# Clearing Agency Standards > Briefs, arguments, decisions, and more. URL: https://www.frixlaw.com/law-library/documents/fr%3A2012-26407 ## Record - **Collection:** Federal Register - **Document type:** Rule - **Published:** November 2, 2012 - **Citation:** 77 FR 66220 ## Text SECURITIES AND EXCHANGE COMMISSION 17 CFR Part 240 [Release No. 34-68080; File No. S7-08-11] RIN 3235 AL13 Clearing Agency Standards AGENCY: Securities and Exchange Commission. ACTION: Final rule. SUMMARY: The Securities and Exchange Commission (“SEC” or “Commission”) is adopting a new rule in accordance with the Securities Exchange Act of 1934 (“Exchange Act”), and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). The new rule establishes minimum requirements regarding how registered clearing agencies must maintain effective risk management procedures and controls as well as meet the statutory requirements under the Exchange Act on an ongoing basis. DATES: Effective Date: January 2, 2013. FOR FURTHER INFORMATION CONTACT: Jeffrey Mooney, Assistant Director; Katherine Martin, Senior Special Counsel; Doyle Horn, Special Counsel; Stephanie Park, Special Counsel; or Justin Byrne, Attorney-Advisor; Office of Clearance and Settlement, Division of Trading and Markets, Securities and Exchange Commission, 100 F Street NE., Washington, DC 20549-7010 at (202) 551-5710. SUPPLEMENTARY INFORMATION: The Commission is adopting rules for the operation of a registered clearing agency that identify minimum standards designed to enhance the regulatory framework for clearing agency supervision. Table of Contents I. Background A. Statutory Framework for the Regulation of Clearing Agencies 1. Introduction 2. Section 17A of the Exchange Act 3. The Dodd-Frank Act a. Title VII of the Dodd-Frank Act b. Title VIII of the Dodd-Frank Act B. International Considerations II. Overview of Proposal and General Comments Received on the Proposing Release and Commission Response A. Summary of the Clearing Agency Standards Proposing Release B. General Comments Received on the Proposing Release and the Commission Response 1. Timing of Implementation 2. Special Attention to Risk Management Standards 3. Coordinated U.S. Domestic and International Standards 4. Appropriate Distinctions Between Clearing Agencies III. Description of Rule 17Ad-22 A. Overview and Scope B. Definitions—Rule 17Ad-22(a) C. Risk Management Requirements for Central Counterparties: Rules 17Ad-22(b)(1)-(4) 1. Rule 17Ad-22(b)(1): Measurement and Management of Credit Exposures 2. Rule 17Ad-22(b)(2): Margin Requirements 3. Rule 17Ad-22(b)(3): Financial Resources 4. Rule 17Ad-22(b)(4): Model Validation D. Participant Access Standards for Central Counterparties: Rules 17Ad-22(b)(5)-(7) 1. Rule 17Ad-22(b)(5): Non-Dealer Member Access 2. Rule 17Ad-22(b)(6): Portfolio Size and Transaction Volume Thresholds Restrictions 3. Rule 17Ad-22(b)(7): Net Capital Restrictions E. Record of Financial Resources and Annual Audited Financial Statements: Rules 17Ad-22(c)(1)-(2) 1. Rule 17Ad-22(c)(1): Record of Financial Resources for Central Counterparties 2. Rule 17Ad-22(c)(2): Clearing Agency Annual Audited Financial Statements F. Minimum Standards for Clearing Agencies: Rules 17Ad-22(d)(1)-(15) 1. Rule 17Ad-22(d)(1): Transparent and Enforceable Rules and Procedures 2. Rule 17Ad-22(d)(2): Participation Requirements 3. Rule 17Ad-22(d)(3): Custody of Assets and Investment Risk 4. Rule 17Ad-22(d)(4): Identification and Mitigation of Operational Risk 5. Rule 17Ad-22(d)(5): Money Settlement Risks 6. Rule 17Ad-22(d)(6): Cost-Effectiveness 7. Rule 17Ad-22(d)(7): Links 8. Rule 17Ad-22(d)(8): Governance 9. Rule 17Ad-22(d)(9): Information on Services 10. Rule 17Ad-22(d)(10): Immobilization and Dematerialization of Securities Certificates 11. Rule 17Ad-22(d)(11): Default Procedures 12. Rule 17Ad-22(d)(12): Timing of Settlement Finality 13. Rule 17Ad-22(d)(13): Delivery Versus Payment 14. Rule 17Ad-22(d)(14): Risk Controls To Address Participants' Failure To Settle 15. Rule 17Ad-22(d)(15): Physical Delivery Risks IV. Paperwork Reduction Act A. Overview and Burden Estimate Comparison To Proposing Release B. Summary of Collection of Information, Use of Information and Comments Received C. Total Initial and Annual Reporting and Recordkeeping Burdens D. Collection of Information Is Mandatory E. Confidentiality V. Economic Analysis A. Overview B. Baseline C. Consideration of Costs, Benefits, and the Effect on Efficiency, Competition and Capital Formation VI. Regulatory Flexibility Act Certification VII. Statutory Authority and Text of Rule 17Ad-22 I. Background A. Statutory Framework for the Regulation of Clearing Agencies 1. Introduction Congress directed the Commission to facilitate the establishment of a national system for the prompt and accurate clearance and settlement of securities transactions when it added Section 17A to the Exchange Act as part of the Securities Acts Amendments of 1975. 1 The Commission's ability to achieve this goal and its supervision of securities clearance and settlement systems is based upon the regulation of registered clearing agencies. Over the years, clearing agencies registered with the Commission have become an essential part of the infrastructure of the U.S. securities markets. Clearing agencies help reduce the costs of securities trading and are required to be carefully structured to manage and reduce counterparty risk. 1 See 15 U.S.C. 78q-1 and S. Rep. No. 94-75, at 4 (1975) (the Senate Committee on Banking, Housing and Urban Affairs urging that “[t]he Committee believes the banking and security industries must move quickly toward the establishment of a fully integrated national system for the prompt and accurate processing and settlement of securities transactions”). The Commission used this experience with regulating clearing agencies to help address developments recently in the over-the-counter (“OTC”) derivatives markets. In December 2008, the Commission acted to facilitate the central clearing of credit default swaps (hereinafter referred to as “credit default swaps” or “CDS”), the largest category of OTC security-based swaps, by permitting certain entities that performed central counterparty (“CCP”) services to clear and settle credit default swaps on a temporary, conditional basis. 2 Consequently, some credit default swaps transactions were centrally cleared prior to the enactment of the Dodd-Frank Act. 2 The Commission authorized five entities to clear credit default swaps. See Exchange Act Release Nos. 60372 (July 23, 2009), 74 FR 37748 (July 29, 2009), 61973 (Apr. 23, 2010), 75 FR 22656 (Apr. 29, 2010) and 63389 (Nov. 29, 2010), 75 FR 75520 (Dec. 3, 2010) (CDS clearing by ICE Clear Europe Limited); 60373 (July 23, 2009), 74 FR 37740 (July 29, 2009), 61975 (Apr. 23, 2010), 75 FR 22641 (Apr. 29, 2010) and 63390 (Nov. 29, 2010), 75 FR 75518 (Dec. 3, 2010) (CDS clearing by Eurex Clearing AG); 59578 (Mar. 13, 2009), 74 FR 11781 (Mar. 19, 2009), 61164 (Dec. 14, 2009), 74 FR 67258 (Dec. 18, 2009), 61803 (Mar. 30, 2010), 75 FR 17181 (Apr. 5, 2010) and 63388 (Nov. 29, 2010), 75 FR 75522 (Dec. 3, 2010) (CDS clearing by Chicago Mercantile Exchange, Inc.); 59527 (Mar. 6, 2009), 74 FR 10791 (Mar. 12, 2009), 61119 (Dec. 4, 2009), 74 FR 65554 (Dec. 10, 2009), 61662 (Mar. 5, 2010), 75 FR 11589 (Mar. 11, 2010) and 63387 (Nov. 29, 2010), 75 FR 75502 (Dec. 3, 2010) (CDS clearing by ICE Trust US LLC); 59164 (Dec. 24, 2008), 74 FR 139 (Jan. 2, 2009) (temporary CDS clearing by LIFFE A&M and LCH.Clearnet Ltd.) (collectively, “CDS Clearing Exemption Orders”). LIFFE A&M and LCH.Clearnet Ltd. allowed their order to lapse without seeking renewal. 2. Section 17A of the Exchange Act Section 17A of the Exchange Act 3 and Rule 17Ab2-1 4 require entities to register with the Commission prior to performing the functions of a clearing agency. Under the statute, the Commission is not permitted to grant registration unless it determines that the rules and operations of the clearing agency meet the standards set forth in Section 17A. 5 If the Commission registers a clearing agency, the Commission oversees the clearing agency to facilitate compliance with the Exchange Act using various tools that include, among other things, the rule filing process for self-regulatory organizations (“SROs”) and on-site examinations by Commission staff. Section 17A(d) also gives the Commission authority to adopt rules for clearing agencies as necessary or appropriate in the public interest, for the protection of investors, or otherwise in furtherance of the purposes of the Exchange Act and prohibits a registered clearing agency from engaging in any activity in contravention of these rules and regulations. 6 Pursuant to Section 21(a) of the Exchange Act, the Commission can invoke its enforcement powers to initiate and conduct investigations to determine violations of the federal securities laws, including those specifically applicable to clearing agencies. 7 In so doing, the Commission may institute civil actions seeking injunctive and other equitable remedies and/or administrative proceedings to, among other things, suspend or revoke registration, impose limitations upon a clearing agency's activities, functions, or operations, or impose other sanctions. 8 3 See 15 U.S.C. 78q-1(b). See also Public Law 111-203 § 763(b) (adding subparagraph (g) to Section 17 of the Exchange Act). 4 See 17 CFR 240.17Ab2-1. 5 Specifically, Sections 17A(b)(3)(A)-(I) identify determinations that the Commission must make about the rules and structure of a clearing agency prior to granting registration. See 15 U.S.C. 78q-1(b)(3)(A)-(I). The staff of the Commission provided guidance on meeting the requirements of Section 17A in its Announcement of Standards for the Registration of Clearing Agencies. See Exchange Act Release No. 16900 (June 17, 1980), 45 FR 41920 (June 23, 1980). 6 See 15 U.S.C. 78q-1(d). 7 See 15 U.S.C. 78u. 8 See id.; see also 15 U.S.C. 78s(h). 3. The Dodd-Frank Act On July 21, 2010, President Barack Obama signed the Dodd-Frank Act into law. 9 The Dodd-Frank Act was enacted to, among other things, promote the financial stability of the United States by improving accountability and transparency in the financial system. 10 9 The Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111-203, 124 Stat. 1376 (2010). 10 See id. a. Title VII of the Dodd-Frank Act Title VII of the Dodd-Frank Act (“Title VII”) provides the Commission and the Commodity Futures Trading Commission (“CFTC”) with enhanced authority to regulate certain OTC derivatives in response to the recent financial crisis. 11 The Dodd-Frank Act is intended to bolster the existing regulatory structure and provide regulatory tools to oversee the OTC derivatives market, which has grown exponentially in recent years and is capable of affecting significant sectors of the U.S. economy. Title VII provides that the CFTC will regulate “swaps,” the Commission will regulate “security-based swaps,” and the CFTC and the Commission will jointly regulate “mixed swaps.” 12 11 See id. secs. 701-774. 12 Section 712(d) of the Dodd-Frank Act provides that the Commission and the CFTC, in consultation with the Board of Governors of the Federal Reserve System, shall further define the terms “swap,” “security-based swap,” “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant,” “eligible contract participant” and “security-based swap agreement.” The Commission and the CFTC jointly adopted rules to further define the terms “swap dealer,” “security-based swap dealer,” “major swap participant,” “major security-based swap participant” and eligible contract participant.” Further Definition of “Swap Dealer,” “Security-Based Swap Dealer,” “Major Swap Participant,” “Major Security-Based Swap Participant” and “Eligible Contract Participant”, Securities Exchange Act Release No. 34-66868 (Apr. 27, 2012). Title VII was designed to provide greater certainty that, wherever possible and appropriate, swap and security-based swap contracts formerly traded exclusively in the OTC market are centrally cleared. 13 The swap and security-based swap markets traditionally have been characterized by privately negotiated transactions entered into by two counterparties, in which each assumes the credit risk of the other counterparty. 14 Clearing of swaps and security-based swaps was at the heart of Congressional reform of the derivatives markets in Title VII. 15 Clearing agencies are broadly defined under the Exchange Act and undertake a variety of functions. 16 One such function is to act as a CCP, which is an entity that interposes itself between the counterparties to a trade. 17 For example, when a security-based swap contract between two counterparties that are members of a CCP is executed and submitted for clearing, it is typically replaced by two new contracts—separate contracts between the CCP and each of the two original counterparties. At that point, the original parties to the transaction are no longer counterparties to each other. Instead, each acquires the CCP as its counterparty, and the CCP assumes the counterparty credit risk of each of the original counterparties that are members of the CCP. 18 Structured and operated appropriately, CCPs may improve the management of counterparty risk and may provide additional benefits such as multilateral netting of trades. 19 The Dodd-Frank Act amended the Exchange Act to require, among other things, that transactions in security-based swaps must be cleared through a clearing agency if they are of a type that the Commission determines must be cleared, unless an exemption from mandatory clearing applies. 20 Title VII of the Dodd-Frank Act also added new provisions to the Exchange Act that require entities that act as a clearing agency with respect to security-based swaps (“security-based swap clearing agencies”) to register with the Commission 21 and require the Commission to adopt rules with respect to security-based swap clearing agencies. 22 Compliance with any such rules is a prerequisite to the registration of a clearing agency with the Commission and is also a condition to the maintenance of its continued registration. 23 Finally, Title VII provided that some of the entities that the Commission permitted to clear and settle credit default swaps on a temporary, conditional basis prior to the July 21, 2010, enactment of the Dodd-Frank Act were deemed to be registered clearing agencies (the “Deemed Registered Provision”). 24 13 See, e.g., Report of the Senate Committee, supra note 11, at 34 (stating that “[s]ome parts of the OTC market may not be suitable for clearing and exchange trading due to individual business needs of certain users. Those users should retain the ability to engage in customized, uncleared contracts while bringing in as much of the OTC market under the centrally cleared and exchange-traded framework as possible.”). 14 See, e.g., Financial Stability Board, Implementing OTC Derivatives Market Reforms (Oct. 25, 2010), available at http://www.financialstabilityboard.org/publications/r_101025.pdf. 15 As previously noted, the Dodd-Frank Act seeks to ensure that, wherever possible and appropriate, derivatives contracts formerly traded exclusively in the OTC market be cleared. See supra note 11. 16 Section 3(a)(23)(A) of the Exchange Act defines the term “clearing agency” to mean any person who acts as an intermediary in making payments or deliveries or both in connection with transactions in securities or who provides facilities for the comparison of data regarding the terms of settlement of securities transactions to reduce the number of settlements of securities transactions or the allocation of securities settlement responsibilities. Such term also means any person, such as a securities depository, who (i) acts as a custodian of securities in connection with a system for the central handling of securities whereby all securities of a particular class or series of any issuer deposited within the system are treated as fungible and may be transferred, loaned or pledged by bookkeeping entry without physical delivery of securities certificates, or (ii) otherwise permits or facilitates the settlement of securities transactions or the hypothecation or lending of securities without physical delivery of securities certificates. 15 U.S.C. 78c(a)(23)(A). 17 See id. An entity that acts as a CCP for securities transactions is a clearing agency as defined in the Exchange Act and is required to register with the Commission. 18 See Cecchetti, Gyntelberg and Hollanders, Central Counterparties for Over-the-Counter Derivatives, Bank for International Settlement Quarterly Review (Sept. 2009), available at http://www.bis.org/publ/qtrpdf/r_qt0909f.pdf. 19 See id. at 46; see also Bank for International Settlements' Committee on Payment and Settlement Systems and Technical Committee of the International Organization of Securities Commissions, Guidance on the Application of the 2004 CPSS-IOSCO Recommendations for Central Counterparties to OTC Derivatives CCPs: Consultative Report (May 2010), available at http://www.bis.org/publ/cpss89.pdf. 20 See 15 U.S.C. 78c-3; Exchange Act Release No. 34-63557 (Dec. 15, 2010), 75 FR 82490 (Dec. 30, 2010); Exchange Act Release No. 34-67286 (June 28, 2012); 34-63556 (Dec. 15, 2010), 75 FR 79992 (Dec. 21, 2010). 21 15 U.S.C. 78q-1(g) (adding subparagraph (g) to Section 17A of the Exchange Act). Pursuant to Section 774 of the Dodd-Frank Act, the requirement in Section 17A(g) of the Exchange Act for security-based swap clearing agencies to be registered with the Commission took effect on July 16, 2011. 22 15 U.S.C. 78q-1(i) and (j). Public Law 111-203 sec. 763(b) (adding subparagraphs (i) and (j) to Section 17A of the Exchange Act). 23 Under the Exchange Act, a clearing agency can be registered with the Commission only if the Commission makes a determination that the clearing agency satisfies the requirements set forth in paragraphs (A) through (I) of Section 17A(b)(3) of the Exchange Act. 15 U.S.C. 78q-1(b)(3). 24 See 15 U.S.C. 78q-1(l). The Deemed Registered Provision applies to certain depository institutions that cleared swaps as multilateral clearing organizations and certain derivatives clearing organizations (“DCOs”) that cleared swaps pursuant to an exemption from registration as a clearing agency. As a result, ICE Clear Credit LLC, ICE Clear Europe Limited and the Chicago Mercantile Exchange, Inc. were deemed registered clearing agencies with the Commission on July 16, 2011, solely for the purpose of clearing security-based swaps. Under this Deemed Registered Provision, an eligible clearing agency is deemed registered for the purpose of clearing security-based swaps and is therefore required to comply with all requirements of the Exchange Act, and the rules thereunder, applicable to registered clearing agencies, including, for example, the obligation to file proposed rule changes under Section 19(b) of the Exchange Act. b. Title VIII of the Dodd-Frank Act In addition to the provisions from Title VII that expand the Commission's authority under the Exchange Act to include activities related to security-based swaps, Title VIII of the Dodd-Frank Act, entitled the Payment, Clearing, and Settlement Supervision Act of 2010 (“Clearing Supervision Act”), establishes an enhanced supervisory and risk control system for systemically important clearing agencies and other financial market utilities (“FMUs”). 25 In part, the Clearing Supervision Act provides that the Commission, considering relevant international standards and existing prudential requirements, may prescribe regulations that contain risk management standards for the operations related to payment, clearing, and settlement activities (“PCS Activities”) 26 of a Designated Clearing Entity or the conduct of designated activities by a Financial Institution. 27 In prescribing such standards, the Commission must consult the Board of Governors of the Federal Reserve System (“Federal Reserve” or “the Board”) and the Financial Stability Oversight Council (“Council”). On July 11, 2011, the Council published a final rule concerning its authority to designate FMUs as systemically important, 28 and on July 18, 2012, the Council designated The Depository Trust Company (“DTC”), Fixed Income Clearing Corporation (“FICC”), National Securities Clearing Corporation (“NSCC”) and The Options Clearing Corporation (“OCC”) as systemically important. 29 25 See infra note 29. Under Section 803 of the Clearing Supervision Act, clearing agencies may be FMUs. Therefore, the Commission may be the Supervisory Agency of a clearing agency that is designated as systemically important (“Designated Clearing Entity”) by the Financial Stability Oversight Council (“Council”). See 12 U.S.C. 5463. The definition of “FMU,” which is contained in Section 803(6) of the Clearing Supervision Act, contains a number of exclusions including, but not limited to, designated contract markets, registered futures associations, swap data repositories, swap execution facilities, national securities exchanges, national securities associations, alternative trading systems, security-based swap data repositories, security-based swap execution facilities, brokers, dealers, transfer agents, investment companies and futures commission merchants. 12 U.S.C. 5462(6)(B). The designation of systemic importance hinges on a determination by the Council that the failure of, or a disruption to, the functioning of the FMU could create, or increase, the risk of significant liquidity or credit problems spreading among financial institutions or markets and thereby threaten the stability of the financial system of the United States. See 12 U.S.C. 5463(a)(2)(A)-(E). The designation of an FMU is significant, in part, because it will subject such designated entity to heightened oversight consistent with the terms of the Clearing Supervision Act. For example, the Clearing Supervision Act requires the Supervisory Agency to examine at least once annually any FMU that the Council has designated as systemically important. The Commission intends to conduct such annual statutory cycle examinations on the Commission's fiscal year basis. The Commission staff anticipates conducting the first annual statutory cycle examination of any designated FMU for which it is the Supervisory Agency in the annual cycle following such designation. 26 Certain post-trade processing activities that are not captured by the Clearing Supervision Act may nevertheless be subject to regulation by the Commission under the Exchange Act. See infra note 100 and accompanying text. 27 See Section 805(a)(2) of the Clearing Supervision Act. Those regulations may govern “(A) the operations related to payment, clearing, and settlement activities of such designated clearing entities; and (B) the conduct of designated activities by such financial institutions.” 12 U.S.C. 5464(a)(2). PCS Activities are defined in Section 803(7) of the Clearing Supervision Act. 12 U.S.C 5462(7). The definition of “financial institution,” which is contained in Section 803(5) of the Clearing Supervision Act, outlines numerous exclusions but defines financial institution as a branch or agency of a foreign bank, an organization operating under Section 25 or 25A of the Federal Reserve Act, a credit union, a broker or dealer, an investment company, an insurance company, an investment adviser, a futures commission merchant, commodity trading advisor or commodity pool operator and any company engaged in activities that are financial in nature or incidental to a financial activity. 12 U.S.C. 5462(5)(A). 28 See 76 FR 44763 (July 27, 2011) (the Council also expects to address the designation of payment, clearing, or settlement activities as systemically important in a separate rulemaking). 29 See 12 U.S.C. 5321 (establishing the Council and designating its voting and nonvoting members); see also 12 U.S.C. 5463 (designation of systemic importance). In accordance with Section 804 of the Clearing Supervision Act, the Council has the authority, on a non-delegable basis and by a vote of not fewer than two-thirds of the members then serving, including the affirmative vote of its chairperson, to designate those FMUs that the Council determines are, or are likely to become, systemically important. The Council may, using the same procedures, rescind such designation if it determines that the FMU no longer meets the standards for systemic importance. Before making either determination, the Council is required to consult with the Board and the relevant Supervisory Agency as determined in accordance with Section 803(8) of the Clearing Supervision Act. Section 804 also sets forth procedures that give entities 30 days advance notice and an opportunity for a hearing prior to being designated as systemically important. B. International Considerations Section 17A(i) of the Exchange Act provides that the Commission, in establishing clearing agency standards and in its oversight of clearing agencies, may conform such standards and such oversight to reflect evolving international standards. 30 Section 805(a) of the Clearing Supervision Act directs the Commission to take into consideration relevant international standards and existing prudential requirements for clearing agencies that are designated as FMUs. 31 The current international standards most relevant to risk management of clearing agencies are the standards developed by the International Organization of Securities Commissions (“IOSCO”) and the Committee on Payment and Settlement Systems (“CPSS”) that are contained in the report entitled Principles for Financial Market Infrastructures (“FMI Report”). 32 The final FMI Report was published on April 16, 2012, and replaces CPSS and IOSCO's previous standards applicable to clearing agencies that were contained in the following reports: Recommendations for Securities Settlement Systems (2001) (“RSSS”) and Recommendations for Central Counterparties (2004) (“RCCP”) (collectively, “CPSS-IOSCO Recommendations”). 33 These international standards were formulated by securities regulators and central banks to promote sound risk-management practices and encourage the safe design and operation of entities that provide clearance and settlement services. The FMI Report harmonizes and, where appropriate, strengthens the previous international standards; it also incorporates additional guidance for OTC derivatives CCPs. 34 30 15 U.S.C. 78q-1(i). 31 12 U.S.C. 5464(a)(1). 32 CPSS-IOSCO, Principles for Financial Market Infrastructures (Apr. 2012), available at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD377.pdf. 33 The complete RSSS and RCCP Reports are available on the Web site of the Bank for International Settlements at http://www.iosco.org/library/pubdocs/pdf/IOSCOPD123.pdf and http://www.iosco.org/library/pubdocs/pdf/IOSCPD176.pdf respectively. The Board applies these standards in its supervisory process and expects systemically important systems, as determined by the Board and subject to its authority, to complete a self-assessment against the standards set forth in the policy. See Policy on Payment System Risk, 72 FR 2518 (Jan. 12, 2007). 34 See FMI Report, supra note 32. II. Overview of Proposal and General Comments Received on the Proposing Release and Commission Response A. Summary of the Clearing Agency Standards Proposing Release On March 3, 2011, the Commission proposed for comment a series of rules related to standards for the operation and governance of clearing agencies (“Proposing Release”). 35 The Proposing Release contained the following proposals: 35 See Exchange Act Release No. 34-64017 (Mar. 3, 2011), 76 FR 14472 (Mar. 16, 2011) (“Proposing Release”), available at http://www.sec.gov/rules/proposed/2011/34-64017fr.pdf. (1) Proposed Rule 17Ad-22, which would require certain minimum standards for all clearing agencies registered with the Commission; (2) Proposed Rule 17Aj-1, which would require dissemination of pricing and valuation information by security-based swap CCPs; (3) Proposed Rule 17Ad-23, which would require all clearing agencies to have adequate safeguards and procedures to protect the confidentiality of trading information of clearing agency participants; (4) Proposed Rule 17Ad-24, which would exempt certain security-based swap dealers and security-based swap execution facilities from the definition of clearing agency; (5) Proposed Rule 17Ab2-1, which would amend an existing Commission rule concerning registration of clearing agencies to account for security-based swap clearing agencies and to make other technical changes; (6) Proposed Rule 17Ad-25, which would require all clearing agencies to have procedures that identify and address conflicts of interest; (7) Proposed Rule 17Ad-26, which would require clearing agencies to set standards for all members of their boards of directors or committees; and (8) Proposed Rule 3Cj-1, which is modeled on Section 3C(j) of the Exchange Act and would require all clearing agencies to designate a chief compliance officer. The Commission also noted in the Proposing Release that the definition of clearing agency under Section 3(a)(23)(A) of Exchange Act includes any person who: • Acts as an intermediary in making payments or deliveries or both in connection with transactions in securities; • Provides facilities for the comparison of data regarding the terms of settlement of securities transactions, to reduce the number of settlements of securities transactions, or for the allocation of securities settlement responsibilities; • Acts as a custodian of securities in connection with a system for the central handling of securities whereby all securities of a particular class or series of any issuer deposited within the system are treated as fungible and may be transferred, loaned, or pledged by bookkeeping entry, without physical delivery of securities certificates (such as a securities depository); or • Otherwise permits or facilitates the settlement of securities transactions or the hypothecation or lending of securities without physical delivery of securities certificates (such as a securities depository). 36 36 15 U.S.C. 78c(a)(23)(A). Based on the Exchange Act definition, the Commission stated its preliminary view that certain post-trade processing services may fall within the clearing agency definition and asked for comments regarding the Commission's preliminary interpretation. Since the publication of the Proposing Release, the Commission has received 25 comment letters on the Proposing Release from a broad range of market participants, and the Commission and staff also had discussions with representatives of clearing agencies, trade associations, public interest groups and other interested parties. 37 The Commission has taken into consideration international initiatives and consulted with other U.S. financial regulators as appropriate, including the CFTC and the Federal Reserve, to inform the Commission's final actions. Commenters generally supported the goals of the proposal. As further discussed below, however, several commenters recommended that the proposal be amended or clarified in certain respects. 37 The comment file is published on the Commission's Web site, available at http://www.sec.gov/comments/s7-08-11/s70811.shtml. See Letter from American Benefits Council, dated May 6, 2011 (“ABC Letter”); letter from Chris Barnard, dated March 21, 2011 (“Barnard Letter”); letter from Dennis M. Kelleher, President & CEO and Steven W. Hall, Securities Specialist, Better Markets, Inc., dated April 29, 2011 (“Better Markets Letter”); letter from Joanne Medero, Richard Prager and Supurna VedBrat, BlackRock, dated April 29, 2011 (“BlackRock Letter”); letter from Craig S. Donohue, CME Group, dated April 29, 2011 (“CME Letter”); letter from Glenn Davis, Senior Research Associate, Council of Institutional Investors, dated April 14, 2011 (“CII Letter”); letter from Ernst & Young, dated April 29, 2011 (“ENY Letter”); letter from Mark Beeston, Chief Executive Officer of Portfolio Risk Services, ICAP®, dated July 7, 2011 (“ICAP Letter”); letter from R. Trabue Bland, Intercontinental Exchange, Inc., dated April 29, 2011 (“ICE Letter”); letter from Robert Pickel, Executive Vice Chairman, International Swaps and Derivatives Association, dated April 29, 2011 (“ISDA Letter”); letter from Ian Axe, CEO, LCH.Clearnet Group Limited, dated April 28, 2010 (“LCH Letter”); letter from Stuart J. Kaswell and Carlotta King, Managed Funds Association, dated March 24, 2011 (“MFA (Kaswell/King) Letter”); letter from Stuart J. Kaswell, Executive Vice President & Managing Director, General Counsel, Managed Funds Association, dated April 29, 2011 (“MFA (Kaswell) Letter”); letter from Kevin Gould, President, Markit TM , dated April 29, 2011 (“Markit TM (April) Letter”); letter from Kevin Gould, President, Markit TM , dated July 26, 2011 (“Markit TM (July) Letter”); letter from Jeff Gooch, CEO, MarkitSERV TM , dated April 29, 2011 (“MarkitSERV TM (April) Letter”); letter from Jeff Gooch, CEO, MarkitSERV TM , dated July 18, 2011 (“MarkitSERV TM (July) Letter”); letter from Norman Reed, General Counsel, Omgeo, dated May 5, 2011 (“Omgeo Letter”); letter from Larry E. Thompson, General Counsel, The Depository Trust & Clearing Corporation, dated April 29, 2011 (“The DTCC (April) Letter”); letter from Larry E. Thompson, General Counsel, The Depository Trust & Clearing Corporation, dated July 21, 2011 (“The DTCC (July) Letter”); letter from William H. Navin, Executive Vice President, General Counsel and Secretary, The Options Clearing Corporation, dated April 29, 2011 (“The OCC Letter”); letter from James Cawley, Co-Founder, Swaps and Derivatives Market Association, dated June 3, 2011 (“SDMA (June) Letter”); letter from Christoffer Mohammar, General Counsel, TriOptima Group, dated April 29, 2011 (“TriOptima Letter”); letter from Richard H. Baker, President & Chief Executive Officer, Managed Funds Association, dated March 24, 2011 (“MFA (Baker) Letter”); letter from James Cawley, Co-Founder, Swaps and Derivatives Market Association, dated April 19, 2011 (“SDMA (April) Letter”). After careful review and consideration of the comments, the Commission is today adopting Rule 17Ad-22, with certain modifications discussed below, to address comments received. As adopted, Rule 17Ad-22 is meant to establish minimum requirements for registered clearing agency risk management practices and operations with due consideration given to equivalent standards of other regulators in the United States 38 and to international standards, as discussed above in Section I.B. We expect to address separately the other proposed rules and matters contained in the Proposing Release as explained in more detail in Section II.B below. 38 See Derivatives Clearing Organization General Provisions and Core Principles 76 FR 69334 (Nov. 8, 2011) (CFTC adopting final regulations to implement certain provisions of Title VII and Title VIII of the Dodd-Frank Act governing DCO activities) (“DCO Release”); Financial Market Utilities 76 FR 18445 (Apr. 4, 2011) (notice of proposed rulemaking to promulgate risk-management standards governing the operations related to the payment, clearance and settlement activities of certain financial market utilities that are designated systemically important by the Council). B. General Comments Received on the Proposing Release and the Commission Response The Proposing Release was published in the Federal Register on March 16, 2011, and the comment period closed on April 29, 2011. 39 The Proposing Release contained proposed rules that cover various aspects of a clearing agency's operations and risk management that are listed in full in Section II.A. In addition to specific comments regarding the substance of the rules in the Proposing Release, a number of the comments the Commission received concern the larger framework for our rulemaking efforts involving clearing agencies and the manner in which the rules may be implemented. These comments focus on issues such as ensuring that: (1) Sufficient time be given to clearing agencies to implement all new standards appropriately; (2) the Commission's regulations relating to risk management standards in particular be given careful consideration and recognize the complexity of the issues involved; (3) the Commission's regulations are consistent with those of other U.S. regulatory agencies and CPSS and IOSCO initiatives; and (4) appropriate distinctions between clearing agencies that provide CCP and central securities depository (“CSD”) services from those that provide post-trade processing services are recognized in the Commission's regulations. 39 See supra note 35. Set forth below is a description of the comments received by the Commission that express concerns about the general approach to clearing agency reform reflected in the Proposing Release. The Commission has carefully considered these general comments that were provided concerning the larger framework for our rule making efforts involving clearing agencies. 40 To address the concerns they raise, we have determined to take the actions described below. 40 See supra note 9, at Preamble. 1. Timing of Implementation a. Comments Received Three commenters asked for the implementation of the proposed rules to be subject to appropriate phase-in periods. 41 One commenter suggested that the appropriate phases should be determined by the Commission in consultation with the affected clearing agencies. 42 Another commenter requested that if the rules are adopted as proposed then they should not become effective for at least two years. 43 Two commenters stated that they believe that implementing all of the proposed rules in the Proposing Release at the same time would require extensive new policies and procedures, drafting, proposing and approval of rules and rule changes, raising additional financial resources, hiring and training of personnel, operational changes and many other tasks that would require clearing agencies to simultaneously respond to separate requirements promulgated under the Dodd-Frank Act. 44 Accordingly, these commenters requested that the Commission provide adequate time to implement necessary changes and expressed that phase-in periods would be appropriate. 41 See The DTCC (April) Letter at 5; The OCC Letter at 17; MFA (Kaswell/King) Letter at 2. 42 See The DTCC (April) Letter at 5. 43 See The OCC Letter at 17 (adding that if the Commission adopts a financial resources standard in Rule 17Ad-22(b)(3) to require a security-based swaps clearing agency that performs CCP services to have enough financial resources to be able to withstand the default of its two largest participants in extreme but plausible market conditions then that requirement should be subject to delayed implementation of at least two years). 44 See id.; The DTCC (April) Letter at 6. One commenter asked the Commission to publish any modifications it may make to the proposed rules for an additional comment period. 45 Others stressed that if the Commission makes significant changes to its proposed rules, then the rules should be republished for further comment. 46 45 See The DTCC (April) Letter at 2. 46 See The OCC Letter at 17. One commenter stated that clearing agency rules such as those related to governance, conflicts of interest, registration, and financial resources should be adopted early in the implementation of rules for the security-based swap market. 47 The commenter also stated that barriers to effective “buy-side” participation in CCPs must be eliminated early in the phase-in process to enable “buy-side” participants to clear voluntarily at the same time as dealers. 48 47 See MFA (Kaswell/King) Letter at Annex A. 48 See id. b. Commission Response In light of the request by commenters for a phased approach to implementation of the clearing agency standards set forth in the Proposing Release, 49 the Commission has decided to address the standards in stages. 49 See supra notes 41-44 and accompanying text. • In the first stage, the Commission is adopting only Rule 17Ad-22. The compliance date for Rule 17Ad-22 will be sixty days from publication in the Federal Register . • The second planned stage in the implementation of standards for clearing agencies is the consideration by the Commission of rules that correspond to proposed Rules 17Aj-1; 17Ad-23; 17Ad-24; 17Ab2-1 and 3Cj-1 as well as the clearing agency governance and conflict of interest concerns that its previous proposal addressed through its proposal of Rule 17Ad-25, Rule 17Ad-26 and Regulation MC. 50 50 Ownership Limitations and Governance Requirements for Security-Based Swap Clearing Agencies, Security-Based Swap Execution Facilities, and National Securities Exchanges with Respect to Security-Based Swaps under Regulation MC, Exchange Act Release No. 344-63107 (Oct. 14, 2010), 75 FR 65882 (Oct. 26, 2010) (“Regulation MC”). • The third planned stage is for the Commission to consider rules tailored to clearing agencies that perform certain post-trade processing services. The Commission sought comment concerning these types of clearing agencies in the Proposing Release and preliminarily intends to propose rules addressed to them as described in more detail in Sections II.B.4 and III.A below. As appropriate, the Commission may also propose rules that will incorporate principles set forth in the FMI Report. The Commission believes the phased approach to implementation provides clearing agencies with the benefit of additional time with respect to some of the requirements contemplated in the Proposing Release, while putting into place minimum standards for operational and risk management practices of registered clearing agencies. This approach will allow the Commission to consider further the comments received on the Proposing Release and evolution of clearance and settlement activity in light of the requirements of Title VII and Title VIII of the Dodd-Frank Act, including the implementation of the mandatory clearing requirements with respect to security-based swaps mandated by the Dodd-Frank Act. Because the Commission is adopting 17Ad-22 largely as proposed, the Commission is not republishing Rule 17Ad-22 for additional comments. We believe that the implementation of these standards is an important first step in crafting regulatory changes contemplated by Title VII and Title VIII of the Dodd-Frank Act as intended by Congress. The adoption of Rule 17Ad-22 will also allow the Commission to coordinate its activities as the supervisory agency for clearing agencies designated as systemically important financial market utilities under Title VIII of the Dodd-Frank Act with the complementary responsibilities of the Federal Reserve. 51 In addition, the Commission believes that the adoption of standards for registered clearing agencies at this time will help facilitate the development of the security-based swap market. Rule 17Ad-22 establishes minimum standards for a wide range of issues, including governance, financial resources and membership. For example, Rules 17Ad-22(b)(5), (6) and (7) are designed to prohibit membership practices that may limit competition among market participants. In particular, Rule 17Ad-22(b)(6) is designed to facilitate correspondent clearing, which will allow buy-side participants to obtain access to CCP services without having to become direct members of a clearing agency. 51 Section 805 of the Clearing Supervision Act provides that (i) the Commission may prescribe standards for designated clearing entities in consultation with the Council and the Board and (ii) the Board may determine that the Commission's existing prudential requirements with respect to designated clearing entities are insufficient to prevent or mitigate significant credit, liquidity, operational or other risks to the financial markets or the financial stability of the United States. 2. Special Attention to Risk Management Standards a. Comments Received Generally, commenters supported the requirements of proposed Rules 17Ad-22(b)(1)-(4) that would govern the risk management standards and practices of registered clearing agencies that perform CCP services or CCPs. 52 However, in several respects, commenters asked the Commission to pay special attention to the technical nature of CCP risk management practices that are addressed by these rules. The comments received by the Commission span a range of views on these matters. But thematically, many of them coalesce around a question of whether the Commission should prescribe detailed specifications within these rules to define compliance standards more clearly or take a less prescriptive approach that affords clearing agencies greater discretion to establish, implement, maintain and enforce policies and procedures based on the facts and circumstances of the individual clearing agency. 52 See discussion infra Section III.C. For instance, proposed Rule 17Ad-22(b)(1) would require a CCP to establish, implement, maintain and enforce written policies and procedures reasonably designed to measure credit exposures to participants at least once a day and limit exposures to potential losses from defaults by its participants in normal market conditions so that the operations of the clearing agency would not be disrupted and non-defaulting participants would not be exposed to losses that they cannot anticipate or control. Of those commenters who asked the Commission to consider modifications to the proposed rule, two suggested that public disclosure requirements should accompany any choice made by a CCP to reduce margin requirements on the basis of an inverse or offsetting correlation between participants' positions. 53 Several others focused on what role the Commission should take in defining “normal market conditions” for purposes of the rule 54 as well as how frequently a CCP should be required to measure its credit exposures 55 and whether such measurements should be required to include the customers of participants. 56 53 See ISDA Letter at 7; Better Markets Letter at 3-4. 54 See The OCC Letter at 7; Better Markets Letter at 3-4. 55 See LCH Letter at 2; Better Markets Letter at 5. 56 See LCH Letter at 2. Proposed Rule 17Ad-22(b)(2) would require a CCP to establish, implement, maintain and enforce written policies and procedures reasonably designed to use margin requirements to limit its credit exposures to participants under normal market conditions and use risk-based models 57 to set margin requirements and review them at least monthly. One commenter argued that CCPs should be required to make their margin-setting methodology available to customers to help them understand the responsibilities that are commensurate with CCP participation. 58 Another commenter suggested clearing agencies should have discretion when complying with the rule to decide which aspects of a margin methodology are appropriate for monthly review. 59 Still other commenters concentrated on the extent to which the Commission should prescribe the parameters of a CCP's margin model, such as the confidence level, amount of data used to inform the standard of “normal market conditions,” and the use of factors such as liquidity and concentration. 60 57 The term “risk-based models” is meant to encompass any models, systems and associated parameters used by clearing agencies to mitigate risks. 58 See MFA (Kaswell) Letter at 2. 59 See The OCC Letter at 7. 60 See, e.g., ISDA Letter at 7; Better Markets Letter at 3-4; The OCC Letter at 7. With respect to proposed Rule 17Ad-22(b)(3), commenters asked the Commission to give further consideration to whether it is appropriate to create different financial resources standards for a security-based swap CCP. As proposed, the rule would require a CCP to establish, implement, maintain and enforce written policies and procedures reasonably designed to maintain sufficient financial resources to withstand, at a minimum, a default by the participant to which it has the largest exposure in extreme but plausible market conditions, provided that a security-based swap clearing agency would be required to maintain sufficient financial resources to withstand, at a minimum, a default by the two participants to which it has the largest exposures in extreme but plausible market conditions. One commenter argued that characteristics of the instruments traded in the security-based swap market support differentiating the requirements of the rule 61 while other commenters advanced reasons for why it may be appropriate for the rule to employ only a single standard. 62 Commenters also highlighted that it is important for the Commission to account for the international standards in this area 63 and they expressed contrasting views about how standardized and prescriptive the Commission should be in specifying the meaning of “extreme but plausible market conditions.” 64 61 See Better Markets Letter at 5. 62 See LCH Letter at 2; The OCC Letter at 8; The DTCC (April) Letter at 12. 63 See The OCC Letter at 9; LCH Letter at 2-3. 64 See Better Markets Letter at 5-6; The DTCC (April) Letter at 10; The OCC Letter at 10. Similarly, some commenters asked the Commission to reconsider how prescriptive it should be in its approach to the requirements of Rule 17Ad-22(b)(4). 65 The proposed rule would require a CCP to establish, implement, maintain and enforce policies and procedures reasonably designed to provide for an annual model validation consisting of the evaluation of the performance of the clearing agency's margin models and the related parameters and assumptions associated with such models by a qualified person who does not perform functions associated with the clearing agency's margin models (except as part of the annual model validation) and does not report to a person who performs those functions. In this area, commenters expressed contrasting views about the appropriate level of detail that should be embedded within the rule to guide clearing agency practices. The comments addressed matters including how frequently a model validation should be performed 66 and, when a model validation is performed, how a CCP should be required to ensure that the process represents a candid, independent and objective assessment. 67 65 See, e.g., The DTCC (April) Letter at 13; The OCC Letter at 11; Better Markets Letter at 6. 66 See The DTCC (April) Letter at 13; Better Markets Letter at 6. 67 See The DTCC (April) Letter at 13-15; The OCC Letter at 11; Better Markets Letter at 6. A more complete discussion of these comments and others that pertain to Rules 17Ad-22(b)(1)-(4) is contained in Section III.C below. b. Commission Response The Commission acknowledges the many thoughtful comments we received regarding the risk management standards and practices reflected in the Proposing Release and agrees that the topic deserves particular care and attention. 68 We also agree with the commenters who pointed out that: 68 See discussion supra Section II.B. • Many of the risk management standards and practices underlying proposed Rule 17Ad-22 require relatively significant judgments to be made and at times there are no established or definitive sources of guidance to aid decision-making. Therefore, for a CCP's risk management practices to be most effective, the CCP must have some degree of flexibility to tailor the practices appropriately to meet the demands of the specific financial markets it serves, and the Commission's interpretation of Rule 17Ad-22 should not be rigidly applied as uniform standards without variation. 69 69 See infra notes 82-84 and accompanying text. • The specific risk management practices most appropriate for any individual CCP and for registered clearing agencies generally are unlikely to remain static. 70 Rather, risk management practices can be expected to evolve to keep pace with changes in technology, market practices and financial professionals' understanding of the characteristics of the markets. 71 70 See infra note 79 and accompanying text. 71 See The DTCC (April) Letter at 6 (“As markets continue to globalize and standards continue to evolve, the Commission should consider additional modifications to its rules, as necessary and appropriate, to meet the important objective that the Commission's rules remain in alignment with global standards.”). For example, the Commission recognizes that a less prescriptive approach can help promote efficient practices and encourage regulated entities to consider how to manage their regulatory obligations and risk management practices in a way that complies with Commission rules while accounting for the particular characteristics of their business and believes the approach reflected in proposed Rule 17Ad-22 is consistent with this perspective. The Commission believes that one outgrowth of this less prescriptive approach is that there may be additional questions from the clearing agencies regarding how various regulatory requirements apply with regard to clearance and settlement services for particular instruments or products having different market characteristics. Commenters were particularly concerned with the application of Rules 17Ad-22(b)(1)-(4) and with particular risk management standards, including, but not limited to, the proper amount of financial resources, measurement and management of credit exposures, back testing, model validation, use of concentration, liquidity and other factors to determine margin requirements, and the appropriate meaning of “extreme but plausible market conditions.” We note that the Commission or its staff may from time to time issue additional guidance to the extent necessary to address questions arising from the dynamic nature of clearing agency risk management practices, changing market practices, and technological advances. To date, the Exchange Act and the related regulations promulgated by the Commission have not established particularized requirements regarding clearing agencies' risk management practices. 72 Nevertheless, CCPs registered as clearing agencies generally adopt margin requirements designed to cover potential losses under normal market conditions to help ensure the financial safety of the enterprise, protect the interests of clearing members, and meet or exceed standards of risk management best practices recognized in the financial services industry generally. 73 Additional charges, including, but not limited to, those contained in separately constituted default or guaranty funds are also used to cover losses beyond that ( i.e., tail events associated with extreme but plausible market conditions). 74 72 See generally Section 17A of the Exchange Act (15 U.S.C. 78q-1) and Standards for Clearing Agency Regulation (Exchange Act Release No. 16900 (June 17, 1980), 45 FR 41920 (June 23, 1980)). 73 See, e.g., NSCC's Assessment of Compliance with the CPSS/IOSCO Recommendations for Central Counterparties (Nov. 14, 2011), available at http://www.dtcc.com/legal/compliance/NSCC_Self_Assessment.pdf. 74 See CME Group letter to CPSS-IOSCO regarding the Consultation Report: Principles for Financial Market Infrastructures (July 28, 2011), available at http://www.bis.org/publ/cpss94/cacomments/cmegroup.pdf. To meet this standard, the current practice of registered CCPs is to calculate daily margin requirements using risk-based models to ensure coverage at a 99% confidence interval over a designated time horizon. 75 Given the history of usage of this standard in CCP practices and international standards, 76 the Commission believes it is appropriate to codify this commonly accepted practice as the minimum benchmark for measuring credit exposures and setting margin requirements. However, the Commission also recognizes that this minimum standard may not be sufficient for all CCPs and believes the rules allow flexibility for CCPs to adopt more conservative approaches when appropriate given the nature of the financial product being cleared, the preferences of their members, or other factors consistent with the general responsibilities of clearing agencies under the Exchange Act to perfect the national clearance and settlement system. 75 See infra Section V.B.2 (discussion on current industry baselines). 76 See infra note 571 and accompanying text. Furthermore, the Commission notes that a CCP can develop rules and procedures that are tailored to its practices and operations in order to meet the demands of the specific financial markets it serves. When a CCP proposes to make rule changes, rule changes are required to be submitted to the Commission under Section 19(b) of the Exchange Act and are subject to review, public comment and approval, as applicable. In addition to the SRO rule filing process, the Commission works closely with each clearing agency it oversees from the point of its application for registration with the Commission and thereafter through examinations and periodic monitoring of the clearing agency's risk management framework and operations. 77 77 See Risk Management Supervision of Designated Clearing Entities (July 2011), Report by the Commission, Board and CFTC to the Senate Committees on Banking, Housing, and Urban Affairs and Agriculture in fulfillment of Section 813 of Title VIII of the Dodd-Frank Act, at 25. 3. Coordinated U.S. Domestic and International Standards a. Comments Received Three commenters strongly encouraged the Commission and the CFTC to coordinate and cooperate in the development of their parallel regulation of clearing agencies and derivatives clearing organizations (“DCOs”) to build a harmonized U.S. framework for OTC derivatives and to bring appropriate consistency to the two agencies' regulation of similar products, practices and markets. 78 78 See ICE Letter at 2; MFA (Kaswell) Letter at 8-9; CME Letter at 4. One commenter stressed that rules applicable to clearance and settlement of single name credit default swaps should be comparable to the final requirements applicable to clearance and settlement of index-based credit default swaps because clearinghouses will undoubtedly service both and therefore different sets of compliance standards could lead to unnecessary operational inefficiencies and may have the unintended consequence of tilting the market in favor of one class of instruments. 79 79 See CME Letter at 4. Three commenters urged the Commission to incorporate specific requirements for processing, clearing and transfer of customer positions. 80 Two of the commenters urged the Commission to adopt specific rules in these areas that are similar to what the CFTC has proposed for DCOs—specifically with respect to proposed Rule 39.12(b)(7). 81 80 See MFA (Kaswell) Letter at 8-9; SDMA (June) Letter at 19; Barnard Letter at 2. 81 See MFA (Kaswell) Letter at 8-9; SDMA (June) Letter at 19 (citing proposed rule 39.12(b)(7) from the CFTC's Requirements for Processing, Clearing and Transfer of Customer Positions, 76 FR 13101 (Mar. 10, 2011) which would require “each derivatives clearing organization to coordinate with each swap execution facility and designated contract market that lists for trading a product that is cleared by the derivatives clearing organization, in developing rules and procedures to facilitate prompt and efficient processing of all contracts, agreements, and transactions submitted to the derivatives clearing organization for clearing.”). The CFTC reserved this rule section in its DCO Release but has not yet adopted the proposed rule as a final requirement. Three commenters expressed a preference for principles-based rather than prescriptive rules. 82 One commenter expressed its belief that the CFTC's proposals for DCOs are overly prescriptive and should be eschewed in favor of case-by-case review of a clearing organizations' proposed rule changes. 83 The commenter added that less prescriptive rules will be easier to reconcile between the two regulatory agencies. 84 82 See CME Letter at 3; The DTCC (April) Letter at 6; The OCC Letter at 2. 83 See The OCC Letter at 2. 84 See id. One commenter strongly encouraged the Commission to avoid final action on its proposed rules before it has clarity on what clearinghouse regulations are ultimately adopted by European and United Kingdom regulators and what approaches to regulation are embraced by the final FMI Report. 85 The commenter argued that this approach would allow the Commission to adopt rules that would not unknowingly force market activity into other jurisdictions by virtue of associated regulatory costs. 86 85 See The OCC Letter at 3. 86 See id. b. Commission Response We recognize that both domestic and foreign regulators may be undertaking similar regulatory initiatives with respect to risk management and operation of clearing agencies. We believe that adopting Rule 17Ad-22 now, largely in the form proposed, and the phased implementation schedule set forth above 87 will ensure that the Commission's rulemaking for clearing agencies will be coordinated with equivalent processes being undertaken by the CFTC and the Federal Reserve in the United States and foreign regulators. As discussed above, the CPSS-IOSCO Recommendations served as the benchmark for the operations of the CCPs and CSDs around the world since the publication of the RSSS in 2001 and the RCCP in 2004, respectively. In addition, the CFTC and Federal Reserve have also considered the CPSS-IOSCO Recommendations in their rulemaking efforts with respect to the clearance and settlement process. Consequently, the final rules that the CFTC recently adopted to govern the activities of a DCO 88 and the rules proposed by the Federal Reserve for certain CCPs and CSDs 89 each borrow from the principles in the CPSS-IOSCO Recommendations and reflect requirements that we believe are consistent with the minimum requirements for registered clearing agencies that the Commission is adopting in Rule 17Ad-22. Because Rule 17Ad-22 will generally codify existing practices that similarly reflect the CPSS-IOSCO Recommendations, the Commission does not believe it will conflict with regulatory requirements that are being implemented by other regulators or in other jurisdictions. 87 See supra Section II.B. 88 See Derivatives Clearing Organization General Provisions and Core Principles, supra note 38. 89 See Financial Market Utilities, supra note 25. 4. Appropriate Distinctions Between Clearing Agencies a. Comments Received In the Proposing Release, the Commission identified certain services in the area of post-trade securities processing that may be captured by the definition of a clearing agency in the Exchange Act. Two commenters generally supported the distinctions the Commission proposed for rules that should apply to all types of clearing agencies versus those that should apply only to CCPs. 90 Several commenters argued that entities that perform certain post-trade processing services ( i.e., comparison of trade data, collateral management and tear-up/compression) are not performing services that fall within the definition of a clearing agency under the Exchange Act and consequently entities that perform these services should not be required to register as a clearing agency or comply with Rule 17Ad-22. 91 90 See TriOptima Letter at 5; ICE Letter at 2. 91 See generally TriOptima Letter; Markit (April) Letter; Markit (July) Letter; MarkitSERV (April) Letter; MarkitSERV (July) Letter; Omgeo Letter. b. Commission Response We are not persuaded by commenters who suggested that post-trade processing services should be automatically excluded from the definition of a clearing agency in the Exchange Act. 92 We believe that view is inconsistent with the plain meaning of the clearing agency definition because the definition of clearing agency in Section 3(a)(23)(A) of the Exchange Act covers any person who acts as an intermediary in making payments or deliveries or both in connection with transactions in securities and provides facilities for the comparison of data regarding the terms of settlement of securities transactions, to reduce the number of settlements of securities transactions, or for the allocation of securities settlement responsibilities. 93 That view also is inconsistent with prior interpretive guidance from the Commission addressing the broader spectrum of activities that are associated with that term. 94 The determination of whether particular activities meet the definition of a clearing agency depends on the totality of the facts and circumstances involved. 95 92 See supra note 91 and accompanying text. 93 See supra note 36. 94 See Confirmation and Affirmation of Securities Trades; Matching, Exchange Act Release No. 34-39829 (Apr. 6, 1998), 63 FR 17943 (Apr. 13, 1998) (noting that “[t]he Commission is of the view that matching constitutes a clearing agency function within the meaning of the clearing agency definition under Section 3(a)(23) of the Exchange Act. Specifically, matching constitutes `comparison of data respecting the terms of settlement of securities transactions.'”). 95 See, e.g., supra note 1, at 91 (the Senate Committee on Banking, Housing and Urban affairs acknowledging that through the intended breadth of the clearing agency definition the Commission even retains authority “to negate, by rule, exclusions in this category in order to assure the prompt and accurate clearance and settlement of securities transactions or to prevent evasions of the Exchange Act”). On July 1, 2011, the Commission published a conditional, temporary exemption from clearing agency registration for entities that perform certain post-trade processing services for security-based swap transactions. 96 The order facilitated the Commission's identification of entities that operate in that area and that accordingly may fall within the clearing agency definition. Several entities complied with the conditions of that order and remain exempt from clearing agency registration under its terms. 97 By allowing potential clearing agency registrants to elect temporary, conditional exemption from registration, the order has given the Commission more time to consider whether these entities meet the clearing agency definition and, if registration is required, to consider what form of regulation may be most appropriate for those services. 96 See, e.g., Exchange Act Release No. 34-64796 (July 1, 2011), 76 FR 39963 (July 7, 2011) (providing an exemption from registration under Section 17A(b) of the Exchange Act, and stating that “[t]he Commission is using its authority under section 36 of the Exchange Act to provide a conditional temporary exemption [from clearing agency registration], until the compliance date for the final rules relating to registration of clearing agencies that clear security-based swaps pursuant to sections 71A(i) and (j) of the Exchange Act, from the registration requirement in Section 17A(b)(1) of the Exchange Act to any clearing agency that may be required to register with the Commission solely as a result of providing Collateral Management Services, Trade Matching Services, Tear Up and Compression Services, and/or substantially similar services for security-based swaps”). 97 The Commission notes further that its adoption of Rule 17Ad-22 does not have any effect on the Commission's order granting a conditional temporary exemption from clearing agency registration for entities that perform certain post-trade processing services for security-based swap transactions. See supra note 96 and accompanying text. The temporary exemption is conditioned on these entities providing the Commission with identifying information and a detailed description of the types of services they provide. Section 17A(g) of the Exchange Act contains a registration requirement for security-based swaps clearing agencies. Section 17A(j) of the Exchange Act requires the Commission to adopt rules governing persons that are registered as clearing agencies for security-based swaps under the Exchange Act, and Section 17A(i) requires security-based swaps clearing agencies to comply with such standards as the Commission may establish by rule as a condition to being registered or maintaining registration. As the Commission previously indicated with respect to the effective date for Section 17A(g), if a Title VII provision requires a rulemaking, such provision will not go into effect “not less than” 60 days after publication of the final related rule. 76 FR 36287, 36302 (June 22, 2011). The Commission has not adopted any rules applicable to clearing agencies that perform services; therefore, the registration requirement of Section 17A(g) will not be applicable to such clearing agencies until the date when rules with respect to such clearing agencies are adopted pursuant to Section 17A(i). The Commission preliminarily agrees with commenters that it is appropriate to consider a tailored framework of regulation for clearing agencies that perform certain post-trade processing services because such activities do not involve the same credit, market and operational risk concerns that are presented by clearing agencies that perform CCP or CSD services. 98 Accordingly, the Commission intends to separately address clearing agencies that perform only post-trade processing services. The Commission has previously distinguished entities that provide certain post-trade services and fall within the definition of clearing agency from those entities that provide services more commonly associated with the functions of a clearing agency ( e.g., CCP and CSD services). 99 As part of its future rulemaking regarding these types of clearing agencies, the Commission may consider whether to apply the future rules to clearing agencies engaged in activities that were separately identified by Congress as PCS Activities in the Clearing Supervision Act. In particular, the Clearing Supervision Act identifies the following as PCS Activities: 98 See supra notes 90-91 and accompanying text. 99 See, e.g., Exchange Act Order No. 34-44188 (Apr. 17, 2001) (providing an exemption from registration as a clearing agency to a subsidiary of Omgeo conducting electronic trade confirmation and matching services). (1) Calculation and communication of unsettled financial transactions between counterparties; (2) netting of transactions; (3) provision and maintenance of trade, contract, or instrument information; (4) management of risks and activities associated with continuing financial transactions; (5) transmittal and storage of payment instructions; (6) movement of funds; (7) final settlement of financial transactions; and (8) other similar functions that the Council may determine. 100 100 12 U.S.C. 5462(7). Accordingly, at this time, the Commission does not intend for Rule 17Ad-22 to apply to clearing agencies that perform post-trade processing services. The scope of Rule 17Ad-22 will be limited to clearing agencies that are registered with the Commission and the rule will not apply to any clearing agencies operating pursuant to an exemption from registration as a clearing agency granted by the Commission, unless the terms of future exemptions specifically contemplate its application, in whole or in part. The Commission has clarified this as part of the final Rule 17Ad-22 adopted today by adding the word “registered” before the term “clearing agency” appearing in the first instance in paragraphs (b), (c)(1), (c)(2), and (d). For this reason, references to the term “clearing agency” in this release are generally intended to capture only registered clearing agencies, unless the context suggests otherwise. The Commission may consider at a later time whether rules tailored to clearing agencies that provide post-trade processing services would be appropriate. III. Description of Rule 17Ad-22 A. Overview and Scope The Commission is adopting Rule 17Ad-22 with minor modifications from the proposal to implement the statutory provisions for clearing agencies under the Exchange Act. Rule 17Ad-22 requires registered clearing agencies to establish, implement, maintain and enforce written policies and procedures that are reasonably designed to meet certain minimum requirements for their operations and risk management practices on an ongoing basis. These minimum requirements will work in tandem with the requirements in Section 17A that the Commission must make certain determinations regarding a clearing agency's rules. The Commission anticipates that the clearing agency's rules and procedures will likely continue to evolve so that the clearing agency can adequately respond to changes in technology, legal requirements, trading volume, trading practices, linkages between financial markets and the financial instruments traded in the markets that a clearing agency serves. Accordingly, registered clearing agencies must evaluate continually and make appropriate updates and improvements to their operations and risk management practices to facilitate the prompt and accurate clearance and settlement of securities transactions and to safeguard securities and funds in their custody or control. Rule 17Ad-22 consists of the following parts: (1) Rule 17Ad-22(a) provides definitions for certain terms; (2) Rule 17Ad-22(b) contains risk management and participation requirements for registered CCPs; (3) Rule 17Ad-22(c) establishes a reporting requirement for registered clearing agencies with respect to certain matters including financial resources and methodologies used to calculate financial requirements; and (4) Rule 17Ad-22(d) requires registered clearing agencies, as applicable, to meet certain minimum standards. As noted above, at this time, the Commission intends for Rule 17Ad-22 to apply only to registered clearing agencies. The Commission may consider at a later time whether any additional rules tailored to clearing agencies that perform post-trade processing services would be appropriate. In addition, Rule 17Ad-22 will not apply to any clearing agencies operating pursuant to an exemption from registration as a clearing agency granted by the Commission unless the terms of future exemptions specifically contemplate its application, in whole or in part. B. Definitions—Rule 17Ad-22(a) 1. Proposed Rule Proposed Rule 17Ad-22(a) contains five definitions. Proposed Rule 17Ad-22(a)(1) would define “central counterparty” as a clearing agency that interposes itself between counterparties to securities transactions to act functionally as the buyer to every seller and as the seller to every buyer. Proposed Rule 17Ad-22(a)(2) would define “central securities depository services” to mean services of a clearing agency that is a securities depository as described in Section 3(a)(23) of the Exchange Act. 101 Proposed Rule 17Ad-22(a)(3) would define “participant,” for the limited purposes of Rules 17Ad-22(b)(3) and 17Ad-22(d)(14), to mean that if a participant controls another participant, or is under common control with another participant, then the affiliated participants shall be collectively deemed to be a single participant. Proposed Rule 17Ad-22(a)(4) would define “normal market conditions,” for the limited purposes of Rules 17Ad-22(b)(1) and (2), to mean conditions in which the expected movement of the price of cleared securities would produce changes in a clearing agency's exposures to its participants that would be expected to breach margin requirements or other risk control mechanisms only one percent of the time. 102 Proposed Rule 17Ad-22(a)(5) would define “net capital,” for the limited purpose of Rule 17Ad-22(b)(7), to have the same meaning as set forth in Rule 15c3-1 under the Exchange Act for broker-dealers or any similar risk adjusted capital calculation for all other prospective clearing members. 103 101 See supra note 36 and accompanying text. 102 The definition of normal market conditions in Rule 17Ad-22(a)(4) is consistent with the corresponding explanation established in the CPSS-IOSCO Recommendations. See RCCP, supra note 33, at 21 (explanatory note number 1). 103 As appropriate, the clearing agency may develop risk-adjusted capital calculations for prospective clearing members that are not broker-dealers. 2. Comments Received Commenters generally supported proposed Rule 17Ad-22(a)(3) because it would require a clearing agency to take account of an entire group of affiliated entities when complying with the financial resources requirements of proposed Rule 17Ad-22(b)(3), as well as the requirements in proposed Rule 17Ad-22(d)(14) for risk controls to address participants' failures to settle. 104 However, one commenter recommended that the rule employ the phrase “participant family” because “participant” on its own may be easily confused with other uses of that term in the Exchange Act and in the rules and regulations thereunder. 105 Accordingly, the commenter suggested that “participant family” should be defined to mean each participant that controls, is controlled by or is under common control with another participant. 106 The commenter recommended that the standard of control for this purpose should be defined as the disclosed ownership of 50% or more of the voting securities or other interests in a participant and that it should be based on information available to the clearing agency. 107 104 See The DTCC (April) Letter at 9-10. 105 See id. 106 See The DTCC (April) Letter at 10. 107 See id. One commenter expressed concern about the definition of “normal market conditions” as conditions in which the expected movement of the price of cleared securities would produce changes in a clearing agency's exposures to its participants that would be expected to breach margin requirements or other risk control mechanisms only one percent of the time. 108 The commenter argued that it would be unusual to define normal market conditions this way ( i.e., using margin requirements as a standard of measure) because margin models are designed to adjust during periods of market turbulence. 109 108 See The OCC Letter at 7. 109 See id. The Commission received no comments on proposed Rules 17Ad-22(a)(1), (2) and (5). 3. Final Rule As described more fully below, the Commission is adopting Rules 17Ad-22(a)(1), (2), (4) and (5) as proposed. We are also adopting Rule 17Ad-22(a)(3) with certain modifications to address concerns of commenters. We agree with commenters who suggested that in the interest of clarity and to avoid confusion with use of the term “participant” elsewhere in Exchange Act regulations, Rule 17Ad-22(a)(3) should be modified so that the term defined by the rule is “participant family” instead of “participant.” We are also modifying Rule 17Ad-22(a)(3) with respect to the language that describes the test for determining when a sufficient relationship of control exists between participants to qualify them as a “participant family.” The definition has been expanded to include entities controlled by a participant and to cover direct and indirect relationships. Accordingly, Rule 17Ad-22(a)(3) now provides that participants will be deemed to be a “participant family” for purposes of Rules 17Ad-22(b)(3) and 17Ad-22(d)(14) when “a participant directly, or indirectly through one or more intermediaries, controls, is controlled by, or is under common control with, another participant.” This modification is intended to respond to the recommendation of commenters and more closely conform the text of Rule 17Ad-22(a)(3) to the language in which this standard appears in other contexts within the U.S. federal securities laws. 110 At the same time, we are not narrowing the definition of control in this context to mean ownership of 50% or more of the voting securities or other interests in a participant. 111 We believe the more appropriate evaluation of control is based on the relationship between the entities and the power, directly or indirectly, to direct the management or policies of a company, whether through ownership of securities, by contract, or otherwise. In conducting this evaluation, clearing agencies should also be guided by the definition of “control” set forth in Rule 405 under the Securities Act of 1933, using the information available to them. 110 See, e.g., 17 CFR 230.405 (using “controls or is controlled by, or is under common control with” in the definition of affiliate found in Rule 405 under the Securities Act of 1933). 111 See supra note 107 and accompanying text. The Commission agrees with the commenter that well-designed margin models include factors that adjust to periods of market turbulence. The Commission, however, is not persuaded by the argument that the definition of normal market conditions in Rule 17Ad-22(a)(4) is at odds with the concept of certain periods of market turbulence. 112 The rule defines “normal market conditions” as those that prevail 99 trading days out of 100. Margin models and other risk control mechanisms designed to adjust during periods of market turbulence are consistent with the definitional standard to the extent they help to reduce the number of trading days during which a clearing agency's exposure to participants are not fully covered by such measures. 112 The Commission notes that the definition of normal market conditions found in Rule 17Ad-22(a) is modeled on the current international standard for determining normal market conditions in the CPSS-IOSCO Recommendations. The definition of “normal market conditions” in Rule 17Ad-22(a)(4) is also modeled on relevant and analogous international standards. The RCCP stipulates that a CCP should limit its exposures to potential losses from defaults by its participants in normal market conditions and defines “normal market conditions” as price movements that produce changes in exposures that are expected to breach margin requirements or other risk controls only 1% of the time. 113 The standard also comports with the international standard for bank capital requirements established by the Bank for International Settlements, which requires banks to measure market risks at a 99% confidence interval when determining regulatory capital requirements. 114 113 See Bank for International Settlements' Committee on Payment and Settlement Systems and Technical Committee of the International Organization of Securities Commissions, Recommendations for Central Counterparties (Nov. 2004), at 18-21, available at http://www.bis.org/publ/cpss64.pdf. 114 See infra Section V.B.2 (discussion on current industry practices). C. Risk Management Requirements for Central Counterparties: Rules 17Ad-22(b)(1)-(4) Rules 17Ad-22(b)(1)-(4) contain several requirements that address risk management practices by registered CCPs. Specifically, the proposed rules would create standards with respect to: (1) Measurement and management of credit exposures; (2) margin requirements; (3) financial resources; and (4) annual evaluations of the performance of the clearing agency's margin models. During the comment period, commenters pointed out that to properly frame these requirements requires a great deal of technical expertise and that a failure to properly allow that expertise to influence final rules adopted by the Commission could result in inefficient requirements that lack the proper degree of flexibility to achieve prudent risk management practices without being overly burdensome. In some cases, commenters argued that personnel at the clearing agencies possess the requisite levels of experience and expertise to help the Commission shape CCP risk management standards. 115 115 See The DTCC (April) Letter at 18-20; The OCC Letter at 12; LCH Letter at 3-4. As an initial matter, the Commission believes that Rules 17Ad-22(b)(1)-(4) are appropriate minimum standards for registered CCPs and that they are consistent with existing international standards of practice. However, we agree that the process of evaluating, testing and refining CCP risk management standards will be ongoing and necessarily include an open dialogue among the CCPs, investors, the Commission and various other interested parties. In particular, the Commission will carefully consider further input from interested parties obtained through outreach to various constituencies and in response to any rules or rule amendments that may be proposed by the Commission upon considering the international standards developed by CPSS-IOSCO in the FMI Report. Further, Rules 17Ad-22(b)(1), (2), and (3) establish targets for clearing agencies to meet without prescribing a particular method. Accordingly, the rules provide clearing agencies with the flexibility to establish risk management procedures ( e.g. , back testing, stress testing, model validation procedures and the composition of financial resources) that are appropriately tailored to current market conditions and can be revised over time to address changes in market conditions. Given the existing use and general understanding by U.S. CCPs and CCPs and regulatory authorities around the world of the RCCP and the principles that form the basis of Rules 17Ad-22(b)(1), (2) and (3), the Commission is adopting these rules largely as proposed. 1. Rule 17Ad-22(b)(1): Measurement and Management of Credit Exposures a. Proposed Rule Proposed Rule 17Ad-22(b)(1), as proposed, would require a CCP to establish, implement, maintain and enforce written policies and procedures reasonably designed to measure its credit exposures to its participants at least once each day, and limit its exposures to potential losses from defaults by its participants under normal market conditions 116 so that the operations of the CCP will not be disrupted and non-defaulting participants will not be exposed to losses that they cannot anticipate or control. 116 See supra note 102 and accompanying text. b. Comments Received Three commenters urged the Commission to consider adopting a more prescriptive version of the rule. 117 Of this group, one suggested that the rule should permit a CCP to use correlated positions to reduce initial margin requirements only if the CCP can demonstrate a robust correlation between those positions under stressed market conditions and the CCP publicly discloses its methodology periodically for determining the correlation and the CCP's resulting margin requirements. 118 Another commenter suggested that a CCP should be required to measure credit exposures several times each business day and to recalculate initial and variation margin for each clearing member and the clearing member's clients more than once each day. 119 The third commenter stated that Rule 17Ad-22(b)(1) should also require the CCP to perform intraday calculations of credit risk exposure when circumstances warrant, including situations where the security-based swap is illiquid, difficult to price, or highly volatile. 120 117 See ISDA Letter at 7; LCH Letter at 2; Better Markets Letter at 5. 118 See ISDA Letter at 7. 119 See LCH Letter at 2. 120 See Better Markets Letter at 5. c. Final Rule The Commission is adopting Rule 17Ad-22(b)(1) as proposed, except for the clarification discussed in Sections II.B.4 and III.A regarding the application of the rule only to registered clearing agencies. We agree with commenters that the risks CCPs face are subject to change over time due to the potential for significant changes in the risk profiles of participants and if those risks are not appropriately measured and managed by the CCP, they can result in the accrual of significant liabilities. 121 The Commission believes that measuring credit exposures once each day is the minimum frequency of measurement that will permit a clearing agency to consider effectively the credit exposures it faces. 121 See supra notes 119-120 (citing the Better Markets Letter and LCH Letter). The Commission agrees with commenters that clearing agencies may need to measure credit exposures more frequently than once each day in order to ensure that the CCP can facilitate the prompt and accurate clearance and settlement of securities transactions and ensure that they operate safely and efficiently. That point of view is reflected in the rule requirement that the measurement must be performed at least once each day. However, the Commission believes that a less prescriptive and more flexible rule sets a more appropriate baseline standard. Each CCP is exposed to participants in different markets characterized by different trading patterns, volumes, liquidity, transparency and other unique market characteristics. Rather than prescribing a specific frequency for risk exposure measurements (other than the once daily minimum), the Commission believes that CCPs should monitor exposure and margin coverage on an intraday basis depending on the individual risk characteristics of their members and businesses, and adjust their risk management processes as needed. This stance is also consistent with our understanding that the practice at many CCPs is to measure credit exposures more than once daily. 122 122 See id. While the Commission also agrees with commenters who expressed the view that a CCP should provide reductions in initial margin requirements based on offsetting or inversely correlated positions only if the CCP can demonstrate a robust correlation between those positions—including under stressed market conditions, 123 the rule is being adopted as proposed. The Commission believes that the determination of whether positions are sufficiently correlated to warrant offsets or whether reductions should be provided at all, is a matter that should be determined by the CCP as it implements its risk management procedures, and submitted to the Commission for review and public comment, as part of the Section 19b-4 rule filing process. The Commission believes that the rule should allow each CCP the flexibility to set margin requirements based on the unique products and markets that it serves. Margin requirements will vary based on a number of factors, including, but not limited to, the type, volume, and volatility of the instruments cleared. It is difficult to make determinations at the rule level regarding the suitability of margin reductions based on adequate position correlations; therefore, the Commission believes it is more appropriate to conduct such methodological evaluations during the supervisory process. 123 See supra note 118 and accompanying text. As adopted, Rule 17Ad-22(b)(1) does not require that a registered CCP publicly disclose its correlation methodology and related margin requirements. 124 Correlation methodology is generally considered confidential by clearing agencies because it is a critical element in determining their margin requirements. While CCPs generally provide this type of information to their participants, it typically is not made public. In this connection, we are adopting Rule 17Ad-22(d)(9), discussed below, which requires each registered CCP to establish, implement, maintain and enforce written policies and procedures reasonably designed to provide market participants with sufficient information to enable them to identify and evaluate the risks and costs associated with using its services. Rule 17Ad-22(d)(9) is intended in part to promote appropriate levels of transparency concerning a CCP's margin practices while allowing registered clearing agencies to tailor disclosure in a way that preserves incentives for business model innovations and responsible competition among clearing agencies. 124 See The OCC Letter at 17; The DTCC (April) Letter at 7. We are also adopting Rule 17Ad-22(b)(1), as it was proposed, to require registered CCPs to establish, implement, maintain, and enforce written policies and procedures reasonably designed to limit their exposures to potential losses from participant defaults. By collecting sufficient margin and having other liquid resources at its disposal, the Commission expects that a clearing agency will be able to limit its exposures to potential losses from defaults by clearing members in normal market conditions. 125 125 See supra note 102 and accompanying text. 2. Rule 17Ad-22(b)(2): Margin Requirements a. Proposed Rule Proposed Rule 17Ad-22(b)(2) would require a CCP to establish, implement, maintain and enforce written policies and procedures reasonably designed to: (i) Use margin requirements to limit its credit exposures to participants under normal market conditions; 126 (ii) use risk-based models to set margin requirements; and (iii) review the models at least monthly. 126 See id. b. Comments Received One commenter recommended that the rule be amended to require that the CCP's margin requirements must be sufficient to limit credit exposures to both the CCP's participants and the clients of the CCP's participants. 127 Another commenter supported standardization of the way CCPs set margin requirements and stated that the final rule should require those clearing agencies to make their margin-setting methodology available to customers. 128 The commenter argued that this disclosure would enable market participants to reasonably anticipate when additional margin may be required and would consequently promote stable liquidity in the marketplace. 129 127 See LCH Letter at 2. 128 See MFA (Kaswell) Letter at 2. 129 See id. (noting that if the Commission requires the creation of these transparent conditions with respect to margin in its final rules, then the commenter would fully support the ability of clearing agencies to have flexibility to modify margin requirements as necessary, including by imposing special margin requirements or requiring intraday posting of margin). In response to a question asked by the Commission in the Proposing Release, one commenter stated that adopting Rule 17Ad-22(b)(2) as proposed is unlikely to create the risk that CCPs will lower margin standards to compete for business. 130 The commenter asserted that integrity in risk management is the primary focus of CCPs, and that a CCP would suffer severe reputational harm if it risked using guaranty fund resources to cover margin deficiencies of clearing members. 131 In addition, according to the commenter, CCPs do not alter margin requirements based on the identity of the individual counterparty. 132 130 See id. 131 See id. 132 See MFA (Kaswell) Letter at 2-3. One commenter contended that certain aspects of a CCP's margin methodology, such as choice of confidence levels (used to estimate expected shortfall), the number of days' data relied on, and the various weights used to determine stress test charges do not need to be reviewed on a monthly basis. 133 If the final rule does require a monthly review, the commenter suggested that the Commission should make clear that CCPs have substantial discretion to determine which aspects of the model are appropriate for the monthly review. 134 In contrast, another commenter asked the Commission to consider a more prescriptive approach to the rule. It suggested that Rule 17Ad-22(b)(2) should be modified to require a clearing agency to use two to three years of historical price data when establishing normal market conditions, consider liquidity and the amount of time necessary to replace a position once a default occurs, and make a showing of significant and reliable correlation of price risks before it is allowed to net initial margin using long and short positions. 135 133 See The OCC Letter at 7. 134 See id. 135 See Better Markets Letter at 3-4. One commenter focused more narrowly on the appropriate confidence level that should be applied to initial margin collected by a clearing agency. 136 The commenter argued that setting the appropriate confidence level is directly tied to the degree of mutualization performed by a clearing agency ( i.e., the lesser the degree of mutualization the higher the appropriate confidence level because the amount of funds available to manage a default will be reduced). 137 136 See ISDA Letter at 7. 137 See id. (stating, for example, that if the clearing agency performs mutualization in its default fund and for clients in omnibus client accounts then a 99% confidence level is completely appropriate. By contrast, if the clearing agency imposes a requirement for individualized client accounts instead of an omnibus account, then the commenter believes that a confidence level greater than 99% is likely appropriate). c. Final Rule The Commission is adopting Rule 17Ad-22(b)(2) as proposed, except for the clarification discussed in Sections II.B.4 and III.A regarding the application of the rule only to registered clearing agencies. This requirement recognizes that the collection of assets ( e.g., cash or securities) from participants provides the clearing agency with assets to limit its exposure to a participant in the event of a participant default. By limiting its credit exposure in this manner, a CCP is less likely to be subject to disruptions in its operations as a result of a participant default, thereby facilitating the prompt and accurate clearance and settlement of securities transactions. The Commission does not believe it is necessary to amend the rule to state that a registered CCP's margin requirements must limit credit exposures to customers of participants as well as participants. 138 Margin requirements applicable to a customer's securities positions are established in accordance with regulations specifically governing customer margin practices 139 and in some cases through additional margin requirements imposed by the participant to address its credit risk to the customer. As a result, even when a participant is transacting on the behalf of a customer, the CCP enters into a transaction only with the participant, and therefore it is the participant's creditworthiness that the clearing agency's margin requirements must adequately address. 138 See supra note 127 and accompanying text. 139 See, e.g., 17 CFR 240.15c3-3 (Customer protection—reserves and custody of securities and Regulation T, 12 CFR 220). The Commission is aware that some CCPs may already have the ability to measure credit exposures to customers of participants as well as to participants. To the extent that such margin practices are already in place or develop over time to help ensure prompt and accurate clearance and settlement in the market the clearing agency serves, we believe those practices can be effective in limiting aggregate credit exposures of clearing agencies. We agree that the ability to limit credit exposures to customers of participants using margin may help inform and shape appropriate credit risk management practices in certain cases—for example, where (i) direct access to a clearing agency by some participants may be relatively more constrained by the operational or financial demands commensurate with participation; (ii) open interest periods associated with the instruments cleared by the clearing agency are relatively significant; or (iii) customer margin requirements are established independently from the CCP ( e.g., pursuant to regulation or by agreement with a participant). However, we believe that, at this time, individual CCPs should develop rules and procedures to address these specific circumstances consistent with their general responsibilities as clearing agencies under the Exchange Act and that rules of this kind would be subject to the rule filing procedures of Section 19b-4. The Commission is not amending Rule 17Ad-22(b)(2) to specify which aspects or components of the CCP's risk-based models must be reviewed in the context of the CCP's monthly review. 140 The Commission recognizes that some assumptions that underlie model parameters may be widely accepted by current convention, and those components therefore may be less likely to become outdated from month to month. On the other hand, the Commission notes that market conditions and risks are constantly changing and CCPs will need to exercise discretion in how they administer their review of those components. 140 See supra note 134 and accompanying text. The Commission notes that, to the extent a CCP believes that an assumption in a model or parameter does not lend itself to empirical testing, a review of that assumption can in some cases be accomplished by the CCP performing a theoretical assessment of that assumption compared to alternative assumptions. For example, a CCP may evaluate the appropriateness of the number of days of market data used in its margin model or the expected amount of time needed to liquidate a security in an event of default by comparing the performance of the margin model when a range of representative values is input. Also consistent with the intent of preserving appropriate flexibility for clearing agencies to tailor their methods of achieving compliance, the Commission is not prescribing a particular confidence level for initial margin in Rule 17Ad-22(b)(2). 141 Rather, subject to Commission oversight, Rule 17Ad-22(b)(2) allows a confidence level determination to be made by the clearing agency as part of the development of its margin parameters and risk-based models. In arriving at an appropriate confidence level, we agree with commenters that the extent of mutualization of financial resources performed by a CCP in its risk management practices and the particular use of individualized client accounts or an omnibus account structure are appropriate factors to consider. 142 The Commission also chose not to stipulate specific requirements pertaining to the scope of historical price data, liquidity and replacement considerations, and the correlation of price risks used in calculating margin requirements, again opting for a more flexible standard. While a clearing agency may take such factors into consideration when determining margin requirements, each registered CCP should be free to develop the best margin methodology to accommodate its unique products and markets. Accordingly, the Commission believes that it should not attempt to prescribe the appropriate margin methodologies for each CCP or financial instrument. 143 141 See supra note 136 and accompanying text. 142 See supra note 137 and accompanying text. 143 See Section 17A discussion supra Section I.A.2 and accompanying text. We agree with commenters who asserted that a CCP's disclosure of its margin-setting methodology to customers facilitates prompt and accurate clearance and settlement by enabling market participants to better plan for margin costs associated with the use of the clearing agency. 144 As noted above, registered CCPs must submit their risk management procedures, including margin methodology, to the Commission for review and public comment as a proposed rule change under Rule 19b-4. The Rule 19b-4 process provides for public disclosure, as well as an opportunity for interested parties to comment on the proposed rule change. In addition, the Commission believes that any reasonable process for implementing risk management practices will involve further, more detailed communication with clearing members and their customers regarding the particular expected results of the practices in identified circumstances. Such communication may involve both direct contacts with members and their customers or indirect contacts through general information published by the CCP on its Web site or in other generally available resources. 144 See supra note 59. 3. Rule 17Ad-22(b)(3): Financial Resources a. Proposed Rule Proposed Rule 17Ad-22(b)(3) would require a CCP to establish, implement, maintain and enforce written policies and procedures reasonably designed to maintain sufficient financial resources to withstand, at a minimum, a default by the participant to which it has the largest exposure in extreme but plausible market conditions, provided that a security-based swap clearing agency would be required to maintain sufficient financial resources to withstand, at a minimum, a default by the two participants (also referred to as the “cover two” standard) to which it has the largest exposures in extreme but plausible market conditions. 145 145 See proposed Rule 17Ad-22(a)(3), supra Section III.B.1 (defining “participant” for purposes of proposed Rule 17Ad-22(b)(3)). b. Comments Received Commenters expressed a wide range of views concerning proposed Rule 17Ad-22(b)(3). Some commenters generally supported the proposed rule. 146 Others expressed concern that the introduction of two different financial resources standards may discourage CCPs from extending their services to security-based swaps or may discourage prospective participants from seeking membership in CCPs for security-based swaps, which would disrupt the goal of the Dodd-Frank Act to promote central clearing. 147 One commenter stated its opinion that no historical or empirical case has been made for changing the way that CCPs currently measure the sufficiency of their financial resources and that no cost-benefit analysis has been done on the impact of any such change on the operations and economics of CCPs. 148 146 See Better Markets Letter at 5 (supporting the rule and stating that it appropriately differentiates between security-based swap and non security-based swap clearing agencies due to unique features of the security-based swap markets, such as jump-to-default risk); see also Barnard Letter at 1 (supporting generally the thrust of the Commission's proposals in the Proposing Release, particularly proposed Rule 17Ad-22 concerning standards for clearing agencies); BlackRock Letter at 2 (supporting Rules 17Ad-22(b)(1)-(7) because these rules will benefit the markets by reducing concentration risk, increasing the diversity of market participants involved in governance, enhancing competition and lowering costs for customers of clearing members); MFA (Kaswell) Letter at 2 (generally supporting the rules proposed under 17Ad-22(b) because they would establish reasonable, objective, risk-based criteria for fair and open access). 147 See LCH Letter at 2; The OCC Letter at 9. 148 See The DTCC (April) Letter at 12. A commenter also suggested that CCPs should consider the simultaneous default of multiple clearing members when sizing their financial resources but that a simultaneous default of the two largest clearing members is an extremely implausible occurrence, and accordingly it is not a scenario that should be embedded as a fixed requirement in the Commission's rules. 149 That commenter stated that it is reasonable to assume a default by the two largest participants would take place in conditions of heightened market volatility, which would cause a CCP to collect more financial resources because of the risk-based nature of margin requirements. 150 149 See The OCC Letter at 8. 150 See The OCC Letter at 9. One commenter disagreed with assertions in the Proposing Release that the performance of CCP services for security-based swaps entails risks that are unique to those products and that those unique risks support the proposed “cover two” requirement. 151 The commenter also stated that accounting for the jump-to-default risk of certain security-based swap instruments ( i.e., credit-default swaps) should be addressed through calculation of financial resource requirements using more extreme market scenarios instead of adjusting the number of participant defaults. 152 The commenter urged the Commission to consider how changes taking place to the infrastructure and risk management practices in the securities markets due to the Dodd-Frank Act may render irrelevant certain risks that are associated with security-based swaps today. 153 151 See The OCC Letter at 8 (expressing by way of example that a total return security-based swap on a single underlying security of a company that has a large market capitalization is a lower risk management challenge for a clearing agency that performs CCP services than a put or a call option on the same underlying security. It expressed a belief that the risk is much the same as a security future on the same underlying). 152 See id. 153 See id. Commenters supported the position that the Commission's regulatory standards for CCPs should be modified where appropriate to account for the relevant work of international standard setters such as the CPSS and IOSCO. 154 However, commenters pointed out that a “cover two” standard would be inconsistent with the existing CPSS-IOSCO Recommendations for financial resources. 155 They also urged the Commission not to require any CCP to increase its liquidity resources or otherwise re-engineer its risk management controls unless and until there is industry and regulatory consensus on the changes that should be made. 156 These commenters encouraged the Commission to ensure that its final rulemakings are aligned with the existing CPSS-IOSCO Recommendations to the closest extent possible. 157 154 See The OCC Letter at 9 (citing CPSS-IOSCO Recommendation for Central Counterparties, Recommendation 3). 155 See id. 156 See The DTCC (April) Letter at 12. 157 See LCH Letter at 2-3; The OCC Letter at 9. Commenters disagreed over what role the Commission should play in defining the term “extreme but plausible market conditions” as that term appears in proposed Rule 17Ad-22(b)(3). 158 One commenter favored a significant role for the Commission. 159 Other commenters agreed that CCPs should be primarily responsible for determining the parameters of the standard because of their unique access to market data and understanding of the range of applicable market conditions. 160 Those commenters stated that Rule 17Ad-22(b)(3) should clarify that a CCP is responsible for determining what constitutes “extreme but plausible market conditions.” 158 See Better Markets Letter at 5-6; The DTCC (April) Letter at 10. 159 See Better Markets Letter at 5-6 (stressing that the Commission should provide concrete guidance on the meaning of “extreme but plausible market conditions” to prevent lax or self-serving interpretation of that standard and to promote consistent practices among clearing agencies that will prevent the adoption of lower standards designed to reduce costs and attract business volume at the expense of stability and risk mitigation. The commenter also expressed that the Commission's definition of the standard should focus on unprecedented periods of illiquidity, volatility and interconnectedness that lead to multiple defaults). 160 See The DTCC (April) Letter at 10; The OCC Letter at 10. c. Final Rule The Commission is adopting Rule 17Ad-22(b)(3) with certain modifications to address concerns raised by commenters, including but not limited to the clarification discussed in Sections II.B.4 and III.A regarding the application of the rule only to registered clearing agencies and clarifications relating to the term “participant family” as discussed above. 161 The Commission believes that requiring a registered CCP, other than a security-based swap CCP, to maintain sufficient financial resources to withstand, at a minimum, a default by the participant family to which it has the largest exposure in extreme but plausible market conditions, reduces the likelihood that a default would create losses that disrupt the operations of the CCP and adversely affect the clearing agency's non-defaulting participants. 161 See supra note 146 (supporting the rule as proposed); see also supra section III.B.3 (discussing the term “participant family”). While the Commission is sensitive to the consequences of establishing a different standard for CCPs that clear security-based swaps, the Commission believes that the financial resources of the entity must be robust enough to accommodate the risks that are particular to each market served—irrespective of whether such analysis results in different standards. The Commission believes that requiring a security-based swap CCP to cover its two largest potential exposures is the appropriate standard due to the nature of these products. Security-based swaps pose unique risk management issues. In particular, credit default swaps, a subset of security-based swaps, are non-linear financial instruments subject to additional risk factors such as jump-to-default risk 162 and asymmetrical risk allocation between short and long counterparties. Unlike other products that also exhibit these characteristics ( e.g., Long-Term Equity Anticipation Securities (LEAPS)), credit default swaps are unique in their size relative to their underlying markets. Recent research shows that notional outstandings in credit default swaps are often close to or greater than the outstanding value of the underlying instruments. 163 The traditional procedures for a clearing agency to handle a default may not be effective and may entail significant risk to a CCP clearing security-based swaps. 164 To address this concern, CCPs have implemented procedures that provide for the management and oversight of the liquidation or transfer of the defaulting member's positions by a default management committee comprising senior CCP staff and representatives from member institutions. 165 162 Jump-to-default risk refers to the expected change in the value of a CDS contract if a credit event were to occur with respect to a reference entity under the terms of the CDS contract, triggering an obligation for the seller of protection under the contract to make a lump sum payment to the protection buyer. Jump-to-default only refers to the incremental information in the determination that a credit event has occurred because the market already prices the probability of a credit event. In practice, credit events are largely anticipated such that jump-to-default results in small changes in value as opposed to a first order pricing effect. Jump-to-default risk exists for all CDS, not merely those on reference entities perceived as risk credits. While the decline in contract value from a credit event is usually bigger for creditworthy reference entities (because the initial contract value is higher and thus has farther to fall), jump-to-default risk can also be measured for distressed reference entities that are expected to suffer a credit event in the near future. As a hypothetical example, market participants might have measured the jump-to-default risk in “Hypothetical Risky Corporation” five-year CDS when the CDS was trading at 70% upfront (that is, a seller would need to receive an up-front payment of 70% of notional value to write the contract) and the expected value in default was 80% upfront (implying a 20% recovery rate) as being equal to 10% of notional value; equally, they might have measured the jump-to-default risk of “Hypothetical Safe Corporation” five-year CDS when it was trading at 0.30% per annum and no up-front payment (roughly equivalent to an up-front payment of 1.5%) with an expected value in default of 60% upfront (implying a 40% recovery rate) as being equal to approximately 58.5% of notional value. See generally Darrell Duffie and Haoxiang Zhu, Does a Central Clearing Counterparty Reduce Counterparty Risk? (Stanford Univ. 2010), available at http://www.stanford.edu/~duffie/DuffieZhu.pdf. 163 See, e.g., Stavros Peristiani, Vanessa Savino, “Are Credit Default Swaps Associated with Higher Corporate Defaults?”, Federal Reserve Bank of New York Staff Report No. 494 (May 2011); Alessandro Fontana and Martin Scheicher, “An analysis of euro area sovereign CDS and their relation with government bonds,” European Central Bank Working Paper Series, No. 1271 (Dec. 2010). 164 For example, when a participant defaults, the CCP terminates all of its contracts with the defaulting participant. The traditional procedures for handling a default, which are used by CCPs for most exchange-traded derivatives, call for the CCP to promptly enter the market and replace the contracts, so as to hedge against further losses on the open positions created by termination of the defaulter's contracts. However, if the markets for the contracts cleared by the CCP are illiquid, entering the market may induce adverse price movements, especially if the defaulting participant's positions are large relative to the overall market for the contracts. See Bank for International Settlement's Committee on Payment and Settlement Systems, New Developments in Clearing and Settlement Arrangements for OTC Derivatives (Mar. 2007). 165 See id. The Commission does not believe that changes in the security-based swap market resulting from the Dodd-Frank Act ( e.g., mandatory clearing requirements, the establishment of the Council, etc. ) have eliminated or will eliminate the additional risk management challenges of security-based swaps noted above. Therefore, the Commission believes that it should codify the existing standard for maintenance of financial resources established by CCPs currently clearing security-based swaps. The Commission notes that current industry participants recognize the need for more stringent financial resource requirements for CCPs that clear credit default swaps. 166 This point is evidenced by the fact that the “cover two” standard has been employed since before the enactment of the Dodd-Frank Act and prior to the adoption of the European Market Infrastructure Regulation (“EMIR”) 167 by the major CCPs clearing credit default swaps, both in the United States and internationally. For example, both of the registered CCPs providing clearing services for credit default swap transactions to customers in the United States, ICE Clear Credit and ICE Clear Europe, already meet a “cover two” standard as does CME Group (“CME”) with respect to its clearing service for index credit default swaps, which is registered with the Commission but does not yet provide CCP services for security-based swaps. 168 LCH.Clearnet, a leading CCP for OTC derivatives in Europe, maintains a “cover two” standard for its credit default swap CCP activities. 169 These practices are consistent with the “cover two” financial resources requirement for European CCPs contained in EMIR. 170 166 See, e.g., ISDA Letter at 1; see also Letter to William C. Dudley from the OTC Derivatives Supervisors Group, dated March 31, 2011, available at http://www.newyorkfed.org/newsevents/news/markets/2011/SCL0331/pdf (generally supporting enhancing the framework for OTC derivatives risk management). 167 Regulation No. 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories, 2012 O.J. (L 201). 168 See CFTC-SEC Staff Roundtable on Clearing of Credit Default Swaps (Oct. 2010), at 123, available at http://www.cftc.gov/ucm/groups/public/@swaps/documents/dfsubmission/ dfsubmission7_102210-transcrip.pdf (Stan Ivanov, ICE Clear Credit stating “at ICE we look at two simultaneous defaults of the two biggest losers upon extreme conditions * * *.”). See also CDS Clearing Solution ICE Clear Europe (June 2012), at 6, available at https://www.theice.com/publicdocs/clear_europe/ICE_Clear_Europe_CDS_Clearing_Overview.pdf (“Guaranty Fund covers simultaneous default of 2 largest Clearing Members”); CME Rulebook, Chapter 8H, Rule 8H07, available at http://www.cmegroup.com/rulebook/CME/I/8H/07.html. 169 See LCH.Clearnet CDS Clearing Rulebook, Chapter 4, Article 4.4.1.2 (May 5, 2012), available at http://www.lchclearnet.com/Images/CDSClear%20Rulebook_ [Text truncated at 120,000 characters. The full text is on the page linked above.] --- Source: Frix Law Library, https://www.frixlaw.com/law-library/documents/fr%3A2012-26407. Public record. Not legal advice.