No-Action Relief from Required Clearing for Swaps Resulting from Multilateral Portfolio Compression Exercises

Summary: No-Action Relief from Required Clearing for Swaps Resulting from Multilateral Portfolio Compression Exercises

U.S. COMMODITY FUTURES TRADING COMMISSION

Three Lafayette Centre

1155 21st Street, NW, Washington, DC 20581

Telephone: (202) 418-5430

Facsimile: (202) 418-5547

aradhakrishnan@cftc.gov

a

Ananda Radhakrishnan

Director

Division of Clearing and Risk

CFTC Letter No. 13-01

No-Action

March 18, 2013

Division of Clearing and Risk

Re: No-Action Relief from Required Clearing for Swaps Resulting from Multilateral

Portfolio Compression Exercises

Dear Ladies and Gentlemen:

This letter is in response to a request dated February 19, 2013, from TriOptima, an entity

that offers multilateral portfolio compression services,1 to the Division of Clearing and Risk

(Division) of the Commodity Futures Trading Commission (Commission), in which TriOptima

requested relief on behalf of swap market participants that participate in multilateral portfolio

compression exercises in the form of confirmation from Division staff that the clearing

requirement under section 2(h)(1)(A) of the Commodity Exchange Act (CEA) and part 50 of

Commission regulations does not apply to (1) swaps that are amended in order to reduce notional

value as part of a multilateral portfolio compression exercise and (2) new swaps that are entered

into to replace the original swaps as a result of a multilateral portfolio compression exercise in

order to reduce notional exposures or aggregate outstanding gross notional exposure

CEA) and part 50 of

Commission regulations does not apply to (1) swaps that are amended in order to reduce notional

value as part of a multilateral portfolio compression exercise and (2) new swaps that are entered

into to replace the original swaps as a result of a multilateral portfolio compression exercise in

order to reduce notional exposures or aggregate outstanding gross notional exposure. The

request focuses on swaps that were executed prior to the date on which the counterparties must

begin complying with the clearing requirement (and therefore, not required to be cleared),2 but

1 Although the relief contained herein was requested by a particular service provider, such relief is available to

all participants in any multilateral portfolio compression exercise, as defined in Commission regulation 23.500(h),

subject to the conditions specified herein.

2 The Commission set forth a specific compliance schedule for market participants to bring their swaps into

compliance with the clearing requirement. See Clearing Requirement Determination Under Section 2(h) of the

CEA, 77 FR 74284, 74319-20 (Dec. 13, 2012) [hereinafter “Clearing Requirement Determination”]. Swap dealers

(SDs), major swap participants (MSPs), and private funds active in the swaps market (active funds) are required to

comply beginning on March 11, 2013, for swaps they enter into on or after that date. All other financial entities are

required to clear swaps beginning on June 10, 2013, for swaps entered into on or after that date, except for accounts

managed by third-party investment managers, as well as ERISA pension plans, which have until September 9, 2013,

to begin clearing swaps entered into on or after that date

inning on March 11, 2013, for swaps they enter into on or after that date. All other financial entities are

required to clear swaps beginning on June 10, 2013, for swaps entered into on or after that date, except for accounts

managed by third-party investment managers, as well as ERISA pension plans, which have until September 9, 2013,

to begin clearing swaps entered into on or after that date. With regard to the credit default swap indices on European

corporate names, iTraxx, the Clearing Requirement Determination provided that, if no derivatives clearing

organization (DCO) offers iTraxx for client clearing by February 11, 2013, the Commission will delay compliance

for those swaps until 60 days after an eligible DCO offers iTraxx indices for client clearing. The Commission

recently announced that iTraxx clearing will commence on April 26, 2013, for SDs, MSPs, and active funds.

Financial entities other than accounts managed by third-party investment managers and ERISA plans are required to

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are subsequently amended or replaced in connection with a multilateral portfolio compression

exercise.

As discussed below, the proposed relief would permit market participants to continue to

use multilateral portfolio compression exercises for reducing the risk of uncleared swaps that

were entered into prior to an applicable compliance date as set forth by the Commission (and

therefore, not required to be cleared), provided that certain conditions are met.

Factual Background and Request for Relief

Multilateral portfolio compression allows swap market participants to net down the size

and/or number of outstanding swaps among them, lower the aggregate gross notional value of

outstanding swaps, and decrease the number of outstanding swaps or the aggregate notional

value of such swaps, thereby reducing operational risk and, in some instances, reducing

counterparty credit risk

or Relief

Multilateral portfolio compression allows swap market participants to net down the size

and/or number of outstanding swaps among them, lower the aggregate gross notional value of

outstanding swaps, and decrease the number of outstanding swaps or the aggregate notional

value of such swaps, thereby reducing operational risk and, in some instances, reducing

counterparty credit risk. For purposes of this letter, the term “multilateral portfolio compression

exercise” has the meaning given to the term in Commission regulation § 23.500(h).3

Commission regulation § 23.500(h) defines the term to mean “an exercise in which multiple

swap counterparties wholly terminate or change the notional value of some or all of the swaps

submitted by the counterparties for inclusion in the portfolio compression exercise and,

depending on the methodology employed, replace the terminated swaps with other swaps whose

combined notional value (or some other measure of risk) is less than the combined notional value

(or some other measure of risk) of the terminated swaps in the compression exercise.”

In a multilateral portfolio compression exercise for uncleared swaps, the compression

service provider analyzes the uncleared swap portfolios of multiple swap market participants and

publishes the optimal solution for the compression cycle based on one of two methods. Under

the first method, the outstanding notional value of the original swap between two counterparties

is reduced by amending the original swap. This “amended swap” method is the predominant

method used in compressions of uncleared interest rate swaps. Under the second method, one or

more existing swaps are terminated and replaced by new swaps that reflect a netting down of

existing notional exposure between the counterparties.4 This “replacement swap” method is

predominantly used in compression exercises for uncleared credit default swaps, but it can also

be used for interest rate swap compression exercises

uncleared interest rate swaps. Under the second method, one or

more existing swaps are terminated and replaced by new swaps that reflect a netting down of

existing notional exposure between the counterparties.4 This “replacement swap” method is

predominantly used in compression exercises for uncleared credit default swaps, but it can also

be used for interest rate swap compression exercises. Counterparties have the option of electing

either of the two methods of compression.

Under the rules of the compression exercise, for either method of compression —

amended swap or replacement swap — the counterparties to the original swap do not change. In

begin clearing iTraxx index swaps entered into on or after July 25, 2013, and all other entities are required to begin

clearing iTraxx index swaps on October 23, 2013, for swaps entered into on or after that date.

3 See Confirmation, Portfolio Reconciliation, Portfolio Compression, and Swap Trading Relationship

Documentation Requirements for Swap Dealers and Major Swap Participants, 77 FR 55904, 55960 (Sept. 11, 2012).

4 In the vast majority of compression exercises there is a reduction in the notional exposures due to netting.

However, in some exercises there is merely an aggregation of outstanding gross exposures arising from multiple

swaps into one replacement swap with no net reduction in notional exposures.

equirements for Swap Dealers and Major Swap Participants, 77 FR 55904, 55960 (Sept. 11, 2012).

4 In the vast majority of compression exercises there is a reduction in the notional exposures due to netting.

However, in some exercises there is merely an aggregation of outstanding gross exposures arising from multiple

swaps into one replacement swap with no net reduction in notional exposures.

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addition, the reference entity and the maximum maturity do not change. Finally, the overall

market risk of the portfolios of the market participants in the compression exercise does not

change.

TriOptima requests that Division staff clarify that amended and replacement swaps,

where the original swap was not required to be cleared at the time of execution but that is

subsequently amended or replaced in connection with a multilateral portfolio compression

exercise after the relevant clearing requirement compliance date (e.g., after March 11, 2013 for a

swap between two SDs), are not required to be cleared solely by virtue of being amended or

replaced through a multilateral portfolio compression exercise.

TriOptima represents that requiring amended swaps or replacement swaps resulting from

a compression exercise to be cleared would alter the credit risk profile for those participating in

the compression exercise because counterparties to the amended or replacement swaps would be

required to face a derivatives clearing organization (DCO) instead of the original bilateral

counterparty. Further, TriOptima represents that because participants would not know in

advance which swaps may be subject to an amendment or replacement, or the notional amount to

be amended or replaced, market participants likely would reconsider their participation in these

industry-wide risk reduction exercises

ce a derivatives clearing organization (DCO) instead of the original bilateral

counterparty. Further, TriOptima represents that because participants would not know in

advance which swaps may be subject to an amendment or replacement, or the notional amount to

be amended or replaced, market participants likely would reconsider their participation in these

industry-wide risk reduction exercises. As a result, TriOptima represents that changing the

required clearing status of the swaps would discourage participation in compression exercises

and inhibit the risk reduction benefits that such exercises provide.

Applicable Regulatory Requirements and Analysis

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,5 in relevant

part, amended section 2(h)(1)(A) of the CEA, which states that “it shall be unlawful for any

person to engage in a swap unless that person submits such swap for clearing to a [DCO] that is

registered under [the CEA] or a [DCO] that is exempt from registration under [the CEA] if the

swap is required to be cleared.”6

On December 13, 2012, the Commission published its first clearing requirement

determination. The determination requires market participants to clear swaps meeting the

specifications of two classes of credit default swaps based on North American and European

corporate entities and four classes of interest rate swaps.7 Commission regulation 50.5(b)

provides that swaps entered into before the relevant compliance date for a particular swap are not

subject to the clearing requirement.8 As described above, the Commission set forth a series of

5 Pub. L. No. 111-203, 124 Stat. 1376 (2010).

6 7 U.S.C. § 2(h)(1)(A).

7 See Clearing Requirement Determination, 77 FR at 74336-37 (establishing Commission regulation 50.4,

which sets forth the classes of swaps that are required to be cleared).

8 Id. at 74337.

requirement.8 As described above, the Commission set forth a series of

5 Pub. L. No. 111-203, 124 Stat. 1376 (2010).

6 7 U.S.C. § 2(h)(1)(A).

7 See Clearing Requirement Determination, 77 FR at 74336-37 (establishing Commission regulation 50.4,

which sets forth the classes of swaps that are required to be cleared).

8 Id. at 74337.

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compliance dates to phase in compliance with the clearing requirement. Swaps entered into

before those compliance dates are not required to be cleared.

In the final rulemaking, the Commission clarified that the clearing requirement applies to

all new swaps, as well as changes in the ownership of a swap, including assignment, novation,

exchange, transfer, or conveyance.9

For purposes of the analysis in this letter, Division staff will assume that the amended or

replacement swaps discussed herein are subject to the clearing requirement under section 2(h) of

the CEA and Commission regulations. In other words, staff is assuming that all swaps subject to

this letter fall within a class of swaps with the specifications set forth in Commission regulation

50.4(a) or (b).

In order to promote the benefits of compression for uncleared swaps, the Division has

determined that it will not recommend enforcement action for failure of market participants to

submit to a DCO for clearing amended swaps or replacement swaps that are generated as part of

a multilateral portfolio compression exercise and are subject to required clearing under

Commission regulation 50.4(a) or (b), provided that certain conditions are met, as described

below.

Division No-Action Position

Based on the foregoing, the Division believes that granting relief is warranted

ubmit to a DCO for clearing amended swaps or replacement swaps that are generated as part of

a multilateral portfolio compression exercise and are subject to required clearing under

Commission regulation 50.4(a) or (b), provided that certain conditions are met, as described

below.

Division No-Action Position

Based on the foregoing, the Division believes that granting relief is warranted.

Accordingly, the Division will not recommend that the Commission take an enforcement action

against any person for failure to comply with the requirement under section 2(h)(1)(A) of the

CEA and part 50 of Commission regulations to clear an amended swap or a replacement swap

that is generated as part of a multilateral portfolio compression exercise, provided that the

following five conditions are met:

1. The “multilateral portfolio compression exercise” generating the amended and

replacement swaps must meet the definition set forth in Commission regulation 23.500(h)

and must involve more than two market participants.

2. No original swap submitted by market participants as part of the multilateral portfolio

compression exercise shall include any swap that has been cleared by a DCO.

3. No original swap submitted by market participants as part of the multilateral portfolio

compression exercise shall include any swap that is required to be cleared under

2(h)(1)(A) of the CEA and part 50 of Commission regulations because it was executed on

or after an applicable compliance date.

4. Each amended swap(s) or replacement swap(s) generated by the multilateral portfolio

compression exercise must:

9 Id. at 74316.

o

compression exercise shall include any swap that is required to be cleared under

2(h)(1)(A) of the CEA and part 50 of Commission regulations because it was executed on

or after an applicable compliance date.

4. Each amended swap(s) or replacement swap(s) generated by the multilateral portfolio

compression exercise must:

9 Id. at 74316.

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a. be generated in accordance with a multilateral portfolio compression service

provider’s established rules and parameters for multilateral portfolio compression

exercises;

b. be entered into between the same counterparties as the original swap(s) that is

amended or terminated;

c. with the exception of reducing the notional amount, have the same material terms

as the original swap(s), as defined in part 45 of Commission regulations,10

including the reference entity, the maximum maturity of the swap, and the

average weighted maturity of the swap; and

d. be entered into for the sole purpose of reducing operational or counterparty credit

risk.

5. Once the original swaps have been selected and submitted by market participants as part

of the multilateral portfolio compression exercise, the multilateral portfolio compression

methodology does not permit participants to specify which swaps may be amended or

replaced.

This letter, and the positions taken herein, represent the view of this Division only, and

do not necessarily represent the position or view of the Commission or of any other office or

division of the Commission. The relief issued by this letter does not excuse persons relying on it

from compliance with any other applicable requirements contained in the CEA or in the

Commission regulations issued thereunder.11 It does not create or confer any rights for or

obligations on any person or persons subject to compliance with the CEA that bind the

Commission or any of its other offices or divisions

mission. The relief issued by this letter does not excuse persons relying on it

from compliance with any other applicable requirements contained in the CEA or in the

Commission regulations issued thereunder.11 It does not create or confer any rights for or

obligations on any person or persons subject to compliance with the CEA that bind the

Commission or any of its other offices or divisions.

Further, this letter, and the relief contained herein, is based upon the representations made

to the Division. Any different, changed, or omitted material facts or circumstances might render

this no-action relief void.

Should you have any questions, please do not hesitate to contact Sarah Josephson,

Deputy Director, at (202) 418-5684, or Brian O’Keefe, Associate Director, at (202) 418-5658.

Sincerely,

Ananda Radhakrishnan

10 For purposes of this letter, “material terms” means all terms of a swap required to be reported in accordance

with part 45 of Commission regulations.

11 For example, the relief provided herein does not excuse persons from any applicable swap reporting

requirements or any requirement under section 2(h)(8) of the CEA.