Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions

Federal RegisterJun 9, 2011

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COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 22 and 190

RIN 3038-AC99

Protection of Cleared Swaps Customer Contracts and Collateral; Conforming Amendments to the Commodity Broker Bankruptcy Provisions

AGENCY:

Commodity Futures Trading Commission.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

The Commodity Futures Trading Commission (the “Commission”) hereby proposes rules to implement new statutory provisions enacted by Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Specifically, the proposed rules contained herein impose requirements on futures commission merchants (“FCMs”) and derivatives clearing organizations (“DCOs”) regarding the treatment of cleared swaps customer contracts (and related collateral), and make conforming amendments to bankruptcy provisions applicable to commodity brokers under the Commodity Exchange Act (the “CEA”).

DATES:

Comments must be received on or before August 8, 2011.

ADDRESSES:

You may submit comments, identified by RIN number 3038-AC99, 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 § 145.9 of the Commission's regulations.

17 CFR 145.9.

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:

Robert B. Wasserman, Associate Director, Division of Clearing and Intermediary Oversight (DCIO), at 202-418-5092 or

rwasserman@cftc.gov;

Jon DeBord, Attorney-Advisor, DCIO, at 202-418-5478 or

jdebord@cftc.gov;

Martin White, Assistant General Counsel, at 202-418-5129 or

mwhite@cftc.gov;

David Reiffen, Senior Economist, Office of the Chief Economist, at 202-418-5602 or

dreiffen@cftc.gov;

or Todd Prono, Financial Economist, Office of the Chief Economist, at 202-418-5460 or

tprono@cftc.gov,

in each case, also at the Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

II. Background

A. Segregation Requirements

B. Implementation Alternatives

C. Solicitation of Public Input Regarding the Alternatives

1. Roundtable

2. ANPR

a. Questions

b. Comments: Background

c. Comments: Discussion

1. Statutory Issues

2. What is the appropriate starting point?

3. Costs

a. Operational Costs

b. The Risk Costs

i. The Physical Segregation Model and the Complete Legal Segregation Model

ii. The Legal Segregation With Recourse Model and the Futures Model

c. Assumptions Underlying Risk Costs

4. Benefits

a. Fellow-Customer Risk and Investment Risk

b. Portability

c. Systemic Risk

d. Induced Changes in Behavior

e. Portfolio Margining

5. The Optional Approach

III. The Proposed Rules

A. Statutory Issues and the Appropriate Starting Point

B. Costs

1. Rationale

2. Questions

C. Benefits

1. Rationale

a. Fellow-Customer Risk and Investment Risk

b. Portability

c. Systemic Risk

d. Induced Changes in Behavior

e. Portfolio Margining

2. Questions

D. Proposing the Complete Legal Segregation Model: Weighing of Costs and Benefits

E. The Optional Approach

1. Rationale

2. Questions

F. Structure of These Proposed Regulations

IV. Section by Section Analysis: Segregation of Cleared Swaps for Customers

A. Proposed Regulation 22.1: Definitions

1. “Segregate” and “Commingle”

2. “Cleared Swap”

3. “Cleared Swaps Customer” and “Customer”

4. “Cleared Swaps Customer Collateral”

5. “Cleared Swaps Customer Account” and “Cleared Swaps Proprietary Account”

6. “Collecting Futures Commission Merchant” and “Depositing Futures Commission Merchant”

B. Proposed Regulation 22.2—Futures Commission Merchants: Treatment of Cleared Swaps Customer Collateral

1. In General

2. Location of Collateral

a. The First Method

b. The Second Method

3. Commingling

4. Limitations on Use

5. Exceptions

a. Permitted Investments

b. Permitted Withdrawals

c. Deposits of Own Money, Securities, or Other Property

d. Residual Financial Interest

e. Requirements as to Amount

i. Background

ii. Proposed Requirement

iii. Question

f. Segregated Account; Daily Computation and Record

C. Proposed Regulation 22.3—Derivatives Clearing Organizations: Treatment of Cleared Swaps Customer Collateral

1. In General

2. Location of Collateral

a. The First Method

b. The Second Method

c. Questions

3. Commingling

4. Exceptions

a. FCM Deposits and Withdrawals

b. Permitted Investments

D. Proposed Regulation 22.4—Futures Commission Merchants and Derivatives Clearing Organizations: Permitted Depositories

1. The Permitted Depositories

2. Question

E. Proposed Regulation 22.5—Futures Commission Merchants and Derivatives

Clearing Organizations: Written Acknowledgment

1. Substantive Requirements

2. Question

F. Proposed Regulation 22.6—Futures Commission Merchants and Derivatives Clearing Organizations: Naming of Cleared Swaps Customer Accounts

G. Proposed Regulation 22.7—Permitted Depositories: Treatment of Cleared Swaps Customer Collateral

H. Proposed Regulation 22.8—Situs of Cleared Swaps Accounts

1. Proposed Requirements

2. Questions

I. Proposed Regulation 22.9—Denomination of Cleared Swaps Customer Collateral and Location of Depositories

J. Proposed Regulation 22.10—Incorporation by Reference

K. Proposed Regulation 22.11—Information To Be Provided Regarding Customers and Their Cleared Swaps

1. Proposed Requirements

2. Questions

L. Proposed Regulation 22.12—Information To Be Maintained Regarding Cleared Swaps Customer Collateral

M. Proposed Regulation 22.13—Additions to Cleared Swaps Customer Collateral

N. Proposed Regulation 22.14—Futures Commission Merchant Failure To Meet a Customer Margin Call in Full

O. Proposed Regulation 22.15—Treatment of Cleared Swaps Customer Collateral on an Individual Basis

P. Proposed Regulation 22.16—Disclosures to Customers

V. Section by Section Analysis: Amendments to Regulation Part 190

A. Background

B. Definition

1. Proposed Amendment to Regulation 190.01(a)—Account Class

2. Proposed New Regulation 190.01(e)—Calendar Day

3. Proposed Amendment to Regulation 190.01(f)—Clearing Organization

4. Proposed Amendment to Regulation 190.01(cc)—Non-Public Customer

5. Proposed Amendment to Regulation 190.01(hh)—Principal Contract

6. Proposed Amendment to Regulation 190.01(ll)—Specifically Identifiable Property

7. Proposed Amendment to Regulation 190.01(pp)—Cleared Swap

C. Proposed Amendments to Regulation 190.02—Operation of the Debtor's Estate Subsequent to the Filing Date and Prior to the Primary Liquidation Date

D. Proposed Amendments to Regulation 190.03—Operation of the Debtor's Estate Subsequent to the Primary Liquidation Date

E. Proposed Amendments to Regulation 190.04—Operation of the Debtor's Estate—General

F. Proposed Amendments to Regulation 190.05—Making and Taking Delivery on Commodity Contracts

G. Proposed Amendments to Regulation 190.06—Transfers

H. Proposed Amendments to Regulation 190.07—Calculation of Allowed Net Equity

I. Proposed Amendments to Regulation 190.09—Member Property

J. Proposed Amendments to Regulation 190.10—General

K. Proposed Amendments to Appendix A to Part 190—Bankruptcy Forms, Bankruptcy

L. Proposed Amendments to Appendix B to Part 190—Special Bankruptcy Distributions

VI. Effective Date

VII. Administrative Compliance

A. Regulatory Flexibility Act

B. Paperwork Reduction Act

1. Introduction

2. Information Provided by Reporting Entities

3. Information Collection Comments

C. Cost-Benefit Analysis

1. Introduction

a. Requirement Under Section 15(a) of the CEA

b. Structure of the Analysis

2. Costs of the Complete Legal Segregation Model, the Legal Segregation With Recourse Model, and the Futures Model

a. Operational Costs

b. Risk Costs

c. Induced Changes in Behavior

d. Portability

e. Potential Preferences of Cleared Swaps Customers

f. The Optional Approach

3. Summary of Benefits of Legal Segregation Models

a. Fellow-Customer Risk

b. Portability and Systemic Risk

c. Induced Changes in Behavior

4. Relevance to Section 15(a)(2) Considerations

a. Protection of Market Participants and the Public

b. Efficiency, Competitiveness, and Financial Integrity of Markets

c. Price Discovery

d. Sound Risk Management

e. Other Public Interest Considerations

5. Public Comment

VIII. Text of Proposed Rules

I. Introduction

The Dodd-Frank Act

mandates that each FCM and DCO “segregate” customer collateral supporting cleared swaps. In other words, the FCM and the DCO (i) must hold such customer collateral in an account (or location) that is separate from the property belonging to the FCM or DCO, and (ii) must not use the collateral of one customer to (A) cover the obligations of another customer or (B) the obligations of the FCM or DCO.

See

Dodd-Frank Act, Public Law 111-203, 124 Stat. 1376 (2010). The text of the Dodd-Frank Act may be accessed at

http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm

See

section 724 of the Dodd-Frank Act. There is some controversy with respect to section 4d(f)(6) of the CEA as applied to a DCO.

See

section II(C) herein.

In order to implement the segregation requirements in the Dodd-Frank Act, the Commission has determined to propose that each FCM and DCO be required to enter (or “segregate”), in its books and records, the cleared swaps of each individual customer and relevant collateral. The Commission also proposes to permit each FCM and DCO to operationally hold (or “commingle”) all relevant collateral in one account. The Commission further proposes that, in the event that an FCM defaults simultaneously with one or more cleared swaps customers, the DCO may access the collateral of the FCM's defaulting cleared swaps customers to cure the default, but not the collateral of the FCM's non-defaulting cleared swaps customers. However, the Commission is continuing to assess the benefits and costs of the proposal, and is considering whether to permit the DCO to access the collateral of non-defaulting cleared swaps customers, after the DCO attempts to cure the default by applying its own capital and the guaranty fund contributions of its non-defaulting FCM members. Moreover, the Commission is also continuing to assess the feasibility of permitting each DCO to choose the level of protection that it would accord to the cleared swaps customer collateral of its FCM members.

In deciding to propose the above requirements, the Commission looked to current practices for the protection of uncleared swaps collateral, as well as current practices for the protection of collateral supporting futures customer contracts. The Commission, through its staff, sought comment from a wide variety of stakeholders (

i.e.,

swaps customers, FCMs, and DCOs), through external meetings

and a public roundtable.

Further, the Commission issued an advanced notice of proposed rulemaking (the “ANPR”).

After carefully considering all comments, the Commission has reached the conclusion that this proposal (i) protects cleared swaps customer collateral in the manner mandated by the Dodd-Frank Act, and (ii) provides the best balance between (A) the benefits of mitigating Fellow-Customer Risk, Investment Risk (as such terms are defined below) and systemic risk, inducing changes in behavior, and enhancing portability as well as potentially facilitating portfolio margining, and (B) the operational and

risk costs

associated with implementation. This notice of proposed rulemaking (the “NPRM”) sets forth the rationale for such conclusion. The Commission requests comment on each element of its rationale, its conclusion, and any alternatives to the proposal that it is considering (such as, whether to permit the DCO to access the collateral of non-defaulting cleared swaps customers and whether to permit each DCO to choose the level of protection for such collateral).

A list of external meetings is available at:

http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_6_SegBankruptcy/index.htm

A transcript of the Staff Roundtable on Individual Customer Collateral Protection (the “Roundtable”) is available at:

http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/dfsubmission6_102210-transcrip.pdf

See

Advance Notice of Proposed Rulemaking for Protection of Cleared Swaps Customers Before and After Commodity Broker Bankruptcies, 75 FR 75162, Dec. 2, 2010.

See

section II(C)(3) below.

II. Background

A. Segregation Requirements

On July 21, 2010, President Obama signed the Dodd-Frank Act. Title VII of the Dodd-Frank Act

amended the CEA

to establish a comprehensive new regulatory framework for swaps and certain security-based swaps. The legislation was enacted to reduce risk, increase transparency, and promote market integrity within the financial system by, among other things: (i) Providing for the registration and comprehensive regulation of swap dealers and major swap participants;

(ii) imposing mandatory clearing and trade execution requirements on clearable swap contracts; (iii) creating robust recordkeeping and real-time reporting regimes; and (iv) enhancing the rulemaking and enforcement authorities of the Commission with respect to, among others, all registered entities and intermediaries subject to the oversight of the Commission.

Pursuant to section 701 of the Dodd-Frank Act, Title VII may be cited as the “Wall Street Transparency and Accountability Act of 2010.”

7 U.S.C. 1

et seq.

In this release, the terms “swap dealer” and “major swap participant” shall have the meanings set forth in section 721(a) of the Dodd-Frank Act, which added sections 1a(49) and (33) of the CEA. However, section 721(c) of the Dodd-Frank Act directs the Commission to promulgate rules to further define, among other terms, “swap dealer” and “major swap participant.” The Commission is in the process of this rulemaking.

See

75 FR 80173, Dec. 21, 2010.

Section 724 of the Dodd-Frank Act prescribes the manner in which cleared swaps (and related collateral)

must be treated prior to and after bankruptcy. Section 724(a) of the Dodd-Frank Act amends section 4d of the CEA to add a new paragraph (f). New section 4d(f) imposes the following requirements on an FCM, as well as any depository thereof (including, without limitation, a DCO):

Proposed regulation 22.1 defines “Cleared Swap” and “Cleared Swaps Customer Collateral.”

1. The FCM must treat and deal with all collateral (including accruals thereon) deposited by a customer

to margin its cleared swaps as belonging to such customer;

Proposed regulation 22.1 defines “Cleared Swaps Customer.”

2. The FCM may not commingle such collateral with its own property and may not, with certain exceptions, use such collateral to margin the cleared swaps of any person other than the customer depositing such collateral;

3. A DCO may not hold or dispose of the collateral that an FCM receives from a customer to margin cleared swaps as belonging to the FCM or any person other than the customer; and

4. The FCM and the DCO may only invest such collateral in enumerated investments.

Section 724(b) of the Dodd-Frank Act governs bankruptcy treatment of cleared swaps by clarifying that cleared swaps are “commodity contracts” within the meaning of section 761(4)(F) of the Bankruptcy Code.

Therefore, in the event of an FCM or DCO insolvency, cleared swaps customers may invoke the protections of Subchapter IV of Chapter 7 of the Bankruptcy Code (“Subchapter IV”). Such protections include: (i) Protected transfers of cleared swaps and related collateral;

and (ii) if cleared swaps are subject to liquidation, preferential distribution of remaining collateral.

11 U.S.C. 761(4)(F).

See, e.g.,

11 U.S.C. 764.

See, e.g.,

11 U.S.C. 766(h) and (i).

B. Implementation Alternatives

The Commission considered several alternatives for implementing new section 4d(f) of the CEA. The first alternative that the Commission explored was legal segregation with operational commingling (the “Legal Segregation Model”). Under the Legal Segregation Model, each FCM and DCO would enter (or “segregate”), in its books and records, the cleared swaps of each individual customer and relevant collateral. Each FCM and DCO would ensure that such entries are separate from entries indicating (i) FCM or DCO obligations or (ii) the obligations of non-cleared swaps customers. Operationally, however, each FCM and DCO would be permitted to hold (or “commingle”) the relevant collateral in one account. Each FCM and DCO would ensure that such account is separate from any account holding FCM or DCO property or holding property belonging to non-cleared swaps customers.

Under the Legal Segregation Model, the FCM, prior to default, would ensure that the DCO does not use the collateral of one cleared swaps customer to support the obligations of another customer by making certain that the value of the cleared swaps collateral that the DCO holds equals or exceeds the value of all cleared swaps collateral that it has received to secure the contracts of the FCM's customers. The Commission considered two possible scenarios after a simultaneous default of the FCM and of one or more cleared swaps customers. First, the Commission contemplated permitting the DCO to access the collateral of the defaulting cleared swaps customers, but not the collateral of the non-defaulting cleared swaps customers (the “Complete Legal Segregation Model”).

Second, the Commission contemplated permitting the DCO to access the collateral of the non-defaulting cleared swaps customers, after the DCO applies its own capital to cure the default, as well as the guaranty fund contributions of its non-defaulting FCM members (the “Legal Segregation with Recourse Model”).

The Complete Legal Segregation Model was referred to as the Legal Segregation with Commingling model in the ANPR.

The Legal Segregation with Recourse Model was known as the Moving Customers to the Back of the Waterfall model in the ANPR.

As its second alternative, the Commission explored full physical segregation (the “Physical Segregation Model”).

Prior to FCM default, the Physical Segregation Model differs from the Legal Segregation Model only operationally. Like the Legal Segregation Model, each FCM and DCO would enter (or “segregate”), in its books and records, the cleared swaps of each individual customer and relevant collateral. However, unlike the Legal Segregation Model, each FCM and DCO would maintain separate individual accounts for the relevant collateral. Hence, prior to default, the FCM would ensure that the DCO does not use the collateral of one cleared swaps customer to support the obligations of another customer by making certain that the DCO does not mistakenly transfer collateral in (i) the account belonging to the former to (ii) the account belonging to the latter. After a simultaneous default of the FCM and of one or more cleared swaps customers, the Physical Segregation Model leads to the same result as the Complete Legal Segregation Model. Specifically, the DCO would be permitted to access the collateral of the defaulting cleared swaps customers, but not the collateral of the non-defaulting customers.

In the ANPR, the Commission referred to this model as Full Physical Segregation.

As its third alternative, the Commission explored replicating the

segregation requirement currently applicable to futures (the “Futures Model”).

Prior to default, the Futures Model shares certain similarities with the Legal Segregation Model. Specifically, each FCM would enter (or “segregate”), in its books and records, the cleared swaps of each individual customer and relevant collateral. Each DCO, however, would recognize, in its books and records, the cleared swaps that an FCM intermediates on a collective (or “omnibus”) basis. Each FCM and DCO would be permitted to hold (or “commingle”) all cleared swaps collateral in one account. After default, the Futures Model shares certain similarities with the Legal Segregation with Recourse Model. Specifically, the DCO would be permitted to access the collateral of the non-defaulting cleared swaps customers. However, under the Futures Model, the DCO would be permitted to access such collateral before applying its own capital or the guaranty fund contributions of non-defaulting FCM members.

See

sections 4d(a) and (b) of the CEA, as well as regulations 1.20 to 1.30. The Futures Model was referred to as the Baseline model in the ANPR.

Finally, the Commission explored permitting a DCO to choose between (i) the Legal Segregation Model (whether Complete or with Recourse), (ii) the Physical Segregation Model, and (iii) the Futures Model, rather than mandating any particular alternative.

C. Solicitation of Public Input Regarding the Alternatives

Throughout the fall and winter of 2010, the Commission sought public comment on the alternatives mentioned above, and on the advisability of permitting the DCO to choose between alternatives. First, the Commission, through its staff, held extensive external meetings with three segments of stakeholders (

i.e.,

DCOs, FCMs, and swaps customers).

Second, on October 22, 2010, the Commission, through its staff, held the Roundtable. Third, on November 19, 2010, the Commission issued the ANPR.

A list of external meetings is available at:

http://www.cftc.gov/LawRegulation/DoddFrankAct/Rulemakings/DF_6_SegBankruptcy/index.htm

1. Roundtable

As the ANPR describes, the Roundtable revealed that stakeholders had countervailing concerns regarding the alternatives that the Commission set forth. On the one hand, a number of swaps customers argued that the Commission should focus on effectively eliminating fellow-customer risk

and investment risk.

Such swaps customers emphasized that (i) they currently transact in uncleared swaps, (ii) they are able to negotiate for individual segregation at independent third parties for collateral supporting such uncleared swaps, and therefore (iii) they are currently subject to neither Fellow-Customer Risk nor Investment Risk. Such customers found it inappropriate that, under certain alternatives that the Commission set forth, they should be subject to Fellow-Customer Risk and Investment Risk when they transact in cleared swaps. As the ANPR noted, pension funds were specifically concerned about whether Fellow-Customer Risk and Investment Risk would be incompatible with their obligations under the Employee Retirement Income Security Act.

“Fellow-Customer Risk” is the risk that a DCO would access the collateral of non-defaulting cleared swaps customers to cure an FCM default. Basically, among other things, an FCM functions as a guarantor of customer transactions with a DCO. Section 4d(f) of the CEA prohibits an FCM from using the collateral deposited by one cleared swaps customer to support the transactions of another customer. Therefore, if one cleared swaps customer owes money to the FCM (

i.e.,

the customer has a debit balance), the FCM, acting as guarantor, must deposit its own capital with the DCO to settle obligations attributable to such customer. If such customer defaults to the FCM, and the obligations attributable to such customer are so significant that the FCM does not have sufficient capital to meet such obligations, then the FCM would default to the DCO.

In general, DCOs maintain packages of financial resources to cure the default. The first element of such packages is the property of the defaulting FCM (

i.e.,

collateral deposited to support FCM proprietary transactions and contributions to the DCO guaranty fund). As mentioned above, other elements of such packages may include: (i) The collateral that the FCM deposited to support the transactions of non-defaulting cleared swaps customers; (ii) a portion of the capital of the DCO; and (iii) contributions to the guaranty fund from other DCO members. Typically, a DCO would exhaust one element before moving onto the next element. Therefore, the risk that the DCO would use any one element depends on the position of that element in the package.

“Investment Risk” is the risk that each cleared swaps customer would share

pro rata

in any decline in the value of FCM or DCO investments of cleared swaps customer collateral. Section 4d(f) of the CEA permits an FCM to invest cleared swaps customer collateral in certain enumerated instruments. The Commission is proposing to expand such instruments to include those referenced in regulation 1.25 (as it may be amended from time to time). Even though (i) such investments are “consistent with the objectives of preserving principal and maintaining liquidity,” and (ii) both the FCM, as well as the DCO, value such investments conservatively (by,

e.g.,

applying haircuts), the value of such investments may decline to less than the value of the collateral originally deposited.

See

regulation 1.25(b) (as proposed to be amended in

Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions,

75 FR 67642, Nov. 3, 2011). In such a situation, all customers would share in the decline

pro rata,

even if the invested collateral belonged to certain customers and not others.

75 FR at 75163.

On the other hand, a number of FCMs and DCOs argued that the benefits of effectively eliminating Fellow-Customer Risk and Investment Risk are outweighed by the costs. With respect to benefits, these FCMs and DCOs noted that the Futures Model has served the futures industry well for many decades. With respect to costs, these FCMs and DCOs described two potential sources. First, FCMs and DCOs stated that, depending on the manner in which the Commission proposes to eliminate or mitigate Fellow-Customer Risk and Investment Risk, they may experience substantial increases to operational costs. Second, and more significantly, FCMs and DCOs stated that they may incur additional risk costs due to proposed financial resources requirements.

Specifically, the Commission has proposed to require each DCO to maintain a package of financial resources sufficient, at a minimum, to:

For a more detailed discussion regarding risk costs, see section II(C)(3)(b) infra.

[e]nable the derivatives clearing organization to meet its financial obligations to its clearing members notwithstanding a default by the clearing member creating the largest financial exposure for the derivatives clearing organization in extreme but plausible market conditions.

Financial Resources Requirements for Derivatives Clearing Organizations,

75 FR 63113, 63118, Oct. 14, 2010 (proposed regulation 39.11(a)(1)).

The Commission has proposed to require systemically-important DCOs to maintain a financial resources package sufficient to cover a default by the two clearing members creating the largest combined financial exposure in extreme but plausible market conditions.

Id.

at 63119 (proposed regulation 39.29(a)).

Some DCOs may have anticipated including collateral from non-defaulting cleared swaps customers as an element in their financial resources packages. If DCOs no longer have access to such collateral, then those DCOs would need to obtain additional financial resources to meet proposed Commission requirements. As the ANPR noted, DCOs stated that they could obtain such financial resources in two ways (or a combination thereof). They can increase the amount of collateral that each cleared swaps customer must provide to margin its cleared swaps. Alternatively, they can increase the amount of capital that each FCM must contribute to the relevant DCO guaranty funds. Both FCMs and DCOs averred that the costs associated with obtaining such additional financial resources may be

substantial, and would ultimately be borne by cleared swaps customers.

75 FR at 75163. For example, one DCO estimated that it would have to increase the amount of collateral that each cleared swaps customer must provide by 60 percent, if it could no longer access the collateral of non-defaulting cleared swaps customers to cure certain defaults.

2. ANPR

a. Questions

Given the countervailing concerns that stakeholders expressed at the Roundtable, the Commission decided to seek further comment through the ANPR on the potential benefits and costs of (i) the Legal Segregation Model (whether Complete or with Recourse), (ii) the Physical Segregation Model, and (iii) the Futures Model. As the ANPR explicitly stated, “[t]he Commission [was] seeking to achieve two basic goals: Protection of customers and their collateral, and minimization of costs imposed on customers and on the industry as a whole.”

Although the ANPR sought comment on the abovementioned models from the general public, it addressed specific questions to the three segments of stakeholders (

i.e.,

DCOs, FCMs, and swaps customers). The Commission asked all three segments to identify the benefits of each model relative to the others. The Commission then asked all three segments to estimate the costs of implementing each model from their perspective. Specifically, for FCMs, the Commission asked for estimates of (i) FCM compliance costs for each model (other than the Futures Model) and (ii) FCM costs resulting from DCOs seeking additional financial resources to meet proposed Commission requirements. For DCOs, the Commission asked for estimates of: (i) DCO, as well as FCM, compliance costs for each model (other than the Futures Model); and (ii) DCO, as well as FCM, costs resulting from DCOs seeking additional financial resources to meet proposed Commission requirements. In addition to the above, the Commission requested comment on the impact of each model on behavior, as well as whether Congress evinced intent for the Commission to adopt any one or more of these models.

b. Comments: Background

The Commission received thirty-one comments from twenty-nine commenters.

Of the commenters, fifteen represented current or potential cleared swaps customers (

i.e.,

buy-side firms or groups),

eight represented FCMs or investment firms (or organizations thereof),

four were DCOs,

one was the National Futures Association (“NFA”), and one was from a legal practitioner.

The Commission invites further comment on any of the issues raised and the factual and analytical points made in the comments received in response to the ANPR.

Federated Investors submitted two comments, both of which focused on the investment of cleared swaps customer collateral. ISDA submitted two comments, an original comment (the “ISDA Original”) and, later, a supplemental comment (the “ISDA Supplemental”).

Buy-side firms or groups (collectively, the “buy-side”) included the following: (i) Alternative Investment Management Association (“AIMA”); (ii) BlackRock, Inc. (“BlackRock”); (iii) California Public Employees Retirement System (“CALPERS”); (iv) Coalition for Derivatives End Users (by Gibson, Dunn & Crutcher); (v) Coalition for Energy End Users; (vi) Committee on Investment of Employee Benefit Assets (“CIEBA”); (vii) Federal Farm Credit Banks Funding Corp.; (viii) Federal Home Loan Banks (“FHLB”); (ix) Fidelity Investments (“Fidelity”); (x) Freddie Mac; (xi) Investment Company Institute; (xii) Managed Funds Association; (xiii) Securities Industry and Financial Markets Association Asset Management Group (“SIFMA-AMG”); (xiv) Tudor Investment Corporation; and (xv) Vanguard.

FCMs or investment firms (or organizations thereof) (collectively, the “FCMs”) included the following: (i) Citigroup Global Markets, Inc. (“Citigroup Capital Markets”); (ii) Federated Investors, Inc. (Freeman and Hawke); (iii) Futures Industry Association; (iv) International Swaps and Derivatives Association (“ISDA”) (Original and Supplemental); (v) Newedge USA, LLC (“Newedge”); (vi) Norges Bank Investment Management; (vii) Securities Industry and Financial Markets Association (“SIFMA”); and (viii) State Street Corporation.

DCOs (collectively, the “DCOs”) included the following: (i) CME Group (“CME”); (ii) IntercontinentalExchange, Inc. (“ICE”); (iii) LCH Clearnet Group (“LCH”); and (iv) Minneapolis Grain Exchange, Inc.

Jerrold Salzman.

The comments were generally divided by the nature of the commenter: most (though not all) of the buy-side commenters favored either the Legal Segregation Model (whether Complete or with Recourse) or the Physical Segregation Model, manifesting a willingness to bear the added costs. Most of the FCMs and DCOs favored the Futures Model. LCH favored the Complete Legal Segregation Model. Finally, ISDA, in its supplemental comment, opined that the most important factor that the Commission should consider is the extent to which a model fostered the portability

of cleared swaps belonging to non-defaulting customers. ISDA noted that the Physical Segregation Model and what is now referred to as the Complete Legal Segregation Model were most conducive to that goal.

Portability refers to the ability to reliably transfer the swaps (and related collateral) of a non-defaulting customer from an insolvent FCM to a solvent FCM, without the necessity of liquidating and re-establishing the swaps.

c. Comments: Discussion

In general, comments to the ANPR addressed the following major issues: (i) Concerns with statutory interpretation; (ii) the appropriate basis for comparison of benefits and costs for each model; (iii) estimates of costs, and the assumptions underlying such estimates; (iv) the benefits of individual collateral protection (

e.g.,

on Fellow-Customer Risk, Investment Risk, systemic risk, induced changes in behavior, and portfolio margining); and (v) the appropriateness of optional models.

1. Statutory Issues

Section 4d(f)(6) of the CEA prohibits “any person, including any derivatives clearing organization * * *” from holding, disposing, or using cleared swaps customer collateral “for deposit in a separate account or accounts * * * as belonging to * * * any person other than the swaps customer of the futures commission merchant.” The emphasis on “separate account or accounts” and the use of “customer” in the singular contrasts with section 4d(b) of the CEA (applicable to futures customer contracts and related collateral). In the ANPR, the Commission asked for comment as to whether Congress evinced intent to create a segregation regime that protects cleared swaps (and related customer collateral) on a more individualized basis than futures (and related customer collateral). In general, commenters presented opposing views. For example, one commenter viewed use of the singular term “customer” in section 4d(f)(6) of the CEA as a “critical difference.”

Similarly, another commenter viewed such use “as direction to the * * * Commission to ensure that customer initial margin [for cleared swaps] is not put at risk on account of actions of other customers.”

In contrast, a third commenter expressed doubt as to whether Congress would “adopt such a subtle method of moving away from [omnibus customer protection] and directing the use of individually segregated accounts for cleared swaps.”

The commenter further observed that it would be anomalous to afford greater protection to cleared

swaps customers, many of which are large and presumed to be sophisticated, than futures customers, some of whom might be individual or “retail” customers.

CIEBA at 4 at note 2.

FHLB at 3 at note 3.

Additionally, some commenters maintained that the Futures Model depends on an interpretive statement issued by the Office of the General Counsel, which they describe as “dated and questionable” in relation to cleared swaps.

See

FHLB at 4, Federal Farm Credit Banks Funding Corporation at 3.

See also

AIMA at 1 (where “client collateral is inadequately protected, ” “lack of confidence in the system * * * can cause customers to seek to avoid losses by liquidating or moving their positions in stressed market conditions, causing `runs' on futures commission merchants, greatly exacerbating market stress and contributing to wider financial instability”).

d. Induced Changes in Behavior

In general, commenters offered different opinions on the appropriate focus of induced changes in behavior analysis. For example, certain commenters focused on the effects of the Futures Model on the motivations of the DCO. As mentioned above, under the Futures Model, a DCO may access the collateral of non-defaulting cleared swaps customers prior to its own capital in the event of an FCM default. Therefore, the above-mentioned commenters argued that under the Futures Model a DCO may be less motivated to ensure that each FCM member is managing the risks posed by cleared swaps customers properly than under Legal Segregation or Physical Segregation models.

See, e.

g.,

Freddie Mac at 3, 4; BlackRock at 5; Vanguard at 7.

Other commenters focused on the effect of the Legal Segregation Model (especially Complete) and the Physical Segregation Model on the motivations of cleared swaps customers and FCMs. First, these commenters argued that such models would cause changes in behavior, because cleared swaps customers benefitting from individual collateral protection would be less motivated to create market discipline by clearing thorough less risky firms.

Second, these commenters contended that FCMs would be less motivated to maintain substantial excess net capital in order to present a more attractive profile to customers.

See, e.

g.,

CME at 4, ISDA Supplemental at 6.

See, e.

g.,

ISDA Supplemental at 6.

Finally, a number of commenters observed that an important consideration in selecting a model is the effect that the model would have on the willingness of cleared swaps customers to maintain excess margin. The more protective of cleared swaps customer collateral a model is, the more likely it is that cleared swaps customers would be willing to maintain excess margin.

e. Portfolio Margining

A number of commenters expressed concern that the use of models other than the Futures Model would create fragmented segregation requirements (whether across securities and commodities accounts, or between different classes of commodities accounts), which in turn would create barriers to the ability of cleared swaps customers to portfolio margin.

See

SIFMA at 3-4, Investment Company Institute at 5-6, Futures Industry Association at 6.

5. The Optional Approach

The Optional Approach may be implemented in two ways. First, the Commission may permit each DCO to offer more than one model for protecting cleared swaps customer contracts and related collateral. For example, certain FCM members may choose the Complete Legal Segregation Model, whereas other FCM members may choose the Legal Segregation with Recourse Model. Second, the Commission may permit each DCO to offer a different model for protecting cleared swaps customer contracts and related collateral. For example, a DCO could choose to offer the Complete Legal Segregation Model to all of its FCM members, whereas another DCO could choose to offer the Futures Model.

Finally, a number of commenters suggested that the Commission permit DCOs the option of offering different models for protecting cleared swaps customer contracts and related collateral (the “Optional Approach”).

However, other commenters found the Optional Approach to be impracticable.

Still other commenters stated that the Optional Approach may not succeed in reducing costs for those cleared swaps customers that do not opt for greater protection, and that the Optional Approach, depending on the manner in which it is structured, may indeed increase the amount of funds such customers have at risk.

See, e.

g.,

Freddie Mac at 3 (“requiring DCOs to provide individual segregation on an optional basis is the best way to achieve the Commission's twin goals of maximizing customer protection and minimizing cost”), NFA at 2 (The “better mousetrap may involve * * * clearing organizations adopting one of the other models discussed by the Commission. The Commission's regulations should ensure that DCOs have the flexibility to offer those alternative structures * * *”).

See, e.

g.,

ICE at 12 (“ICE's general sense is that any bifurcated or optional model will further complicate the settlement process and lead to greater uncertainty during times of financial stress”), Investment Company Institute at 6 (“Due to the host of legal, regulatory, operational and other issues which would be presented, ICI does not believe that it would be appropriate to implement individual customer protection on an optional rather than a mandatory basis in connection with this rulemaking proceeding * * *”).

See, e.

g.,

ISDA Original at 13 (“if highly credit worthy customers choose the more expensive, higher protection option,” pooling may be less effective from the point of view of the DCO, which may be required to increase initial margin for all customers, including those choosing to bear fellow customer risk, forcing the latter to bear both increased funding cost and a greater amount of funds at risk).

III. The Proposed Rules

After carefully considering all comments, the Commission has decided to propose the Complete Legal Segregation Model in this NPRM for the following reasons.

First, as discussed in section III(A) herein, the Commission believes that section 4d(f) of the CEA provides it with authority to propose the Complete Legal Segregation Model. Further, the Commission believes that the language of section 4d(f) of the CEA supports strongly considering the current swaps practice.

Second, as discussed in section III(D) herein, the Commission believes that the Complete Legal Segregation Model provides the best balance between benefits and costs in order to protect market participants and the public. Section III(B) herein describes the Commission's evaluation of the costs of each model, whereas section III(C) herein describes the Commission's evaluation of the benefits of each model.

As mentioned in section I (

Introduction

) herein, the Commission is continuing to assess the benefits and costs of the Complete Legal Segregation Model. As part of such assessment, the Commission is considering whether to adopt, in the alternative, the Legal Segregation with Recourse Model. Further, the Commission is continuing to assess the feasibility of the Optional Approach and the Futures Model, and seeks comments thereon.

The Commission requests comments on (i) its proposal, (ii) whether it should adopt, in the alternative, the Legal Segregation with Recourse Model, and (iii) whether it should adopt the Optional Approach or the Futures Model. The Commission has set forth specific questions below.

A. Statutory Issues and the Appropriate Starting Point

Section 4d(f) of the CEA provides the Commission with the authority to afford individualized protection to cleared swaps customer collateral. As mentioned above, new section 4d(f)(6) of the CEA prohibits “any person, including any derivatives clearing organization * * * ” from holding, disposing, or using customer collateral “for deposit in a separate account or accounts * * * as belonging to * * * any person other than the swaps customer of the futures commission merchant.” The reference to “separate account or accounts” and the use of “customer” in the singular contrasts with section 4d(b) of the CEA, which governs the handling of customer collateral by DCOs in the futures market. Section 4d(b) prohibits a DCO from holding, disposing, or using customer collateral “for deposit in a separate account * * * as belonging to * * * any person other than the customers of such futures commission merchant,” using the plural form “customers” to refer to the property of customers collectively. The contrast between sections 4d(b) and 4d(f)(6) of the CEA suggests that the Commission need not treat cleared swaps customer collateral in the same manner as futures customer collateral. This is particularly true because the reference to “separate account or accounts” and “customer” in section 4d(f)(6) of the CEA accords with the individual collateral protection currently available in the swaps markets and contrasts with the omnibus approach traditionally used in futures markets. For the same reason, the Commission is persuaded that the costs of and protections provided by current swaps practices are highly relevant to the evaluation of alternative models for implementing the statute.

B. Costs

For additional discussion of cost issues, with particular reference to the costs of the proposed Complete Legal Segregation Model and the Legal

Segregation with Recourse Model relative to the Futures Model, see the cost-benefit analysis at section VII(C) infra.

1. Rationale

As mentioned above, the Commission believes that current swaps practices

forms an appropriate perspective for considering the costs of each model for protecting cleared swaps customer collateral. The Commission further believes that the operational costs and Risk Costs that commenters have identified for each model should be examined in light of the current practice of many swaps customers to incur costs to obtain individual collateral protection with independent third-parties.

With respect to operational costs, the Commission notes that commenters appeared to have relied upon appropriate assumptions in their estimates for the Legal Segregation Model (whether Complete or with Recourse) and the Physical Segregation Model.

With respect to Risk Costs, the Commission observes that commenters appeared to have relied upon appropriate assumptions in their estimates for the Legal Segregation with Recourse Model and the Futures Model.

In contrast, the Commission finds, at least initially, persuasive the comments questioning the estimates of Risk Costs for the Complete Legal Segregation Model and the Physical Segregation Model, to the extent that such estimates are based on the assumption that collateral from non-defaulting cleared swaps customers would be fully available to DCOs in practice.

The Commission is not persuaded by the claim that it may be difficult for FCMs and DCOs to maintain separate models for futures customer collateral and cleared swaps customer collateral. Many FCMs are part of organizations that currently (and in the future will) maintain separate models for futures and uncleared swaps, and there has been no evidence of problems with the ability of such FCMs to operate both business lines. Indeed, there are DCOs that currently maintain different guaranty funds for cleared swaps and futures contracts, and that apply materially different margin models to such contracts (

e.g.,

futures contracts vs. credit default swaps vs. interest rate swaps), again without reported trouble.

Regarding the comment stating that the Legal Segregation with Recourse Model would result in a “wealth transfer” from the DCO and its FCM members to cleared swaps customers, the Commission notes that such comment did not include an estimate for any additional costs resulting from such “transfer.” Moreover, such statement is simply the obverse of the observation by other commenters that the Futures Model would involve implicit costs to customers.

See, e.

g.,

Federal Farm Credit Banks Funding Corp. at 3 (“Under the [futures] model, the hundreds of millions of dollars that the System Banks will likely post as initial margin and variation margin for cleared trades would be at economic risk”).

For example, the size of the customer account at Lehman declined substantially in the days before its bankruptcy filing and caused DCOs to declare it in default. For additional discussion of the relationship of estimates of Risk Costs to assumptions about the availability of the collateral of non-defaulting customers in the event of an FCM default, see the discussion of fellow-customer behavior and “diversification” effects in relation to the design of a DCO's financial resources package in the cost-benefit analysis at section VII(C)(2)(b) infra.

2. Questions

The Commission seeks comment on potential operational costs associated with implementing the Futures Model, and whether such costs could vary depending on the volume of swaps to be cleared.

Further, the Commission seeks comment on potential operational costs and Risk Costs for all models other than the Futures Model, especially with respect to (i) the extent to which such costs could be offset against the costs that swaps customers currently incur to obtain individual collateral protection, and (ii) the extent to which such costs may correspond to the implicit costs that customers may bear due to Fellow-Customer Risk.

The Commission also seeks comment on the assumptions underlying estimates of Risk Costs for the Complete Legal Segregation Model and the Physical Segregation Model.

• Specifically, is it plausible that an FCM might decline gradually over time rather than in a sudden event? If so, is it plausible that customers of such a declining FCM might transfer their cleared swaps and related collateral to another FCM?

• If the Commission were to permit a DCO to access collateral from non-defaulting cleared swaps customers to cure a default, would it be prudent, in light of answers to the foregoing questions, for the DCO to rely upon such collateral in calculating the financial resources package that it must hold? Why or why not, or to what extent? If not, or if only to a limited extent, how does that conclusion affect the Risk Costs for the Complete Legal Segregation Model (as well as the Physical Segregation Model)? Do DCOs account for potential differences between fellow customer collateral at the time of calculation and expected fellow-customer collateral at the time of default in their default resource calculations? If so, how?

In addition, as discussed above, a number of commenters on the ANPR suggested that consideration of the costs and benefits of all models should be informed by the protections for collateral obtained by customers in the existing swaps market and of the costs incurred for such protections.

The Commission invites additional comment on these subjects, including quantitative information. Specifically, the Commission invites the submission of additional information on the costs of each level of protection, as well as the submission of detailed quantitative information on the effects, if any, of the absence of Fellow-Customer Risk on guaranty fund levels, margin levels and other economic characteristics of the use of collateral in the cleared swaps market. Additionally, the Commission invites the submission of detailed quantitative information on the costs currently incurred to protect collateral in the cleared and uncleared swaps markets.

See

section II(C)(2)(c)(2) supra.

Finally, some commenters on the ANPR stated that swaps, including cleared swaps, have inherent characteristics that differentiate them from exchange-traded futures contracts and that affect the magnitude of the exposure that Cleared Swaps Customers have to Fellow-Customer Risk.

The Commission invites additional comment on the prevalence of such characteristics and their bearing on the costs and benefits of the proposed rule and potential alternatives.

See, e.g.,

note 38, supra.

C. Benefits

For additional discussion of benefits issues, with particular reference to the benefits of the proposed Complete Legal Segregation Model and the Legal Segregation with Recourse Model relative to the Futures Model, see the cost-benefit analysis at section VII(C) infra.

1. Rationale

a. Fellow-Customer Risk and Investment Risk

The Commission agrees with commenters that the Legal Segregation Model (whether Complete or with Recourse) and the Physical Segregation Model would mitigate Fellow-Customer Risk and Investment Risk to differing extents. With respect to Fellow-Customer Risk, the Commission believes that: (i) The Physical Segregation Model would eliminate Fellow-Customer Risk, albeit only to the extent permitted under the Bankruptcy Code;

(ii) the Complete Legal Segregation Model would largely mitigate Fellow-Customer Risk in FCM defaults of all magnitudes;

and (iii) the Legal Segregation with Recourse Model would

largely mitigate Fellow-Customer Risk

in all but the most extreme FCM defaults.

As discussed further below, section 766(h) of the Bankruptcy Code, 11 U.S.C. 766(h), requires that customer property be distributed “ratably to customers on the basis and to the extent of such customers' allowed net equity claims * * *.”

Because the DCO would allocate collateral between defaulting and non-defaulting cleared swaps customers based on information the FCM provided the day prior to default, such allocation would not reflect movement in the cleared swaps portfolio of such customers on the day of default.

Id.

The Commission agrees with commenters that the Physical Segregation Model would eliminate Investment Risk because the FCM and DCO would invest the collateral of one cleared swaps customer separately from the collateral of another such customer. Therefore, the FCM or DCO may attribute losses on such investments to one particular customer. The Commission believes that the Legal Segregation Model (whether Complete or with Recourse) and the Futures Model would not mitigate Investment Risk. Such models permit the FCM and DCO to hold the collateral of all cleared swaps customers in one account, and therefore neither the FCM nor the DCO would be able to attribute investments (and losses thereon) to one particular customer.

b. Portability

The Commission agrees with commenters that the Complete Legal Segregation Model and the Physical Segregation Model would enhance portability of the cleared swaps of non-defaulting customers in the event of an FCM default. The Commission notes that the Legal Segregation with Recourse Model would not likely facilitate portability to the same extent, because the DCO is unlikely to release the collateral of such non-defaulting customers until it has completed the process of liquidating the portfolio of the defaulting FCM and customers. Therefore, even if the DCO or trustee ports the cleared swaps of non-defaulting customers, such customers may need to post additional collateral at the non-defaulting FCM to support such swaps. Such customers may not be able to meet such increased capital demands, especially during a time of resource scarcity.

c. Systemic Risk

The Commission agrees with comments that the Complete Legal Segregation Model and the Physical Segregation Model would most mitigate systemic risk by enhancing portability of the cleared swaps of non-defaulting customers in the event that an FCM defaults. The Commission notes that certain international regulators also emphasize the importance of portability. For example, the Consultative Report on the Principles for Financial Market Infrastructures (the “CPSS-IOSCO Principles”)

issued by the Committee on Payment and Settlement Systems (“CPSS”) and the Technical Committee of the International Organization of Securities Commissions (“IOSCO,” and together “CPSS-IOSCO”) and the Proposal for a Regulation on OTC Derivatives, Central Counterparties and Trade Repositories by the European Parliament and Council (the “EU Proposal”)

highlight the importance of portability of cleared swaps customer contracts and related collateral. As stated in the CPSS-IOSCO Principles, the “[e]fficient and complete portability of customer positions and collateral is important in both pre-default and post-default scenarios, but is particularly critical when a participant defaults or is undergoing insolvency proceedings”.

The EU Proposal explains that segregation and portability are “critical to effectively reduc[ing] counterparty credit risk through the use of [central counterparties], to achiev[ing] a level playing field among European [central counterparties] and to protect the legitimate interests of clients of clearing members”.

See

CPSS-IOSCO, CPSS-IOSCO Principles (March 10, 2011), available at

http://www.bis.org/publ/cpss94.pdf.

See

European Commission, EU Proposal (Sept. 15, 2010), available at

http://ec.europa.eu/internal_market/financial-markets/docs/derivatives/20100915_proposal_en.pdf.

See

CPSS-IOSCO Principles at 69.

See

EU Proposal at 10 (Sept. 15, 2010).

d. Induced Changes in Behavior

See

section VII(C)(2) herein for a description of induced changes in behavior for DCOs if the Commission adopts either the Complete Legal Segregation or the Legal Segregation with Recourse Models.

The Commission agrees with commenters that argued that the better the protection that a model affords to the collateral of non-defaulting cleared swaps customers, the more likely customers would leave excess margin at an FCM. In contrast, the Commission does not find persuasive arguments that the Legal Segregation Model (especially Complete) and the Physical Segregation Model would cause changes in behavior, by (i) discouraging cleared swaps customers from creating market discipline by clearing through less risky firms,

or (ii) discouraging FCMs from maintaining substantial excess net capital to present a more attractive profile to customers.

See, e.g.,

CME at 4, ISDA Supplemental at 6.

See,

e.g.,

ISDA Supplemental at 6.

With respect to (i), cleared swaps customers generally cannot exert material market discipline because they lack information to accurately assess the risk of their FCMs. For example, certain commenters noted that cleared swaps customers cannot obtain information about the risk profile of fellow customers.

Buy-side commenters reinforced such observation by stating that they would not want fellow customers learning of their own risk profiles.

Even if FCMs were to disclose general policies regarding the risk profiles of customers that they accept, it is not clear how cleared swaps customers would learn about exceptions to the FCM policies that may be granted. Given the foregoing, the Commission is interested in whether FCM disclosures to cleared swaps customers could be improved. What measures could FCMs take to provide more comprehensive and useful disclosures regarding their proprietary risks and the risk profiles of their customers? For example, one commenter suggested that the Commission could require FCM disclosures to include the following:

E.g.,

ADM at 3, BlackRock at 5, CIEBA at 2, 4-6, FFCB at 4, FHLB at 1, MFA at 8, Tudor at 2.

E.g.,

BlackRock at 5, FHLB at 2.

• The FCM's total equity, regulatory capital and net worth;

• The dollar value of the FCM's proprietary margin requirements as a percentage of its segregated and secured customer margin requirements;

• What number of the FCM's customers comprise an agreed significant percentage of its customer segregated funds;

• The aggregate notional value of non-hedged, principal OTC transactions into which the FCM has entered;

• The amount, generic source and purpose of any unsecured and uncommitted short-term funding the FCM is using;

• The aggregate amount of financing the FCM provides for customer transactions involving illiquid financial products for which it is difficult to obtain timely and accurate prices;

• The percentage of defaulting assets (debits and deficits) the FCM had during the prior year compared to its year-end segregated and secured customer funds; and

• A summary of the FCM's current risk practices, controls and procedures.

See

NewEdge at 3 to 5.

The Commission requests comment as to whether it would make the FCM disclosure more useful to customers if such disclosure contained one or more of the elements above. Which elements would be most helpful to customers? What would be the cost to FCMs of generating such disclosures? What would be the costs and benefits to

customers of receiving and reviewing such disclosures?

With respect to (ii), the Commission notes that FCMs have claimed in recent net capital rulemakings that Commission capital requirements are sufficient.

If such capital requirements are sufficient, it would appear that excess net capital is not necessary.

See, e.g.,

Newedge Letter of June 8, 2009 at 2 (“increasing capital requirements does not necessarily ensure fiscal solvency.”),

id.

at 4 (increasing capital requirements would be anti-competitive). (Attachment B to the Newedge comment to this rulemaking).

See

section VII(C)(2)(c) infra for additional discussion of induced changes in behavior for DCOs, including effects on monitoring of FCM risk, if the Commission adopts either the Complete Legal Segregation or the Legal Segregation with Recourse Models.

e. Portfolio Margining.

See

section IV(A)(2) herein for a more detailed description of Commission orders under section 4d(f) of the CEA.

In response to concerns regarding the impact of models other than the Futures Model on portfolio margining,

the Commission believes that such impact would likely be positive. Specifically, a DCO could more easily justify to the Commission that issuing an order under section 4d(f) of the CEA (or approving rules permitting commingling pursuant to proposed regulation 39.15(b)(2))

is appropriate if the regulations under such section mitigate Fellow-Customer Risk, since the impact of any different risk from the product being brought into the portfolio would be limited to the customer who chooses to trade that product. This is in contrast to the Futures Model, where the risks that the product being brought into the portfolio affect customers who do not—and would not—trade that product.

See

SIFMA at 3-4, Investment Company Institute at 5-6, Futures Industry Association at 6.

See

Notice of Proposed Rulemaking on Risk Management Requirements for Derivatives Clearing Organizations, 76 FR 3698 (Jan. 20, 2011).

2. Questions

The Commission seeks comment on the above analysis of benefits accorded by each model, including whether there are any additional benefits that the Commission should consider. What benefits would be realized by, alternatively, adopting the Futures Model?

D. Proposing the Complete Legal Segregation Model: Weighing of Costs and Benefits

As mentioned above, commenters generally agreed that customers would bear the costs of implementing any model. Therefore, the Commission believes that it is appropriate to give weight to the preference of customers. The Commission finds it compelling that most (although not all) buy-side commenters to the ANPR favored a model other than the Futures Model. The Commission notes that models other than the Futures Model would provide more individualized protection to cleared swaps customer collateral in accordance with section 4d(f) of the CEA. Any such model may provide substantial benefits in the form of (i) decreased Fellow-Customer Risk (as well as Investment Risk, in certain circumstances), (ii) increased likelihood of portability, (iii) decreased systemic risk, and (iv) positive impact on portfolio margining. The Commission seeks additional comments, in particular from customers, as to whether and why, in light of this NPRM, they favor or oppose adoption of the Futures Model. The Commission anticipates that, to the extent it decides to adopt the Futures Model, the proposed rule text from proposed regulation 22.2 to proposed regulation 22.10 would implement such model. The Commission notes that changes to the language of proposed regulation 22.15 may be necessary. Specifically, proposed regulation 22.15 would need to include an additional section to the effect that a DCO may, if its rules so provide, use the Cleared Swaps Customer Collateral of all Cleared Swaps Customers of a Depositing Futures Commission Merchant that has defaulted on a payment to the DCO with respect to its Cleared Swaps Customer Account.

In choosing between the Legal Segregation Model (whether Complete or with Recourse) and the Physical Segregation Model, the Commission notes that the operational costs for the Physical Segregation Model are substantially higher than the operational costs for the Legal Segregation Model (whether Complete or with Recourse).

With respect to benefits, the Commission believes that the Physical Segregation Model provides only incremental advantages over the Legal Segregation Model (whether Complete or with Recourse) with respect to the mitigation of Fellow-Customer Risk. The Physical Segregation Model, unlike the Legal Segregation Model (whether Complete or with Recourse), does eliminate Investment Risk. However, the Commission notes that (i) it is in the process of further addressing Investment Risk by proposing amendments to regulation 1.25, and (ii) each FCM and DCO already values investments conservatively. Finally, the Commission observes that the Physical Segregation Model generally enhances portability to the same extent as the Complete Legal Segregation Model, and therefore would have similar effects on systemic risk. The Physical Segregation Model and the Legal Segregation Model (whether Complete or with Recourse) would likely enhance portfolio margining to the same extent.

Consequently, after weighing the potential costs and benefits of the Physical Segregation Model, the Commission has decided that this model does not provide the best balance, in that it provides similar benefits as the Legal Segregation Model (whether Complete or with Recourse), but costs more to implement. Hence, the Commission has determined not to propose the Physical Segregation Model.

In choosing between the Complete Legal Segregation Model and the Legal Segregation with Recourse Model, the Commission notes that commenters have argued that implementing the former would result in significant Risk Costs, whereas implementing the latter would result in no Risk Costs. As mentioned above, the Commission finds, at least initially, persuasive comments that question the assumptions underlying the estimates of Risk Costs for the Complete Legal Segregation Model. Nevertheless, the Commission recognizes that such assumptions form an area of divergence between commenters, and therefore asks for additional comment on the Risk Costs for the Complete Legal Segregation Model. The Commission observes that operational costs for the Complete Legal Segregation Model and the Legal Segregation with Recourse Model are approximately the same.

With respect to benefits, the Commission notes that the Complete Legal Segregation Model would mitigate Fellow-Customer Risk even in extreme FCM defaults, unlike the Legal Segregation with Recourse Model. Further, the Complete Legal Segregation Model would enhance portability (and therefore mitigate systemic risk) to a significantly greater extent than the Legal Segregation with Recourse Model. Finally, the Complete Legal Segregation Model would have an incremental advantage over the Legal Segregation with Recourse Model with respect to impact on portfolio margining.

Consequently, after weighing the potential costs and benefits, the Commission has determined that the Complete Legal Segregation Model provides the best balance, and therefore has determined to propose the Complete Legal Segregation Model. Nevertheless, because the Commission is still evaluating the costs associated with such model, as well as with the Legal

Segregation with Recourse Model, the Commission is also considering the Legal Segregation with Recourse Model.

See

generally section IV(O) below.

E. The Optional Approach

1. Rationale

As mentioned above, a number of commenters urged the Commission to propose the Optional Approach. The Commission has preliminarily declined to propose the Optional Approach because it may not be compatible with the Bankruptcy Code and regulation part 190 (“Part 190”). Specifically, if customer collateral cannot be transferred, section 766(h) of the Bankruptcy Code

requires that such collateral be distributed on a

pro rata

basis. In implementing this section of the Bankruptcy Code, the Commission has created in Part 190 the “account class” concept, which enables customer collateral to be separated into different categories for distribution depending on the type of customer (

i.e.,

futures customer, foreign futures customer, and cleared swaps customer) holding a claim. All customers belonging to one “account class” would share

pro rata

in the collateral attributed to that “account class.” Therefore, all cleared swaps customers would belong to one “account class,” and would share

pro rata

in the cleared swaps collateral remaining after their contracts are ported or liquidated. If, under the Optional Approach, certain cleared swaps customers had chosen a model that provided more individual collateral protection while others had not, the former would still share in any shortfalls in cleared swaps customer collateral resulting from the choices of the latter. The Commission notes that the “account class” concept, which has been tested and upheld in prior bankruptcy proceedings, has never permitted customers transacting in the same type of contracts, with two different segregation requirements, to be deemed participants in separate “account classes.”

11 U.S.C. 761(h).

The Commission created the “account class” concept in adopting original part 190.

See

46 FR 57535 (Nov. 24, 1981). The Commission noted that “the accounts held by a commodity broker would be divided into four types or classes: Futures accounts, foreign futures accounts, leverage accounts and commodity options accounts, which correspond to the four estates a commodity broker may have based upon the different types of transactions it handles for customers.”

Id.

at 57536. These classes corresponded to different definitions of “customer” found in section 761(9) of the Bankruptcy Code: With respect to a “futures commission merchant,” a “foreign futures commission merchant,” a “leverage transaction merchant,” and a “commodity options dealer.”

See

11 U.S.C. 761(9).

In making that proposal, the Commission cited to text in the House Report for the 1978 Bankruptcy Code concerning those definitions, which noted that:

It is anticipated that a debtor with multifaceted characteristics will have separate estates for each different kind of customer. Thus, a debtor that is a leverage transaction merchant and a commodity options dealer would have separate estates for the leverage transaction customers and for the options customers, and a general estate for other creditors.

See

H.R. Rep. 95-595 at 355, 1978 U.S.C.C.A.N. 5963, 6346.

In the release adopting part 190, the Commission added another “account class,” delivery accounts, for property related to the making or taking of physical delivery by a customer. Delivery accounts are not mentioned in section 761(9) of the Bankruptcy Code, but are, again, related to a “different kind of customer.”

See

48 FR 8716, 8731 (Mar. 1, 1983). Similarly, in April of 2010, the Commission added another “account class,” for cleared OTC transactions. Once again, this represented a “separate estate” for a “different kind of customer.”

See

75 FR 17297 (Apr. 6, 2010). Separating cleared swaps customers by the type of model the DCO adopts does not fit this tested rubric: The customers are all of the same “kind,” namely, all cleared swaps customers.

Moreover, as a number of commenters have noted, optional models may cause legal, regulatory, operational and other complexities.

See, e.g.,

ICE at 12, Investment Company Institute at 6, LCH at 7.

2. Questions

It may be possible for the Commission to resolve the incompatibility between (i) the Optional Approach and (ii) the Bankruptcy Code and Part 190, by permitting DCOs to require that FCMs establish separate legal entities, each of which is limited to clearing at DCOs that use only one of (A) the Complete Legal Segregation Model or (B) the Legal Segregation with Recourse Model. The Commission notes, however, that this approach might cause concerns with respect to open access and competition. The Commission seeks comment on the practicability of this approach.

• What costs (including implementation, operational, and capital) would such DCOs and FCMs incur?

• Would FCMs be willing to establish such separate legal entities? What systemic risk impacts might there be, if any?

• Would such an approach create benefits or burdens in other contexts?

• What would be the effect of this approach on competition and on opening FCM access to clearing organizations?

In addition, the Commission seeks comment on whether the Optional Approach should be expanded to add the Futures Model as an option. If so, what would be the impact on (1) costs, (2) the protection of Cleared Swaps Customer Collateral, and (3) the existence of effective choice by customers?

The Commission also seeks comment on whether to implement a model that permits DCOs to offer the Physical Segregation Model for cleared swaps customer collateral for some set of customers of their FCM members, with the remaining cleared swaps customer collateral staying in an omnibus account under the Futures Model. (Under this model, the customers in question would hold claims with respect to the collateral placed in physical segregation directly against the DCO rather than against the FCM through which the customers clear.)

See

comment from Jerrold Salzman, available at

http://comments.cftc.gov/PublicComments/ViewComment.aspx?id=42253&SearchText

= (discussing the legal segregation of certain customer accounts as a way to minimize fellow customer risk).

• How would such a model work in the ordinary course of business (

i.e.,

pre-FCM member default)? For example, how would an FCM and a DCO structure their respective cash flows to accommodate such model? To the extent that an FCM or DCO may structure their cash flows in different ways, what are the issues, costs, or risks of each way?

• What changes to proposed Part 22 and Part 190 should the Commission make to accommodate this model?

• Who (

e.g.,

the cleared swaps customer, FCM member, and DCO) would have what rights in cleared swaps customer collateral at every stage of clearing (including with respect to initial margin and variation payments and collections)?

• In the event of an FCM bankruptcy, would such cleared swaps customer collateral constitute “customer property” subject to ratable distribution pursuant to section 766(h) of the Bankruptcy Code?

○ To what extent would the answer to this question depend on the manner in which the FCM and the DCO structured their respective cash flows in the ordinary course of business?

○ To the extent cleared swaps customer collateral is removed from “customer property”:

■ What vulnerabilities might that raise for the protection of such collateral in an FCM or a DCO bankruptcy? For example, is there a risk that, in some circumstances, such property might be deemed to be part of a bankrupt FCM's or DCO's bankruptcy estate subject to the claims of creditors other than the relevant swaps customers?

■ What changes would need to be made to self-regulatory organization audit programs to ensure protection of

cleared swaps customer collateral pre-bankruptcy?

• Should such a model be an option elected by cleared swaps customers, or mandatory for defined “high-risk” customers?

○ By whom would the definition of “high-risk” be set?

○ What criteria should be included in the definition of “high risk”?

○ Would the definition of “high risk” vary by asset class?

• To the extent the model is optional by a cleared swaps customer, to what extent might there be a tendency for cleared swaps customers posing greater risk to remain in the omnibus pool? What policy concerns, if any, might be raised by the inclusion of a larger concentration of cleared swaps customers posing greater risk in the omnibus pool?

Please provide a detailed quantitative analysis of the costs and benefits of this model relative to other models that are being considered in this NPRM, and relative to the existing uncleared swaps market. Please specify how each cost and benefit would be ultimately allocated to, or borne by, cleared swaps customers, FCMs and DCOs. Specifically, how would this type of model affect operational costs and Risk Costs?

F. Structure of These Proposed Regulations

Proposed regulation part 22 (“Part 22”) establishes the basic architecture for protecting cleared swaps customer collateral through the promulgation of definitions and procedures for the segregation of cleared swaps pertaining to customers, as well as associated collateral. The Commission intends for proposed Part 22 to incorporate legal segregation, and to parallel, for the most part, the substance of corresponding provisions in part 1 to Title 17 (the “Part 1 Provisions”), in updated and clarified form, with respect to issues such as requirements for treatment of customer funds on a day-to-day basis, required amounts of collateral in customer accounts, and required qualifications for permitted depositories. While most of the proposed regulations in Part 22 will remain the same for the Complete Legal Segregation Model and the Legal Segregation with Recourse Model, proposed regulation 22.15 sets forth alternatives to take into account the fact that, under the Legal Segregation with Recourse Model, following an event of default a DCO would be able to access the collateral of non-defaulting cleared swaps customers after the DCO applied (i) its own capital to cure the default and (ii) the guaranty fund contributions of its non-defaulting FCM members.

The infrastructure supporting legal segregation is established in proposed regulations 22.11-22.16, including (i) the requirement that an FCM transmit to its DCO daily information regarding customers and their swaps, (ii) tools that the DCO may use to manage the risk it incurs with respect to individual customers, (iii) steps the FCM is required to take if it fails to meet a cleared swaps customer margin call in full, and (iv) an explicit requirement that cleared swaps customer collateral be treated on an individual basis. The Commission requests comment on whether Part 22 differs in substance from the Part 1 Provisions, other than in the specific instances described in this NPRM.

In addition, proposed revisions to Part 190 of the Commission's regulations generally implement changes wrought by the Dodd-Frank Act, including the inclusion of swaps cleared with a DCO as customer contracts for all commodity brokers, the inclusion of swaps execution facilities as a category of trading venue, and additional conforming changes to time periods. Additional proposed changes have been made to conform Part 190 to current market practices (

e.g.,

providing for auctions of swaps portfolios in the event of a commodity broker insolvency).

IV. Section by Section Analysis: Segregation of Cleared Swaps for Customers

A. Proposed Regulation 22.1: Definitions

Proposed regulation 22.1 establishes definitions for,

inter alia,

the following terms: “cleared swap,” “cleared swaps customer,” “cleared swaps customer account,” “cleared swaps customer collateral,” “cleared swaps proprietary account,” “clearing member,”

“collecting futures commission merchant,” “commingle,” “customer,” “depositing futures commission merchant,” “permitted depository,”

and “segregate.”

Under the Commission's proposal, the term “clearing member” means “any person that has clearing privileges such that it can process, clear and settle trades through a derivatives clearing organization on behalf of itself or others. The derivatives clearing organization need not be organized as a membership organization.”

The Commission is proposing to define “permitted depository” as a depository that meets the following conditions:

(a) The depository must (subject to proposed regulation 22.9) be one of the following types of entities:

(1) A bank located in the United States;

(2) a trust company located in the United States;

(3) a Collecting Futures Commission Merchant registered with the Commission (but only with respect to a Depositing Futures Commission Merchant providing Cleared Swaps Customer Collateral); or

(4) a derivatives clearing organization registered with the Commission; and

(b) the FCM or the DCO must hold a written acknowledgment letter from the depository as required by proposed regulation 22.5.

See

also the discussion under section IV(D).

1. “Segregate” and “Commingle”

The Commission has never defined the terms “segregate” and “commingle,” although the Part 1 Provisions make extensive use of these terms. Regulation 22.1 proposes definitions for these terms that are intended to codify the common meaning of such terms under the Part 1 Provisions. Pursuant to the proposal, to “segregate” two or more items means to keep them in separate accounts and to avoid combining them in the same transfer between accounts. In contrast, to “commingle” two or more items means to hold them in the same account, or to combine such items in a transfer between accounts. For purposes of these definitions, to keep items in separate accounts means: (i) To hold tangible items

physically separate within one's own organization; (ii) to deposit tangible or intangible items

with a Permitted Depository (as discussed further below) in separate accounts; and (iii) to reflect tangible or intangible items in separate entries in books and records. To hold items in the same account means exactly the opposite—namely, (i) to hold tangible items physically together within one's own organization; (ii) to deposit tangible or intangible items with a Permitted Depository in the same account; and (iii) to reflect tangible or intangible items in the same entries in books and records.

Tangible items may include,

e.g.,

gold ingots or warehouse receipts, as discussed further below.

Intangible items may include,

e.g.,

wire transfers or dematerialized securities, as discussed further below.

2. “Cleared Swap”

The term “Cleared Swap” has no analog in the Part 1 Provisions. Regulation 22.1 proposes a definition that incorporates section 1a(7) of the CEA,

as added by section 721 of the Dodd-Frank Act. This definition then excludes, for purposes of Part 22 only, cleared swaps (and related collateral) that, pursuant to Commission order under section 4d(a) of the CEA,

are

commingled with futures contracts (and related collateral) in an account established for the futures contracts. The definition conversely includes, for purposes of Part 22 only, futures contracts or foreign futures contracts (and, in each case, related collateral) that, pursuant to Commission order under section 4d(f) of the CEA,

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are commingled with cleared swaps (and related collateral) in an account established for the cleared swaps. The rationale for such exclusion and inclusion is that, under Commission precedent,

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once cleared swaps (and related collateral) are commingled with futures contracts (and related collateral) in a futures account, the Part 1 Provisions and the Bankruptcy Rules would apply to the cleared swaps (and related collateral) as if such swaps constituted futures contracts (and related collateral). Similarly, once futures contracts or foreign futures contracts (and, in each case, related collateral) are commingled with cleared swaps (and related collateral) in a cleared swaps account, the proposed definition of “Cleared Swap” would apply Part 22 and the Bankruptcy Rules to the former contracts as if they constituted cleared swaps (and related collateral). Therefore, the proposed definition of “Cleared Swap,” with such exclusion and inclusion, simply extends Commission precedent.

7 U.S.C. 1a(7). The Commission is working on regulations, along with the Securities and Exchange Commission, that would further define certain key terms of the Dodd-Frank Act, including “swaps.”

See Definitions Contained in Title VII of Dodd-Frank Wall Street Reform and Consumer Protection Act,

75 FR 51429 (Aug. 20, 2010). Such regulations, when finalized, would automatically be incorporated in the definition of “cleared swap” cited herein.

7 U.S.C. 6d(a).

100

7 U.S.C. 6d(f).

101

For example, current regulation 190.01(a) states: “* * * if positions in commodity contracts that would otherwise belong to one account class (and the money, securities, and/or other property margining, guaranteeing, or securing such positions), are, pursuant to a Commission order, commingled with positions in commodity contracts of the futures account class (and the money, securities, and/or other property margining, guaranteeing, or securing such positions), then the former positions (and the relevant money, securities, and/or other property) shall be treated, for purposes of this part, as being held in an account of the futures account class.” 17 CFR 190.01(a). In the notice proposing current regulation 190.01(a), 74 FR 40794 (Aug. 13, 2009), the Commission stated that the regulation codified two previous interpretative statements: (i) The Interpretative Statement Regarding Funds Related to Cleared-Only Contracts Determined To Be Included in a Customer's Net Equity, 73 FR 65514 (Nov. 4, 2008); and (ii) the Interpretative Statement Regarding Funds Determined to be Held in the Futures Account Type of Customer Account Class, 69 FR 69510 (Nov. 30, 2004).

3. “Cleared Swaps Customer” and “Customer”

Regulation 22.1 proposes a definition of “Cleared Swaps Customer” that has two elements. First, an entity holding a Cleared Swaps Proprietary Account (as discussed further below) is not a “Cleared Swaps Customer” with respect to the Cleared Swaps (and related collateral) in that account. Such exclusion is consistent with regulation 1.3,

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which defines “customer” and “commodity customer” for futures contracts. Second, an entity is only a “Cleared Swaps Customer” with respect to its Cleared Swaps (and related collateral). Additionally, the same entity may be a “customer” or “commodity customer” (as regulation 1.3 defines such terms) with respect to its futures contracts, and a “foreign futures or foreign options customer” (as regulation 30.1(c)

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defines such term) with respect to its foreign futures contracts.

104

Because certain provisions of Part 22 distinguish the status of such entity (i) as a “Cleared Swaps Customer” and (ii) as a “customer” or “commodity customer” or “foreign futures or options customer,” regulation 22.1 proposes a definition for “Customer” that includes any customer of an FCM other than a “Cleared Swaps Customer.”

102

17 CFR 1.3.

103

17 CFR 30.1(c).

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The contracts (and related collateral) of such entity would be subject to three different segregation regimes. Specifically, the entity would be entitled to the protections of (i) the Corresponding Provisions with respect to its futures contracts (and related collateral), (ii) regulation 30.7 with respect to its foreign futures contracts (and related collateral), and (iii) Part 22 with respect to its Cleared Swaps (and related collateral).

4. “Cleared Swaps Customer Collateral”

Regulation 22.1 proposes to define “Cleared Swaps Customer Collateral” to include money, securities, or other property that an FCM or a DCO receives, from, for, or on behalf of a Cleared Swaps Customer, which (i) is intended to or does margin, guarantee, or secure a Cleared Swap,

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or (ii) if the Cleared Swap is in the form or nature of an option, constitutes the settlement value of such option. Additionally, regulation 22.1 proposes to define “Cleared Swaps Customer Collateral” to include “accruals,” which are the money, securities, or other property that an FCM or DCO receives, either directly or indirectly, as incident to or resulting from a Cleared Swap that the FCM intermediates for a Cleared Swaps Customer.

106

105

Proposed regulation 22.1 provides that “Cleared Swaps Customer Collateral” includes collateral that an FCM or a DCO receives from, for, or on behalf of a Cleared Swaps Customer that either (i) is actually margining, guaranteeing, or securing a Cleared Swap or (ii) is intended to margin, guarantee, or secure a Cleared Swap. This provision is a clarification of “customer funds” as defined in regulation 1.3, which includes “all money, securities, and property received by a futures commission merchant or by a clearing organization from, for, or on behalf of, customers or option customers * * * to margin, guarantee, or secure futures contracts.”

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The Commission does not intend to include in Part 22 a parallel to regulation 1.21, given that (i) regulation 22.1 proposes to broadly include “accruals” in the definition of “Cleared Swaps Customer Collateral” and (ii) regulation 22.2(c) proposes to permit an FCM to commingle the “Cleared Swaps Customer Collateral” of multiple “Cleared Swaps Customers.”

Regulation 1.21 states: “All money received directly or indirectly by, and all money and equities accruing to, a futures commission merchant from any clearing organization or from any clearing member or from any member of a contract market incident to or resulting from any trade, contract or commodity option made by or through such futures commission merchant on behalf of any commodity or option customer shall be considered as accruing to such commodity or option customer within the meaning of the Act and these regulations. Such money and equities shall be treated and dealt with as belonging to such commodity or option customer in accordance with the provisions of the Act and these regulations. Money and equities accruing in connection with commodity or option customers' open trades, contracts, or commodity options need not be separately credited to individual accounts but may be treated and dealt with as belonging undivided to all commodity or option customers having open trades, contracts, or commodity option positions which if closed would result in a credit to such commodity or option customers.” 17 CFR 1.21.

The Commission requests comment on whether it should include in Part 22 a parallel to regulation 1.21.

In general, the proposed definition parallels regulation 1.3,

107

which defines “customer funds” for futures contracts. However, the proposed definition differs from regulation 1.3 in three instances.

108

First, the proposed definition explicitly includes a Cleared Swap in the form or nature of an option as “Cleared Swaps Customer Collateral.” The Commission believes that such change appropriately clarifies that a Cleared Swap functioning as an option, but not labeled as one, falls within the scope of the proposed definition. Second, the proposed definition does not explicitly include option premiums as “Cleared Swaps Customer Collateral.” The Commission believes that such amounts are already incorporated in the settlement value of the option, and that listing such amounts separately may cause unnecessary confusion. Third, the proposed definition explicitly includes in “accruals” the money, securities, or other property that a DCO may receive relating to the Cleared Swap that an FCM intermediates for a Cleared Swap Customer. The Commission believes that such inclusion is appropriate since proposed regulation 22.3 permits a DCO to invest the “Cleared Swaps Customer Collateral” that it receives from the FCM in accordance with regulation 1.25.

109

Therefore, any increases in value

resulting from the investment would properly belong to the Cleared Swaps Customer, and would constitute another form of “Cleared Swaps Customer Collateral.”

107

17 CFR 1.3.

108

In addition to these three instances, the proposed definition does not incorporate certain parallels to regulation 1.3 (exclusion from “customer funds” of collateral to secure security futures products in a securities account) because such parallels are not applicable to the context of Cleared Swaps (and related collateral).

109

17 CFR 1.25.

5. “Cleared Swaps Customer Account” and “Cleared Swaps Proprietary Account”

Regulation 22.1 proposes to define “Cleared Swaps Customer Account” as (i) an account that an FCM maintains at a Permitted Depository (as such term is discussed below) for the Cleared Swaps (and related collateral) of its Cleared Swaps Customers, or (ii) an account that a DCO maintains at a Permitted Depository, for collateral related to Cleared Swaps that the FCM members intermediate for their Cleared Swaps Customers. The proposed definition does not include any physical locations in which an FCM or a DCO may itself hold tangible Cleared Swaps Customer Collateral. As described below, regulations 22.2 and 22.3 propose to define such physical locations as the “FCM Physical Location” and the “DCO Physical Location,” respectively. The proposed definition is consistent with regulation 1.3,

110

which defines “futures account.” However, the proposed definition provides greater specificity than regulation 1.3 regarding (i) the entities maintaining the “Cleared Swaps Customer Account” (

i.e.,

the FCM or DCO) and (ii) the Permitted Depositories for a “Cleared Swaps Customer Account.”

110

17 CFR 1.3.

Regulation 22.1 proposes a definition for “Cleared Swaps Proprietary Account” that is substantially similar to regulation 1.3, which defines “Proprietary Account” for futures contracts.

111

The proposed definition contains a proviso, in paragraph (b)(8), that states “an account owned by any shareholder or member of a cooperative association of producers, within the meaning of section 6a of the Act, which association is registered as an FCM and carries such account on its records, shall be deemed to be a Cleared Swaps Customer Account and not a Cleared Swaps Proprietary Account of such association, unless the shareholder or member is an officer, director, or manager of the association.” This proviso parallels paragraph viii in the definition of “Proprietary Account” in regulation 1.3. The Commission requests comment on whether this proviso remains relevant, and, in particular, with respect to Cleared Swaps.

111

Id.

6. “Collecting Futures Commission Merchant” and “Depositing Futures Commission Merchant”

The terms “Collecting Futures Commission Merchant” and “Depositing Futures Commission Merchant” have no analogs in the Part 1 Provisions. Regulation 22.1 proposes to define a “Collecting Futures Commission Merchant” as one that carries Cleared Swaps on behalf of another FCM and the Cleared Swaps Customers of that other FCM and, as part of doing so, collects Cleared Swaps Customer Collateral. In contrast, regulation 22.1 proposes to define a “Depositing Futures Commission Merchant” as one that carries Cleared Swaps on behalf of its Cleared Swaps Customers through a Collecting Futures Commission Merchant, and, as part of doing so, deposits Cleared Swaps Customer Collateral with such Collecting Futures Commission Merchant. Regulation 22.7, as described below, proposes to employ the terms “Collecting Futures Commission Merchant” and “Depositing Futures Commission Merchant” to delineate the circumstances in which one FCM may serve as a Permitted Depository to another.

B. Proposed Regulation 22.2—Futures Commission Merchants: Treatment of Cleared Swaps Customer Collateral

Regulation 22.2 proposes requirements for an FCM's treatment of Cleared Swaps Customer Collateral, as well as the associated Cleared Swaps.

1. In General

Regulation 22.2(a) proposes to require an FCM to treat and deal with the Cleared Swaps of Cleared Swaps Customers, as well as associated Cleared Swaps Customer Collateral, as belonging to the Cleared Swaps Customers. In other words, the FCM may not use Cleared Swaps Customer Collateral to cover or support (i) its own obligations or (ii) the obligations of Customers (

e.g.,

entities transacting in futures or equities contracts). Such proposal parallels regulations 1.20(a) and 1.26(a), which apply to “customer funds,” and obligations purchased with customer funds, for futures contracts.

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Regulation 1.20(a) states: “Under no circumstances shall any portion of customer funds be obligated to a clearing organization, any member of a contract market, a futures commission merchant, or any depository except to purchase, margin, guarantee, secure, transfer, adjust or settle trades, contracts or commodity option transactions of commodity or option customers.” 17 CFR 1.20(a).

2. Location of Collateral

Regulation 22.2(b) proposes to require that an FCM segregate all Cleared Swaps Customer Collateral that it receives. Such proposal parallels regulations 1.20(a) and 1.26(a).

113

Additionally, regulation 22.2(b) proposes to require that an FCM adopt one of two methods to hold segregated Cleared Swaps Customer Collateral, which parallel either implicit assumptions or explicit provisions of regulation 1.20(a).

113

Regulation 1.20(a) states: “All customer funds shall be separately accounted for and segregated as belonging to commodity or option customers.”

Id.

Regulation 1.26(a) states: “Each futures commission merchant who invests customer funds in instruments described in Sec. 1.25 shall separately account for such instruments and segregate such instruments as belonging to such commodity or option customers.” 17 CFR 1.26.

a. The First Method

Paralleling an implicit assumption of regulations 1.20(a) and 1.26(a), the first method permits the FCM to hold Cleared Swaps Customer Collateral itself.

114

Continuing such parallel, the first method limits the FCM to holding tangible collateral (

e.g.,

gold ingots or warehouse receipts) because no FCM currently serves as a depository registered with domestic or foreign banking regulators, and because of uncertainty regarding the effectiveness of such segregation if an FCM that was so registered held intangible collateral in its own accounts. Finally, the first method requires the FCM, in holding such Cleared Swaps Customer Collateral, to:

114

Regulation 1.20(a) does not require that an FCM hold “customer funds” in a depository. Rather, it applies certain requirements to the holding of “customer funds

when

deposited with any bank, trust company, clearing organization or another futures commission merchant * * *” (emphasis added). In the absence of a requirement to use a depository, regulation 1.20(a) must implicitly permit the FCM to hold “customer funds” itself.

Id.

Regulation 1.26(a) contains similar language regarding the use of a depository.

Id.

• Physically separate the collateral from FCM property (

e.g.,

in a box or vault);

• Clearly identify each physical location (an “FCM Physical Location”) in which it holds such collateral as a “Location of Cleared Swaps Customer Collateral” (

e.g.,

by affixing a label or sign to the box or vault);

• Ensure that the FCM Physical Location provides appropriate protection for such collateral (

e.g.,

by confirming that the box or vault has locks and is fire resistant); and

• Record in its books and records the amount of such collateral separately from FCM funds (

i.e.,

to reflect the reality of physical separation in books and records).

b. The Second Method

Paralleling an explicit provision of regulations 1.20(a) and 1.26(a),

115

the second method permits the FCM to hold Cleared Swaps Customer Collateral outside of itself,

i.e.,

at a depository.

116

Continuing that parallel, the second method limits the FCM to certain Permitted Depositories (as further discussed below), and requires that the FCM deposit such collateral in a Cleared Swaps Customer Account.

115

Regulation 1.20(a) states: “All customer funds shall be separately accounted for and segregated as belonging to commodity or option customers. Such customer funds when deposited with any bank, trust company, clearing organization or another futures commission merchant shall be deposited under an account name which clearly identifies them as such and shows that they are segregated as required by the Act and this part.”

Id.

Regulation 1.26(a) contains similar language.

Id.

116

If an FCM chooses to accept intangible Cleared Swaps Customer Collateral, then the proposal effectively requires the FCM to maintain such collateral outside of itself. If the FCM accepts tangible Cleared Swaps Customer Collateral (

e.g.,

a gold ingot) and transfers such collateral to a depository (

e.g.,

a DCO), the FCM will be considered to be depositing such collateral rather than maintaining the collateral itself.

3. Commingling

Regulation 22.2(c) proposes to permit an FCM to commingle the Cleared Swaps Customer Collateral of multiple Cleared Swaps Customers, while prohibiting the FCM from commingling Cleared Swaps Customer Collateral with:

• FCM property, except as permitted under proposed regulation 22.2(e) (as discussed below); or

• “Customer funds” for futures contracts (as regulation 1.3 defines such term) or the “foreign futures or foreign options secured amount” (as regulation 1.3 defines such term), except as permitted by a Commission rule, regulation or order (or a derivatives clearing organization rule approved pursuant to regulation 39.15(b)(2)).

117

As the discussion on the proposed definition of “Cleared Swaps” highlights, if the Commission adopts a rule or regulation or issues an order pursuant to section 4d(a) of the CEA, or if the Commission approves DCO rules pursuant to proposed regulation 39.15(b)(2) permitting such commingling, the Commission would apply the Corresponding Provisions and Part 190 to the Cleared Swap (and related collateral) as if the swap constituted a futures contract (and related collateral).

In contrast, if the Commission adopts a rule or regulation or issues an order pursuant to section 4d(f) of the CEA, or if the Commission approves DCO rules pursuant to proposed regulation 39.15(b)(2) permitting such commingling, the proposed definition of “Cleared Swap” would operate to apply Part 22 and Part 190 to (i) the futures contract (and related collateral) or (ii) the foreign futures contract (and related collateral) as if such contracts constituted Cleared Swaps (and related collateral).

Proposed regulation 22.2(c) parallels regulations 1.20(a), 1.20(c), and 1.26(a).

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Regulations 1.20(a) and 1.26(a) implicitly (i) permit the FCM to commingle “customer funds” from multiple futures customers and (ii) prohibit the FCM from commingling “customer funds” with either FCM funds or funds supporting customer transactions in non-futures contracts. Specifically, regulation 1.20(a) states: “All customer funds shall be separately accounted for and segregated as belonging to commodity or option customers.” Similarly, regulation 1.26(a) states: “Each futures commission merchant who invests customer funds in instruments described in Sec. 1.25 shall separately account for such instruments and segregate such instruments as belonging to such commodity or option customers.” 17 CFR 1.20(a) and 1.26(a).

Regulation 1.20(c), in contrast, first explicitly prohibits an FCM from commingling the “customer funds” of one futures customer with (i) “customer funds” of another futures customer, (ii) funds supporting customer transactions in non-futures contracts (

e.g.,

the “foreign futures and options secured amount,” as defined in regulation 1.3), and (iii) FCM funds. Specifically, regulation 1.20(c) states: “Each futures commission merchant shall treat and deal with the customer funds of a commodity customer or of an option customer as belonging to such commodity or option customer. All customer funds shall be separately accounted for, and shall not be commingled with the money, securities, or property of a futures commission merchant or of any other person. * * *” Notwithstanding the foregoing, however, regulation 1.20(c) then permits an FCM to commingle “customer funds” of multiple futures customers for convenience. Specifically, regulation 1.20(c) contains the following proviso: “

Provided, however,

that customer funds treated as belonging to the commodity or option customers of a futures commission merchant may for convenience be commingled and deposited in the same account or accounts with any bank or trust company, with another person registered as a futures commission merchant, or with a clearing organization. * * *” Regulation 1.20(c) does not contain a similar exception for (i) funds supporting customer transactions in non-futures contracts or (ii) FCM funds. 17 CFR 1.20(c).

4. Limitations on Use

Regulation 22.2(d) proposes certain limitations on the use that an FCM may make of Cleared Swaps Customer Collateral. First, regulation 22.2(d)(1) proposes to prohibit an FCM from using, or permitting the use of, the Cleared Swaps Customer Collateral or one Cleared Swaps Customer to purchase, margin, or settle the Cleared Swaps, or any other transaction, of a person other than the Cleared Swaps Customer. Such proposal parallels regulation 1.20(c) and 1.22.

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Second, regulation 22.2(d)(2) proposes to prohibit an FCM from using Cleared Swaps Customer Collateral to margin, guarantee, or secure the non-Cleared Swap contracts (

e.g.,

futures or foreign futures contracts) of the entity constituting the Cleared Swaps Customer.

120

Such proposal parallels regulation 1.22.

121

119

Regulation 1.20(c) states: “All customer funds shall be separately accounted for, and shall not * * * be used to secure or guarantee the trades, contracts or commodity options, or to secure or extend the credit, of any person other than the one for whom the same are held.”

Id.

Regulation 1.22 states: “No futures commission merchant shall use, or permit the use of, the customer funds of one commodity and/or option customer to purchase, margin, or settle the trades, contracts, or commodity options of, or to secure or extend the credit of, any person other than such customer or option customer.” 17 CFR 1.22.

120

As mentioned above, an entity may simultaneously transact (i) futures contracts, (ii) foreign futures contracts, and (iii) Cleared Swaps. Such entity would constitute a Cleared Swaps Customer only with respect to its Cleared Swaps.

121

Regulation 1.22 further states: “Customer funds shall not be used to carry trades or positions of the same commodity and/or option customer other than in commodities or commodity options traded through the facilities of a contract market.” 17 CFR 1.22.

Regulation 22.2(d)(2) proposes to prohibit an FCM from imposing, or permitting the imposition of, a lien on Cleared Swaps Customer Collateral, including on any FCM residual financial interest therein (as regulation 22.2(e)(3) discusses further). The Commission believes that such a prohibition, in the event that an FCM becomes insolvent, would preempt the claim of an FCM creditor against any portion of the Cleared Swaps Customer Collateral, and would thereby prevent the FCM creditor from interfering with the porting of such collateral to a solvent FCM.

Regulation 22.2(d)(3) proposes to prohibit an FCM from claiming that any of the following constitutes Cleared Swaps Customer Collateral:

• Money invested in the securities, memberships, or obligations of any DCO, DCM, SEF, or SDR; or

• Money, securities, or other property that any DCO holds and may use for a purpose other than to margin, guarantee, secure, transfer, adjust or settle the obligations incurred by the FCM on behalf of its Cleared Swaps Customers.

Such proposal parallels regulation 1.24.

122

Regulation 1.24 states: “Money held in a segregated account by a futures commission merchant shall not include: (a) Money invested in obligations or stocks of any clearing organization or in memberships in or obligations of any contract market; or (b) money held by any clearing organization which it may use for any purpose other than to purchase, margin, guarantee, secure, transfer, adjust, or settle the contracts, trades, or commodity options of the commodity or option customers of such futures commission merchant.” 17 CFR 1.24.

5. Exceptions

Regulation 22.2(e) proposes certain exceptions to the abovementioned requirements and limitations.

a. Permitted Investments

Proposed regulation 22.2(e)(1) constitutes an exception to regulation 22.2(d) (Limitations on Use). Regulation 22.2(e)(1) proposes to allow an FCM to

invest Cleared Swaps Customer Collateral in accordance with regulation 1.25, as such regulation may be amended from time to time. Regulation 1.25 delineates permitted investments of “customer funds” (as regulation 1.3 defines such term) for futures contracts.

123

One commenter, Federated Investors, Inc. (Freeman and Hawke), argues that limitations on the investment of customer collateral in money market mutual funds are inappropriate for futures, and even more inappropriate for swaps. As mentioned above, the Commission has proposed amendments to regulation 1.25.

See Investment of Customer Funds and Funds Held in an Account for Foreign Futures and Foreign Options Transactions,

75 FR 67642 (Nov. 3, 2010). With respect to limitations on investment of cleared swaps customer collateral, the Dodd-Frank Act provides, in newly-enacted section 4d(f)(4) of the CEA, that such collateral

* * * may be invested in obligations of the United States, in general obligations of any State or of any political subdivision of a State, and in obligations fully guaranteed as to principal and interest by the United States, or in any other investment that the Commission may by rule or regulation prescribe * * *.

Thus, with the exception of the specified government obligations, Congress chose not to mandate any specific acceptable customer investments. In exercising the power granted under section 4d(f)(4) to expand the universe of acceptable customer investments, the Commission is seeking the same goals as in regulation 1.25—namely, preserving principal and maintaining liquidity.

See

75 FR at 67646. Accordingly, the Commission is proposing to incorporate the provisions of regulation 1.25 (as amended from time to time) by reference.

By allowing certain investments of Cleared Swaps Customer Collateral, proposed regulation 22.2(e)(1) parallels regulation 1.20(c).

124

Regulation 1.20(c) states: “* * * customer funds may be invested in instruments described in Sec. 1.25.” 17 CFR 1.20(c).

b. Permitted Withdrawals

Proposed regulation 22.2(e)(2) permits an FCM to withdraw Cleared Swaps Customer Collateral for such purposes as meeting margin calls at a DCO or a Collecting FCM, or to meet charges lawfully accruing in connection with a cleared swap, such as brokerage or storage charges. Regulation 22.2(e)(2) parallels regulation 1.20(c) and implements section 4d(f)(3)(A)(ii).

c. Deposits of Own Money, Securities, or Other Property

Proposed regulation 22.2(e)(3) constitutes an exception to regulations 22.2(b) (Location of Cleared Swaps Customer Collateral) and (c) (Commingling). Regulation 22.2(e)(3) proposes to permit an FCM: (i) To place its own property in an FCM Physical Location or (ii) to deposit its own property in a Cleared Swaps Customer Account.

125

As further explained below, proposed regulation 22.2(f) (Requirements as to Amount) mandates an FCM to use its own capital to cover the negative account balance of any Cleared Swaps Customer. To avoid the possibility of a deficiency,

126

an FCM may choose to place or deposit, in advance, its own property in an FCM Physical Location or a Cleared Swaps Customer Account, as applicable. By permitting such placement or deposit, proposed regulation 22.2(e)(3) parallels regulation 1.23.

127

125

Regulation 22.2(e)(3) proposes to permit an FCM to deposit only those securities that are unencumbered and are of the types specified in regulation 1.25. Such proposal accords with regulation 1.23.

See

infra note 127. The Commission notes, however, that this proposal does not, and is not meant to, require a DCO to accept all of the types of securities or other property specified in regulation 1.25.

126

See

regulation 1.12(h) (requiring an FCM that learns of a deficiency in segregated funds to notify the Commission and the FCM's designated self-regulatory organization of that deficiency).

127

Regulation 1.23 states: “The provision in section 4d(a)(2) of the Act and the provision in § 1.20(c), which prohibit the commingling of customer funds with the funds of a futures commission merchant, shall not be * * * construed to prevent a futures commission merchant from adding to such segregated customer funds such amount or amounts of money, from its own funds or unencumbered securities from its own inventory, of the type set forth in § 1.25, as it may deem necessary to ensure any and all commodity or option customers' accounts from becoming under segregated at any time.” 17 CFR 1.23.

d. Residual Financial Interest

Proposed regulation 22.2(e)(4) clarifies that, if an FCM places or deposits its own property in an FCM Physical Location or a Cleared Swaps Customer Account, as applicable, then that property becomes Cleared Swaps Customer Collateral. This regulation would permit an FCM to retain a residual financial interest in property in excess of that necessary to comport with proposed regulation 22.2(f) (Requirements as to Amount). It allows the FCM to make withdrawals from the FCM Physical Location or the Cleared Swaps Customer Account, as applicable, so long as the FCM first ascertains that such withdrawals do not surpass its residual financial interest. In general, proposed regulation 22.2(e)(4) parallels regulation 1.23.

128

Regulation 1.23 states, in addition to the text in note 127 supra: “The provision in section 4d(a)(2) of the Act and the provision in § 1.20(c), which prohibit the commingling of customer funds with the funds of a futures commission merchant, shall not be construed to prevent a futures commission merchant from having a residual financial interest in the customer funds, segregated as required by the Act and the rules in this part and set apart for the benefit of commodity or option customers * * * The books and records of a futures commission merchant shall at all times accurately reflect its interest in the segregated funds. A futures commission merchant may draw upon such segregated funds to its own order, to the extent of its actual interest therein, including the withdrawal of securities held in segregated safekeeping accounts held by a bank, trust company, contract market, clearing organization or other futures commission merchant. Such withdrawal shall not result in the funds of one commodity and/or option customer being used to purchase, margin or carry the trades, contracts or commodity options, or extend the credit of any other commodity customer, option customer or other customer.”

Id.

e. Requirements as to Amount

i. Background

Proposed regulation 22.2(f) sets forth an explicit calculation for the value of Cleared Swaps Customer Collateral that each FCM must hold, which parallels the implicit calculation in the Part 1 Provisions. The Part 1 Provisions clearly require an FCM to segregate “customer funds” (as regulation 1.3 defines such term) for futures contracts.

129

However, the Part 1 Provisions also consider “customer funds” to be fungible. Specifically, because the Part 1 Provisions permit FCM commingling of “customer funds” from multiple futures customers

130

and FCM investment of such funds,

131

the Part 1 Provisions implicitly allow an FCM to meet its obligations without maintaining the exact property that each futures customer conveys. The Part 1 Provisions do require an FCM to maintain, at a minimum, an overall amount of “customer funds” in segregation.

132

Nevertheless, the Part 1 Provisions do not set forth an explicit calculation for such amount. Instead, the Part 1 Provisions imply that an FCM must maintain an amount in segregation that would prevent the FCM from using the “customer funds” of one futures customer to “secure or guarantee the trades, contracts or commodity options, or to secure or extend the credit of any person other than the one for whom the same are held.”

133

Form 1-FR-FCM builds upon this implicit calculation.

129

See

regulations 1.20(a) and (c) and 1.26(a).

130

See

regulation 1.20(c).

131

See

regulations 1.20(c) and 1.25.

132

Regulation 1.32 states: “Each futures commission merchant must compute as of the close of each business day, on a currency-by-currency basis * * * (2) the amount of such customer funds required by the Act and these regulations to be on deposit in segregated accounts on behalf of such commodity and option customers. * * *” 17 CFR 1.32.

133

Regulation 1.20.

ii. Proposed Requirement

Consistent with the intention of the Commission to incorporate updated and clarified versions of the Part 1 Provisions in Part 22, the Commission proposes an explicit calculation for the amount of Cleared Swaps Customer Collateral that an FCM must maintain in segregation. As such this calculation is intended only to make explicit what the Part 1 Provisions left implicit, the

calculation does not materially differ in the Form 1-FR-FCM from the calculation for “customer funds” of futures customers.

First, regulation 22.2(f) proposes to define “account” to reference FCM's books and records pertaining to the Cleared Swaps Customer Collateral of a particular Cleared Swaps Customer.

Second, regulation 22.2(f) proposes to require an FCM to reflect in its account for each Cleared Swaps Customer the market value of any Cleared Swaps Collateral that it receives from such customer, as adjusted for:

• Any uses that proposed regulation 22.2(d) permits;

• Any accruals or losses on investments permitted by proposed regulation 22.2(e) that, pursuant to the applicable FCM customer agreement, are creditable or chargeable to such Cleared Swaps Customer;

• Any charges lawfully accruing to the Cleared Swaps Customer, including any commission, brokerage fee, interest, tax, or storage fee; and

• Any appropriately authorized distribution or transfer of the Cleared Swaps Collateral.

Third, regulation 22.2(f) proposes to categorize accounts of Cleared Swaps Customers as having credit or debit balances. Accounts where the market value of Cleared Swaps Customer Collateral is positive after adjustments have credit balances. Conversely, accounts where the market value of Cleared Swaps Customer Collateral is negative after adjustments have debit balances.

Fourth, regulation 22.2(f) proposes to require an FCM to maintain in segregation, in its FCM Physical Location and/or its Cleared Swaps Customer Accounts at Permitted Depositories, an amount equal to the sum of any credit balances that Cleared Swaps Customers have in their accounts, excluding from such sum any debit balances that Cleared Swaps Customers have in their accounts (the “Collateral Requirement”).

Finally, regulation 22.2(f) proposes an exception to the exclusion of debit balances, which parallels regulation 1.32(b).

134

Specifically, to the extent that a Cleared Swaps Customer deposited “readily marketable securities” with the FCM to secure a debit balance in its account, then the FCM must include such balance in the Collateral Requirement. “Readily marketable” is proposed to be defined as having a “ready market” as such latter term is defined in rule 15c3-1(c)(11) of the Securities and Exchange Commission (§ 241.15c3-1(c)(11) of this title). Regulation 22.2(f) proposes to deem a debit balance “secured” only if the FCM maintains a security interest in the “readily marketable securities,” and holds a written authorization to liquidate such securities in its discretion. To determine the amount of the debit balance that the FCM must include in the Collateral Requirement, regulation 22.2(f) proposes to require the FCM: (i) To determine the market value of such securities, and (ii) to reduce such market value by applicable percentage deductions (

i.e.,

“securities haircuts”) as set forth in rule 15c3-1(c)(2)(vi) of the Securities and Exchange Commission. The FCM would include in the Collateral Requirement that portion of the debit balance, not exceeding 100 percent, which is secured by such reduced market value.

134

Regulation 1.32(b) states: “In computing the amount of funds required to be in segregated accounts, a futures commission merchant may offset any net deficit in a particular customer's account against the current market value of readily marketable securities, less applicable percentage deductions (

i.e.,

“securities haircuts”) as set forth in rule 15c3-1(c)(2)(vi) of the Securities and Exchange Commission (17 CFR 241.15c3-1(c)(2)(vi)), held for the same customer's account. The futures commission merchant must maintain a security interest in the securities, including a written authorization to liquidate the securities at the futures commission merchant's discretion, and must segregate the securities in a safekeeping account with a bank, trust company, clearing organization of a contract market, or another futures commission merchant. For purposes of this section, a security will be considered readily marketable if it is traded on a “ready market” as defined in rule 15c3-1(c)(11)(i) of the Securities and Exchange Commission (17 CFR 240.15c3-1(c)(11)(i)).” 17 CFR 1.32(b).

iii. Question

The Commission requests comment on the Collateral Requirement proposed in regulation 22.2(f). Specifically, the Commission requests comment on whether the explicit calculation of such Collateral Requirement materially differs from the implicit calculation in the Part 1 Provisions for segregated “customer funds” of futures customers.

f. Segregated Account; Daily Computation and Record

Regulation 22.2(g), paralleling regulation 1.32,

135

proposes to require an FCM to compute, as of the close of each business day, on a currency-by-currency basis:

135

Regulation 1.32(a) states: “Each futures commission merchant must compute as of the close of each business day, on a currency-by-currency basis: (1) The total amount of customer funds on deposit in segregated accounts on behalf of commodity and option customers; (2) the amount of such customer funds required by the Act and these regulations to be on deposit in segregated accounts on behalf of such commodity and option customers; and (3) the amount of the futures commission merchant's residual interest in such customer funds.” 17 CFR 1.32(a).

• The aggregate market value of the Cleared Swaps Customer Collateral in all FCM Physical Locations and all Cleared Swaps Customer Accounts at Permitted Depositories (the “Collateral Value”);

• The Collateral Requirement; and

• The amount of the residual financial interest that the FCM holds in such Cleared Swaps Customer Collateral (

i.e.,

the difference between the Collateral Value and the Collateral Requirement).

Regulation 22.2(g), further paralleling regulation 1.32,

136

proposes to require the FCM to complete the abovementioned computation prior to noon on the next business day, and to keep all computations, together with supporting data, in accordance with regulation 1.31. “Noon” refers to noon in the time zone where the FCM's principal office is located.

136

Regulation 1.32(c) states: “The daily computations required by this section must be completed by the futures commission merchant prior to noon on the next business day and must be kept, together with all supporting data, in accordance with the requirements of § 1.31.” 17 CFR 1.32(c).

C. Proposed Regulation 22.3—Derivatives Clearing Organizations: Treatment of Cleared Swaps Customer Collateral

Regulation 22.3 proposes requirements for DCO treatment of Cleared Swaps Customer Collateral from FCMs, as well as the associated Cleared Swaps. Such requirements generally parallel the Part 1 Provisions.

1. In General

Regulation 22.3(a) proposes to require a DCO to treat and deal with the Cleared Swaps Customer Collateral deposited by an FCM as belonging to the Cleared Swaps Customers of such FCM and not other persons, including, without limitation, the FCM. In other words, the DCO may not use Cleared Swaps Customer Collateral to cover or support (i) the obligations of the FCM depositing the Cleared Swaps Customer Collateral, (ii) the obligations of any other FCM, or (iii) the obligations of Customers (

e.g.,

entities transacting in futures or equities contracts) of any FCM. Such proposal parallels regulation 1.20(a), which applies to “customer funds” for futures contracts.

137

See

note 112 supra.

2. Location of Collateral

Regulation 22.3(b) proposes to require that a DCO segregate all Cleared Swaps Customer Collateral that it receives from

FCMs. Such proposal parallels regulations 1.20(b) and 1.26(b).

138

Additionally, regulation 22.2(b) proposes to require that a DCO adopt one of two methods to hold segregated Cleared Swaps Customer Collateral, which parallel either implicit assumptions or explicit provisions of regulation 1.20(b).

138

Regulation 1.26(b) states: “Each clearing organization which invests money belonging or accruing to commodity or option customers of its clearing members in instruments described in § 1.25 shall separately account for such instruments and segregate such instruments as belonging to such commodity or option customers.” 17 CFR 1.26(b).

a. The First Method

Paralleling an implicit assumption of regulations 1.20(b) and 1.26(b), the first method permits the DCO to hold Cleared Swaps Customer Collateral itself.

139

Continuing such parallel, the first method limits the DCO to holding tangible collateral (

e.g.,

gold ingots or warehouse receipts) because no DCO serves as a depository for intangible collateral. Finally, the first method requires the FCM, in holding such Cleared Swaps Customer Collateral, to:

139

Regulation 1.20(b) does not require that a DCO hold “customer funds” from FCMs in a depository. Rather, it applies certain requirements to the holding of “customer funds

when

deposited in a bank or trust company * * *” (emphasis added). In the absence of a requirement to use a depository, regulation 1.20(b) must implicitly permit the DCO to hold “customer funds” from FCMs itself.

Id.

Regulation 1.26(b) contains similar language regarding the use of a depository.

Id.

• Physically separate (

e.g.,

in a box or vault) such collateral from its own property, the property of any FCM, and the property of any other person that is not a Cleared Swaps Customer of an FCM;

• Clearly identify each physical location (the “DCO Physical Location”) in which it holds such collateral as a “Location of Cleared Swaps Customer Collateral” (

e.g.,

by affixing a label or sign to the box or vault);

• Ensure that each such DCO Physical Location provides appropriate protection for such collateral (

e.g.,

by confirming that the box or vault has locks and is fire resistant); and

• Record in its books and records the amount of such collateral separately from its own funds, the funds of any FCM, and the funds of any other person that is not a Cleared Swaps Customer of an FCM (

i.e.,

to reflect the reality of physical separation in books and records).

b. The Second Method

Paralleling explicit provisions of regulations 1.20(b) and 1.26(b),

140

the second method permits the DCO to hold Cleared Swaps Customer Collateral from FCMs outside of itself.

141

Continuing such parallel, the second method limits the DCO to certain Permitted Depositories (as further discussed below), and requires that the DCO maintain a Cleared Swaps Customer Account with each Permitted Depository.

140

Regulation 1.20(b) states: “All customer funds received by a clearing organization from a member of the clearing organization to purchase, margin, guarantee, secure or settle the trades, contracts or commodity options of the clearing member's commodity or option customers and all money accruing to such commodity or option customers as the result of trades, contracts or commodity options so carried shall be separately accounted for and segregated as belonging to such commodity or option customers, and a clearing organization shall not hold, use or dispose of such customer funds except as belonging to such commodity or option customers. Such customer funds when deposited in a bank or trust company shall be deposited under an account name which clearly shows that they are the customer funds of the commodity or option customers of clearing members, segregated as required by the Act and these regulations.”

Id.

Regulation 1.26(b) contains similar language.

Id.

141

If a DCO chooses to accept intangible Cleared Swaps Customer Collateral from an FCM, then the proposal effectively requires the DCO to maintain such collateral outside of itself.

c. Questions

As described above, both the first and second methods incorporate assumptions with respect to DCO structure that were true when regulations 1.20(b) and 1.26(b) were first adopted and remain true currently. However, the Commission recognizes that DCO structure may change after the Dodd-Frank Act and the regulations thereunder become effective. Notably, the Commission recognizes that a depository registered with either domestic or foreign banking regulators may seek to become a DCO, and that such depository may seek to hold Cleared Swaps Customer Collateral, as well as other forms of customer property. The Commission therefore requests comment on what, if any, changes to proposed regulation 22.3 may be appropriate to accommodate such possibility. Specifically, the Commission requests comment on whether a DCO that is also a registered depository should be permitted to hold both tangible and intangible forms of Cleared Swaps Customer Collateral from FCMs itself. What challenges might this arrangement pose to protection (including effective segregation) of Cleared Swaps Customer Collateral (as well as other forms of customer property)? How might these challenges be addressed?

3. Commingling

Regulation 22.3(c) proposes to permit a DCO to commingle the Cleared Swaps Customer Collateral that it receives from multiple FCMs on behalf of their Cleared Swaps Customers, while prohibiting the DCO from commingling Cleared Swaps Customer Collateral with:

• The money, securities, or other property belonging to the DCO;

• The money, securities, or other property belonging to any FCM; or

• Other categories of funds that it receives from an FCM on behalf of Customers, including “customer funds” for futures contracts (as regulation 1.3 defines such term) or the “foreign futures or foreign options secured amount” (as regulation 1.3 defines such term), except as permitted by a Commission rule, regulation or order (or by a derivatives clearing organization rule approved pursuant to regulation 39.15(b)(2)).

142

See

note 117 supra.

Proposed regulation 22.3(c) parallels regulations 1.20(a), 1.20(b), and 1.26(b).

143

Regulations 1.20(a), 1.20(b), and 1.26(b) implicitly (i) permit the DCO to commingle the “customer funds” that it receives from multiple FCMs and (ii) prohibit the DCO from commingling “customer funds” with DCO funds, FCM funds, or funds supporting customer transactions in non-futures contracts. Specifically, regulation 1.20(a) states: “All customer funds shall be separately accounted for and segregated as belonging to commodity or option customers.” Regulation 1.20(b) further develops such language, as detailed in note 140 supra. Similarly, regulation 1.26(b) states: “Each clearing organization which invests money belonging or accruing to commodity or option customers of its clearing members in instruments described in § 1.25 shall separately account for such instruments and segregate such instruments as belonging to such commodity or option customers.” 17 CFR 1.20(a), 1.20(b), and 1.26(a).

4. Exceptions

Regulations 22.3(d) and (e) propose certain exceptions to the abovementioned requirements and limitations.

a. FCM Deposits and Withdrawals

Regulation 22.3(d) constitutes an exception to regulation 22.3(c) (Commingling). Regulation 22.3(d) proposes to allow a DCO to place money, securities, or other property belonging to an FCM in a DCO Physical Location, or deposit such money, securities, or other property in the relevant Cleared Swaps Customer Account, pursuant to an instruction

from the FCM. Regulation 22.3(d) further proposes to permit FCM withdrawals of money, securities, or other property from a DCO Physical Location or Cleared Swaps Customer Account. As discussed below, a DCO functions as a Permitted Depository for an FCM. Proposed regulation 22.3 enables such function, by facilitating (i) FCM deposits of its own money, securities, or other property in its Cleared Swaps Customer Account at the DCO,

144

and (ii) FCM withdrawals of its residual financial interest in the Cleared Swaps Customer Collateral.

145

144

See

proposed regulation 22.2(d)(2).

145

See

proposed regulation 22.2(d)(3).

b. Permitted Investments

Regulation 22.3(e) constitutes an exception to regulation 22.3(b)(1) (Location of Cleared Swaps Collateral) and regulation 22.15 (Treatment of Cleared Swaps Collateral on an Individual Basis). Regulation 22.3(e) proposes to allow a DCO to invest Cleared Swaps Customer Collateral in accordance with regulation 1.25, which delineates permitted investments of “customer funds” (as regulation 1.3 defines such term) for futures contracts.

D. Proposed Regulation 22.4—Futures Commission Merchants and Derivatives Clearing Organizations: Permitted Depositories

1. The Permitted Depositories

Regulation 22.4 proposes a list of depositories permitted to hold Cleared Swaps Customer Collateral (the “Permitted Depositories”). For a DCO or an FCM, a Permitted Depository must (subject to regulation 22.9) be: (i) A bank located in the United States; (ii) a trust company located in the United States; or (iii) a DCO. As discussed further below, regulation 22.9 incorporates regulation 1.49 with respect to Permitted Depositories located outside the United States.

146

An FCM may also serve as a Permitted Depository, but only if it is a “Collecting Futures Commission Merchant” carrying the Cleared Swaps (and related Cleared Swaps Customer Collateral) of a “Depositing Futures Commission Merchant” (as regulation 22.1 proposes to define each such term). Before an entity may serve as a Permitted Depository, the DCO or FCM seeking to maintain a Cleared Swaps Customer Account must obtain a written acknowledgement letter, as discussed further below.

146

While there is some ambiguity as to whether regulation 1.49 currently applies to DCOs given the provisions of current regulation 39.2, the Commission has proposed amendments that would remove regulation 39.2.

See Risk Management Requirements for Derivatives Clearing Organizations,

76 FR 3698, 3714 (Jan. 20, 2011). Thus, if the proposed amendments are finalized as written, DCOs would be subject to the requirements set forth in regulation 1.49. In addition, notwithstanding regulation 39.2, the Commission and industry have proceeded on the basis that the requirements of regulation 1.49 apply to DCOs.

In general, proposed regulation 22.4 parallels regulations 1.20, 1.26 and 1.49(d)(2), with the exception of allowing an FCM to serve as a Permitted Depository only if the FCM is a “Collecting Futures Commission Merchant.”

147

The Commission believes that such a limitation is appropriate, because the purpose for allowing an FCM to serve as a Permitted Depository is to facilitate the clearing of swaps carried by an FCM that is not a member of a particular DCO (

i.e.,

the Depositing Futures Commission Merchant) through another FCM that is a member of that DCO (

i.e.,

the Collecting Futures Commission Merchant).

148

147

Regulations 1.20(a) and (c) imply that an FCM may deposit “customer funds” with “any bank, trust company, clearing organization or another futures commission merchant.” Regulation 1.20(b) implies than a DCO may deposit “customer funds” from FCMs with “a bank or trust company.” Regulations 1.26(a) and (b) contain similar language. Regulation 1.49(d)(2) clarifies that an FCM or DCO may deposit “customer funds” in the United States only with “(i) A bank or trust company; (ii) A futures commission merchant registered as such with the Commission; or (iii) A derivatives clearing organization.” 17 CFR 1.20, 1.26, and 1.49(d)(2).

148

See

section 4d(f)(3)(A)(ii) of the CEA, as amended by section 724 of the Dodd-Frank Act (explicitly stating that Cleared Swaps Customer Collateral may be withdrawn to margin, guarantee, secure, transfer, adjust, or settle a Cleared Swap with a DCO, or any member of a DCO, and not explicitly allowing withdrawals for any other purpose (except for permitted investments)).

2. Question

The Commission seeks public comment on whether the limitation that it is proposing for an FCM serving as a Permitted Depository is appropriate.

E. Proposed Regulation 22.5—Futures Commission Merchants and Derivatives Clearing Organizations: Written Acknowledgement

1. Substantive Requirements

As mentioned above, a DCO or FCM must obtain a written acknowledgement letter from a potential Permitted Depository before opening a Cleared Swaps Customer Account.

149

Regulation 22.5 proposes substantive requirements for such letter. First, regulation 22.5 proposes to mandate that the FCM or DCO obtain a written acknowledgement letter in accordance with regulations 1.20 and 1.26, which shall apply to Cleared Swaps Customer Collateral as if such collateral constituted “customer funds” (as regulation 1.3 defines such term). The Commission seeks comment as to whether such incorporation by reference is the most appropriate way to proceed, or whether the Commission should publish a separate form acknowledgement letter for swaps. In what way should such separate form letter differ from the form letter previously published for futures customer funds?

150

149

The function of a written acknowledgment letter is to ensure that a potential Permitted Depository is aware that (i) the FCM or DCO is opening a Cleared Swaps Customer Account, (ii) the funds deposited in such account constitute Cleared Swaps Customer Collateral, and (iii) such Cleared Swaps Customer Collateral is subject to the requirements of section 4d(f) of the CEA and Part 22 (when finalized).

150

See

75 FR 47738 (Aug. 9, 2010) (proposing form acknowledgment letters for customer funds and secured amount funds).

Second, regulation 22.5 proposes to exempt the FCM or DCO from the requirement to obtain a written acknowledgement letter, if the potential Permitted Depository is a DCO that has adopted rules providing for the segregation of Cleared Swaps Customer Collateral. This proposed exemption is consistent with regulation 1.20.

151

Currently, with respect to an FCM, regulation 1.20(a) states: “Each regis

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