Over-the-Counter Derivatives
Federal RegisterMay 12, 1998
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COMMODITY FUTURES TRADING COMMISSION
17 CFR Parts 34 and 35
Over-the-Counter Derivatives
AGENCY: Commodity Futures Trading Commission.
ACTION: Concept Release.
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SUMMARY: The Commodity Futures Trading Commission (``CFTC'' or
``Commission'') has been engaged in a comprehensive regulatory reform
effort designed to update the agency's oversight of both exchange and
off-exchange markets. As part of this reform effort, the Commission is
reexamining its approach to the over-the-counter (``OTC'') derivatives
market.
OTC derivatives are contracts executed outside of the regulated
exchange environment whose value depends on (or derives from) the value
of an underlying asset, reference rate, or index. They are used by
market participants to perform a wide variety of important risk
management functions. The CFTC's last major regulatory actions
involving OTC derivatives were regulatory exemptions for certain swaps
and hybrid instruments adopted in January 1993. Since that time, the
OTC derivatives market has grown dramatically in both volume and
variety of products offered and has attracted many new end-users of
varying degrees of sophistication. The market has also changed, with
new products being developed, with some products becoming more
standardized, and with systems for central execution or clearing being
studied or proposed.
The Commission hopes that the public comments filed in response to
this release will constitute an important source of relevant data and
analysis that will assist it in determining whether its current
regulatory approach continues to be appropriate or requires
modification. The Commission wishes to maintain adequate safeguards
without impairing the ability of the OTC derivatives market to continue
to grow and the ability of U.S. entities to remain competitive in the
global financial marketplace. The Commission has identified a broad
range of issues and potential approaches in order to generate detailed
analysis from commenters. The Commission urges commenters to analyze
the benefits and burdens of any potential regulatory modifications in
light of current market realities. The Commission has no preconceived
result in mind. The Commission is open both to evidence in support of
easing current restrictions and evidence indicating a need for
additional safeguards. The Commission also welcomes comment on the
extent to which certain matters are being or can be adequately
addressed through self-regulation, either alone or in conjunction with
some level of government oversight, or through the regulatory efforts
of other government agencies.
New regulatory restrictions ultimately adopted, if any, will be
adopted only after publication for additional public comment and will
be applied prospectively only. This release in no
[[Page 26115]]
way alters the current status of any instrument or transaction under
the Commodity Exchange Act. All currently applicable exemptions,
interpretations, and policy statements issued by the Commission
regarding OTC derivatives products remain in effect, and market
participants may continue to rely upon them.
DATES: Comments must be received on or before July 13, 1998.
ADDRESSES: Comments should be mailed to Jean A. Webb, Secretary,
Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st
Street, NW, Washington, D.C. 20581; transmitted by facsimile to (202)
418-5521; or transmitted electronically to {[email protected]}.
Reference should be made to ``Over-the-Counter Derivatives Concept
Release.''
FOR FURTHER INFORMATION CONTACT: I. Michael Greenberger, Director,
David M. Battan, Special Counsel, or John C. Lawton, Associate
Director, Division of Trading and Markets, Commodity Futures Trading
Commission, Three Lafayette Centre, 1155 21st Street N.W., Washington,
D.C. 20581 (202) 418-5430.
SUPPLEMENTARY INFORMATION:
I. Introduction
A. Description of Over-the-Counter Products and Markets
B. Purpose of This Release
II. Current Exemptions
A. Swaps
1. Policy Statement
2. Part 35
B. Hybrid Instruments
1. Background
2. Part 34
III. Issues for Comment
A. Background
B. Potential Changes to Current Exemptions
1. Eligible Transactions
2. Eligible Participants
3. Clearing
4. Transaction Execution Facilities
5. Registration
6. Capital
7. Internal Controls
8. Sales Practices
9. Recordkeeping
10. Reporting
C. Self-Regulation
IV. Summary of Request for Comment
I. Introduction
A. Description of Over-the-Counter Products and Markets
Over-the-counter (OTC) derivatives are contracts executed outside
of the regulated exchange environment whose value depends on (or
derives from) the value of an underlying asset, reference rate or
index.\1\ The classes of underlying assets from which a derivative
instrument may derive its value include physical commodities (e.g.,
agricultural products, metals, or petroleum), financial instruments
(e.g., debt and interest rate instruments or equity securities),
indexes (e.g., based on interest rates or securities prices), foreign
currencies, or spreads between the value of such assets.
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\1\See Group of Thirty, Derivatives: Practices and Principles 2
(1993).
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Like exchange-traded futures and option contracts, OTC derivatives
are used to perform a wide variety of important risk management
functions. End-users employ OTC derivatives to address risks from
volatility in interest rates, foreign exchange rates, commodity prices,
and equity prices, among other things. OTC derivative instruments also
can be used to assume price risk in order to increase investment yields
or to speculate on price changes. Participants in the OTC derivatives
market include banks, other financial service providers, commercial
corporations, insurance companies, pension funds, colleges and
universities, and governmental entities.
Use of OTC derivatives has grown at very substantial rates over the
past few years. According to the most recent market survey by the
International Swaps and Derivatives Association (``ISDA''), the
notional value of new transactions reported by ISDA members in interest
rate swaps, currency swaps, and interest rate options during the first
half of 1997 increased 46% over the previous six-month period.\2\ The
notional value of outstanding contracts in these instruments was
$28.733 trillion, up 12.9% from year-end 1996, 62.2% from year-end
1995, and 154.2% from year-end 1994.\3\ ISDA's 1996 market survey noted
that there were 633,316 outstanding contracts in these instruments as
of year-end 1996, up 47% from year-end 1995, which in turn represented
a 40.7% increase over year-end 1994.\4\ An October 1997 report by the
General Accounting Office (``GAO'') suggests that the market value of
those OTC derivatives represents ``about 3 percent'' of the notional
amount.\5\ Applying the 3% figure to the most recent ISDA number for
contracts outstanding for the first half of 1997 indicates that the
world-end market value of these OTC derivatives transactions is over
$860 billion.
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\2\ International Swaps and Derivatives Association, Summary of
Recent Market Survey Results, ISDA Market Survey, available at
(http://www.isda.org).
\3\ Id.
\4\ Id.
\5\ General Accounting Office, GAO/GGD-98-5, OTC Derivatives:
Additional Oversight Could Reduce Costly Sales Practice Disputes 3
n.6 (1997) [hereinafter ``1997 GAO Report'']. The notional amount
represents the amount upon which payments to the parties to a
derivatives transaction are based and is the most commonly used
measure of outstanding derivatives transactions. Notional amounts
generally overstate the amount at risk and the market value of such
transactions.
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While OTC derivatives serve important economic functions, these
products, like any complex financial instrument, can present
significant risks if misused or misunderstood by market participants. A
number of large, well publicized, financial losses over the last few
years have focused the attention of the financial services industry,
its regulators, derivatives end-users, and the general public on
potential problems and abuses in the OTC derivatives market.\6\ Many of
these losses have come to light since the last major regulatory actions
by the CFTC involving OTC derivatives, the swaps and hybrid instruments
exemptions issued in January 1993.\7\
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\6\ See, e.g., Jerry A. Markham, Commodities Regulation: Fraud,
Manipulation & Other Claims, Section 27.05 nn. 2-22.1 (1997)
(listing 22 examples of significant losses in financial derivatives
transactions); 1997 GAO Report at 4 (stating that the GAO identified
360 substantial end-user losses). Some of these transactions
involved instruments that are not subject to the CEA.
\7\ Each of these exemptions is discussed in Part II, below.
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B. Purpose of This Release
The Commission has been engaged in a comprehensive regulatory
reform effort designed to update the agency's oversight of both
exchange and off-exchange markets.\8\ As part of this process, the
Commission believes that it is appropriate to reexamine its regulatory
approach to the OTC derivatives market taking into account developments
since 1993. The purpose
[[Page 26116]]
of this release is to solicit comments on whether the regulatory
structure applicable to OTC derivatives under the Commission's
regulations should be modified in any way in light of recent
developments in the marketplace and to generate information and data to
assist the Commission in assessing this issue.
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\8\ See, e.g., Proposed Rulemaking Permitting Future-Style
Margining of Commodity Options, 62 FR 66569 (Dec. 19, 1997); Concept
Release on the Denomination of Customer Funds and the Location of
Depositories, 62 FR 67841 (Dec. 30, 1997); Account Identification
for Eligible Bunched Orders, 63 FR 695 (Jan. 7, 1998); Maintenance
of Minimum Financial Requirements by Futures Commission Merchants
and Introducing Brokers, 63 FR 2188 (Jan. 14, 1998); Requests for
Exemptive, No-Action and Interpretative Letters, 63 FR 3285 (Jan.
22, 1998); Regulation of Noncompetitive Transactions Executed on or
Subject to the Rules of a Contract Market, 63 FR 3708 (Jan. 26,
1998); Distribution of Risk Disclosure Statements by Futures
Commission Merchants and Introducing Brokers, 63 FR 8566 (Feb. 20,
1998); Amendments to Minimum Financial Requirements for Futures
Commission Merchants, 63 FR 12713 (March 16, 1998); Two-Part
Documents for Commodity Pools, 63 FR 15112 (March 30, 1998); and
Trade Options on the Enumerated Agricultural Commodities, 63 FR
18821 (April 16, 1998). See also Application of FutureCom, Ltd. as a
Contract Market in Live Cattle Futures and Options, 62 FR 62566
(Nov. 24, 1997) (Internet-based trading system); Application of
Cantor Financial Futures Exchange as a Contract Market in US
Treasury Bond, Ten-Year Note, Five-Year Note and Two-Year Note
Futures Contracts, 63 FR 5505 (Feb. 3, 1998) (electronic trading
system).
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The market has continued to grow and to evolve in the past five
years. As indicated above, volume has increased dramatically. New end-
users of varying levels of sophistication have begun to participate in
this market. Products have proliferated, with some products becoming
increasingly standardized. Systems for centralized execution and
clearing are being proposed.
The Commission hopes that the public comments filed in response to
this release will constitute an important source of relevant data and
analysis that will assist it in determining how best to maintain
adequate regulatory safeguards without impairing the ability of the OTC
derivatives market to continue to grow and the ability of U.S. entities
to remain competitive in the global financial marketplace. The
Commission has no preconceived result in mind. The Commission wishes to
draw on the knowledge and expertise of a broad spectrum of interested
parties including OTC derivatives dealers, end-users of derivatives,
other regulatory authorities, and academicians. The Commission urges
commenters to provide detail on current custom and practice in the OTC
derivatives marketplace in order to assist the Commission in gauging
the practical effect of current exemptions and potential modifications.
The Commission is open both to evidence in support or broadening
its exemptions and to evidence indicating a need for additional
safeguards. Serious consideration will be given to the views of all
interested parties before regulatory changes, if any, are proposed. In
evaluating the comments and ultimately deciding on its course of
action, the Commission will, of course, also engage in its own research
and analysis. Any proposed changes will be carefully designed to avoid
unduly burdensome or duplicative regulation that might adversely affect
the continued vitality of the market and will be published for public
comment. Moreover, any changes which impose new regulatory obligations
or restrictions will be applied prospectively only.
As this process goes forward, the Commission is mindful of the
industry's need to retain flexibility in designing new products as well
as the need for legal certainty concerning the enforceability of
agreements. Therefore, the Commission wishes to emphasize that, as was
the case with other recent concept releases, this release identifies a
broad range of issues in order to stimulate public discussion and to
elicit informed analysis. This release does not in any way alter the
current status of any instrument or transaction under the CEA. All
currently applicable exemptions, interpretations, and policy statements
issued by the Commission regarding OTC derivatives products remain in
effect, and market participants may continue to rely upon them.
II. Current Exemptions \9\
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\9\ In addition to the exemptions discussed in the text, the CEA
excludes certain transactions. Forward contracts are excluded in
section 1a(11) of the CEA, 7 U.S.C. 1A(11). The Treasury Amendment
of the CEA excludes ``transactions in foreign currency, security
warrants, security rights, resales of installment loan contracts,
repurchase options, government securities, or mortgage and mortgage
purchase commitments, unless such transactions involve the sale
thereof for future delivery conducted on a board or trade.'' Section
2(a)(1)(A)(ii), 7 U.S.C. 2(ii). Furthermore, options on securities
or securities indexes are excluded from the Act. Section
2(a)(1)(B)(i), 7 U.S.C. 2a(i). The Commission by order has also
exempted certain transactions in energy products from the provisions
of the CEA. Exemption for Certain Contracts Involving Energy
Products, 58 FR 21286 (April 20, 1993). In addition, the Commission
has exempted certain trade options. 17 C.F.R. 32.4; Trade Options on
Enumerated Agricultural Commodities, 63 FR 18821 (April 16, 1998).
The Commission has also exempted certain transactions in which U.S.
customers establish or offset foreign currency options on the Honk
Kong Futures Exchange. Petition of the Philadelphia Stock Exchange,
Inc. for Exemptive Relief To Permit United States Customers To
Establish or Offset Positions in Certain Foreign Currency Options on
the Hong Kong Futures Exchange, Ltd. Through Registered Broker-
Dealers, 62 FR 15659 (April 2, 1997).
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A. Swaps
1. Policy Statement
The Policy Statement was adopted by the Commission on July 21,
1989.\10\ It provides a safe harbor from regulation by the Commission
under the CEA for qualifying agreements. It addresses only swaps
settled in cash, with foreign currencies considered to be cash.\11\
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\10\ 54 FR 30694 (July 21, 1989).
\11\ Id. at 30696.
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To qualify for a safe harbor from regulation under the Policy
Statement, a swap agreement must have all of the following
characteristics: (1) individually tailored terms; (2) an absence of
exchange-style offset; (3) an absence of a clearing organization or
margin system; (4) undertaken in conjunction with a line of business;
and (5) not marketed to the general public.
These conditions limit the applicability of the Policy Statement
primarily to agreements entered into by institutional and commercial
entities such as corporations, commercial and investment banks, thrift
institutions, insurance companies, governments and government-sponsored
or -chartered entities. The Commission indicated however, that the
restrictions did not ``preclude dealer transactions in swaps undertaken
in conjunction with a line of business, including financial
intermediation services.'' \12\ Moreover, the restrictions reflect the
Commission's understanding that qualifying transactions will be entered
into with the expectation of performance by the counterparties, will be
bilaterally negotiated as to material economic terms based upon
individualized credit determinations, and will be documented by the
parties in an agreement (or series of agreements) that is not
standardized.\13\ The restrictions are not intended to prevent the use
of master agreements between two counterparties, provided that the
material terms of the master agreement and the transaction
specifications are individually tailored by the parties.\14\
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\12\ Id. at 30697.
\13\ Id at 30696-97.
\14\ See id. at 30696 n. 17.
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2. Part 35
The Futures Trading Practices Act of 1992 (``1992 Act'') \15\ added
subsections (c) and (d) to section 4 of the Act. Section 4(c)(1) \16\
authorizes the Commission, by rule, regulation or order, to exempt any
agreement, contract or transaction, or class thereof from the exchange-
trading requirements of Section 4(a) or any other requirement of the
Act other than Section 2(a)(1)(B). Section 4(c)(2) \17\ provides that
the Commission may not grant any exemption unless the Commission
determines that the transaction will be entered into solely between
``appropriate persons.'' \18\ that the exchange trading requirements of
Section 4(a) should not be applied, that the agreement, contract or
transaction in question will not have a material adverse effect on the
ability of the Commission or any contract market to discharge its
regulatory or self-regulatory duties under the Act, and that the
exemption would be consistent with the public interest and the purposes
of the Act.
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\15\ Pub. L. No. 102-546 (1992), 106 Stat 3590, 3629.
\16\ 7 U.S.C. 6(c)(1).
\17\ 7 U.S.C. 6(c)(2).
\18\ 7 U.S.C. 6(c)(3).
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The Commission may grant exemptions ``either unconditionally or on
stated terms or conditions.'' \19\ Thus,
[[Page 26117]]
Section 4(c) gives the Commission the authority to tailor its
regulatory program to fit the realities of the marketplace and the
needs of market participants.
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\19\ 7 U.S.C. 6(c)(1). Section 4(d), 7 U.S.C. 6(d), provides
that
[t]he granting of an exemption under this section shall not
affect the authority of the Commission under any other provision of
the Act to conduct investigations in order to determine compliance
with the requirements or conditions of such exemption or to take
enforcement action for any violation of any provision of this Act or
any rule, regulation or order thereunder caused by failure to comply
with or satisfy such conditions or requirements.
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Part 35 of the Commission's regulations exempts swap agreements
meeting specified criteria from the provisions of the CEA and the
Commission's regulations promulgated thereunder except for the
following: Section 2(a)(1)(B) of the CEA; \20\ the antifraud provisions
set forth in Sections 4b and 4o of the CEA \21\ and Commission Rule
32.9; \22\ and the antimanipulation provisions set forth in Sections
6(c) and 9(a)(2) of the CEA.\23\ The Part 35 swap exemption is
retroactive and effective as of October 23, 1974, the date of enactment
of the Commodity Futures Trading Commission at of 1974.\24\ Part 35 was
promulgated under authority granted to the Commission by Section 4(c)
of the Act.\25\
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\20\ 7 U.S.C. 2a. Section 2(a)(1)(B) of the Act establishes the
respective jurisdiction of the CFTC and of the SEC over different
instruments and restricts or prohibits certain types of securities
futures.
\21\ 7 U.S.C. 6b and 6o.
\22\ Regulation 32.9, 17 CFR 32.9, prohibits fraud in connection
with commodity options transactions.
\23\ 7 U.S.C. 9 and 13(a)(2).
\24\ Pub. L. No. 93-463 (1974), 88 Stat. 1389. See Commission
Regulation 35.1(a) and Exemption for Certain Swap Agreements, 58 FR
5587 at 5588 (January 22, 1993) (adopting Part 35 Rules).
\25\ In issuing the swap exemption, the Commission also acted
pursuant to its authority to regulate options under Section 4c(b) of
the CEA, 7 U.S.C. 6c(b). See Exemption for Certain Swap Agreements,
58 FR 5587 at 5589 (Jan. 22, 1993).
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To be eligible for exemptive treatment under Part 35, an agreement:
(1) must be a swap agreement as defined in Regulation 35.1(b)(1); (2)
must be entered into solely between eligible swap participants; (3)
must not be a part of a fungible class of agreements that are
standardized as to their material economic terms; (4) must include as a
material consideration the creditworthiness of a party with an
obligation under the agreement; and (5) must not be entered into and
traded on or through a multilateral transaction execution facility.
These criteria were designed to assure that the exempted swaps
agreements met the requirements set forth by Congress in Section 4(c)
of the CEA and ``to promote domestic and international market
stability, reduce market and liquidity risks in financial markets,
including those markets (such as futures exchanges) linked to swap
markets and eliminate a potential source of systemic risk.'' \26\
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\26\ Id. at 5588.
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The definition of ``swap agreement'' provided in Regulation
35.1(b)(1) is as follows:
Swap agreement means: (i) An agreement (including terms and
conditions incorporated by reference therein) which is a rate swap
agreement, basis swap, forward rate agreement, commodity swap,
interest rate option, forward foreign exchange agreement, rate cap
agreement, rate floor agreement, rate collar agreement, currency
swap agreement, cross-currency rate swap agreement, currency option,
any other similar agreement (including any option to enter into any
of the foregoing); (ii) Any combination of the foregoing; or (iii) A
master agreement for any of the foregoing together with all
supplements thereto.
This definition is the same as the definition of swap agreement set
forth in Section 4(c)(5)(B) of the CEA.\27\
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\27\ See id. at 5589.
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Regulation 35.1(b)(2) defines ``eligible swap participant'' as
follows:
(i) A bank or trust company (acting on its own behalf or on
behalf of another eligible swap participant);
(ii) A savings association or credit union;
(iii) An insurance company;
(iv) An investment company subject to regulation under the
Investment Company Act of 1940 . . . or a foreign person performing
a similar role or function subject as such to foreign regulation,
provided that such investment company or foreign person is not
formed solely for the specific purpose of constituting an eligible
swap participant;
(v) A commodity pool formed and operated by a person subject to
regulation under the Act or a foreign person performing a similar
role or function subject as such to foreign regulation, provided
that such commodity pool or foreign person is not formed solely for
the specific purpose of constituting an eligible swap participant
and has total assets exceeding $5,000,000;
(vi) A corporation, partnership, proprietorship, organization,
trust, or other entity not formed solely for the specific purpose of
constituting an eligible swap participant (A) which has total assets
exceeding $10,000,000; or (B) the obligations of which under the
swap agreement are guaranteed or otherwise supported by a letter of
credit * * * or other agreement by any such entity referenced in
this subsection (vi)(A) * * * or * * * in paragraph (i), (ii),
(iii), (iv), (v), (vi) or (viii) of this section; or (C) which has a
net worth of $1,000,000 and enters into the swap agreement in
connection with * * * its business; or which has a net worth of
$1,000,000 and enters into the swap agreement to manage the risk of
an asset or liability owned or incurred in the conduct of its
business or reasonably likely to be owned or incurred in * * * its
business;
(vii) An employee benefit plan subject to the Employee
Retirement Income Security Act of 1974 or a foreign person
performing a similar role or function subject as such to foreign
regulation with total assets exceeding $5,000,000, or whose
investment decisions are made by a bank, trust company, insurance
company, investment adviser subject to regulation under the
Investment Advisers Act of 1940 * * * or a commodity trading advisor
subject to regulation under the Act;
(viii) Any governmental entity (including the United States, any
state, or any foreign government) or political subdivision thereof,
or any multinational or supranational entity or any instrumentality,
agency, or department of any of the foregoing;
(ix) A broker-dealer subject to regulation under the Securities
Exchange Act of 1934 * * * or a foreign person performing a similar
role or function subject as such to foreign regulation, acting on
its own behalf or on the behalf of another eligible swap
participant: Provided, however, that if such broker-dealer is a
natural person or proprietorship, the broker-dealer must also meet
the requirements of either subsection (vi) or (xi) of this section;
(x) A futures commission merchant, floor broker, or floor trader
subject to regulation under the Act or a foreign person performing a
similar role or function subject as such to foreign regulation,
acting on its own behalf or on behalf of another eligible swap
participant: Provided, however, that if such futures commission
merchant, floor broker or floor trader is a natural person or
proprietorship, the futures commission merchant, floor broker or
floor trader must also meet the requirements of subsection (vi) or
(xi) of this section; or
(xi) Any natural person with total assets exceeding at least
$10,000,000.
The definition of ``eligible swap participant'' in Regulation
35.1(b)(2) is based on the list of appropriate persons set forth in
Section 4(c)(3)(A)-(J) of the CEA. However, the Commission, relying on
authority provided in Section 4(c)(3)(K) of the CEA, adjusted those
definitions when it adopted Part 35. These adjustments reflected the
international character of the swaps market by assuring that both
foreign and United States entities could quality for treatment as
eligible swap participants. In addition, the Commission raised the
threshold for the net worth or total asset test that must be met by
certain eligible swap participants. It applied this test as an
indication of a swap participant's financial sophistication and
background.\28\ The Commission indicated its belief that the definition
of ``eligible swap participant,'' as adopted, would not adversely
affect the swap market as it then existed.\29\
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\28\ See id. at 5589-90.
\29\ See id. at 5590.
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The remaining conditions that must be satisfied by swap agreements
in order
[[Page 26118]]
to qualify for the Part 35 exemption are meant, among other goals, to
assure that the exemption does not permit the establishment of an
unregulated exchange-like market in swaps.\30\ These conditions require
that the creditworthiness of any party having an obligation under the
swap agreement must be a material consideration in entering into the
agreement and prohibit a swap that is part of a fungible class of
agreements, standardized as to their material economic terms, or that
is entered into and traded on or through a multilateral transaction
execution facility from qualifying for the Part 35 exemption. The
Commission has made clear that the Part 35 exemption does not extend to
transactions that are subject to a clearing system where the credit
risk of individual counterparties to each other is effectively
eliminated.\31\
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\30\ See id. at 5590-91.
\31\ See id. at 5591.
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These conditions do not prevent parties who wish to rely on the
Part 35 exemption from undertaking bilateral collateral or margining
arrangements nor from applying bilateral or multiparty netting
arrangements to their transactions, provided however that, in the case
of multilateral netting arrangements, the underlying gross obligations
among the parties are not extinguished until all netted obligations are
fully performed.\32\ Nor is the Part 35 restriction on multilateral
transaction execution facilities meant to preclude parties who engage
in negotiated, bilateral transactions from using computer or other
electronic facilities to communicate simultaneously with other
participants, so long as they do not use such facilities to enter
orders or execute transactions.\33\
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\32\ See id.
\33\ See id.
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Similarly, standardization of terms that are not material economic
terms does not necessarily prevent an agreement from qualifying for an
exemption under Part 35, provided that the material economic terms of
the swap agreement remain subject to individual negotiation by the
parties.\34\ In this respect, the Commission has explained that:
\34\ See id. at 5590.
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[T]he phrase ``material economic terms'' is intended to
encompass terms that define the rights and obligations of the
parties under the swap agreement, and that as a result, may affect
the value of the swap at origination or thereafter. Examples of such
terms may include notional amount, amortization, maturity, payment
dates, fixed and floating rates or prices (including method by which
such rates or prices may be determined), payment computation
methodologies, and any rights to adjust any of the foregoing.\35\
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\35\ Id. at 5590 n. 24.
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B. Hybrid Instruments
1. Background
In 1989, the Commission recognized that certain instruments
combined characteristics of securities or bank deposits with
characteristics of futures or options and wished to exclude from CEA
regulation those hybrid instruments whose commodity-dependent value was
less than their commodity-independent value. The Commission issued a
Statutory Interpretation Concerning Certain Hybrid Instruments
(``Interpretation'') \36\ which excluded from regulation under the CEA
and CFTC regulations debt securities within the meaning of Section 2(1)
of the Securities Act of 1933 and time deposits within the meaning of
12 CFR Section 204.2(c)(1) that had the following characteristics: (1)
indexation to a commodity on no more than a one-to-one basis; (2) a
limited maximum loss; (3) inclusion of a significant commodity
component; (4) lack of a severable commodity component; (5) no required
delivery of a commodity by means of an instrument specified in the
rules of a designated contract market; and (6) no marketing of the
instruments as futures contracts or commodity options.\37\
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\36\ 54 FR 1139 (January 11, 1989).
\37\ Id.
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Later in 1989, the Commission adopted Part 34, which exempted
certain hybrid instruments with commodity option components from the
CEA and from the Commission's regulations.\38\ While Part 34 expanded
the category of hybrid instruments that were considered to be outside
of the CEA and the Commission's regulations, the Commission explicitly
stated that it intended not ``to address the entire universe of hybrid
instruments in the proposed rules, but rather to establish an exemptive
framework'' that would apply to certain instruments in which issuers
had expressed an interest to that point.\39\ In 1990, the Commission
issued a revised Interpretation designed to conform the
Interpretation's treatment of hybrids with the treatment of hybrids in
Part 34.\40\ The revised Interpretation expanded the class of
securities and depository accounts eligible as hybrid instruments and
expanded the class of institutions eligible to transact in hybrids.
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\38\ 54 FR 30684 (July 21, 1989).
\39\ Id.
\40\ 55 FR 13582 (April 11, 1990).
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Congress included a provision in the 1992 Act permitting the
Commission to exempt any transaction from all provisions of the CEA
except Section 2(a)(1)(B). Using this new authority contained in
Section 4(c) of the CEA, the CFTC substantially modified the Part 34
regulations to exempt certain hybrids (including, for the first time,
hybrid instruments with futures-like components) from most provisions
of the CEA and from the Commission's regulations.
2. Part 34
A hybrid instrument is defined in Part 34 of the Commission's
regulations as an equity security, a debt security, or a depository
instrument with at least one commodity-dependent component that has a
payment feature similar to that of a commodity futures contract, a
commodity option contract or a combination thereof.\41\ Part 34 exempts
such hybrids, and those transacting in and/or providing advice or other
services with respect to such hybrids, from all provisions of the CEA
except Section 2(a)(1)(B) of the CEA, provided that a number of
conditions are met.\42\ The conditions include: (1) a requirement that
the issuer must receive full payment of the hybrid's purchase price;
\43\ (2) a prohibition on requiring additional out-of-pocket payments
to the issuer during the hybrid's life or at its maturity; \44\ (3) a
prohibition on marketing the instrument as a futures contract or
commodity option; \45\ (4) a prohibition on settlement by delivery of
an instrument specified as a delivery instrument in the rules of a
designated contract market; \46\ (5) a requirement that the hybrid be
initially sold or issued subject to federal or state securities or
banking laws to persons permitted thereunder to purchase the
instrument; \47\ and (6) a requirement that the sum of the values of
the commodity-dependent components of a hybrid instrument be less than
the value of the commodity-independent components.\48\
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\41\ 17 CFR 34.2(a) (1997).
\42\ 17 CFR 34.3(a) (1997).
\43\ 17 CFR 34.3(a)(3)(i) (1997).
\44\ Id.
\45\ 17 CFR 34.3(a)(3)(ii) (1997).
\46\ 17 CFR 34.3(a)(3)(iii) (1997).
\47\ 17 CFR 34.3(a)(4) (1997).
\48\ 17 CFR 34.3(a)(2) (1997).
---------------------------------------------------------------------------
In imposing the first two conditions of Part 34's exemptions--the
requirement that the issuer of a hybrid instrument receive full payment
of the hybrid's purchase price and the ban on out-of-pocket payments
from a hybrid purchaser or holder to the instrument's issuer--the
Commission sought to limit the possible losses due to the
[[Page 26119]]
commodity-dependent components of a hybrid instrument, reasoning that
an instrument permitting the accrual of losses in excess of the face
value of such instrument is more akin to a position in a commodity
derivative than to a debt, equity, or depository instrument.\49\ The
third condition outlined above, a limitation on marketing the
instrument as a futures contract or a commodity option, was intended to
prevent purveyors of hybrid instruments from misleading investors as to
the nature, legal status and form of regulatory supervision to which
such instruments are subject.\50\ The Commission did not want potential
buyers to believe that hybrids were subject to the full protections of
the CEA.
---------------------------------------------------------------------------
\49\ Regulation of Hybrid Instruments, 58 FR 5580 at 5585
(January 22, 1993) (promulgating current Part 34 Rules).
\50\ Regulation of Hybrid Instruments, 54 FR 1128 at 1135
(January 11, 1989) (proposing original Part 34 Rules).
---------------------------------------------------------------------------
The fourth condition noted above, a prohibition on settlement by a
contract market delivery instrument, was designed to guard against
interference with deliverable supplies for settlement of exchange-
traded futures or options contracts.\51\ In adopting the fifth
condition, a limitation on persons permitted to purchase an instrument,
the Commission was seeking both to address customer protection concerns
and Congress's concern, as embodied in Section 4(c)(2)(B)(i) of the
CEA,\52\ that only transactions entered into between appropriate
persons may be exempted from the CEA.\53\
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\51\ 58 FR 5580 at 5582.
\52\ 7 U.S.C. 6(c)(2)(B)(i).
\53\ 58 FR 5580 at 5585.
---------------------------------------------------------------------------
This sixth requirement is referred to as the ``predominance test.''
\54\ It was designed in response to authorization granted by Congress
in Section 4(c)(5)(A) of the CEA for the Commission to exempt hybrids,
which were predominantly securities or depository instruments. The
predominance test starts from the premise that hybrid instruments can
be viewed as a combination of simpler instruments, the payments on
which can be viewed as either commodity-independent or commodity-
dependent. The payments on a hybrid's commodity-independent component
are not indexed or calculated by reference to the price of an
underlying commodity, including any index, spread or basket of
commodities; the payments on a hybrid's commodity-dependent component
are so indexed or referenced.
---------------------------------------------------------------------------
\54\ 17 CFR 34.3(a)(2) (1997).
---------------------------------------------------------------------------
For a hybrid instrument to be exempted by Part 34, the present
value of the returns associated with the commodity-independent
component of an instrument (including any return of principal) must be
greater than the ``commodity-dependent value'' of the instrument. In
order to calculate the commodity-dependent value of a hybrid, Part 34
conceptually decomposes a hybrid's commodity-dependent portion into
options. The absolute values of the premiums of all implicit options
that are at- or out-of-the-money are summed to arrive at the commodity-
dependent value of the hybrid instrument.\55\ These values are
calculated as of the time of issuance of the hybrid instrument.\56\
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\55\ More specifically, the absolute net value of all put option
premiums with strike prices less than or equal to the reference
price would be added to the absolute net value of all call option
premiums with strike prices greater than or equal to the reference
price. 58 FR 5580 at 5584. ``Reference price'' is defined in
Regulation 34.2(g), 17 CFR 34.2(g), ``as the nearest current spot or
forward price at which a commodity-dependent payment becomes non-
zero, or in the case where two potential reference prices exist, the
price that results in the greatest commodity-dependent value.''
\56\ 58 FR 5580 at 5584-85.
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III. Issues for Comment
A. Background
As the foregoing discussion indicates, the Commission has
recognized that differences between exchange-traded markets and the OTC
derivatives market warrant differences in regulatory treatment.
Pursuant to the exemptions, activity in the OTC derivatives market has
generally been limited to decentralized, principal-to-principal
transactions between large traders. This has significant regulatory
implications.
The OTC derivatives market does not appear to perform the same
price discovery function as centralized exchange markets. Accordingly,
certain regulatory requirements related to price discovery have not
been applied to the OTC derivatives market. Thus, for example, the
Commission has not suggested that it should preapprove contract design
in the OTC derivatives market as it does for exchanges.
Similarly, the decentralization of trading in the OTC market and
the relative sophistication of the participants have meant that issues
of financial integrity and customer protection differ from exchange
markets. Thus for example, while the Commission has retained its fraud
authority for the swap market, it has not required segregation of
customer funds.
Developments in the market in the last five years, however,
indicate the need to review the current exemptions. As mentioned above,
new end-users have entered the market, new products have been
developed, some products have become more standardized, and systems for
centralized execution and clearing have been proposed. The terms and
conditions of the exemptions may need adjustment to reflect changes in
the marketplace and to facilitate continued growth and innovation.
In addition, the explosive growth in the OTC market in recent years
has been accompanied by an increase in the number and size of losses
even among large and sophisticated users which purport to be trying to
hedge price risk in the underlying cash markets. Market losses by end-
users may lead to allegations of fraud or misrepresentation after they
enter transactions they do not fully understand. Moreover, as the use
of the market has increased, entities such as pension funds and school
districts have been affected by derivatives losses in addition to
corporate shareholders.\57\
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\57\ See 1997 GAO Report at 71.
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Accordingly, the Commission believes it is appropriate at this time
to consider whether any modifications to the scope or the terms and
conditions of the swap and hybrid instrument exemptions are needed to
enhance the fairness, financial integrity, and efficiency of this
market. The Commission reiterates that the items listed below are
intended solely to encourage useful public comment.
The Commission urges commenters to analyze the benefits and burdens
of any potential modifications in light of current market realities. In
some areas, regulatory relief or expanded access to the market may be
warranted while in others additional safeguards may be appropriate. The
Commission is especially interested in whether modifications can be
designed to stimulate growth. This might be accomplished, for example,
by increasing legal certainty and investor confidence, thereby
attracting new market participants, or by facilitating netting and
other transactional efficiencies, thereby reducing costs. As discussed
below, the Commission also welcomes comment on the extent to which
certain matters can be adequately addressed through self-regulation.
Finally, the Commission invites other regulators to express their views
on the issues raised in this release and, in particular, how best to
achieve effective coordination among regulators. The Commission
anticipates that, where other regulators have adequate programs or
standards in place to address
[[Page 26120]]
particular areas, the Commission would defer to those regulators in
those areas.
B. Potential Changes to Current Exemptions
The exemptions provided by Part 34 and Part 35 reflect
circumstances in the relevant market at the time of their adoption. As
noted, the Commission believes that it should review these exemptions
in light of current market conditions. At the most general level, three
issues are presented with respect to these exemptions: first, what
criteria should be applied in determining whether a transaction or
instrument is eligible for exemption from the CEA; second, what should
be the scope of that exemption; and third, what conditions should be
imposed, if any, to ensure that the public interest and the policies of
the CEA are served.
1. Eligible Transactions
(a) Swaps. Part 35 sets forth certain criteria that an instrument
must meet in order to qualify for the swap exemption. These criteria
impose restrictions upon the design and execution of transactions that
distinguish the exempted swap transactions from exchange-traded
products.\58\ Given the changes in the swap market since Part 35 was
adopted, the Commission seeks comments as to whether the criteria set
forth in Part 35 continue to provide a meaningful, objective basis for
exempting transactions from provisions of the CEA and CFTC regulations.
---------------------------------------------------------------------------
\58\ CFTC, OTC Derivatives Markets and Their Regulation 78-79
(1993) (``CFTC OTC Derivatives Report'') (discussing swaps
exemption).
---------------------------------------------------------------------------
In particular, some swap agreements have become highly
standardized. The Part 35 exemption does not extend to ``fungible
agreements, standardized as to their material economic terms.'' The
Commission seeks comment on whether this part of the Part 35 criteria
provides sufficient guidance for parties involved in swaps. Parties may
have difficulty in readily assessing whether a particular transaction
qualifies for treatment under the Part 35 exemption.
In order to provide greater clarity, the Commission could adopt
additional or alternative requirements governing exempted swap
agreements. For example, the Commission could provide additional detail
concerning the concept of fungibility in this context. The Commission
could also clearly specify which terms of an agreement would be
considered to be material economic terms under Part 35.
Moreover, subject to consideration of the requirements set forth in
Sections 4(c)(1) and (c)(2) of the CEA, the Commission could consider
expanding the scope of the swap exemption so that it more clearly
applies to certain classes of transactions that exhibit some degree of
standardization. In this regard, while Section 4(c)(5)(B) authorizes
the Commission to exempt non-fungible swaps, the lack of fungibility is
not a necessary criterion under Sections 4(c)(1) or (c)(2) for
exercising exemptive authority.
Request for comment. The Commission requests comment on whether the
swaps exemption should be extended to fungible instruments and, if so,
under what circumstances. The Commission is also seeking more general
comment as to whether the swaps exemption continues to fulfill its
stated goals. In this regard, the Commission is interested in
commenters' views on what changes in the current rules may be needed to
assure that Part 35 provides legal certainty to the current market and
fulfills the statutory goals set forth in Section 4(c) of the CEA.
In particular, the Commission requests comment on the following
questions.
1. In what ways has the swap market changed since the Commission
adopted Part 35. Please address:
(a) the nature of the products;
(b) the nature of the participants, both dealers and end-users;
(c) the location of transactions;
(d) the business structure of participants (e.g., the use of
affiliates for transacting OTC derivatives);
(e) the nature of counterparty relationships;
(f) the mechanics of execution;
(g) the methods for securing obligations; and
(h) the impact of the current regulatory structure on any of the
foregoing.
2. What are the mechanisms for disseminating the prices for swap
transactions?
3. Does the swap market serve as a vehicle for price discovery in
underlying cash markets? If so, how? Please describe.
4. To what extent is the swap market used for hedging? To what
extent is it used for speculation? Please provide details.
5. Is there a potential for transactions in the swap market to be
used to manipulate commodity prices? Please explain.
6. To what degree is the swap market intermediated, i.e., to what
extent do entities
(a) act as brokers bringing end-users together?
(b) act as dealers making markets in products?
Please describe the intermediaries in the market and the extent and
nature of their activities.
7. To what extent do swap market participants act in more than one
capacity (e.g., as principal in some transactions and broker in
others)?
8. In light of current market conditions, do the existing Part 35
requirements provide reasonable, objective criteria for determining
whether particular swaps transactions are exempted under the CEA?
Should the meaning of terms such as ``fungible,'' ``material economic
terms,'' or ``material consideration'' be clarified or modified in any
way? If so, how?
9. What steps can the Commission take to promote greater legal
certainty in the swap market?
10. What types of documentation are relevant in determining whether
a particular transactions falls within the swaps exemption and/or the
Policy Statement? Should the Commission set standards in this regard?
11. If the current restrictions set forth in the Part 35
requirements negatively affect or potentially limit the OTC market or
its development in the United States, what changes would alleviate the
negative effects? Should the exemption in Part 35 be broadened in any
manner?
12. What steps, if any, can the Commission take to promote greater
efficiency in the swap market, such as for example, by facilitating
netting?
13. Are any changes in regulation relating to the design or
execution of exempted swap transactions needed to protect the interests
of end-users in the swap market? Are there changes in regulation that
would attract new end-users to the market or lead existing end-users to
increase their participation?
14. Should distinctions be made between swaps that are cash-settled
and swaps that provide for physical delivery? Please explain.
15. Should transactions in fungible instruments be permitted under
the swaps exemption?
16. To what extent should the creditworthiness of a counterparty
continue to be required to be a material consideration under the swaps
exemption? Please explain.
(b) Hybrid instruments. Part 34 was designed to exempt from
Commission regulation instruments in which the commodity futures or
option characteristics were subordinate to their characteristics as
securities and deposits. Some experienced practitioners have stated
that the definition of a hybrid instrument under Part 34 is extremely
complex and difficult to understand and to apply. Moreover, the
Commission staff has
[[Page 26121]]
recently reviewed several hybrid instruments that had very significant
commodity components yet were apparently eligible for exemption under
Part 34's technical definition.
For example, the Commission staff recently reviewed an instrument
structured as a medium-term debt instrument paying a small quarterly
coupon rate. At maturity, after subtracting out a ``factor'' reflecting
certain costs borne by the issuer, the purchaser would receive a
payment that was based on the performance of an index of futures
contract prices with no upward limit on the commodity-based return.
Moreover, the holder could lose its entire investment based on a
downward movement in the commodity index. Commission staff believed
that, under Part 34 as currently written, the instrument apparently
would be exempt from regulation under the CEA. A regulatory definition
that treats the entire principal as ``commodity independent'' despite
the fact that all of the principal on this instrument could be lost as
a direct result of movement in the commodity index warrants additional
analysis.
Another conceptual concern with the current definition is the
manner in which it assigns value to the ``commodity dependent''
component. Futures-like elements are analyzed as a combination of
offsetting at-the-money puts and calls. The sum of the absolute values
of these option premiums is the assigned value of the futures-like
component. Some observers have suggested that this test is not an
appropriate measure of the commodity dependent value. As Part 34 is
currently structured, whether or not an instrument qualifies for an
exemption depends critically on the total volatility of the commodity-
dependent portion. This creates three potential problems. First, the
technical knowledge needed to identify the commodity-dependent
volatility may be a challenge for some market participants. Second, for
two instruments that are identical except for their commodity-dependent
volatility, one might be classified as exempt while the other might
not. Indeed, if the volatility of the underlying commodity changes
through time, the classification of identical hybrid instruments issued
on different dates might be different. Thus, Part 34 may create some
undesirable ambiguity regarding which instruments qualify for an
exemption. Third, it appears to be paradoxical that short-term
instruments are more likely to be classified as exempt than long-term
instruments even though short-term instruments generally are more akin
to exchange-traded futures in many respects.
If the Commission were to modify or to clarify the predominance
test in a way that resulted in more instruments being found to have a
predominant commodity-dependent component, the Commission could
exercise its authority under Section 4(c) to exempt some or all of such
instruments subject to specified terms and conditions. As is the case
today, instruments in which the commodity-independent component was
predominant would not be subject to any such terms and conditions.
Request for comment. The Commission requests comment on the
foregoing analysis. It welcomes alternative suggestions for analyzing
hybrid instruments and for simplifying the definition of exempt hybrid
instruments.
17. In what ways has the hybrid instrument market changed since the
Commission adopted Part 34? Please address:
(a) the nature of the products;
(b) the nature of the participants, both dealers and end-users;
(c) the location of transactions;
(d) the nature of the counterparty relationships;
(e) the mechanics of execution;
(f) the methods for securing obligations; and
(g) the impact of the current regulatory structure on any of the
foregoing.
18. What are the mechanisms for disseminating prices for hybrid
instrument transactions?
19. Does the hybrid instrument market serve as a vehicle for price
discovery in underlying commodities? If so, how? Please describe.
20. To what extent is the hybrid instrument market used for
hedging? To what extent is it used for speculation? Please provide
details.
21. Is there a potential for transactions in the hybrid instrument
market to be used to manipulate commodity prices? Please explain.
22. To what degree is the hybrid instrument market intermediated,
i.e., to what extent do entities
(a) act as brokers bringing end-users together?
(b) act as dealers making markets in products?
Please describe the intermediaries in the market and the extent and
nature of their activities and the extent to which transactions in
these instruments are subject to other regulatory regimes.
23. To what extent do hybrid instrument market participants act in
more than one capacity (e.g., as a principal in some transactions and
broker in others)?
24. In light of current market conditions, do the existing Part 34
requirements provide reasonable, objective criteria for determining
whether a particular hybrid instrument performs the functions of a
futures or option or those of a security or depository instrument? Are
the criteria easily understood and applied by participants in the
market? Do they properly distinguish types of instruments? If not,
should they be changed? How?
25. What steps, if any, can the Commission take to promote greater
legal certainty in the hybrid instrument market? Please explain.
26. Should Part 34 be amended to reflect more accurately or more
simply whether commodity-dependent components predominate over
commodity-independent components?
27. Are changes in regulation relating to the design or execution
of transactions in exempted hybrid instruments needed to protect the
interests of end-users in the hybrid instrument market? Are there
changes in regulation that would attract new end-users to the market or
lead existing end-users to increase their participation?
28. Should the Commission exercise its authority to exempt any
hybrid instruments with a predominant commodity component subject to
specified terms and conditions? Please explain.
2. Eligible Participants
Section 4(c)(2) states that ``the Commission shall not grant any
exemption under'' authority granted therein ``unless the Commission
determines that . . . the agreement, contract or transaction will be
entered into solely between appropriate persons.'' Section 4(c)(3)
further states that ``the term `appropriate person' shall be limited''
to the classes of persons specifically listed therein including
``[s]uch other persons that the Commission determines to be appropriate
in light of their financial or other qualifications or the
applicability of appropriate regulatory protections.''
(a) Swaps. Part 35 currently contains a requirement that an exempt
swap agreement be between eligible swap participants, as defined in
Regulation 35.1(b)(2). The list of eligible swap participants in Part
35 is based substantially on the list of ``appropriate person'' defined
in the CEA. The Commission seeks comments as to whether the current
list of eligible swap participants should be modified in any way. The
Commission requests comment regarding whether the definition is
adversely affecting the
[[Page 26122]]
swaps market by excluding persons who should be included or,
alternatively, by including persons who are not, or should not be,
active in the current market. The Commission also seeks comment on
whether additional persons should be added and, if so, whether
additional protections would be appropriate. In either case, commenters
are asked to describe such persons and the protections they need, if
any.
Any potential change must be analyzed in light of the stated
Congressional intent that any exempted transaction must be entered into
solely by appropriate persons as defined in Section 4(c)(3)(A)-(K) of
the Act. In addition, any changes to the definition of eligible swap
participant would be considered in light of any other relevant changes
that may result from Commission follow-up to this concept release.
(b) Hybrid instruments. As discussed above, if the Commission were
to modify the predominance test under Part 34, it might also decide to
exempt certain commodity-like hybrid instruments subject to specified
terms and conditions. The Commission invites analysis on the potential
applicability of an appropriate person standard in that context.
Request for comment. 29. Should the current list of eligible swap
participants be expanded in any way? Should it be contracted in any
way? If so, how and why?
30. Are there currently eligible swap participants who would
benefit from additional protections? Are there potential swap
participants who are not currently eligible but would be appropriate
subject to additional protections? In either case, please describe the
types of persons and the types of protections.
31. Should the Commission establish a class of eligible
participants for the trading of hybrid instruments with a predominant
commodity-dependent component? If so, please describe.
32. Is it advisable to use a single definition of sophisticated
investor whenever that concept arises under the Commission's
regulations? If so, what definition should apply?
3. Clearing
Clearing of swaps is not permitted under Part 35. The Commission
expressly stated that:
The exemption does not extend to transactions that are subject
to a clearing system where the credit risk of individual members of
the system to each other in a transaction to which each is a
counterparty is effectively eliminated and replaced by a system of
mutualized risk of loss that binds members generally whether or not
they are counterparties to the original transaction.\59\
---------------------------------------------------------------------------
\59\ 54 FR 5587 at 5591.
Regulation 35.2 provides, however, that ``any person may apply to
the Commission for exemption from any of the provisions of the Act
(except 2(a)(1)(B)) for other arrangements or facilities, on such terms
and conditions as the Commission deems appropriate. * * *'' The
Commission included this proviso in order to hold open the possibility
that swap agreements cleared through an organized clearing facility
could be exempted from requirements of the Act under appropriate terms
and conditions. The Commission affirmatively stated that the proviso
``reflects the Commission's determination to encourage innovation in
developing the most efficient and effective types of systemic risk
reduction'' and that ``a clearing house system for swap agreements
could be beneficial to participants and the public generally.'' \60\
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\60\ Id. at 5591 n.30.
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In the years since Part 35 was issued, interest in developing
clearing mechanisms for swaps and other OTC derivatives has increased.
The Commission has had extensive discussions with several organizations
engaged in designing clearing facilities.\61\ The Commission believes
that these efforts have reached a stage where it is necessary to
consider and to formulate a program for appropriate oversight and
exemption of swaps clearing.
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\61\ Not all the proposed arrangements have included the
mutualization of risks among members of a clearing organization. In
some cases, a single entity proposed to support the clearing
arrangements using its own assets.
---------------------------------------------------------------------------
Clearing organizations can provide many benefits to participants,
such as the reduction of counterparty credit risk, the reduction of
transaction and administrative costs, and an increase in liquidity.
They also can provide benefits to the public at large by increasing
transparency. These benefits are obtained at the cost of concentrating
risk in the clearing organization. Accordingly, a greater need may
exist for oversight of the operations of a clearing organization than
for any single participant in an uncleared market.
In the 1993 CFTC OTC Derivatives Report, the Commission stated that
the regulatory issues presented by a facility for clearing swaps
``would depend materially upon the facility's design, such as, for
example, the extent to which the construction of such a facility is
consistent with the minimum standards for netting systems recommended
by the Report of the Committee on Interbank Netting Schemes of the
Central Banks of the Group of Ten Countries (Lamfalussy Report).'' \62\
Comment is requested concerning the usefulness of the Lamfalussy
standards in this context.
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\62\ CFTC OTC Derivatives Report at 136-37. The Lamfalussy
standards are the following:
1. Netting schemes should have a well-founded legal basis under
all relevant jurisdictions;
2. Netting scheme participants should have a clear understanding
of the impact of the particular scheme on each of the financial
risks affected by the netting process;
3. Multilateral netting systems should have clearly-defined
procedures for the management of credit risks and liquidity risks
which specify the respective responsibilities of the netting
provider and the participants. These procedures should also ensure
that all parties have both the incentives and the capabilities to
manage and contain each of the risks they bear and that limits are
placed on the maximum level of credit exposure that can be produced
by each participant.
4. Multilateral netting systems should, at a minimum, be capable
of ensuring the timely completion of daily settlements in the event
of an inability to settle by the participant with the largest single
net-debit position;
5. Multilateral netting systems should have objective and
publicly-disclosed criteria for admission which permit fair and open
access; and
6. All netting schemes should ensure the operational reliability
of technical systems and the availability of back-up facilities
capable of completing daily processing requirements.
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The Commission has identified the following core elements that
should be addressed: the functions that an OTC derivatives clearing
facility would perform; the products it would clear; the standards it
would impose on participants; and the risk management tools it would
employ. As discussed below, the Commission invites comments on each of
these topics.
(a) Functions. An OTC derivatives clearing facility could perform a
variety of functions ranging from simple trade comparison and
recordation to netting of obligations to the guarantee of performance.
For example, the Commission notes that, in jurisdictions other than the
U.S., there may not be a clearing guarantee, or the guarantee may
attach at a time other than the initiation of the trade. The Commission
requests comment on which of these functions, if any, should be
permitted and under what circumstances.
(b) Products cleared. The definition of the term ``swap agreement''
in Regulation 35.1(b)(1) is very broad. Financial engineers are
continually designing new products that fall within that definition but
have novel characteristics. As a practical matter, the Commission
believes that any OTC derivatives clearing facility would be most
likely in the context of ``plain vanilla'' products for which prices
can be readily established and for which there is some standardization
as to
[[Page 26123]]
terms. The Commission requests comment on whether the range of products
that may be cleared through an OTC derivative clearing facility, or
their terms of settlement, should be limited in any way.
(c) Admission standards. The class of eligible swap participants
ias defined in Regulation 35.1(b)(2). There is an inherent tension
between the desire to promote open and competitive markets by allowing
access.\63\ and the desire to maintain financial integrity by imposing
admission standards. The Commission requests comment on what standards,
if any, it should establish, or permit an OTC derivatives clearing
facility to establish, for admission as a clearing participant. Comment
is also requested on whether clearing should be limited to transactions
undertaken on a principal-to-principal basis or whether agency
transactions should be included.\64\
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\63\ See Section 15 of the Act, 7 U.S.C. 19.
\64\ Current Part 35 allows only certain eligible swap
participants to act on the behalf of another eligible swap
participant. See 17 CFR 35.1(b)(2) (1997).
---------------------------------------------------------------------------
(d) Risk management tools. An OTC derivatives clearing facility
could choose from among many potential risk management tools. These
include capital requirements for participants, reporting requirements,
position or exposure limits, collateral requirements, segregation
requirements, mark-to-market or other valuation procedures, risk
modeling programs, auditing procedures, and information-sharing
arrangements. The clearing facility could also draw upon its own
capital, its lines of credit, any guarantee funds financed by clearing
members, or other arrangements for sharing losses among participants.
The relevance of these various items would depend, of course, on the
functions the clearing facility performed and the products its cleared.
The Commission requests comment on how best to assure that a clearing
facility uses appropriate risk management tools without preventing
flexibility in the design of such tools or inhibiting the evolution of
new risk management technology.
(e) Other considerations. Permitting OTC products to be cleared may
make them more like exchange-traded products. The Commission welcomes
comment on how best to promote fair competition and even-handed
regulation in the context of the clearance of OTC derivative products.
In approving Part 35, the Commission noted that it was ``mindful of
the costs of duplicative regulation \65\ and added the proviso to
Regulation 35.2 that the Commission would consider ``the applicability
of other regulatory regimes'' in addressing petitions for further
exemptive relief relating to swaps facilities. The Commission
recognizes that existing clearing facilities that are regulated by
another federal regulatory authority because the clear products subject
to that regulator's jurisdiction may wish to develop swap clearing
facilities. The Commission requests comment on how to address this
situation.
---------------------------------------------------------------------------
\65\ 58 FR 5587 at 5591 n.30.
---------------------------------------------------------------------------
Request for comment. 33. Are any swaps currently subject to any
type of clearing function, either in the U.S. or abroad? If so, please
provide details.
34. Would permitting swap clearing facilities promote market growth
and assist U.S. participants in remaining competitive? If so, please
describe the appropriate elements of a program for the oversight of
swap clearing organizations.
35. Should there be a limit on the clearing functions permitted for
swaps?
36. Should there be a limit on the range of products that may be
cleared through a swap clearing facility?
37. Should there be standards for admission as a clearing
participant?
38. What types of risk management tools should a clearing facility
employ?
39. To what degree would cleared swaps be similar to exchange
traded products? How best can the Commisison promote fair competition
and even-handed regulation in this context?
40. How should the Commission address OTC derivative clearing
facilities that are subject to another regulatory authority by virtue
of conducting activities subject to that regulator's jurisdiction?
4. Transaction Execution Facilities
Regulation 35.2(d) provides that a swap agreement may not be
entered into or traded on or through a multilateral transaction
execution facility (``MTEF'').\66\ In the release issuing Part 35, the
Commission described an MTEF as:
\66\ 17 CFR 35.2(d) (1997).
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[A] physical or electronic facility in which all market makers
and other participants that are members simultaneously have the
ability to execute transactions and bind both parties by accepting
offers which are made by one member and open to all members of the
facility.\67\
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\67\58 FR 5587 at 5591.
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The Commission specified that the MTEF limitation did not:
[P]reclude participants from engaging in privately negotiated
bilateral transactions, even where these participants use computer
or other electronic facilities, such as ``broker screens,'' to
communicate simultaneously with other participants so long as they
do not use such systems to enter orders to execute transactions.\68\
\68\ Id.
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The Commission noted that there were no swap MTEFs in existence at
that time.\69\ Consistent with the proviso in Regulation 35.2, the
Commission invited application for appropriate exemptive relief for
such facilities as they were developed.\70\
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\69\ Id.
\70\ Id.
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The Commission is requesting comment on whether the regulatory
approach to execution facilities should be modified in any way.
Specifically, the Commission invites comment on whether the description
of MTEFs set forth above is sufficiently clear, whether it accurately
delineates the relevant features, and how the Commission should address
other types of entities that facilitate execution, such as market
makers or bulletin board services. The Commission recognized when it
promulgated Part 35 that MTEFs ``could provide important benefits in
terms of increased liquidity and price transparency.'' \71\ The
Commission seeks comment on whether it should permit swaps to be traded
through an MTEF or other similar facilities and, if so, what terms and
conditions should be applied. It also seeks comment on the degree to
which such trading would be similar to exchange trading and the degree
to which similar safeguards are needed. As in the case of clearing
facilities, the Commission is mindful of the need to promote fair
competition between and even-handed regulation of exchanges and the
swap market.
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\71\ Id.
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Part 36 of the Commission's regulations \72\ was designed to allow
reduced regulation for exchange trading limited to sophisticated
traders. It was intended to ``permit * * * exchange-traded products
greater flexibility in competing with foreign exchange-traded products
and with both foreign and domestic over-the-counter transactions while
maintaining basic customer protection, financial integrity and other
protections associated with trading in an exchange environment.'' \73\
No contract market has applied for exemption under Part 36. An analysis
of the perceived strengths and weaknesses of Part 36 may be a useful
starting point in determining an appropriate regulatory regime for
execution facilities. Accordingly, the Commission requests comment on
whether elements
[[Page 26124]]
of Part 36 should be applicable to execution facilities. Proposals for
modification of Part 36 are welcome.
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\72\ 17 CFR 36.1-36.9 (1997).
\73\ Section 4(c) Contract Market Transactions, 60 FR 51323
(Oct. 2, 1995).
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Request for comment. 41. Should the definition of MTEF be changed
in any way to provide more clarity?
42. Are MTEFs or other types of execution facilities currently
being used for swap trading, either in the U.S. or abroad? If so,
please provide details.
43. What terms and conditions, if any, should be applied to
execution facilities? Please address potential competitive effects on
current exchange trading and the degree to which similar requirements
should be made applicable. Please also address the strengths and
weaknesses of current Part 36 for this purpose.
5. Registration
Registration has been called ``the kingpin in [the CEA's] statutory
machinery, giving the Commission the information about participants in
commodity trading which it so vitally requires to carry out its other
statutory functions of monitoring and enforcing the Act.\74\
Registration identifies participants in the markets and allows for a
``screening'' process by requiring applicants to meet fitness
standards. Registration may also facilitate enforcement of fraud
prohibitions. In addition, the requirement to register may trigger
other standards and obligations for registrants under the CEA and
Commission rules.\75\ Part 34 and Part 35 of the Commission's
regulations currently exempt parties from the registration requirements
of the Act with respect to qualifying transactions.
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\74\ Commodity Futures Trading Commission v. British American
Commodity Options Corp., 560 F.2d 135 at 139-40 (2d Cir. 1977) cert.
denied, 438 U.S. 905 (1978).
\75\ See, e.g., Sections 8a(2) and 8a(3) of the Act (statutory
disqualification) and Regulation 1.12 (requirement that registered
futures commission merchants (``FCMs'') and registered introducing
brokers (``IBs''), or any person who files an application to be so
registered, notify the Commission if its capital falls below minimum
capital requirements); Regulation 1.15 (risk assessment reporting
for registered FCMs); Regulation 1.17 (minimum capital requirements
for registered FCMs and registered IBs); Regulation 4.21
(requirement that commodity pool operators (``CPOs'') who are
registered or required to be registered deliver a disclosure
document to clients or potential clients). Other regulations,
however, may be applicable to parties whether or not they are
registered or required to be registered. See, e.g., Part 189 (large
trader reporting requirements).
---------------------------------------------------------------------------
The Commission seeks comment on whether registration requirements
for dealers or intermediaries would be useful or necessary for the
Commission in its oversight of the OTC derivatives market. Registration
would identify key players in the OTC derivatives markets but would not
necessarily trigger the full range of regulations applicable to
registered persons involved in exchange-traded futures and options.
Instead it could be related to separate and limited OTC derivatives
market regulations. Alternatively, the Commission seeks comment on
whether it would be appropriate to adopt a notice filing, requiring
parties involved in certain activities within the OTC derivatives
markets to identify themselves to the Commission.
In addressing this issue, commenters should consider, among other
things, whether a distinction should be made between swaps and hybrid
instruments. Comment also would be useful on whether it would be
sufficient that a person is registered or regulated by another federal
agency so that the Commission should waive any registration
requirements for such persons with respect to OTC derivatives
transactions.
Differences between the OTC derivative market and exchange-traded
futures and option markets may affect the need for registration in the
context of OTC derivatives trading. For example, since swap
transactions occur among institutional participants who bilaterally
negotiate an agreement, there may be reduced value added in requiring
dealers or advisors to undergo fitness checks. Such institutional
participants would likely have the resources to investigate the fitness
of potential counterparties and advisors.
Request for comment. 44. What benefits might arise from requiring
registration of dealers, intermediaries, advisors, or others involved
in OTC derivative transactions? Should any requirement be in the form
of a notice filing or full registration?
45. What criteria should be used in determining the types of
transactions and the types of market participants subject to
registration requirements?
46. Should regulation by other federal agencies be a factor in
permitting an exemption from registration or notice filing?
47. What role should membership in a designated self-regulatory
organization play?
6. Capital
Capital requirements have long been considered important for
assuring a firm's ability to perform its obligations to its customers
and to its counterparties and for controlling systemic risk. The
Commission currently imposes no capital requirements on participants in
the OTC derivatives markets. Given the sophistication of the
participants, the generally principal-to-principal nature of their
relationships with one another, the fact that OTC derivatives dealers
typically do not hold customer's funds in an agency relationship (in
contrast to futures commission merchants or broker-dealers), and the
applicability of other regulatory capital standards to many market
participants, capital requirements may be unnecessary.
The Commission seeks to explore whether regulatory capital might
serve a useful function in the context of the OTC derivatives markets.
For example, regulatory capital might provide an OTC derivatives
dealer's counterparties with independent assurance of the
creditworthiness of the dealer or might prevent the dealer from
assuming excessive leverage. Capital requirements might also serve the
function of providing early warning of financial difficulties.
Request for comment. 48. Are any capital requirements for OTC
derivatives dealers needed? Why? What benefits would they provide to
the market? What burdens would they impose?
49. Should any reporting or disclosure requirements be established
for dealers as an alternative to capital requirements in order to
permit counterparties to evaluate their creditworthiness adequately?
Please explain.
50. Do ratings by nationally recognized statistical rating
organizations fulfill the function of assuring end-user counterparties
of the creditworthiness of OTC derivatives dealers?
7. Internal Controls
The importance of internal controls for financial services firms
generally and for derivatives dealers in particular is widely
recognized.\76\ The Commission has long required information concerning
risk management and internal control systems from FCMs, as well as
prompt reporting of any material inadequacies in such systems.\77\
Close attention to risk management and internal control systems may be
especially important in an environment where capital standards (whether
imposed by regulators or internally) are reduced and are based on the
results of internal value-at-risk models and calculations rather than
on more standardized ``haircuts.'' While a
[[Page 26125]]
complete discussion of internal control programs is beyond the scope of
this release, the following elements of such a program are generally
considered particularly important: effective models for measuring
market and credit risk exposure; careful procedures for continuously
validating those models, including rigorous backtesting and stress
testing; netting arrangements that are enforceable in the relevant
jurisdictions (and programs to review their enforceability on a regular
basis); and a risk monitoring unit which reports directly to senior
management, is independent of the business units being monitored, and
has the necessary training and resources to accomplish its control
objectives.
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\76\ See, e.g., DPG Framework at 13-22; IOSCO, The Implications
for Securities Regulators of the Increased use of Value at Risk
Models by Securities Firms, Section 2 (Jul. 1995); Basle Committee
on Banking Supervision, Framework for the Evaluation of Internal
Control Systems at 1 (Jan. 1998); Group of Thirty, Derivatives:
Practices and Principles at 2 (1993).
\77\ See, e.g., Regulations 1.14(a)(1)(ii); 1.15(a)(1)(ii);
1.16(e)(2).
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Request for comment. 51. Would OTC derivatives market participants
benefit from internal control guidelines? If so, what market
participants should be covered?
52. What provisions should be included in internal control
requirements, if any?
53. How should compliance with any internal control requirements be
monitored (e.g., regular audits, periodic spot checks, required
reports)?
54. Who should be responsible for monitoring compliance with any
internal control requirements (e.g., regulatory agencies, SROs,
independent auditors)?
55. Could and should internal control standards serve as a
substitute for regulatory capital requirements?
8. Sales Practices
As noted in the Introduction, a significant number of participants
in the OTC derivatives markets have experienced large financial losses
since the Commission's last regulatory initiatives involving OTC
derivatives. The 1997 GAO Report notes that ``[s]ales practice concerns
were raised in 209, or 58 percent, of [the] losses [reviewed in the
Report] and were associated with an estimated $3.2 billion in losses.''
\78\ Size and sophistication of a market participant may not provide
meaningful protection against sales practice concerns, such as fraud.
---------------------------------------------------------------------------
\78\ 1997 GAO Report at 71.
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The parties to OTC derivatives transactions are commonly referred
to as end-users and dealers.\79\ End-users and OTC derivatives dealers
may have differing views concerning the respective responsibilities of
the parties to an OTC derivatives transaction. According to a survey
undertaken in conjunction with the GAO Report, ``about one-half of all
end-users of plain vanilla or more complex OTC derivatives believed
that a fiduciary relationship of some sort existed in some or all
transactions between them and their dealer.'' \80\ By contrast, ``two
dealer groups issued guidance asserting that such transactions are
conducted on a principal-to-principal, or an `arm's-length,' basis
unless more specific responsibilities are agreed to in writing or
otherwise provided by law.'' \81\ These differences in view can create
problems, especially because of the extraordinary complexity of some
OTC derivatives instruments and the information disparity between a
derivatives dealer and many end-users. Therefore, comments concerning
whether there is a need for sales practice rules applicable to OTC
derivatives dealers would be useful.
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\79\ By ``end-users'' the Commission is referring generally to
participants who use derivatives to manage financial risks and
opportunities that arise in the course of their businesses. Dealers
are distinguished from end-users by their willingness to make two-
way markets in OTC derivatives, either for end-users or for other
dealers. See however, Derivatives Policy Group, Framework for
Voluntary Oversight (Mar. 1995) (``DPG Framework'') (the Framework
was developed by a group of six major investment firms). The DPG
Framework refers to dealers as ``professional intermediaries'' and
to end-users as ``nonprofessional counterparties.'' This difference
in articulation is symptomatic of the differing views that sometimes
exist among the participants in these markets concerning their
respective roles.
\80\ 1997 GAO Report at 5.
\81\ Id. See DPG Framework at 9; and Federal Reserve Bank of New
York, Principles and Practices for Wholesale Financial Market
Transactions 1 (Aug. 17, 1995) (the Principles and Practices were
developed by a group of six financial industry trade associations in
coordination with the Federal Reserve Bank of New York).
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In granting the Part 35 swaps exemption, the Commission retained
the applicability of its basic antifraud and antimanipulation
authority.\82\ In addition, some OTC derivatives transactions are
subject to sales practice standards administered by other financial
regulatory agencies. For example, both the Office of the Comptroller of
the Currency and the Federal Reserve Board have issued guidance
addressing sales practice issues in the context of a bank's overall
responsibilities for managing the risks of its financial activities,
including OTC derivatives.\83\
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\82\ See 17 CFR 35.2 (1997).
\83\ See, e.g., OCC, Banking Circular 277: Risk Management of
Financial Derivatives, BC-277, 1993 WL 640326 (OCC) (Oct. 23, 1993);
OCC Bulletin, Questions and Answers Re: BCC 277, OCC 94-31, 1994 WL
194290 (OCC) (May 10, 1994); and Division of Banking Supervision and
Regulation, Board of Governors of the Federal Reserve System,
Examining Risk Management and Internal Controls for Trading
Activities of Banking Organizations, [SR 93-69 (FIS)], (Dec. 20,
1993). These are not sales practice standards in the usual sense but
bank risk management standards.
---------------------------------------------------------------------------
The Commission seeks comments concerning potential sales practice
standards for principal-to-principal transactions between dealers and
end-users. The Commission would also welcome information from
commenters concerning the volume of transactions, if any, in which
dealers act strictly as agents, rather than principals, in facilitating
transactions between two end-users and whether any specific sales
practice rules should apply to such agency transactions. Likewise, the
Commission would welcome comments on the volume of transactions in
which dealers trade directly with other dealers for their own
proprietary accounts and whether any specific sales practice rules
should apply to those dealer-to-dealer transactions.
(a) Disclosure. Traditionally, the most fundamental regulatory
protection in the area of sales practices has been the duty to disclose
risks and other material information concerning transactions to
potential customers. Disclosure concerns have often been raised with
respect to OTC derivatives transactions. For example, the DPG
Framework, in its section on counterparty relationships, states that
dealers should consider providing new end-users with ``[g]eneric [r]isk
[d]isclosure,'' which it characterizes as ``disclosure statements
generally identifying the principal risks associated with OTC
derivatives transactions and clarifying the nature of the relationship
between the [dealer] and its counterparties.'' \84\ This section of the
DPG Framework goes on to provide additional details on the nature of
the relationship to be clarified, stating the DPG's view that ``OTC
derivatives transactions are predominantly arm's-length transactions in
which each counterparty has a responsibility to review and evaluate the
terms and conditions, and the potential risks and benefits, of
prospective transactions * * *.'' \85\ However, the DPG Framework
provides no further guidance as the nature or content of the generic
risk disclosure.\86\ Comment is
[[Page 26126]]
solicited on whether risk disclosure should be required and, if so, the
nature and content of such disclosure.
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\84\ DPG Framework at 37. The 1997 GAO Report recommends that
the CFTC and SEC establish a mechanism for determining that the DPG
firms are, in fact, following this and other sales practice
standards in the DPG Framework.
\85\ Id.
\86\ The section of the DPG Framework on risk management
controls lists five basic risks of OTC derivative transactions:
market risk, credit risk, liquidity risk, legal risk, and
operational risk. Id. at 14-15. in addition to these firm-specific
risks, the CFTC OTC Derivatives Report lists a number of potential
risks arising from OTC derivatives activities generally, including
the complexity of the derivatives marketplace, the fact that dealer
activity tends to be concentrated in a relatively small number of
large entities, the lack of transparency, and systemic risk. See
CFTC OTC Derivatives Report at 112-122. It may also be appropriate
to consider whether to require dealers to disclose to prospective
end-users other material information concerning OTC derivatives
transactions, such as the relationship of the parties, the material
terms of the contract, periodic reports of the status of the end-
user's account, information on how the value of the OTC derivatives
instrument would be affected by changes in the markets for the
underlying components, and other similar information.
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(b) Customer information. Comment is also solicited on whether it
would be appropriate to require the dealer to obtain certain
information from the end-user. Such information might include, for
example:
net worth information;
information confirming that the end-user is within the
class of eligible participants set out in Section 35.1 of the
Commission's regulations; \87\ or
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\87\ 17 CFR 35.1(b)(2) (1997).
---------------------------------------------------------------------------
information demonstrating that the end-user is authorized
to enter into the transaction.
(c) Other possible sales practice rules. Potential sales practice
rules might also include provisions requiring dealers to supervise
sales personnel and other employees responsible for handling the
accounts of end-user customers. One element of such supervision might
be to ensure that sales personnel are properly trained.
The Commission also wishes to consider what regime, if any, would
be appropriate for overseeing the implementation and enforcement of any
sales practice rules for OTC derivatives, including the costs and
benefits of alternative oversight mechanisms. In that context, the
Commission is seeking comments on: (1) the appropriate direct
regulatory role of the CFTC with respect to potential sales practice
rules; (2) the appropriate regulatory role of other financial
regulatory agencies, including the applicability of any sales practice
rules administered by other agencies and the degree of deference that
should be accorded to such rules; and (3) the appropriate sales
practice role of industry self-regulatory bodies, including the degree
of CFTC oversight necessary to assure that any industry self-regulatory
standards are properly implemented and enforced.
Request for comment. 56. Since Part 35 was adopted, has the swap
market experienced significant problems concerning fraud or sales
practice abuses? Since Part 34 was adopted, has the hybrid instrument
market experienced significant problems concerning fraud or sales
practice abuses? If so, please describe.
57. Is there a need for any sales practice rules in the OTC
derivatives market? If so, what should the rules provide, and to whom
and under what circumstances should they be applicable?
58. Is there a need for risk disclosures by OTC derivatives dealers
to end-users? If so, what risks should be disclosed?
59. Should OTC derivatives dealers be required to supplement any
required generic risk disclosure statement with additional firm- or
transaction-specific disclosures? If so, what should such disclosures
cover?
60. What kind of disclosures, if any, should dealers make to end-
users clarifying the nature of the relationship between the parties?
Should there be rules establishing duties of the OTC derivatives dealer
to its customers, and if so, what should they require?
61. What kind of disclosures, if any, should dealers make
concerning the material terms of OTC derivatives contracts, including
methods for calculating price, value, profit and loss, as well as the
amount of commissions, fees and other costs involved?
62. What other kinds of disclosures, if any, might be appropriate
concerning, for example, potential conflicts of interest, the dealer's
policies on helping end-users to unwind transactions and matters such
as the dealer's financial soundness, experience, or track record?
63. Should dealers be required to make periodic status reports to
end-users concerning the status of their OTC derivatives positions
(e.g., value, profits and losses)? If so, what kind of reports should
be required, and how often should such reports be made?
64. Should dealers be required to collect information concerning
their end-user customers? If so, what kind of information? Should
dealers be required to retain documentation in their files concerning
such information, and if so, what kind of documentation (e.g.,
confirming that particular information has been collected and reviewed
by management to assure transactions are in conformity with the end-
user's investment goals and policies)?
65. What sales practice rules, if any, should apply to transactions
where a dealer is acting as an agent or broker to facilitate a
principal-to-principal transaction between two end-users? Similarly,
what sales practice rules, if any, should apply to dealer-to-dealer
transactions where both dealers are trading for their own proprietary
accounts?
66. Should dealers have to comply with different sales practice
standards in dealing with end-users having different levels of
sophistication, based, for example, or portfolio size, investment
experience, or some other measure? If so, please elaborate.
67. Should dealers be required to follow any supervision
requirements in connection with the activities of sales personnel and
other employees responsible for handling the accounts of end-user
customers? Should complex or highly leveraged transactions require
prior approval by senior management of the dealer?
68. What is the appropriate regime for formulating and overseeing
the implementation and enforcement of possible sales practices rules,
including the appropriate roles of the Commission, other financial
regulators and industry self-regulatory bodies?
9. Recordkeeping
The Commission has not required any recordkeeping requirements for
OTC derivatives dealers or other OTC market participants. Having
retained authority over fraudulent and manipulative behavior in the OTC
derivative market, the Commission wishes comment on whether some
recordkeeping requirements would facilitate its exercise of that
authority. Provisions requiring the retention of written records of
transactions with counterparties, for example, might be considered. The
Commission requests comment on whether there should be specific
recordkeeping requirements for transactions in the OTC derivatives
markets and, if so, what types of records should be kept and by whom.
Request for comment. 69. Are recordkeeping requirements for
participants in the OTC derivatives markets needed? If so, what records
should be required? Who should be required to keep them?
10. Reporting
The Commission currently does not impose reporting requirements on
OTC derivatives market participants.\88\ The
[[Page 26127]]
Commission requests comment on whether specific reporting requirements
for participants in the OTC derivatives markets are needed and, if so,
what reports should be made and by whom. If the Commission were to
establish reporting requirements, it would coordinate with other
regulatory agencies and, to the extent possible, accept reports
provided to other regulatory agencies in satisfaction of the
Commission's requirements. The Commission solicits comment concerning
how these goals might best be accomplished.
---------------------------------------------------------------------------
\88\ The DPG has established voluntary reporting requirements.
See DPG Framework at 23-25. The DPG has committed to regular
periodic reporting and to respond in good faith to ad hoc requests
for additional information by the CFTC. Id. at 1. The DPG member
firms currently provide to the Commission on a quarterly basis a
report detailing for each member except Credit Suisse First Boston:
(1) a Credit-Concentration Report listing (on a ``no-names'' basis)
the top 20 OTC derivatives exposures and, for each exposure, the
internal credit rating, the industry segment, the current net
exposure, the next replacement value, the gross replacement values
(receivable and payable) and the potential additional credit
exposure (at a ten-day, 99-percent confidence interval); (2) a
Portfolio Summary listing, by credit rating category and industry
segment, the current net exposure, net replacement value, and gross
replacement values; (3) a Geographic Distribution listing, by
country, the current net exposure, the net replacement value, and
the gross replacement values; (4) a Net Revenues Report listing, by
product category and month, the net revenue; and (5) a Consolidated
Activity Report listing, by product category, the aggregate notional
amount.
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Request for comment. 70. Should the Commission establish reporting
requirements for participants in the OTC derivatives markets? If so,
what information should be reported? By whom?
C. Self-Regulation
Having identified areas in which current exemptions might be
modified, the Commission is also interested in the views of commenters
concerning whether, and to what extent, any needed changes concerning
the oversight of the OTC derivatives market could be accomplished
through initiatives of industry bodies either voluntarily or through a
self-regulatory organization empowered to establish rules and subject
to Commission oversight. The Commission notes that several industry
organizations already exist with an interest in maintaining and
improving the integrity of the OTC derivatives marketplace. These
organizations include, among others, the Derivatives Policy Group, the
International Swaps and Derivatives Association, the Group of Thirty,
and the End-Users of Derivatives Association. Industry groups have
already issued a number of voluntary initiatives aimed at reducing
risks and promoting stability and integrity in the OTC derivatives
marketplace.\89\ The Commission is interested in exploring the extent
to which concerns described in this release might be addressed, and
adequate oversight of the OTC derivatives marketplace might be
attained, through industry bodies or through self-regulatory
organizations.
---------------------------------------------------------------------------
\89\See, e.g.: Framework for Voluntary Oversight, supra;
Principles and Practices for Wholesale Financial Market
Transactions, supra; and Global Derivatives Study Group, Group of
Thirty, Derivatives: Practices and Principles, supra.
---------------------------------------------------------------------------
Request for comment. 71. How effective are current self-regulatory
efforts? What are their strengths and weaknesses?
72. Are there particular areas among those discussed above where
self-regulation could obviate the need for government regulation?
73. Please discuss the costs and benefits of existing voluntary
versus potential mandatory self-regulatory regimes.
74. If a self-regulatory regime were adopted, what mechanism would
best assure effective oversight by the Commission?
75. How best can the Commission achieve effective coordination with
other regulators in connection with the oversight of the OTC
derivatives market?
IV. Summary of Request for Comment
Commenters are invited to discuss the broad range of concepts and
approaches described in this release. The Commission specifically
requests commenters to compare the advantages and disadvantages of the
possible changes discussed above with those of the existing regulatory
framework. In addition to responding to the specific questions
presented, the Commission encourages commenters to submit any other
relevant information or views.
Issued in Washington, D.C. this 6th day of May, 1998, by the
Commodity Futures Trading Commission.
By the Commission (Chairperson BORN, Commissioners TULL and
SPEARS; Commissioner HOLUM dissenting).
Jean A. Webb,
Secretary of the Commission.
Dissenting Remarks of Commissioner Barbara Pedersen Holum, Concept
Release, Over-the-Counter Derivatives
In Section 4(c)(1) of the Commodity Exchange Act, Congress
authorized the Commission to exempt certain transactions ``[i]n order
to promote responsible economic or financial innovation and fair
competition.'' Indeed, it appears that the dramatic growth in volume
and the products offered in the OTC derivatives market may be
attributed in part to the Commission's past exemptive action. In the
spirit of the Commission's ongoing regulatory review program, it is
appropriate to examine the continuing applicability of the existing
exemptions, focusing on the expanding economic significance of the OTC
market. However, in my judgement,the release goes beyond the scope of
regulatory review by exploring regulatory areas that may be
inapplicable to an OTC market. Accordingly, I am dissenting from the
majority's decision to issue the Concept Release on OTC Derivatives in
its current form.
Dated: May 6, 1998.
Barbara Pedersen Holum,
Commissioner.
[FR Doc. 98-12539 Filed 5-11-98; 8:45 am]
BILLING CODE 6351-01-M
This is a copy of a public record, reproduced as it was published. It is not legal advice, and it may not be the version a court would rely on. Check the official source before you cite it.