No-Action Relief from Required Clearing for Partial Novation and Partial Termination of Swaps

Summary: No-Action Relief from Required Clearing for Partial Novation and Partial Termination of Swaps

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. 13-02

No-Action

March 20, 2013

Division of Clearing and Risk

Mr. Robert G. Pickel

Chief Executive Officer

International Swaps and Derivatives Association, Inc.

1001 Pennsylvania Avenue, NW, Suite 600

Washington, D.C. 20004

Re: No-Action Relief from Required Clearing for Partial Novation and Partial

Termination of Swaps

Dear Mr. Pickel:

This letter is in response to a request dated March 10, 2013, from The International

Swaps and Derivatives Association, Inc. (ISDA), on behalf of its members and other similarly

situated persons, to the Division of Clearing and Risk (Division) of the Commodity Futures

Trading Commission (Commission), in which ISDA requested an interpretative letter regarding

whether the remaining portion of a swap between the original counterparties that is partially

novated or partially terminated is subject to the clearing requirement under section 2(h)(1)(A) of

the Commodity Exchange Act (CEA) and part 50 of the Commission’s regulations. The request

is limited to the partial novation or partial termination of swaps that were executed prior to the

date on which counterparties must begin complying with the clearing requirement (and therefore,

not required to be cleared).1

1 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

Commodity Exchange Act, 77 FR 74284, 74319-20 (Dec. 13, 2012) (hereinafter the “Clearing Requirement

Determination”)

e cleared).1

1 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

Commodity Exchange Act, 77 FR 74284, 74319-20 (Dec. 13, 2012) (hereinafter the “Clearing Requirement

Determination”). Swap dealers (SDs), major swap participants (MSPs), and private funds active in the swap market

(active funds) were 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. 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 begin clearing iTraxx index swaps entered into on or after July 25, 2013, and all

ntil 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 begin clearing iTraxx index swaps entered into on or after July 25, 2013, and all

2

Factual Background and Request for Relief

ISDA represents that when the two counterparties to an uncleared swap (the “original

counterparties” to an “original swap”) agree to novate or terminate an original swap in full, that

swap no longer exists between the original counterparties and so there is nothing between them

(with respect to that original swap) that could be subject to the clearing requirement. The

original swap was not required to be cleared when it was executed because the original swap was

executed prior to the date on which the counterparties were required to comply with the clearing

requirement.

ISDA further explains that when the original counterparties wish to novate or terminate

an original swap in part (a “partial novation” or “partial termination,” respectively), they may

agree to an amendment that reduces the notional amount of the original swap. The remaining

portion of the original swap between the original counterparties after such reduction by a partial

novation or partial termination is referred to in ISDA’s letter as the “stub swap.” ISDA

represents that the terms of the original swap, including the terms that define the remaining cash

flows, continue to govern the stub swap (apart from the reduction in the notional amount of that

swap).

Under a partial termination, all terms of the stub swap, apart from the reduction of the

notional amount, remain the same. The original counterparties remain the same and no third

parties are involved in the transaction

riginal swap, including the terms that define the remaining cash

flows, continue to govern the stub swap (apart from the reduction in the notional amount of that

swap).

Under a partial termination, all terms of the stub swap, apart from the reduction of the

notional amount, remain the same. The original counterparties remain the same and no third

parties are involved in the transaction. Under a partial novation, one of the two original

counterparties novates2 part of the original swap to a third party (the “novated swap”). As with

partial terminations, for the remainder of the original swap (i.e., the stub swap), all terms, apart

from the reduction of the notional amount, remain the same.

According to ISDA, imposing required clearing on the stub swap, under either a partial

novation or a partial termination, would create distorted incentives for risk and investment

management decisions.

ISDA states that it does not request relief from required clearing for circumstances where

the original counterparties enter into and book a new swap that fully or partially offsets the risk

of an existing uncleared swap and thereby achieve a similar economic result to a full termination,

a partial novation, or a partial termination. ISDA further acknowledges that in the context of

partial novations, the novated swap, which was executed between one of the original

counterparties and a third party, may be subject to required clearing.3

other entities are required to begin clearing iTraxx index swaps on October 23, 2013, for swaps entered into on or

after that date. See http://www.cftc.gov/PressRoom/PressReleases/pr6521-13.

2 For purposes of this letter, novation means a change in ownership of the swap or portion of the notional amount of

the swap

other entities are required to begin clearing iTraxx index swaps on October 23, 2013, for swaps entered into on or

after that date. See http://www.cftc.gov/PressRoom/PressReleases/pr6521-13.

2 For purposes of this letter, novation means a change in ownership of the swap or portion of the notional amount of

the swap.

3 The novated portion of the original swap may be subject to required clearing depending on whether (1) it is a swap

that falls into one of the classes of swaps set forth under Commission regulation 50.4(a) or (b), and (2) the date of

partial novation occurs on or after the applicable compliance date for both counterparties to the novated swap.

3

ISDA represents that its proposed interpretation is consistent with the goal of required

clearing, namely reducing counterparty credit risk. According to ISDA, a partial termination by

its nature reduces the counterparty credit risk posed by a swap, because it reduces the notional

size of that swap, and a partial novation reduces the notional size of the swap as between the

original counterparties.

Applicable Regulatory Requirements and Analysis

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010,4 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 derivatives

clearing organization [(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.”5

On November 29, 2012, the Commission adopted final rules implementing its first

Clearing Requirement Determination

unlawful for any

person to engage in a swap unless that person submits such swap for clearing to a derivatives

clearing organization [(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.”5

On November 29, 2012, the Commission adopted final rules implementing its first

Clearing Requirement Determination. Under these rules, market participants are required 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.6 As described

above, the Commission set forth a series of compliance dates to phase in compliance with the

clearing requirement. 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.7

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.8 Commission regulation 50.2 provides that swaps subject to

a clearing requirement need to be submitted for clearing no later than the day of execution.9

Under Commission regulation 23.506(b), SDs and MSPs executing swaps subject to the clearing

requirement must submit such swaps to a DCO as soon as technologically practicable after

execution, but no later than the close of business on the day of execution.10 In addition, SDs and

MSPs that are clearing members of a DCO must accept or reject each trade submitted by or for it

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

5 7 U.S.C. § 2(h)(1)(A).

6 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).

7 Id. at 74337.

8 Id

s of a DCO must accept or reject each trade submitted by or for it

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

5 7 U.S.C. § 2(h)(1)(A).

6 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).

7 Id. at 74337.

8 Id. at 74316.

9 Id. at 74336.

10 See 17 CFR § 23.506(b), 77 FR 21278, 21307 (Apr. 9, 2012); see also Clearing Requirement Determination, 77

FR at 74314 n.138 (discussing the application of Commission regulations 50.2 and 23.506(b)).

4

“as quickly as would be technologically practicable if fully automated systems were used.”11

Likewise, futures commission merchants (FCMs) that are clearing members of a DCO must

accept or reject each trade submitted by or for it or its customers “as quickly as would be

technologically practicable if fully automated systems were used.”12

For purposes of the following analysis in this letter, the Division assumes that each swap,

other than an original swap, discussed herein is subject to the clearing requirement under section

2(h) of the CEA and part 50 of the Commission’s regulations because (1) the swap is within a

class of swaps with the specifications set forth in Commission regulations 50.4(a) and (b), and

(2) the swap was executed or subject to an ownership change, including by assignment, novation,

exchange, transfer, or conveyance, after an applicable compliance date. When both conditions

are met, this letter will refer to the swap as “subject to required clearing.”

This no-action letter applies to partial terminations and partial novations, as those terms

are defined in this letter

2) the swap was executed or subject to an ownership change, including by assignment, novation,

exchange, transfer, or conveyance, after an applicable compliance date. When both conditions

are met, this letter will refer to the swap as “subject to required clearing.”

This no-action letter applies to partial terminations and partial novations, as those terms

are defined in this letter. After an applicable compliance date, market participants that enter into

new swaps that are in one of the classes of swaps that is required to be cleared must submit those

newly-executed swaps to a DCO for clearing pursuant to section 2(h) of the CEA and part 50 of

the Commission’s regulations. This requirement applies to all new swaps that are subject to

required clearing, even if those swaps fully or partially offset the risks of swaps that were

executed prior to an applicable compliance date for required clearing. All new swaps, including

those that offset the risk of original swaps, are subject to required clearing, unless an exception

or exemption under part 50 of the Commission’s regulations applies.13

As noted above, ISDA has represented that an original swap that is executed prior to an

applicable compliance date and is fully terminated (after an applicable compliance date) such

that the original swap no longer exists between the original counterparties, is not subject to

required clearing. Consistent with the Commission’s statements in the Clearing Requirement

Determination with regard to which swaps are required to be cleared, the Division confirms that

if the original swap is fully terminated (meaning the terms are fully extinguished with no

remaining obligations for either counterparty), the original swap is not subject to required

clearing because it has ceased to exist.14 From an operational standpoint, the two records of the

11 See 17 CFR § 23.610(b), 77 FR at 21308 (establishing the rule for SDs and MSPs)

ap is fully terminated (meaning the terms are fully extinguished with no

remaining obligations for either counterparty), the original swap is not subject to required

clearing because it has ceased to exist.14 From an operational standpoint, the two records of the

11 See 17 CFR § 23.610(b), 77 FR at 21308 (establishing the rule for SDs and MSPs). Under Commission regulation

39.12(b)(7)(iii), a DCO must have rules providing that the DCO will accept or reject all swaps listed for clearing as

quickly as would be technologically practicable if fully automated systems were used. See 77 FR at 21310.

12 See 17 CFR § 1.74(b), 77 FR at 21307 (establishing the rule for FCMs).

13 For purposes of this letter, the term “offset” means that the risks of one or more swaps compensate for the risks of

another swap or swaps.

14 For purposes of this letter a swap that is “fully terminated” means that the rights and obligations under the original

swap are extinguished, other than the right to receive, or obligation to pay, a single termination payment with respect

to the termination of such rights and obligations, provided that such payment shall be due and payable promptly

following the termination.

5

original swap that exist in the trading and/or recordkeeping systems15 of the original

counterparties must be changed to reflect the full termination.16

With regard to an original swap that is fully novated from one of the original

counterparties to a third party, the Division confirms that if the ownership interest of one of the

original counterparties to the original swap is fully transferred to a third party (meaning the

rights and obligations of one of the original counterparties to the swap are fully extinguished),

the original swap is not subject to required clearing because it no longer exists as between the

original counterparties

a third party, the Division confirms that if the ownership interest of one of the

original counterparties to the original swap is fully transferred to a third party (meaning the

rights and obligations of one of the original counterparties to the swap are fully extinguished),

the original swap is not subject to required clearing because it no longer exists as between the

original counterparties. Again, from an operational standpoint, the record of the original swap

that exists in the trading and/or recordkeeping system of the original counterparty that is

transferring its ownership interest to a third party must be changed to reflect the full termination

of its rights and responsibilities.17 The novated swap between the remaining original

counterparty to the original swap and a third party is a new swap based on a change of ownership

and is subject to required clearing.18

With regard to partial terminations and partial novations, for purposes of this letter, the

following definitions shall apply to the relief provided below:

Original swap means a swap that was executed between two original counterparties prior

to an applicable compliance date that would, but for execution prior to the applicable compliance

date, be subject to required clearing.

Stub swap means the portion of an original swap that remains after two counterparties

have agreed to reduce the notional amount of their original swap on or after an applicable

compliance date, but all other terms of the swap remain the same as the original swap.

Novated swap means the portion of an original swap that is transferred from one of the

original counterparties to a third party on or after an applicable compliance date. Such novated

swap is subject to required clearing

reed to reduce the notional amount of their original swap on or after an applicable

compliance date, but all other terms of the swap remain the same as the original swap.

Novated swap means the portion of an original swap that is transferred from one of the

original counterparties to a third party on or after an applicable compliance date. Such novated

swap is subject to required clearing.

Fully terminate means that the rights and obligations under the original swap are

extinguished, other than the right to receive, or obligation to pay, a single termination payment

15 To the extent that an original counterparty has both trading and recordkeeping systems, both systems must be

changed.

16 The termination of the original swap must be reported, as applicable, under parts 43, 45, and/or 46 of the

Commission’s regulations. SDs and MSPs executing terminations must confirm such swap transactions under

Commission regulation 23.501.

17 The termination of the original swap must be reported, as applicable, under parts 43, 45, and/or 46 of the

Commission’s regulations. SDs and MSPs executing terminations must confirm such swap transactions under

Commission regulation 23.501.

18See 17 CFR § 50.2, Clearing Requirement Determination, 77 FR at 74336 (establishing the treatment of swaps

subject to a clearing requirement). The novated swap also is subject to applicable reporting requirements under

parts 43, 45, and/or 46 of the Commission’s regulations, and SDs and MSPs executing novated swaps must confirm

such swap transactions under Commission regulation 23.501.

18See 17 CFR § 50.2, Clearing Requirement Determination, 77 FR at 74336 (establishing the treatment of swaps

subject to a clearing requirement). The novated swap also is subject to applicable reporting requirements under

parts 43, 45, and/or 46 of the Commission’s regulations, and SDs and MSPs executing novated swaps must confirm

such swap transactions under Commission regulation 23.501.

6

with respect to the termination of such rights and obligations, provided that such payment is due

and payable promptly following the termination.

Partially terminate means to extinguish all rights and obligations for a stated portion of

the notional amount of an original swap, other than the right to receive, or obligation to pay, a

single termination payment with respect to the termination of such rights and obligations,

provided that such payment is due and payable promptly following the termination.

Partially novate means to transfer the ownership of a stated portion of the notional

amount of an original swap from one of the original counterparties to an original swap to a third

party.

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 clear a stub swap as required under section 2(h)(1)(A) of the

CEA and part 50 of the Commission’s regulations, provided that the following conditions are

met:

1. The original swap that is partially novated or partially terminated was not cleared by a

DCO.

2. The original swap was executed prior to the compliance date for required clearing

applicable to such a swap.

3. With respect to partially terminating an original swap:

a. the records of the original swap that exist in the trading and/or recordkeeping

systems of the original counterparties are amended solely to reflect the reduced

notional amount of the original swap;

b

d by a

DCO.

2. The original swap was executed prior to the compliance date for required clearing

applicable to such a swap.

3. With respect to partially terminating an original swap:

a. the records of the original swap that exist in the trading and/or recordkeeping

systems of the original counterparties are amended solely to reflect the reduced

notional amount of the original swap;

b. the stated portion of the original swap that is terminated is fully terminated, apart

from the stated portion that is the stub swap; and

c. all other terms of the stub swap remain the same as the terms of the original swap.

4. With respect to partially novating an original swap:

a. the records of the original swap that exist in the trading and/or recordkeeping

systems of the original counterparties are amended solely to reflect the reduced

notional amount of the original swap;

b. all other terms of the stub swap remain the same as the terms of the original swap;

and

c. the novated swap is submitted for clearing pursuant to section 2(h)(1)(A) of the

CEA and part 50 of Commission regulations.

7

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.19 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

reate 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

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

any requirement under section 2(h)(8) of the CEA, or, for SDs and MSPs, any requirement under part 23 of the

Commission’s regulations, including the confirmation requirement under 17 CFR § 23.501.