# Clearing Requirement Determination Under Section 2(h) of the CEA

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URL: https://www.frixlaw.com/law-library/documents/fr%3A2012-18382

## Record

- **Collection:** Federal Register
- **Document type:** Proposed Rule
- **Published:** August 7, 2012
- **Citation:** 77 FR 47170

## Text

COMMODITY FUTURES TRADING COMMISSION
17 CFR Part 50
RIN 3038-AD86
Clearing Requirement Determination Under Section 2(h) of the CEA

AGENCY:

Commodity Futures Trading Commission.

ACTION:

Notice of proposed rulemaking.

SUMMARY:

The Commodity Futures Trading Commission (Commission or CFTC) is proposing regulations to establish a clearing requirement under new section 2(h)(1)(A) of the Commodity Exchange Act (CEA or Act), enacted under Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The regulations would require that certain classes of credit default swaps (CDS) and interest rate swaps (IRS), described herein, be cleared by a derivatives clearing organization (DCO) registered with the Commission. The Commission also is proposing regulations to prevent evasion of the clearing requirement and related provisions.

DATES:

Comments must be received on or before September 6, 2012.

ADDRESSES:

You may submit comments, identified by RIN number 3038-AD86, by any of the following methods:

• The agency's Web site, at
http://comments.cftc.gov.
Follow the instructions for submitting comments through the Web site.

•
Mail:
David A. Stawick, Secretary of the Commission, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street NW., Washington, DC 20581.

•
Hand Delivery/Courier:
Same as mail above.

•
Federal eRulemaking Portal: http://www.regulations.gov.
Follow the instructions for submitting comments.

Please submit your comments using only one method.

All comments must be submitted in English, or if not, accompanied by an English translation. Comments will be posted as received to
http://www.cftc.gov.
You should submit only information that you wish to make available publicly. If you wish the Commission to consider information that you believe is exempt from disclosure under the Freedom of Information Act, a petition for confidential treatment of the exempt information may be submitted according to the procedures established in § 145.9 of the Commission's regulations.
1

1
17 CFR 145.9. Commission regulations referred to herein are found on the Commission's Web site.

The Commission reserves the right, but shall have no obligation, to review, pre-screen, filter, redact, refuse or remove any or all of your submission from
http://www.cftc.gov
that it may deem to be inappropriate for publication, such as obscene language. All submissions that have been redacted or removed that contain comments on the merits of the rulemaking will be retained in the public comment file and will be considered as required under the Administrative Procedure Act and other applicable laws, and may be accessible under the Freedom of Information Act.

FOR FURTHER INFORMATION CONTACT:

Sarah E. Josephson, Deputy Director, 202-418-5684,
sjosephson@cftc.gov;
Brian O'Keefe, Associate Director, 202-418-5658,
bokeefe@cftc.gov;
or Erik Remmler, Associate Director, 202-418-7630,
eremmler@cftc.gov,
Division of Clearing and Risk, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Background

A. Financial Crisis

B. Central Role of Clearing in the Dodd-Frank Act

C. G-20 and International Commitments on Clearing

D. Overview of Section 2(h) and § 39.5

E. Submissions From DCOs

II. Review of Swap Submissions

A. General Description of Information Considered

B. Commission Processes for Review and Surveillance of DCOs

C. Credit Default Swaps

D. Proposed Determination Analysis for Credit Default Swaps

E. Interest Rate Swaps

F. Proposed Determination Analysis for Interest Rate Swaps

III. Proposed Rule

A. Proposed § 50.1 Definitions

B. Proposed § 50.2 Treatment of Swaps Subject to a Clearing Requirement

C. Proposed § 50.3 Notice to the Public

D. Proposed § 50.4 Classes of Swaps Required To Be Cleared

E. Proposed § 50.5 Clearing Transition Rules

F. Proposed § 50.6 Delegation of Authority

G. Proposed § 50.10 Prevention of Evasion of the Clearing Requirement and Abuse of an Exception or Exemption to the Clearing Requirement

IV. Implementation

V. Cost Benefit Considerations

A. Statutory and Regulatory Background

B. Overview of Swap Clearing

C. Consideration of the Costs and Benefits of the Commission's Action

D. Costs and Benefits of the Rule as Compared to Alternatives

E. Section 15(a) Factors

VI. Related Matters

A. Regulatory Flexibility Act

B. Paperwork Reduction Act

I. Background

A. Financial Crisis

In the fall of 2008, a series of large financial institution failures triggered a financial and economic crisis that threatened to freeze U.S. and global credit markets. As a result of these failures, unprecedented governmental intervention was required to ensure the stability of the U.S. financial system.
2

These failures revealed the vulnerability of the U.S. financial system and economy to wide-spread systemic risk resulting from, among other things, poor risk management practices of financial firms and the lack of supervisory oversight for a financial institution as a whole.
3

2
On October 3, 2008, President Bush signed the Emergency Economic Stabilization Act of 2008, which was principally designed to allow the U.S. Department of the Treasury and other government agencies to take action to restore liquidity and stability to the U.S. financial system (
e.g.,
the Troubled Asset Relief Program—also known as TARP—under which the U.S. Department of the Treasury was authorized to purchase up to $700 billion of troubled assets that weighed down the balance sheets of U.S. financial institutions).
See
Public Law 110-343, 122 Stat. 3765 (2008).

3

See
Financial Crisis Inquiry Commission, “The Financial Crisis Inquiry Report: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States,” Jan. 2011, at xxviii, available at
http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf.

The financial crisis also illustrated the significant risks that an uncleared, over-the-counter (OTC) derivatives market can pose to the financial system. As the Financial Crisis Inquiry Commission explained:

The scale and nature of the [OTC] derivatives market created significant systemic risk throughout the financial system and helped fuel the panic in the fall of 2008: millions of contracts in this opaque and deregulated market created interconnections among a vast web of financial institutions through counterparty credit risk, thus exposing the system to a contagion of spreading losses and defaults.
4

4

See id.
at 386.

Certain OTC derivatives, such as CDS, played a prominent role during the crisis. According to a white paper by the U.S. Department of the Treasury, “the sheer volume of these [CDS] contracts overwhelmed some firms that had promised to provide payment of the CDS and left institutions with losses that they believed they had been

protected against.”
5

In particular, AIG reportedly issued uncleared CDS transactions covering more than $440 billion in bonds, leaving it with obligations that it could not cover as a result of changed market conditions.
6

As a result of AIG's CDS exposure, the Federal government bailed out the firm with over $180 billion of taxpayer money in order to prevent AIG's failure and a possible contagion event in the broader economy.
7

5

Financial Regulatory Reform: A New Foundation,
June 2009, available at:
http://www.treasury.gov/initiatives/Documents/FinalReport_web.pdf
and cited in S. Rep. 111-176 at 29-30 (Apr. 30, 2010).

6
Adam Davidson, “How AIG fell apart,” Reuters, Sept. 18, 2008, available at
http://www.reuters.com/article/2008/09/18/us-how-aig-fell-apart-idUSMAR85972720080918.

7
Hugh Son, “AIG's Trustees Shun `Shadow Board,' Seek Directors,” Bloomberg, May 13, 2009, available at
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aaog3i4yUopo&refer=us.

More broadly, the President's Working Group (PWG) on Financial Policy noted shortcomings in the OTC derivative markets as a whole during the crisis. The PWG identified the need for an improved integrated operational structure supporting OTC derivatives, specifically highlighting the need for an enhanced ability to manage counterparty risk through “netting and collateral agreements by promoting portfolio reconciliation and accurate valuation of trades.”
8

These issues were exposed in part by the surge in collateral required between counterparties during 2008, when the International Swaps and Derivatives Association (ISDA) reported an 86% increase in the collateral in use for OTC derivatives, indicating not only the increase in risk, but also circumstances in which positions may not have been collateralized.
9

8
The President's Working Group on Financial Markets, “Policy Statements on Financial Market Developments,” Mar. 2008, available at
http://www.treasury.gov/resource-center/fin-mkts/Documents/pwgpolicystatemktturmoil_03122008.pdf.

9
ISDA, ISDA Margin Survey, 2009, available at
http://www.isda.org/c_and_a/pdf/ISDA-Margin-Survey-2009.pdf.

With only limited checks on the amount of risk that a market participant could incur, great uncertainty was created among market participants. A market participant did not know the extent of its counterparty's exposure, whether its counterparty was appropriately hedged, or if its counterparty was dangerously exposed to adverse market movements. Without central clearing, a market participant bore the risk that its counterparty would not fulfill its payment obligations pursuant to a swap's terms (counterparty credit risk). As the financial crisis deepened, this risk made market participants wary of trading with each other. As a result, markets quickly became illiquid and trading volumes plummeted. The dramatic increase in “TED spreads” evidenced this mistrust.
10

These spreads increased from a long-term average of approximately 30 basis points to 464 basis points.
11

10
The TED spread measures the difference in yield between three-month Eurodollars as represented by London Interbank Offered Rate (LIBOR), and three-month Treasury Bills. LIBOR contains credit risk while T-bills do not. As the spread got larger, it meant that lenders demanded more return to compensate for credit risk then they would need if they loaned the money to the U.S. Department of the Treasury without any credit risk.

11
The U.S. Financial Crisis: Credit Crunch and Yield Spreads, by James R. Barth et al., page 5, available at:
http://apeaweb.org/confer/bei08/papers/blp.pdf.

The failure to adequately collateralize the risk exposures posed by OTC derivatives, along with the contagion effects of the vast web of counterparty credit risk, led many to conclude that OTC derivatives should be centrally cleared. For instance, in 2008, the Federal Reserve Bank of New York (FRBNY) began encouraging market participants to establish a central counterparty to clear CDS.
12

For several years prior, the FRBNY had led a targeted effort to enhance operational efficiency and performance in the OTC derivatives market by increasing automation in processing and by promoting sound back office practices, such as timely confirmation of trades and portfolio reconciliation. Beginning with CDS in 2008, the FRBNY and other primary supervisors of OTC derivatives dealers increasingly focused on central clearing as a means of mitigating counterparty credit risk and lowering systemic risk to the markets as a whole. Both regulators and market participants alike recognized that risk exposures would have been monitored, measured, and collateralized through the process of central clearing.

12

See
Federal Reserve Bank of New York, Press Release, “New York Fed Welcomes Further Industry Commitments on Over-the-Counter Derivatives,” Oct. 31, 2008, available at
http://www.newyorkfed.org/newsevents/news/markets/2008/an081031.html,
which references documents prepared by market participants describing the importance of clearing.
See also
Ciara Linnane and Karen Brettell, “NY Federal Reserve pushes for central CDS counterparty,” Reuters, Oct. 6, 2008, available at
http://www.reuters.com/article/2008/10/06/cds-regulation-idUSN0655208920081006.

B. Central Role of Clearing in the Dodd-Frank Act

Recognizing the peril that the U.S. financial system faced during the financial crisis, Congress and the President came together to pass the Dodd-Frank Act in 2010. Title VII of the Dodd-Frank Act establishes a comprehensive new regulatory framework for swaps, and the requirement that swaps be cleared by DCOs is one of the cornerstones of that reform. The CEA, as amended by Title VII, now requires a swap: (1) To be cleared through a DCO if the Commission has determined that the swap, or group, category, type, or class of swap, is required to be cleared, unless an exception to the clearing requirement applies; (2) to be reported to a swap data repository (SDR) or the Commission; and (3) if the swap is subject to a clearing requirement, to be executed on a designated contract market (DCM) or swap execution facility (SEF), unless no DCM or SEF has made the swap available to trade.
13

13
The Commission has proposed rules that would establish a separate process for determining whether a swap has been made “available to trade” by a DCM or SEF. Those rules, and any determinations made under those rules, will be finalized separately from the proposed clearing requirements discussed herein.
See
Process for a Designated Contract Market or Swap Execution Facility to Make a Swap Available to Trade Under Section 2(h)(8) of the Commodity Exchange Act, 76 FR 77728 (Dec. 14, 2011).

Clearing is at the heart of the Dodd-Frank financial reform. According to the Senate Report:
14

14
S. Rep. 111-176, at 32 (April 30, 2010).
See also
Letter from Senators Christopher Dodd and Blanche Lincoln to Congressmen Barney Frank and Collin Peterson (June 30, 2010) (“Congress determined that clearing is at the heart of reform—bringing transactions and counterparties into a robust, conservative, and transparent risk management framework.”).

As a key element of reducing systemic risk and protecting taxpayers in the future, protections must include comprehensive regulation and rules for how the OTC derivatives market operates. Increasing the use of central clearinghouses, exchanges, appropriate margining, capital requirements, and reporting will provide safeguards for American taxpayers and the financial system as a whole.

The Commission believes that a clearing requirement will reduce counterparty credit risk and provide an organized mechanism for collateralizing the risk exposures posed by swaps. According to the Senate Report:
15

15
S. Rep. 111-176, at 33.

With appropriate collateral and margin requirements, a central clearing organization can substantially reduce counterparty risk and provide an organized mechanism for clearing transactions. * * * While large losses are to be expected in derivatives trading, if those positions are fully margined there will be no loss to counterparties and the overall financial system and none of the uncertainty about potential exposures that contributed to the panic in 2008.

Notably, Congress did not focus on just one asset class, such as CDS; rather, Congress determined that all swaps that a DCO plans to accept for clearing must be submitted to the Commission for a determination as to whether or not those swaps are required to be cleared pursuant to section 2(h)(2)(D) of the CEA.

C. G-20 and International Commitments on Clearing

The financial crisis generated international consensus on the need to strengthen financial regulation by improving transparency, mitigating systemic risk, and protecting against market abuse. As a result of the widespread recognition that transactions in the OTC derivatives market increased risk and uncertainty in the economy and became a significant contributor to the financial crisis, a series of policy initiatives were undertaken to better regulate the financial markets.

In September 2009, leaders of the Group of 20 (G-20)—whose membership includes the United States, the European Union, and 18 other countries—agreed that: (1) OTC derivatives contracts should be reported to trade repositories; (2) all standardized OTC derivatives contracts should be cleared through central counterparties and traded on exchanges or electronic trading platforms, where appropriate, by the end of 2012; and (3) non-centrally cleared contracts should be subject to higher capital requirements.

In June 2010, the G-20 leaders reaffirmed their commitment to achieve these goals. In its October 2010 report on Implementing OTC Derivatives Market Reforms (the October 2010 Report), the Financial Stability Board (FSB) made twenty-one recommendations addressing practical issues that authorities may encounter in implementing the G-20 leaders' commitments.
16

The G-20 leaders again reaffirmed their commitments at the November 2011 Summit, including the end-2012 deadline. The FSB has issued three implementation progress reports. The most recent report urged jurisdictions to push forward aggressively to meet the G-20 end-2012 deadline in as many reform areas as possible. On mandatory clearing, the report observed that “[j]urisdictions now have much of the information they requested in order to make informed decisions on the appropriate legislation and regulations to achieve the end-2012 commitment to centrally clear all standardised OTC derivatives.”
17

16

See
“Implementing OTC Derivatives Market Reforms,” Financial Stability Board, Oct. 25, 2010, available at
http://www.financialstabilityboard.org/publications/r_101025.pdf.

17
OTC Derivatives Working Group, “OTC Derivatives Market Reforms: Third Progress Report on Implementation,” Financial Stability Board, June 15, 2012, available at
http://www.financialstabilityboard.org/publications/r_120615.pdf.

Specifically with regard to required clearing, the Technical Committee of the International Organization of Securities Commissions (IOSCO) has published a final report,
Requirements for Mandatory Clearing,
outlining recommendations that regulators should follow to carry out the G-20's goal of requiring standardized swaps to be cleared.
18

18
IOSCO's report, published in February 2012, is available at
https://www.iosco.org/library/pubdocs/pdf/IOSCOPD374.pdf.

D. Overview of Section 2(h) and § 39.5

The Commission has promulgated § 39.5 of its regulations to implement procedural aspects section 2(h) of the CEA.
19

Regulation 39.5 establishes procedures for: (1) Determining the eligibility of a DCO to clear swaps; (2) the submission of swaps by a DCO to the Commission for a clearing requirement determination; (3) Commission initiated reviews of swaps; and (4) the staying of a clearing requirement.

19

See
76 FR 44464 (July 26, 2011); 17 CFR 39.5.

This determination and rule proposed today would require that certain swaps submitted by Commission-registered DCOs are required to be cleared under section 2(h) of the CEA. Under section 2(h)(1)(A), “it shall be unlawful for any person to engage in a swap unless that person submits such swap for clearing to a [DCO] that is registered under [the CEA] or a [DCO] that is exempt from registration under [the CEA] if the swap is required to be cleared.”
20

20

See
section 2(h) of the CEA. A clearing requirement determination also may be initiated by the Commission. Section 2(h)(2)(A)(i) of the CEA requires the Commission on an ongoing basis to “review each swap, or any group, category, type, or class of swaps to make a determination as to whether the swap, category, type or class of swaps should be required to be cleared.” As previously noted, the Commission intends to consider swaps submitted by DCOs prior to undertaking any Commission-initiated reviews.

A clearing requirement determination may be initiated by a swap submission. Section 2(h)(2)(B)(i) of the CEA requires a DCO to “submit to the Commission each swap, or any group, category, type or class of swaps that it plans to accept for clearing, and provide notice to its members of the submission.” In addition under section 2(h)(2)(B)(ii) of the CEA, “[a]ny swap or group, category, type, or class of swaps listed for clearing by a [DCO] as of the date of enactment shall be considered submitted to the Commission.”

E. Submissions From DCOs

On February 1, 2012, Commission staff sent a letter requesting that DCOs submit all swaps that they were accepting for clearing as of that date, pursuant to § 39.5.
21

The Commission received submissions relating to CDS and IRS clearing from: the International Derivatives Clearinghouse Group (IDCH) on February 17, 2012; the CME Group (CME), ICE Clear Credit, ICE Clear Europe, each dated February 22, 2012, and a submission from LCH.Clearnet Limited (LCH) on February 24, 2012.
22

21
The letter made it clear that DCOs should submit both pre-enactment swaps and swaps for which DCOs have initiated clearing since enactment of the Dodd-Frank Act. Pre-enactment swaps refer to those swaps that DCOs were accepting for clearing as of July 21, 2010, the date of enactment of the Dodd-Frank Act.

22
Other swaps submissions were received from Kansas City Board of Trade (KCBT) and the Natural Gas Exchange (NGX). KCBT and NGX do not accept any CDS or IRS for clearing.

This proposal's clearing requirement determination would cover certain CDS and IRS currently being cleared by a DCO. The Commission intends subsequently to consider other swaps submitted by DCOs, such as agricultural, energy, and equity indices.

The decision to focus on CDS and IRS in the initial clearing requirement determination is a function of both the market importance of these swaps and the fact that they already are widely cleared. In order to move the largest number of swaps to required clearing in its initial determination, the Commission believes that it is prudent to focus on those swaps that have the highest market shares and market impact. Further, for these swaps there is already a blueprint for clearing and appropriate risk management. CDS and IRS fit these considerations and therefore are well suited for required clearing consideration.
23

23
The Commission will consider all other swaps submitted under § 39.5(b) as soon as possible after this proposal is published. These other swaps include certain CDS that were submitted to the Commission subsequent to the initial February 2012 submissions discussed above. If the Commission determines that additional swaps should be required to be cleared such determination likely will be proposed as a new class under proposed § 50.4, as discussed below.

Significantly, market participants have recommended that the Commission take this approach. In their joint comment letter to the Commission's proposed Compliance and Implementation Schedule for the clearing requirement, the Futures Industry Association (FIA), ISDA, and the Securities Industry and Financial Markets Association (SIFMA) opined

that CDS and IRS should be required to be cleared first because they are already being cleared.
24

FIA, ISDA, and SIFMA commented further that it would make sense for the Commission to require commodity and equity swaps to be cleared later because fewer of these swaps are currently being cleared. Similarly, the letter sent by the Alternative Investment Management Association (AIMA) in response to Commissioner O'Malia's request for comment concerning the implementation of the clearing requirement
25

argues that the Commission should first review those swaps currently being cleared and then swaps that currently trade in large numbers.

24
FIA/ISDA/SIFMA comment letter to the Notice of Proposed Rulemaking, Swap Transaction Compliance and Implementation Schedule: Clearing and Trade Execution Requirements under Section 2(h) of the CEA, 76 FR 58186 (Sept. 20, 2011). This comment letter is available on the Commission's Web site at:
http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1093&ctl00_ctl00_cphContentMain_MainContent_gvCommentListChangePage=2.

25
On July 28, 2011, Commissioner O'Malia released a letter seeking public comment on the manner in which the Commission should determine (i) which swaps would be subject to the clearing requirement and (ii) whether to grant a stay of a clearing requirement. Commissioner O'Malia's letter, as well as AIMA's letter, are available on the Commission's Web site at:
http://www.cftc.gov/About/Commissioners/ScottDOMalia/reviewofswaps.

IRS accounts for about $500 trillion of the $650 trillion global OTC swaps market, in notional dollars—the highest market share of any class of swaps.
26

LCH claims to clear about $302 trillion of those—meaning that, in notional terms, LCH clears approximately 60% of the IRS market.
27

While CDS indices do not have as prominent a market share as IRS, CDS indices are capable of having a sizeable market impact, as they did during the 2008 financial crisis. Overall, the CDS marketplace has almost $29 trillion in notional outstanding across both single and multi-name products.
28

CDS on standardized indices accounts for about $10 trillion of the global OTC market in notional dollar amount outstanding.
29

Since March 2009, the ICE Clear Credit and ICE Clear Europe have combined to clear over $30 trillion in gross notional for all CDS.
30

Because of the market shares and market impacts of these swaps, and because these swaps are currently being cleared, the Commission decided to review CDS and IRS in its initial clearing requirement determination. The Commission recognizes that while this is an appropriate basis for this initial proposal, swap clearing is likely to evolve and clearing requirement determinations made at later times may be based on a variety of other factors beyond the extent to which the swaps in question are already being cleared.

26
Bank of International Settlements (BIS) data, December 2011, available at
http://www.bis.org/statistics/otcder/dt1920a.pdf.

27

Id.;
LCH data.

28
BIS data, December 2011, available at
http://www.bis.org/statistics/otcder/dt1920a.pdf.

29

Id.

30
ICE Clear Credit data, as of the April 26, 2012 clearing cycle.

II. Review of Swap Submissions

A. General Description of Information Considered

The Commission reviewed each of the submissions in detail. Based on these submissions, the Commission was able to consider the ability of an individual DCO to clear a given swap, as well as to consider the information supplied cumulatively across all submissions for a given swap. The analysis included reviews of the DCOs' existing rule frameworks and their risk management policies. The Commission relied on industry data as available, such as publicly available Depository Trust and Clearing Corporation (DTCC) data from the Trade Information Warehouse (TIW) on CDS transactions. Other publicly available data sources, such as data from the Bank of International Settlements (BIS) on the OTC derivatives markets are analyzed and cited throughout this notice of proposed rulemaking. The Commission also was able to review letters from market participants directly related to the clearing requirement.
31

Other market input on the clearing requirement could be taken from comments received with regard to rules relating to the proposed Swap Transaction Compliance and Implementation Schedule: Clearing and Trade Execution Requirements under Section 2(h) of the CEA
32

and the Process for Review of Swaps for Mandatory Clearing.
33

This notice of proposed rulemaking also reflects consultation with the staff of the Securities and Exchange Commission (SEC), prudential regulators, and international regulatory authorities. As § 39.5 provides for a 30-day comment period for any clearing determination, the final clearing requirement will be informed by public feedback.

31

See
responses to Commissioner O'Malia's letter of June 28, 2011 requesting input on the clearing determination available on the Commission's Web site, available at
http://www.cftc.gov/About/Commissioners/ScottDOMalia/reviewofswaps.

32

See
comment file for Swap Transaction Compliance and Implementation Schedule: Clearing and Trade Execution Requirements under Section 2(h) of the CEA, 76 FR 58186 (Sept. 20, 2011), available at
http://comments.cftc.gov/PublicComments/CommentList.aspx?id=1093.

33

See
comment file for Process for Review of Swaps for Mandatory Clearing, 75 FR 67277 (Nov. 2, 2010), available at
http://comments.cftc.gov/PublicComments/CommentList.aspx?id=890.

B. Commission Processes for Review and Surveillance of DCOs

i. Part 39 Regulations Set Forth Standards for Compliance

Section 2(h)(2)(D)(i) of the CEA provides that the Commission shall review whether the submissions are consistent with section 5b(c)(2) of the CEA. Section 5b(c)(2) of the CEA sets forth eighteen core principles with which DCOs must comply to be registered and to maintain registration. The core principles address numerous issues, including financial resources, participant and product eligibility, risk management, settlement procedures, default management, system safeguards, reporting, recordkeeping, public information, and legal risk.

All of the DCOs that submitted swaps for review are registered with the Commission and their submissions identify swaps that they are already clearing. Consequently, the Commission has been reviewing and monitoring compliance by the DCOs with the core principles for the submitted swaps. For purposes of reviewing whether the submissions are consistent with section 5b(c)(2) of the CEA, the Commission will rely on both the information received in the submissions themselves and on its ongoing review and risk surveillance programs. These processes are summarized below to provide a better understanding of the information the Commission uses in its review of consistency of the submissions with the core principles. The Commission believes this overview is particularly helpful for this rulemaking because the clearing requirement proposed herein is the first such undertaking by the Commission under the provisions of the Dodd-Frank Act.

The primary objective of the CFTC supervisory program is to ensure compliance with applicable provisions of the CEA and implementing regulations, and in particular, the core principles applicable to DCOs. A primary concern of the program is to monitor and mitigate potential risks that can arise in derivatives clearing activities for the DCO, its members, and entities using the DCO's services. Accordingly, the CFTC supervisory program takes a risk-based approach.

In addition to the core principles set forth in section 5b(c)(2) of the CEA, section 5c(c) of the CEA governs the procedures for review and approval of new products, new rules, and rule amendments submitted to the

Commission by DCOs. Part 39 of the CFTC's regulations implements sections 5b and 5c(c) of the CEA by establishing specific requirements for compliance with the core principles as well as procedures for registration, for implementing DCO rules, and for clearing new products. Part 40 of the CFTC's regulations sets forth additional provisions applicable to a DCO's submission of rule amendments and new products to the CFTC.

The Commission has means to enforce compliance, including the Commission's ability to sue the DCO in federal court for civil monetary penalties,
34

issue a cease and desist order,
35

or suspend or revoke the registration of the DCO.
36

In addition, any deficiencies or other compliance issues observed during ongoing monitoring or an examination are frequently communicated to the DCO and various measures are used by the Commission to ensure that the DCO appropriately addresses such issues, including escalating communications within the DCO management and requiring the DCO to demonstrate, in writing, timely correction of such issues.

34

See
section 6c of the CEA.

35

See
section 6b of the CEA.

36

See
section 5e of the CEA.

ii. Initial Registration Application Review and Periodic In-Depth Reviews

Section 5b of the CEA requires a DCO to register with the Commission. In order to do so, an organization must submit an application demonstrating that it complies with the core principles. During the review period, the Commission generally conducts an on-site review of the prospective DCO's facilities, asks a series of questions, and reviews all documentation received. The Commission may ask the applicant to make changes to its rules to comply with the CEA and the Commission's regulations.

After registration, the Commission conducts examinations of DCOs to determine whether the DCO is in compliance with the CEA and Commission regulations. The examination consists of a planning phase where staff reviews information the Commission has on hand to determine whether the information raises specific issues and to develop an examination plan. The examination team participates in a series of meetings with the DCO at its facility. Commission staff also communicates with relevant DCO staff, including senior management, and reviews documentation. Data produced by the DCO is independently tested. Finally, when relevant, walk-through testing is conducted for key DCO processes.

iii. Commission Daily Risk Surveillance

Commission risk surveillance staff monitors the risks posed to and by DCOs, clearing members, and market participants, including market risk, liquidity risk, credit risk, and concentration risk. This analysis includes reviews of daily, large trader reporting data obtained from market participants, clearing members, and DCOs, which is available at the trader, clearing member, and DCO levels. Relevant margin and financial resources information is also included within the analysis.

Commission staff regularly conducts back-testing to review margin coverage at the product level and follows up with the relevant DCO regarding any exceptional results. Independent stress testing of portfolios is conducted on a daily, weekly, and ad hoc basis. The independent stress tests may lead to individual trader reviews and/or futures commission merchant (FCM) risk reviews to gain a deeper understanding of a trading strategy, risk philosophy, risk controls and mitigants, and financial resources at the trader and/or FCM level. The traders and FCMs that have a higher risk profile are then reviewed during the Commission's on-site review of a DCO's risk management procedures.

C. Credit Default Swaps

i. Submissions Provided Information per § 39.5

Pursuant to § 39.5, the Commission received filings with respect to CDS from CME, ICE Clear Credit, and ICE Clear Europe.
37

The CME and ICE Clear Credit submissions included the CDS that each clear on North American corporate indices, covering various tenors and series. The ICE Clear Europe submission includes, among other swaps, the CDS contracts on European corporate indices that they clear, with information on each of the different tenors and series. Each of the submissions contained information relating to the five statutory factors set forth in section 2(h)(2)(D) of the CEA and other information required under § 39.5.

37
In the case of CME and ICE Clear Europe, the submissions also included other swaps beyond those in the CDS and IRS categories. These submissions, including a description of the specific swaps covered, are available at
http://www.cftc.gov/IndustryOversight/IndustryFilings/index.htm.

CME, ICE Clear Credit, and ICE Clear Europe provided notice of their § 39.5 swap submissions to their members by posting their submissions on their respective Web sites.
38

The submissions also are published on the Commission's Web site.

38
Available at:
http://www.cmegroup.com/market-regulation/rule-filings.html
and
https://www.theice.com/publicdocs/regulatory_filings/ICEClearCredit_022212.pdf.
ICE Clear Europe did not provide a link to its relevant Web page.

Regulation 39.5(b)(3)(viii) also directs a DCO's submission to include a summary of any views on the submission expressed by members. CME's submission did not address this. In their submissions, ICE Clear Credit and ICE Clear Europe stated that neither has solicited nor received any comments to date and will notify the Commission of any such comments. The Commission expects that DCOs will provide any feedback they receive regarding their submissions to the Commission for consideration.

ii. Background on Market

A credit default swap is a bilateral contract that allows the counterparties to trade or hedge the risk that an underlying entity will default—in most cases, either a corporate or a sovereign borrower. The protection buyer makes a quarterly premium payment until a pre-defined credit event occurs or until the swap agreement matures. In return, the protection seller assumes the financial loss in case the reference borrower becomes insolvent or an underlying security defaults. In addition to such “single name” CDS described above, the market also developed CDS to cover multi-name baskets of entities. While these baskets can be specifically created by the parties in a bespoke swap transaction, the large majority of multi-name baskets are based on both standardized indices and standardized swap agreements. These index CDS can cover up to 125 reference entities. Each of these entities may be weighted equally within the index or have different weightings depending on the terms of the specific index. Unlike a single name CDS, these contracts generally continue until the swap agreement reaches its scheduled termination date. Under the contract, the protection seller would assume the financial loss associated with, and make payment to the protection buyer on, each of the individual entities in the index that suffers a credit event until the swap's maturity. Those entities suffering a credit event would be removed from the index. The swap would continue on the remaining names, with the protection buyer making reduced quarterly premium

payments based upon the now smaller index covered by the swap.

The most recent BIS study
39

found that, as of December 2011, the size of the overall CDS marketplace exceeded $28.6 trillion in notional amount outstanding. Of that amount, $11.8 trillion was in multi-name CDS agreements. Within this sub-category of CDS, CDS on indices accounted for more than 89% of the total notional amount outstanding. This continues a trend as CDS on standardized indices have seen increasing volumes relative to other multi-name instruments such as synthetic collateralized debt obligations and other bespoke products.

39

See
BIS data, available at
http://www.bis.org/statistics/otcder/dt1920a.pdf.

Multiple providers have established CDS indices to be used by market participants. These providers typically establish an index's constituents, as well as standard terms and tenors. They also may provide on-going pricing services for their indices. The CDS indices owned and managed by Markit have the dominant market share within this class of CDS. There are other providers of CDS indices, though to date, those indices have not been widely used. Currently none of the indices are the basis for any CDS cleared by a DCO.
40

The Markit CDX family of indices is the standard North American credit default swap family of indices, with the primary corporate indices being the CDX North American Investment Grade (consisting of 125 investment grade corporate reference entities
41

) (CDX.NA.IG) and the CDX North American High Yield (consisting of 100 high yield corporate reference entities) (CDX.NA.HY). The standard currency for CDS on these indices is the U.S. dollar.

40
S&P/ISDA have, for example, co-branded additional indices for use in the CDS marketplace. These indices cover similar classes of reference entities as the Markit indices. To date, however, the use of these indices by market participants has been limited. With insufficient data regarding outstanding notional amounts and trading volumes, the Commission does not believe it appropriate to include these indices in the mandatory clearing determination. To the extent other providers establish indices with demonstrable open interest, trading volumes and pricing sources, the Commission will consider them for inclusion either within the current proposed classes of swaps, or within a separate class of swaps. Exclusion for the proposed classes only means that the CDS on such indices are not subject to a clearing requirement, and has no other impact on the use of such indices by market participants.

41
The term “reference entities” refers to those entities that form the basis of an index. For the indices discussed in this proposal, all of the reference entities are corporate entities. For example, when one of those corporate entities declares bankruptcy, it may trigger a credit event under the terms of the index. A credit event also may be declared when a reference entity fails to pay on an outstanding debt.

Additionally, Markit owns and manages the iTraxx indices covering reference entities in the European and Asia/Pacific markets. The primary indices for the European markets are the iTraxx Europe which covers 125 European investment grade corporate reference entities, the iTraxx Europe Crossover covering 50 European high yield reference entities and the iTraxx Europe High Volatility, which is a 30-entity subset of the European investment grade index. These indices are generally denominated in euro.

Beyond those discussed above, Markit provides more granular indices covering specific corporate sectors in both the United States and Europe. Markit also provides indices that cover non-corporate reference entities, including indices of sovereign reference entities from around the world, U.S. municipal issuers and structured finance issuers. Some of the sector specific CDS, particularly those based on indices in the iTraxx family have significant volumes. For example, the iTraxx Europe Senior Financials referencing European financial institutions has over $13 billion in net notional and 3,711 open contracts for Series 17 according to DTCC data.
42

Those contracts are not currently cleared by a DCO and thus have not been submitted to the Commission. Therefore, these contracts are not being considered as part of the proposed clearing requirement determination discussed herein. To the extent these contracts were to be cleared by a DCO in the future, the DCO would be required to submit those contracts to the Commission for review pursuant to § 39.5. If those contracts were not cleared by any DCO, they may still be subject to a Commission-initiated review pursuant to § 39.5(c) in the future.

42

See www.dtcc.com.
Data as of May 21, 2012.

As administrator of these indices, Markit reviews the composition of underlying reference entities in the indices every six months. Once Markit establishes the constituents to be included within the indices, a new series of the respective index is created. Additionally, each time one of the reference entities within an index suffers a credit event, a new version of an existing series of the index is created. In addition to the series and version variations that may exist on the index, the parties can choose the tenor of the CDS on a given index. While the 5-year tenor is the most common, and therefore most liquid, other standard tenors may include 1-, 2-, 3-, 7-, and 10-year swaps.

Beyond these administrative functions, Markit, in conjunction with ISDA, has established standardized transaction terms and legal documentation in the form of standard terms supplements and confirmations for their indices. In the vast majority of cases, transactions using the indices are executed using these standard terms, although the indices also may be used in connection with non-standard transactions. A particular CDS index agreement will only be eligible to be cleared by a DCO to the extent the agreement is based upon the standard terms. Consistent with the movement of the CDS market to standardized contracts and spreads, cleared contracts all use standardized spreads of 100 or 500 basis points on the cost of protection, with the use of the upfront payments to accurately capture the cost of the credit protection on the indices.
43

43
ISDA's Big Bang Protocol in April 2009, in addition to providing the “hardwiring” necessary for Auction Settlement and the establishment of the Credit Derivatives Determination Committees, also created a new standardized North American corporate CDS contract with fixed scheduled termination dates, fixed payment and accrual dates, and standardized coupons.
See http://www.isda.org/companies/auctionhardwiring/auctionhardwiring.html.

The CDS cleared by CME, ICE Clear Credit, and ICE Clear Europe that were submitted to the Commission are standardized contracts providing credit protection on an untranched basis, meaning that settlement is not limited to a specific range of losses upon the occurrence of credit events among the reference entities included within an index. Besides single name CDS, these untranched CDS on indices are the only type of CDS being cleared by these DCOs. Other swaps like credit index tranches, options, and first- or Nth-to-default baskets on these indices are not currently cleared.

Both CME and ICE Clear Credit have submitted standard untranched CDS on the CDX.NA.IG and the CDX.NA.HY indices that they clear. CME offers the CDX.NA.IG at the 3-, 5-, 7- and 10-year tenors for each series going back to Series 9 for those contracts that have not reached their termination date. For the North American high yield index, CME offers clearing for Series 11 and each subsequent series at the 5-year tenure.

ICE Clear Credit offers CDX.NA.IG Series 8 and all subsequent series of that index that are still outstanding at the 5- and 10-year tenors. Additionally, Series 8 to Series 10 are cleared at the 7-year tenor. For the high yield index, ICE Clear Credit clears all series from the current series through the CDX.NA.HY Series 9 at the 5-year tenor.

In addition to these indices, ICE Clear Credit has also cleared the CDX North American Investment Grade High Volatility (consisting 30 names from the CDX.NA.IG) (CDX.NA.IG.HVOL). ICE Clear Credit is not however clearing Series 18, the most recently established series of the CDX.NA.IG.HVOL or Series 17, given the limited trading volumes for this swap. ICE Clear Credit only clears the CDX.NA.IG.HVOL for Series 9 through Series 16, and only at the 5-year tenor.

ICE Clear Europe, another registered DCO, made a submission covering the index CDS that it clears. Similar to the other submissions, the contracts that ICE Clear Europe clears are focused on corporate reference entities, though in this case, the entities are based in Europe. Also, similar to the CME and ICE Clear Credit submissions, the swaps cleared by ICE Clear Europe are indices owned and administered by Markit. ICE Clear Europe clears the euro-denominated contracts referencing the iTraxx Europe, the iTraxx Europe Crossover, and the iTraxx Europe High Volatility. For the iTraxx Europe and Crossover, ICE Clear Europe clears outstanding contracts in the Series 7 and 8, respectively, through the current series. For the High Volatility index, ICE Clear Europe clears outstanding contracts in the Series 9 through the current series. In terms of tenors, ICE Clear Europe clears the 5-year tenor for all swaps, as well as the 10-year tenor for the iTraxx Europe index.

Based upon those portions of the CME, ICE Clear Credit, and ICE Clear Europe swap submissions relating to the cleared CDS contracts discussed above, as well as the analysis conducted by the Commission pursuant to § 39.5(b) and set forth below, the Commission is reviewing the following classes of swaps for purposes of the clearing requirement.

iii. CDS Trading and Risk Management

The indices were created in the mid-2000s. Parties to these OTC contracts could use the indices to express their bullish or bearish sentiments on credit as an asset class, or to actively manage their credit exposures.
44

As standardized contracts and indices, they had increased liquidity and were cheaper and easier to enter into than a customized transaction. Following the financial crisis, the popularity of such bespoke transactions like synthetic collateral debt obligations decreased and the standardized indices continued to grow.

44
Generally the market for all CDS is driven by dealers. Recent estimates found that about 74% of CDS trading takes place among 20 dealer-banks worldwide, according to data from DTCC., which runs a central registry for credit derivatives.
See http://www.bloomberg.com/news/2011-11-01/selling-more-insurance-on-shaky-european-debt-raises-risk-for-u-s-banks.html.

Markit licenses its indices to market making financial institutions. Notwithstanding that these contracts trade as OTC products, the standardization of the contracts has allowed for them to be completed and confirmed electronically by a number of service providers. The 5-year tenor is the most liquid of the tenors. Similarly, the current “on-the-run” series tend to see the most liquidity, while the older “off-the-run” series tend to see less liquidity.
45

Many investors exit positions in an existing series when a new series “rolls,” explaining increased liquidity in the “on-the-run” series. As noted above, the pricing for the contract is generally set at a standardized rate of 100 or 500 basis points, with upfront payments exchanged to compensate for the actual price of the credit protection being provided.

45
The term “on-the-run” refers to current series of an index, while older series are referred to “off-the-run.” Each six months when a new series is created (or “rolls” using market terminology), the new series is considered the “on-the-run” index, and all others are considered “off-the-run.”

For the DCOs clearing these swaps, the key factors in managing the risk of CDS portfolios that they clear are changes in the price of the swaps, the idiosyncratic risk related to the default of a reference entity, and the liquidity risk associated with unwinding a portfolio of a defaulting clearing member. While differing in the specific margin methodologies, each of the DCOs uses methodologies designed to capture 99% of potential portfolio losses over a five-day period. The DCOs will stress CDS portfolios with shifts both up and down in the price of the CDS, as well as with changes to the slope of the term structure of the CDS pricing curve. Idiosyncratic risk will be captured by a “jump-to-default” analysis in which widely held reference entities are assumed to default with limited or no recovery. Liquidity risk seeks to capture the cost of liquidating a portfolio, with assumed higher costs associated with concentrated portfolios.

The DCOs conduct end-of-day settlement on the CDS, using prices submitted by clearing members that hold a cleared position in that swap. According to DCO rules, the submitted prices may be traded against, such that members are incentivized to submit accurate pricing data. The DCOs analyze the submitted data to remove any outliers.
46

The DCOs then calculate a composite spread or price by aggregating all the prices individually submitted, after deleting the outliers.
47

The more liquid a particular swap, the more price submissions will be made.

46
Clearing rules generally provide for a mechanism for DCOs to levy fines against clearing members for failure to submit accurate prices across the full term structure for a given product.

47
The theoretical spread/price of the index may be calculated by looking at the spread/price of each of the individual constituents in the index, though this may not account for the actual demand to buy or sell protection based on the index itself.

In the event of a default of a clearing member, the DCOs have the ability to conduct an auction for other members to bid on all or a portion of the defaulting member's portfolio of CDS positions. To the extent that the DCO was unable to sell the entire portfolio, the clearing rules require the non-defaulting clearing members to accept an apportionment of such portfolio if required by the DCO. To the extent the market for a swap is more liquid, the chances for a successful auction would likely be increased. Further, to the extent an auction is unsuccessful, a more liquid market would give the clearing member receiving such an apportionment a better opportunity to successfully sell or otherwise offset the risk associated with the CDS it accepted.

In addition to the CDS indices, ICE Clear Credit and ICE Clear Europe also offer single name CDS
48

for clearing. Of the $29 trillion in CDS notional outstanding, approximately $17 trillion is in single name swaps according to the latest market survey of BIS.
49

As part of their margining methodology, DCOs are seeking approval to offer portfolio margining for the single name CDS and the CDS indices held within a given portfolio.
50

Given that the single name reference entities will likely also be constituents of a given index within a portfolio, the Commission generally believes that such portfolio margining initiatives are consistent with the sound risk management policies for DCOs that are required under § 39.13(g)(4). Moreover, DCOs such as ICE Clear Credit already use margining methodologies that provide for appropriate portfolio margining treatment with regard to clearing

members' proprietary positions.
51

The Commission is committed to working toward establishing similar portfolio margining programs for DCOs clearing customer positions in CDS indices and single name CDS.

48
Such single name CDS are defined as “security-based swaps” under section 721(a) of the Dodd-Frank Act.

49

See
BIS data, available at
http://www.bis.org/statistics/otcder/dt1920a.pdf.

50

See
ICE Clear Credit's petitions to the Commission and SEC, dated October 4, 2011. The petition to the Commission is available at
http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/iceclearcredit100411public.pdf.

51
See ICE Clear Credit's certification to the Commission, dated as of November 25, 2011. The certification is available at
http://www.cftc.gov/stellent/groups/public/@rulesandproducts/documents/ifdocs/rul112511icecc001.pdf.

iv. CDS Classes Based on Key Specifications

Under § 39.5, the decision of the Commission to require that a group, category, type, or class of swaps be required to be cleared is informed by a number of factors. As an initial matter, the Commission looks to the submissions of the DCO themselves with regard to the swaps they submit. After analyzing the key attributes of the swaps submitted, the Commission is proposing to establish two classes of CDS subject to the clearing requirement. The first class is based on the North American untranched indices and the second class is based on the European untranched indices.

Given the different markets that the CDS indices cover, the different currencies and other logistical differences in how the CDS markets and documentation work, the Commission believes this is an appropriate basis for separate classes. In the case of the submissions received to date, the U.S. dollar-denominated CDS covering North America corporate credits would be a separate class of CDS from a euro-denominated CDS referencing European obligations.

The nature of the underlying reference entities for the CDS serve to establish the another specification. Each index referenced was a broad-based pool of corporate entities. These indices included both investment grade and high yield corporate entities and they were not limited by a specific sector type. The data available for corporate CDS transactions, including the CDS indices, is substantial. As new swaps are cleared and considered by class, the nature of the underlying index will continue to be a factor in the establishment of such classes.

As noted above, the regional differences in the way CDS indices are traded and cleared warrant a separate specification based upon common market standards established within the regions. Beyond different currencies, the key terms of the underlying CDS, including the relevant credit events, may differ with direct impact on the clearing and risk management of these products by DCOs.

The actual indices included within a class are also specified. As only certain indices for a type of reference entity may have significant trading volumes and be cleared within a particular region, it is necessary to identify those specific indices within the classes.

The classes are also being defined by particular tenors for the various indices included within the class. Given varying outstanding notional amounts and trading volumes on different tenors of existing indices, the Commission has analyzed the impact of including all or only select tenors within a given class. In addition, applicable series are identified within each tenor so that market participants can identify whether a particular series of given index is required to be cleared.

Finally, the nature of the CDS itself referencing the underlying indices will be a factor as well. Each of the submissions dealt only with untranched CDS on the indices. There is a significant market for tranched swaps using the indices, where parties to the CDS contract agree to address only a certain range of losses along the entire loss distribution curve. Other swaps such as first or “Nth” to default baskets, and options, also exist on the indices.

v. Identification of Specifications

The Commission is proposing two classes of CDS contracts subject to the clearing requirement. The first class would be untranched CDS contracts referencing corporate entities in North America via Markit's CDX.NA.IG and CDX.NA.HY indices. The second class would include untranched CDS referencing European corporate entities via Markit's iTraxx Europe, iTraxx Europe Crossover and iTraxx Europe High Volatility. The following table sets forth the specific specifications of each class:

Table 1

North American Untranched CDS Indices Class

Specification

1. Reference Entities
Corporate.

2. Region
North America.

3. Indices
CDX.NA.IG.

CDX.NA.HY.

4. Tenor
CDX.NA.IG: 3Y, 5Y, 7Y, 10Y.

CDX.NA.HY: 5Y.

5. Applicable Series
CDX.NA.IG 3Y: Series 15 and all subsequent Series, up to and including the current Series.

CDX.NA.IG 5Y: Series 11 and all subsequent Series, up to and including the current Series.

CDX.NA.IG 7Y: Series 8 and all subsequent Series, up to and including the current Series.

CDX.NA.IG 10Y: Series 8 and all subsequent Series, up to and including the current Series.

CDX.NA.HY 5Y: Series 11 and all subsequent Series, up to and including the current Series.

6. Tranched
No.

European Untranched CDS Indices Class

Specification

1. Reference Entities
Corporate.

2. Region
Europe.

3. Indices
iTraxx Europe.

iTraxx Europe Crossover.

iTraxx Europe HiVol.

4. Tenor
iTraxx Europe: 5Y, 10Y.

iTraxx Europe Crossover: 5Y.

iTraxx Europe HiVol: 5Y.

5. Applicable Series
iTraxx Europe 5Y: Series 10 and all subsequent Series, up to and including the current Series.

iTraxx Europe 10Y: Series 7 and all subsequent Series, up to and including the current Series.

iTraxx Europe Crossover 5Y: Series 10 and all subsequent Series, up to and including the current Series.

iTraxx Europe HiVol 5Y: Series 10 and all subsequent Series, up to and including the current Series.

6. Tranched
No.

The Commission is proposing to separate the classes of corporate swaps between the North American contracts and European contracts. The Commission believes that indices based on other types of entities would be viewed as a separate class and would be subject to a separate determination by the Commission. For example, given the differences that exist with regard to volumes and risk management of indices based on sovereign issuers, it is likely that such CDS would represent their own class of swaps. Similarly, to the extent indices from other regions were submitted by a DCO, it is likely that the Commission would take the view that they are part of their own class of swaps as well.

The Commission believes it appropriate to define the classes of swaps as untranched CDS contracts referencing the broad-based corporate indices of Markit. These corporate indices have the most net notional outstanding, the most trading volumes, and the best available pricing. The risk management frameworks for the corporate index swaps are the most well-established, and have the most available data in terms of CDS spreads and corporate default studies for analysis of the underlying constituents of the indices. Agreements based on these indices also are widely accepted and use standardized terms.
52

52
To the extent other vendors successfully develop similar indices, the Commission would conduct the analysis required by § 39.5, either on its own initiative or based on a DCO submission. If based on that analysis the Commission issued a clearing requirement determination, it is likely that such indices would be considered to be part of an existing class of CDS that are required to be cleared.

Both of the CDS classes presented herein assume that the relevant CDS agreement will use the standardized terms established by Markit/ISDA with regard to the specific index and be denominated in a currency that is accepted for clearing by DCOs. To the extent that a CDS agreement on an index listed within the classification is not accepted for clearing by any DCO because it uses non-standard terms or is denominated in a currency that makes it ineligible for clearing, that CDS would not be subject to the requirement that it be cleared, notwithstanding that the CDS is based on such index.

With regard to the specific indices, the Commission has not included the CDX.NA.IG.HVOL within the North American swap class. While older series of this swap were cleared at the 5-year tenor by ICE Clear Credit, neither of the two most recent series has been cleared, given the lack of trading volume in this swap. The swap is not offered for clearing by CME. To the extent that any DCO decides to clear future series of this particular indice, it would need to be submitted pursuant to § 39.5, at which time, the Commission would be able to revisit the profile of the underlying index and determine whether swap contracts associated with this index should be subject to a clearing requirement.

ICE Clear Europe continues to clear the iTraxx Europe High Volatility through the current series at the 5-year tenor, notwithstanding declines in the volume for the recent series. Overall, the outstanding notional amounts and trading volumes are substantially less than those of the other iTraxx swaps. Recent DTCC data indicates that the gross notional amounts on contracts on the iTraxx Europe High Volatility index was $1.8 billion, representing less than 1% of those volumes for the European investment grade index and approximately 2.5% of the European high yield index for the same series.
53

53

See www.dtcc.com.
Data as of May 21, 2012.

Notwithstanding the relatively small volumes, the Commission is proposing to include the iTraxx Europe High Volatility index within the class of European corporate indices subject to required clearing at this time. Because the current on-the-run series of this particular index is cleared, unlike the similar North American contract, the Commission believes the contract should be included within the class of European corporate swaps that is required to be cleared.

With regard to tenors, Markit, as administrator of the indices, publishes the initial spreads on the roll for each of the tenors offered for a given indice. For the CDX.NA.IG, it publishes spreads for the 1-, 2-, 3-, 5-, 7-, and 10-year tenors. For the CDX.NA.HY, the spreads are set for the 3-, 5-, 7-, and 10-year tenors. For the iTraxx Europe, Crossover and High Volatility, spreads are similarly set for the 3-, 5-, 7-, and 10-year tenors.

Notwithstanding these various tenor offerings, the 5-year tenor for all indices is by far the most liquid tenor in the CDS marketplace. As a result, each DCO clears the 5-year tenor of the CDS index swaps that they clear. CME additionally offers clearing for 3-, 7-, and 10-year tenors on the CDX.NA.IG. ICE Clear Credit offers clearing on the 10-year tenor for the North American investment grade swap in addition to the 5-year contract. In the past, ICE Clear Credit has cleared the 7-year tenor of that index, but has not offered that tenor since Series 10. For the iTraxx indices, ICE Clear Europe offers the 10-year tenor on the investment grade index, in addition to the 5-year tenor.

Based upon its analysis of the § 39.5 factors, the Commission is proposing that each of the 3-, 5-, 7-, and 10-year tenors be included within the class of swaps subject to the clearing requirement determination for CDX.NA.IG. While the DCO submissions indicate varying degrees of trading volumes among the indices at tenors other than the 5-year tenor, there are clearly large notional volumes and trading activity across the products as a whole. The risk management frameworks and methodologies employed by the DCOs should not be substantially impacted or can be adjusted to accommodate additional tenors. The remaining factors should be unchanged.

The Commission is proposing to exclude the 1- and 2-year tenors of the CDX.NA.IG from the class at this point. The Commission would like to see more data on the volumes of these tenors. Importantly, these tenors of swaps have not been submitted to the Commission by a DCO, so the Commission could review them when submitted by a DCO or on its own initiative pursuant to the § 39.5(c). Because many investors use the 5-year tenor to take a view on credit as an asset class, and then exit the position when the new index rolls rather than hold a less liquid position in an off-the-run swap, the Commission is concerned that those seeking to avoid clearing may shift to the 1- or 2-year tenor to take a position on credit. The Commission will monitor volumes in the swaps at these tenors and evaluate

whether a change in the class of swaps to include these tenors is warranted.

With regard to the CDX.NA.HY, the Commission's proposal will be limited to the 5-year tenor, the predominant tenor in this contract.
54

Similarly, the Commission's proposal with regard to the iTraxx indices will capture only those tenors that are currently offered for clearing—the 5- and 10-year tenors for the iTraxx Europe, and the 5-year tenors for the iTraxx Crossover and the iTraxx High Volatility.

54
After its initial submission, ICE Clear Credit added the CDX.NA.HY, Series 15, 3-year contract to its list of CDS contracts eligible for clearing. The Commission has reviewed this contract, but is not including this particular contract within its proposed determination. The Commission will monitor volumes in the product at these tenors and evaluate whether a change in the class of swaps to include additional tenors is warranted.

The Commission's proposed clearing determination will be limited to only those series of a given index, which are currently being cleared. Therefore, no swaps referencing a series prior to Series 8 for the CDX.NA.IG and CDX.NA.HY would be required to be cleared. For the iTraxx Europe and iTraxx Europe Crossover, no contracts referencing a series prior to Series 7 would be required to be cleared, and in the case of the iTraxx Europe High Volatility, no series prior to Series 9 would be required to be cleared.
55

55
As discussed in further detail below, the clearing requirement would not require existing swaps in the older series to be cleared. The requirement is prospective, only requiring newly executed swaps in these older series to be cleared.

Further, to the extent that any contract is of a tenor such that it is scheduled to terminate prior to July 1, 2013, such contract would not be part of this proposed clearing determination. Given the implementation periods provided for under § 50.25, discussed below in Section IV, the Commission does not want to create a situation where certain market participants would be required to clear a contract based upon their status under the implementation provisions, but other parties would never be required to clear that same contract before its scheduled termination.

The Commission also is proposing that the classes be limited to untranched CDS agreements on the aforementioned indices where the contract covers the entire index loss distribution of the index and settlement is not linked to a specified number of defaults. Tranched swaps, first- or “Nth” to-default, options, or any other product variations on these indices are excluded from these classes. These other swaps based on the indices, such as tranches, have very different profiles in terms of the § 39.5 analysis. Besides very different notional and trading volumes, the risk management processes and operations may be significantly different. The Commission believes it appropriate to consider tranched swaps and other variations on the indices as outside of the classes of swaps proposed herein. Such swaps, if submitted, likely would be viewed as a separate class.

D. Proposed Determinations Analysis for Credit Default Swaps

Section 2(h)(2)(D)(i) of the CEA requires the Commission to review whether a swap submission under section 2(h)(2)(B) is consistent with section 5b(c)(2) of the CEA. Section 2(h)(2)(D)(ii) of the CEA also requires the Commission to consider five factors in a determination based on a Commission initiated review or a swap submission: (1) The existence of significant outstanding notional exposures, trading liquidity, and adequate pricing data; (2) the availability of rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the contract on terms that are consistent with the material terms and trading conventions on which the contract is then traded; (3) the effect on the mitigation of systemic risk, taking into account the size of the market for such contract and the resources of the DCO available to clear the contract; (4) the effect on competition, including appropriate fees and charges applied to clearing; and (5) the existence of reasonable legal certainty in the event of the insolvency of the relevant DCO or one or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property.

i. Consistency With Core Principles for Derivatives Clearing Organizations

Section 2(h)(2)(D)(i) of the CEA requires the Commission to review whether a submission is consistent with the core principles for DCOs. Each of the DCO submissions relating to CDS provided data to support the Commission's analysis of the five factors under section 2(h)(2)(D) of the CEA. The Commission also was able to call upon independent analysis conducted with regard to CDS market, as well as its knowledge and reviews of the registered DCOs' operations and risk management processes, covering items such as product selection criteria, pricing sources, participant eligibility, and other relevant rules. The discussion of all of these factors is set forth below.

The swaps submitted by CME, ICE Clear Credit, and ICE Clear Europe pursuant to § 39.5(b) are currently being cleared by those organizations. As discussed above, the risk management, rules, and operations used by each DCO to clear these swaps are subject to review by the Commission risk management, legal, and examinations staff on an on-going basis.

Additionally, each of the DCOs has established procedures for the review of any new swaps offered for clearing. Before the indices referenced herein were accepted for clearing by any of the DCOs, they were subject to review by the risk management functions of those organizations. Such analysis generally focuses on the ability to risk manage positions in the potential swaps and on any specific operational issues that may arise from the clearing of such swaps. In the case of the former, this involves ensuring that adequate pricing data is available, both historically and on a “going forward” basis, such that a margining methodology could be established, back-tested, and used on an on-going basis. Operational issues may include analysis of additional contract terms for new swaps that may require different settlement procedures. Each of the contracts submitted by CME, ICE Clear Credit, and ICE Clear Europe and discussed herein has undergone an internal review process by the respective DCO and has been determined to be within their product eligibility standards.

As part of their rule frameworks, each of the DCOs also maintains participant eligibility requirements. On April 20, 2012, CME filed its amended rule concerning CDS Clearing Member Obligations and Qualifications (Rule 8H04). Pursuant to the amended rule, published to comply with Commission Regulation 39.12(a)(2), a CDS clearing member would have to maintain at least $50 million of capital. The amended rule would also require a CDS clearing member's minimum capital requirement to be “scalable” to the risks it poses. Further, CME already has client clearing available for its CDS index contracts.

Similarly, on March 23, 2012, ICE Clear Credit filed its amended Rule 201(b) to incorporate the $50 million minimum capital requirement for clearing members. ICE Clear Credit also has client clearing available for its CDX index contracts.

ICE Clear Europe has adopted similar rules to comply with § 39.12(a)(2), and has instituted changes to its rules to permit client clearing of its iTraxx contracts.

In their submissions, CME and ICE Clear Credit enclosed their risk management procedures. In its submission, ICE Clear Europe references

its risk management procedures, which it had previously submitted to the Commission in connection with its application to register as a DCO. As part of its risk management and examination functions, the Commission reviews each DCO's risk management procedures, including its margining methodologies.

ICE Clear Credit uses a multi-factor model to margin the indices discussed herein, as well as single name CDS. The margining methodology is designed to capture the risk of movements in credit spreads, liquidation costs, jump-to-default risk for those names on which credit protection has been sold, large position concentration risks, interest rate sensitivity, and basis risk associated with offsetting index derived single names and opposite “outright” single names. These factors are similarly used by ICE Clear Europe to calculate the margining requirements for their iTraxx swap listings and the underlying single name constituents. The CME's CDS model also weighs a number of factors to calculate the initial margin for a portfolio of CDS positions. These include macro-economic risk factors, such as movements associated with systematic risk resulting in large shifts in credit spreads across a portfolio, shifts in credit spreads based on tenors and changes in relative spreads between investment grade and high yield spreads. Additional factors include specific sector risks, the idiosyncratic risk of extreme moves in particular reference entities and the liquidity risk associated with unwinding the portfolio. In all cases, the methodologies are designed to protect against any 5-day move in the value of the given CDS portfolio, with a 99% confidence level.

In addition to initial margin, each of the clearinghouses collects variation margin on a daily basis to capture changes in the mark-to-market value of the positions. To do this, the clearinghouses calculate end-of-day settlement prices using clearing member price submissions for cleared swaps. Each of the clearinghouses maintains processes for ensuring the quality of member price submissions, including the ability to compel trades at quoted prices on a random basis and to enforce fines on incomplete or incorrect submissions. ICE Clear Credit and ICE Clear Europe also use Markit services for CDX and iTraxx submissions. CME uses other third party data providers for pricing support as necessary on its cleared CDS products.

In addition to the end-of-day settlement, each of the clearinghouses monitors positions throughout the day and maintains the ability to require margin on an intraday basis. Triggers may be set based upon the erosion of margin to a specific level or a call may be made at the discretion of the clearinghouse. When necessary, DCOs apply concentration charges to a clearing member's house or customer account in order to address situations where the DCO believes a given position may be under-collateralized because the size of the position relative to the size of the market may increase the cost of liquidating the position.

In addition to the initial margin and variation margin collected by each DCO, each of the clearinghouses maintains a separate guaranty fund for its CDS clearing business. Using a combination of factors from their margining methodologies, positions are stressed to replicate extreme but plausible market conditions. Using these stressed results, each of the clearinghouses sizes its guaranty fund to cover the positions of its two largest debtor clearing members. Clearing members are required to contribute to the guaranty fund based on their relative positions.

To the extent a clearing member was unable to meet a margin call, or otherwise violated clearinghouse rules, each of the clearinghouses has the ability to find a clearing member in default. In such cases, each of the clearinghouses has established procedures by which it attempts to minimize the risk associated with a defaulting member's positions. A clearinghouse would activate its default committee, seconding traders from clearing participants, to work to partition the portfolio for sale and for hedging purposes. The clearinghouse would then conduct an auction among its clearing participants for the sale of the portfolio. To the extent certain positions were unsold, each of the clearinghouses has the ability to allocate such positions to the remaining clearing members.

While other resources of the clearinghouse would be available in the event of a default of a clearing member, including clearinghouse contributions, the initial margin and guaranty fund contributions make up the primary financial resources of the clearinghouses. In total, CFTC-registered DCOs are currently holding more than $20 billion in aggregate in initial margin to cover cleared CDS positions.
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Additionally, publicly available data shows that CME's CDS guaranty fund has approximately $629 million; ICE Clear Credit has a guaranty fund equal to $4.4 billion; and ICE Clear Europe has a guaranty fund €2.7 billion for its CDS business.
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In addition to the guaranty fund contributions made by clearing members, each of the clearinghouses also makes contributions to their respective funds, ranging in amounts from $50 to $100 million.
58

56
Based on Commission data for registered DCOs as of May 10, 2012.

57

See http://www.cmegroup.com/clearing/cme-clearing-overview/safeguards.html
for data regarding CME's guaranty fund, as of May 10, 2012;
https://www.theice.com/clear_credit.jhtml
for data on the size of ICE Clear Credit's guaranty fund; and
https://www.theice.com/clear_europe_cds.jhtml
for data on the size of ICE Clear Europe's guaranty fund for CDS, as of May 10, 2012.

58
Many DCOs also have rules allowing for an assessment of the remaining clearing members in the event of a default.

Based upon the Commission's on-going risk management and rule reviews, and its annual examinations of the DCOs, the Commission believes that the submissions of CME, ICE Clear Credit, and ICE Clear Europe are consistent with section 5b(c)(2) of the CEA and the related Commission regulations. In analyzing the CDS products submissions discussed herein, the Commission does not believe that a clearing determination with regard to the specified CDS products would be inconsistent with CME, ICE Clear Credit, or ICE Clear Europe's continued ability to maintain such compliance with the DCO core principles.

ii. Consideration of the Five Statutory Factors for Clearing Requirement Determinations

a. Outstanding Notional Exposures, Trading Liquidity, and Adequate Pricing Data

Section 2(h)(2)(D)(ii)(I) of the CEA requires the Commission to take into account the existence of outstanding notional exposures, trading liquidity, and adequate pricing data. As discussed earlier, the most recent BIS data has shown significant growth in the use of CDS on index products, with notional amounts growing by 40% over the most recent annual reporting period. Overall, CDS on index products account for 37% of all notional amounts of CDS contracts outstanding, with over $10 trillion in notional outstanding.

The predominant provider of CDS indices is Markit. Markit has indices covering corporate and sovereign entities, among others, in the United States, Europe, and Asia. Recent Markit data shows daily transaction volumes of 1,561 transactions using its licensed family of CDX indices, and 1,266 daily transactions using its European iTraxx index swaps.
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Further, it shows a rolling monthly average of $663 billion in gross notional amount for the CDX family of indices and €499 billion for

the iTraxx family. Nearly all of the CDX contracts and volumes come from indices that would be subject to the proposed clearing requirement determination. For the iTraxx, more than 79% of those daily contract volumes and 82% of the daily gross notional volumes come from the iTraxx investment grade and high yield indices contemplated by the proposed clearing requirement determination.

59
Based on data published on
www.markit.com
as of May 23, 2012.

One point highlighted by this data, however, is the declining trading liquidity in the off-the-run series that can occur. Of the volumes noted by Markit, nearly 60% was in the current on-the-run series, as compared to all other outstanding series combined. The submissions of ICE Clear Credit, ICE Clear Europe, and CME also note the decline in average weekly gross notional amounts and contracts for benchmark tenors for off-the-run indices. The decline however can be more precipitous among older off-the-run indices. While many market factors can contribute to the actual volumes for a specific off-the-run contract, subject to certain exceptions, the trend is generally toward lower volumes.

Set forth below is a table of data taken from DTCC as of May 22, 2012, highlighting the net notional amounts and outstanding contracts across all tenors available for each series in the proposed determination.
60

60
Data available at
www.dtcc.com.
In 2006, DTCC began providing warehouse services for confirmed CDS trades through its Trade Information Warehouse (TIW). With the commitment of global market participants in 2009 to ensure that all OTC derivatives trades are recorded by a central repository, TIW has become a global repository for all CDS trades. With all major market participants submitting their trades to the TIW, it is estimated that 98% of all CDS trades are included within the warehouse, making it the primary source of CDS transaction data.

BILLING CODE 6351-01-P

EP07AU12.000

Notwithstanding the declining volumes that occur when an index is no longer on-the-run, the Commission does not believe that is sufficient reason to exclude the older series from the classes of CDS. As the DTCC data indicates, there are still significant volumes of outstanding notional amounts in each of these series. From the perspective of the clearinghouse, the risk management of the older series of swaps should not provide significant additional challenges. With the significant notional and contract volumes still outstanding at DTCC, many clearing members already have these positions on their books and are meeting their risk management requirements, even in the face of declining trading volumes. Finally, while the volumes may decline, the data included in the submissions indicates that volume still does exist, and parties should be able trade as necessary. Additionally, as discussed further below, the clearing requirement would apply only to new swaps executed in the off-the-run indices.

Given the contract and notional volumes listed above, there is adequate data available on pricing. The pricing for the CDS on these indices is fairly consistent across clearinghouses. The clearinghouses generally require a clearing member with open interest in a particular index to provide a price on that index for end of day settlement purposes. After applying a process to remove clear outliers, a composite price is calculated using the remaining prices. To ensure the integrity of the submissions, clearing members' prices may be “actionable,” meaning that they may form the basis of an actual trade that the member will be forced to enter. Clearinghouses also have compliance programs that may result in fines for clearing members that fail to submit accurate pricing data.

Beyond clearing member submissions, there are a number of third-party vendors that provide pricing services on these swaps. Third-party vendors typically source their data from a broader range of dealers. The data includes both direct contributions as well as feeds to automated trading systems. This data is reviewed for outliers and aggregated for distribution.

b. Availability of Rule Framework, Capacity, Operational Expertise and Resources, and Credit Support Infrastructure

Section 2(h)(2)(D)(ii)(II) of the CEA requires the Commission to take into account the availability of rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the contract on terms that are consistent with the material terms and trading conventions on which the contract is then traded. The Commission preliminarily has determined that this factor is satisfied by each of CME, ICE Clear Credit, and ICE Clear Europe.

CME, ICE Clear Credit, and ICE Clear Europe, respectively, currently are clearing the swaps each submitted under § 39.5. As such, they have developed respective rule frameworks, capacity, operational expertise and resources, and credit support infrastructure to clear the contracts on terms that are consistent with the material terms and trading conventions on which the contracts currently are trading. The Commission believes that these are scalable and that CME, ICE Clear Credit, and ICE Clear Europe would be able to risk manage the additional swaps that might be submitted due to the clearing requirement determination.

Following the financial crisis, the major market participants committed in 2009 to the substantial reforms to the OTC derivatives markets.
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Among the commitments from CDS dealers and buy side participants was to actively engage with central counterparties to broaden the range of cleared swaps and market participants. These changes were in addition to those generated through organizations like ISDA and their protocols impacting CDS. For broadly traded swaps like the CDS indices, the ultimate impact of these initiatives was operational platforms, rule frameworks, and other infrastructure initiatives that replicated the bilateral market and supported the move of these CDS to a centrally cleared environment. In this way, the CDS clearing services offered by DCOs, including CME, ICE Clear Credit, and ICE Clear Europe, were designed to be cleared in a manner that is consistent with the material terms and trading conventions of a bilateral, uncleared market.

61

See
the June 2, 2009 letter to The Honorable William C. Dudley, President of the Federal Reserve Bank of New York, available at
http://www.newyorkfed.org/newsevents/news/markets/2009/060209letter.pdf.

In addition, CME, ICE Clear Credit, and ICE Clear Europe are registered DCOs. To be registered as such, CME, ICE Clear Credit, and ICE Clear Europe have, on an on-going basis, demonstrated to the Commission that they are each in compliance with the core principles set forth in the CEA and Commission regulations, as discussed above. As a general matter, any DCO that does not have the rule framework, capacity, operational expertise and resources, and credit support infrastructure to clear the swaps that are subject to mandatory clearing is not in compliance with the core principles or the Commission regulations promulgating these principles.

The Commission requests comment on all aspects of this factor, including whether or not commenters agree that an applicant's status as a registered DCO is sufficient for meeting the factor's requirements.

c. Effect on the Mitigation of Systemic Risk

Section 2(h)(2)(D)(ii)(III) of the CEA requires the Commission to take into account the effect on the mitigation of systemic risk, taking into account the size of the market for such contract and the resources of the DCO available to clear the contract. The Commission agrees with the § 39.5 swap submissions of the CME, ICE Clear Credit, and ICE Clear Europe that requiring certain classes of CDS to be cleared would reduce systemic risk in this sector of the swaps market. As CME noted, the 2008 financial crisis demonstrated the potential for systemic risk arising from the interconnectedness of OTC derivatives market participants and the limited transparency of bilateral,
i.e.
uncleared, counterparty relationships. According to the Quarterly Report (Third Quarter 2011) on Bank Trading and Derivatives Activities of the Office of the Comptroller of the Currency (OCC Report),
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CDS index products account for a significant percentage of the notional value of swaps positions held by financial institutions. According to ICE Clear Credit, the CDS indices it offers for clearing are among the most actively traded swaps with the largest pre-clearing outstanding positions, and ICE Clear Credit's clearing members are among the most active market participants. ICE Clear Credit also noted that its clearing members clear a significant portion of their clearing-eligible portfolio.

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Available at:
http://occ.treas.gov/topics/capital-markets/financial-markets/trading/derivatives/dq311.pdf.

Clearing the CDS indices subject to this proposal will reduce systemic risk in the following ways: Mitigating counterparty credit risk because the DCO would become the buyer to every seller of CDS indices subject to this proposal and vice versa; providing counterparties with daily mark-to-market valuations and exchange of variation margin pursuant to a risk management framework; posting initial margin with the clearinghouse in order to cover potential future exposures in the event of a default; achieving multilateral netting, which substantially reduces the number and notional amount of outstanding bilateral positions; reducing swap counterparties' operational burden by consolidating collateral management and cash flows; and eliminating the need for novations or tear-ups because clearing members may offset opposing positions.

As discussed previously, the clearinghouses collect substantial amounts of collateral in the form of initial margin and guaranty fund contributions to cover potential losses on CDS portfolios. The methodologies for calculating these amounts are based on covering 5-day price movements on a portfolio with a 99% confidence level for initial margin, and longer liquidation periods and higher confidence levels under “extreme but plausible” conditions in the case of guaranty fund requirements. Beyond these financial resources, the clearinghouses have in place established risk monitoring processes, system safeguards, and default management procedures, which are subject to testing and review, to address potential systemic shocks to the financial markets.

The Commission requests comment on all aspects of this factor, including the risk mitigation associated with proposed clearing determination.

d. Effect on Competition

Section 2(h)(2)(D)(ii)(IV) of the CEA requires the Commission to take into account the effect on competition, including appropriate fees and charges applied to clearing. Of particular concern to the Commission is whether this proposed determination would harm competition by creating, enhancing, or entrenching market power in an affected product or service market, or facilitating the exercise of market power.
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Under U.S. Department of Justice guidelines, market power is viewed as the ability “to raise price [including clearing fees and charges], reduce output, diminish innovation, or otherwise harm customers as a result of

diminished competitive constraints or incentives.”
64

63

See
U.S. Department of Justice and the Federal Trade Commission, Horizontal Merger Guidelines [hereinafter “Horizontal Merger Guidelines”] at § 1(Aug. 19, 2010), available at
http://www.justice.gov/atr/public/guidelines/hmg-2010.pdf.

64

Id.; see

also
U.S. Department of Justice (DOJ) and the Federal Trade Commission (FTC), Antitrust Guidelines for Collaborations Among Competitors at § 1.2 (April 2000), available at
http://www.ftc.gov/os/2000/04/ftcdojguidelines.pdf
(“The central question is whether the relevant agreement likely harms competition by increasing the ability or incentive profitably to raise price above or reduce output, quality, service, or innovation below what likely would prevail in the absence of the relevant agreement”).

The Commission has identified the following putative product and service markets as potentially affected by this proposed clearing determination: A DCO service market encompassing those clearinghouses that currently (or with relative ease in the future could) clear the CDS subject to this proposal, and a CDS product market or markets encompassing the CDS that are subject to this determination.
65

Without defining the precise contours of these markets at this time,
66

the Commission recognizes that, depending on the interplay of several factors, this proposed swap determination potentially could impact competition within the affected markets. Of particular importance to whether any impact is, overall, positive or negative, is: (1) Whether the demand for these clearing services and swaps is sufficiently elastic that a small but significant increase above competitive levels would prove unprofitable because users of the CDS products and DCO clearing services would substitute other products/clearing services co-existing in the same market(s), and (2) the potential for new entry into these markets. The availability of substitute products/clearing services to compete with those encompassed by this proposed determination, and the likelihood of timely, sufficient new entry in the event prices do increase above competitive levels, each operate independently to constrain anticompetitive behavior.

65
Included among these could be a separate product market for CDS indices licensing.

66
The federal antitrust agencies, the DOJ and FTC, use the “hypothetical monopolist test” as a tool for defining antitrust markets for competition analysis purposes. The test “identif[ies] a set of products that are reasonably interchangeable with a product,” and thus deemed to reside in the same relevant antitrust product or service market. “[T]he test requires that a hypothetical profit-maximizing firm, not subject to price regulation, that was the only present and future seller of those products (`hypothetical monopolist') likely would impose at least a small but significant and non-transitory increase in price (`SSNIP') on at least one product in the market.” In most cases, a SSNIP of five percent is posited. If consumers would respond to the hypothesized SSNIP by substituting alternatives to a significant degree to render it unprofitable, those alternative products/services are included within the relevant market. This methodological exercise is repeated until it has been determined that consumers have no further interchangeable products/services available to them. Horizontal Merger Guidelines at § 4.1.

Any competitive import would likely stem from the fact that proposed determination would (1) remove the alternative of not clearing the CDS subject to this proposal, and/or (2) single out Markit indices and certain tenors for determination. The proposed determination would not specify what CDS products (or products that compete with the proposed CDS classes) may or may not be offered, traded, or voluntarily cleared; or who may or may not compete to provide clearing services for the CDS subject to this proposal (as well as those not required to be cleared). With respect to the first potential area of competitive import, to the extent that parties to the CDS subject to this proposal consider clearing the transactions reasonably interchangeable with not clearing them, the proposed determination would eliminate at least one competitive substitute within the clearinghouse services market for the CDS subject to this proposal. Given the risk-mitigation purpose and benefit of migration to voluntary CDS clearing, however, the Commission sees some basis to doubt that, under the “hypothetical monopolist” methodology,
67

counterparties to cleared swaps would consider the alternative of not clearing CDS under this proposal as a reasonable substitute to a degree sufficient that they should be viewed as populating the same relevant market.
68

And, if the alternative of not clearing the proposed classes of CDS falls outside of the relevant services market that includes clearing, the proposed clearing determination should not impact competition in the clearing services market. The Commission requests comment on the extent to which foregoing clearing is considered reasonably interchangeable with clearing the CDS subject to this proposal and, in particular, if parties transacting cleared swaps in these classes would forego clearing if clearinghouses raised the price of clearing five percent. The Commission also requests comment on whether a different percentage than five percent should be used.

67

See id.

68
In other words, the Commission questions that, faced with a five percent non-transitory increase in the price of clearing the identified CDS classes, including fees and other charges, that the parties to these CDS transactions would forego clearing in sufficient volume to render the price increase unprofitable.

Moreover, even if cleared and non-cleared transactions in the proposed CDS clearing requirement are now within the same relevant market, removing the uncleared option through this proposed rulemaking is not determinative of negative competitive impact. Other factors—including the availability of other substitutes within the market or potential for new entry into the market—may constrain market power.

The Commission recognizes that currently no DCO clears CDS indices licensed by any other provider than Markit, suggesting the possibility that currently the clearing service market may be limited to the three providers (CME, ICE Clear Credit, and ICE Clear Europe) now clearing CDS indices licensed by Markit. This could be indicative, but is not dispositive, of whether a concentrated clearing services market susceptible to exercises of market power exists. The possibility remains that uncleared transactions on other indices, as well as cleared and uncleared transactions on Markit indices of tenors not included within the proposed determination, may also populate the affected clearing services market to constrain CME, ICE Clear Credit, and ICE Clear Europe from exercising market power.
69

The Commission requests comment on the extent to which uncleared transactions on non-Markit indices, and cleared and uncleared transactions on Markit indices of tenors not included within the proposed determination, are considered reasonably interchangeable with clearing the CDS subject to this proposal; and, in particular, if parties transacting cleared CDS subject to this proposal would substitute uncleared transactions on non-Markit indices and/or transactions on Markit CDS tenors not subject to this proposal if clearinghouses raised the price of clearing the CDS required to be cleared five percent.

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Stated another way, competitive or potentially competitive CDS indices other than Markit, or for Markit CDS tenors other than those subject to this proposal, may offer a reasonably interchangeable substitute for cleared transactions in the proposed classes proposed, particularly if the price of clearing the required classes increased five percent.

Additionally, the potential for new entry may constrain market power in an otherwise concentrated clearing services market. The Commission does not foresee that the proposed determination constructs barriers that would deter or impede new entry into a clearing services market.
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Indeed, there is some

basis to expect that the determination could foster an environment conducive to new entry. For example, the proposed clearing determinations, and the prospect that more may follow, is likely to reinforce, if not encourage, growth in demand for clearing services. Demand growth, in turn, can enhance the sales opportunity, a condition hospitable to new entry.
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Further, this proposed determination may increase the incentive of competing indices providers (for illustration purposes, Standard & Poor's) to support a new clearing services entrant through some form of partnership or other sponsorship effort. The Commission requests comment on the extent to which (1) entry barriers currently do or do not exist with respect to a clearing services market for the identified CDS classes; (2) the proposed determinations may lessen or increase these barriers; and (3) the proposed determinations otherwise may encourage, discourage, facilitate, and/or dampen new entry into the market.

70
That said, the Commission recognizes that (1) to the extent the clearing services market for the CDS subject to this proposal, after foreclosing uncleared swaps, would be limited to a concentrated few participants with highly aligned incentives, and (2) the clearing services market is insulated from new competitive entry through barriers—
e.g.,
high sunk capital cost requirements; high switching costs to transition from embedded, incumbents; and access restrictions, the proposed

determination could have a negative competitive impact by increasing market concentration.

71

See, e.g
.,
Horizontal Merger Guidelines at § 9.2 (entry likely if it would be profitable which is in part a function of “the output level the entrant is likely to obtain”).

Also, while the proposed rule does single out Markit indices and certain CDS tenors for required clearing, for reasons similar to those discussed above, this does not foreclose competition from CDS on other indices or tenors, and may in fact encourage it. For example, the Commission anticipates that an attempt by Markit to increase indices licensing fees would present a competitive opportunity for current and potential future indices providers to capture market share and/or entrants to leverage from market entry. The Commission requests comment on the extent to which competition in identified Markit CDS product markets may be impacted, including any expected impact on the price of Markit indices licenses, cost of swaps in the required classes, and entry conditions.

In addition to what is noted above, the Commission requests comment, and quantifiable data, on whether the required clearing of any or all of these swaps will create conditions that create, increase, or facilitate an exercise of (1) clearing services market power in CME, ICE Clear Credit, ICE Clear Europe, and/or any other clearing service market participant, including conditions that would dampen competition for clearing services and/or increase the cost of clearing services, and/or (2) market power in any product markets for Markit indices and CDS tenors, including conditions that would dampen competition for these product markets and/or increase the cost of CDS involving the proposed clearing requirement. The Commission seeks comment, and quantifiable data, on the likely cost increases associated with clearing, particularly those fees and charges imposed by DCOs, and the effects of such increases on counterparties currently participating in the market. The Commission also seeks comment regarding the effect of competition on risk management by DCOs. The Commission welcomes comment on any other aspect of this factor.

e. Legal Certainty in the Event of the Insolvency

Section 2(h)(2)(D)(ii)(V) of the CEA requires the Commission to take into account the existence of reasonable legal certainty in the event of the insolvency of the relevant DCO or one or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds, and property. The Commission is proposing this clearing requirement based on its view that there is reasonable legal certainty with regard to the treatment of customer and swap counterparty positions, funds, and property in connection with cleared swaps, namely the CDS indices subject to this proposal, in the event of the insolvency of the relevant DCO (CME, ICE Clear Credit, or ICE Clear Europe) or one or more of the DCO's clearing members.

The Commission concludes that, in the case of a clearing member insolvency at CME or ICE Clear Credit, subchapter IV of Chapter 7 of the U.S. Bankruptcy Code (11 U.S.C. 761-767) and Part 190 of the Commission's regulations would govern the treatment of customer positions.
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Pursuant to section 4d(f) of the CEA, a clearing member accepting funds from a customer to margin a cleared swap, must be a registered FCM. Pursuant to 11 U.S.C. 761-767 and Part 190 of the Commission's regulations, the customer's CDS positions, carried by the insolvent FCM, would be deemed “commodity contracts.”
73

As a result, neither a clearing member's bankruptcy nor any order of a bankruptcy court could prevent either CME or ICE Clear Credit from closing out/liquidating such positions. However, customers of clearing members would have priority over all other claimants with respect to customer funds that had been held by the defaulting clearing member to margin swaps, such as the customers' positions in CDS indices subject to this proposal.
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Thus, customer claims would have priority over proprietary claims and general creditor claims. Customer funds would be distributed to swaps customers, including CDS customers, in accordance with Commission regulations and section 766(h) of the Bankruptcy Code. Moreover, the Bankruptcy Code and the Commission's rules thereunder (in particular 11 U.S.C. 764(b) and 17 CFR 190.06) permit the transfer of customer positions and collateral to solvent clearing members.

72
The Commission observes that an FCM or DCO also may be subject to resolution under Title II of the Dodd-Frank Act to the extent it would qualify as covered financial company (as defined in section 201(a)(8) of the Dodd-Frank Act).

73
If an FCM is also registered as a broker-dealer, certain issues related to its insolvency proceeding would also be governed by the Securities Investor Protection Act.

74
Claims seeking payment for the administration of customer property would share this priority.

Similarly, 11 U.S.C. 761-767 and Part 190 would govern the bankruptcy of a DCO, in conjunction with DCO rules providing for the termination of outstanding contracts and/or return of remaining clearing member and customer property to clearing members.

With regard to ICE Clear Europe, the Commission understands that the default of a clearing member of ICE Clear Europe would be governed by the rules of that DCO. ICE Clear Europe, a DCO based in the United Kingdom, has represented that under English law its rules would supersede English insolvency laws. Under its rules, ICE Clear Europe would be permitted to close out and/or transfer positions of a defaulting clearing member that is an FCM pursuant to the U.S. Bankruptcy Code and Part 190 of the Commission's regulations. According to ICE Clear Europe's submission, the insolvency of ICE Clear Europe itself would be governed by both English insolvency law and Part 190.

ICE Clear Europe has obtained legal opinions that support the existence of such legal certainty in relation to the protection of customer and swap counterparty positions, funds, and property in the event of the insolvency of one or more of its clearing members. In addition, ICE Clear Europe has obtained a legal opinion from U.S. counsel regarding compliance with the protections afforded to FCM customers under New York law.

The Commission requests comment on its conclusions with regard to legal certainty in the event of an insolvency of CME, ICE Clear Credit, ICE Clear

Europe, or one of such DCOs' clearing members.

Request for Comment

The Commission requests comment on all aspects of the proposed classes of CDS to be included within the clearing requirement and the proposed determination. The Commission may consider alternatives to the proposed CDS classes and is requesting comment on the following questions:

• Should the Commission include all tenors, such as the 1- or 2-year tenor for Markit indices, for each index included within the class, notwithstanding the fact that those are tenors not currently cleared by a DCO? Will market participants be incentivized to use such contracts to avoid the clearing requirement?

• Should the Commission limit its determination to the most liquid tenors of the CDX.NA.IG such as the 5- and 10-year tenors, and exclude other tenors such as the 3- and 7-year tenors, which are less liquid?

• Is the Commission correct in believing that risk management frameworks and methodologies supporting existing cleared offerings can be adjusted to address additional tenors with limited changes?

• Should the Commission structure its clearing requirement such that indices that become older off-the-run indices are no longer subject to the requirement? In such a proposal, how should the Commission treat those off-the-run indices, such CDX.NA.IG Series 9, that have remained extremely active notwithstanding being off-the-run? Should the Commission establish some type of threshold of trading to exclude off-the-run indices from the requirement? How would the Commission construct a rule to indicate that an off-the-run index is no longer subject to clearing?

• To the extent off-the-run indices were excluded from the clearing requirement, would market participants be incentivized to trade in older off-the-run indices, as opposed to current on-the-run indices?

• The CDS indices proposed to be included within the clearing requirement are currently offered by DCOs and are among the most liquid CDS. Is there any factor within the five statutory that do not support inclusion with the clearing requirement? Are there other factors outside of those five factors with regard to these particular offerings that weigh against inclusion in a clearing determination?

E. Interest Rate Swaps

i. Introduction

Interest rate swaps are agreements wherein counterparties agree to exchange payments based on a series of cash flows over a specified period of time typically calculated using two different rates multiplied by a notional amount. As of June 2011, the BIS estimated that over $500 trillion in notional amount of single currency interest rate swaps were outstanding
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representing 75 to 80%of the total estimated notional amount of derivatives outstanding.
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Based on these factors and on the swap submissions received under § 39.5(b), the Commission believes that interest rate swaps represent a substantial portion of the swaps market and warrant consideration by the Commission for required clearing.

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BIS, OTC Derivatives Market Activity in the First Half of 2011, November 2011, Table 1 [hereinafter “BIS data”]. The BIS data provides the broadest market-wide estimates of interest rate swap activity available to the Commission.

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Id.

The Commission's consideration of the interest rate swap submissions (IRS submissions) is presented in two parts. The first part, this Section II.E, discusses the Commission's rationale for determining how to classify and define the interest rate swaps identified in the DCO submissions to be considered for the clearing requirement. The second part, Section II.F, presents the Commission's consideration of the IRS submissions in accordance with section 2(h)(2)(D) of the CEA.

Unlike certain CDS or futures contracts, there are a large number of different, variable contract specifications available and used in interest rate swap transactions. As an indication of this variability, the Commission notes that over 10,500 different combinations of significant interest rate swap terms were identified for trades executed in a single three month period in 2010.
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This variability creates a challenge for DCOs to specify the interest rate swaps for which clearing services are available and for the Commission to define what kinds of interest rate swaps will be subject to the clearing requirement. Notwithstanding this variability in swap terms, parties generally seek common economic results when entering into interest rate swaps, and there are common contract definitions and conventions that make classifying and clearing interest rate swaps possible. Identifying and analyzing these commonalities is necessary for effective classification of the swaps that will be subject to a proposed clearing requirement determination for interest rate swaps. Accordingly, a summary of the DCO submissions received by the Commission is followed by a discussion of how interest rate swaps are traded and risk managed and an analysis of the primary interest rate swap classes that are cleared and the product specifications used to identify interest rate swap products within each class. Thereafter, in Section II.F the Commission considers each of the interest rate swap classes and the primary specifications that are identified in the IRS submissions using the five factors identified in section 2(h)(2)(D) of the CEA to determine which interest rate swaps shall be required to be cleared.

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Federal Reserve Bank of New York Staff Reports, “An Analysis of OTC Interest Rate Derivatives Transactions: Implications for Public Reporting” (March 2012) at 3 [hereinafter “NY Fed Analysis”], available at
http://www.newyorkfed.org/research/staff_reports/sr557.pdf.

ii. Submissions Received

The Commission received submissions from three DCOs eligible to clear interest rate swaps (IRS submissions): LCH.Clearnet Limited (LCH), the clearing division of the Chicago Mercantile Exchange Inc. (CME), and International Derivatives Clearinghouse, LLC (IDCH).
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The IRS submissions received by the Commission are available at
http://www.cftc.gov/IndustryOversight/IndustryFilings/index.htm.
Submission materials marked by the submitting DCO for confidential treatment pursuant to §§ 39.5(b)(5) and 145.9(d) are not available for public review.

The following table summarizes the interest rate swap classes and significant specifications identified in the IRS submissions as currently available for clearing by each DCO. The classes and swap specifications are described in more detail below.

Table 3—Interest Rate Swap Submissions Summary

LCH
CME
IDCH

Swap Classes
Fixed-to-floating, basis, forward rate agreements (FRAs), overnight index swaps (OIS)
Fixed-to-floating
Fixed-to-floating, basis, FRAs, OIS.

Currencies
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USD, EUR, GBP, JPY, AUD, CAD, CHF, SEK, CZK, DKK, HKD, HUF, NOK, NZD, PLN, SGD, and ZAR
USD, EUR, GBP, JPY, CAD, and CHF
USD.

Rate Indexes

For Fixed-to-floating, basis, FRAs:
LIBOR in seven currencies, BBR-BBSW, BA-CDOR, PRIBOR, CIBOR-DKNA13, CIBOR2-DKNA13, EURIBOR-Telerate, EURIBOR-Reuters, HIBOR-HIBOR, HIBOR-HKAB, HIBOR-ISDC, BUBOR-Reuters, NIBOR, BBR-FRA, BBR-Telerate, PLN-WIBOR, PLZ-WIBOR, STIBOR, SOR-Reuters, JIBAR

USD-LIBOR, CAD-BA, CHF-LIBOR, GBP-LIBOR, JPY-LIBOR, and EURIBOR
USD-LIBOR.

For OIS:
FEDFUNDS, SONIA, EONIA, TOIS

Maximum Stated Termination Dates

For Fixed-to-floating, basis, FRAs:
USD, EUR, and GBP out to 50 years, AUD, CAD, CHF, SEK and JPY out to 30 years and the remaining nine currencies out to 10 years

USD, EUR, GBP out to 50 years, and CAD, JPY, CHF, AUD out to 30 years

For Fixed-to-floating:
30 years.

For OIS:
USD, EUR, GBP, and CHF out to two years

For OIS, and FRAs:
two years.

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In this proposal, currencies are identified either by their full name or by the three letter ISO currency designation for the currency.

Each of the IRS submissions provided information specified under § 39.5(b) for such swap submissions or provided references to Web sites or other sources for such information, including, for example, information previously provided to the Commission for other purposes. Each submitter also has described how it provided notice to its members as required by § 39.5(b)(3)(viii).

LCH has been clearing OTC interest rate swaps since 1999 through its SwapClear service. In its IRS submission, LCH indicates that it clears more than 50% of the interest rate swap market by notional amount.
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As of its submission date, February 24, 2012, LCH reported that it had cleared and held outstanding about one million trades with an aggregate notional amount over $283 trillion. LCH accepted for clearing fixed-to-floating and basis swaps in seventeen currencies (including variable notional swaps in three currencies), overnight index swaps in four currencies, and forward rate agreements in 10 currencies. Swaps accepted for clearing must have certain product specifications identified by LCH, which help it administer clearing and manage risk appropriately.
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Of the three interest rate swap submitters, LCH has been clearing the longest, clears the broadest range of interest rate swaps, and clears the largest portion of the interest rate swap market at this time. As of March 2011, LCH implemented client clearing in both Europe and the U.S. Prior to that date, both parties to a swap had to be LCH members to be able to clear a swap with LCH.

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LCH letter, dated February 24, 2012, at 1, stating that the market share percentage estimate is based upon BIS statistics and SwapClear volumes as of January 31, 2012.

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These specifications can be found on LCH's Web site at
http://www.lchclearnet.com/Images/General%20Regulations_tcm6-43737.pdf.

CME began clearing interest rate swaps on October 18, 2010. CME's IRS submission indicates that CME is currently clearing fixed-to-floating swaps in six currencies with an identified set of product specifications and has open interest in three currencies. In its submission, CME recommended a clearing requirement determination for all non-option interest rate swaps denominated in a currency cleared by any qualified DCO.

In September 2010, IDCH amended its rule book to provide for clearing interest rate swaps. IDCH is eligible to clear U.S. dollar denominated fixed-to-floating swaps, overnight index swaps, and forward rate agreements, which have certain product specifications as identified in its submission. IDCH had no outstanding cleared positions for these swaps as of the date of this proposal.

Furthermore, the interest rate swaps identified in the three IRS submissions are all single currency swaps with no optionality, as defined by the applicable DCO.

iii. Interest Rate Swap Market Conventions and Risk Management

Unlike certain CDS for which highly standardized terms have been developed, or futures, the terms of which are set by the exchanges, interest rate swaps are broad in scope and present a wide range of vari

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Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2012-18382. Public record. Not legal advice.