DCR and DMO Interpretation regarding use by a derivatives clearing organization of a firm or forced trades process. Request for Interpretation Regarding the Applicability of Commission Regulation 37.3(a)(1) and Sectio...

Summary: DCR and DMO Interpretation regarding use by a derivatives clearing organization of a firm or forced trades process. Request for Interpretation Regarding the Applicability of Commission Regulation 37.3(a)(1) and Section 2(h)(8) of the Commodity Exchange Act to Derivatives Clearing Organizations and their Clearing Members.

U.S. COMMODITY FUTURES TRADING COMMISSION

Three Lafayette Centre

1155 21st Street, NW, Washington, DC 20581

Telephone: (202) 418-5430

Facsimile: (202) 418-5547

Division of Clearing and

Risk

CFTC Letter No. 15-51

Interpretation

September 18, 2015

Division of Clearing and Risk

Sarah Williams

ICE Clear Credit

Staff Attorney

353 North Clark, Suite 3100

Chicago, IL 60654

Re: Request for Interpretation Regarding the Applicability of Commission Regulation

37.3(a)(1) and Section 2(h)(8) of the Commodity Exchange Act to Derivatives Clearing

Organizations and their Clearing Members

Dear Ms. Williams:

This letter responds to your request for an interpretation by the Division of Clearing and

Risk and the Division of Market Oversight (collectively, the “Divisions”) regarding Commodity

Futures Trading Commission (“Commission”) Regulation 37.3(a)(1).1 By letter dated September

2, 2015, you have asked for clarification as to whether a derivatives clearing organization’s

(“DCO”) use of a “firm or forced trades” process to help determine end-of-day swap pricing

information would require the DCO to register with the Commission as a swap execution facility

(“SEF”). You have also asked whether the swaps resulting from such a process would be subject

to the trade execution requirement of Section 2(h)(8) of the CEA.2 Finally, you have asked for

confirmation that the DCO would be the counterparty required under Part 45 of the Commission’s

regulations to report data for swaps created by a firm or forced trades process

on as a swap execution facility

(“SEF”). You have also asked whether the swaps resulting from such a process would be subject

to the trade execution requirement of Section 2(h)(8) of the CEA.2 Finally, you have asked for

confirmation that the DCO would be the counterparty required under Part 45 of the Commission’s

regulations to report data for swaps created by a firm or forced trades process.

Background

Regulation 37.3(a)(1) requires “[a]ny person operating a facility that offers a trading

system or platform in which more than one market participant has the ability to execute or trade

swaps with more than one other market participant on the system or platform” to register the

facility as a SEF or as a designated contract market (“DCM”). This regulation implements

Section 5h(a)(1) of the CEA,3 the goal of which is “to promote the trading of swaps on swap

1 Commission regulations referred to herein are found at 17 C.F.R. ch. 1 (2015).

2 7 U.S.C. § 2(h)(8).

3 7 U.S.C. § 7b–3(a)(1).

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execution facilities and to promote pre-trade price transparency in the swaps market.”4 As the

Commission noted when Regulation 37.3(a)(1) was adopted, by requiring trading of swaps on

SEFs and DCMs, “all market participants will benefit from viewing the prices of available bids

and offers and from having access to transparent and competitive trading systems or platforms.”5

DCOs help mitigate risk in the derivatives markets by, among other things, reducing

counterparty credit risk and providing an organized mechanism for collateralizing risk exposures.6

One method of collateralizing risk exposures is through variation margin, which is “a payment

made by a party to a…swap to cover the current exposure arising from changes in the market

value of the position since the trade was executed or the previous time the position was marked to

market.”7

The amount of variation margin a party to a swap pays to the DCO is based on the

changing p

One method of collateralizing risk exposures is through variation margin, which is “a payment

made by a party to a…swap to cover the current exposure arising from changes in the market

value of the position since the trade was executed or the previous time the position was marked to

market.”7

The amount of variation margin a party to a swap pays to the DCO is based on the

changing price or value of the swap. Some DCOs use a “firm or forced trades” process to

determine the price of certain swaps for which public market prices are not available. Although

the details of the relevant procedures vary, a DCO using a firm or forced trades process will

generally require its clearing members to submit both bid and ask prices for the relevant swaps.

The DCO matches the bid and ask prices submitted by the various clearing members and, under

certain conditions, requires a clearing member to buy or sell a swap at a price based on the

clearing member’s submitted price. This process may include a random component; for example,

at least one DCO only effects firm or forced trades on certain trading days, some of which are

determined randomly and are only identified to members after the DCO has effected the trades.

The firm or forced trades process is intended to ensure the integrity of end-of-day pricing by

incentivizing clearing members to submit fair and accurate bid and ask prices.

A DCO’s obligation to pay or collect variation margin is embodied in Regulation 39.14(b),

which requires that a DCO “effect a settlement with each clearing member at least once each

business day.” Regulation 39.13(g)(5) requires that a DCO have “a reliable source of timely price

data” and implement “written procedures and sound valuation models for addressing

circumstances where pricing data is not readily available or reliable.” Pricing data may not be

readily available or reliable where there is no continuous liquid market for a given product,8 and

you have represented that a firm or forced trades proce

5) requires that a DCO have “a reliable source of timely price

data” and implement “written procedures and sound valuation models for addressing

circumstances where pricing data is not readily available or reliable.” Pricing data may not be

readily available or reliable where there is no continuous liquid market for a given product,8 and

you have represented that a firm or forced trades process is a way in which a DCO that clears such

products may attempt to comply with its regulatory obligations.

Because a firm or forced trades process results in the creation of a new swap, this process

potentially implicates the clearing requirement of Section 2(h)(1) of the CEA and the trade

execution requirement of Section 2(h)(8) of the CEA. Section 2(h)(1) provides that “[i]t shall be

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

4 Section 5h(e) of the CEA, 7 U.S.C. § 7b–3(e).

5 Core Principles and Other Requirements for Swap Execution Facilities, 78 Fed. Reg. 33,476, 33,477 (June 4, 2013).

6 See, e.g., Derivatives Clearing Organization General Provisions and Core Principles, 76 Fed. Reg. 69334 (Nov. 8,

2011).

7 Regulation 1.3(fff).

8 See Risk Management Requirements for Derivatives Clearing Organizations, 76 Fed. Reg. 3698, 3705 (Jan. 20,

2011).

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[DCO] that is registered under [the CEA]…if the swap is required to be cleared.”9 Section 2(h)(8)

of the CEA requires that a swap subject to the Section 2(h)(1) clearing requirement must be

executed on a DCM or SEF, unless no DCM or SEF makes such swap available to trade or such

swap qualifies for the clearing exception under Section 2(h)(7) of the CEA.10

Finally, Part 45 of the Commission’s regulations requires that certain data pertaining to

swaps be reported to swap data repositories (“SDRs”). Regulation 45.811 specifies which swap

counterparty is the “reporting counterparty,” responsible for reporting such data

SEF makes such swap available to trade or such

swap qualifies for the clearing exception under Section 2(h)(7) of the CEA.10

Finally, Part 45 of the Commission’s regulations requires that certain data pertaining to

swaps be reported to swap data repositories (“SDRs”). Regulation 45.811 specifies which swap

counterparty is the “reporting counterparty,” responsible for reporting such data. The Commission

has proposed amending Regulation 45.8 to require, among other things, that the relevant DCO

report the necessary data for certain swaps.12

The Division of Market Oversight has previously issued and extended time-limited no-

action relief from certain requirements as applied to a firm or forced trades context.13

Discussion

You have inquired whether a DCO’s use of a firm or forced trade process may require it to

register as a SEF on the basis that it operates “a facility that offers a trading system or platform in

which more than one market participant has the ability to execute or trade swaps with more than

one other market participant on the system or platform” under Regulation 37.3(a)(1).

In connection with the SEF registration requirement, the Commission noted, both when

proposing and adopting the SEF regime under Part 37, that it “views the CEA section 5h(a)(1)

registration requirement as applying only to facilities that meet the SEF definition in CEA section

1a(50).” The Commission added that Section 1a(50) defines a SEF as, in part, “a trading system or

platform in which multiple participants have the ability to execute or trade swaps by accepting

bids and offers made by multiple participants in the facility or system, through any means of

interstate commerce….”14

A SEF provides participants “the ability to execute or trade swaps by accepting bids and

offers made by multiple participants.” That implies a functionality that market participants may

exercise in their discretion to submit orders for execution and enter into desired trades

ids and offers made by multiple participants in the facility or system, through any means of

interstate commerce….”14

A SEF provides participants “the ability to execute or trade swaps by accepting bids and

offers made by multiple participants.” That implies a functionality that market participants may

exercise in their discretion to submit orders for execution and enter into desired trades. Here, in

the context of a DCO’s use of a firm or forced trades process, DCO clearing members are not

9 Section 2(h)(1)(a) of the CEA, 7 U.S.C. § 2(h)(1)(a). Regulation 39.5 specifies the process through which the

Commission determines whether a swap, or a group, category, type, or class of swaps, is required to be cleared.

10 Regulation 37.10 specifies the process through which a SEF makes a swap available to trade and, therefore, subject

to the CEA Section 2(h)(8) trade execution requirement.

11 Regulation 45.8.

12 Amendments to Swap Data Recordkeeping and Reporting Requirements for Cleared Swaps, 80 Fed. Reg. 52,544

(proposed Aug. 31, 2015).

13 See CFTC Letter No. 14-119 (Sept. 29, 2014), available at:

http://www.cftc.gov/LawRegulation/CFTCStaffLetters/14-119; CFTC Letter No. 13-86 (Dec. 31, 2013), available at:

http://www.cftc.gov/LawRegulation/CFTCStaffLetters/13-86; CFTC Letter No. 13-36 (June 27, 2013), available at:

http://www.cftc.gov/LawRegulation/CFTCStaffLetters/13-36; and CFTC Letter No. 12-59 (Dec. 19, 2012), available

at http://www.cftc.gov/LawRegulation/CFTCStaffLetters/12-59.

14 See Core Principles and Other Requirements for Swap Execution Facilities, 78 Fed. Reg. 33476 at 33481 (June 4,

2013) (internal citations omitted); see also 76 Fed. Reg. 1214, 1219 (Jan. 7, 2011).

7, 2013), available at:

http://www.cftc.gov/LawRegulation/CFTCStaffLetters/13-36; and CFTC Letter No. 12-59 (Dec. 19, 2012), available

at http://www.cftc.gov/LawRegulation/CFTCStaffLetters/12-59.

14 See Core Principles and Other Requirements for Swap Execution Facilities, 78 Fed. Reg. 33476 at 33481 (June 4,

2013) (internal citations omitted); see also 76 Fed. Reg. 1214, 1219 (Jan. 7, 2011).

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seeking to enter into a swap transaction and may not wish to do so. Instead, they are placed into

trades with a counterparty selected by the DCO as part of a process in which clearing members are

required to participate, in order for the DCO to fulfill its regulatory obligations. Furthermore, a

DCO using a firm or forced trades process does not provide its participants the ability to accept

bids and offers made by multiple participants. Instead, the DCO requires its clearing members to

submit prices and then, based on those submissions, selects clearing members to enter into swaps,

whether those clearing members wish to enter into a swap or not. A clearing member may be

required to enter into a swap at a price based on its submission to incentivize clearing members to

offer fair and accurate pricing data, but clearing members are not placing bids and offers through

the DCO.

The regulatory requirements imposed on SEFs further illustrate that the Commission did

not contemplate DCOs registering as SEFs in connection with an activity such as the firm or

forced trade process

r into a swap at a price based on its submission to incentivize clearing members to

offer fair and accurate pricing data, but clearing members are not placing bids and offers through

the DCO.

The regulatory requirements imposed on SEFs further illustrate that the Commission did

not contemplate DCOs registering as SEFs in connection with an activity such as the firm or

forced trade process. SEFs are required to ensure that their operations comply with a minimum

trading functionality requirement15 including provision of an order book.16 In connection with this

requirement, the Commission has stated that “an acceptable SEF system or platform must provide

at least a minimum functionality to allow market participants the ability to make executable bids

and offers, and to display them to all other market participants on the SEF.”17 A DCO operating a

firm or forced trade process cannot provide for transparent bids and offers, as doing so would

leave its end-of-day pricing process exposed to manipulation. In addition, the relatively small

number of trades that DCOs generate pursuant to their end-of-day pricing procedures, by their

very nature as trades made on a somewhat randomized basis, cannot be conducted openly on a

SEF.

Finally, the Divisions note that because DCOs are already regulated by the Commission,

their end-of-day pricing practices, which they have implemented to comply with the pricing and

settlement requirements discussed above, are already subject to Commission examination and

supervision. The Divisions do not intend to suggest that registration with the Commission in one

capacity, such as registration as a DCO, excuses a registrant from the requirement to comply with

other applicable Commission regulations or excuses a registrant from applying for registration in

such additional capacities as its activities warrant

are already subject to Commission examination and

supervision. The Divisions do not intend to suggest that registration with the Commission in one

capacity, such as registration as a DCO, excuses a registrant from the requirement to comply with

other applicable Commission regulations or excuses a registrant from applying for registration in

such additional capacities as its activities warrant. A registered swap dealer, for example, that

chooses to offer a multilateral platform to execute or trade swaps would not be excused from the

SEF registration requirement as a result of its pre-existing status as a Commission registrant.

However, given the other factors discussed above, the fact that a DCO which uses a firm or forced

trades process is subject to examination and oversight by Commission staff provides comfort that

the absence of SEF registration does not mean that the relevant activities will avoid regulatory

scrutiny.

In addition, a swap generated as a result of a firm or forced trade process is not subject to

the clearing and trade execution requirements. Even if a swap created through a firm or forced

trade process meets the specifications of a swap required to be cleared,18 the fact that the DCO

itself is a counterparty to the swap means that the swap cannot be submitted to the DCO for

clearing. Therefore, such swaps cannot logically be subject to the clearing requirement.

15 Regulation 37.3(a)(2).

16 Regulation 37.3(a)(3).

17 78 Fed. Reg. 33,476 at 33,484.

18 Regulation 50.4.

swap required to be cleared,18 the fact that the DCO

itself is a counterparty to the swap means that the swap cannot be submitted to the DCO for

clearing. Therefore, such swaps cannot logically be subject to the clearing requirement.

15 Regulation 37.3(a)(2).

16 Regulation 37.3(a)(3).

17 78 Fed. Reg. 33,476 at 33,484.

18 Regulation 50.4.

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Moreover, the trade execution requirement only applies when the relevant swap is subject to the

clearing requirement. Thus, swaps created through a firm or forced trade process are not subject

to the trade execution requirement.

Swaps created by the firm or forced trade process would qualify as “clearing swaps,” which

the Commission has proposed to be defined as swaps “created pursuant to the rules of a [DCO] that

[have] a [DCO] as a counterparty,”19 and must be reported as required under the Part 45 swap data

reporting regulations. The Divisions note that the Commission has proposed amending Regulation

45.8 to require that the DCO be the reporting counterparty for clearing swaps.

Conclusion

Accordingly, the Divisions do not interpret Section 5h(a)(1) of the CEA and Regulation

37.3(a)(1) as requiring a DCO to register as a SEF solely due to its use of a firm or forced trades

process, and do not interpret Sections 2(h)(1) and 2(h)(8) of the CEA as requiring a swap

generated as a result of such a process to be subject to the clearing and trade execution

requirements. Finally, the Divisions agree that the DCO should be the reporting counterparty for

swaps created by the firm or forced trades process for purposes of Part 45 of the Commission’s

regulations.

This letter represents the position of the Divisions only and does not necessarily represent

the views of the Commission or those of any other division or office of the Commission

ution

requirements. Finally, the Divisions agree that the DCO should be the reporting counterparty for

swaps created by the firm or forced trades process for purposes of Part 45 of the Commission’s

regulations.

This letter represents the position of the Divisions only and does not necessarily represent

the views of the Commission or those of any other division or office of the Commission. Should

you have questions regarding this matter, please contact Brian Baum, Special Counsel

(bbaum@cftc.gov, 202-418-5654) or Riva Adriance, Senior Special Counsel (radriance@cftc.gov,

202-418-5494).

Sincerely,

Phyllis Dietz

Vincent A. McGonagle

Acting Director

Director

Division of Clearing and Risk

Division of Market Oversight

19 See proposed amendments to Regulation 45.1, 80 Fed. Reg. 52,544, supra note 12, at 52,572.