on the clearing determination available on the
Commission’s Web site, available at http://www.cftc.gov/About/Commissioners/ScottDOMalia/reviewofswaps.
32 See comment file for Swap Transaction Compliance and
Implementation Schedule: Clearing and Trade Execution Requirements
under Section 2(h) of the CEA, 76 FR 58186 (Sept. 20, 2011),
available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1093.
33 See comment file for Process for Review of Swaps for
Mandatory Clearing, 75 FR 67277 (Nov. 2, 2010), available at http://comments.cftc.gov/PublicComments/CommentList.aspx?id=890.
—————————————————————————
B. Commission Processes for Review and Surveillance of DCOs
i. Part 39 Regulations Set Forth Standards for Compliance
Section 2(h)(2)(D)(i) of the CEA provides that the Commission shall
review whether the submissions are consistent with section 5b(c)(2) of
the CEA. Section 5b(c)(2) of the CEA sets forth eighteen core
principles with which DCOs must comply to be registered and to maintain
registration. The core principles address numerous issues, including
financial resources, participant and product eligibility, risk
management, settlement procedures, default management, system
safeguards, reporting, recordkeeping, public information, and legal
risk.
All of the DCOs that submitted swaps for review are registered with
the Commission and their submissions identify swaps that they are
already clearing. Consequently, the Commission has been reviewing and
monitoring compliance by the DCOs with the core principles for the
submitted swaps. For purposes of reviewing whether the submissions are
consistent with section 5b(c)(2) of the CEA, the Commission will rely
on both the information received in the submissions themselves and on
its ongoing review and risk surveillance programs. These processes are
summarized below to provide a better understanding of the information
the Commission uses in its review of consistency of the submissions
with the core principles. The Commission believes this overview is
particularly helpful for this rulemaking because the clearing
requirement proposed herein is the first such undertaking by the
Commission under the provisions of the Dodd-Frank Act.
The primary objective of the CFTC supervisory program is to ensure
compliance with applicable provisions of the CEA and implementing
regulations, and in particular, the core principles applicable to DCOs.
A primary concern of the program is to monitor and mitigate potential
risks that can arise in derivatives clearing activities for the DCO,
its members, and entities using the DCO’s services. Accordingly, the
CFTC supervisory program takes a risk-based approach.
In addition to the core principles set forth in section 5b(c)(2) of
the CEA, section 5c(c) of the CEA governs the procedures for review and
approval of new products, new rules, and rule amendments submitted to
the
[[Page 47174]]
Commission by DCOs. Part 39 of the CFTC’s regulations implements
sections 5b and 5c(c) of the CEA by establishing specific requirements
for compliance with the core principles as well as procedures for
registration, for implementing DCO rules, and for clearing new
products. Part 40 of the CFTC’s regulations sets forth additional
provisions applicable to a DCO’s submission of rule amendments and new
products to the CFTC.
The Commission has means to enforce compliance, including the
Commission’s ability to sue the DCO in federal court for civil monetary
penalties,34 issue a cease and desist order,35 or suspend or revoke
the registration of the DCO.36 In addition, any deficiencies or other
compliance issues observed during ongoing monitoring or an examination
are frequently communicated to the DCO and various measures are used by
the Commission to ensure that the DCO appropriately addresses such
issues, including escalating communications within the DCO management
and requiring the DCO to demonstrate, in writing, timely correction of
such issues.
—————————————————————————
34 See section 6c of the CEA.
35 See section 6b of the CEA.
36 See section 5e of the CEA.
—————————————————————————
ii. Initial Registration Application Review and Periodic In-Depth
Reviews
Section 5b of the CEA requires a DCO to register with the
Commission. In order to do so, an organization must submit an
application demonstrating that it complies with the core principles.
During the review period, the Commission generally conducts an on-site
review of the prospective DCO’s facilities, asks a series of questions,
and reviews all documentation received. The Commission may ask the
applicant to make changes to its rules to comply with the CEA and the
Commission’s regulations.
After registration, the Commission conducts examinations of DCOs to
determine whether the DCO is in compliance with the CEA and Commission
regulations. The examination consists of a planning phase where staff
reviews information the Commission has on hand to determine whether the
information raises specific issues and to develop an examination plan.
The examination team participates in a series of meetings with the DCO
at its facility. Commission staff also communicates with relevant DCO
staff, including senior management, and reviews documentation. Data
produced by the DCO is independently tested. Finally, when relevant,
walk-through testing is conducted for key DCO processes.
iii. Commission Daily Risk Surveillance
Commission risk surveillance staff monitors the risks posed to and
by DCOs, clearing members, and market participants, including market
risk, liquidity risk, credit risk, and concentration risk. This
analysis includes reviews of daily, large trader reporting data
obtained from market participants, clearing members, and DCOs, which is
available at the trader, clearing member, and DCO levels. Relevant
margin and financial resources information is also included within the
analysis.
Commission staff regularly conducts back-testing to review margin
coverage at the product level and follows up with the relevant DCO
regarding any exceptional results. Independent stress testing of
portfolios is conducted on a daily, weekly, and ad hoc basis. The
independent stress tests may lead to individual trader reviews and/or
futures commission merchant (FCM) risk reviews to gain a deeper
understanding of a trading strategy, risk philosophy, risk controls and
mitigants, and financial resources at the trader and/or FCM level. The
traders and FCMs that have a higher risk profile are then reviewed
during the Commission’s on-site review of a DCO’s risk management
procedures.
C. Credit Default Swaps
i. Submissions Provided Information per Sec. 39.5
Pursuant to Sec. 39.5, the Commission received filings with
respect to CDS from CME, ICE Clear Credit, and ICE Clear Europe.37
The CME and ICE Clear Credit submissions included the CDS that each
clear on North American corporate indices, covering various tenors and
series. The ICE Clear Europe submission includes, among other swaps,
the CDS contracts on European corporate indices that they clear, with
information on each of the different tenors and series. Each of the
submissions contained information relating to the five statutory
factors set forth in section 2(h)(2)(D) of the CEA and other
information required under Sec. 39.5.
—————————————————————————
37 In the case of CME and ICE Clear Europe, the submissions
also included other swaps beyond those in the CDS and IRS
categories. These submissions, including a description of the
specific swaps covered, are available at http://www.cftc.gov/IndustryOversight/IndustryFilings/index.htm.
—————————————————————————
CME, ICE Clear Credit, and ICE Clear Europe provided notice of
their Sec. 39.5 swap submissions to their members by posting their
submissions on their respective Web sites.38 The submissions also are
published on the Commission’s Web site.
—————————————————————————
38 Available at: http://www.cmegroup.com/market-regulation/rule-filings.html and https://www.theice.com/publicdocs/regulatory_filings/ICEClearCredit_022212.pdf. ICE Clear Europe did not provide
a link to its relevant Web page.
—————————————————————————
Regulation 39.5(b)(3)(viii) also directs a DCO’s submission to
include a summary of any views on the submission expressed by members.
CME’s submission did not address this. In their submissions, ICE Clear
Credit and ICE Clear Europe stated that neither has solicited nor
received any comments to date and will notify the Commission of any
such comments. The Commission expects that DCOs will provide any
feedback they receive regarding their submissions to the Commission for
consideration.
ii. Background on Market
A credit default swap is a bilateral contract that allows the
counterparties to trade or hedge the risk that an underlying entity
will default–in most cases, either a corporate or a sovereign
borrower. The protection buyer makes a quarterly premium payment until
a pre-defined credit event occurs or until the swap agreement matures.
In return, the protection seller assumes the financial loss in case the
reference borrower becomes insolvent or an underlying security
defaults. In addition to such “single name” CDS described above, the
market also developed CDS to cover multi-name baskets of entities.
While these baskets can be specifically created by the parties in a
bespoke swap transaction, the large majority of multi-name baskets are
based on both standardized indices and standardized swap agreements.
These index CDS can cover up to 125 reference entities. Each of these
entities may be weighted equally within the index or have different
weightings depending on the terms of the specific index. Unlike a
single name CDS, these contracts generally continue until the swap
agreement reaches its scheduled termination date. Under the contract,
the protection seller would assume the financial loss associated with,
and make payment to the protection buyer on, each of the individual
entities in the index that suffers a credit event until the swap’s
maturity. Those entities suffering a credit event would be removed from
the index. The swap would continue on the remaining names, with the
protection buyer making reduced quarterly premium
[[Page 47175]]
payments based upon the now smaller index covered by the swap.
The most recent BIS study39 found that, as of December 2011, the
size of the overall CDS marketplace exceeded $28.6 trillion in notional
amount outstanding. Of that amount, $11.8 trillion was in multi-name
CDS agreements. Within this sub-category of CDS, CDS on indices
accounted for more than 89% of the total notional amount outstanding.
This continues a trend as CDS on standardized indices have seen
increasing volumes relative to other multi-name instruments such as
synthetic collateralized debt obligations and other bespoke products.
—————————————————————————
39 See BIS data, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.
—————————————————————————
Multiple providers have established CDS indices to be used by
market participants. These providers typically establish an index’s
constituents, as well as standard terms and tenors. They also may
provide on-going pricing services for their indices. The CDS indices
owned and managed by Markit have the dominant market share within this
class of CDS. There are other providers of CDS indices, though to date,
those indices have not been widely used. Currently none of the indices
are the basis for any CDS cleared by a DCO.40 The Markit CDX family
of indices is the standard North American credit default swap family of
indices, with the primary corporate indices being the CDX North
American Investment Grade (consisting of 125 investment grade corporate
reference entities 41) (CDX.NA.IG) and the CDX North American High
Yield (consisting of 100 high yield corporate reference entities)
(CDX.NA.HY). The standard currency for CDS on these indices is the U.S.
dollar.
—————————————————————————
40 S&P/ISDA have, for example, co-branded additional indices
for use in the CDS marketplace. These indices cover similar classes
of reference entities as the Markit indices. To date, however, the
use of these indices by market participants has been limited. With
insufficient data regarding outstanding notional amounts and trading
volumes, the Commission does not believe it appropriate to include
these indices in the mandatory clearing determination. To the extent
other providers establish indices with demonstrable open interest,
trading volumes and pricing sources, the Commission will consider
them for inclusion either within the current proposed classes of
swaps, or within a separate class of swaps. Exclusion for the
proposed classes only means that the CDS on such indices are not
subject to a clearing requirement, and has no other impact on the
use of such indices by market participants.
41 The term “reference entities” refers to those entities
that form the basis of an index. For the indices discussed in this
proposal, all of the reference entities are corporate entities. For
example, when one of those corporate entities declares bankruptcy,
it may trigger a credit event under the terms of the index. A credit
event also may be declared when a reference entity fails to pay on
an outstanding debt.
—————————————————————————
Additionally, Markit owns and manages the iTraxx indices covering
reference entities in the European and Asia/Pacific markets. The
primary indices for the European markets are the iTraxx Europe which
covers 125 European investment grade corporate reference entities, the
iTraxx Europe Crossover covering 50 European high yield reference
entities and the iTraxx Europe High Volatility, which is a 30-entity
subset of the European investment grade index. These indices are
generally denominated in euro.
Beyond those discussed above, Markit provides more granular indices
covering specific corporate sectors in both the United States and
Europe. Markit also provides indices that cover non-corporate reference
entities, including indices of sovereign reference entities from around
the world, U.S. municipal issuers and structured finance issuers. Some
of the sector specific CDS, particularly those based on indices in the
iTraxx family have significant volumes. For example, the iTraxx Europe
Senior Financials referencing European financial institutions has over
$13 billion in net notional and 3,711 open contracts for Series 17
according to DTCC data.42 Those contracts are not currently cleared
by a DCO and thus have not been submitted to the Commission. Therefore,
these contracts are not being considered as part of the proposed
clearing requirement determination discussed herein. To the extent
these contracts were to be cleared by a DCO in the future, the DCO
would be required to submit those contracts to the Commission for
review pursuant to Sec. 39.5. If those contracts were not cleared by
any DCO, they may still be subject to a Commission-initiated review
pursuant to Sec. 39.5(c) in the future.
—————————————————————————
42 See www.dtcc.com. Data as of May 21, 2012.
—————————————————————————
As administrator of these indices, Markit reviews the composition
of underlying reference entities in the indices every six months. Once
Markit establishes the constituents to be included within the indices,
a new series of the respective index is created. Additionally, each
time one of the reference entities within an index suffers a credit
event, a new version of an existing series of the index is created. In
addition to the series and version variations that may exist on the
index, the parties can choose the tenor of the CDS on a given index.
While the 5-year tenor is the most common, and therefore most liquid,
other standard tenors may include 1-, 2-, 3-, 7-, and 10-year swaps.
Beyond these administrative functions, Markit, in conjunction with
ISDA, has established standardized transaction terms and legal
documentation in the form of standard terms supplements and
confirmations for their indices. In the vast majority of cases,
transactions using the indices are executed using these standard terms,
although the indices also may be used in connection with non-standard
transactions. A particular CDS index agreement will only be eligible to
be cleared by a DCO to the extent the agreement is based upon the
standard terms. Consistent with the movement of the CDS market to
standardized contracts and spreads, cleared contracts all use
standardized spreads of 100 or 500 basis points on the cost of
protection, with the use of the upfront payments to accurately capture
the cost of the credit protection on the indices.43
—————————————————————————
43 ISDA’s Big Bang Protocol in April 2009, in addition to
providing the “hardwiring” necessary for Auction Settlement and
the establishment of the Credit Derivatives Determination
Committees, also created a new standardized North American corporate
CDS contract with fixed scheduled termination dates, fixed payment
and accrual dates, and standardized coupons. See http://www.isda.org/companies/auctionhardwiring/auctionhardwiring.html.
—————————————————————————
The CDS cleared by CME, ICE Clear Credit, and ICE Clear Europe that
were submitted to the Commission are standardized contracts providing
credit protection on an untranched basis, meaning that settlement is
not limited to a specific range of losses upon the occurrence of credit
events among the reference entities included within an index. Besides
single name CDS, these untranched CDS on indices are the only type of
CDS being cleared by these DCOs. Other swaps like credit index
tranches, options, and first- or Nth-to-default baskets on these
indices are not currently cleared.
Both CME and ICE Clear Credit have submitted standard untranched
CDS on the CDX.NA.IG and the CDX.NA.HY indices that they clear. CME
offers the CDX.NA.IG at the 3-, 5-, 7- and 10-year tenors for each
series going back to Series 9 for those contracts that have not reached
their termination date. For the North American high yield index, CME
offers clearing for Series 11 and each subsequent series at the 5-year
tenure.
ICE Clear Credit offers CDX.NA.IG Series 8 and all subsequent
series of that index that are still outstanding at the 5- and 10-year
tenors. Additionally, Series 8 to Series 10 are cleared at the 7-year
tenor. For the high yield index, ICE Clear Credit clears all series
from the current series through the CDX.NA.HY Series 9 at the 5-year
tenor.
[[Page 47176]]
In addition to these indices, ICE Clear Credit has also cleared the
CDX North American Investment Grade High Volatility (consisting 30
names from the CDX.NA.IG) (CDX.NA.IG.HVOL). ICE Clear Credit is not
however clearing Series 18, the most recently established series of the
CDX.NA.IG.HVOL or Series 17, given the limited trading volumes for this
swap. ICE Clear Credit only clears the CDX.NA.IG.HVOL for Series 9
through Series 16, and only at the 5-year tenor.
ICE Clear Europe, another registered DCO, made a submission
covering the index CDS that it clears. Similar to the other
submissions, the contracts that ICE Clear Europe clears are focused on
corporate reference entities, though in this case, the entities are
based in Europe. Also, similar to the CME and ICE Clear Credit
submissions, the swaps cleared by ICE Clear Europe are indices owned
and administered by Markit. ICE Clear Europe clears the euro-
denominated contracts referencing the iTraxx Europe, the iTraxx Europe
Crossover, and the iTraxx Europe High Volatility. For the iTraxx Europe
and Crossover, ICE Clear Europe clears outstanding contracts in the
Series 7 and 8, respectively, through the current series. For the High
Volatility index, ICE Clear Europe clears outstanding contracts in the
Series 9 through the current series. In terms of tenors, ICE Clear
Europe clears the 5-year tenor for all swaps, as well as the 10-year
tenor for the iTraxx Europe index.
Based upon those portions of the CME, ICE Clear Credit, and ICE
Clear Europe swap submissions relating to the cleared CDS contracts
discussed above, as well as the analysis conducted by the Commission
pursuant to Sec. 39.5(b) and set forth below, the Commission is
reviewing the following classes of swaps for purposes of the clearing
requirement.
iii. CDS Trading and Risk Management
The indices were created in the mid-2000s. Parties to these OTC
contracts could use the indices to express their bullish or bearish
sentiments on credit as an asset class, or to actively manage their
credit exposures.44 As standardized contracts and indices, they had
increased liquidity and were cheaper and easier to enter into than a
customized transaction. Following the financial crisis, the popularity
of such bespoke transactions like synthetic collateral debt obligations
decreased and the standardized indices continued to grow.
—————————————————————————
44 Generally the market for all CDS is driven by dealers.
Recent estimates found that about 74% of CDS trading takes place
among 20 dealer-banks worldwide, according to data from DTCC., which
runs a central registry for credit derivatives. See http://www.bloomberg.com/news/2011-11-01/selling-more-insurance-on-shaky-european-debt-raises-risk-for-u-s-banks.html.
—————————————————————————
Markit licenses its indices to market making financial
institutions. Notwithstanding that these contracts trade as OTC
products, the standardization of the contracts has allowed for them to
be completed and confirmed electronically by a number of service
providers. The 5-year tenor is the most liquid of the tenors.
Similarly, the current “on-the-run” series tend to see the most
liquidity, while the older “off-the-run” series tend to see less
liquidity.45 Many investors exit positions in an existing series when
a new series “rolls,” explaining increased liquidity in the “on-the-
run” series. As noted above, the pricing for the contract is generally
set at a standardized rate of 100 or 500 basis points, with upfront
payments exchanged to compensate for the actual price of the credit
protection being provided.
—————————————————————————
45 The term “on-the-run” refers to current series of an
index, while older series are referred to “off-the-run.” Each six
months when a new series is created (or “rolls” using market
terminology), the new series is considered the “on-the-run” index,
and all others are considered “off-the-run.”
—————————————————————————
For the DCOs clearing these swaps, the key factors in managing the
risk of CDS portfolios that they clear are changes in the price of the
swaps, the idiosyncratic risk related to the default of a reference
entity, and the liquidity risk associated with unwinding a portfolio of
a defaulting clearing member. While differing in the specific margin
methodologies, each of the DCOs uses methodologies designed to capture
99% of potential portfolio losses over a five-day period. The DCOs will
stress CDS portfolios with shifts both up and down in the price of the
CDS, as well as with changes to the slope of the term structure of the
CDS pricing curve. Idiosyncratic risk will be captured by a “jump-to-
default” analysis in which widely held reference entities are assumed
to default with limited or no recovery. Liquidity risk seeks to capture
the cost of liquidating a portfolio, with assumed higher costs
associated with concentrated portfolios.
The DCOs conduct end-of-day settlement on the CDS, using prices
submitted by clearing members that hold a cleared position in that
swap. According to DCO rules, the submitted prices may be traded
against, such that members are incentivized to submit accurate pricing
data. The DCOs analyze the submitted data to remove any outliers.46
The DCOs then calculate a composite spread or price by aggregating all
the prices individually submitted, after deleting the outliers.47 The
more liquid a particular swap, the more price submissions will be made.
—————————————————————————
46 Clearing rules generally provide for a mechanism for DCOs
to levy fines against clearing members for failure to submit
accurate prices across the full term structure for a given product.
47 The theoretical spread/price of the index may be calculated
by looking at the spread/price of each of the individual
constituents in the index, though this may not account for the
actual demand to buy or sell protection based on the index itself.
—————————————————————————
In the event of a default of a clearing member, the DCOs have the
ability to conduct an auction for other members to bid on all or a
portion of the defaulting member’s portfolio of CDS positions. To the
extent that the DCO was unable to sell the entire portfolio, the
clearing rules require the non-defaulting clearing members to accept an
apportionment of such portfolio if required by the DCO. To the extent
the market for a swap is more liquid, the chances for a successful
auction would likely be increased. Further, to the extent an auction is
unsuccessful, a more liquid market would give the clearing member
receiving such an apportionment a better opportunity to successfully
sell or otherwise offset the risk associated with the CDS it accepted.
In addition to the CDS indices, ICE Clear Credit and ICE Clear
Europe also offer single name CDS 48 for clearing. Of the $29
trillion in CDS notional outstanding, approximately $17 trillion is in
single name swaps according to the latest market survey of BIS.49 As
part of their margining methodology, DCOs are seeking approval to offer
portfolio margining for the single name CDS and the CDS indices held
within a given portfolio.50 Given that the single name reference
entities will likely also be constituents of a given index within a
portfolio, the Commission generally believes that such portfolio
margining initiatives are consistent with the sound risk management
policies for DCOs that are required under Sec. 39.13(g)(4). Moreover,
DCOs such as ICE Clear Credit already use margining methodologies that
provide for appropriate portfolio margining treatment with regard to
clearing
[[Page 47177]]
members’ proprietary positions.51 The Commission is committed to
working toward establishing similar portfolio margining programs for
DCOs clearing customer positions in CDS indices and single name CDS.
—————————————————————————
48 Such single name CDS are defined as “security-based
swaps” under section 721(a) of the Dodd-Frank Act.
49 See BIS data, available at http://www.bis.org/statistics/otcder/dt1920a.pdf.
50 See ICE Clear Credit’s petitions to the Commission and SEC,
dated October 4, 2011. The petition to the Commission is available
at http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/iceclearcredit100411public.pdf.
51 See ICE Clear Credit’s certification to the Commission,
dated as of November 25, 2011. The certification is available at
http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/rul112511icecc001.pdf.
—————————————————————————
iv. CDS Classes Based on Key Specifications
Under Sec. 39.5, the decision of the Commission to require that a
group, category, type, or class of swaps be required to be cleared is
informed by a number of factors. As an initial matter, the Commission
looks to the submissions of the DCO themselves with regard to the swaps
they submit. After analyzing the key attributes of the swaps submitted,
the Commission is proposing to establish two classes of CDS subject to
the clearing requirement. The first class is based on the North
American untranched indices and the second class is based on the
European untranched indices.
Given the different markets that the CDS indices cover, the
different currencies and other logistical differences in how the CDS
markets and documentation work, the Commission believes this is an
appropriate basis for separate classes. In the case of the submissions
received to date, the U.S. dollar-denominated CDS covering North
America corporate credits would be a separate class of CDS from a euro-
denominated CDS referencing European obligations.
The nature of the underlying reference entities for the CDS serve
to establish the another specification. Each index referenced was a
broad-based pool of corporate entities. These indices included both
investment grade and high yield corporate entities and they were not
limited by a specific sector type. The data available for corporate CDS
transactions, including the CDS indices, is substantial. As new swaps
are cleared and considered by class, the nature of the underlying index
will continue to be a factor in the establishment of such classes.
As noted above, the regional differences in the way CDS indices are
traded and cleared warrant a separate specification based upon common
market standards established within the regions. Beyond different
currencies, the key terms of the underlying CDS, including the relevant
credit events, may differ with direct impact on the clearing and risk
management of these products by DCOs.
The actual indices included within a class are also specified. As
only certain indices for a type of reference entity may have
significant trading volumes and be cleared within a particular region,
it is necessary to identify those specific indices within the classes.
The classes are also being defined by particular tenors for the
various indices included within the class. Given varying outstanding
notional amounts and trading volumes on different tenors of existing
indices, the Commission has analyzed the impact of including all or
only select tenors within a given class. In addition, applicable series
are identified within each tenor so that market participants can
identify whether a particular series of given index is required to be
cleared.
Finally, the nature of the CDS itself referencing the underlying
indices will be a factor as well. Each of the submissions dealt only
with untranched CDS on the indices. There is a significant market for
tranched swaps using the indices, where parties to the CDS contract
agree to address only a certain range of losses along the entire loss
distribution curve. Other swaps such as first or “Nth” to default
baskets, and options, also exist on the indices.
v. Identification of Specifications
The Commission is proposing two classes of CDS contracts subject to
the clearing requirement. The first class would be untranched CDS
contracts referencing corporate entities in North America via Markit’s
CDX.NA.IG and CDX.NA.HY indices. The second class would include
untranched CDS referencing European corporate entities via Markit’s
iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe High
Volatility. The following table sets forth the specific specifications
of each class:
Table 1
————————————————————————
————————————————————————
North American Untranched CDS Indices Class
————————————————————————
Specification
1. Reference Entities…………. Corporate.
2. Region……………………. North America.
3. Indices…………………… CDX.NA.IG.
CDX.NA.HY.
4. Tenor…………………….. CDX.NA.IG: 3Y, 5Y, 7Y, 10Y.
CDX.NA.HY: 5Y.
5. Applicable Series………….. CDX.NA.IG 3Y: Series 15 and all
subsequent Series, up to and
including the current Series.
CDX.NA.IG 5Y: Series 11 and all
subsequent Series, up to and
including the current Series.
CDX.NA.IG 7Y: Series 8 and all
subsequent Series, up to and
including the current Series.
CDX.NA.IG 10Y: Series 8 and all
subsequent Series, up to and
including the current Series.
CDX.NA.HY 5Y: Series 11 and all
subsequent Series, up to and
including the current Series.
6. Tranched………………….. No.
————————————————————————
European Untranched CDS Indices Class
————————————————————————
Specification
1. Reference Entities…………. Corporate.
2. Region……………………. Europe.
3. Indices…………………… iTraxx Europe.
iTraxx Europe Crossover.
iTraxx Europe HiVol.
4. Tenor…………………….. iTraxx Europe: 5Y, 10Y.
iTraxx Europe Crossover: 5Y.
iTraxx Europe HiVol: 5Y.
5. Applicable Series………….. iTraxx Europe 5Y: Series 10 and all
subsequent Series, up to and
including the current Series.
[[Page 47178]]
iTraxx Europe 10Y: Series 7 and all
subsequent Series, up to and
including the current Series.
iTraxx Europe Crossover 5Y: Series
10 and all subsequent Series, up to
and including the current Series.
iTraxx Europe HiVol 5Y: Series 10
and all subsequent Series, up to
and including the current Series.
6. Tranched………………….. No.
————————————————————————
The Commission is proposing to separate the classes of corporate
swaps between the North American contracts and European contracts. The
Commission believes that indices based on other types of entities would
be viewed as a separate class and would be subject to a separate
determination by the Commission. For example, given the differences
that exist with regard to volumes and risk management of indices based
on sovereign issuers, it is likely that such CDS would represent their
own class of swaps. Similarly, to the extent indices from other regions
were submitted by a DCO, it is likely that the Commission would take
the view that they are part of their own class of swaps as well.
The Commission believes it appropriate to define the classes of
swaps as untranched CDS contracts referencing the broad-based corporate
indices of Markit. These corporate indices have the most net notional
outstanding, the most trading volumes, and the best available pricing.
The risk management frameworks for the corporate index swaps are the
most well-established, and have the most available data in terms of CDS
spreads and corporate default studies for analysis of the underlying
constituents of the indices. Agreements based on these indices also are
widely accepted and use standardized terms.52
—————————————————————————
52 To the extent other vendors successfully develop similar
indices, the Commission would conduct the analysis required by Sec.
39.5, either on its own initiative or based on a DCO submission. If
based on that analysis the Commission issued a clearing requirement
determination, it is likely that such indices would be considered to
be part of an existing class of CDS that are required to be cleared.
—————————————————————————
Both of the CDS classes presented herein assume that the relevant
CDS agreement will use the standardized terms established by Markit/
ISDA with regard to the specific index and be denominated in a currency
that is accepted for clearing by DCOs. To the extent that a CDS
agreement on an index listed within the classification is not accepted
for clearing by any DCO because it uses non-standard terms or is
denominated in a currency that makes it ineligible for clearing, that
CDS would not be subject to the requirement that it be cleared,
notwithstanding that the CDS is based on such index.
With regard to the specific indices, the Commission has not
included the CDX.NA.IG.HVOL within the North American swap class. While
older series of this swap were cleared at the 5-year tenor by ICE Clear
Credit, neither of the two most recent series has been cleared, given
the lack of trading volume in this swap. The swap is not offered for
clearing by CME. To the extent that any DCO decides to clear future
series of this particular indice, it would need to be submitted
pursuant to Sec. 39.5, at which time, the Commission would be able to
revisit the profile of the underlying index and determine whether swap
contracts associated with this index should be subject to a clearing
requirement.
ICE Clear Europe continues to clear the iTraxx Europe High
Volatility through the current series at the 5-year tenor,
notwithstanding declines in the volume for the recent series. Overall,
the outstanding notional amounts and trading volumes are substantially
less than those of the other iTraxx swaps. Recent DTCC data indicates
that the gross notional amounts on contracts on the iTraxx Europe High
Volatility index was $1.8 billion, representing less than 1% of those
volumes for the European investment grade index and approximately 2.5%
of the European high yield index for the same series.53
—————————————————————————
53 See www.dtcc.com. Data as of May 21, 2012.
—————————————————————————
Notwithstanding the relatively small volumes, the Commission is
proposing to include the iTraxx Europe High Volatility index within the
class of European corporate indices subject to required clearing at
this time. Because the current on-the-run series of this particular
index is cleared, unlike the similar North American contract, the
Commission believes the contract should be included within the class of
European corporate swaps that is required to be cleared.
With regard to tenors, Markit, as administrator of the indices,
publishes the initial spreads on the roll for each of the tenors
offered for a given indice. For the CDX.NA.IG, it publishes spreads for
the 1-, 2-, 3-, 5-, 7-, and 10-year tenors. For the CDX.NA.HY, the
spreads are set for the 3-, 5-, 7-, and 10-year tenors. For the iTraxx
Europe, Crossover and High Volatility, spreads are similarly set for
the 3-, 5-, 7-, and 10-year tenors.
Notwithstanding these various tenor offerings, the 5-year tenor for
all indices is by far the most liquid tenor in the CDS marketplace. As
a result, each DCO clears the 5-year tenor of the CDS index swaps that
they clear. CME additionally offers clearing for 3-, 7-, and 10-year
tenors on the CDX.NA.IG. ICE Clear Credit offers clearing on the 10-
year tenor for the North American investment grade swap in addition to
the 5-year contract. In the past, ICE Clear Credit has cleared the 7-
year tenor of that index, but has not offered that tenor since Series
10. For the iTraxx indices, ICE Clear Europe offers the 10-year tenor
on the investment grade index, in addition to the 5-year tenor.
Based upon its analysis of the Sec. 39.5 factors, the Commission
is proposing that each of the 3-, 5-, 7-, and 10-year tenors be
included within the class of swaps subject to the clearing requirement
determination for CDX.NA.IG. While the DCO submissions indicate varying
degrees of trading volumes among the indices at tenors other than the
5-year tenor, there are clearly large notional volumes and trading
activity across the products as a whole. The risk management frameworks
and methodologies employed by the DCOs should not be substantially
impacted or can be adjusted to accommodate additional tenors. The
remaining factors should be unchanged.
The Commission is proposing to exclude the 1- and 2-year tenors of
the CDX.NA.IG from the class at this point. The Commission would like
to see more data on the volumes of these tenors. Importantly, these
tenors of swaps have not been submitted to the Commission by a DCO, so
the Commission could review them when submitted by a DCO or on its own
initiative pursuant to the Sec. 39.5(c). Because many investors use
the 5-year tenor to take a view on credit as an asset class, and then
exit the position when the new index rolls rather than hold a less
liquid position in an off-the-run swap, the Commission is concerned
that those seeking to avoid clearing may shift to the 1- or 2-year
tenor to take a position on credit. The Commission will monitor volumes
in the swaps at these tenors and evaluate
[[Page 47179]]
whether a change in the class of swaps to include these tenors is
warranted.
With regard to the CDX.NA.HY, the Commission’s proposal will be
limited to the 5-year tenor, the predominant tenor in this
contract.54 Similarly, the Commission’s proposal with regard to the
iTraxx indices will capture only those tenors that are currently
offered for clearing–the 5- and 10-year tenors for the iTraxx Europe,
and the 5-year tenors for the iTraxx Crossover and the iTraxx High
Volatility.
—————————————————————————
54 After its initial submission, ICE Clear Credit added the
CDX.NA.HY, Series 15, 3-year contract to its list of CDS contracts
eligible for clearing. The Commission has reviewed this contract,
but is not including this particular contract within its proposed
determination. The Commission will monitor volumes in the product at
these tenors and evaluate whether a change in the class of swaps to
include additional tenors is warranted.
—————————————————————————
The Commission’s proposed clearing determination will be limited to
only those series of a given index, which are currently being cleared.
Therefore, no swaps referencing a series prior to Series 8 for the
CDX.NA.IG and CDX.NA.HY would be required to be cleared. For the iTraxx
Europe and iTraxx Europe Crossover, no contracts referencing a series
prior to Series 7 would be required to be cleared, and in the case of
the iTraxx Europe High Volatility, no series prior to Series 9 would be
required to be cleared.55
—————————————————————————
55 As discussed in further detail below, the clearing
requirement would not require existing swaps in the older series to
be cleared. The requirement is prospective, only requiring newly
executed swaps in these older series to be cleared.
—————————————————————————
Further, to the extent that any contract is of a tenor such that it
is scheduled to terminate prior to July 1, 2013, such contract would
not be part of this proposed clearing determination. Given the
implementation periods provided for under Sec. 50.25, discussed below
in Section IV, the Commission does not want to create a situation where
certain market participants would be required to clear a contract based
upon their status under the implementation provisions, but other
parties would never be required to clear that same contract before its
scheduled termination.
The Commission also is proposing that the classes be limited to
untranched CDS agreements on the aforementioned indices where the
contract covers the entire index loss distribution of the index and
settlement is not linked to a specified number of defaults. Tranched
swaps, first- or “Nth” to-default, options, or any other product
variations on these indices are excluded from these classes. These
other swaps based on the indices, such as tranches, have very different
profiles in terms of the Sec. 39.5 analysis. Besides very different
notional and trading volumes, the risk management processes and
operations may be significantly different. The Commission believes it
appropriate to consider tranched swaps and other variations on the
indices as outside of the classes of swaps proposed herein. Such swaps,
if submitted, likely would be viewed as a separate class.
D. Proposed Determinations Analysis for Credit Default Swaps
Section 2(h)(2)(D)(i) of the CEA requires the Commission to review
whether a swap submission under section 2(h)(2)(B) is consistent with
section 5b(c)(2) of the CEA. Section 2(h)(2)(D)(ii) of the CEA also
requires the Commission to consider five factors in a determination
based on a Commission initiated review or a swap submission: (1) The
existence of significant outstanding notional exposures, trading
liquidity, and adequate pricing data; (2) the availability of rule
framework, capacity, operational expertise and resources, and credit
support infrastructure to clear the contract on terms that are
consistent with the material terms and trading conventions on which the
contract is then traded; (3) the effect on the mitigation of systemic
risk, taking into account the size of the market for such contract and
the resources of the DCO available to clear the contract; (4) the
effect on competition, including appropriate fees and charges applied
to clearing; and (5) the existence of reasonable legal certainty in the
event of the insolvency of the relevant DCO or one or more of its
clearing members with regard to the treatment of customer and swap
counterparty positions, funds, and property.
i. Consistency With Core Principles for Derivatives Clearing
Organizations
Section 2(h)(2)(D)(i) of the CEA requires the Commission to review
whether a submission is consistent with the core principles for DCOs.
Each of the DCO submissions relating to CDS provided data to support
the Commission’s analysis of the five factors under section 2(h)(2)(D)
of the CEA. The Commission also was able to call upon independent
analysis conducted with regard to CDS market, as well as its knowledge
and reviews of the registered DCOs’ operations and risk management
processes, covering items such as product selection criteria, pricing
sources, participant eligibility, and other relevant rules. The
discussion of all of these factors is set forth below.
The swaps submitted by CME, ICE Clear Credit, and ICE Clear Europe
pursuant to Sec. 39.5(b) are currently being cleared by those
organizations. As discussed above, the risk management, rules, and
operations used by each DCO to clear these swaps are subject to review
by the Commission risk management, legal, and examinations staff on an
on-going basis.
Additionally, each of the DCOs has established procedures for the
review of any new swaps offered for clearing. Before the indices
referenced herein were accepted for clearing by any of the DCOs, they
were subject to review by the risk management functions of those
organizations. Such analysis generally focuses on the ability to risk
manage positions in the potential swaps and on any specific operational
issues that may arise from the clearing of such swaps. In the case of
the former, this involves ensuring that adequate pricing data is
available, both historically and on a “going forward” basis, such
that a margining methodology could be established, back-tested, and
used on an on-going basis. Operational issues may include analysis of
additional contract terms for new swaps that may require different
settlement procedures. Each of the contracts submitted by CME, ICE
Clear Credit, and ICE Clear Europe and discussed herein has undergone
an internal review process by the respective DCO and has been
determined to be within their product eligibility standards.
As part of their rule frameworks, each of the DCOs also maintains
participant eligibility requirements. On April 20, 2012, CME filed its
amended rule concerning CDS Clearing Member Obligations and
Qualifications (Rule 8H04). Pursuant to the amended rule, published to
comply with Commission Regulation 39.12(a)(2), a CDS clearing member
would have to maintain at least $50 million of capital. The amended
rule would also require a CDS clearing member’s minimum capital
requirement to be “scalable” to the risks it poses. Further, CME
already has client clearing available for its CDS index contracts.
Similarly, on March 23, 2012, ICE Clear Credit filed its amended
Rule 201(b) to incorporate the $50 million minimum capital requirement
for clearing members. ICE Clear Credit also has client clearing
available for its CDX index contracts.
ICE Clear Europe has adopted similar rules to comply with Sec.
39.12(a)(2), and has instituted changes to its rules to permit client
clearing of its iTraxx contracts.
In their submissions, CME and ICE Clear Credit enclosed their risk
management procedures. In its submission, ICE Clear Europe references
[[Page 47180]]
its risk management procedures, which it had previously submitted to
the Commission in connection with its application to register as a DCO.
As part of its risk management and examination functions, the
Commission reviews each DCO’s risk management procedures, including its
margining methodologies.
ICE Clear Credit uses a multi-factor model to margin the indices
discussed herein, as well as single name CDS. The margining methodology
is designed to capture the risk of movements in credit spreads,
liquidation costs, jump-to-default risk for those names on which credit
protection has been sold, large position concentration risks, interest
rate sensitivity, and basis risk associated with offsetting index
derived single names and opposite “outright” single names. These
factors are similarly used by ICE Clear Europe to calculate the
margining requirements for their iTraxx swap listings and the
underlying single name constituents. The CME’s CDS model also weighs a
number of factors to calculate the initial margin for a portfolio of
CDS positions. These include macro-economic risk factors, such as
movements associated with systematic risk resulting in large shifts in
credit spreads across a portfolio, shifts in credit spreads based on
tenors and changes in relative spreads between investment grade and
high yield spreads. Additional factors include specific sector risks,
the idiosyncratic risk of extreme moves in particular reference
entities and the liquidity risk associated with unwinding the
portfolio. In all cases, the methodologies are designed to protect
against any 5-day move in the value of the given CDS portfolio, with a
99% confidence level.
In addition to initial margin, each of the clearinghouses collects
variation margin on a daily basis to capture changes in the mark-to-
market value of the positions. To do this, the clearinghouses calculate
end-of-day settlement prices using clearing member price submissions
for cleared swaps. Each of the clearinghouses maintains processes for
ensuring the quality of member price submissions, including the ability
to compel trades at quoted prices on a random basis and to enforce
fines on incomplete or incorrect submissions. ICE Clear Credit and ICE
Clear Europe also use Markit services for CDX and iTraxx submissions.
CME uses other third party data providers for pricing support as
necessary on its cleared CDS products.
In addition to the end-of-day settlement, each of the
clearinghouses monitors positions throughout the day and maintains the
ability to require margin on an intraday basis. Triggers may be set
based upon the erosion of margin to a specific level or a call may be
made at the discretion of the clearinghouse. When necessary, DCOs apply
concentration charges to a clearing member’s house or customer account
in order to address situations where the DCO believes a given position
may be under-collateralized because the size of the position relative
to the size of the market may increase the cost of liquidating the
position.
In addition to the initial margin and variation margin collected by
each DCO, each of the clearinghouses maintains a separate guaranty fund
for its CDS clearing business. Using a combination of factors from
their margining methodologies, positions are stressed to replicate
extreme but plausible market conditions. Using these stressed results,
each of the clearinghouses sizes its guaranty fund to cover the
positions of its two largest debtor clearing members. Clearing members
are required to contribute to the guaranty fund based on their relative
positions.
To the extent a clearing member was unable to meet a margin call,
or otherwise violated clearinghouse rules, each of the clearinghouses
has the ability to find a clearing member in default. In such cases,
each of the clearinghouses has established procedures by which it
attempts to minimize the risk associated with a defaulting member’s
positions. A clearinghouse would activate its default committee,
seconding traders from clearing participants, to work to partition the
portfolio for sale and for hedging purposes. The clearinghouse would
then conduct an auction among its clearing participants for the sale of
the portfolio. To the extent certain positions were unsold, each of the
clearinghouses has the ability to allocate such positions to the
remaining clearing members.
While other resources of the clearinghouse would be available in
the event of a default of a clearing member, including clearinghouse
contributions, the initial margin and guaranty fund contributions make
up the primary financial resources of the clearinghouses. In total,
CFTC-registered DCOs are currently holding more than $20 billion in
aggregate in initial margin to cover cleared CDS positions.56
Additionally, publicly available data shows that CME’s CDS guaranty
fund has approximately $629 million; ICE Clear Credit has a guaranty
fund equal to $4.4 billion; and ICE Clear Europe has a guaranty fund
[euro]2.7 billion for its CDS business.57 In addition to the guaranty
fund contributions made by clearing members, each of the clearinghouses
also makes contributions to their respective funds, ranging in amounts
from $50 to $100 million.58
—————————————————————————
56 Based on Commission data for registered DCOs as of May 10,
2012.
57 See http://www.cmegroup.com/clearing/cme-clearing-overview/safeguards.html for data regarding CME’s guaranty fund, as of May
10, 2012; https://www.theice.com/clear_credit.jhtml for data on the
size of ICE Clear Credit’s guaranty fund; and https://www.theice.com/clear_europe_cds.jhtml for data on the size of ICE
Clear Europe’s guaranty fund for CDS, as of May 10, 2012.
58 Many DCOs also have rules allowing for an assessment of the
remaining clearing members in the event of a default.
—————————————————————————
Based upon the Commission’s on-going risk management and rule
reviews, and its annual examinations of the DCOs, the Commission
believes that the submissions of CME, ICE Clear Credit, and ICE Clear
Europe are consistent with section 5b(c)(2) of the CEA and the related
Commission regulations. In analyzing the CDS products submissions
discussed herein, the Commission does not believe that a clearing
determination with regard to the specified CDS products would be
inconsistent with CME, ICE Clear Credit, or ICE Clear Europe’s
continued ability to maintain such compliance with the DCO core
principles.
ii. Consideration of the Five Statutory Factors for Clearing
Requirement Determinations
a. Outstanding Notional Exposures, Trading Liquidity, and Adequate
Pricing Data
Section 2(h)(2)(D)(ii)(I) of the CEA requires the Commission to
take into account the existence of outstanding notional exposures,
trading liquidity, and adequate pricing data. As discussed earlier, the
most recent BIS data has shown significant growth in the use of CDS on
index products, with notional amounts growing by 40% over the most
recent annual reporting period. Overall, CDS on index products account
for 37% of all notional amounts of CDS contracts outstanding, with over
$10 trillion in notional outstanding.
The predominant provider of CDS indices is Markit. Markit has
indices covering corporate and sovereign entities, among others, in the
United States, Europe, and Asia. Recent Markit data shows daily
transaction volumes of 1,561 transactions using its licensed family of
CDX indices, and 1,266 daily transactions using its European iTraxx
index swaps.59 Further, it shows a rolling monthly average of $663
billion in gross notional amount for the CDX family of indices and
[euro]499 billion for
[[Page 47181]]
the iTraxx family. Nearly all of the CDX contracts and volumes come
from indices that would be subject to the proposed clearing requirement
determination. For the iTraxx, more than 79% of those daily contract
volumes and 82% of the daily gross notional volumes come from the
iTraxx investment grade and high yield indices contemplated by the
proposed clearing requirement determination.
—————————————————————————
59 Based on data published on www.markit.com as of May 23,
2012.
—————————————————————————
One point highlighted by this data, however, is the declining
trading liquidity in the off-the-run series that can occur. Of the
volumes noted by Markit, nearly 60% was in the current on-the-run
series, as compared to all other outstanding series combined. The
submissions of ICE Clear Credit, ICE Clear Europe, and CME also note
the decline in average weekly gross notional amounts and contracts for
benchmark tenors for off-the-run indices. The decline however can be
more precipitous among older off-the-run indices. While many market
factors can contribute to the actual volumes for a specific off-the-run
contract, subject to certain exceptions, the trend is generally toward
lower volumes.
Set forth below is a table of data taken from DTCC as of May 22,
2012, highlighting the net notional amounts and outstanding contracts
across all tenors available for each series in the proposed
determination.60
—————————————————————————
60 Data available at www.dtcc.com. In 2006, DTCC began
providing warehouse services for confirmed CDS trades through its
Trade Information Warehouse (TIW). With the commitment of global
market participants in 2009 to ensure that all OTC derivatives
trades are recorded by a central repository, TIW has become a global
repository for all CDS trades. With all major market participants
submitting their trades to the TIW, it is estimated that 98% of all
CDS trades are included within the warehouse, making it the primary
source of CDS transaction data.
—————————————————————————
BILLING CODE 6351-01-P
[[Page 47182]]
[GRAPHIC] [TIFF OMITTED] TP07AU12.000
Notwithstanding the declining volumes that occur when an index is
no longer on-the-run, the Commission does not believe that is
sufficient reason to exclude the older series from the classes of CDS.
As the DTCC data indicates, there are still significant volumes of
outstanding notional amounts in each of these series. From the
perspective of the clearinghouse, the risk management of the older
series of swaps should not provide significant additional challenges.
With the significant notional and contract volumes still outstanding at
DTCC, many clearing members already have these positions on their books
and are meeting their risk management requirements, even in the face of
declining trading volumes. Finally, while the volumes may decline, the
data included in the submissions indicates that volume still does
exist, and parties should be able trade as necessary. Additionally, as
discussed further below, the clearing requirement would apply only to
new swaps executed in the off-the-run indices.
Given the contract and notional volumes listed above, there is
adequate data available on pricing. The pricing for the CDS on these
indices is fairly consistent across clearinghouses. The clearinghouses
generally require a clearing member with open interest in a particular
index to provide a price on that index for end of day settlement
purposes. After applying a process to remove clear outliers, a
composite price is calculated using the remaining prices. To ensure the
integrity of the submissions, clearing members’ prices may be
“actionable,” meaning that they may form the basis of an actual trade
that the member will be forced to enter. Clearinghouses also have
compliance programs that may result in fines for clearing members that
fail to submit accurate pricing data.
Beyond clearing member submissions, there are a number of third-
party vendors that provide pricing services on these swaps. Third-party
vendors typically source their data from a broader range of dealers.
The data includes both direct contributions as well as feeds to
automated trading systems. This data is reviewed for outliers and
aggregated for distribution.
[[Page 47183]]
b. Availability of Rule Framework, Capacity, Operational Expertise and
Resources, and Credit Support Infrastructure
Section 2(h)(2)(D)(ii)(II) of the CEA requires the Commission to
take into account the availability of rule framework, capacity,
operational expertise and resources, and credit support infrastructure
to clear the contract on terms that are consistent with the material
terms and trading conventions on which the contract is then traded. The
Commission preliminarily has determined that this factor is satisfied
by each of CME, ICE Clear Credit, and ICE Clear Europe.
CME, ICE Clear Credit, and ICE Clear Europe, respectively,
currently are clearing the swaps each submitted under Sec. 39.5. As
such, they have developed respective rule frameworks, capacity,
operational expertise and resources, and credit support infrastructure
to clear the contracts on terms that are consistent with the material
terms and trading conventions on which the contracts currently are
trading. The Commission believes that these are scalable and that CME,
ICE Clear Credit, and ICE Clear Europe would be able to risk manage the
additional swaps that might be submitted due to the clearing
requirement determination.
Following the financial crisis, the major market participants
committed in 2009 to the substantial reforms to the OTC derivatives
markets.61 Among the commitments from CDS dealers and buy side
participants was to actively engage with central counterparties to
broaden the range of cleared swaps and market participants. These
changes were in addition to those generated through organizations like
ISDA and their protocols impacting CDS. For broadly traded swaps like
the CDS indices, the ultimate impact of these initiatives was
operational platforms, rule frameworks, and other infrastructure
initiatives that replicated the bilateral market and supported the move
of these CDS to a centrally cleared environment. In this way, the CDS
clearing services offered by DCOs, including CME, ICE Clear Credit, and
ICE Clear Europe, were designed to be cleared in a manner that is
consistent with the material terms and trading conventions of a
bilateral, uncleared market.
—————————————————————————
61 See the June 2, 2009 letter to The Honorable William C.
Dudley, President of the Federal Reserve Bank of New York, available
at http://www.newyorkfed.org/newsevents/news/markets/2009/060209letter.pdf.
—————————————————————————
In addition, CME, ICE Clear Credit, and ICE Clear Europe are
registered DCOs. To be registered as such, CME, ICE Clear Credit, and
ICE Clear Europe have, on an on-going basis, demonstrated to the
Commission that they are each in compliance with the core principles
set forth in the CEA and Commission regulations, as discussed above. As
a general matter, any DCO that does not have the rule framework,
capacity, operational expertise and resources, and credit support
infrastructure to clear the swaps that are subject to mandatory
clearing is not in compliance with the core principles or the
Commission regulations promulgating these principles.
The Commission requests comment on all aspects of this factor,
including whether or not commenters agree that an applicant’s status as
a registered DCO is sufficient for meeting the factor’s requirements.
c. Effect on the Mitigation of Systemic Risk
Section 2(h)(2)(D)(ii)(III) of the CEA requires the Commission to
take into account the effect on the mitigation of systemic risk, taking
into account the size of the market for such contract and the resources
of the DCO available to clear the contract. The Commission agrees with
the Sec. 39.5 swap submissions of the CME, ICE Clear Credit, and ICE
Clear Europe that requiring certain classes of CDS to be cleared would
reduce systemic risk in this sector of the swaps market. As CME noted,
the 2008 financial crisis demonstrated the potential for systemic risk
arising from the interconnectedness of OTC derivatives market
participants and the limited transparency of bilateral, i.e. uncleared,
counterparty relationships. According to the Quarterly Report (Third
Quarter 2011) on Bank Trading and Derivatives Activities of the Office
of the Comptroller of the Currency (OCC Report),62 CDS index products
account for a significant percentage of the notional value of swaps
positions held by financial institutions. According to ICE Clear
Credit, the CDS indices it offers for clearing are among the most
actively traded swaps with the largest pre-clearing outstanding
positions, and ICE Clear Credit’s clearing members are among the most
active market participants. ICE Clear Credit also noted that its
clearing members clear a significant portion of their clearing-eligible
portfolio.
—————————————————————————
62 Available at: http://occ.treas.gov/topics/capital-markets/financial-markets/trading/derivatives/dq311.pdf.
—————————————————————————
Clearing the CDS indices subject to this proposal will reduce
systemic risk in the following ways: Mitigating counterparty credit
risk because the DCO would become the buyer to every seller of CDS
indices subject to this proposal and vice versa; providing
counterparties with daily mark-to-market valuations and exchange of
variation margin pursuant to a risk management framework; posting
initial margin with the clearinghouse in order to cover potential
future exposures in the event of a default; achieving multilateral
netting, which substantially reduces the number and notional amount of
outstanding bilateral positions; reducing swap counterparties’
operational burden by consolidating collateral management and cash
flows; and eliminating the need for novations or tear-ups because
clearing members may offset opposing positions.
As discussed previously, the clearinghouses collect substantial
amounts of collateral in the form of initial margin and guaranty fund
contributions to cover potential losses on CDS portfolios. The
methodologies for calculating these amounts are based on covering 5-day
price movements on a portfolio with a 99% confidence level for initial
margin, and longer liquidation periods and higher confidence levels
under “extreme but plausible” conditions in the case of guaranty fund
requirements. Beyond these financial resources, the clearinghouses have
in place established risk monitoring processes, system safeguards, and
default management procedures, which are subject to testing and review,
to address potential systemic shocks to the financial markets.
The Commission requests comment on all aspects of this factor,
including the risk mitigation associated with proposed clearing
determination.
d. Effect on Competition
Section 2(h)(2)(D)(ii)(IV) of the CEA requires the Commission to
take into account the effect on competition, including appropriate fees
and charges applied to clearing. Of particular concern to the
Commission is whether this proposed determination would harm
competition by creating, enhancing, or entrenching market power in an
affected product or service market, or facilitating the exercise of
market power.63 Under U.S. Department of Justice guidelines, market
power is viewed as the ability “to raise price [including clearing
fees and charges], reduce output, diminish innovation, or otherwise
harm customers as a result of
[[Page 47184]]
diminished competitive constraints or incentives.” 64
—————————————————————————
63 See U.S. Department of Justice and the Federal Trade
Commission, Horizontal Merger Guidelines [hereinafter “Horizontal
Merger Guidelines”] at Sec. 1(Aug. 19, 2010), available at http://www.justice.gov/atr/public/guidelines/hmg-2010.pdf.
64 Id.; see also U.S. Department of Justice (DOJ) and the
Federal Trade Commission (FTC), Antitrust Guidelines for
Collaborations Among Competitors at Sec. 1.2 (April 2000),
available at http://www.ftc.gov/os/2000/04/ftcdojguidelines.pdf
(“The central question is whether the relevant agreement likely
harms competition by increasing the ability or incentive profitably
to raise price above or reduce output, quality, service, or
innovation below what likely would prevail in the absence of the
relevant agreement”).
—————————————————————————
The Commission has identified the following putative product and
service markets as potentially affected by this proposed clearing
determination: A DCO service market encompassing those clearinghouses
that currently (or with relative ease in the future could) clear the
CDS subject to this proposal, and a CDS product market or markets
encompassing the CDS that are subject to this determination.65
Without defining the precise contours of these markets at this
time,66 the Commission recognizes that, depending on the interplay of
several factors, this proposed swap determination potentially could
impact competition within the affected markets. Of particular
importance to whether any impact is, overall, positive or negative, is:
(1) Whether the demand for these clearing services and swaps is
sufficiently elastic that a small but significant increase above
competitive levels would prove unprofitable because users of the CDS
products and DCO clearing services would substitute other products/
clearing services co-existing in the same market(s), and (2) the
potential for new entry into these markets. The availability of
substitute products/clearing services to compete with those encompassed
by this proposed determination, and the likelihood of timely,
sufficient new entry in the event prices do increase above competitive
levels, each operate independently to constrain anticompetitive
behavior.
—————————————————————————
65 Included among these could be a separate product market for
CDS indices licensing.
66 The federal antitrust agencies, the DOJ and FTC, use the
“hypothetical monopolist test” as a tool for defining antitrust
markets for competition analysis purposes. The test “identif[ies] a
set of products that are reasonably interchangeable with a
product,” and thus deemed to reside in the same relevant antitrust
product or service market. “[T]he test requires that a hypothetical
profit-maximizing firm, not subject to price regulation, that was
the only present and future seller of those products (`hypothetical
monopolist’) likely would impose at least a small but significant
and non-transitory increase in price (`SSNIP’) on at least one
product in the market.” In most cases, a SSNIP of five percent is
posited. If consumers would respond to the hypothesized SSNIP by
substituting alternatives to a significant degree to render it
unprofitable, those alternative products/services are included
within the relevant market. This methodological exercise is repeated
until it has been determined that consumers have no further
interchangeable products/services available to them. Horizontal
Merger Guidelines at Sec. 4.1.
—————————————————————————
Any competitive import would likely stem from the fact that
proposed determination would (1) remove the alternative of not clearing
the CDS subject to this proposal, and/or (2) single out Markit indices
and certain tenors for determination. The proposed determination would
not specify what CDS products (or products that compete with the
proposed CDS classes) may or may not be offered, traded, or voluntarily
cleared; or who may or may not compete to provide clearing services for
the CDS subject to this proposal (as well as those not required to be
cleared). With respect to the first potential area of competitive
import, to the extent that parties to the CDS subject to this proposal
consider clearing the transactions reasonably interchangeable with not
clearing them, the proposed determination would eliminate at least one
competitive substitute within the clearinghouse services market for the
CDS subject to this proposal. Given the risk-mitigation purpose and
benefit of migration to voluntary CDS clearing, however, the Commission
sees some basis to doubt that, under the “hypothetical monopolist”
methodology,67 counterparties to cleared swaps would consider the
alternative of not clearing CDS under this proposal as a reasonable
substitute to a degree sufficient that they should be viewed as
populating the same relevant market.68 And, if the alternative of not
clearing the proposed classes of CDS falls outside of the relevant
services market that includes clearing, the proposed clearing
determination should not impact competition in the clearing services
market. The Commission requests comment on the extent to which
foregoing clearing is considered reasonably interchangeable with
clearing the CDS subject to this proposal and, in particular, if
parties transacting cleared swaps in these classes would forego
clearing if clearinghouses raised the price of clearing five percent.
The Commission also requests comment on whether a different percentage
than five percent should be used.
—————————————————————————
67 See id.
68 In other words, the Commission questions that, faced with a
five percent non-transitory increase in the price of clearing the
identified CDS classes, including fees and other charges, that the
parties to these CDS transactions would forego clearing in
sufficient volume to render the price increase unprofitable.
—————————————————————————
Moreover, even if cleared and non-cleared transactions in the
proposed CDS clearing requirement are now within the same relevant
market, removing the uncleared option through this proposed rulemaking
is not determinative of negative competitive impact. Other factors–
including the availability of other substitutes within the market or
potential for new entry into the market–may constrain market power.
The Commission recognizes that currently no DCO clears CDS indices
licensed by any other provider than Markit, suggesting the possibility
that currently the clearing service market may be limited to the three
providers (CME, ICE Clear Credit, and ICE Clear Europe) now clearing
CDS indices licensed by Markit. This could be indicative, but is not
dispositive, of whether a concentrated clearing services market
susceptible to exercises of market power exists. The possibility
remains that uncleared transactions on other indices, as well as
cleared and uncleared transactions on Markit indices of tenors not
included within the proposed determination, may also populate the
affected clearing services market to constrain CME, ICE Clear Credit,
and ICE Clear Europe from exercising market power.69 The Commission
requests comment on the extent to which uncleared transactions on non-
Markit indices, and cleared and uncleared transactions on Markit
indices of tenors not included within the proposed determination, are
considered reasonably interchangeable with clearing the CDS subject to
this proposal; and, in particular, if parties transacting cleared CDS
subject to this proposal would substitute uncleared transactions on
non-Markit indices and/or transactions on Markit CDS tenors not subject
to this proposal if clearinghouses raised the price of clearing the CDS
required to be cleared five percent.
—————————————————————————
69 Stated another way, competitive or potentially competitive
CDS indices other than Markit, or for Markit CDS tenors other than
those subject to this proposal, may offer a reasonably
interchangeable substitute for cleared transactions in the proposed
classes proposed, particularly if the price of clearing the required
classes increased five percent.
—————————————————————————
Additionally, the potential for new entry may constrain market
power in an otherwise concentrated clearing services market. The
Commission does not foresee that the proposed determination constructs
barriers that would deter or impede new entry into a clearing services
market.70 Indeed, there is some
[[Page 47185]]
basis to expect that the determination could foster an environment
conducive to new entry. For example, the proposed clearing
determinations, and the prospect that more may follow, is likely to
reinforce, if not encourage, growth in demand for clearing services.
Demand growth, in turn, can enhance the sales opportunity, a condition
hospitable to new entry.71 Further, this proposed determination may
increase the incentive of competing indices providers (for illustration
purposes, Standard & Poor’s) to support a new clearing services entrant
through some form of partnership or other sponsorship effort. The
Commission requests comment on the extent to which (1) entry barriers
currently do or do not exist with respect to a clearing services market
for the identified CDS classes; (2) the proposed determinations may
lessen or increase these barriers; and (3) the proposed determinations
otherwise may encourage, discourage, facilitate, and/or dampen new
entry into the market.
—————————————————————————
70 That said, the Commission recognizes that (1) to the extent
the clearing services market for the CDS subject to this proposal,
after foreclosing uncleared swaps, would be limited to a
concentrated few participants with highly aligned incentives, and
(2) the clearing services market is insulated from new competitive
entry through barriers–e.g., high sunk capital cost requirements;
high switching costs to transition from embedded, incumbents; and
access restrictions, the proposed determination could have a
negative competitive impact by increasing market concentration.
71 See, e.g., Horizontal Merger Guidelines at Sec. 9.2 (entry
likely if it would be profitable which is in part a function of
“the output level the entrant is likely to obtain”).
—————————————————————————
Also, while the proposed rule does single out Markit indices and
certain CDS tenors for required clearing, for reasons similar to those
discussed above, this does not foreclose competition from CDS on other
indices or tenors, and may in fact encourage it. For example, the
Commission anticipates that an attempt by Markit to increase indices
licensing fees would present a competitive opportunity for current and
potential future indices providers to capture market share and/or
entrants to leverage from market entry. The Commission requests comment
on the extent to which competition in identified Markit CDS product
markets may be impacted, including any expected impact on the price of
Markit indices licenses, cost of swaps in the required classes, and
entry conditions.
In addition to what is noted above, the Commission requests
comment, and quantifiable data, on whether the required clearing of any
or all of these swaps will create conditions that create, increase, or
facilitate an exercise of (1) clearing services market power in CME,
ICE Clear Credit, ICE Clear Europe, and/or any other clearing service
market participant, including conditions that would dampen competition
for clearing services and/or increase the cost of clearing services,
and/or (2) market power in any product markets for Markit indices and
CDS tenors, including conditions that would dampen competition for
these product markets and/or increase the cost of CDS involving the
proposed clearing requirement. The Commission seeks comment, and
quantifiable data, on the likely cost increases associated with
clearing, particularly those fees and charges imposed by DCOs, and the
effects of such increases on counterparties currently participating in
the market. The Commission also seeks comment regarding the effect of
competition on risk management by DCOs. The Commission welcomes comment
on any other aspect of this factor.
e. Legal Certainty in the Event of the Insolvency
Section 2(h)(2)(D)(ii)(V) of the CEA requires the Commission to
take into account the existence of reasonable legal certainty in the
event of the insolvency of the relevant DCO or one or more of its
clearing members with regard to the treatment of customer and swap
counterparty positions, funds, and property. The Commission is
proposing this clearing requirement based on its view that there is
reasonable legal certainty with regard to the treatment of customer and
swap counterparty positions, funds, and property in connection with
cleared swaps, namely the CDS indices subject to this proposal, in the
event of the insolvency of the relevant DCO (CME, ICE Clear Credit, or
ICE Clear Europe) or one or more of the DCO’s clearing members.
The Commission concludes that, in the case of a clearing member
insolvency at CME or ICE Clear Credit, subchapter IV of Chapter 7 of
the U.S. Bankruptcy Code (11 U.S.C. 761-767) and Part 190 of the
Commission’s regulations would govern the treatment of customer
positions.72 Pursuant to section 4d(f) of the CEA, a clearing member
accepting funds from a customer to margin a cleared swap, must be a
registered FCM. Pursuant to 11 U.S.C. 761-767 and Part 190 of the
Commission’s regulations, the customer’s CDS positions, carried by the
insolvent FCM, would be deemed “commodity contracts.” 73 As a
result, neither a clearing member’s bankruptcy nor any order of a
bankruptcy court could prevent either CME or ICE Clear Credit from
closing out/liquidating such positions. However, customers of clearing
members would have priority over all other claimants with respect to
customer funds that had been held by the defaulting clearing member to
margin swaps, such as the customers’ positions in CDS indices subject
to this proposal.74 Thus, customer claims would have priority over
proprietary claims and general creditor claims. Customer funds would be
distributed to swaps customers, including CDS customers, in accordance
with Commission regulations and section 766(h) of the Bankruptcy Code.
Moreover, the Bankruptcy Code and the Commission’s rules thereunder (in
particular 11 U.S.C. 764(b) and 17 CFR 190.06) permit the transfer of
customer positions and collateral to solvent clearing members.
—————————————————————————
72 The Commission observes that an FCM or DCO also may be
subject to resolution under Title II of the Dodd-Frank Act to the
extent it would qualify as covered financial company (as defined in
section 201(a)(8) of the Dodd-Frank Act).
73 If an FCM is also registered as a broker-dealer, certain
issues related to its insolvency proceeding would also be governed
by the Securities Investor Protection Act.
74 Claims seeking payment for the administration of customer
property would share this priority.
—————————————————————————
Similarly, 11 U.S.C. 761-767 and Part 190 would govern the
bankruptcy of a DCO, in conjunction with DCO rules providing for the
termination of outstanding contracts and/or return of remaining
clearing member and customer property to clearing members.
With regard to ICE Clear Europe, the Commission understands that
the default of a clearing member of ICE Clear Europe would be governed
by the rules of that DCO. ICE Clear Europe, a DCO based in the United
Kingdom, has represented that under English law its rules would
supersede English insolvency laws. Under its rules, ICE Clear Europe
would be permitted to close out and/or transfer positions of a
defaulting clearing member that is an FCM pursuant to the U.S.
Bankruptcy Code and Part 190 of the Commission’s regulations. According
to ICE Clear Europe’s submission, the insolvency of ICE Clear Europe
itself would be governed by both English insolvency law and Part 190.
ICE Clear Europe has obtained legal opinions that support the
existence of such legal certainty in relation to the protection of
customer and swap counterparty positions, funds, and property in the
event of the insolvency of one or more of its clearing members. In
addition, ICE Clear Europe has obtained a legal opinion from U.S.
counsel regarding compliance with the protections afforded to FCM
customers under New York law.
The Commission requests comment on its conclusions with regard to
legal certainty in the event of an insolvency of CME, ICE Clear Credit,
ICE Clear
[[Page 47186]]
Europe, or one of such DCOs’ clearing members.
Request for Comment
The Commission requests comment on all aspects of the proposed
classes of CDS to be included within the clearing requirement and the
proposed determination. The Commission may consider alternatives to the
proposed CDS classes and is requesting comment on the following
questions:
Should the Commission include all tenors, such as the 1-
or 2-year tenor for Markit indices, for each index included within the
class, notwithstanding the fact that those are tenors not currently
cleared by a DCO? Will market participants be incentivized to use such
contracts to avoid the clearing requirement?
Should the Commission limit its determination to the most
liquid tenors of the CDX.NA.IG such as the 5- and 10-year tenors, and
exclude other tenors such as the 3- and 7-year tenors, which are less
liquid?
Is the Commission correct in believing that risk
management frameworks and methodologies supporting existing cleared
offerings can be adjusted to address additional tenors with limited
changes?
Should the Commission structure its clearing requirement
such that indices that become older off-the-run indices are no longer
subject to the requirement? In such a proposal, how should the
Commission treat those off-the-run indices, such CDX.NA.IG Series 9,
that have remained extremely active notwithstanding being off-the-run?
Should the Commission establish some type of threshold of trading to
exclude off-the-run indices from the requirement? How would the
Commission construct a rule to indicate that an off-the-run index is no
longer subject to clearing?
To the extent off-the-run indices were excluded from the
clearing requirement, would market participants be incentivized to
trade in older off-the-run indices, as opposed to current on-the-run
indices?
The CDS indices proposed to be included within the
clearing requirement are currently offered by DCOs and are among the
most liquid CDS. Is there any factor within the five statutory that do
not support inclusion with the clearing requirement? Are there other
factors outside of those five factors with regard to these particular
offerings that weigh against inclusion in a clearing determination?
E. Interest Rate Swaps
i. Introduction
Interest rate swaps are agreements wherein counterparties agree to
exchange payments based on a series of cash flows over a specified
period of time typically calculated using two different rates
multiplied by a notional amount. As of June 2011, the BIS estimated
that over $500 trillion in notional amount of single currency interest
rate swaps were outstanding 75 representing 75 to 80%of the total
estimated notional amount of derivatives outstanding.76 Based on
these factors and on the swap submissions received under Sec. 39.5(b),
the Commission believes that interest rate swaps represent a
substantial portion of the swaps market and warrant consideration by
the Commission for required clearing.
—————————————————————————
75 BIS, OTC Derivatives Market Activity in the First Half of
2011, November 2011, Table 1 [hereinafter “BIS data”]. The BIS
data provides the broadest market-wide estimates of interest rate
swap activity available to the Commission.
76 Id.
—————————————————————————
The Commission’s consideration of the interest rate swap
submissions (IRS submissions) is presented in two parts. The first
part, this Section II.E, discusses the Commission’s rationale for
determining how to classify and define the interest rate swaps
identified in the DCO submissions to be considered for the clearing
requirement. The second part, Section II.F, presents the Commission’s
consideration of the IRS submissions in accordance with section
2(h)(2)(D) of the CEA.
Unlike certain CDS or futures contracts, there are a large number
of different, variable contract specifications available and used in
interest rate swap transactions. As an indication of this variability,
the Commission notes that over 10,500 different combinations of
significant interest rate swap terms were identified for trades
executed in a single three month period in 2010.77 This variability
creates a challenge for DCOs to specify the interest rate swaps for
which clearing services are available and for the Commission to define
what kinds of interest rate swaps will be subject to the clearing
requirement. Notwithstanding this variability in swap terms, parties
generally seek common economic results when entering into interest rate
swaps, and there are common contract definitions and conventions that
make classifying and clearing interest rate swaps possible. Identifying
and analyzing these commonalities is necessary for effective
classification of the swaps that will be subject to a proposed clearing
requirement determination for interest rate swaps. Accordingly, a
summary of the DCO submissions received by the Commission is followed
by a discussion of how interest rate swaps are traded and risk managed
and an analysis of the primary interest rate swap classes that are
cleared and the product specifications used to identify interest rate
swap products within each class. Thereafter, in Section II.F the
Commission considers each of the interest rate swap classes and the
primary specifications that are identified in the IRS submissions using
the five factors identified in section 2(h)(2)(D) of the CEA to
determine which interest rate swaps shall be required to be cleared.
—————————————————————————
77 Federal Reserve Bank of New York Staff Reports, “An
Analysis of OTC Interest Rate Derivatives Transactions: Implications
for Public Reporting” (March 2012) at 3 [hereinafter “NY Fed
Analysis”], available at http://www.newyorkfed.org/research/staff_reports/sr557.pdf.
—————————————————————————
ii. Submissions Received
The Commission received submissions from three DCOs eligible to
clear interest rate swaps (IRS submissions): LCH.Clearnet Limited
(LCH), the clearing division of the Chicago Mercantile Exchange Inc.
(CME), and International Derivatives Clearinghouse, LLC (IDCH).78
—————————————————————————
78 The IRS submissions received by the Commission are
available at http://www.cftc.gov/IndustryOversight/IndustryFilings/index.htm. Submission materials marked by the submitting DCO for
confidential treatment pursuant to Sec. Sec. 39.5(b)(5) and
145.9(d) are not available for public review.
—————————————————————————
The following table summarizes the interest rate swap classes and
significant specifications identified in the IRS submissions as
currently available for clearing by each DCO. The classes and swap
specifications are described in more detail below.
[[Page 47187]]
Table 3–Interest Rate Swap Submissions Summary
—————————————————————————————————————-
LCH CME IDCH
—————————————————————————————————————-
Swap Classes…………………. Fixed-to-floating, basis, Fixed-to-floating……… Fixed-to-floating,
forward rate agreements basis, FRAs, OIS.
(FRAs), overnight index
swaps (OIS).
Currencies 79………………. USD, EUR, GBP, JPY, AUD, USD, EUR, GBP, JPY, CAD, USD.
CAD, CHF, SEK, CZK, DKK, and CHF.
HKD, HUF, NOK, NZD, PLN,
SGD, and ZAR.
Rate Indexes…………………. For Fixed-to-floating, USD-LIBOR, CAD-BA, CHF- USD-LIBOR.
basis, FRAs: LIBOR in LIBOR, GBP-LIBOR, JPY-
seven currencies, BBR- LIBOR, and EURIBOR.
BBSW, BA-CDOR, PRIBOR,
CIBOR-DKNA13, CIBOR2-
DKNA13, EURIBOR-Telerate,
EURIBOR-Reuters, HIBOR-
HIBOR, HIBOR-HKAB, HIBOR-
ISDC, BUBOR-Reuters,
NIBOR, BBR-FRA, BBR-
Telerate, PLN-WIBOR, PLZ-
WIBOR, STIBOR, SOR-
Reuters, JIBAR.
For OIS: FEDFUNDS, SONIA,
EONIA, TOIS.
Maximum Stated Termination Dates.. For Fixed-to-floating, USD, EUR, GBP out to 50 For Fixed-to-
basis, FRAs: USD, EUR, years, and CAD, JPY, CHF, floating: 30 years.
and GBP out to 50 years, AUD out to 30 years.
AUD, CAD, CHF, SEK and
JPY out to 30 years and
the remaining nine
currencies out to 10
years.
For OIS: USD, EUR, GBP, …………………….. For OIS, and FRAs:
and CHF out to two years. two years.
—————————————————————————————————————-
—————————————————————————
79 In this proposal, currencies are identified either by their
full name or by the three letter ISO currency designation for the
currency.
—————————————————————————
Each of the IRS submissions provided information specified under
Sec. 39.5(b) for such swap submissions or provided references to Web
sites or other sources for such information, including, for example,
information previously provided to the Commission for other purposes.
Each submitter also has described how it provided notice to its members
as required by Sec. 39.5(b)(3)(viii).
LCH has been clearing OTC interest rate swaps since 1999 through
its SwapClear service. In its IRS submission, LCH indicates that it
clears more than 50% of the interest rate swap market by notional
amount.80 As of its submission date, February 24, 2012, LCH reported
that it had cleared and held outstanding about one million trades with
an aggregate notional amount over $283 trillion. LCH accepted for
clearing fixed-to-floating and basis swaps in seventeen currencies
(including variable notional swaps in three currencies), overnight
index swaps in four currencies, and forward rate agreements in 10
currencies. Swaps accepted for clearing must have certain product
specifications identified by LCH, which help it administer clearing and
manage risk appropriately.81 Of the three interest rate swap
submitters, LCH has been clearing the longest, clears the broadest
range of interest rate swaps, and clears the largest portion of the
interest rate swap market at this time. As of March 2011, LCH
implemented client clearing in both Europe and the U.S. Prior to that
date, both parties to a swap had to be LCH members to be able to clear
a swap with LCH.
—————————————————————————
80 LCH letter, dated February 24, 2012, at 1, stating that the
market share percentage estimate is based upon BIS statistics and
SwapClear volumes as of January 31, 2012.
81 These specifications can be found on LCH’s Web site at
http://www.lchclearnet.com/Images/General%20Regulations_tcm6-43737.pdf.
—————————————————————————
CME began clearing interest rate swaps on October 18, 2010. CME’s
IRS submission indicates that CME is currently clearing fixed-to-
floating swaps in six currencies with an identified set of product
specifications and has open interest in three currencies. In its
submission, CME recommended a clearing requirement determination for
all non-option interest rate swaps denominated in a currency cleared by
any qualified DCO.
In September 2010, IDCH amended its rule book to provide for
clearing interest rate swaps. IDCH is eligible to clear U.S. dollar
denominated fixed-to-floating swaps, overnight index swaps, and forward
rate agreements, which have certain product specifications as
identified in its submission. IDCH had no outstanding cleared positions
for these swaps as of the date of this proposal.
Furthermore, the interest rate swaps identified in the three IRS
submissions are all single currency swaps with no optionality, as
defined by the applicable DCO.
iii. Interest Rate Swap Market Conventions and Risk Management
Unlike certain CDS for which highly standardized terms have been
developed, or futures, the terms of which are set by the exchanges,
interest rate swaps are broad in scope and present a wide range of
variable product classes and product specifications within each class.
A data set of interest rate swaps electronically recorded over a three
month period in 2010 by 14 large dealers for which one of those dealers
was a party to each swap, contained over 10,500 different combinations
of product classes, currencies, tenors, and forward periods.82 The
data set also included eight different general product classes (e.g.,
fixed-to-floating, basis, forward rate agreements, swaptions, etc.), 28
currencies, 53 different rate indexes, and stated termination dates
from one month to 55 years. In addition, dozens of different contract
term conventions were identified.
—————————————————————————
82 See “ODSG data” described below. The ODSG data set, while
the broadest available providing trade-by-trade details, is limited
in that it excludes trades that needed to be manually confirmed or
that did not include a G14 Dealer.
—————————————————————————
Notwithstanding the large variety of contracts, there are
commonalities that make it possible to categorize interest rate swaps
for clearing purposes. Firstly, the vast majority of interest rate
swaps use the ISDA definitions and contract conventions that allow
market participants to agree quickly on common terms for each
transaction. In fact, the three DCOs clearing interest rate swaps all
use ISDA definitions in their product specifications.
Secondly, counterparties enter into swaps to achieve particular
economic results. While the results desired may differ in small ways
depending on each
[[Page 47188]]
counterparty’s specific circumstances and goals, there are certain
common swap conventions that are used to identify and achieve commonly
desired economic results when entering into interest rate swaps. For
example, a party that is trying to hedge variable interest rate risk
may enter into a fixed rate to floating rate swap, or a party that is
seeking to fix interest rates for periods in the future may enter into
a forward rate agreement.
The IRS submissions classify interest rate swaps on this basis by
identifying commonly known classes of swaps that they clear including:
fixed rate to floating rate swaps, that are sometimes referred to as
plain vanilla swaps (fixed-to-floating swaps); floating rate to
floating rate swaps, also referred to as basis swaps (basis swaps);
overnight index swaps (OIS); and forward rate agreements (FRAs).83
These class terms are also being used in industry efforts to develop a
taxonomy for interest rate swaps.84
—————————————————————————
83 These are sometimes also referred to as “types,”
“categories,” or “groups.” For purposes of this determination,
the Commission is using the term “class,” in order to be
consistent with the approach taken by the European Securities and
Markets Authority (ESMA) in its Discussion Paper, “Draft Technical
Standards for the Regulation on OTC Derivatives, CCPs, and Trade
Repositories,” (Feb. 16, 2012), available at http://www.esma.europa.eu/system/files/2012-95.pdf. It is also noted that
other categorizations are sometimes used for certain purposes.
However, these four classes are common terms used by the DCOs and
are common terms used in industry taxonomies.
84 See, e.g., ISDA Swap Taxonomies, available at http://www2.isda.org/identifiers-and-otc-taxonomies/; Financial Products
Markup Language, available at http://www.fpml.org/; and the NY Fed
Analysis.
—————————————————————————
Furthermore, within these general classes, certain specifications
such as currency, reference interest rate index, and stated termination
date (also referred to as maturity date), are essential for defining
the economic result that will be achieved. For example, a party located
in the United States who seeks to hedge interest rate risk that is in
U.S. dollars will most likely enter into a U.S. dollar swap as opposed
to a swap in different currency. The party will also enter into a swap
whose interest rate index correlates with the floating rate the party
is trying to hedge and will specify a termination date that coincides
with when the subject interest rate risk terminates. Each of the IRS
submissions naturally use these common specifications when identifying
the swaps that the DCO clears. Within each of those specifications,
there are common terms used by the DCOs, which allows for further
classification of the full range of interest rate swaps that are
executed.
Accordingly, while there are a wide variety of interest rate swaps
when taking into account all possible contract specifications, certain
specifications are commonly used by the DCOs and market participants.
This allows for the identification of classes of swaps and primary
specifications within each class that reflect the economic goals market
participants seek to achieve and that are based on market conventions
used by the DCOs to define which interest rate swap products they will
clear. For example, fixed-to-floating swaps comprise roughly 50% of
interest rate swaps, U.S. dollar denominated swaps account for
approximately 35% of the total outstanding notional amount of swaps,
and U.S. dollar LIBOR is the floating rate index used for approximately
80% of U.S. dollar swaps traded.85
—————————————————————————
85 See below for a discussion of available market sources.
—————————————————————————
The DCOs also risk manage interest rate swaps collectively on a
portfolio basis rather than on a transaction or product specific basis.
All three DCOs primarily assess risk at the portfolio-level. In other
words, when looking at the risk posed by an interest rate swap
portfolio, DCOs do not assess the risk of any one particular swap or
swap class within the portfolio. Instead, the DCOs analyze the
cumulative risk of a position’s components. This concept of risk
aggregation is also used within the context of the DCOs’ margining
methodologies. All three DCOs use margin methodologies based on
portfolio margining as opposed to margining individual swaps or swap
categories and subsequently developing offsets and charges across
different swaps or classes of swaps.
By looking at risk on a portfolio basis, the DCOs take into account
how swaps with different attributes, such as underlying currency,
stated termination dates, underlying floating rate indexes, swap
classes, etc., are correlated and thus can offset risk across
attributes. This is possible because, although individual transactions
may have unique contract terms, given the commonalities of transactions
as discussed above, swap portfolios can be risk managed on a cumulative
value basis taking into account correlations among the cleared swaps.
Consequently, DCOs can be expected to fairly, rapidly, and efficiently
manage the risk of interest rate swaps in a default scenario through a
small number of large hedging transactions that hedge large numbers of
similarly correlated positions held by the defaulting party.86 As
such, liquidity for specific, individual swaps is not the focus of DCOs
from a risk management perspective. Rather, liquidity is viewed as a
function of whether a portfolio of swaps has common specifications that
are determinative of the economics of the swaps in the portfolio such
that a DCO can price and risk manage the portfolio through block
hedging and auctions in a default situation.
—————————————————————————
86 After putting on these hedging positions, the DCO has the
time needed to address any residual risk of the defaulted portfolio
through auctioning off the defaulted portfolio together with the
hedging transactions.
—————————————————————————
A real life example of how this works is provided by LCH’s
management of the Lehman Brothers cleared interest rate swap portfolio
following Lehman’s bankruptcy in September 2008. Upon Lehman’s default,
LCH needed to risk manage a portfolio of approximately 66,000 interest
rate swaps, which it hedged with approximately 100 new trades in less
than five days. Once LCH executed these initial hedges, it was left
with a relatively risk neutral portfolio. However, some risk still
remained given that the hedges did not match the original trades
exactly. Once the portfolio was hedged, LCH asked clearing members to
price and bid on all, or subdivided portions, of the original Lehman
portfolio with the hedging trades. For example, clearing members with
live open positions in U.S. dollar swaps were asked to bid for the
relatively hedged U.S. dollar portfolio. Through the bidding process,
LCH was able to hedge and auction off all risk related to Lehman’s
interest rate swap portfolio existing at the time of its bankruptcy and
only used approximately 35% of the initial margin Lehman had
posted.87
—————————————————————————
87 See LCH IRS submission, at 4.
—————————————————————————
iv. Interest Rate Swap Classification for Clearing Requirement
Determinations
Section 2(h)(2)(A) of the CEA provides that the Commission “shall
review each swap, or any group, category, type, or class of swaps to
make a determination as to whether” any thereof shall be required to
be cleared. In reviewing the IRS submissions, the Commission has
considered whether its clearing requirement determination should
address individual swaps, or categories, types, classes, or other
groups of swaps.
Based on the market conventions as discussed above, and the DCO
recommendations in the IRS submissions, the Commission is proposing a
clearing requirement for four classes of interest rate swaps: fixed-to-
floating swaps, basis swaps, OIS, and
[[Page 47189]]
FRAs. According to the IRS submissions, LCH offers all four classes for
clearing, IDCH offers three of them for clearing, and CME offers one of
them for clearing.88
—————————————————————————
88 LCH clears all four classes of swap products; IDCH is
eligible to clear fixed-to-floating swaps, OIS, and FRAs; and CME
clears fixed-to-floating swaps.
—————————————————————————
These four classes represent a substantial portion of the interest
rate swap market. The following table provides an indication of the
outstanding positions in each class.
Table 4–Interest Rate Swaps Notional and Trade Count by Class 89
—————————————————————————————————————-
Notional Gross notional Total trade
Swap class amount (USD percent of Total trade count percent
BNs) total count of total
—————————————————————————————————————-
Fixed-to-Floating…………………………. $299,818 52 3,239,092 75
FRA……………………………………… 67,145 12 202,888 5
OIS……………………………………… 43,634 8 109,704 3
Basis……………………………………. 27,593 5 119,683 3
Other……………………………………. 132,162 23 617,637 14
—————————————————————
Total………………………………… 570,352 100 4,289,004 100
—————————————————————————————————————-
—————————————————————————
89 TriOptima data, as of March 16, 2012. See Section II.F
below for a description of the TriOptima Data. The TriOptima data
provides information on nine other classes of swaps, none of which
is included in the IRS submissions. Notably, one other type,
swaptions, exceeded FRAs and basis swaps in terms of number of
transactions completed in the sample. On a notional amount basis,
swaptions represented less than half the notional amount of FRAs
traded and a little less than the notional amount of basis swaps.
Regardless, because swaptions are not being cleared by any DCOs at
this time, they are not being considered in this proposal.
—————————————————————————
At this time, there are no standard definitions in federal statutes
or existing Commission regulations for these interest rate swap
classes. In addition, while various class definitions are used in the
derivatives literature, there are no commonly used definitions in the
market. Accordingly, for purposes of discussing the clearing
requirement determination in this proposal, the Commission has
developed the following class definitions based on information provided
by the submitting DCOs and market conventions.
To define the four interest rate swap classes in a manner that
works across all three DCOs making IRS submissions and for the interest
rate swap market generally, it is useful first to summarize how
interest rate swaps work. As noted above, in an interest rate swap, the
parties exchange payments based on a series of cash flows over a
specified period of time calculated using two different interest rates
multiplied by a notional amount. One party to the swap agrees to pay
the amount equal to one of the interest rates specified multiplied by
the notional amount and the other party agrees to pay the amount equal
to the other interest rate specified times the notional amount.90
Each such payment stream is typically referred to as one “leg” or
“side” of the swap transaction.
—————————————————————————
90 By contract, the two parties to an OTC swap often (but not
always) agree that only one payment is due and owing on each payment
date equal to the net positive amount equal to the excess amount of
the larger amount due from one party over the smaller amount due
from the other party. For cleared swaps, generally speaking, the
amount payable to or by a party on any given day is determined based
on the aggregate net amount due from or owed to the party for all of
its positions that are cleared.
—————————————————————————
Using this background, the four classes of swaps are defined as
follows, for purposes of this proposal:
1. “Fixed-to-floating swap”: A swap in which the payment or
payments owed for one leg of the swap is calculated using a fixed rate
and the payment or payments owed for the other leg are calculated using
a floating rate.
2. “Floating-to-floating swap” or “basis swap”: A swap in which
the payments for both legs are calculated using floating rates.
3. “Forward Rate Agreement” or “FRA”: A swap in which payments
are exchanged on a pre-determined date for a single specified period
and one leg of the swap is calculated using a fixed rate and the other
leg is calculated using a floating rate that is set on a pre-determined
date.
4. “Overnight indexed swap” or “OIS”: A swap for which one leg
of the swap is calculated using a fixed rate and the other leg is
calculated using a floating rate based on a daily overnight rate.
The LCH and CME IRS submissions addressed issues of classification
for purposes of the interest rate swap clearing requirement. In its
submission, LCH discussed the classification of interest rate swaps and
recommended establishing clearing requirements for classes of interest
rate swaps. LCH stated:
We believe that it is counterproductive to define every single
attribute and combination that could be found in an [interest rate]
swap, and furthermore it would always be possible to create
additional attributes that would move a swap outside of the mandate.
We do not believe that the Commission should define the almost
limitless combination of swap attributes currently used by the
market. We recommend defining a subset of easily identifiable
features that determine a swap subject to mandatory clearing if that
swap is cleared by a registered DCO that satisfies the five factors
in the Act and the Commission’s regulations.
More specifically, LCH recommended that the Commission use the
following specifications to classify interest rate swaps for purposes
of making a clearing determination: (i) Swap class (i.e., what the two
legs of the swap are (fixed-to-floating, basis, OIS, etc.)), (ii)
floating rate definitions used, (iii) the currency in which the
notional and payment amounts are specified, (iv) stated final term of
the swap (also known as maturity), (v) notional structure over the life
of the swap (constant, amortizing, roller coaster, etc.), (vi) floating
rate frequency, (vii) whether optionality is included, and (viii)
whether a single currency or more than one currency is used for
denominating payments and notional amount. In effect, LCH recommended
the use of a set of basic product specifications to identify and
describe each class of swaps subject to the clearing requirement.
CME recommended a clearing determination for all non-option
interest rate swaps denominated in a currency cleared by any qualified
DCO. CME’s request is similar to LCH’s recommendation in that CME
identifies currency and optionality as factors to consider. In
addition, CME’s request focuses on defining swaps subject to the
[[Page 47190]]
clearing requirement in a manner that can be used by all DCOs and not
by reference to a specific DCO. IDCH did not recommend a particular
approach for structuring the clearing determination.
The Commission agrees with the general approach suggested by LCH
and is proposing to establish a clearing requirement for classes of
swaps, rather than for individual swap products.
As an alternative, the Commission considered whether to establish
clearing requirements on a product-by-product basis. Such a
determination would need to identify the multitude of legal
specifications of each product that would be subject to the clearing
requirement. Although the industry uses standardized definitions and
conventions, the product descriptions would be lengthy and require
counterparties to compare all of the legal terms of their particular
swap against the terms of the many different swaps that would be
included in a clearing requirement. In this regard, LCH stated that the
clearing requirement “would be sub-optimal for the overall market if
participants are forced to read pages of rules to decipher whether or
not a swap is required to be cleared, or to have to make complex and
time consuming decisions at the point of execution.” 91 The
Commission shares this view and believes that for interest rate swaps,
a product-by-product determination could be unnecessarily burdensome
for market participants in trying to assess whether each swap
transaction is subject to the requirement. A class-based approach would
allow market participants to determine quickly whether they need to
submit their swap to a DCO for clearing by checking initially whether
the swap has the basic specifications that define each class subject to
the clearing requirement.92
—————————————————————————
91 LCH IRS submission, at 6.
92 In addition, as noted by LCH, a product-by-product
requirement may be evaded more easily because the specifications of
a particular swap contract would need to match the specifications of
each product subject to a clearing requirement. The clearing
requirement could be evaded by adding, deleting, or modifying one or
more of the contract’s specifications, including minor
specifications that have little or no impact on the economics of the
swap. By using a class-based approach that allows for ranges of
contract specifications established by the DCOs within each class,
the Commission is reducing the potential for evasion in accordance
with section 2(h)(4)(A) of the CEA, which directs the Commission to
prescribe rules necessary to prevent evasion of the clearing
requirements.
—————————————————————————
A product-by-product designation also would be difficult to
administer because the Commission would be required to consider each
and every product submitted. On the other hand, designating classes of
interest rate swaps for the clearing requirement provides a cost
effective, workable method for the Commission to review new swap
products that DCOs will submit for clearing determinations on a going
forward basis without undertaking a full Commission review of each and
every swap product. For each new swap, or group, class, type, or
category of swap submitted, the DCO can identify whether it believes
the submission falls within a class of swaps already subject to the
clearing requirement. For such swaps, as described in greater detail
below, the Commission is proposing to delegate to the Director of the
Division of Clearing and Risk, with the consultation of the General
Counsel, the authority to confirm whether the swap fits within the
identified class and is therefore subject to the clearing requirement.
In this way, DCOs will not be required to submit lengthy submissions,
and the Commission need not review swaps that are already part of a
class of swaps that the Commission has determined are subject to a
clearing requirement pursuant to section 2(h)(2) of the CEA. Only swaps
that are in a new swap class that has not previously been reviewed,
because it contains one or more class level specifications that are not
contained within a class that has previously been reviewed, would be
subject to full Commission review.
Request for Comment
The Commission invites comment on the interest rate swaps class
definitions.
Are the definitions in harmony with industry practice?
Should the Commission establish a clearing requirement for
classes of swaps or for individual swap products?
Would a product-by-product determination impose a greater
burden on market participants than the proposed class-based approach?
v. Interest Rate Swap Specifications
After consideration of the IRS submissions received, the practical
considerations of classifying swaps as described in the preceding
section, the portfolio-based risk management approaches used by DCOs,
and existing market practice for classifying and trading swap products
based on common economic results, the Commission has analyzed the IRS
submissions received pursuant to section 2(h)(2)(D) of the CEA and
Sec. 39.5, and is proposing to classify the interest rates swaps
submitted using the following affirmative specifications for each
class: (i) Currency in which the notional and payment amounts are
specified; (ii) rates referenced for each leg of the swap; and (iii)
stated termination date of the swap. The Commission also is proposing
three “negative” specifications for each class: (i) No optionality
(as specified by the DCOs); (ii) no dual currencies; and (iii) no
conditional notional amounts.93
—————————————————————————
93 The term “conditional notional amount” refers to notional
amounts that can change over the term of a swap based on a condition
established by the parties upon execution such that the notional
amount of the swap is not a known number or schedule of numbers, but
may change based on the occurrence of some future event. This term
does not include what are commonly referred to as “amortizing” or
“roller coaster” notional amounts for which the notional amount
changes over the term of the swap based on a schedule of notional
amounts known at the time the swap is executed. Furthermore, it
would not include a swap containing early termination events or
other terms that could result in an early termination of the swap if
a DCO clears the swap with those terms.
—————————————————————————
The Commission has chosen these three affirmative specifications
because it believes that they are fundamental specifications used by
counterparties to determine the economic result of a swap transaction
for each party. Counterparties enter into swaps to achieve particular
economic results. For example, counterparties may enter into interest
rate swaps to hedge an economic risk, to facilitate a purchase, or to
take a view on the future direction of an interest rate. The
counterparties enter into a swap that they believe will best achieve
their desired economic result at a reasonable cost.
The classes of swaps reflect general categories of desired economic
results. As noted above, the IRS submissions identified four different
classes of swap contracts that are being cleared at this time: Fixed-
to-floating swaps, basis swaps, OIS, and FRAs. These classes of
interest rates swaps reflect industry categorization and allow
counterparties to achieve a particular economic result. For example, a
fixed-to-floating swap may be used by a counterparty to hedge interest
rate risk related to bonds it has issued or which it owns. Because the
categorization of interest rate swaps into one of these basic classes
reflects fundamental characteristics of a particular swap,
counterparties can immediately assess whether a particular swap they
are considering might be of a class that is subject to required
clearing.
All three submitters also identified currency as a specification
for distinguishing swaps that are subject to clearing.94 A swap that
requires
[[Page 47191]]
calculation or payment in a currency different than the currency of the
related underlying purposes of the swap would introduce currency
risk.95 Thus, the currency designated for the swap is a basic factor
in precisely achieving the economic results of the swap desired by each
party. For example, if a party wants to hedge a commercial business
risk denominated in dollars, then the party is likely to enter into a
swap calculated and payable in dollars. Entering into a swap in a
currency that is different from the currency in which the risk to be
hedged is denominated would unnecessarily introduce currency risk and
reduce the effectiveness of the swap.
—————————————————————————
94 As noted above, the notional amount of the swap is a
critical element to pricing every swap because it is the amount by
which the interest rate for each leg is multiplied by to calculate
the payment streams for each counterparty. However, the notional
amount is not really a specification that differentiates one class
of swaps from another because every swap has a notional amount. By
contrast, the currency in which the notional and payment amounts are
specified does distinguish one class of swaps from others.
95 For example, parties seeking to hedge interest rate risk in
connection with bonds or to invest funds using swaps are more likely
to enter into swaps that designate the same currency in which the
bonds are payable or that the funds to be invested are held.
—————————————————————————
The swaps listed by all three DCOs in their IRS submissions all
identified the interest rates used for each leg of the swap as a basic
term that defines the swap. The rates are basic determinants of the
economic value of each stream of payments of an interest rate swap. It
is therefore an important determinant for achieving each party’s
desired economic result. For example, if a party wants to hedge a loan
obligation for which the interest rate is based on the London Interbank
Offered Rate (commonly referred to as LIBOR), then the party can
accurately hedge that risk by entering into a swap for which it
receives LIBOR to offset its variable LIBOR risk. Using a different
variable rate index would unnecessarily add basis risk to the swap and
inhibit the party’s desired result of hedging the risk inherent in
changes in LIBOR over the life of its loan.
Finally, the stated termination date, or maturity, of a swap is a
basic specification for establishing the value of a swap transaction
because interest rate swaps are based on an exchange of payments over a
specified period of time ending on the stated termination date. The
value of a swap at any one point in time depends in part on the value
of each payment stream over the remaining life of the swap. For
example, if a party wants to hedge variable interest rate risk for
bonds it has issued that mature in ten years, it will generally enter
into a swap with a stated termination date that matches the final
maturity date of the bonds being hedged.96 To terminate the swap
prior to such date would result in only a partial hedge and to execute
a swap with a stated termination date that is later than the final bond
maturity date would simply create exposed rate risk during the extended
period beyond the final maturity date of the bonds.
—————————————————————————
96 Although hedging an economic risk expected to remain
outstanding for ten years with a matching ten year swap may
generally be the most efficient and precise approach, the Commission
recognizes that parties may achieve a similar result by using swaps
with different stated termination dates. However, such substitution
generally provides a less precise hedge.
—————————————————————————
As a general matter, the four class-defining specifications
identified by the Commission are used by all three submitters when
identifying the swaps they clear. By using these basic specifications
to identify the swaps subject to the clearing requirement,
counterparties contemplating entering into a swap can determine quickly
as a threshold matter whether the particular swap may be subject to a
clearing requirement. If the swap has the basic specifications of a
class of swaps subject to a clearing requirement, the parties will know
that they need to verify whether a DCO will clear that particular swap.
This will reduce the burden on swap counterparties related to
determining whether a particular swap may be subject to the clearing
requirement.
The Commission also considered whether to define classes of swaps
on the basis of other product specifications. Other potential
specifications are numerous because of the nearly limitless alternative
interest rate swaps that are theoretically possible. These alternative
specifications fall into two general categories: Specifications that
are commonly used to address mechanical issues for most swaps, and
specifications that are less common and address idiosyncratic issues
related to the particular needs of a counterparty. Examples of
specifications that are commonly used to address mechanical issues for
most swaps considered by the Commission include: Floating rate reset
tenors, floating rate reset dates, reference city for business days,
business day convention, day count fraction, spread added or subtracted
from the variable rate, compounding method, effective date, averaging
method, payment dates, period end dates, upfront payments, and consent
to legal jurisdiction. These specifications are specifically identified
for most swap transactions executed today. While these specifications
may affect the value of the swap in a mechanical way, they are not,
generally speaking, fundamental to determining the economic result the
parties are trying to achieve. For example, the day count fraction
selected affects calculation periods and therefore the amounts payable
for each payment period. However, the parties, and the DCOs, can make
mechanical adjustments to period pricing at the time a swap is cleared
based on the day count fraction alternative selected by the parties and
the day count fraction does not drive the economic result the parties
are trying to achieve.
Furthermore, DCOs can provide clearing for the standard
alternatives of each of these specifications without affecting risk
management. Using the same day count fraction example, LCH will accept
U.S. dollar-LIBOR trades for clearing with nine alternative day count
fractions based on the common day count fractions used in the
market.97 While this specification, and other specifications of this
kind, may affect the amounts owed on a swap, they can be accounted for
mechanically in the payment amount calculations and do not change the
substantive economic result the parties want to achieve.
—————————————————————————
97 Each DCO identifies the standard term or range of terms it
will accept for each specification. Accordingly, swap counterparties
can review the DCO’s product specifications to determine whether a
swap will satisfy the DCO’s requirements for these specifications.
Additionally, DCOs are likely to develop a screening mechanism by
which a party can enter the terms of a specific swap and determine
whether the DCO will clear it. It is also likely that third-party
vendors will develop or are developing similar screeners to apply to
multiple DCOs. If counterparties want to enter into a swap that is
in a class subject to required clearing and no DCO will clear the
swap because it has other specifications that the DCOs will not
accept, then the parties can still enter into that transaction on an
uncleared basis.
—————————————————————————
Examples of the latter are special representations added to address
particular legal issues, unique termination events, special fees, and
conditions tied to events specific to the parties. None of the DCOs
clear interest rate swaps with terms in the second group. Accordingly,
such specifications are not included in the classes of swaps subject to
the clearing requirement proposed by this rule, and the Commission
considered only the first group of more common specifications that are
identified by the submitting DCOs in their product specifications.
In short, the Commission recognizes that these other specifications
may have an effect on the economic result to be achieved with the
swap.98 However, it
[[Page 47192]]
believes that counterparties may account for the effects of such
specifications with adjustments to other specifications or in the price
of the swap. Furthermore, DCOs account for various alternatives or
range of alternatives for these terms without impairing risk
management. Finally, as described above in more detail, including these
specifications in the description of the swaps subject to a clearing
requirement could increase the burden on counterparties when checking
whether a swap may be subject to required clearing. Accordingly, the
Commission has determined not to include other, non-class defining
specifications in the swap class definition.
—————————————————————————
98 LCH recommended in its submission that floating rate tenor
(also known as frequency) also be a class level specification and
the Commission acknowledges that floating rate tenor can, in some
cases, be a fundamental specification for achieving the economic
benefits of an interest rate swap. However, it is the Commission’s
preliminary view that floating rate tenor is more akin to the other
non-class specifications in that it is not fundamental to all
economic results that may be considered by parties when
contemplating a swap and it is a specification for which the DCOs
can fairly easily offer all of the standard tenors that parties may
consider.
—————————————————————————
The Commission also considered whether there are product
specifications that the Commission should explicitly exclude from the
initial clearing requirement determination. In this regard, the
Commission considered swaps with optionality, multiple currency swaps,
and swaps with conditional notional amounts. The Commission determined
that these three specifications should be included as so-called
“negative” specifications.
Optionality and swaps referencing more than one currency for
calculation or payment purposes, raise concerns regarding adequate
pricing measures and consistency across swap contracts that make them
difficult for DCOs to effectively risk manage. LCH, CME, and IDCH
currently do not clear interest rate swaps with such specifications.
Furthermore, LCH and CME indicated that interest rate swaps with
optionality or that reference multiple currencies should not be
included for consideration of a clearing requirement at this time. LCH
noted that, at this time, there is a lack of reliable market data and
no market consensus on valuation models for swaps with these
specifications, which significantly impairs a DCO’s ability to set
margin levels effectively for such products. Given these factors, the
Commission is proposing to exclude swaps with optionality or that
reference multiple currencies from this clearing requirement
determination.
Finally, LCH recommended that the Commission exclude from the
clearing requirement swaps whose notional amount over the term of the
swap is conditional, and therefore, at the time of execution, cannot be
definitively identified by a number or schedule of numbers for the term
of the swap. For example, the parties may agree to a formula for
calculating the notional amount based on an index or the occurrence of
future events such as prepayments on a pool of mortgages. The IRS
submissions indicated that all three submitters would clear swaps with
constant notional amounts through the final termination date. LCH also
clears amortizing and roller coaster notional schedules for certain
classes of swaps so long as the notional amounts for the contract are
known at the time the swap is cleared. None of the DCOs clears swaps
for which the notional amount throughout the term of the swap is not
specifically known at the time the swap is executed. The Commission
understands that conditional notional amount swaps are, at this time,
difficult for DCOs to price effectively and risk manage. Accordingly,
while this may change over time if certain market conventions develop
in this area, conditional notional amount swaps cannot be subject to
the clearing requirement determination.
To reach a determination as to which interest rate swaps shall be
subject to the clearing requirement, the Commission will consider in
the following section the IRS submissions received pursuant to section
2(h)(2)(D) of the CEA and Sec. 39.5 within the framework of the
classes and specifications identified. In summary, the Commission will
consider four classes of interest rate swaps for the clearing
requirement: Fixed-to-floating swaps, basis swaps, FRAs, and OIS.
Within each class, the Commission will further consider the following
product specifications to define which swaps shall be required to be
cleared: Currency, floating rate indexes referenced, stated termination
dates, use of dual currencies, optionality, and notional amount
certainty.
Request for Comments
The Commission invites comment on the six principle swap
specifications identified by the Commission as being used by
counterparties to determine the economic result of a swap transaction
within each class.
Should more specifications be added? If so, what are they
and how are they fundamental to determining the economic result of a
swap? Should any of the specifications be eliminated?
F. Proposed Determination Analysis for Interest Rate Swaps
i. Consistency With Core Principles for Derivatives Clearing
Organizations
Section 2(h)(2)(D)(i) of the CEA requires the Commission to review
whether a swap submission is consistent with the core principles for
DCOs in making its clearing determination. LCH, CME, and IDCH already
clear all swaps identified in their respective IRS submissions and
therefore each is subject to the Commission’s review and surveillance
procedures summarized above. Accordingly, the three DCOs already are
required to comply with the core principles set forth in section
5b(c)(2) of the CEA with respect to the swaps being considered by the
Commission for the clearing requirement.
To monitor compliance, the Commission has conducted periodic
examinations of LCH, CME, and IDCH. During an examination, the
Commission requests certain data regarding cleared transactions, fund
transfers, margin requirement calculations, risk management testing and
other issues that is provided as of a specific review date. In this
manner, the Commission gets a snap-shot of information that the
Commission staff uses to reconcile selected accounts and other
information. Subsequently, the Commission goes onsite, typically for
several days, to interview relevant parties and to test whether various
policies and procedures established by the DCOs in their respective
rule books comply with the CEA’s core principles for DCOs and other
regulatory requirements.
As discussed above, following the review of data and the onsite
visits, the Commission undertakes extensive analysis and discusses any
questions and potential deficiencies with staff and management of the
DCO to address any deficiencies and improvements that can be
implemented by the DCO. To ensure that the DCOs are in compliance with
the core principles, a detailed analysis is done to assess the DCO’s
policies and procedures regarding pricing, margining, back-testing, and
their IRS portfolio risk management procedures. Furthermore, the
Commission assesses the DCOs’ procedures and policies regarding: (1)
Onboarding new clearing members; (2) establishing the financial
resources available to the DCOs and testing the sufficiency of those
resources; and (3) assessing the default management and settlement
procedures.
More specifically, the DCOs give the Commission documentation that
details relevant official policies and
[[Page 47193]]
procedures. The DCOs also provide evidence (such as margining, pricing
data, and back-testing results) that confirms that the policies and
methodologies are effective. Finally, the Commission goes onsite to the
DCOs and interviews relevant parties and observes the procedures real-
time to confirm that the DCOs are in effect following their stated
policies. Additionally, the Commission, if feasible, will independently
verify the analysis of any data provided by the DCOs.
The Commission’s Risk Surveillance Group (RSG) conducts daily risk
management surveillance of all DCOs.99 If any issues arise, the RSG
and the DCOs work in concert to understand and quickly address those
issues. CME, LCH, and IDCH have worked collaboratively with the
Commission in this regard and have provided accessible points of
contact within the DCOs’ respective organizations to expedite
information flow.
—————————————————————————
99 The only exception is IDCH. At this time, RSG does not
actively monitor the risk posed by IDCH and its participants because
IDCH does not have any open interest.
—————————————————————————
All three submitting DCOs have asserted that they are capable of
maintaining compliance with the core principles following a clearing
requirement determination for the swaps that they clear, and the
Commission has no reason to believe such assertions are not accurate at
this time. The Commission does not believe that subjecting any of the
interest rates swaps identified in the IRS submissions to a clearing
requirement would alter compliance by the respective DCOs with the core
principles. Accordingly, the Commission believes that each of the IRS
submissions are consistent with section 5b(c)(2) of the CEA.
Request for Comment
The Commission requests comment on whether the proposed
interest rate swaps clearing requirement determination would alter any
DCO’s ability to comply with the DCO core principles.
ii. Consideration of the Five Statutory Factors for Clearing
Requirement Determinations
As explained above, section 2(h)(2)(D)(ii) of the CEA identifies
five factors the Commission shall take into account in making a
clearing requirement determination. The process for submission and
review of swaps for a clearing requirement determination is further
detailed in Sec. 39.5. This section provides the Commission’s
consideration of the five factors in the context of the requirements of
Sec. 39.5 for interest rate swaps.
a. Outstanding Notional Exposures, Trading Liquidity, and Adequate
Pricing Data
Section 2(h)(2)(D)(ii)(I) of the CEA requires the Commission to
take into account the existence of outstanding notional exposures,
trading liquidity, and adequate pricing data. For purposes of this
factor, the Commission considered the market data regarding outstanding
notional amounts, trade liquidity, and pricing. Unlike CDS for which
substantially all of the trading data has been collected and is stored
in one place, there is no single data source for notional exposures and
trading liquidity for the entire interest rate swap market.100
However, the Commission considered several sources of data on the
interest rate swap market that collectively provides the information
the Commission needs to make a clearing requirement determination. The
data sources considered include: general quarterly estimates published
by the Bank for International Settlements (BIS data); market data
published weekly by TriOptima (TriOptima data) covering swap trade
information submitted voluntarily by 14 large derivatives dealers (G14
Dealers); trade-by-trade data provided voluntarily by the G14 Dealers
to the OTC Derivatives Supervisors Group for a three month period
between June and August 2010 (ODSG data); and trade-by-trade data
provided by LCH for the first calendar quarter of 2012 and summary
cleared swap open interest information (LCH data).101 The G14 Dealers
and LCH trade-by-trade data was provided to the Commission on a
confidential basis and consent was granted for publication of the
summary information in this proposal.
—————————————————————————
100 See Bank of England, “Thoughts on Determining Central
Clearing Eligibility of OTC Derivatives,” Financial Stability Paper
No. 14, March 2012, at 11, available at http://www.bankofengland.co.uk/publications/Documents/fsr/fs_paper14.pdf.
101 All DCOs are required to begin providing daily trade-by-
trade data to the Commission as of November 8, 2012. CME also
provided some information in this area, but because CME clears a
small set of interest rate swaps for a relatively short period of
time, CME’s data is considered too limited to provide any indication
of the complete interest rate swap market. The Commission recognizes
that the LCH data also has limited value for its consideration of
the first factor because it includes only cleared swaps, and not
uncleared swaps. However, because LCH clears a large portion of the
swaps products it offers clearing for (based on available
information, LCH has cleared approximately 50 to 90 percent of the
dealer open interest in the different interest rate swap products
that it clears), its data provides some indication of the possible
notional exposures and liquidity in the products submitted by LCH
that the Commission is considering. Given the limitations on other
available data, the Commission believes it is useful to consider the
LCH data along with the market-wide BIS data, ODSG data, and
TriOptima data.
—————————————————————————
Each of these data sources has a number of limitations that are
important to understand when considering the data. The following is a
brief discussion of these limitations and how the data sets, when
considered together, provide a more complete picture of outstanding
notional amounts, trade liquidity, and pricing for the Commission’s
consideration of the swaps submitted.
The BIS data set covers the largest portion of the interest rate
swap market over time and therefore is useful for reaching general
conclusions regarding full market size and longer term market trends.
However, the BIS data provides only summary information that is not
granular enough to inform the clearing requirement considerations at
the proposed class level.
TriOptima’s data set updates are published weekly and provide more
detail than the BIS data covering most of the class level
specifications considered by the Commission. The TriOptima data is
limited to the extent it only contains information gathered by
TriOptima and therefore does not include all OTC interest rate swaps.
Also, the TriOptima data shows outstanding notional and trade numbers
as of a set date and does not provide an indication of trade liquidity
over time.102
—————————————————————————
102 The TriOptima data does not indicate how many trades are
new for each reporting period rather than carry-over trades from the
prior period. Accordingly, it is not possible to determine the
amount of new trading activity from one reporting period to the
next.
—————————————————————————
The ODSG data provided detailed information on a trade-by-trade
basis, thereby providing sufficient information for class-level
consideration. This information is useful for considering trading
liquidity. However, the ODSG data set is limited in several ways that
can skew analysis of the data. The ODSG data covered transactions
confirmed on the MarkitWire platform, a trade confirmation service
offered by MarkitSERV, between June 1, 2010 and August 31, 2010, where
at least one party was a G14 Dealer. The dataset does not include
transactions that took place between two non-G14 Dealer parties, with
such parties representing an estimated 11% of the notional volume
activity in MarkitSERV.103 The number of non-G14 Dealer swap trades
that are not entered on MakitSERV has not been estimated and could be
significant. The omission of certain classes of participants and trades
in the
[[Page 47194]]
sample will bias transaction and notional volume statistics downward.
It may also distort the proportions of products seen relative to each
other.
—————————————————————————
103 NY Fed Analysis at 6.
—————————————————————————
The ODSG dataset also does not include transactions that were
manually confirmed either by choice or necessity. It is estimated that
the data set represents roughly 78% of G14 Dealer interest rate
transaction activity.104 The three-month time frame in 2010 also
introduces limitations into analysis of the data set. This time frame
represented a period in the midst of historically low central bank
interest rate policy across major currencies and novel liquidity
measures taken in response to the 2008 financial crisis. The short
period also could be affected by seasonal patterns, and the possibility
exists that the markets have fundamentally changed since the data was
gathered. The lack of manually confirmed trades in the data suggests an
overrepresentation of standardized transactions such as OIS and plain
vanilla interest rate swaps and underrepresentation of non-standard
classes such as exotics and basis swaps. For instance, exotic product
structures not eligible for electronic matching are estimated to make
up 2% of the OTC interest rate derivative market.105
—————————————————————————
104 Id. at 6.
105 Id. at 5.
—————————————————————————
The LCH data provides summary data on outstanding notional amounts
for different classes of swaps and the first quarter 2012 data provide
detailed information on a trade-by-trade basis thereby providing
sufficient information for class-level consideration. The LCH data is
limited in that it only includes swaps cleared by LCH. It is noted,
however, that LCH has cleared about 50% of the interest rate swap
market and higher levels of certain kinds of swaps indicating a
reasonably high inclusion rate. This data set also has the advantage of
being more current than the ODSG data and BIS data and is specific to
the swaps that are under consideration in this Commission
determination.
The TriOptima data and ODSG data are both based, in large part, on
data provided by the G14 Dealers. Additionally, the TriOptima data is
published by TriOptima in formats that, for the class specifications
considered by the Commission, can be analyzed in a manner similar to
the analysis of the ODSG data. In fact, the Commission has found the
TriOptima data and the ODSG data to be complementary in some ways. The
TriOptima data is current and provides fairly detailed information
about the gross notional amounts and total trade numbers for each class
specification considered in this proposal. However, the TriOptima data
does not provide enough information to assess periodic trade liquidity
for each specification. Because the ODSG data is provided on a trade-
by-trade basis, the Commission and other regulators have been able to
make more granular assessments of this information, particularly for
purposes of considering trading liquidity. Accordingly, although the
ODSG data is nearly two years old, it is useful for confirming whether
observations based on the current TriOptima data are consistent with
historical trends and also to indicate trading liquidity.
For this proposal, the Commission is considering only the swaps
identified in the DCOs’ IRS submissions. Accordingly, where possible,
the Commission presents and discusses only the data for swaps
identified in the submissions. For example, although the ODSG data
identifies twenty-eight different currencies in which swaps were traded
during the period covered by the data set, only the seventeen
currencies identified in the submissions were considered. In addition,
the ODSG data shows all transactions recorded on MarkitServ including
not only new, price-forming transactions, but also administrative
transactions such as amendments, assignments, compression trades, and
internal, inter-affiliate trades that may not be price forming.106
Because the Commission is considering notional amounts and trading
liquidity, non-price-forming trades have been removed from the ODSG
data presented below.
—————————————————————————
106 The NY Fed Analysis noted that for the ODSG interest rate
swap data set the number and volume of non-price-forming trades were
significantly greater than the number and volume of trades that were
new economic activity. NY Fed Analysis, at 8.
—————————————————————————
The following analysis of interest rate swap data is presented
based on the four swap classes and class specifications discussed
above. This information is used by the Commission to determine whether
there exists significant outstanding notional amounts, trading
liquidity, and pricing data to include each class and specification
identified in the IRS submissions.
1. Interest Rate Swap Class
The Commission first considered data relevant to the different
interest rate swap classes included in the IRS submissions starting
with the BIS data.
—————————————————————————
107 BIS data.
108 This row excludes FRAs and options.
Table 5–Bank for International Settlements Interest Rate Swaps Outstanding Notional by Class 107
[Amounts in billions of U.S. dollars]
——————————————————————————————————————————————————–
June 2009 Dec. 2009 June 2010 Dec. 2010 June 2011 Dec. 2011
——————————————————————————————————————————————————–
All Derivatives………………………………….. $594,553 $603,900 $582,685 $601,046 $706,884 $647,762
Interest Rate Swaps 108…………………………. 341,903 349,288 347,508 364,377 441,201 402,611
FRAs……………………………………………. 46,812 51,779 56,242 51,587 55,747 50,576
Options…………………………………………. 48,513 48,808 48,081 49,295 56,291 50,911
———————————————————————————————–
Total interest rate swaps……………………… 437,228 449,875 451,831 465,260 553,240 504,098
——————————————————————————————————————————————————–
The BIS data shows only notional amounts for three large
categories: FRAs, swaps with options, and other interest rate swaps. It
does not provide information on daily trading liquidity or break out
other kinds of interest rate swaps such as basis swaps, OIS, or
inflation swaps.
However, the BIS data is useful in providing certain big picture
information. It indicates that interest rate swaps in total constitute
nearly 80% of the derivatives market and interest rate swap notional
amounts generally increased for all three kinds of swaps between 2008
and 2011. Additionally, all three classes of swaps identified by the
BIS data have substantial notional amounts outstanding. As of December
2011, FRAs had about $50.5 trillion outstanding, options had about $51
trillion outstanding, and other interest rate swaps had about $403
trillion
[[Page 47195]]
outstanding. Furthermore, the BIS data shows that over the three year
period covered in Table 5, total interest rate swaps reported grew by
about 15%. Given this information, none of the kinds of swaps
identified by the BIS should be eliminated from consideration by the
Commission for a clearing requirement based on the BIS data alone.
However, the BIS data does not provide enough detail to reach further
determinations regarding the swaps identified in the IRS submissions.
—————————————————————————
109 TriOptima data, as of March 16, 2012. The TriOptima data
provides information on nine other classes of swaps, none of which
is included in the submissions. Notably, one other type, swaptions,
exceeded FRAs and basis swaps in terms of number of transactions
completed in the sample. On a notional amount basis, swaptions
represented less than half the notional amount of FRAs traded and a
little less than the notional amount of basis swaps. Regardless,
because swaptions were not included in the list of swaps cleared in
the IRS submissions, swaptions are not being considered for the
clearing requirement determination because no DCO is clearing
swaptions at this time.
110 NY Fed Analysis at 7. The ODSG data includes swaps entered
into between June and August, 2010 as voluntarily reported by the
G14 Dealers. The ODSG data provides information on other classes of
swaps, none of which is included in the submissions.
Table 6–TriOptima Data Interest Rate Swaps Outstanding Notional and Trade Count by Class 109
—————————————————————————————————————-
Notional Percent of
Swap class amount (USD Percent of Total trade total trade
BNs) total notional count count
—————————————————————————————————————-
Fixed-to-Floating…………………………. $299,818 52 3,239,092 75
FRA……………………………………… 67,145 12 202,888 5
OIS……………………………………… 43,634 8 109,704 3
Basis Swap……………………………….. 27,593 5 119,683 3
Other……………………………………. 132,162 23 617,637 14
—————————————————————
Total………………………………… 570,352 100.00 4,289,004 100
—————————————————————————————————————-
Table 7–ODSG Data Interest Rate Swaps Trading Activity by Class 110
—————————————————————————————————————-
Average
Notional weekly Average
Swap class amount traded Trade count in notional weekly number
in quarter quarter traded (USD of trades
(USD BNs) BNs)
—————————————————————————————————————-
Fixed-to-Floating…………………………. $15,858 123,337 $1,201 9,344
OIS……………………………………… 16,563 12,792 1,255 969
FRA……………………………………… 6,931 5,936 525 450
Basis Swap……………………………….. 2,307 3,173 175 240
Other……………………………………. 2,820 16,073 214 1,218
—————————————————————
Total………………………………… 44,479 161,311 3,370 12,221
—————————————————————————————————————-
The TriOptima data and the ODSG data identify notional amounts and
trade counts for all four classes of swaps identified in the IRS
submissions. Outstanding notional amounts are provided in the TriOptima
data and BIS data. Trading liquidity as an indication of how
effectively DCOs can risk manage a portfolio of swaps can be evidenced
in several ways. The data available for this purpose includes total
notional amount outstanding, total number of swaps outstanding, and the
average number of transactions over a given period of time. The
TriOptima data indicates liquidity through the total notional amount
outstanding and total number of trades outstanding at a given time. The
ODSG data provides an indication of liquidity in terms of the number of
trades during the calendar quarter covered by the data and the average
weekly number of trades during the period.
The TriOptima data shows that all four classes have significant
outstanding notional amounts with basis swaps being the lowest at about
$27.6 trillion and the highest being fixed-to-floating swaps at $288.8
trillion. Total trade counts for each type are also significant with
the lowest being 109,704 for OIS and the highest being fixed-to-
floating swaps at 3,239,092. The ODSG data confirms these observations
historically.
The average number of swap trades per week for each class of swaps
is shown in the last column of Table 7. According to the ODSG data set,
basis swaps were traded at the lowest frequency compared to the other
three classes at 240 times on average each week during the ODSG data
period. Because the ODSG data is from the summer of 2010 and gross
notional amounts and trading activity in interest rate swaps have both
increased generally, the Commission believes that trading activity has
likely increased for all classes.
—————————————————————————
111 The data covers swaps cleared by LCH during the first
calendar quarter, 2012. Total Notional Outstanding Cleared is as of
March 31, 2012.
Table 8–LCH Data Interest Rate Swaps Notional Outstanding and Trade Count Cleared by Classes 111
—————————————————————————————————————-
Average
Notional Number of weekly Average Total notional
Swap class cleared in swaps cleared notional weekly number outstanding
Quarter (USD in quarter traded (USD of trades (USD BNs)
BNs) BNs)
—————————————————————————————————————-
Fixed-to-Floating…………… $17,022 117,780 $1,309 9,060 $226,016
FRA……………………….. 11,271 31,630 867 2,433 27,707
OIS……………………….. 8,731 6,848 672 527 36,510
[[Page 47196]]
Basis……………………… 1,610 2,940 124 226 11,378
——————————————————————————-
Total………………….. 38,634 159,198 2,972 12,246 301,612
—————————————————————————————————————-
The LCH data generally confirms the assessment of market-wide data.
There is substantial outstanding notional volumes and trade liquidity
for each of the four classes already being cleared at LCH.
LCH cleared the following percentage of each class of swap as
reported by TriOptima: 112
—————————————————————————
112 Percentages are calculated based on total notional amount
cleared by LCH divided by total notional outstanding as reported by
TriOptima. The TriOptima data is used because it is the most current
data set that provides data broken out according to the classes
currently being cleared.
—————————————————————————
75% of the Fixed-to-Floating swaps,
41% of FRAs,113
—————————————————————————
113 LCH started clearing FRAs in December 2011 and cleared
volumes have increased significantly each month since the start
date.
—————————————————————————
84% of OIS, and
41% of Basis Swaps.
Accordingly, a substantial portion of each class is already being
cleared voluntarily.
Swap Class Conclusion
The Commission concludes that the four classes of swaps currently
being cleared have significant outstanding notional amounts and trading
liquidity. The Commission further notes that a substantial percentage
of each of the four classes is already cleared by DCOs.
2. Currency
As discussed above in Section II.E, the currency in which the
notional and payment amounts are specified is a primary product
specification and all four data sources provide interest rate swap data
by currency.
—————————————————————————
114 BIS data.
Table 9–Bank for International Settlements: Interest Rate Swaps Notional by Currency 114
(Amounts Outstanding in Billions of U.S. Dollars)
——————————————————————————————————————————————————–
June 2009 Dec 2009 June 2010 Dec 2010 June 2011 Dec 2011
——————————————————————————————————————————————————–
EUR…………………………………………….. $160,668 $175,790 $161,515 $177,831 $219,094 $184,702
USD…………………………………………….. 154,174 153,373 164,119 151,583 170,623 161,864
JPY…………………………………………….. 57,452 53,855 55,395 59,509 65,491 66,819
GBP…………………………………………….. 32,591 34,257 36,219 37,813 50,109 43,367
CAD…………………………………………….. 3,227 3,427 4,411 4,247 6,905 6,397
SEK…………………………………………….. 5,294 4,696 4,461 5,098 5,832 5,844
CHF…………………………………………….. 4,713 4,807 4,650 5,114 6,170 5,395
Other…………………………………………… 19,108 19,669 21,061 24,064 29,017 29,709
All Currencies…………………………………… 437,228 449,875 451,831 465,260 553,240 504,098
——————————————————————————————————————————————————–
The BIS data addresses seven of the seventeen currencies identified
in the submissions individually. All seven currencies have substantial
outstanding notional amounts as of December 2011, ranging from nearly
$5.4 trillion for the Swiss franc to about $185 trillion in euro.
Although several currencies showed decreases in total notional
outstanding from one reporting period to the next, most such decreases
were around ten percent or less, and, after such decreases, total
notional amounts for those currencies generally rebounded.115 For all
currencies, the outstanding notional amounts were higher at the end of
the most recent three-year period as compared to the beginning of the
period.
—————————————————————————
115 To some extent, such decreases may have resulted from
increased trade compression exercises during the subsequent
reporting period.
116 TriOptima data, as of March 16, 2012.
—————————————————————————
The Commission believes that the BIS data supports the conclusion
that there exists significant outstanding notional amounts in each
currency identified in the BIS data and that there is no indication
that notional amounts in those currencies are decreasing at a rate that
would warrant elimination of those currencies from consideration for a
clearing requirement.
Table 10–TriOptima Data Interest Rate Swaps Outstanding Notional and Trade Count by Currency 116
—————————————————————————————————————-
Notional Percent of
Currency amount (USD Percent of Total trade total trade
BNs Eqv.) total notional count count
—————————————————————————————————————-
Euro…………………………………….. $176,481 36 1,115,504 28
US Dollar………………………………… 175,777 35 1,300,862 33
Yen……………………………………… 64,083 13 568,871 14
British Pound…………………………….. 43,337 9 419,611 11
Other 117………………………………. 36,4905 7 536,887 14
—————————————————————
[[Page 47197]]
Total………………………………… 496,168 100 3,941,735 100
—————————————————————————————————————-
Table 11–ODSG Data Interest Rate Swaps Notional Trading Activity by Currency 118
—————————————————————————————————————-
Average
Notional weekly Average
Currency traded in Trade count in notional weekly number
quarter (USD quarter traded (USD of trades
BNs) BNs)
—————————————————————————————————————-
EUR……………………………………… $18,410 45,114 $1,395 3,418
USD……………………………………… 11,013 48,876 834 3,703
GBP……………………………………… 7,248 16,282 549 1,233
JPY……………………………………… 4,263 18,799 323 1,424
Other 119………………………………. 3,048 20,412 231 1,546
—————————————————————
Total………………………………… 43,982 149,483 3,332 11,324
—————————————————————————————————————-
The TriOptima data shows that total outstanding notional amounts as
of March 16, 2012, ranged from $400 billion for Czech koruna to over
$176 trillion notional amount for euros.120 While there may be
sufficient outstanding notional amounts in all seventeen currencies,
the Commission takes note that there is a clear demarcation between the
four currencies with the highest outstanding notional amounts: euro,
U.S. dollar, British pound, and yen, and all other currencies. As Table
10 shows, the four top currencies range from about 9% to 36% of the
total notional amount of all interest rate swaps outstanding and 11%to
33% of the total number of trades. The remaining currencies range from
about 2% down to 0.1% of the total notional amount traded and 3% down
to 0.2%of total number of trades. In fact, the four major currencies
accounted for about 93% of the total notional amount outstanding in the
TriOptima data set.
—————————————————————————
117 Thirteen other currencies are cleared by LCH: AUD, CHF,
SEK, CAD, ZAR, NZD, NOK, HKD, PLN, SGD, HUF, DKK, and CZK.
118 The ODSG data includes swaps entered into between June and
August 2010 as voluntarily reported by the G14 Dealers.
119 Includes the 13 other currencies cleared by LCH identified
in its IRS submission. The ODSG data identified an additional 11
other currencies that were not cleared by any of the submitters.
120 TriOptima data, as of March 16, 2012.
—————————————————————————
The ODSG data provides an indication of trading liquidity in terms
of average weekly notional amount traded and number of new trades
completed during the period covered by the data set. Of the four major
currencies, Japanese yen had the lowest weekly average notional at $323
billion and the British pound had the lowest average number of trades
each week at 1,233.
The TriOptima data provides an overall, more current view of trades
outstanding, which provides a broader picture of the trading potential
for each currency for purposes of DCO risk management. As of March 16,
2012, all but one of the seventeen currencies had outstanding trade
counts in excess of 14,000 with the exception being the Danish krone at
6,849. Again, the four highest currencies by trade count: euro, U.S.
dollar, British pound, and yen, accounted for about 85% of the total
number of trades recorded and outstanding at the time the data was
collected.
Table 12–LCH Data Interest Rate Swaps Notional Outstanding and Trade Count Cleared by Currency 121
——————————————————————————————————————————————————–
Notional cleared Number of swaps Average weekly Average weekly Total notional
Currency in quarter cleared in notional traded number of outstanding
(USD BNs) quarter (USD BNs) trades (USD BNs)
——————————————————————————————————————————————————–
EUR………………………………………………….. $19,207 61,039 $1,477 4,695 $115,695
USD………………………………………………….. 12,111 51,710 932 3,978 107,734
GBP………………………………………………….. 2,801 12,976 216 998 25,339
JPY………………………………………………….. 2,799 12,374 215 952 37,696
Other………………………………………………… 1,716 21,099 132 1,623 15,146
—————————————————————————————–
Total…………………………………………….. 38,634 159,198 2,972 12,246 301,612
——————————————————————————————————————————————————–
The LCH data shows that the relative notional amount and number of
swaps in each currency cleared is generally correlated with the
notional amount and number of swaps of each currency reported by the
more general market data sets. As a percentage of the total notional
amount outstanding as reported by TriOptima, LCH cleared the following
percentages: 122
—————————————————————————
121 The data covers swaps cleared by LCH during the first
calendar quarter, 2012. Total Notional Outstanding is as of March
31, 2012.
122 The TriOptima data is used for this calculation because it
is the most current data set that provides data broken out according
to the classes currently being cleared.
—————————————————————————
66% of euro,
61% of U.S. dollars,
[[Page 47198]]
58% of British pounds,
59% of Japanese yen, and
42% of other currencies.
Of the interest rate swaps identifying U.S. dollars, euro, British
pounds or yen as the applicable currency, significantly more than half
are already being cleared by LCH. While the level of clearing of other
currencies is, on a combined basis reasonably high at 42%, the
Commission notes the level is noticeably lower than the percentage of
swaps being cleared for the top four currencies.
Currency Specification Conclusion
The Commission believes that all of the data sets demonstrate the
existence of significant outstanding notional amounts and trading
liquidity in the seventeen currencies identified in the submissions.
However, the Commission notes that swaps using the four currencies with
the highest outstanding notional amounts and trade frequency: euro,
U.S. dollar, British pound, and yen, account for an outsized portion of
both notional amounts outstanding and trading volumes. Furthermore, the
Commission notes that these four currencies are already being cleared
more than the other currencies generally.
While it is important that this determination include a substantial
portion of the interest rate swaps traded to have a substantive,
beneficial impact on systemic risk, the Commission also recognizes that
the proposed rule is the Commission’s first swap clearing requirement
determination. As noted in the phased implementation rules for the
clearing requirement, the Commission believes that introducing too much
required clearing too quickly could unnecessarily increase the burden
of the clearing requirement on market participants. In recognition of
these considerations, the Commission will focus the remainder of this
initial clearing requirement determination analysis on swaps
referencing the four most heavily traded currencies. The Commission
notes that the decision not to include the other thirteen currencies at
this time does not limit the Commission’s authority to reconsider
required clearing of those currencies in the future.
The Commission requests comment on whether any of the other
thirteen currencies identified above should be included in the initial
clearing requirement determination for interest rate swaps.
3. Floating Rate Index Referenced
The ODSG data and LCH data provide an indication of the rate
indices used on a transaction-by-transaction basis. Rate indexes are
currency specific. However, the BIS data and the TriOptima data do not
provide information on the different rate indices referenced in
interest rate swaps. The following tables present trading activity data
for each rate index identified in the IRS submissions as being cleared
for each of the four currencies the Commission is proposing to include
in the clearing requirement determination.
—————————————————————————
123 The ODSG data includes swaps entered into between June and
August, 2010 as voluntarily reported by the G14 Dealers. This table
includes only rate indexes used for the G4 currencies and that are
cleared by LCH.
124 “Eur-Euribor” category includes both Eur-Euribor-Reuters
and Eur-Euribor-Telerate, which are both cleared by LCH.
* “EONIA”, “SONIA”, and “FedFunds” are floating rate
indexes used to calculate OIS amounts only. The other indexes listed
in the table are used for fixed-to-floating swaps, basis swaps, and
FRAs.
125 The data includes swaps cleared by LCH during the first
calendar quarter, 2012.
Table 13–ODSG Data Interest Rate Swaps Trading Activity by Rate Index 123
—————————————————————————————————————-
Notional traded Average weekly
Rate Index in quarter (USD Trade count for notional traded Average weekly
BNs) quarter (USD BNs) number of trades
—————————————————————————————————————-
EUR-EURIBOR 124………………. $9,366 38,213 $710 2,895
USD-LIBOR……………………… 9,080 46,620 688 3,532
EUR-EONIA *……………………. 9,022 6,496 684 492
GBP-SONIA *……………………. 4,934 2,011 374 152
JPY-LIBOR……………………… 4,015 18,491 304 1,401
GBP-LIBOR……………………… 2,296 12,417 174 941
USD-FedFunds *…………………. 1,887 1,951 143 148
EUR-LIBOR……………………… 1 5 0 0
—————————————————————————
Total……………………… 40,602 126,204 3,076 9,561
—————————————————————————————————————-
Table 14–LCH Data Interest Rate Swaps Notional Outstanding and Trade Count by Rate Index125
—————————————————————————————————————-
Notional cleared Number of swaps Average weekly
Rate index (by currency) in quarter (USD cleared in notional traded Average weekly
BNs) quarter (USD BNs) number of trades
—————————————————————————————————————-
EURO
EURIBOR……………………. $13,444 57,157 $1,034 4,397
EONIA……………………… 5,763 3,882 443 299
US Dollar
LIBOR……………………… 10,905 50,197 839 3,861
FEDFUND……………………. 1,206 1,513 93 116
GBP
LIBOR……………………… 1,067 11,550 82 888
SONIA……………………… 1,734 1,426 134 110
Yen
LIBOR……………………… 2,799 12,374 215 952
Other Indexes………………….. 1,716 21,099 132 1,623
—————————————————————————
Total………………….. 38,634 159,198 2,972 12,246
—————————————————————————————————————-
[[Page 47199]]
The ODSG data shows minimal activity for EUR-LIBOR with about 1
billion of notional amount and five trades made for the three-month
period in 2010 that the ODSG data covers. EUR-LIBOR does not appear on
the LCH data table because, although swaps referencing that index can
be cleared at LCH, LCH had no open interest for that index as of March
31, 2012. Given the minimal notional amounts and trade liquidity for
the EUR-LIBOR index, the Commission has determined not to include EUR-
LIBOR under the clearing requirement.
The other rate indexes all show significant notional amounts and
trading liquidity. The rates with the least activity, the U.S. dollar
Fedfund index and British pound-LIBOR index, each have over one
trillion dollars in notional outstanding already cleared at LCH and on
a weekly basis, $93 billion and $82 billion in notional amount,
respectively, were cleared per week on average. In terms of number of
trades cleared at LCH, swaps referencing Fedfunds were cleared on
average 116 times per week and swaps referencing British pound-LIBOR
were cleared 888 times per week on average. All of the other indices
currently cleared have similar or substantially higher number of trades
and notional amounts cleared.126
—————————————————————————
126 British pound-SONIA has about the same number of trades
and per week trading average as Fedfunds, but has a higher
outstanding notional amount at $1.734 trillion.
—————————————————————————
The rate indexes used for OTC interest rate swaps and the interest
rate swaps identified for clearing by the DCOs reference not only the
generic index, but a reference definition for the index such as the
ISDA definition or Reuters definition. These reference definitions
refer to the generic index and in addition, typically identify
specifically where the calculating party shall look up the index and
sometimes at what time the calculating party shall look up the index
for calculation purposes. Additionally, these reference indices provide
a standard alternative if the index is not available from the
designated source at the designated time. While the Commission
recognizes the importance of these features of the reference
definitions and that each swap, both cleared and uncleared, should have
these features, such features need not be included in the index rate
specification for the Commission’s clearing requirement determination
because they are not definitive for the economic result achieved.
Rather, the generic index itself is. If the parties to a swap identify
a specific reference definition for an index, they need only confirm
whether the DCO accepts that reference definition. If it does not, then
the swap in question is not accepted for clearing and it is not subject
to the clearing requirement.
Rate Index Specification Conclusion
The Commission concludes that with the exception of the EURO-LIBOR
index, all of the rate indexes identified in the IRS submissions have
significant outstanding notional amounts and trading liquidity. The
Commission further notes that significant notional amounts of these
rate indexes are already cleared by DCOs.
4. Stated Termination Dates
Stated termination date (sometimes referred to as “maturities”)
data is often presented by aggregating stated termination dates for
swaps into specified term periods or “buckets.” The IRS submissions
show that the DCOs have been clearing interest rate swaps with final
termination dates out to at least ten years for all seventeen
currencies and out to 50 years for some classes and currencies cleared.
The use of maturity buckets eases the discussion of the range of
termination dates. As the tables below show, interest rate swaps can be
multi-year contracts with termination dates out to fifty years or more
depending on the class and currency of the swap. Also, stated
termination dates can fall on any day of the year. Given this continuum
of termination dates, the DCOs have indicated that they manage the
cleared swap portfolio risk using a swap curve.127 Swap curves are
also used by market participants to price interest rate swaps. By
pricing swaps in this way, the economic results of an interest rate
swap can be fairly closely approximated, and therefore hedged, using
two or more other swaps with different maturities principally by
matching the weighted average duration of those swaps with the duration
of the swap being hedged.128 In the same manner, a large portfolio of
interest rate swaps can be hedged fairly closely with a small number of
hedging swaps that have the same duration as the entire portfolio or
subsets of related swaps within the portfolio. In effect, for DCO risk
management purposes, the termination dates of interest rate swaps are
assessed based on how they affect the overall duration aspects of the
portfolio of swaps cleared.129 Accordingly, the primary determination
with respect to the stated termination date specification is, for each
class and currency, at what point, if any, along the continuum of swap
maturities is there insufficient notional outstanding and trading
liquidity to structure the swap curve effectively for DCO risk
management purposes.
—————————————————————————
127 The “swap curve” is the term generally used by market
participants for interest rate swap pricing and is similar to, and
is sometimes established, in part, based on, “yield curves” used
for pricing bonds.
128 Other factors, such as convexity, may also be taken into
account in determining the appropriate hedge ratio between the
initial swap and the other swaps used to hedge its exposure.
129 For further discussion of the use of portfolio risk
management by DCOs, see the discussion of interest rate swap market
conventions and risk management in Section II.E above.
—————————————————————————
The TriOptima data provided sufficient detail to discern notional
amounts and trade counts only for each swap class. The ODSG data
provided sufficient detail to discern notional amounts and trade counts
only for each currency. The LCH data provided enough detail for both
swap class and currency.
Regarding maturity buckets, the BIS data only provides information
for interest rate swaps in three periods: up to one year, between one
year and five years, and more than five years. Because the BIS data
does not provide granular detail beyond the five year maturity date, it
does not provide enough detail to inform the Commission’s determination
regarding the IRS submissions under consideration. Accordingly, the BIS
data was not considered for the stated termination date specification.
Table 15–TriOptima Data Interest Rate Swaps Notional by Maturity Period and Class 130
[U.S. dollar equivalent in billions]
——————————————————————————————————————————————————–
Maturity 0<=2 Maturity 2<=5 Maturity 5<=10 Maturity Maturity Maturity 30+
Product type years years years 10<=20 years 20<=30 years Years
——————————————————————————————————————————————————–
Fixed-to-Floating:
–Notional…………………………………… $118,523 $80,101 $66,049 $19,872 $13,207 $2,067
[[Page 47200]]
–Trade Count………………………………… 823,434 890,622 908,880 303,927 270,074 42,155
FRA:
–Notional…………………………………… $66,040 $1,060 $45 $0 $0 $0
–Trade Count………………………………… 201,164 1,646 78 0 0 0
OIS:
–Notional…………………………………… $41,783 $1,450 $258 $64 $74 $4
–Trade Count………………………………… 77,982 26,067 3,740 1,376 510 29
Basis Swap:
–Notional…………………………………… $17,324 $6,032 $2,633 $950 $561 $94
–Trade Count………………………………… 39,632 34,080 24,590 12,638 8,197 546
——————————————————————————————————————————————————–
Table 16–LCH Data: Interest Rate Swaps Notional Outstanding Cleared by Maturity Period and Class131
[U.S. dollar equivalent in billions]
——————————————————————————————————————————————————–
Maturity 0<=2 Maturity 2<=5 Maturity 5<=10 Maturity Maturity Maturity
Product type years years years 10<=20 years 20<=30 years 30<=50 years
——————————————————————————————————————————————————–
Fixed-to-Floating:
–Notional…………………………………… $7,773 $4,448 $3,569 $747 $463 $52
–Trade Count………………………………… 22,431 34,930 40,086 8,551 10,701 1,127
FRA:
–Notional…………………………………… $11,184 $0 $0 $0 $0 $0
–Trade Count………………………………… 31,584 0 0 0 0 0
OIS:
–Notional…………………………………… $8,714 $0 $0 $0 $0 $0
–Trade Count………………………………… 6,848 0 0 0 0 0
Basis Swap:
–Notional…………………………………… $1,423 $129 $37 $14 $5 $1
–Trade Count………………………………… 1,485 736 394 226 84 15
——————————————————————————————————————————————————–
The TriOptima data and LCH data presented above is useful in
considering the distribution of final termination dates based on swap
class. For fixed-to-floating swaps and basis swaps, there was
significant outstanding notional amounts and number of trades for all
maturity buckets.
—————————————————————————
130 TriOptima data, as of March 16, 2012.
131 The data covers swaps cleared by LCH during the first
calendar quarter, 2012.
—————————————————————————
For FRAs, the TriOptima data shows a steep drop off after two
years, although there is still over $1 trillion dollars of outstanding
notional amount in the 2<=5 year bucket and 1,646 trades. The notional
amount outstanding falls below $50 billion after the five year
maturity. The LCH data shows substantial outstanding notional amounts
out to two years and none thereafter. The IRS submissions provide that
the DCOs do not clear FRAs with payment dates beyond three years.
Accordingly, the Commission need not consider FRAs with maturities
beyond three years until such time as a DCO submits such swaps for
clearing.
For OIS, the TriOptima data shows notional amounts for all maturity
buckets, but the drop off was steep beyond two years. After ten years,
outstanding notional amounts drop below $100 billion for each maturity
bucket. The LCH data shows no outstanding notional amounts cleared
beyond two years. The IRS submissions provide that the DCOs do not
accept for clearing OIS swaps beyond two years. Accordingly, the
Commission is not considering OIS swaps beyond two years in this
clearing requirement determination.
—————————————————————————
132 The ODSG data includes swaps entered into between June and
August, 2010 as voluntarily reported by the G14 Dealers. Only
currencies and swap classes identified in the IRS submissions are
included.
Table 17–ODSG Data: Interest Rate Swaps Trading Activity by Maturity Period and Currency 132
[U.S. dollar equivalent in billions]
——————————————————————————————————————————————————–
Maturity 0<=2 Maturity 2<=5 Maturity Maturity Maturity Maturity
Currency years years 5<=10 years 10<=20 years 20<=30 years 30<=50 years
——————————————————————————————————————————————————–
EUR…………………………………………….. $14,596 $1,699 $1,510 $447 $287 $34
USD…………………………………………….. 6,796 1,991 1,999 247 220 5
GBP…………………………………………….. 6,521 348 263 72 54 17
JPY…………………………………………….. 2,970 782 448 91 16 0
Other…………………………………………… 2,597 325 142 16 3 0
———————————————————————————————–
Total……………………………………….. 33,480 5,143 4,362 872 580 56
——————————————————————————————————————————————————–
[[Page 47201]]
Table 18–LCH Data Interest Rate Swaps Notional Outstanding Cleared by Maturity Period and Currency 133
[U.S. Dollar Equivalent in Billions]
——————————————————————————————————————————————————–
Maturity 0<=2 Maturity 2<=5 Maturity Maturity Maturity Maturity
Currency years years 5<=10 years 10<=20 years 20<=30 years 30<=50 years
——————————————————————————————————————————————————–
EUR…………………………………………….. $14,697 $1,922 $1,759 $477 $269 $35
USD…………………………………………….. 8,850 1,796 1,176 154 133 2
GBP…………………………………………….. 2,143 256 268 59 51 16
JPY…………………………………………….. 2,204 254 262 56 12 0
Other…………………………………………… 1,200 349 141 13 3 0
———————————————————————————————–
Total……………………………………….. 29,094 4,577 3,606 760 468 53
——————————————————————————————————————————————————–
The ODSG data and LCH data in the two preceding tables show
notional amounts traded for maturity buckets by currency. As shown,
there were traded and cleared notional amounts for euro, U.S. dollars
and British pounds out to the 30 to 50 year bucket and for yen out to
the twenty to thirty year bucket. The LCH data confirms that
substantial notional amounts of euros, U.S. dollars and British pounds
are being cleared out to fifty years and yen out to 30 years.
—————————————————————————
133 The data covers swaps cleared by LCH during the first
calendar quarter, 2012.
—————————————————————————
Stated Termination Date Specification Conclusion
For the classes of swaps, the TriOptima data show that there is
significant outstanding notional amounts and number of trades out to 50
years for fixed-to-floating swaps and basis swaps, out to three years
for OIS, and out to two years for FRAs. With respect to currencies, the
ODSG data set and LCH data show significant outstanding notional
amounts and number of trades out to 50 years for U.S. dollars, euros,
and British pounds and out to 30 years for yen.
5. Adequate Pricing Data
In reaching its proposed determination, the Commission also is
taking into account the adequacy of the pricing data for the four
classes of interest rate swaps. LCH submits there is adequate pricing
data for its risk and default management. It explains that its risk and
default management is based on the following factors under normal and
stressed conditions:
Outstanding notional, by maturity bucket and currency;
Number of participants with live open positions, by
maturity bucket and currency;
Notional throughput of the market, by maturity bucket and
currency;
Size tradable by maturity bucket that would not adjust the
market price;
Number of potential direct clearing members clearing the
products that are part of the mutualized default fund and default
management process;
Interplay between on-the-run and off-the-run contracts;
and
Product messaging components and structure.
LCH carries out a fire drill of its default management procedures
and readiness twice a year. According to LCH, the fire drill presents
an opportunity to further benchmark market liquidity and behavior and
for models and assumptions to be recalibrated based on practitioner
input. LCH also tests liquidity assumptions from the outset when
developing clearing capabilities for a new product and thereafter, on a
daily basis. This testing informs how LCH develops and modifies its
risk management framework to provide adequate risk coverage in
compliance with the core principles applicable to DCOs. Based on this
framework, LCH contends that there is adequate pricing data for the
swaps offered for clearing.
IDCH submits that there is adequate pricing data to produce the
IDCH-generated discount curve (the IDCH Curve). IDCH values each open
position at the end of each trading day by valuing each leg of the cash
flows of the contract (fixed and floating) according to discount
factors produced by the IDCH Curve. The IDCH Curve is a zero-coupon
yield curve that is updated on a continual basis and includes a
composite of swap rates. IDCH generates a unique IDCH Curve for each
reference rate that is available for clearing and calibrates each of
these IDCH Curves to the discount curve to value at-market instruments
at par.
CME publicly represents that its interest rate swap valuations are
fully transparent and rely on pricing inputs obtained from wire service
feeds. Further, CME uses conventional pricing methodologies, including
OIS discounting, to produce its zero coupon curve. In addition,
customers are provided with direct access to daily reports showing
curve inputs, daily discount factors, and valuations for each cleared
swap position.
It is also worth noting that those interest rate swaps that are the
subject of this proposal are capable of being priced off of deep and
liquid debt markets. Because of the stability of access to pricing data
from these markets, the pricing data for non-exotic interest rate swaps
that are currently being cleared is generally viewed as non-
controversial.
Based on consideration of the existence of significant outstanding
notional exposures, trading liquidity, and adequate pricing data, the
Commission preliminarily has determined to include interest rate swaps
with the following specifications in the clearing requirement rule.
Table 19–Interest Rate Swap Determination
—————————————————————————————————————-
—————————————————————————————————————-
Fixed-to-Floating Swap Class
—————————————————————————————————————-
Specification
1. Currency………………… U.S. Dollar (USD). Euro (EUR)…….. Sterling (GBP)…. Yen (JPY).
2. Floating Rate Indexes…….. LIBOR…………. EURIBOR……….. LIBOR…………. LIBOR.
3. Stated Termination Date Range 28 days to 50 28 days to 50 28 days to 50 28 days to 30
years. years. years. years.
[[Page 47202]]
4. Optionality……………… No……………. No……………. No……………. No.
5. Dual Currencies………….. No……………. No……………. No……………. No.
6. Conditional Notional Amounts. No……………. No……………. No……………. No.
—————————————————————————————————————-
Basis Swap Class
—————————————————————————————————————-
Specification
1. Currency………………… U.S. Dollar (USD). Euro (EUR)…….. Sterling (GBP)…. Yen (JPY).
2. Floating Rate Indexes…….. LIBOR…………. EURIBOR……….. LIBOR…………. LIBOR.
3. Stated Termination Date Range 28 days to 50 28 days to 50 28 days to 50 28 days to 30
years. years. years. years.
4. Optionality……………… No……………. No……………. No……………. No.
5. Dual Currencies………….. No……………. No……………. No……………. No.
6. Conditional Notional Amounts. No……………. No……………. No……………. No.
—————————————————————————————————————-
Forward Rate Agreement Class
—————————————————————————————————————-
Specification
1. Currency………………… U.S. Dollar (USD). Euro (EUR)…….. Sterling (GBP)…. Yen (JPY).
2. Floating Rate Indexes…….. LIBOR…………. EURIBOR……….. LIBOR…………. LIBOR.
3. Stated Termination Date Range 3 days to 3 years. 3 days to 3 years. 3 days to 3 years. 3 days to 3 years.
4. Optionality……………… No……………. No……………. No……………. No.
5. Dual Currencies………….. No……………. No……………. No……………. No.
6. Conditional Notional Amounts. No……………. No……………. No……………. No.
—————————————————————————————————————-
Overnight Index Swap Class
—————————————————————————————————————-
Specification
1. Currency………………… U.S. Dollar (USD). Euro (EUR)…….. Sterling (GBP)….
2. Floating Rate Indexes…….. FedFunds………. EONIA…………. SONIA………….
3. Stated Termination Date Range 7 days to 2 years. 7 days to 2 years. 7 days to 2 years.
4. Optionality……………… No……………. No……………. No…………….
5. Dual Currencies………….. No……………. No……………. No…………….
6. Conditional Notional Amounts. No……………. No……………. No…………….
—————————————————————————————————————-
Request for Comments
Should the Commission consider other data to determine
whether there are outstanding notional exposures, trading liquidity, or
adequate pricing data to support the proposed clearing requirements? If
so, please provide or identify any additional data that may assist the
Commission in this regard.
Do the four classes of interest rate swaps that would be
subject to the proposed clearing requirement have significant
outstanding notional amounts and trading liquidity?
Should the Commission include the other thirteen
currencies currently being cleared in its initial clearing requirement
determination?
Should the Commission include stated termination dates
that are shorter than those that are listed, particularly for the
fixed-to-floating and basis swaps?
If the option in an interest rate swaption is exercised
and not cash settled, should the resulting swap be subject to the
clearing requirement if it meets the specifications included in the
proposed clearing requirement?
Is there adequate pricing data for DCO risk and default
management of the interest rate swaps that would be subject to the
proposed rule?
b. Availability of Rule Framework, Capacity, Operational Expertise
and Resources, and Credit Support Infrastructure
Section 2(h)(2)(D)(ii)(II) of the CEA requires the Commission to
take into account the availability of rule framework, capacity,
operational expertise and resources, and credit support infrastructure
to clear the proposed classes of swaps on terms that are consistent
with the material terms and trading conventions on which they are now
traded. The Commission believes that LCH, CME, and IDCH have developed
rule frameworks, capacity, operational expertise and resources, and
credit support infrastructure to clear the interest rate swaps they
currently clear on terms that are consistent with the material terms
and trading conventions on which those swaps are being traded. The
Commission notes that LCH already clears more than half the global
interest rate swaps in the four proposed classes of the clearing
requirement and that CME and IDCH also already clear the more commonly
traded swaps under this clearing requirement proposal.
Importantly, the Commission notes that the three DCOs each
developed their interest rate swap clearing offerings in conjunction
with market participants and in response to the specific needs of the
marketplace. In this manner, the clearing services of each DCO are
designed to be consistent with the material terms and trading
conventions of a bilateral, uncleared market.
LCH submits that it has the capability and expertise to not only
manage the risks inherent in the current book of interest rate swaps
cleared, but also the capability to manage the increased volume that
the clearing requirement for all of its currently clearable products
could generate. LCH states that its clearing model seamlessly allows
interest rate swaps to be cleared on identical terms for both new and
existing, bilateral OTC swaps. Existing bilateral swaps are regularly
back loaded into LCH’s cleared swaps book. In order to be able to
securely risk manage, and technologically and operationally process
this volume of trades and diversity of underlying product (i.e., all of
the unique underlying features of every single swap), LCH has developed
operational models, controls, and risk algorithms to ensure that it can
process trades, and is capable of calculating the level of risk it has
with any counterparty–both direct clearing members and their
customers. LCH believes its SwapClear service is proof that the
interest rate swap market and all of its features can
[[Page 47203]]
be safely cleared with the right systems, controls, risk management,
operational framework, and expertise, and it points to the orderly and
successful close out of the Lehman Brothers International Europe’s
interest rate swap portfolio. LCH notes that in so doing, no other
clearing member or clearing member’s customer was harmed and, less than
half of the defaulter’s initial margin was used.
CME’s submission cites to its rule books to demonstrate the
availability of rule framework, capacity, operational expertise and
resources, and credit support infrastructure to clear qualified,
interest rate swap contracts on terms that are consistent with the
material terms and trading conventions on which the contracts are then
traded.
IDCH submits that its rule book provides a rule framework for
clearing members and customers of clearing members to clear U.S. dollar
interest rate swaps on terms that are consistent with the material
terms and trading conventions on which they would trade interest rate
swaps and forward rate agreements in the OTC market. The IDCH rule book
also sets forth clearing member criteria and obligations, and
descriptions of the clearing process, the settlement process (including
the collection of performance bond and protection of customer
collateral), and the default process.
IDCH also claims that it has the capacity, operational expertise
and resources, and credit support infrastructure to clear U.S. dollar
interest rate swaps on terms that are consistent with the material
terms and trading conventions on which interest rate swaps and forward
rate agreements are traded in the OTC market. IDCH states that it has
the financial capacity to clear such swaps as demonstrated by the
financial resources backing its obligations under the cleared
contracts, which includes initial margin posted by clearing members
(for their proprietary account and customer accounts), guaranty fund
deposits posted by clearing members, and assessment powers against
clearing members. IDCH notes that it has been registered as a DCO since
2008 and has dedicated tremendous resources to developing its
operational capacity to clear interest rate swaps. It claims that the
capacity of the IDCH clearing systems is scalable and has been tested
to manage the anticipated volume of interest rate contracts. IDCH also
says that its clearing systems presently have the capacity to manage
the clearing of up to 220,000 contracts with 550 value-at-risk (VaR)
scenarios being used for portfolio revaluation. The architecture of the
systems is designed to be scalable with hardware and has been tested to
manage the clearing of up to two million interest rate swaps using the
same 550 VaR scenarios for revaluation.
Having taken into account the three DCOs’ availability of rule
framework, capacity, operational expertise and resources, and credit
support infrastructure, the Commission is proposing the determination
and rules described below.
Request for Comments
The Commission requests comment on all aspects of this
factor, including whether or not commenters agree that the three DCOs
clearing interest rate swaps can satisfy the factor’s requirements.
Has the Commission sufficiently taken into account the
three DCOs’ availability of rule framework, capacity, operational
expertise and resources, and credit support infrastructure? Are there
additional or alternative considerations that should be reviewed by the
Commission?
c. Effect on the Mitigation of Systemic Risk
Section 2(h)(2)(D)(ii)(III) of the CEA requires the Commission to
take into account the effect on the mitigation of systemic risk, taking
into account the size of the market for such contract and the resources
of the DCO available to clear the contract. CME, LCH, and IDCH submit
that subjecting interest rate swaps to central clearing would help
mitigate systemic risk. As noted above, the Commission believes that
the market for these swaps is significant and mitigating counterparty
risk through clearing likely would reduce systemic risk in that market
and in the industry, generally.
According to LCH, if all clearable swaps are required to be
cleared, the inevitable result will be a less disparate marketplace
from a systemic risk perspective. CME submits that the 2008 financial
crisis demonstrated the potential for systemic risk arising from the
interconnectedness of OTC derivatives market participants and submits
that centralized clearing will reduce systemic risk.
IDCH submits that, given the tremendous size of the interest rate
derivatives market, the potential mitigation of systemic risk through
centralized clearing of interest rate swaps is significant. IDCH argues
that clearing such swaps brings the risk mitigation and collateral and
operational efficiency afforded to cleared and exchange-traded futures
contracts to bilaterally negotiated OTC interest rate derivatives. The
submission of interest rate swaps for clearing affords the parties the
credit, risk management, capital, and operational benefits of central
counterparty clearing of such transactions, and facilitates collateral
efficiency. Cleared swaps allow market participants to free up
counterparty credit lines that would otherwise be committed to open
bilateral contracts. Additionally, according to IDCH, an efficient
system for centralized clearing allows parties to mitigate the risk of
a bilateral OTC derivative. Instead of holding offsetting positions
with different counterparties and being exposed to the risk of each
counterparty, a party may enter into an economically offsetting
position that is cleared. Although the positions are not offset, the
initial margin requirement will be reduced to close to zero. To
eliminate risk without using centralized clearing, the party must enter
into a tear-up agreement with the counterparty, or enter into a
novation.
While the clearing requirement would remove a large portion of the
interconnectedness of current OTC markets that leads to systemic risk,
the Commission notes that central clearing, by its very nature,
concentrates risk in a handful of entities. However, the Commission
observes that central clearing was developed and designed to handle
such concentration of risk.
LCH has extensive experience risk managing very large volumes of
interest rate swaps; as noted above, it is believed that about half of
the interest rate swaps are cleared by LCH. CME submits that it has the
necessary resources available to clear the swaps that are the subject
of its submission. The Commission notes that CME or its predecessors
have cleared futures since 1898 and is the largest futures
clearinghouse in the world. CME has not defaulted during that time.
IDCH submits that the IDCH framework provides IDCH with scalable
financial resources sufficient to clear a large volume of interest rate
swaps.
Accordingly, the Commission believes that LCH, CME, and IDCH would
be able to manage the risk posed by clearing swaps that are required to
be cleared. In addition, the Commission believes that the central
clearing of the interest rate swaps that are the subject of this
proposal would serve to mitigate counterparty credit risk thereby
having a positive effect on the reducing systemic risk. Having taken
into account the effect on the mitigation of systemic risk, the
Commission is proposing the determination and rules described below.
[[Page 47204]]
Request for Comments
Would the proposed clearing requirement reduce systemic
risk?
Would the proposed clearing requirement increase the risk
to LCH, CME, or IDCH? If so, please explain why.
Are LCH, CME, and IDCH capable of handling any increased
risk that would result from the proposed clearing requirement?
d. Effect on Competition
Section 2(h)(2)(D)(ii)(IV) of the CEA requires the Commission to
take into account the effect on competition, including appropriate fees
and charges applied to clearing. As discussed above, of particular
concern to the Commission is whether this proposed determination would
harm competition by creating, enhancing, or entrenching market power in
an affected product or service market, or facilitating the exercise of
market power. Market power is viewed as the ability to raise price,
including clearing fees and charges, reduce output, diminish
innovation, or otherwise harm customers as a result of diminished
competitive constraints or incentives.134
—————————————————————————
134 See Section II.D above for more detailed discussion.
—————————————————————————
The Commission has identified one putative service market as
potentially affected by this proposed clearing determination: A DCO
service market encompassing those clearinghouses that currently (or
with relative ease in the future could) clear the interest rate swaps
subject to this proposal. Without defining the precise contours of this
market at this time, the Commission recognizes that, depending on the
interplay of several factors, this proposed clearing requirement
potentially could impact competition within the affected market. Of
particular importance to whether any impact is, overall, positive or
negative, is: (1) Whether the demand for these clearing services and
swaps is sufficiently elastic that a small but significant increase
above competitive levels would prove unprofitable because users of the
interest rate swap products and DCO clearing services would substitute
other clearing services co-existing in the same market(s); and (2) the
potential for new entry into this market. The availability of
substitute clearing services to compete with those encompassed by this
proposed determination, and the likelihood of timely, sufficient new
entry in the event prices do increase above competitive levels, each
operate independently to constrain anticompetitive behavior.
Any competitive import would likely stem from the fact that the
proposed determination would remove the alternative of not clearing for
interest rate swaps subject to this proposal. The proposed
determination would not specify who may or may not compete to provide
clearing services for the interest rate swaps subject to this proposal
(as well as those not required to be cleared).
To the extent that parties to interest rate swaps subject to this
proposal consider clearing the swaps reasonably interchangeable with
not clearing them, the proposed determination would eliminate at least
one competitive substitute within the clearinghouse services market for
the interest rate swaps identified in this proposal. Given the risk-
mitigation purpose and benefit of migration to voluntary interest rate
swap clearing, however, the Commission sees some basis to doubt that
counterparties to cleared swaps would consider the alternative of not
clearing interest rate swaps subject to this proposal as a reasonable
substitute to a degree sufficient that they should be viewed as
populating the same relevant market.135 Furthermore, if the
alternative of not clearing the interest rate swaps subject to this
proposal falls outside of the relevant services market that includes
clearing, the proposed clearing determination should not impact
competition in the clearing services market. The Commission requests
comment on the extent to which foregoing clearing is considered
reasonably interchangeable with clearing the interest rate swaps
subject to this proposal and, in particular, if parties transacting
interest rate swaps subject to this proposal would forego clearing if
clearinghouses raised the price of clearing five percent. The
Commission also requests comment on whether a different percentage than
five percent should be used.
—————————————————————————
135 In other words, the Commission questions that, faced with
an assumed five percent non-transitory increase in the price of
clearing the identified interest rate swaps, including fees and
other charges, that the parties to these interest rate swap
transactions would forego clearing in sufficient volume to render
the price increase unprofitable.
—————————————————————————
Moreover, even if cleared and non-cleared transactions of the type
subject to this proposal are now within the same relevant market,
removing the uncleared option through this proposed rulemaking is not
determinative of negative competitive impact. Other factors–including
the availability of other substitutes within the market or potential
for new entry into the market–may constrain market power.
Additionally, the potential for new entry may constrain market
power in an otherwise concentrated clearing services market. The
Commission does not foresee that the proposed determination constructs
barriers that would deter or impede new entry into a clearing services
market.136 Indeed, there is some basis to expect that the
determination could foster an environment conducive to new entry. For
example, the proposed clearing determinations, and the prospect that
more may follow, is likely to reinforce, if not encourage, growth in
demand for clearing services. Demand growth, in turn, can enhance the
sales opportunity, a condition hospitable to new entry.137 The
Commission requests comment on the extent to which: (1) Entry barriers
currently do or do not exist with respect to a clearing services market
for the interest rate swaps subject to this proposal; (2) the proposed
determinations may lessen or increase these barriers; and (3) the
proposed determinations otherwise may encourage, discourage,
facilitate, and/or dampen new entry into the market.
—————————————————————————
136 That said, the Commission recognizes that (1) to the
extent the clearing services market for the interest rate swaps
identified in this proposal, after foreclosing uncleared swaps,
would be limited to a concentrated few participants with highly
aligned incentives, and (2) the clearing services market is
insulated from new competitive entry through barriers–e.g., high
sunk capital cost requirements; high switching costs to transition
from embedded, incumbents; and access restrictions–the proposed
determination could have a negative competitive impact by increasing
market concentration.
137 See, e.g., Horizontal Merger Guidelines at Sec. 9.2
(entry likely if it would be profitable which is in part a function
of “the output level the entrant is likely to obtain”).
—————————————————————————
Request for Comments
In addition to what is noted above, the Commission requests
comment, and quantifiable data, on whether the required clearing of any
or all of these swaps will create conditions that create, increase, or
facilitate an exercise of: (1) Clearing services market power in LCH,
CME, and IDCH, and/or any other clearing service market participant,
including conditions that would dampen competition for clearing
services and/or increase the cost of clearing services; and/or (2)
market power in any product markets for interest rate swaps, including
conditions that would dampen competition for these product markets and/
or increase the cost of interest rate swaps involving the interest rate
swaps identified in this proposal. The Commission seeks comment, and
quantifiable data, on the likely cost increases associated with
clearing, particularly those fees and charges
[[Page 47205]]
imposed by DCOs, and the effects of such increases on counterparties
currently participating in the market. The Commission also seeks
comment regarding the effect of competition on DCO risk management. The
Commission also welcomes comment on any other aspect of this factor.
e. Legal Certainty in the Event of the Insolvency
Section 2(h)(2)(D)(ii)(V) of the CEA requires the Commission to
take into account the existence of reasonable legal certainty in the
event of the insolvency of the relevant DCO or one or more of its
clearing members with regard to the treatment of customer and swap
counterparty positions, funds, and property. The Commission is
proposing this clearing requirement based on its view that there is
reasonable legal certainty with regard to the treatment of customer and
swap counterparty positions, funds, and property in connection with
cleared swaps, namely the interest rate swaps subject to this proposal,
in the event of the insolvency of the relevant DCO (CME, LCH, or IDCH)
or one or more of the DCO’s clearing members.
The Commission concludes that, in the case of a clearing member
insolvency at CME or IDCH, subchapter IV of Chapter 7 of the U.S.
Bankruptcy Code (11 U.S.C. 761-767) and Part 190 of the Commission’s
regulations would govern the treatment of customer positions.138
Pursuant to section 4d(f) of the CEA, a clearing member accepting funds
from a customer to margin a cleared swap, must be a registered FCM.
Pursuant to 11 U.S.C. 761-767 and Part 190 of the Commission’s
regulations, the customer’s interest rate swap positions, carried by
the insolvent FCM, would be deemed “commodity contracts.” 139 As a
result, neither a clearing member’s bankruptcy nor any order of a
bankruptcy court could prevent either CME or IDCH from closing out/
liquidating such positions. However, customers of clearing members
would have priority over all other claimants with respect to customer
funds that had been held by the defaulting clearing member to margin
swaps, such as the interest rate swaps subject to this proposal.140
Thus, customer claims would have priority over proprietary claims and
general creditor claims. Customer funds would be distributed to swap
customers, including interest rate swap customers, in accordance with
Commission regulations and section 766(h) of the Bankruptcy Code.
Moreover, the Bankruptcy Code and the Commission’s rules thereunder (in
particular 11 U.S.C. 764(b) and 17 CFR 190.06) permit the transfer of
customer positions and collateral to solvent clearing members.
—————————————————————————
138 The Commission observes that an FCM or DCO also may be
subject to resolution under Title II of the Dodd-Frank Act to the
extent it would qualify as covered financial company (as defined in
section 201(a)(8) of the Dodd-Frank Act).
139 If an FCM is also registered as a broker-dealer, certain
issues related to its insolvency proceeding would also be governed
by the Securities Investor Protection Act.
140 Claims seeking payment for the administration of customer
property would share this priority.
—————————————————————————
Similarly, 11 U.S.C. 761-767 and Part 190 would govern the
bankruptcy of a DCO, in conjunction with DCO rules providing for the
termination of outstanding contracts and/or return of remaining
clearing member and customer property to clearing members.
With regard to LCH, the Commission understands that the default of
a clearing member of LCH would be governed by the rules of that DCO.
LCH, a DCO based in the United Kingdom, has represented that under
English law its rules would supersede English insolvency laws. Under
its rules, LCH would be permitted to close out and/or transfer
positions of a defaulting clearing member that is an FCM pursuant to
the U.S. Bankruptcy Code and Part 190 of the Commission’s regulations.
According to LCH’s submission, the insolvency of LCH itself would be
governed by both English insolvency law and Part 190.
LCH has obtained legal opinions that support the existence of such
legal certainty in relation to the protection of customer and swap
counterparty positions, funds, and property in the event of the
insolvency of one or more of its clearing members. In addition, LCH has
obtained a legal opinion from U.S. counsel regarding compliance with
the protections afforded to FCM customers under New York law.
Request for Comments
The Commission invites comment regarding whether there is
reasonable legal certainty in the event of an insolvency of a DCO or
one or more of its clearing members with regard to the treatment of
customer and swap counterparty positions, funds, and property.
III. Proposed Rule
The Commission is proposing the following rules under section
2(h)(2), as well as its authority under sections 5b(c)(2)(L) and 8a(5)
of the CEA. In issuing a determination regarding whether a swap or
class of swaps is required to be cleared, “the Commission may require
such terms and conditions to the requirement as the Commission
determines to be appropriate.” 141
—————————————————————————
141 Section 2(h)(2)(D)(iii) of the CEA.
—————————————————————————
A. Proposed Sec. 50.1 Definitions
Proposed Sec. 50.1 sets forth two defined terms: “business day”
and “day of execution.” The definition of business day would exclude
Saturdays, Sundays, and legal holidays. This definition is being
proposed as a means of addressing situations where executing
counterparties are located in different time zones. It is intended to
avoid difficulties associated with end-of-day trading by deeming swaps
executed after 4:00pm, or on a day other than a business day, to have
been executed on the immediately succeeding business day. The
Commission recognizes that market participants should not be required
to maintain back-office operations 24 hours a day or 7 days a week in
order to meet the proposed deadline for submitting swaps that are
required to be cleared to a DCO. The Commission also is attempting to
be sensitive to possible concerns about timeframes that may discourage
trade execution late in the day. To account for time-zone issues, the
“day of execution” has been defined to be the calendar day of the
party to the swap that ends latest, giving the parties the maximum
amount of time to subject their swaps to a DCO while still requiring
such submission on a same-day basis.
B. Proposed Sec. 50.2 Treatment of Swaps Subject to a Clearing
Requirement
Proposed Sec. 50.2(a) would require all persons, other than those
who elect the exception for non-financial entities in accordance with
Sec. 39.6, to submit a swap that is part of the class described in
Sec. 50.4 for clearing by a DCO as soon as technologically practicable
and no later than the end of the day of execution. The objective of
this provision is to ensure that swaps subject to a clearing
requirement are submitted to DCOs for clearing in a timely manner. The
Commission notes that this proposal regarding timing of submission to a
DCO is consistent with the real-time public reporting rules and the
rules mandating deadlines for the reporting of swap data to SDRs, both
of which use “as soon as technologically practicable” as the
applicable standard.142
—————————————————————————
142 See 17 CFR 43.2, Real-Time Public Reporting of Swap
Transaction Data, 77 FR 1182, 1243-44 (Jan. 9, 2012); and 17 CFR
45.3, Swap Data Recordkeeping and Reporting Requirements, 77 FR
2136, 2199-2200 (Jan. 13, 2012).
—————————————————————————
For purposes of this rule, the Commission clarifies that submission
of a swap by a market participant to its FCM clearing member would be
deemed
[[Page 47206]]
to meet the requirements for submitting the swap to a DCO. Once a
customer submits a swap to its FCM, the timeliness considerations are
governed by other straight-through-processing rules recently finalized
by the Commission.143 Under Sec. 1.74(a), FCMs that are clearing
members of DCOs shall coordinate with DCOs to establish systems that
enable the FCM or DCO to accept or reject each trade submitted for
clearing by a customer of the FCM as quickly as would be
technologically practicable if fully automated systems were used.
Similarly, under Sec. 1.74(b), FCM clearing members must accept or
reject each trade submitted to it by a customer as quickly as would be
technologically practicable if fully automated systems were used. Those
market participants that clear on their own behalf would be required to
submit their swaps to a DCO directly and pursuant to the proposed
timeframe.
—————————————————————————
143 Customer Clearing Documentation, Timing of Acceptance for
Clearing, and Clearing Member Risk Management, 77 FR 21278, 21307
(Apr. 9, 2012).
—————————————————————————
Proposed Sec. 50.2(b) would require persons subject to Sec.
50.2(a) to undertake reasonable efforts to determine whether a swap is
required to be cleared. The Commission would consider such reasonable
efforts to include checking the Commission’s Web site or the DCO’s Web
site for verification of whether a swap is required to be cleared.
Similarly, market participants could consult third-party service
providers for such verification. This reasonable efforts standard is
intended to provide market participants with clarity as to what is
expected of them when they enter into a swap that has the
specifications of one of the classes identified in proposed Sec. 50.4.
Ideally, DCOs will design and develop systems that will enable
market participants and trading platforms to check whether or not their
swap is subject to a clearing requirement and be provided with an
answer within seconds (or faster). This technology would provide a
single-stop solution for the market with regard to checking eligibility
under a required clearing regime.
C. Proposed Sec. 50.3 Notice to the Public
Proposed Sec. 50.3(a) would require each DCO to post on its Web
site a list of all swaps that it will accept for clearing and clearly
indicate which of those swaps the Commission has determined are
required to be cleared pursuant to part 50 of the Commission’s
regulations and section 2(h)(1) of the CEA. The proposed rule builds
upon the requirements of Sec. 39.21(c)(1), which requires each DCO to
disclose publicly information concerning the terms and conditions of
each contract, agreement, and transaction cleared and settled by the
DCO. Proposed Sec. 50.3(b) would require the Commission to post on its
Web site a list of those swaps it has determined are required to be
cleared and all DCOs that are eligible to clear such classes of swaps.
The Commission believes that this will provide market participants with
sufficient notice regarding which swaps are subject to a clearing
requirement.
D. Proposed Sec. 50.4 Classes of Swaps Required To Be Cleared
As discussed at length above, proposed Sec. 50.4 sets forth the
classes of interest rate swaps and CDS that the Commission has
determined are required to be cleared. Proposed Sec. 50.4(a) includes
a table listing those types of interest rate swaps the Commission would
require to be cleared; proposed Sec. 50.4(b) includes a table listing
those types of CDS indices the Commission would require to be cleared.
The Commission believes that this format provides market participants
with a clear understanding of which swaps are required to be cleared.
By using basic specifications to identify the swaps subject to the
clearing requirement, counterparties contemplating entering into a swap
can determine quickly as a threshold matter whether or not the
particular swap may be subject to a clearing requirement. If the swap
has the basic specifications of a class of swaps determined to be
subject to a clearing requirement, the parties will know that they need
to verify whether a DCO will clear that particular swap. This will
reduce the burden on swap counterparties related to determining whether
a particular swap may be subject to the clearing requirement.
E. Proposed Sec. 50.5 Clearing Transition Rules
Proposed Sec. 50.5 would codify section 2(h)(6) of the CEA. Under
proposed Sec. 50.5(a), swaps that are part of a class described in
Sec. 50.4 but were entered into before the enactment of the Dodd-Frank
Act would be exempt from clearing so long as the swap is reported to an
SDR pursuant to Sec. 44.02 and section 2(h)(5)(A) of the CEA.
Similarly, under proposed Sec. 50.5(b), swaps entered into after the
enactment of the Dodd-Frank Act but before the application of the
clearing requirement would be exempt from the clearing requirement if
reported pursuant to Sec. 44.03 and section 2(h)(5)(B) of the Act.
F. Proposed Sec. 50.6 Delegation of Authority
Proposed Sec. 50.6(a) would delegate to the Director of the
Division of Clearing and Risk, or the Director’s designee, with the
consultation of the General Counsel or the General Counsel’s designee,
the authority to determine whether a swap falls within a class of swaps
described in Sec. 50.4 and to communicate such a determination to the
relevant DCOs. The Commission believes that the Division of Clearing
and Risk has the requisite expertise to make such a determination and
that the most expeditious way for the marketplace to be apprised of a
such a determination would be for the Division of Clearing and Risk to
make the determination itself and to communicate it directly to the
relevant DCOs.
Swaps that contain the specifications described in Sec. 50.4 would
be presumed to fall within a class of swaps already subject to a
clearing requirement. In this manner, the Commission hopes to
facilitate DCOs’ ability to add new swaps to particular classes without
undue burden.
G. Proposed Sec. 50.10 Prevention of Evasion of the Clearing
Requirement and Abuse of an Exception or Exemption to the Clearing
Requirement
The Commission is proposing Sec. 50.10 to prevent evasion of the
clearing requirement and prevent abuse of any exemption or exception to
the clearing requirement under the Commission’s new rulemaking
authority provided in the Dodd-Frank Act amendments to sections
2(h)(4)(A) 144 (Prevention of Evasion) and 2(h)(7)(F) 145 (Abuse of
the End-User Exception) of the CEA and under the Commission’s existing
rulemaking authority in section 8a(5) 146 (General Rulemaking
Authority) of the CEA. Proposed Sec. 50.10 would prohibit (a) evasions
of the requirements of section 2(h), (b) abuse of the end-user
exception to the clearing requirement, and (c) abuse of any exemption
or exception to the requirements of section 2(h), including any
exemption or exception that the Commission may provide by rule,
regulation, or order.
—————————————————————————
144 Section 2(h)(4) of the CEA, 7 U.S.C. 2(h)(4).
145 Section 2(h)(7)(F) of the CEA, 7 U.S.C. 2(h)(7)(F).
146 Section 8a(5) of the CEA, 7 U.S.C. 12a(5).
—————————————————————————
Section 2(h) of the CEA provides two express rulemaking provisions
specifically addressing prevention of evasion and prevention of abuse
of the clearing requirement. Section 2(h)(4)(A) states that the
Commission shall prescribe rules and issue interpretations
[[Page 47207]]
of rules as determined by the Commission to be necessary to prevent
evasions of the clearing requirements under section 2(h) of the CEA.
Section 2(h)(7)(F) provides that the Commission may prescribe such
rules or issue interpretations of the rules as the Commission
determines to be necessary to prevent abuse of the exceptions to the
clearing requirement. The Commission preliminarily views evasion of the
clearing requirement and abuse of an exemption or exception to the
clearing requirement, including the end-user exception, to be related
concepts and are informed by new enforcement authority under the Dodd-
Frank Act, which added new sections 6(e)(4)-(5) 147 and 9(a)(6) 148
to CEA.
—————————————————————————
147 Section 6(e)(4)-(5) of the CEA, 7 U.S.C. 9a(4)-(5).
148 Section 9(a)(6) of the CEA, 7 U.S.C. 13(a)(6).
—————————————————————————
Proposed Sec. 50.10(a) would make it unlawful for any person to
knowingly or recklessly evade, participate in, or facilitate an evasion
of any of the requirements of section 2(h) of the CEA. Proposed Sec.
50.10(a) is informed by and consistent with section 6(e)(4) and (5) of
the CEA, which states that any DCO, SD, or MSP that “knowingly or
recklessly evades or participates in or facilitates an evasion of the
requirements of section 2(h) shall be liable for a civil monetary
penalty in twice the amount otherwise available for a violation of
section 2(h).” Proposed Sec. 50.10(a), however, would apply to any
person. In addition, proposed Sec. 50.10(a) would apply to any
requirement under section 2(h) of the CEA or any Commission rule or
regulation promulgated thereunder. These requirements include the
clearing requirement under section 2(h)(1), reporting of data under
section 2(h)(5), and the trade execution requirement under section
2(h)(8), among other requirements.149
—————————————————————————
149 For example, it would be a violation of proposed Sec.
50.10(a) for a SEF to knowingly or recklessly evade or participate
in or facilitate an evasion of the trade execution requirement under
section 2(h)(8).
—————————————————————————
The Commission notes, however, that section 2(h)(1)(A) 150 of the
CEA provides that it “shall be unlawful for any person to engage in a
swap unless that person submits such swap for clearing” to a DCO if
the swap is required to be cleared. Unlike the knowing or reckless
standard under proposed Sec. 50.10(a), section 2(h)(1)(A) imposes a
non-scienter standard on swap market participants. Therefore, any
person engaged in a swap that is required to be cleared under section
2(h) and proposed Part 50 of the Commission’s Regulations, and such
person did not submit the swap for clearing, absent an exemption or
exception, would be subject to a Commission enforcement action
regardless of whether the person knowingly or recklessly failed to
submit the swap for clearing.
—————————————————————————
150 Section 2(h)(1)(A) of the CEA, 7 U.S.C. 2(h)(1)(A).
—————————————————————————
Proposed Sec. 50.10(b) makes it unlawful for any person to abuse
the end-user exception to the clearing requirement as provided under
section 2(h)(7) of the CEA and Sec. 39.6.151 Proposed Sec. 50.10(b)
is adopted under the authority in both section 2(h)(4)(A) and section
2(h)(7)(F). The Commission preliminarily believes that an abuse of the
end-user exception to the clearing requirement may also, depending on
the facts and circumstances, be an evasion of the requirements of
section 2(h). The Commission’s view is informed by section 9(a)(6) of
the CEA, which cross-references both the prevention of evasion
authority in section 2(h)(4) and prevention of abuse of the exception
to the clearing requirement in section 2(h)(7)(F). Section 9(a)(6)
states that it “shall be a felony punishable by a fine of not more
than $1,000,000 or imprisonment for not more than 10 years, or both,
together with the costs of prosecution, for * * * [a]ny person to abuse
the end user clearing exemption under section 2(h)(4), as determined by
the Commission.” Therefore, the Commission is proposing to interpret a
violation of section 9(a)(6) of the CEA to also be a violation of
proposed Sec. 50.10(b).
—————————————————————————
151 See End-User Exception to the Clearing Requirement for
Swaps, adopted by the Commission on July 10, 2012, available at
www.cftc.gov.
—————————————————————————
Proposed Sec. 50.10(c) makes it unlawful for any person to abuse
any exemption or exception to the requirements of section 2(h) of the
CEA, including any exemption or exception, as the Commission may
provide by rule, regulation, or order. This provision is informed by
the Dodd-Frank Act amendments in section 2(h)(4)(A) to prescribe rules
necessary to prevent evasions of the clearing requirements, section
2(h)(7)(F) to prescribe rules necessary to prevent abuse of the
exceptions to the clearing requirements, and the Commission’s general
rulemaking authority in section 8a(5) to promulgate rules that, in the
judgment of the Commission, are reasonably necessary to accomplish any
purposes of the CEA. Therefore, the Commission preliminarily believes
that proposed Sec. 50.10(c) is necessary to prevent abuses of any
exemption or exception to the requirements of section 2(h).
The Commission believes a “principles-based” approach to proposed
Sec. 50.10 is appropriate. The Commission is not proposing to provide
a bright-line test of non-evasive or abusive conduct, because such an
approach may be a roadmap for engaging in evasive or abusive conduct or
activities. Nevertheless, the Commission is proposing additional
guidance regarding evasion and abuse in order to provide clarity to
market participants.152
—————————————————————————
152 Examples described in the guidance are illustrative and
not exhaustive of the transactions, instruments, or entities that
could be considered evasive. In considering whether a transaction,
instrument, or entity is evasive, the Commission will consider the
facts and circumstances of each situation.
—————————————————————————
The Commission proposes to interpret these rules in a manner
similar to its interpretation of the anti-evasion rules that it
recently adopted in its rulemaking to further define the term
swap.153 The Commission proposes to determine on a case-by-case
basis, whether particular transactions or other activities constitute
an evasion of the requirements of section 2(h) of the CEA or the
regulations promulgated thereunder or an abuse of any exemption or
exception to the requirements of section 2(h). Each such transaction or
activity would be evaluated on a case-by-case basis with consideration
given to all the facts and circumstances.
—————————————————————————
153 See Further Definition of “Swap,” “Security-Based
Swap,” and “Security-Based Swap Agreement”; Mixed Swaps;
Security-Based Swap Agreement Recordkeeping, Section VII, adopted by
the Commission on July 10, 2012, available at www.cftc.gov.
—————————————————————————
Similar to its approach in the rules further defining the term
“swap,” the Commission proposes that it would not consider
transactions or other activities structured in a manner solely
motivated by a legitimate business purpose to constitute evasion or
abuse. Additionally, when determining whether particular conduct is an
evasion of the requirements of section 2(h) or an abuse of any
exemptions or exceptions to those requirements, the Commission will
consider the extent to which the conduct involves deceit, deception, or
other unlawful or illegitimate activity.
The Commission recognizes that market participants may engage in
conduct or activities, such as structuring a transaction in a
particular way, for legitimate business purposes, without any intention
to evade the requirements of section 2(h) of the CEA or abuse any
exemptions or exceptions thereunder. Thus, in evaluating whether a
person has evaded such requirements or abused
[[Page 47208]]
an exemption or exception, the Commission proposes to consider the
extent to which a person has a legitimate business purpose in
connection with the relevant conduct or activities. This proposed
analytical method will be useful in the overall analysis of potentially
knowingly or recklessly evasive conduct or abusive conduct. The
Commission proposes to view legitimate business purpose considerations
on a case-by-case basis in conjunction with all other relevant facts
and circumstances.
Moreover, the Commission recognizes that it is possible that a
person intending to evade the requirements of section 2(h) or abuse an
exemption or exception thereunder may attempt to justify its actions by
claiming that such actions are legitimate business practices in its
industry. Therefore, the Commission proposes to retain the flexibility,
via an analysis of all relevant facts and circumstances, to confirm not
only the legitimacy of the business purpose of those actions but
whether the actions could still be determined to be evasive or abusive.
Because market participants engage in conduct and activities, such as
structuring transactions and instruments, in a particular way for
various reasons, it is essential that all relevant facts and
circumstances be considered, including legitimate business purposes,
before reaching any conclusion as to evasion or abuse.
When determining whether a particular activity constitutes an
evasion of the requirements of section 2(h) or an abuse of any
exemption or exception to such requirements, the Commission proposes to
consider the extent to which the activity involves deceit, deception,
or other unlawful or illegitimate activity. The Commission believes
that although it is likely that fraud, deceit, or unlawful activity
will be present where evasion or abuse has occurred, these factors are
not prerequisites to finding a violation of proposed rule Sec. 50.10.
Rather, fraud, deceit, or unlawful activity is one circumstance the
Commission proposes to consider when evaluating a person’s conduct or
activities.
Finally, when considering all the relevant facts and circumstances
under a potential violation of proposed rule Sec. 50.10, the
Commission would not consider the form, label, or written documentation
of any relevant agreement, contract or transaction to be dispositive.
This approach is intended to prevent evasion and abuse through clever
draftsmanship of a form, label, or other written documentation.
Therefore, the Commission proposes to look beyond the form of the
agreement, contract or transaction to examine its actual substance and
purpose to prevent any evasion or abuse through clever draftsmanship.
In addition to the prohibitions under proposed Sec. 50.10, the
Commission notes that additional provisions of the CEA may also be
applicable to evasive or abusive practices. For example, the Commission
notes that swaps, whether cleared or uncleared, must be reported to a
registered SDR, or if no SDR will accept the swap, to the
Commission.154 In that regard, the Commission has proposed that to be
eligible to qualify for certain exceptions or to be able to rely on
certain exemptions, at least one party to the swap must report certain
information to an SDR or to the Commission. Regulation 39.6(b)(4), for
example, requires at least one party to a swap that has elected to use
the end-user exception to the clearing requirement to report whether
the swap is used to hedge or mitigate commercial risk.155
—————————————————————————
154 See section 2(a)(13)(G) of the CEA, 7 U.S.C. 2(a)(13)(G),
and section 4r(a)(1) of the CEA, 7 U.S.C. 6r(a)(1).
155 See End-User Exception to the Clearing Requirement for
Swaps, adopted by the Commission on July 10, 2012, available at
www.cftc.gov.
—————————————————————————
Considering this regulatory regime, certain evasive or abusive
practices, such as making false statements or submission in connection
with the clearing requirement, may also violate other provisions of the
CEA. For example, section 6(c)(2) 156 of the CEA, which makes it
unlawful for any person to make any false or misleading statement of
material fact to the Commission, including in any report filed with the
Commission or any other information relating to a swap. Furthermore,
section 9(a)(4) 157 of the CEA makes it a felony for any person to
willfully falsify a material fact, make any false or fraudulent
statements or representations, or make or use any false writing or
document or fraudulent statement or entry to an SDR. Thus, the
Commission may bring enforcement actions under proposed Sec. 50.10,
section 6(c)(2), and section 9(a)(4), among other statutory provisions
and rules, to prevent evasions of the requirements of section 2(h) and
abuses of any exemption or exception to such requirements.
—————————————————————————
156 Section 6(c)(2) of the CEA, 7 U.S.C. 9(c)(2).
157 Section 9(a)(4) of the CEA, 7 U.S.C. 13(a)(4). See also
section 9(a)(3) of the CEA, 7 U.S.C. 13(a)(3).
—————————————————————————
Request for Comment
The Commission requests comment on all aspects of the proposed
rules and specifically on:
Should the Commission clarify in the proposed rules that
the clearing requirement applies to all new swaps and all changes in
the ownership of a swap, such as assignment, novation, exchange,
transfer, or conveyance?
Is proposed Sec. 50.10 and the guidance set forth in this
section sufficient to address concerns of evasion of the requirements
of section 2(h) or an abuse of any exemption or exception to such
requirements? Is further guidance necessary? If so, what further
guidance would be appropriate?
Should the Commission prohibit certain specific practices
that would be evasions of the requirements of section 2(h)?
Should the Commission prohibit certain specific practices
that would be an abuse of the end-user exception?
Should the Commission prohibit certain specific practices
that would be an abuse of any other exemption or exception to the
requirements of section 2(h)?
IV. Implementation
The Commission is proposing to require compliance with the clearing
requirement for the classes of swaps identified in proposed Sec. 50.4
according to the compliance schedule contained in Sec. 50.25.158
Under this schedule, compliance with the clearing requirement will be
phased by type of market participant entering into a swap subject to
the clearing requirement.
—————————————————————————
158 The Commission proposed a compliance schedule for the
clearing requirement in September 2011, 76 FR 58186 (Sept. 20,
2011), and is finalizing 17 CFR 50.25 concurrently.
—————————————————————————
V. Cost Benefit Considerations
A. Statutory and Regulatory Background
The regulations contained in this proposal identify certain classes
of swaps that are required to be cleared pursuant to the Dodd-Frank
Act’s 159 clearing requirement incorporated within amended section
2(h)(1)(A) of the CEA.160 This clearing requirement is designed to
standardize and reduce counterparty risk associated with swaps, and, in
turn, mitigate the potential
[[Page 47209]]
systemic impact of such risks and reduce the likelihood for swaps to
cause or exacerbate instability in the financial system. It reflects a
fundamental premise of the Dodd-Frank Act: the use of properly
functioning central clearing can reduce systemic risk.
—————————————————————————
159 Dodd-Frank Wall Street Reform and Consumer Protection Act,
Public Law 111-203, 124 Stat. 1376 (2010).
160 This section states: “It shall be unlawful for any person
to engage in a swap unless that person submits such swap for
clearing to a derivatives clearing organization that is registered
under this Act or a derivatives clearing organization that is exempt
from registration under this Act if the swap is required to be
cleared.”
—————————————————————————
Regulation 39.5 provides an outline for the Commission’s review of
swaps for required clearing.161 Regulation 39.5 allows the Commission
to review swaps submitted by DCOs or those swaps that the Commission
opts to review on its own initiative.162 Under section 2(h)(2)(D) of
the CEA, in reviewing swaps for required clearing, the Commission must
take into account the following factors: (1) Significant outstanding
notional exposures, trading liquidity and adequate pricing data, (2)
the availability of rule framework, capacity, operational expertise and
credit support infrastructure, (3) the effect on the mitigation of
systemic risk, (4) the effect on competition and (5) the existence of
reasonable legal certainty in the event of the insolvency of the DCO or
one or more of its clearing members.163 Regulation 39.5 also directs
DCOs to provide to the Commission other information, such as product
specifications, participant eligibility standards, pricing sources,
risk management procedures, a description of the manner in which the
DCO has provided notice of the submission to its members and any
additional information requested by the Commission. This information is
designed to assist the Commission in identifying those swaps that are
required to be cleared.
—————————————————————————
161 76 FR 44464 (July 26, 2011).
162 See Sec. 39.5(b), Sec. 39.5(c). Under section
2(h)(2)(B)(ii) of the CEA, “[a]ny swap or group, category, type, or
class of swaps listed for clearing by a [DCO] as of the date of
enactment shall be considered submitted to the Commission.”
163 Section 2(h)(2)(D) of the CEA and Sec. 39.5(b)(ii).
—————————————————————————
B. Overview of Swap Clearing
i. How Clearing Reduces Risk
When a bilateral swap is cleared, the clearinghouse becomes the
counterparty to each of the original participants in the swap. This
standardizes counterparty risk for the original swap participants in
that they each bear the same risk–i.e., the risk attributable to
facing the clearinghouse as counterparty. In addition, clearing
mitigates counterparty risk to the extent that the clearinghouse is a
more creditworthy counterparty relative to the original swap
participants. Clearinghouses have demonstrated resilience in the face
of past market stress. Most recently, they remained financially sound
and effectively settled positions in the midst of turbulent events in
2007-2008 that threatened the financial health and stability of many
other types of entities.
Given the variety of effective clearinghouse tools to monitor and
manage counterparty risk, the Commission believes that DCOs will
continue to be some of the most creditworthy counterparties in the swap
markets. These tools include the contractual right to: (1) Collect
initial and variation margin associated with outstanding swap
positions; (2) mark positions to market regularly (usually one or more
times per day) and issue margin calls whenever the margin in a
customer’s account has dropped below predetermined levels set by the
DCO; (3) adjust the amount of margin that is required to be held
against swap positions in light of changing market circumstances, such
as increased volatility in the underlying product; and (4) close out
the swap positions of a customer that does not meet margin calls within
a specified period of time.
Moreover, in the event that a clearing member defaults on their
obligations to the DCO, the latter has a number of remedies to manage
associated risks, including transferring the swap positions of the
defaulted member, and covering any losses that may have accrued with
the defaulting member’s margin on deposit. In order to transfer the
swap positions of a defaulting member and manage the risk of those
positions while doing so, the DCO has the ability to: (1) Hedge the
portfolio of positions of the defaulting member to limit future losses;
(2) partition the portfolio into smaller pieces; (3) auction off the
pieces of the portfolio, together with their corresponding hedges, to
other members of the DCO; and (4) allocate any remaining positions to
members of the DCO. In order to cover the losses associated with such a
default, the DCO would typically draw from (in order): (1) The initial
margin posted by the defaulting member; (2) the guaranty fund
contribution of the defaulting member; (3) the DCO’s own capital
contribution; (4) the guaranty fund contribution of non-defaulting
members; and (5) an assessment on the non-defaulting members. These
mutualized risk mitigation capabilities are largely unique to
clearinghouses, and help to ensure that they remain solvent and
creditworthy swap counterparties even when dealing with defaults by
their members or other challenging market circumstances.
ii. Movement of Swaps Into Clearing
There is significant evidence that some parts of the OTC swap
markets (the IRS and CDS markets in particular) have been migrating
into clearing over the last few years in response to natural market
incentives as well as in anticipation of the Dodd-Frank Act’s clearing
requirement. LCH Clearnet data, for example, shows that the outstanding
volume of interest rate swaps cleared by LCH has grown steadily since
at least November 2007, as has the monthly registration of new trade
sides. Data provided to the Commission shows that the notional amount
of cleared IRS is approximately $72 trillion as of January 2007, and
just over $236 trillion in September 2010, an increase of 228% in three
and a half years.164 Together, those facts indicate increased demand
for LCH clearing services related to interest rate swaps, a portion of
which preceded the Dodd-Frank Act.165 Data available through CME and
TriOptima indicate similar patterns of growing demand for interest rate
swap clearing services, though their publically available data does not
provide a picture of demand prior to the passage of the Dodd-Frank
Act.166
—————————————————————————
164 Data provided to the Commission by LCH.
165 See http://www.lchclearnet.com/swaps/volumes/.
166 See http://www.cmegroup.com/trading/interest-rates/cleared-otc/index.html#data and http://www.trioptima.com/repository/historical-reports.html.
—————————————————————————
In addition to IRS clearing, major CDS market participants are
clearing their CDS indices and single names in significant volumes. As
explained above, in 2008, the Federal Reserve Bank of New York (FRBNY)
began encouraging market participants to establish a central
counterparty to clear CDS.167 In the past four years, CDS clearing
has grown significantly. In total, CFTC-registered DCOs are currently
holding more than $20 billion in aggregate in initial margin to cover
cleared CDS positions.168 Additionally, publicly available data shows
that CME’s CDS guaranty fund has approximately $629 million; ICE Clear
Credit has a guaranty fund equal to $4.4 billion; and ICE Clear Europe
has a
[[Page 47210]]
guaranty fund [euro]2.7 billion for its CDS business.169
—————————————————————————
167 See Federal Reserve Bank of New York, Press Release, “New
York Fed Welcomes Further Industry Commitments on Over-the-Counter
Derivatives,” Oct. 31, 2008, available at http://www.newyorkfed.org/newsevents/news/markets/2008/an081031.html, which
references documents prepared by market participants describing the
importance of clearing. See also Ciara Linnane and Karen Brettell,
“NY Federal Reserve pushes for central CDS counterparty,” Reuters,
Oct. 6, 2008, available at http://www.reuters.com/article/2008/10/06/cds-regulation-idUSN0655208920081006.
168 Based on Commission data for registered DCOs as of May 10,
2012.
169 See http://www.cmegroup.com/clearing/cme-clearing-overview/safeguards.html for data regarding CME’s guaranty fund, as
of May 10, 2012; https://www.theice.com/clear_credit.jhtml for data
on the size of ICE Clear Credit’s guaranty fund; and https://www.theice.com/clear_europe_cds.jhtml for data on the size of ICE
Clear Europe’s guaranty fund for CDS, as of May 10, 2012.
—————————————————————————
Notably, the move toward central clearing has been particularly
pronounced during times of crisis, as market participants have
voluntarily used central clearing as a way of protecting against
counterparty credit risk. The bankruptcy of Enron, in 2001, led to the
emergence of clearing for OTC energy swaps in the United States. After
Enron’s failure, many counterparties to energy swaps realized the
benefits of substituting the creditworthiness of a clearing house for
that of their bilateral counterparties. Much of the impetus for moving
OTC energy swaps into clearing resulted from the credit crisis that
developed following Enron’s collapse.170 According, to CME, its
ClearPort service “filled a major void in the aftermath of the Enron
collapse, particularly in the OTC market for natural gas, which was
left without a central OTC marketplace.” 171
—————————————————————————
170 “Has OTC Energy Clearing Finally Taken Off?” in Markets
03, a publication from FIA available at: http://www.futuresindustry.org/downloads/Outlook/OTCenergy.pdf. See also,
“Energy: An example for regulators to study,” Financial Times, Nov
3, 2011, available at http://www.ft.com/intl/cms/s/0/c5bfba26-fb3e-11e0-8df6-00144feab49a.html#axzz1zkpvIkJd.
171 CME Group, “Stepping Out of Uncertainty,” (2009),
available at http://www.cmegroup.com/company/history/magazine/Summer2009/steppingout.html.
—————————————————————————
iii. The Clearing Requirement and Role of the Commission
In the Dodd-Frank Act, Congress directed that clearing shift from a
voluntary practice to a mandatory practice for certain swaps and gave
the Commission responsibility for determining which swaps would be
required to be cleared. Therefore, the costs and benefits of required
clearing are attributable, in part, to the Act itself, and, in part, to
Commission action, taking the form of an exercise of discretion to
determine which swaps are required to be cleared. Because the
requirements of the Dodd-Frank Act and the discretion of the Commission
operate in concert in this way, it is impossible to distinguish
precisely between those costs and benefits that result from the Dodd-
Frank Act’s clearing requirement, considered in the abstract, and those
that result from the Commission’s determinations that particular types
of swaps will be required to be cleared. Also, because voluntary
clearing of swaps has increased over past years (may be due in part to
anticipation of the clearing requirement to be imposed under the Dodd-
Frank Act, but may also be due in part to a realization of the benefits
of clearing after the financial crisis), it is impossible to determine
precisely the extent to which any increased use of clearing would
result from statutory or regulatory requirements, as compared to swap
market participants’ desires to use clearing to obtain its risk-
reducing benefits.172
—————————————————————————
172 It is also possible that some market participants would
respond to the proposed rule’s requirement that certain types of
swaps be cleared by decreasing their use of such swaps. This
possibility contributes to the uncertainty regarding how the
proposed rule will affect the quantity of swaps that are cleared.
—————————————————————————
The Commission also recognizes that there might not be a linear
relationship between the quantity of swaps that are cleared (whether
measured by number of swaps, the notional value of swaps or some other
measure of swap quantity, such as the exposure resulting from the
swaps) and the costs and benefits resulting from clearing. For example,
if the Commission were to assume that the proposed rule would result in
a doubling of the quantity of a certain type of swap that is cleared,
it would not necessarily be the case that the costs and benefits of
clearing that type of swap would double. Rather, the relationship could
be non-linear for a variety of reasons (such as variations among the
users of that type of swap). In fact, it may be reasonable to assume
that where the costs of clearing are relatively low and the benefits
are relatively high, market participants already voluntarily clear
swaps even in the absence of a clearing requirement. The Commission
requests comment on the relationship between the requirement that the
swaps identified in the proposal be cleared and the costs and benefits
of that requirement, including on whether that relationship is linear
or non-linear.
For all these reasons, the Commission has determined that the costs
and benefits related to the required clearing of the classes of IRS and
CDS subject to this proposal are attributable, in part to (1)
Congress’s stated goal of reducing systemic risk by, among other
things, requiring clearing of swaps and (2) the Commission’s discretion
in selecting swaps or classes of swaps in order to achieve those ends.
The Commission will discuss the costs and benefits of the overall move
from voluntary clearing to required clearing for the swaps subject to
this proposal.
The Commission requests comment on this assumption, and in
particular on the extent to which swap market participants’ use of
clearing results from a regulatory requirement that specific swaps be
cleared (i.e., the rules proposed here), the Dodd-Frank Act’s general
clearing requirement, or other motivations for the use of clearing,
including, among other things, independent business reasons and
incentives from other regulators, such as prudential authorities.
C. Consideration of the Costs and Benefits of the Commission’s Action
i. CEA Section 15(a)
Section 15(a) of the CEA requires the Commission to consider the
costs and benefits of its actions before promulgating a regulation
under the CEA or issuing certain orders. Section 15(a) further
specifies that the costs and benefits shall be evaluated in light of
the following five broad areas of market and public concern: (1)
Protection of market participants and the public; (2) efficiency,
competitiveness and financial integrity of futures markets; (3) price
discovery; (4) sound risk management practices; and (5) other public
interest considerations. Accordingly, the Commission considers the
costs and benefits resulting from its own discretionary determinations
with respect to the section 15(a) factors.
In the sections that follow the Commission considers: (1) Costs and
benefits of required clearing for the classes of swaps identified in
this proposal; (2) alternatives contemplated by the commission and
their costs and benefits relative to the approach proposed herein; (3)
the impact of required clearing for the proposed classes of swaps on
the 15(a) factors.
ii. Costs and Benefits of Required Clearing Under the Proposal
In order to clear swaps in the classes identified in this proposal,
certain market participants are likely to face certain startup and
ongoing costs relating to technology and infrastructure, new or updated
legal agreements, ongoing fees from service providers, and costs
related to collateralization of their positions. The per-entity costs
related to changes in technology, infrastructure, and legal agreements
are likely to vary widely, depending on each market participant’s
existing technology infrastructure, legal agreements, operations, and
anticipated needs in each of these areas. For market participants that
already use clearing, some of these costs may be expected to be lower,
while the opposite would
[[Page 47211]]
likely be true for market participants that begin to use clearing only
because of the requirement. The costs of collateralization, on the
other hand, are likely to vary depending on whether an entity is
subject to capital requirements or not, and the differential between
the cost of capital for the assets they uses as collateral, and the
returns they realize on those assets. Commenters are requested to
address the extent to which factors such as these will affect the costs
of clearing for various market participants.
There are also significant benefits associated with increased
clearing, including reducing and standardizing counterparty risk,
increased transparency, and easier access to the swap markets. These
effects together will contribute significantly to the stability and
efficiency of the financial system. It is impossible, at this point, to
quantify these benefits with any degree of precision. The Commission
notes, however, that the extraordinary financial system turbulence of
2008 has had profound and long-lasting adverse effects on the real
economy, and therefore reducing systemic risk provides significant, if
unquantifiable, benefits.173 Also, as is the case for the costs
related to clearing, these benefits would be relatively less to the
extent that market participants are already using clearing in the
absence of a requirement. Commenters are requested to address this
aspect of the analysis as well.
—————————————————————————
173 For example, the PEW Economic Policy Group estimates total
costs of the acute stage of the crisis for U.S. interests were
approximately $12.04 trillion, including lost GDP, wages, real
estate wealth, equity wealth, and fiscal costs. Their estimates
include $7.4 trillion in losses in the equity markets between June
2008 and March 2009, but do not include subsequent gains in equity
markets that restored markets to their mid-2008 levels by the end of
2009. In addition, their calculations do not include continued
declines in real estate markets subsequent to March 2009. See Pew
Economic Policy Group, “The Cost of the Financial Crisis: The
Impact of the September 2008 Economic Collapse,” March 2010. The
IMF estimated that the cost to the banking sector of the financial
crisis through 2010 was approximately $2.2 trillion and reported a
range of estimates for total cost to the taxpayer of GSE bailouts
that ranged from $160 billion (Office of Management and Budget,
February 2010) to $500 billion (Barclays Capital, December 2009).
See IMF, “Global Financial Stability Report: Responding to the
Financial Crisis and Measuring Systemic Risks,” October 2010. Both
studies acknowledge that the estimates are subject to uncertainties.
—————————————————————————
a. Technology, Infrastructure, and Legal Costs
With respect to technology, for market participants that already
use swap clearing or transact in futures, many of the backend
requirements for technology that supports cleared swaps are likely to
be quite similar, and therefore necessary changes to those systems are
likely to require a relatively lower costs. Market participants that
are not currently using clearing for swaps or transacting in futures,
however, may need to implement appropriate middleware to connect with
an FCM that will clear their transactions.
Similarly for legal fees, the costs related to clearing the swaps
that are subject to the proposed clearing requirement are likely to
vary widely depending on whether market participants already use
clearing or transact in futures. For those market participants that
have not already engaged an FCM, it has been estimated that smaller
financial institutions will spend between $2,500 and $25,000 reviewing
and negotiating legal agreements when establishing a new business
relationship with an FCM.174 The Commission does not have information
necessary to confirm these estimates or determine to what degree these
estimates would apply to larger entities establishing a relationship
with an FCM. In addition, the Commission does not have information to
determine costs associated with entities that already have established
relationships with one or more FCMs but need to revise those
agreements. In all cases such costs are likely to depend significantly
on the specific business needs of each entity and therefore are
expected to vary widely among market participants.
—————————————————————————
174 See Chatham Financial letter at 2, available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=58077 and
Webster Bank letter at 3, available at http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=58076.
—————————————————————————
In addition, the Commission is exercising the anti-evasion
rulemaking authority granted to it by the Dodd-Frank Act. Generally,
proposed rule Sec. 50.10 states that it is unlawful for any person to
knowingly or recklessly evade or participate in or facilitate an
evasion of the requirements of section 2(h) of the CEA, to abuse the
exception to the clearing requirement as provided under section 2(h)(7)
of the CEA and Commission rule Sec. 39.6, or to abuse any exemption or
exception to the requirements of section 2(h) of the CEA, including any
exemption or exception as the Commission may provide by rule,
regulation, or order.
Although proposed rule Sec. 50.10 does not set forth a bright line
test to define evasion or abuse, the proposed rule is expected to help
ensure that would-be evaders cannot engage in conduct or activities
that constitute an evasion of the requirements of section 2(h) or an
abuse of any exemption or exception to such requirements. The
Commission also proposes guidance as to how it would determine if such
evasion or abuse has occurred, while at the same time preserving the
Commission’s ability to determine, on a case-by-case basis, with
consideration given to all the facts and circumstances, that other
types of transactions or activities constitute an evasion or abuse
under proposed Sec. 50.10.
The Commission proposes that participants in the markets should
already have policies and procedures in place to ensure that their
employees, affiliates, and agents will refrain from engaging in
activities, including devising transactions, for the purpose of
evading, or in reckless disregard of, the requirements of section 2(h)
of the CEA and Commission rules and regulations promulgated thereunder
or to abuse any exemption or exception to such requirements. Given that
the proposed rule imposes no affirmative duties (i.e., reporting or
recordkeeping), it is unlikely that it will impose any additional
ongoing costs beyond the pre-existing costs associated with ensuring
that the firm is not engaging in unlawful conduct. In that regard, the
Commission believes that it will not be necessary for firms that
currently have adequate compliance programs to hire additional staff or
significantly upgrade their systems to comply with the proposed rule.
Firms may, however, incur some one-time costs such as costs associated
with training traders and staff on the proposed rule. In addition,
market participants may incur costs when deciding whether particular
conduct or activity could be construed as being an evasion of the
requirements of section 2(h) or an abuse of any exemption or exception
to such requirements. However, the proposed rules and proposed guidance
explain what constitutes evasive or abusive conduct, which should serve
to mitigate such costs.
The Commission requests comment, including any quantifiable data
and analysis, on the changes that market participants will have to make
to their technological and legal infrastructures in order to clear the
swaps that are subject to the proposed clearing requirement. How many
market participants may have to establish new relationships with FCMs,
or significantly upgrade those relationships? What updates to legal
documentation are necessary, if any, for entities that already have an
existing FCM relationship? If commenting on this subject, please
clarify whether the comment relates to market participants that
currently transact in: (1) Uncleared
[[Page 47212]]
swaps without margin agreements; (2) uncleared swaps with margin
agreements; (3) cleared swaps; and/or (4) futures. If possible, please
quantify costs and the specific platforms being implemented, or changes
being made to existing platforms.
b. Ongoing Costs Related to FCMs and Other Service Providers
In addition to costs associated with technological and legal
infrastructure, market participants transacting in swaps subject to the
proposed clearing requirement will bear ongoing costs associated with
fees charged by FCMs. Regarding fees, DCOs typically charge FCMs an
initial transaction fee for each of the FCM’s customers’ IRS that are
cleared, as well as an annual maintenance fee for each of their
customers’ open positions. Not including customer-specific and volume
discounts, the transaction fees for IRS at the CME range from $1 to $24
per million notional amount for IRS and the maintenance fees are $2 per
year per million notional amount for open positions.175 LCH
transaction fees for IRS range from $1-$20 per million notional amount,
and the maintenance fee ranges from $5-$20 per swap per month,
depending on the number of outstanding swap positions that an entity
has with the clearinghouse.176 For CDS, ICE Clear Credit charges an
initial transaction fee of $6 per million notional amount. There is no
maintenance fee charged by ICE for maintaining open CDS positions.177
—————————————————————————
175 See CME pricing charts at: http://www.cmegroup.com/trading/cds/files/CDS-Fees.pdf;
http://www.cmegroup.com/trading/interest-rates/files/CME-IRS-Customer-Fee.pdf;
and http://www.cmegroup.com/trading/interest-rates/files/CME-IRS-Self-Clearing-Fee.pdf [hereinafter “CME Pricing Charts”].
176 See LCH pricing for clearing services related to OTC IRS
at: http://www.lchclearnet.com/swaps/swapclear_for_clearing_members/fees.asp.
177 See ICE Clear Credit fees for CDS at: https://www.theice.com/publicdocs/clear_credit/circulars/ICEClearCredit%20Fee%20Schedule%20Notice_FINAL.pdf.
—————————————————————————
FCMs will also bear additional fees with respect to their house
accounts at the DCO to the extent that they clear more swaps due to the
clearing requirement. For example, for IRS that they clear through CME,
clearing members are charged a transaction fee that ranges from $0.75
to $18.00 per million notional, depending on the transaction
maturity.178 Members, however, are not charged annual maintenance
fees for their open house positions.179 For CDS, clearing members at
ICE Clear Credit are charged $5 per transaction per million notional
and there is no maintenance fee.180
—————————————————————————
178 See CME Pricing Charts.
179 See id.
180 See LCH pricing for clearing services related to OTC IRS
at: http://www.lchclearnet.com/swaps/swapclear_for_clearing_members/fees.asp.
—————————————————————————
As discussed above, it is difficult to predict precisely how the
proposed requirement to clear the classes of swaps covered by this
proposed rule will increase the use of swap clearing, as compared to
the use of clearing that would occur in the absence of the requirement.
However, the Commission expects that application of the clearing
requirement to the swaps covered by the proposed rule will generally
increase the use of clearing, leading to the ongoing transaction costs
noted above.
In addition, the Commission understands that FCM customers that
only transact in swaps occasionally are typically required to pay a
monthly or annual fee to each FCM that ranges from $75,000 to $125,000
per year.181 Again, although it is impossible to predict precisely
how many FCM customers would be subject to such fees based on the
proposed clearing requirement for CDS and IRS, the Commission expects
that some market participants that previously did not use clearing
would be subject to the requirements of the proposed rule.
—————————————————————————
181 See letters from Chatham and Webster Bank.
—————————————————————————
The Commission requests comment on whether the cited fee
information is accurate and typical, as well as, the extent to which
such fees are expected to result from the requirement to clear the
classes of swaps subject to the proposed rule. Comment is also
requested on whether the increased use of clearing that may result is
expected to change such fees, and if so, how. The Commission also
requests additional comment, data, and analysis regarding the fee
structures of FCMs in general, and in particular as they relate to the
clearing of the types of swaps covered by the proposed rule.
Specifically, the Commission requests comment on the following:
Do the fees described above typically include fees charged
by the DCO to the FCM for the FCM customer’s swap positions?
Do FCMs typically charge a similar fee to customers that
are more active in trading swaps, and are such fees are generally
greater, lesser, or similar to the fees charged to less active
institutions?
Do such maintenance fees exist for larger customers, and
if so, approximately how much charged?
c. Costs Related to Collateralization of Cleared Swap Positions
As mentioned above, market participants that enter into the classes
of swaps covered by the proposed rule will be required to post
collateral at the DCO. Of course, the incremental cost of collateral
resulting from the application of the proposed clearing requirement
depends on the extent to which such swaps are already being cleared
(even in the absence of the requirement) or otherwise collateralized.
The incremental cost also depends on whether such swaps are, if not
collateralized, priced to include implicit contingent liabilities and
counterparty risk born by the counterparty to the swap.
A conservative approach would be to assume that the swaps that
would be covered by the proposed clearing requirement currently are
uncleared, completely uncollateralized, and not priced to include
implicit contingent liabilities and counterparty risk born by the
counterparty. In this case, imposition of the clearing requirement for
those types of swaps would create additional costs due to: (1) The
spread between cost of capital and returns on that capital for assets
posted to meet initial margin for the entire term of the swap; and (2)
the spread between cost of capital and returns on that capital for
assets posted to meet the variation margin to the extent a party is
“out of the money” on each swap. Under the assumptions mentioned
above, if every IRS and CDS that is not currently cleared were moved
into clearing, the maximum additional initial margin that would need to
be posted is approximately $19.2 billion for IRS and $53 billion for
CDS. However, for the reasons described below, these numbers likely
overestimate the amount of additional initial margin that would need to
be posted.182
—————————————————————————
182 There also is a possibility that the numbers calculated
above under-estimate the amount of additional initial margin that
will need to be posted under a required clearing regime for IRS and
CDS. For instance, there may be numerous market participants with
directional portfolios that will be unable to benefit from margin
offsets. However, the Commission continues to believe that its
estimates are more likely to overstate the required additional
margin.
—————————————————————————
The Commission calculated its estimated additional initial margin
amounts based on the following assumptions. According to
representations made to the Commission by LCH, they clear approximately
51% of the IRS market. The total amount of initial margin on deposit at
LCH for IRS is approximately $20 billion.183 Therefore, if all
remaining IRS were moved into
[[Page 47213]]
clearing, approximately $19.2 billion ($20B/0.51-$20B = 19.2B) would
have to be posted in initial margin.
—————————————————————————
183 The total amount of initial margin on deposit at CME for
IRS is $5 billion, but for purposes of this estimate, the Commission
is not including that amount.
—————————————————————————
Similarly, the initial margin related to CDS currently on deposit
at CME, ICE Clear Credit, and ICE Clear Europe is approximately $21.4
billion.184 This amount includes initial margin based on both index-
based CDS and single-name CDS positions. BIS data indicates that
approximately 36.6% of the CDS market comprises index-based CDS.185
If we assume that approximately 36.6% of the overall portfolio-based
CDS margin (i.e., CDS indices and single-name CDS margined together)
currently held by DCOs for CDS positions is related to index-based CDS,
and then add any margin held by DCOs attributable solely to index-based
CDS, we can estimate that approximately $9.0 billion in margin
currently held by those DCOs is related to index-based CDS. ISDA data
indicates that 14.5% of the index-based CDS market is currently
cleared.186 Therefore, if the entire index-based CDS market moved
into clearing, $53 billion ($9.0/.145-$9.0 = $53) in initial margin
would have to be posted at DCOs.187 Again, it is highly probable that
these estimates significantly overstate the amount of additional
capital that would be posted for a number of reasons described below.
—————————————————————————
184 The total amount of initial margin on deposit only
includes those amounts reported to the Commission by registered
DCOs. Other clearinghouses, such as LCH.Clearnet.SA, clear the
indices included in the proposed determination, however, the
relative size of the open interest in the relevant CDS indices is
substantially smaller than each of the DCOs included in this
calculation.
185 BIS estimates that the gross notional value of outstanding
CDS contracts is $28.6 trillion, and that $10.5 trillion of that is
index related CDS. See BIS data, available at http://www.bis.org/statistics/otcder/dt21.pdf.
186 ISDA has estimated that 14.5% of the index-based CDS
market is currently being cleared, whereas the total outstanding
notional at CME, ICE Clear Europe, and ICE Clear Credit represents
approximately 7.5% of the global index-based CDS market estimated by
BIS. Such a discrepancy would be expected if one or more of the
following occurred: (1) If ISDA overestimated the percentage of the
index-based CDS that is currently being cleared; (2) if BIS
overestimated the size of the global index-based swap market; (3) if
a significant amount of compression occurs as index-based CDS are
moved into clearing; and/or (4) if a significant portion of the
cleared index-based CDS market is held at clearinghouses other than
CME, ICE Clear Europe, and ICE Clear Credit. The Commission believes
that the compression of CDS positions moving into clearing is the
most likely explanation, and therefore has used the ISDA estimate.
However, the Commission also requests comment from the public
regarding the accuracy of ISDA and BIS estimates regarding index-
based CDS markets, and requests from the public any additional data
for purposes of determining with greater certainty how much of the
index-based CDS market is currently being cleared.
187 Both estimates assume that additional IRS brought into
clearing would have similar margin requirements per unit of notional
to those IRS that are already in clearing, and assumes that
additional CDS brought into clearing would have similar margin
requirements per unit of notional to those CDS that are already
being cleared. These assumptions, in turn, imply similar levels of
liquidity, compression, netting, and similar tenors for the swaps
that are currently cleared and those that are not. While the
Commission recognizes that these factors are not likely to be
identical among both groups of products, adequate information to
quantify the impact of each of these possible differences between
the two groups of swaps on the amount of additional collateral that
would have to be posted is not available.
—————————————————————————
First, this analysis assumes that every IRS and index-based CDS not
currently cleared is brought into clearing under the proposed rule.
However, in this rule the Commission has proposed required clearing
only for certain classes of IRS and CDS, and not for all IRS and CDS.
Therefore, there will still be certain types of IRS, such as those
related to the thirteen additional currencies cleared by LCH, that are
not required to be cleared. Moreover, the clearing requirement will
apply only to new swap transactions whereas market estimates include
legacy transactions.
In addition, non-financial entities entering into swaps for the
purpose of hedging or mitigating commercial risk are not required to
use clearing under section 2(h)(7) of the CEA. As a consequence, many
entities will not be required to clear, even when entering into IRS or
CDS that are otherwise required to be cleared. Third, some IRS and CDS
involve cross-border transactions to which the Commission’s clearing
requirement will not apply.188 Fourth, collateral is already posted
with respect to many non-cleared IRS and CDS. ISDA conducted a recent
survey which reported that 93.4% of all trades involving credit
derivatives, and 78.1% of all trades involving fixed income derivatives
are subject to collateral agreements.189 Moreover, ISDA estimated
that the aggregate amount of collateral in circulation in the non-
cleared OTC derivatives market at the end of 2011 was approximately
$3.6 trillion.190
—————————————————————————
188 See Cross-Border Application of Certain Swaps Provisions
of the Commodity Exchange Act, 77 FR 41213 (July 12, 2012).
189 See ISDA Margin Survey 2012, at 15, available at: http://www2.isda.org/functional-areas/research/surveys/margin-surveys/.
Although it is unclear exactly how many of the derivatives covered
by this survey are swaps, it is reasonable to assume that a large
part of them are.
190 This estimate, however, does not adjust for double
counting of collateral assets. The same survey reports that as much
as 91.1% of cash used as collateral and 43.8% of securities used as
collateral are being reused, and therefore are counted two or more
times in the ISDA survey. See ISDA Margin Survey 2012, at 20 and 11,
respectively.
—————————————————————————
In any case, it is reasonable to assume that the requirement to
clear the swaps covered by the proposed rule will result in increased
use of clearing and increased posting of collateral with respect to
such swaps. To calculate the additional collateral cost to market
participants, we must estimate the difference between the cost of
capital for the additional collateral and the returns on that capital.
In comments regarding other Commission rules, commenters have often
taken the view that the difference between the cost and returns on
capital for funds that are used as collateral is substantial.
In a study commissioned by the Working Group of Commercial Energy
Firms, for example, NERA used an estimate of 13.08% for the pre-tax
weighted average cost of capital for the firm, and an estimate of 3.49%
for the pre-tax yield on collateral, for a difference as 9.59% which
NERA used as the net pre-tax cost of collateral.191 However, these
estimates use the borrowing costs for the entire firm, but only
consider the returns on capital for one part of the firm, when
determining the spread between the two. The result is an over-stated
difference, and therefore a higher cost associated with collateral than
would result if the costs of capital and returns of capital were
compared on a consistent basis.192
—————————————————————————
191 The NERA study is available at: http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=50037 and their comments
defending their cost of capital are available in their letter at
http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=57015.
192 This aspect of the NERA study has been described in
greater detail by MIT professors John Parsons and Antonio Mello,
available at: http://bettingthebusiness.com/2012/01/22/phantom-costs-to-the-swap-dealer-designation-and-otc-reform/ and http://bettingthebusiness.com/2012/03/19/nera-doubles-down/.
—————————————————————————
However, the Commission notes that this cost is not only likely
overstated, for the reasons mentioned above, but that it also may not
be a new cost. Rather, it is a displacement of a cost that is embedded
in uncleared, uncollateralized swaps. Entering into a swap is costly
for any market participant because of the default risk posed by its
counterparty, whether the counterparty is a DCO, swap dealer, or other
market participant. When a market participant faces the DCO, the DCO
accounts for that counterparty risk by requiring collateral to be
posted, and the cost of capital for the collateral is part of the cost
that is necessary in order to maintain the swap position. When a market
participant faces a dealer or other counterparty in an uncleared swap,
however, the uncleared swap contains an implicit line of credit upon
which the market participant effectively draws when its swap position
is out of
[[Page 47214]]
the money. Counterparties charge for this implicit line of credit in
the spread they offer on uncollateralized, uncleared swaps. It can be
shown that the cash flows of an uncollateralized swap (i.e., a swap
with an implicit line of credit) are, over time, substantially
equivalent to the cash flows of a collateralized swap with an explicit
line of credit.193 And because the counterparty risk created by the
implicit line of credit is the same as the counterparty risk that would
result from an explicit line of credit provided to the same market
participant, to a first order approximation, the charge for each should
be the same as well.194 This means that the cost of capital for
additional collateral posted as a consequence of requiring
uncollateralized swaps to be cleared does not introduce an additional
cost, but rather takes a cost that is implicit in an uncleared,
uncollateralized swap and makes it explicit. This observation applies
to capital costs associated with both initial margin and variation
margin.
—————————————————————————
193 Mello, Antonio S., and John E. Parsons, “Margins,
Liquidity, and the Cost of Hedging.” MIT Center for Energy and
Environmental Policy Research, May 2012, available at http://dspace.mit.edu/bitstream/handle/1721.1/70896/2012-005.pdf?sequence=1.
194 See id., Mello and Parsons state in their paper, “Hedging
is costly. But the real source of the cost is not the margin posted,
but the underlying credit risk that motivates counterparties to
demand that margin be posted.” Id. at 12. They go on to demonstrate
that, “To a first approximation, the cost charged for the non-
margined swap must be equal to the cost of funding the margin
account. This follows from the fact that the non-margined swap just
includes funding of the margin account as an embedded feature of the
package.” Id. at 15-16.
—————————————————————————
The Commission invites further comment regarding the total amount
of additional collateral that would be posted due to required clearing
of the classes of swaps designated in this proposal. Furthermore, the
Commission invites comment regarding the cost of capital and returns on
capital for that collateral, as well as on the cost of the implicit
line of credit embedded in uncleared, uncollateralized swaps. The
Commission, in particular, welcomes any quantifiable data and analysis
that commenters are willing to share regarding these subjects.
Another impact of the proposed rule may be that financial
institutions are required to hold additional capital with respect to
their swap positions pursuant to prudential regulatory capital
requirements. Basel III standards are designed to incentivize central
clearing of derivatives by applying a lower capital weighting to them
than for similar uncleared derivatives positions. Therefore, the
Commission expects that the capital that financial institutions are
required to hold is likely to be reduced as a consequence of their
increased use of swap clearing. The Commission invites comment on the
effects of required clearing on the capital requirements for financial
institutions. To the extent possible, please quantify the relevant
costs and benefits and explain the effect of the relevant capital
standards.
In addition, operational costs may result from the collateral
requirements that apply to the proposed clearing requirement. With
uncleared swaps, counterparties may agree not to collect variation
margin until certain thresholds of exposure are reached, thus reducing
or perhaps entirely eliminating the need to exchange variation margin
as exposure changes. DCOs, on the other hand, collect and pay variation
margin on a daily basis and sometimes more frequently. As a
consequence, increased required clearing may increase certain
operational costs associated with moving variation margin to and from
the DCO. On the other hand, increased clearing is also likely to lead
to benefits from reduced operational costs related to valuation
disputes, as parties to cleared swaps agree to abide by the DCO’s
valuation procedures. To the extent that the requirement to clear the
types of swaps covered by the proposed rule leads to increased use of
clearing, these costs and benefits are likely to result. The Commission
invites further comment regarding the costs and benefits associated
with operational differences related to the collateralization of
uncleared versus cleared swaps.
Increases in clearing as a result of the proposed clearing
requirement also may result in additional costs for clearing members in
the form of guaranty fund contributions. However, it also may be that
increased clearing of swaps would decrease guaranty fund contributions
for certain clearing members. Market participants that currently
transact swaps bilaterally and do not clear such swaps must either
become clearing members of an appropriate DCO or submit such swaps for
clearing through an existing clearing member, once the clearing
requirement applies to such swaps. A party that chooses to become a
clearing member of a DCO must make a guaranty fund contribution. A
party that chooses to clear swaps through an existing clearing member
may have a share of the clearing member’s guaranty fund contribution
passed along to it in the form of fees. While the addition of new
clearing members and new customers for existing clearing members may
result in existing clearing members experiencing an increase in their
guaranty fund requirements, it should be noted that if (1) new clearing
members are not among the two clearing members used to calculate the
guaranty fund and (2) any new customers trading through a clearing
member do not increase the size of uncollateralized risks at either of
the two clearing members used to calculate the guaranty fund, all else
held constant, existing clearing members may experience a decrease in
their guaranty fund requirement.195
—————————————————————————
195 In order to calculate the size of their guaranty funds,
clearinghouses for swaps generally stress their clearing members’
portfolios under a number of extreme, but plausible, scenarios in
order to identify the two clearing members with the largest losses.
The resulting loss calculation of those two clearing members is used
to size the guaranty fund. Once that amount is established, the
clearinghouse will require contributions of all clearing members
based on their relative “losses” under the stress scenarios.
Assuming that the portfolios of new clearing members and new
customers do not alter the overall sizing of the guaranty fund, but
that the new clearing members are making contributions to the
guaranty fund based on their relative potential losses, the overall
guaranty fund contribution for existing clearing members may
decrease.
—————————————————————————
d. Benefits of Clearing
As noted above, the benefits of swap clearing, in general, are
significant. Thus, to the extent that the proposed clearing requirement
for certain classes of IRS and CDS leads to increased use of clearing,
these benefits are likely to result. As is the case for the costs noted
above, it is impossible to predict the precise extent to which the use
of clearing will increase as a result of the proposed rule, and
therefore the benefits of the proposed rule cannot be precisely
quantified. But the Commission believes that the benefits of increased
clearing resulting from the proposed rule will be significant, because
the classes of swaps required to be cleared by the proposed rule
represent a substantial portion of the total swap markets. Currently
outstanding IRS and CDS indices have notional amounts of about $504
trillion and $10.4 trillion, respectively, which is a substantial part
of the $648 trillion notional global swaps market.196 As noted above,
the proposed rule requires that only certain classes of IRS and CDS
indices be cleared, but such classes likely represent the most common
swaps within those overall asset classes, and therefore are likely to
constitute a relatively large portion of those asset classes. By
requiring these particular swaps to be cleared, the benefits of
clearing are expected to be realized across a relatively large portion
of the
[[Page 47215]]
market. The Commission requests comment on whether such benefits will
result from the proposed rule and, if so, the expected magnitude of
such benefits.
—————————————————————————
196 BIS data, December 2011, available at: http://www.bis.org/statistics/derstats.htm.
—————————————————————————
The proposed rule’s requirement that certain classes of swaps be
cleared is expected to increase the number of swaps in which market
participants will face a DCO, and therefore, will face a highly
creditworthy counterparty. DCOs are some of the most creditworthy
counterparties in the swap market because they have at their disposal a
number of risk management tools that enable them to manage counterparty
risk effectively. Those tools include contractual rights that enable
them to use margin to manage current and potential future exposure, to
close out and transfer defaulting positions while minimizing losses
that result from such defaults, and to protect solvency during the
default of one or more members through a waterfall of financial
contributions from which they can draw, as outlined above. Also,
clearing protects swap users from the risk of having to share in loss
mutualization among FCMs if one DCO member defaults and such measures
are necessary.
This proposed rule requires that classes of swaps that are required
to be cleared must be submitted to clearing “as soon as
technologically practicable after execution, but in any event by the
end of the day of execution.” 197 This conforms to the requirements
established in the recently finalized rule regarding timing of
acceptance for clearing,198 which is designed to promote rapid
submission of these swaps for clearing and reduce the unnecessary
counterparty risk that can develop between the time of execution and
submission to clearing.199
—————————————————————————
197 See proposed Sec. 50.2(a).
198 See Client Clearing Documentation, Timing of Acceptance
for Clearing, and Clearing Member Risk Management, 77 FR 21278 (Apr.
9, 2012).
199 The Commission notes that if a market participant executed
a swap that is required to be cleared on a SEF or DCM, then that
market participant will be deemed to have met their obligation to
submit the swap to a DCO because of the straight-through processing
rules previously adopted by the Commission.
—————————————————————————
The Commission expects that the requirement for rapid submission,
processing, and acceptance or rejection of swaps for clearing will be
beneficial in several respects. It is important to note that when two
parties enter into a bilateral swap with the intention of clearing it,
each party bears counterparty risk until the swap is cleared. Once the
swap is cleared, the clearinghouse becomes the counterparty to each of
the original parties, which minimizes and standardizes counterparty
risk.
Where swaps of the type covered by the proposed rule are not
executed on an exchange, the proposed rule should significantly reduce
the amount of time needed to process them. Although costs associated
with latency-period counterparty credit risk cannot be completely
eliminated in this context, the rules will reduce the need to
discriminate among potential counterparties in off-exchange swaps, as
well as the potential costs associated with rejected swaps. By reducing
the counterparty risk that could otherwise develop during the latency
period, these rules promote a market in which all eligible market
participants have access to counterparties willing to trade on terms
that approximate the best available terms in the market. This may
improve price discovery and promote market integrity.
In addition, absent proposed Sec. 50.10 and related
interpretations, certain risks could increase in a manner that the
Commission would not be able to measure accurately. Proposed Sec.
50.10 and related interpretations are expected to bring the appropriate
scope of swaps within the requirements of section 2(h), which will
facilitate the achievement of the benefits of swap clearing and trade
execution, among others. Activity conducted solely for a legitimate
business purpose, absent other indicia of evasion or abuse, would not
constitute a violation of proposed Sec. 50.10 as described in the
Commission’s proposed interpretation.
D. Costs and Benefits of the Proposed Rule as Compared to Alternatives
The Commission’s proposal to apply the clearing requirement
initially to certain CDS and IRS is a function of both the market
importance of these products and the fact that they already are widely
cleared. In order to move the largest number of swaps to required
clearing in its initial determination, the Commission believes that it
is prudent to focus on swaps that are widely used and for which there
is already a blueprint for clearing and appropriate risk management.
CDS and IRS that match these factors are therefore well suited for
required clearing.
As noted above, IRS with a notional amount of $504 trillion are
currently outstanding–the highest proportion of the $648 trillion
global swaps market of any class of swaps.200 CDS indices with a
notional amount of about $10.4 trillion are currently outstanding.201
While CDS indices do not have as prominent a share of the entire swaps
market as IRS, uncleared CDS is capable of having a sizeable market
impact, as it did during the 2008 financial crisis. In addition, many
of the swaps within each of the classes proposed for required clearing
are already cleared by one or more clearinghouses. LCH claims to clear
IRS with a notional amount of about $284 trillion–meaning that, in
notional terms, LCH clears 51% of the interest rate swap market.202
The swap market has made a smooth transition into clearing CDS on its
own initiative. As a result, DCOs, FCMs, and many market participants
already have experience clearing the types of swaps that have been
proposed for required clearing. The Commission expects, therefore, that
DCOs and FCMs are equipped to handle the increases in volume and
outstanding notional amount in these swaps that is likely to be cleared
as the result of the proposed rule. Because of the wide use of these
swaps and their importance to the market, and because these swaps are
already cleared safely, the Commission is proposing to subject certain
types of IRS and CDS to the initial clearing requirement.
—————————————————————————
200 BIS data, June 2011, available at http://www.bis.org/publ/otc_hy1111.pdf.
201 See id.
202 See id.
—————————————————————————
The Commission is proposing certain key specifications for CDS and
IRS that will inform whether a particular swaps falls within one of the
classes of swaps that are required to be cleared. The two classes of
CDS that are required to be cleared are (1) U.S. dollar-denominated CDS
covering North America corporate credits and (2) euro-denominated CDS
referencing European obligations. The four classes of IRS required to
be cleared are (1) fixed-to-floating swaps, (2) basis swaps, (3) OIS,
and (4) FRAs.
Regarding CDS, the Commission has outlined three key specifications
comprising (1) region and nature of reference entity, (2) the nature of
the CDS itself, and (3) tenor. Each of these specifications will assist
market participants in determining whether a swap falls within the CDS
classes of swaps required to be cleared. For the first, a
distinguishing characteristic is whether the reference entity is in
North American or European and whether it is one of Markit’s CDX.NA.IG,
CDX.NA.HY, iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe
High Volatility indices. The second key specification relates to
whether the CDS is tranched or untranched. The classes that are
required to be cleared include only untranched CDS where the contract
covers the entire index loss
[[Page 47216]]
distribution of the indice and settlement is not linked to a specified
number of defaults. Tranched swaps, first- or “Nth” to-default,
options, or any other product variations on these indices are excluded
from these classes. Finally, the third key specification entails
whether a swap falls within a tenor, specific to an index, that is
required to be cleared. The Commission has determined that each of the
3-, 5-, 7-, and 10-year tenors be included within the class of swaps
subject to the clearing requirement determination for CDX.NA.IG; the 5-
year tenor be included for CDX.NA.HY; each of the 5- and 10-year for
ITraxx Europe; the 5-year for ITraxx Europe Crossover; and, the 5-year
for ITraxx Europe High Volatility. In addition, it should be noted that
only certain series will be viewed as required to be cleared.
The Commission had a number of alternatives to that proposed.
First, the Commission could have used a narrower or broader group of
reference entities. For example, the Commission has not included the
CDX.NA.IG.HVOL within the North American swap class. While doing so
would have increased the number of swaps required to be cleared, the
Commission questions whether there is sufficient liquidity to justify
required clearing at this time given that the recent series of
CDX.NA.IG.HVOL have not been cleared by ICE (and are not offered at all
by CME).
The Commission could also have endeavored to include tranched CDS.
The Commission recognizes that there is a significant market for
tranched swaps using the indices. In these transactions, parties to the
CDS contract agree to address only a certain range of losses along the
entire loss distribution curve. Other swaps such as first or “Nth” to
default baskets, and options, also exist on the indices. However, these
swaps are not being cleared currently and were not submitted by a DCO
for consideration under Sec. 39.5.
Regarding tenor, the Commission could have included more of those
offered within the classes of swaps required to be cleared. For
example, the CDX.NA.IG has 1- and 2-year tenors and the CDX.NA.HY, has
3-, 7-, and 10-year tenors that have not been included among the
specified tenors. The iTraxx Europe has 3- and 7-year tenors and the
Crossover and High Volatility each have 3-, 7-, and 10-year tenors that
have not been included. In addition, the Commission could have included
all series of active indices. The concern, regarding both tenors and
series, is that certain tenors and series have lower liquidity and may
be difficult for a DCO to adequately risk manage. While including more
tenors and series would have increased the volume of swaps required to
be cleared to some degree, the Commission proposes that doing so may
have raised costs for DCOs and other market participants and been less
desirable relative to the factors established in Sec. 39.5.
With regard to IRS, as mentioned above, the Commission is proposing
a clearing requirement for four classes of interest rate swaps: fixed-
to-floating swaps, basis swaps, OIS, and FRAs. Within those four
classes, the Commission is proposing three affirmative specifications
for each class ((i) Currency used for in which the notional and payment
amounts are specified, (ii) rates referenced for each leg of the swap,
and (iii) stated termination date of the swap) and three “negative”
specifications for each class ((i) No optionality (as specified by the
DCOs); (ii) no dual currencies; and (iii) no conditional notional
amounts).
The Commission considered whether to establish clearing
requirements on a product-by-product basis. Such a determination would
need to identify the multitude of legal specifications of each product
that would be subject to the clearing requirement. Although the
industry uses standardized definitions and conventions, the product
descriptions would be lengthy and require counterparties to compare all
of the legal terms of their particular swap against the terms of the
many different swaps that would be included in a clearing requirement.
The Commission believes that for interest rate swaps, a product-by-
product determination could be unnecessarily burdensome for market
participants in trying to assess whether each swap transaction is
subject to the requirement. A class-based approach would allow market
participants to determine quickly whether they need to submit their
swap to a DCO for clearing by checking initially whether the swap has
the basic specifications that define each class subject to the clearing
requirement.
As an alternative to the classes selected, LCH recommended that the
Commission use the following specifications to classify interest rate
swaps for purposes of making a clearing determination: (i) Swap class
(i.e., what the two legs of the swap are (fixed-to-floating, basis,
OIS, etc.)), (ii) floating rate definitions used, (iii) the currency
designated for swap calculations and payments, (iv) stated final term
of the swap (also known as maturity), (v) notional structure over the
life of the swap (constant, amortizing, roller coaster, etc.), (vi)
floating rate frequency, (vii) whether optionality is included, and
(viii) whether a single currency or more than one currency is used for
denominating payments and notional amount. CME recommended a clearing
determination for all non-option interest rate swaps denominated in a
currency cleared by any qualified DCO.
These alternative specifications fall into two general categories:
specifications that are commonly used to address mechanical issues for
most swaps, and specifications that are less common and address
idiosyncratic issues related to the particular needs of a counterparty.
Examples of the latter are special representations added to address
particular legal issues, unique termination events, special fees, and
conditions tied to events specific to the parties. None of the DCOs
clear interest rate swaps with terms in the second group. As for
mechanical specifications, while the Commission recognizes that such
specifications may affect the value of the swap, such specifications
are not, generally speaking, fundamental to determining the economic
result the parties are trying to achieve.203 The Commission has
proposed the three affirmative specifications described above because
it believes that they are fundamental specifications used by
counterparties to determine the economic result of a swap transaction
for each party.
—————————————————————————
203 As noted in Section II.E above, mechanical specifications
include characteristics such as floating rate reset tenors,
reference city for business days, business day convention, and
others that have some small impact on valuation but that do not
fundamentally alter the economic consequence of the swap for the
parties that enter into it.
—————————————————————————
The Commission also could have avoided the negative specifications
for IRS, which would have had the effect of potentially including more
IRS swaps within the universe of those required to be cleared. However,
the Commission believes that swaps with optionality, multiple currency
swaps, and swaps with conditional notional amounts raise concerns
regarding adequate pricing measures and consistency across swap
contracts. Such contingencies make them difficult for DCOs to
effectively risk manage. Additionally, at this time, no DCO is offering
them for clearing.
Another alternative considered by the Commission, but not proposed,
was that of stating the clearing requirement in terms of a particular
type of swap, rather than using broad characteristics to describe the
type of swaps for which clearing would be required. For example, rather
than requiring that all IRS that meet the six specifications in
proposed Sec. 50.4(a) be cleared, the rule could have specified that
only certain
[[Page 47217]]
sub-types of those IRS–such as all such IRS with a term of five
years–are required to be cleared. Such an approach might permit the
Commission to account for variation in liquidity and outstanding
notional values among different sub-types of swap, and thereby focus
the clearing requirement on very particular swaps to account for these
differences within the same general class. Also, generally speaking,
limiting the clearing requirement to fewer swaps could reduce some
costs associated with clearing.
However, this advantage was weighed against an important
disadvantage of this approach. A highly focused clearing requirement
could increase the ability for market participants to replicate the
economic results of a swap that is required to be cleared by
substituting a swap not required to be cleared; this greater latitude
for clearing avoidance, in turn, could increase systemic risk and
dampen the beneficial effects of clearing noted above.204 Under the
approach proposed by the Commission, all swaps that fall within
identified classes are covered by the clearing requirement, which
reduces the risk of such avoidance and the associated reduction of
benefits. Moreover, stating the clearing requirement in more general
terms reduces the costs associated with determining whether or not a
particular swap is subject to the clearing requirement.
—————————————————————————
204 For instance, in the example noted above, swaps with a
term of five years and one day would not be required to be cleared.
—————————————————————————
The Commission invites comment on the costs and benefits of
identifying classes of swaps for clearing in a more focused or more
general manner. If possible, please quantify costs and benefits that
result either from the approach proposed by the Commission or from
alternatives that you believe the Commission should consider.
The Commission also considered proposing required clearing for all
seventeen currencies of IRS that are currently offered for clearing,
but decided instead to propose required clearing at this time for IRS
in four currencies (EUR, USD, GBP, and JPY). The Commission recognizes
that requiring IRS in all seventeen currencies submitted by LCH
Clearnet to be cleared would provide the benefit of some incremental
reduction in overall counterparty, and thus systemic, risk attendant to
clearing a greater portion of IRS. However, as noted above, the
Commission proposes that initiating the clearing requirement in a
measured manner with respect to IRS in the four specified currencies
familiar to many market participants is the preferable approach at this
time because it would give market participants an opportunity to
identify and address any operational challenges related to required
clearing. Moreover, the currencies included in the proposed classes
constitute approximately 93% of cleared IRS, which suggests that
significant reductions in counterparty risk and gains in systemic
protection will be accomplished by limiting the clearing determination
to them.
Similarly, the Commission considered requiring clearing of all CDS
that are currently being cleared, but decided not to include, in the
initial clearing requirement, certain types of CDS that have a less
significant role in the current market.205
—————————————————————————
205 For instance, the Commission decided not to include
CDX.NA.IG.HiVOL from the proposed determination given the lack of
volume in the current on-the-run and recent off-the-run series. In
addition, CME currently does not clear any HiVOL contracts, and ICE
Clear Credit no longer clears the most recent series.
—————————————————————————
The Commission invites further comment on its decision-making with
regard to the classes of IRS and CDS that would be required to be
cleared. Commenters are also invited to submit any data or other
information that they may have quantifying or qualifying the costs and
benefits of the proposal with their comment letters.
E. Section 15(a) Factors
As noted above, the requirement to clear the classes of swaps
covered by the proposed rule is expected to result in increased use of
clearing, although it is impossible to quantify with certainty the
extent of that increase. Thus, this section discusses the expected
results from an overall increase in the use of swap clearing in terms
of the factors set forth in section 15(a) of the CEA.
i. Protection of Market Participants and the Public
As described above, required clearing of the classes of swaps
identified in this proposed rule is expected to reduce counterparty
risk for market participants that clear those swaps because they will
face the DCO rather than another market participant that lacks the full
array of risk management tools that the DCO has at its disposal. This
also reduces uncertainty in times of market stress because market
participants facing a DCO are less concerned with the impact of such
stress on the solvency of their counterparty for cleared trades.
By proposing to require clearing of certain classes of swaps, all
of which are already available for clearing, the Commission expects to
encourage a smooth transition by creating an opportunity for market
participants to work out challenges related to required clearing of
swaps while operating in familiar terrain. More specifically, the DCOs
will clear an increased volume of swaps that they already understand
and have experience managing. Similarly, FCMs likely will realize
increased customer and transaction volume as the result of the
requirement, but will not have to simultaneously learn how to
operationalize clearing for new types of swaps. And the experience of
FCMs with these products is also likely to benefit customers that are
new to clearing, as the FCM guides them through initial experiences
with cleared swaps.206
—————————————————————————
206 As discussed in Section II.C and II.E above, DCOs offering
clearing for CDS and IRS have established extensive risk management
practices, which focus on the protection of market participants. See
also Sections II.D and II.F for a discussion of the effect on the
mitigation of systemic risk in the CDS market and in the IRS market,
as well as the protection of market participants during insolvency
events at either the clearing member or DCO level.
—————————————————————————
In addition, uncleared swaps subject to collateral agreements can
be the subject of valuation disputes. These valuation disputes
sometimes require several months, or longer, to resolve.
Uncollateralized exposure can grow significantly during that time,
leaving one of the two parties exposed to counterparty risk that was
intended to be covered through a collateral agreement. DCOs reduce
valuation disputes for cleared swaps as well as the risk that
uncollateralized exposure can develop and accumulate during the time
when such a dispute would have otherwise occurred, thus providing
additional protection to market participants who transact in swaps that
are required to be cleared.207
—————————————————————————
207 See Sections II.D and II.F above for a further discussion
of how DCOs obtain adequate pricing data for the CDS and IRS that
they clear. Based on this pricing data, valuation disputes are
minimized, if not eliminated for cleared swaps.
—————————————————————————
As far as costs are concerned, market participants that do not
currently have established clearing relationships with an FCM will have
to set up and maintain such a relationship in order to clear swaps that
are required to be cleared. As discussed above, market participants
that conduct a limited number of swaps per year will likely be required
to pay monthly or annual fees that FCM’s charge to maintain both the
relationship and outstanding swap positions belonging to the customer.
In addition, the FCM is likely to pass along fees charged by the DCO
for establishing and maintaining open positions.
[[Page 47218]]
ii. Efficiency, Competitiveness, and Financial Integrity of Swap
Markets
Swap clearing, in general, is expected to reduce uncertainty
regarding counterparty risk in times of market stress and promote
liquidity and efficiency during those times. Increased liquidity
promotes the ability of market participants to limit losses by exiting
positions effectively when necessary in order to manage risk during a
time of market stress.
In addition, to the extent that positions move from facing multiple
counterparties in the bilateral market to being run through a smaller
number of clearinghouses, clearing facilitates increased netting. This
reduces the amount of collateral that a party must post in margin
accounts.
As discussed in Sections II.D and II.F above, in setting forth this
proposal, the Commission took into account a number of specific factors
that relate to the financial integrity of the swap markets.
Specifically, the discussion above includes an assessment of whether
the DCOs clearing CDS and IRS have the rule framework, capacity,
operational expertise and resources, and credit support infrastructure
to clear CDS and IRS on terms that are consistent with the material
terms and trading conventions on which the contract is then traded. The
proposal also considered the resources of DCOs to handle additional
clearing, as well as the existence of reasonable legal certainty in the
event of a clearing member or DCO insolvency.208
—————————————————————————
208 See Section II.C and II.E.
—————————————————————————
As discussed above, bilateral swaps create counterparty risk that
may lead market participants to discriminate among potential
counterparties based on their creditworthiness. Such discrimination is
expensive and time consuming insofar as market participants must
conduct due diligence in order to evaluate a potential counterparty’s
creditworthiness. Requiring certain types of swaps to be cleared
reduces the number of transactions for which such due diligence is
necessary, thereby contributing to the efficiency of the swap markets.
In proposing a clearing requirement for both CDS and IRS, the
Commission must consider the effect on competition, including
appropriate fees and charges applied to clearing. As discussed in more
detail in Sections II.D and II.F above, there are a number of potential
outcomes that may result from required clearing. Some of these outcomes
may impose costs, such as if a DCO possessed market power and exercised
that power in an anticompetitive manner, and some of the outcomes would
be positive, such as if the clearing requirement facilitated a stronger
entry-opportunity for competitors.
As far as costs are concerned, the markets for some swaps within
the classes that are proposed to be required to be cleared may be less
liquid than others. All other things being equal, swaps for which the
markets are less liquid have the potential to develop larger current
uncollateralized exposures after a default on a cleared position, and
therefore will require posting of relatively greater amounts of initial
margin.
iii. Price Discovery
Clearing, in general, encourages better price discovery because it
eliminates the importance of counterparty creditworthiness in pricing
swaps cleared through a given DCO. That is, by making the counterparty
creditworthiness of all swaps of a certain type essentially the same,
prices should reflect factors related to the terms of the swap, rather
than the idiosyncratic risk posed by the entities trading it.209
—————————————————————————
209 See Chen, K., et al. “An Analysis of CDS Transactions:
Implications for Public Reporting,” September 2011, Federal Reserve
Bank of New York Staff Reports, at 14, available at http://www.newyorkfed.org/research/staff_reports/sr517.pdf.
—————————————————————————
As discussed in sections II.D and II.F above, DCOs obtain adequate
pricing data for the CDS and IRS that they clear. Each DCO establishes
a rule framework for its pricing methodology and rigorously tests its
pricing models to ensure that the cornerstone of its risk management
regime is as sound as possible.
iv. Sound Risk Management Practices
If a firm enters into swaps to hedge certain positions and then the
counterparty to those swaps defaults unexpectedly, the firm could be
left with large outstanding exposures. As stated above, when a swap is
cleared the DCO becomes the counterparty facing each of the two
original participants in the swap. This standardizes and reduces
counterparty risk for each of the two original participants. To the
extent that a market participant’s hedges comprise swaps that are
required to be cleared, the requirement enhances their risk management
practices by reducing their counterparty risk.
In addition, from systemic perspective, required clearing reduces
the complexity of unwinding/transferring swap positions from large
entities that default. Procedures for transfer of swap positions and
mutualization of losses among DCO members are already in place, and the
Commission anticipates that they are much more likely to function in a
manner that enables rapid transfer of defaulted positions than legal
processes that would surround the enforcement of bilateral contracts
for uncleared swaps.210
—————————————————————————
210 As discussed in Sections II.C and II.E above, sound risk
management practices are critical for all DCOs, especially those
offering clearing for CDS and IRS. In the discussion above, the
Commission considered whether each DCO submission under review was
consistent with the core principles for DCOs. In particular, the
Commission considered the DCO submissions in light of Core Principle
D, which relates to risk management. See also Sections II.D and II.F
for a discussion of the effect on the mitigation of systemic risk in
the CDS market and in the IRS market, as well as the protection of
market participants during insolvency events at either the clearing
member or DCO level.
—————————————————————————
v. Other Public Interest Considerations
In September 2009, the President and the other leaders of the
“G20” nations met in Pittsburgh and committed to a program of action
that includes, among other things, central clearing of all standardized
swaps.211 Together, IRS and CDS represent more than 75% of the
notional amount of outstanding swaps, and therefore, requiring the most
active, standardized classes of swaps within those groups to be cleared
represents a significant step toward the fulfillment of that
commitment.
—————————————————————————
211 A list of the G20 commitments made in Pittsburgh can be
found at: http://www.g20.utoronto.ca/analysis/commitments-09-pittsburgh.html.
—————————————————————————
VI. Related Matters
A. Regulatory Flexibility Act
The Regulatory Flexibility Act (RFA) requires that agencies
consider whether the rules they propose will have a significant
economic impact on a substantial number of small entities and, if so,
provide a regulatory flexibility analysis respecting the impact.212
The clearing requirement determinations and rules proposed by the
Commission will affect only eligible contract participants (ECPs)
because all persons that are not ECPs are required to execute their
swaps on a DCM, and all contracts executed on a DCM must be cleared by
a DCO, as required by statute and regulation; not by operation of any
clearing requirement.213
—————————————————————————
212 See 5 U.S.C. 601 et seq.
213 To the extent that this rulemaking affects DCMs, DCOs, or
FCMs, the Commission has previously determined that DCMs, DCOs, and
FCMs are not small entities for purposes of the RFA. See,
respectively and as indicated, 47 FR 18618, 18619, Apr. 30, 1982
(DCMs and FCMs); and 66 FR 45604, 45609, Aug. 29, 2001 (DCOs).
—————————————————————————
[[Page 47219]]
The Commission has previously determined that ECPs are not small
entities for purposes of the RFA.214 However, in its proposed
rulemaking to establish a schedule to phase in compliance with certain
provisions of the Dodd-Frank Act, including the clearing requirement
under section 2(h)(1)(A) of the CEA, the Commission received a joint
comment (Electric Associations Letter) from the Edison Electric
Institute (EEI), the National Rural Electric Cooperative Association
(NRECA) and the Electric Power Supply Association (EPSA) asserting that
certain members of NRECA may both be ECPs under the CEA and small
businesses under the RFA.215 These members of NRECA, as the
Commission understands, have been determined to be small entities by
the Small Business Administration (SBA) because they are “primarily
engaged in the generation, transmission, and/or distribution of
electric energy for sale and [their] total electric output for the
preceding fiscal year did not exceed 4 million megawatt hours.”216
Although the Electric Associations Letter does not provide details on
whether or how the NRECA members that have been determined to be small
entities use the IRS and CDS that are the subject of this rulemaking,
the Electric Associations Letter does state that the EEI, NRECA and
EPSA members “engage in swaps to hedge commercial risk.” 217
Because the NRECA members that have been determined to be small
entities would be using swaps to hedge commercial risk, the Commission
expects that they would be able to use the end-user exception from the
clearing requirement and therefore would not be affected to any
significant extent by this rulemaking.
—————————————————————————
214 See 66 FR 20740, 20743 (Apr. 25, 2001).
215 See joint letter from EEI, NRECA, and ESPA, dated Nov. 4,
2011, (Electric Associations Letter), commenting on Swap Transaction
Compliance and Implementation Schedule: Clearing and Trade Execution
Requirements under Section 2(h) of the CEA, 76 FR 58186 (Sept. 20,
2011).
216 Small Business Administration, Table of Small Business
Size Standards, Nov. 5, 2010.
217 See Electric Associations Letter, at 2. The letter also
suggests that EEI, NRECA, and EPSA members are not financial
entities. See id., at note 5, and at 5 (the associations’ members
“are not financial companies”).
—————————————————————————
Thus, because nearly all of the ECPs that may be subject to the
proposed clearing requirement are not small entities, and because the
few ECPs that have been determined by the SBA to be small entities are
unlikely to be subject to the clearing requirement, the Chairman, on
behalf of the CFTC, hereby certifies pursuant to 5 U.S.C. 605(b) that
the rules herein will not have a significant economic impact on a
substantial number of small entities. The Commission invites public
comment on this determination.
B. Paperwork Reduction Act
The Paperwork Reduction Act (PRA) 218 imposes certain
requirements on federal agencies (including the Commission) in
connection with conducting or sponsoring any collection of information
as defined by the PRA. Proposed Sec. 50.3(a), which would require each
DCO to post on its Web site a list of all swaps that it will accept for
clearing and clearly indicate which of those swaps the Commission has
determined are required to be cleared, builds upon the requirements of
Sec. 39.21(c)(1), which requires each DCO to disclose publicly
information concerning the terms and conditions of each contract,
agreement, and transaction cleared and settled by the DCO. Thus, this
rulemaking will not require a new collection of information from any
persons or entities. The Commission invites public comment on whether
this rulemaking will require a new collection of information.
—————————————————————————
218 44 U.S.C. 3507(d).
—————————————————————————
List of Subjects in 17 CFR Part 50
Business and industry, Clearing, Swaps.
In consideration of the foregoing, and pursuant to the authority in
the Commodity Exchange Act, as amended, and in particular section 2(h)
of the Act, the Commission hereby adopts an amendment to Chapter I of
Title 17 of the Code of Federal Regulation by proposing to amend part
50 as follows:
PART 50–CLEARING REQUIREMENT AND RELATED RULES
1. The authority citation for part 50 reads as follows:
Authority: 7 U.S.C. 2(h), 7a-1 as amended by Pub. L. 111-203,
124 Stat. 1376.
2. Add new part 50 to read as follows:
PART 50–CLEARING REQUIREMENT AND RELATED RULES
Subpart A–Definitions and Clearing Requirement
Sec.
Sec. 50.1 Definitions.
50.2 Treatment of swaps subject to a clearing requirement.
50.3 Notice to the public.
50.4 Classes of swaps required to be cleared.
50.5 Swaps exempt from a clearing requirement.
50.6 Delegation of Authority.
50.7-9 [Reserved]
50.10 Prevention of Evasion of the Clearing Requirement and Abuse of
an Exception or Exemption to the Clearing Requirement.
50.11-24 [Reserved]
Subpart B–Compliance Schedule
50.25 Clearing Requirement Compliance Schedule.
50.26-49 [Reserved]
Subpart C–Exceptions to Clearing Requirement
Sec. 50.50-100 [Reserved]
Sec. 50.1 Definitions.
For the purposes of this part,
Business day means any day other than a Saturday, Sunday, or
[legal] holiday.
Day of execution means the calendar day of the party to the swap
that ends latest, provided that if a swap is (A) entered into after
4:00 p.m. in the location of a party, or (B) entered into on a day that
is not a business day in the location of a party, then such swap shall
be deemed to have been entered into by that party on the immediately
succeeding business day of that party, and the day of execution shall
be determined with reference to such business day.
Sec. 50.2 Treatment of swaps subject to a clearing requirement.
(a) All persons executing a swap that (1) is not subject to an
exception under section 2(h)(7) of the Act and Sec. 39.6, and (2) is
included in a class of swaps identified in Sec. 50.4, shall submit
such swap to a derivatives clearing organization for clearing as soon
as technologically practicable after execution, but in any event by the
end of the day of execution.
(b) Each person subject to the requirements of paragraph (a) shall
undertake reasonable efforts to verify whether a swap is required to be
cleared.
Sec. 50.3 Notice to the public.
(a) In addition to its obligations under Sec. 39.21(c)(1), each
derivatives clearing organization shall make publicly available on its
Web site a list of all swaps that it will accept for clearing and
identify which swaps on the list are required to be cleared under
section 2(h)(1) of the Act and this part.
(b) The Commission shall maintain a current list of all swaps that
are required to be cleared and all derivatives clearing organizations
that are eligible to clear such swaps on its Web site.
[[Page 47220]]
Sec. 50.4 Classes of swaps required to be cleared.
(a) Interest rate swaps. Swaps that have the following
specifications are required to be cleared under section 2(h)(1) of the
Act, and shall be cleared pursuant to the rules of any derivatives
clearing organization eligible to clear such swaps under Sec. 39.5(a)
of this chapter.
—————————————————————————————————————-
—————————————————————————————————————-
Fixed-to-Floating Swap Class
—————————————————————————————————————-
Specification
1. Currency………………… U.S. Dollar (USD). Euro (EUR)…….. Sterling (GBP)…. Yen (JPY).
2. Floating Rate Indexes…….. LIBOR…………. EURIBOR……….. LIBOR…………. LIBOR.
3. Stated Termination Date Range 28 days to 50 28 days to 50 28 days to 50 28 days to 30
years. years. years. years.
4. Optionality……………… No……………. No……………. No……………. No.
5. Dual Currencies………….. No……………. No……………. No……………. No.
6. Conditional Notional Amounts. No……………. No……………. No……………. No.
—————————————————————————————————————-
Basis Swap Class
—————————————————————————————————————-
Specification
1. Currency………………… U.S. Dollar (USD). Euro (EUR)…….. Sterling (GBP)…. Yen (JPY).
2. Floating Rate Indexes…….. LIBOR…………. EURIBOR……….. LIBOR…………. LIBOR.
3. Stated Termination Date Range 28 days to 50 28 days to 50 28 days to 50 28 days to 30
years. years. years. years.
4. Optionality……………… No……………. No……………. No……………. No.
5. Dual Currencies………….. No……………. No……………. No……………. No.
6. Conditional Notional Amounts. No……………. No……………. No……………. No.
—————————————————————————————————————-
Forward Rate Agreement Class
—————————————————————————————————————-
Specification
1. Currency………………… U.S. Dollar (USD). Euro (EUR)…….. Sterling (GBP)…. Yen (JPY).
2. Floating Rate Indexes…….. LIBOR…………. EURIBOR……….. LIBOR…………. LIBOR.
3. Stated Termination Date Range 3 days to 3 years. 3 days to 3 years. 3 days to 3 years. 3 days to 3 years.
4. Optionality……………… No……………. No……………. No……………. No.
5. Dual Currencies………….. No……………. No……………. No……………. No.
6. Conditional Notional Amounts. No……………. No……………. No……………. No.
—————————————————————————————————————-
Overnight Index Swap Class
—————————————————————————————————————-
Specification
1. Currency………………… U.S. Dollar (USD). Euro (EUR)…….. Sterling (GBP)…. Yen (JPY).
2. Floating Rate Indexes…….. FedFunds………. EONIA…………. SONIA…………. ………………
3. Stated Termination Date Range 7 days to 2 years. 7 days to 2 years. 7 days to 2 years.
4. Optionality……………… No……………. No……………. No……………. ………………
5. Dual Currencies………….. No……………. No……………. No……………. ………………
6. Conditional Notional Amounts. No……………. No……………. No……………. ………………
—————————————————————————————————————-
(b) Credit default swaps. Swaps that have the following
specifications are required to be cleared under section 2(h)(1) of the
Act, and shall be cleared pursuant to the rules of any derivatives
clearing organization eligible to clear such swaps under Sec. 39.5(a)
of this chapter.
————————————————————————
————————————————————————
North American Untranched CDS Indices Class
————————————————————————
Specification
1. Reference Entities…………. Corporate.
2. Region……………………. North America.
3. Indices…………………… CDX.NA.IG.
CDX.NA.HY.
4. Tenor…………………….. CDX.NA.IG: 3Y, 5Y, 7Y, 10Y.
CDX.NA.HY: 5Y.
5. Applicable Series………….. CDX.NA.IG 3Y: Series 15 and all
subsequent Series, up to and
including the current Series.
CDX.NA.IG 5Y: Series 11 and all
subsequent Series, up to and
including the current Series.
CDX.NA.IG 7Y: Series 8 and all
subsequent Series, up to and
including the current Series.
[[Page 47221]]
CDX.NA.IG 10Y: Series 8 and all
subsequent Series, up to and
including the current Series.
CDX.NA.HY 5Y: Series 11 and all
subsequent Series, up to and
including the current Series.
6. Tranched………………….. No.
————————————————————————
European Untranched CDS Indices Class
————————————————————————
Specification
1. Reference Entities…………. Corporate.
2. Region……………………. Europe.
3. Indices…………………… iTraxx Europe.
iTraxx Europe Crossover.
iTraxx Europe HiVol.
4. Tenor…………………….. iTraxx Europe: 5Y, 10Y
iTraxx Europe Crossover: 5Y.
iTraxx Europe HiVol: 5Y.
5. Applicable Series………….. iTraxx Europe 5Y: Series 10 and all
subsequent Series, up to and
including the current Series.
iTraxx Europe 10Y: Series 7 and all
subsequent Series, up to and
including the current Series.
iTraxx Europe Crossover 5Y: Series
10 and all subsequent Series, up to
and including the current Series.
iTraxx Europe HiVol 5Y: Series 10
and all subsequent Series, up to
and including the current Series.
6. Tranched………………….. No.
————————————————————————
Sec. 50.5 Clearing Transition Rules.
(a) Swaps entered into before July 21, 2010 shall be exempt from
the clearing requirement under Sec. 50.2 if reported to a swap data
repository pursuant to section 2(h)(5)(A) of the Act and Sec. 44.02 of
this chapter.
(b) Swaps entered into before the application of the clearing
requirement for a particular class of swaps under Sec. 50.2 and Sec.
50.4 shall be exempt from the clearing requirement if reported to a
swap data repository pursuant to section 2(h)(5)(B) of the Act and
Sec. 44.03 of this chapter.
Sec. 50.6 Delegation of Authority.
(a) The Commission hereby delegates to the Director of the Division
of Clearing and Risk or such other employee or employees as the
Director may designate from time to time, with the consultation of the
General Counsel or such other employee or employees as the General
Counsel may designate from time to time, the authority:
(1) To determine whether one or more swaps submitted by a
derivatives clearing organization under Sec. 39.5 falls within a class
of swaps as described in Sec. 50.4; and
(2) To notify all relevant derivatives clearing organizations of
that determination.
(b) The Director of the Division of Clearing and Risk may submit to
the Commission for its consideration any matter which has been
delegated in this section. Nothing in this section prohibits the
Commission, at its election, from exercising the authority delegated in
this section.
Sec. 50.7-9 [Reserved].
Sec. 50.10 Prevention of Evasion of the Clearing Requirement and
Abuse of an Exception or Exemption to the Clearing Requirement.
(a) It shall be unlawful for any person to knowingly or recklessly
evade or participate in or facilitate an evasion of the requirements of
section 2(h) of the Act or any Commission rule or regulation
promulgated thereunder.
(b) It shall be unlawful for any person to abuse the exception to
the clearing requirement as provided under section 2(h)(7) of the Act
and Sec. 39.6 of this chapter.
(c) It shall be unlawful for any person to abuse any exemption or
exception to the requirements of section 2(h) of the Act, including any
exemption or exception as the Commission may provide by rule,
regulation, or order.
By the Commission.
Issued in Washington, DC, on July 24, 2012.
Sauntia S. Warfield,
Assistant Secretary of the Commission.
Appendices to Clearing Requirement Determination Under Section 2(h) of
the CEA–Commission Voting Summary and Statements of Commissioners
Note: The following appendices will not appear in the Code of
Federal Regulations.
Appendix 1–Commission Voting Summary
On this matter, Chairman Gensler and Commissioners Sommers,
Chilton, O’Malia and Wetjen voted in the affirmative; no
Commissioner voted in the negative.
Appendix 2–Statement of Chairman Gary Gensler
I support the proposal to require certain interest rate swaps
and credit default swap (CDS) indices to be cleared as provided by
the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-
Frank Act).
For over a century, through good times and bad, central clearing
in the futures market has lowered risk to the broader public. Dodd-
Frank financial reform brings this effective model to the swaps
market. One of the primary benefits of swaps market reform is that
standard swaps between financial firms will move into central
clearing, which will significantly lower the risks of the highly
interconnected financial system.
The Dodd-Frank Act requires the Commission to determine whether
a swap is required to be cleared. For purposes of this first set of
determinations, the Commission has looked to swaps that are
currently cleared based upon submissions from eight derivatives
clearing organizations (DCOs).
This first proposed clearing determination would require that
swaps within identified classes be cleared by a DCO. This first
determination includes interest rate swaps in four currencies, as
well as five CDS indices. The proposal addresses swaps that five
DCOs are already clearing, including standard interest rate swaps in
U.S. dollars, euros, British pounds and Japanese yen, as well as a
number of CDS indices, including North American and European
corporate names. Subsequently, the Commission will consider other
swaps, such as agricultural, energy and equity indices.
I believe that the Commission’s proposed determination for each
class satisfies the five factors provided for by Congress in the
Dodd-Frank Act, including the first factor that addresses
outstanding exposures, liquidity and pricing data.
Under the proposal, a DCO would be required to post on its Web
site a list of all swaps it will accept for clearing and must
[[Page 47222]]
indicate which swaps the Commission had determined are required to
be cleared.
I look forward to receiving public input on this proposed rule.
Appendix 2–Statement of Commissioner Scott D. O’Malia
I respectfully concur with the Commodity Futures Trading
Commission’s (“Commission”) proposal to establish a clearing
requirement for certain classes of credit default swaps and interest
rate swaps pursuant to the Commission’s authority under new section
2(h)(1)(A) of the Commodity Exchange Act (“CEA”).1 Centralized
clearing is a vital part of the Dodd-Frank Act reforms and is
expected to reduce counterparty credit risks, improve transparency
and fairness around the setting of margin requirements, increase
market liquidity, and reduce overall systemic risks.
—————————————————————————
1 7 U.S.C. 2(h). Congress amended section 2(h) of the CEA
under section 723 of the Dodd-Frank Wall Street Reform and Consumer
Protection Act, Public Law 111-203, 124 Stat. 1376 (2010) (“Dodd-
Frank Act”).
—————————————————————————
I am pleased that the Commission’s proposal thoughtfully
incorporates comments received in response to my July 28, 2011
letter 2 to the public seeking comment on the five substantive
criteria that the Commission is required to consider in making
mandatory clearing determinations.3 The comments help provide the
necessary clarity and guidance that the markets have sought
regarding how the Commission will consider and weigh these criteria.
—————————————————————————
2 My letter, and comments submitted in response thereto, can
be found on the Commission’s Web site at: http://www.cftc.gov/About/Commissioners/ScottDOMalia/reviewofswaps.
3 Specifically, section 2(h)(2)(D)(ii) requires the Commission
consider the following five factors based on a Commission initiated
review of a swap submission: (1) The existence of significant
outstanding notional exposures, trading liquidity, and adequate
pricing of data; (2) the availability of rule framework, capacity
operational expertise and resources, and credit support
infrastructure to clear the contract on terms that are consistent
with the material terms and trading conventions on which the
contract is then traded; (3) the effect on the mitigation of
systemic risk, taking into account the size of the market for such
contract and the resources of the derivatives clearing organization
(“DCO”) available to clear the contract; (4) the effect on
competition, including appropriate fees and charges applied to
clearing; and (5) the existence of reasonable legal certainty in the
event of the insolvency of the relevant DCO (or one or more of its
clearing members) with regard to the treatment of customer and swap
counterparty positions, funds, and property.
—————————————————————————
Today’s proposal also (1) includes a more reasoned cost-benefit
analysis that is based on an appropriate pre-Dodd-Frank baseline,
(2) discusses a variety of alternatives based on public comments,
and (3) asks a series of questions in the absence of available data.
Once again, I am encouraged that Commission staff is working with
technical experts from the Office of Management and Budget (“OMB”)
to improve our cost-benefit analyses. It is my hope that the
Commission’s final rule similarly benefits from our cooperative
relationship with OMB.
Once this proposal is published in the Federal Register, the 90-
day clock will start. The Commission will review all comments, and
discuss its final determination for clearing the majority of swaps
in due course. I implore commenters to provide feedback and to
submit data as soon as possible so that the Commission can account
for the actual impact that today’s rule will have on market
liquidity, margining, and the reduction of risks.
[FR Doc. 2012-18382 Filed 8-6-12; 8:45 am]
BILLING CODE 6351-01-P
Last Updated: August 7, 2012
[ad_2]
Source link
