# 76 FR 3698: Risk Management Requirements for Derivatives Clearing Organizations

> Federal · Regulations · In force

URL: https://www.frixlaw.com/law-library/statutes/FR_PRORULE_2011-690

## Section

- **Citation:** 76 FR 3698
- **Heading:** Risk Management Requirements for Derivatives Clearing Organizations
- **Jurisdiction:** Federal
- **Kind:** Regulations
- **Status:** In force
- **Text as of:** August 14, 2026
- **Source:** Compiled text
- **Location:** Federal Register / Vol. 76 / 76 FR 3698

## Text

COMMODITY FUTURES TRADING COMMISSION 17 CFR Part 39 RIN 3038-AC98 Risk Management Requirements for Derivatives Clearing Organizations AGENCY:
Commodity Futures Trading Commission.

ACTION:
Notice of proposed rulemaking.

SUMMARY:
The Commodity Futures Trading Commission (Commission) is proposing regulations to implement Title VII and Title VIII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). Proposed regulations would establish the regulatory standards for compliance with derivatives clearing organization (DCO) Core Principles C (Participant and Product Eligibility), D (Risk Management), E (Settlement Procedures), F (Treatment of Funds), G (Default Rules and Procedures), and I (System Safeguards). For DCOs that are designated by the Financial Stability Oversight Council as systemically important DCOs (SIDCOs), the Commission is proposing heightened standards in the area of system safeguards supporting business continuity and disaster recovery and a provision that would implement the Commission's special enforcement authority over SIDCOs. The Commission also is proposing certain additional amendments including replacement of the current part 39 appendix A, Application Guidance and Compliance With Core Principles, with an application form for entities seeking to register as DCOs, technical amendments to reorganize part 39 of the Commission's regulations, and amendments to supplement reporting and public information requirements proposed in a previous rulemaking.

DATES:
Submit comments on or before March 21, 2011.

ADDRESSES:
You may submit comments, identified by RIN number, by any of the following methods:
• Agency Web site, via its Comments Online process: http://comments.cftc.gov . Follow the instructions for submitting comments through the Web site.
• Mail: David A. Stawick, Secretary of the Commission, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581
You may submit comments, identified by RIN number, by any of the following methods:
• Agency Web site, via its Comments Online process: http://comments.cftc.gov . Follow the instructions for submitting comments through the Web site.
• Mail: David A. Stawick, Secretary of the Commission, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581.
• Hand Delivery/Courier: Same as mail above.
• Federal eRulemaking Portal: http://www.Regulations.gov. Follow the instructions for submitting comments.
Please submit comments by only one method. All comments must be submitted in English, or if not, accompanied by an English translation. Comments will be posted as received to http://www.cftc.gov . You should submit only information that you wish to make available publicly. If you wish the Commission to consider information that may be exempt from disclosure under the Freedom of Information Act (FOIA), a petition for confidential treatment of the exempt information may be submitted according to the procedures established in § 145.9 of the Commission's regulations. 1 The Commission reserves the right, but shall have no obligation, to review, pre-screen, filter, redact, refuse, or remove any or all of your submission from http://www.cftc.gov that it may deem to be inappropriate for publication, such as obscene language. All submissions that have been redacted or removed that contain comments on the merits of the rulemaking will be retained in the public comment file and will be considered as required under the Administrative Procedure Act and other applicable laws, and may be accessible under FOIA.
1 Commission regulations referred to herein are found at 17 CFR Ch. 1 (2010). They are accessible on the Commission's Web site at http://www.cftc.gov .
FOR FURTHER INFORMATION CONTACT:
John C. Lawton, Deputy Director, 202-418-5480, jlawton@cftc.gov; Phyllis P. Dietz, Associate Director, 202-418-5449, pdietz@cftc.gov, Robert B
e Act and other applicable laws, and may be accessible under FOIA.
1 Commission regulations referred to herein are found at 17 CFR Ch. 1 (2010). They are accessible on the Commission's Web site at http://www.cftc.gov .
FOR FURTHER INFORMATION CONTACT:
John C. Lawton, Deputy Director, 202-418-5480, jlawton@cftc.gov; Phyllis P. Dietz, Associate Director, 202-418-5449, pdietz@cftc.gov, Robert B. Wasserman, Associate Director, 202-418-5092, rwasserman@cftc.gov (System Safeguards); and Jonathan Lave, Special Counsel, 202-418-5983, jlave@cftc.gov, Division of Clearing and Intermediary Oversight, Commodity Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, NW., Washington, DC 20581; and Julie A. Mohr, Associate Director, 312-596-0568, jmohr@cftc.gov; and Anne C. Polaski, Special Counsel, 312-596-0575, apolaski@cftc.gov, Division of Clearing and Intermediary Oversight, Commodity Futures Trading Commission, 525 West Monroe Street, Chicago, Illinois 60661.

SUPPLEMENTARY INFORMATION:
Table of Contents
I. Background A. Title VII of the Dodd-Frank Act B. Title VIII of the Dodd-Frank Act C. Dodd-Frank Act rulemaking initiative II. Discussion A. Registration procedures B. Implementation of DCO core principles 1. Participant and product eligibility (a) Participant eligibility (i) Fair and open access (ii) Financial resources (iii) Operational requirements (iv) Monitoring, reporting, and enforcement (b) Product eligibility 2
I of the Dodd-Frank Act B. Title VIII of the Dodd-Frank Act C. Dodd-Frank Act rulemaking initiative II. Discussion A. Registration procedures B. Implementation of DCO core principles 1. Participant and product eligibility (a) Participant eligibility (i) Fair and open access (ii) Financial resources (iii) Operational requirements (iv) Monitoring, reporting, and enforcement (b) Product eligibility 2. Risk management (a) General (b) Risk management framework (c) Chief risk officer (d) Measurement of credit exposure (e) Limitation of exposure to potential losses from defaults (f) Margin requirements (i) General (ii) Methodology and coverage (iii) Independent validation (iv) Spread margins (v) Price data (vi) Daily review and back tests (vii) Customer margin (1) Gross margin for customer accounts (2) Customer initial margin requirements (3) Withdrawal of customer initial margin (viii) Time deadlines (g) Other risk control mechanisms (i) Risk limits (ii) Large trader reports (iii) Stress tests (iv) Portfolio compression (v) Clearing members' risk management policies and procedures (vi) Additional authority 3. Settlement procedures (a) Daily settlements (b) Settlement banks (c) Settlement finality (d) Recordkeeping (e) Netting arrangements (f) Physical delivery 4. Treatment of funds (a) Required standards and procedures (b) Segregation of funds and assets (c) Holding of funds and assets (i) Types of assets (ii) Valuation (iii) Haircuts (iv) Concentration limits (v) Pledged assets (d) Permissible investments 5. Default rules and procedures (a) General (b) Default management plan (c) Default procedures (d) Insolvency of a clearing member 6
hysical delivery 4. Treatment of funds (a) Required standards and procedures (b) Segregation of funds and assets (c) Holding of funds and assets (i) Types of assets (ii) Valuation (iii) Haircuts (iv) Concentration limits (v) Pledged assets (d) Permissible investments 5. Default rules and procedures (a) General (b) Default management plan (c) Default procedures (d) Insolvency of a clearing member 6. System safeguards (a) General (i) Definitions (ii) Program of risk analysis (iii) Elements of program (iv) Standards for program (v) Business continuity and disaster recovery (vi) Location of resources; outsourcing (vii) Notification of Commission staff; recordkeeping (viii) Testing (ix) Coordination of business continuity and disaster recovery plan (b) SIDCOs (i) Determining which DCOs will be subject to enhanced BC-DR obligations (ii) Recovery time objective (iii) Geographic diversity (iv) Testing (v) Effective date 7. Special enforcement authority over SIDCOs C. Additional amendments 1. Technical amendments to reorganize part 39 2. Supplemental provisions for proposed § 39.19 3. Technical amendments to proposed § 39.21 III. Effective Date IV. Section 4(c) V. Related Matters A. Regulatory Flexibility Act B. Paperwork Reduction Act C. Cost-benefit analysis I. Background
A. Title VII of the Dodd-Frank Act
On July 21, 2010, President Obama signed the Dodd-Frank Act. 2 Title VII of the Dodd-Frank Act 3 amended the Commodity Exchange Act (CEA) 4 to establish a comprehensive regulatory framework to reduce risk, increase transparency, and promote market integrity within the financial system by, among other things: (1) Providing for the registration and comprehensive regulation of swap dealers and major swap participants; (2) imposing clearing and trade execution requirements on standardized derivative products; (3) creating rigorous recordkeeping and real-time reporting regimes; and (4) enhancing the Commission's rulemaking and enforcement authorities with respect to all registered entities and intermediaries subject to
for the registration and comprehensive regulation of swap dealers and major swap participants; (2) imposing clearing and trade execution requirements on standardized derivative products; (3) creating rigorous recordkeeping and real-time reporting regimes; and (4) enhancing the Commission's rulemaking and enforcement authorities with respect to all registered entities and intermediaries subject to the Commission's oversight.
2 See Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010). The text of the Dodd-Frank Act may be accessed at http://www.cftc.gov/LawRegulation/OTCDERIVATIVES/index.htm.
3 Pursuant to section 701 of the Dodd-Frank Act, Title VII may be cited as the “Wall Street Transparency and Accountability Act of 2010.”
4 7 U.S.C. 1 et seq.
Section 725(c) of the Dodd-Frank Act amended Section 5b(c)(2) of the CEA, which sets forth core principles with which a DCO must comply to be registered and to maintain registration as a DCO.
The core principles were added to the CEA by the Commodity Futures Modernization Act of 2000 (CFMA). 5 The Commission did not adopt implementing rules and regulations, but instead promulgated guidance for DCOs on compliance with the core principles. 6 Under section 5b(c)(2), as amended by the Dodd-Frank Act, Congress expressly confirmed that the Commission may adopt implementing rules and regulations pursuant to its rulemaking authority under section 8a(5) of the CEA. 7
5 See Commodity Futures Modernization Act of 2000, Pub. L. 106-554, 114 Stat. 2763 (2000).
6 See 17 CFR part 39, app. A.
7 Section 8a(5) of the CEA authorizes the Commission to promulgate such regulations “as, in the judgment of the Commission, are reasonably necessary to effectuate any of the provisions or to accomplish any of the purposes of [the CEA].” 7 U.S.C. 12a(5).
The Commission continues to believe that each DCO should be afforded an appropriate level of discretion in determining how to operate its business within the statutory framework
izes the Commission to promulgate such regulations “as, in the judgment of the Commission, are reasonably necessary to effectuate any of the provisions or to accomplish any of the purposes of [the CEA].” 7 U.S.C. 12a(5).
The Commission continues to believe that each DCO should be afforded an appropriate level of discretion in determining how to operate its business within the statutory framework. At the same time, the Commission recognizes that specific, bright-line regulations may be necessary in order to facilitate DCO compliance with a given core principle and, ultimately, to protect the integrity of the U.S. clearing system. Accordingly, in developing the proposed regulations, the Commission has endeavored to strike an appropriate balance between establishing general prudential standards and prescriptive requirements.
In this notice of proposed rulemaking, the Commission proposes to adopt regulations to implement six DCO core principles. Those core principles, all of which were amended by the Dodd-Frank Act, are C (Participant and Product Eligibility), D (Risk Management), E (Settlement Procedures), F (Treatment of Funds), G (Default Rules and Procedures), and I (System Safeguards).
B. Title VIII of the Dodd-Frank Act
Section 802(b) of the Dodd-Frank Act states that the purpose of Title VIII is to mitigate systemic risk in the financial system and promote financial stability. Section 804 authorizes the Financial Stability Oversight Council (Council) to designate entities involved in clearing and settlement as systemically important. 8
8 See Advance Notice of Proposed Rulemaking Regarding Authority to Designate Financial Market Utilities as Systemically Important, available at http://www.treasury.gov/initiatives/Pages/FSOC-index.aspx .
Section 805(a) of the Dodd-Frank Act allows the Commission to prescribe regulations for those DCOs that the Council has determined are systemically important
ement as systemically important. 8
8 See Advance Notice of Proposed Rulemaking Regarding Authority to Designate Financial Market Utilities as Systemically Important, available at http://www.treasury.gov/initiatives/Pages/FSOC-index.aspx .
Section 805(a) of the Dodd-Frank Act allows the Commission to prescribe regulations for those DCOs that the Council has determined are systemically important. The Commission is proposing to adopt enhanced requirements for SIDCOs regarding system safeguards for business continuity and disaster recovery in proposed § 39.30.
Section 807(c) of the Dodd-Frank Act provides the Commission with special enforcement authority over SIDCOs, which the Commission is proposing to implement in proposed § 39.31.
C. Dodd-Frank Act Rulemaking Initiative
This proposed rulemaking is the last in a series of proposed rulemakings issued for the purpose of implementing the DCO core principles. 9 Through the proposed regulations, the Commission seeks to enhance legal certainty for DCOs, clearing members, and market participants by providing a regulatory framework to support DCO risk management practices overall and, in turn, strengthen the financial integrity of the futures markets and swap markets subject to Commission oversight.
9 See e.g., 75 FR 78185 (Dec. 15, 2010) (Core Principles J, Reporting; K, Recordkeeping; L, Public Information; and M, Information Sharing); 75 FR 77576 (Dec. 13, 2010) (Core Principles A, Compliance; H, Rule Enforcement; N, Antitrust Considerations; and R, Legal Risk); 75 FR 63732 (Oct. 18, 2010) (Core Principle P, Conflicts of Interest); and 75 FR 63113 (Oct. 14, 2010) (Core Principle B, Financial Resources).
With this in mind, the Commission also is proposing to establish greater uniformity and transparency in the DCO application process by adopting a registration application form that will facilitate greater efficiency and consistency in processing submissions
FR 63732 (Oct. 18, 2010) (Core Principle P, Conflicts of Interest); and 75 FR 63113 (Oct. 14, 2010) (Core Principle B, Financial Resources).
With this in mind, the Commission also is proposing to establish greater uniformity and transparency in the DCO application process by adopting a registration application form that will facilitate greater efficiency and consistency in processing submissions. The Commission is further proposing certain technical amendments to update and conform provisions of part 39 to the CEA, as amended by the Dodd-Frank Act.
The Commission requests comment on all aspects of the rules proposed herein, as well as comment on the specific provisions and issues highlighted in the discussion below.
II. Discussion
A. Registration Procedures
As proposed in an earlier notice of proposed rulemaking, the Commission intends to continue to voluntarily apply a 180-day time frame for review of DCO registration applications, but eliminate the 90-day expedited review period for such applications. 10 Related to this, the Commission is now proposing additional revisions to the requirements for DCO registration in order to clarify the application submission and review process and to achieve greater efficiency for both applicants and the Commission.
10 See 75 FR at 77586. Although the CEA does not require the Commission to review DCO applications within a prescribed time period or subject to any prescribed procedures, the Commission adopted a 90-day expedited review period and, in the alternative, the 180-day time period and procedures specified in section 6(a) of the CEA for review of applications for designation of a contract market.
The Commission is proposing to revise appendix A to part 39, “Application Guidance and Compliance With Core Principles,” by removing the current content and substituting in its 11
11 In separate rulemakings, the Commission is proposing applications for designation as a contract market and registration as a swap execution facility
for review of applications for designation of a contract market.
The Commission is proposing to revise appendix A to part 39, “Application Guidance and Compliance With Core Principles,” by removing the current content and substituting in its 11
11 In separate rulemakings, the Commission is proposing applications for designation as a contract market and registration as a swap execution facility. This approach is similar to the SEC's use of the Form CA for securities clearing agency applications, available at https://www.sec.gov .
The Commission's objective in adopting an application form is to streamline the DCO registration process, having learned from experience that the general guidance contained in the current appendix A does not provide sufficiently specific instructions to applicants. As a result, the registration process has been prolonged in some cases because of the need for Commission staff to provide applicants with additional guidance about the nature of the information that is required in order for the Commission to conclude that the applicant has demonstrated its ability to comply with the core principles.
The Commission proposes to amend § 39.3(d), “Guidance for applicants and registrants,” and redesignate it as § 39.3(a)(2). The amended provision would state that any person seeking to register as a DCO would be required to submit a completed Form DCO as provided in appendix A to part 39, including all applicable exhibits. Use of the Form DCO also would be required for amendments to a pending application or requests for an amendment to an existing DCO registration. Section 39.3(a)(2) would clarify that an applicant, upon its own initiative, could file additional information that might be necessary or helpful to the Commission in processing the application. The Commission strongly encourages prospective applicants to submit any additional information that could be useful to the Commission.
The proposed appendix A containing the Form DCO is set forth in this notice of proposed rulemaking
fy that an applicant, upon its own initiative, could file additional information that might be necessary or helpful to the Commission in processing the application. The Commission strongly encourages prospective applicants to submit any additional information that could be useful to the Commission.
The proposed appendix A containing the Form DCO is set forth in this notice of proposed rulemaking. The Commission requests comment on the potential benefits and disadvantages of requiring the use of a standardized application. In addition, the Commission requests comment on the content of the proposed application including specific exhibits.
Proposed § 39.3(a)(3) would clarify that the filing of a completed Form DCO would be a minimum requirement and would not create a presumption that the application is materially complete 12 or that supplemental information will not be required by the Commission. At any time during the application review process, the Commission may request that the applicant submit supplemental information in order for the Commission to process the application.
12 Section 6(a) of the CEA, 7 U.S.C. 8(a), provides that the Commission must approve or deny an application for designation of a contract market within 180 days of the filing of the application. However, “[i]f the Commission notifies the person that its application is materially incomplete and specifies the deficiencies in the application, the running of the 180-day period shall be stayed from the time of such notification until the application is resubmitted in completed form.”
Under proposed § 39.3(a)(4), an applicant would be required to promptly amend its Form DCO if it discovered a material omission or error, or if there is a material change in any information already provided to the Commission.
Proposed § 39.3(a)(5) would largely incorporate applicable language of § 40.8(a), which identifies those parts of a DCO application that are available to the public
orm.”
Under proposed § 39.3(a)(4), an applicant would be required to promptly amend its Form DCO if it discovered a material omission or error, or if there is a material change in any information already provided to the Commission.
Proposed § 39.3(a)(5) would largely incorporate applicable language of § 40.8(a), which identifies those parts of a DCO application that are available to the public. 13 Those parts are: the first page of the cover sheet, proposed rules (Exhibit A-1), the applicant's regulatory compliance chart (Exhibit A-2), a narrative summary of the applicant's proposed clearing activities (Exhibit A-3), documents establishing the applicant's legal status (Exhibit A-8), documents setting forth the applicant's corporate and governance structure (Exhibits A-7 and Q), and any other part of the application not covered by a request for confidential treatment subject to FOIA and filed in accordance with the requirements of § 145.9 of the Commission's regulations. 14 The Commission notes that it expects to continue its practice of posting DCO applications on its Web site for a public comment period (typically 30 days).
13 See 75 FR 67282 (Nov. 2, 2010) (provisions common to registered entities).
14 See 5 U.S.C. 552 and § 145.9 of the Commission's regulations (regarding petitions for confidential treatment of information submitted to the Commission).
Proposed § 39.3(b)(1) would stay the running of the 180-day review period if an application was materially incomplete, consistent with the Commission's authority with respect to the designation of a contract market under section 6(a) of the CEA. The delegation provision of current § 39.3(g) would be redesignated as paragraph (b)(2). This provision authorizes the Director of the Division of Clearing and Intermediary Oversight or the Director's designee, with the concurrence of the General Counsel or the General Counsel's designee, to notify an applicant that the application is materially incomplete and the running of the 180-day period is stayed
legation provision of current § 39.3(g) would be redesignated as paragraph (b)(2). This provision authorizes the Director of the Division of Clearing and Intermediary Oversight or the Director's designee, with the concurrence of the General Counsel or the General Counsel's designee, to notify an applicant that the application is materially incomplete and the running of the 180-day period is stayed.
The Commission requests comment on all aspects of the proposed amendments to § 39.3, including the costs associated with the application process and possible means for streamlining the process further.
B. Implementation of DCO Core Principles
1. Participant and Product Eligibility
Core Principle C, as amended by the Dodd-Frank Act, 15 requires each DCO to establish appropriate admission and continuing eligibility standards for members of, and participants in, the DCO, 16 including sufficient financial resources and operational capacity to meet the obligations arising from participation. Core Principle C further requires that such participation and membership requirements be objective, be publicly disclosed, and permit fair and open access. Core Principle C also requires that each DCO establish and implement procedures to verify compliance with each participation and membership requirement, on an ongoing basis. With respect to product eligibility, Core Principle C requires that each DCO establish appropriate standards for determining the eligibility of agreements, contracts, or transactions submitted to the DCO for clearing. 17 The Commission is proposing to adopt
15 Section 5b(c)(2)(C) of the CEA; 7 U.S.C. 7a-1(c)(2)(C) (Core Principle C).
16 Core Principle C, as well as the other core principles that are discussed herein, refer to “members of, and participants in” a DCO. The Commission interprets this phrase to mean persons with clearing privileges, and has used the term “clearing member” in describing the requirements of each core principle and in the text of the proposed regulations described herein
c)(2)(C) (Core Principle C).
16 Core Principle C, as well as the other core principles that are discussed herein, refer to “members of, and participants in” a DCO. The Commission interprets this phrase to mean persons with clearing privileges, and has used the term “clearing member” in describing the requirements of each core principle and in the text of the proposed regulations described herein. In a separate notice of proposed rulemaking, the Commission has proposed to amend the definition of “clearing member” in § 1.3(c) to mean “any person that has clearing privileges such that it can process, clear and settle trades through a derivatives clearing organization on behalf of itself or others. The derivatives clearing organization need not be organized as a membership organization.” See 75 FR at 77585.
17 Prior to amendment by the Dodd-Frank Act, Core Principle C provided that
[t]he applicant shall establish—
(i) appropriate admission and continuing eligibility standards (including appropriate minimum financial requirements) for members of and participants in the organization; and
(ii) appropriate standards for determining eligibility of agreements, contracts, or transactions submitted to the applicant.
(a) Participant eligibility.
As noted above, Core Principle C requires that a DCO's admission and continuing eligibility standards for clearing members must be objective and publicly disclosed. 18 Proposed § 39.12(a) would codify these requirements, and would make clear that such requirements must be risk-based.
18 Section 5b(c)(2)(C)(iii) of the CEA; 7 U.S.C. 7a-1(c)(2)(C)(iii) (Core Principle C).
rticipant eligibility.
As noted above, Core Principle C requires that a DCO's admission and continuing eligibility standards for clearing members must be objective and publicly disclosed. 18 Proposed § 39.12(a) would codify these requirements, and would make clear that such requirements must be risk-based.
18 Section 5b(c)(2)(C)(iii) of the CEA; 7 U.S.C. 7a-1(c)(2)(C)(iii) (Core Principle C).
(i) Fair and open access.
Core Principle C mandates that participation requirements must “permit fair and open access.” 19 It also mandates that clearing members must have “sufficient financial resources and operational capacity to meet obligations arising from participation in the derivatives clearing organization.” 20 Although there is potential for tension between these goals, the Commission believes that they can be harmonized. Proposed § 39.12 is designed to ensure that participation requirements do not unreasonably restrict any entity from becoming a clearing member while, at the same time, limiting risk to the DCO and its clearing members. The Commission believes that more widespread participation could reduce the concentration of clearing member portfolios and diversify risk. It could also increase competition by allowing more entities to become clearing members.
19 Id.
20 Id.
Proposed § 39.12(a)(1) would require a DCO to establish participation requirements that permit fair and open access. To achieve fair and open access, proposed § 39.12(a)(1)(i) would prohibit a DCO from adopting a particular restrictive participation requirement if it could adopt a less restrictive requirement that would not materially increase risk to the DCO or its clearing members.
Proposed § 39.12(a)(1)(ii) would require a DCO to permit a market participant to become a clearing member if it met the DCO's participation requirements
access, proposed § 39.12(a)(1)(i) would prohibit a DCO from adopting a particular restrictive participation requirement if it could adopt a less restrictive requirement that would not materially increase risk to the DCO or its clearing members.
Proposed § 39.12(a)(1)(ii) would require a DCO to permit a market participant to become a clearing member if it met the DCO's participation requirements. Proposed § 39.12(a)(1)(iii) would prohibit participation requirements that have the effect of excluding or limiting clearing membership of certain types of market participants unless the DCO can demonstrate that the restriction is necessary to address credit risk or deficiencies in the participants' operational capabilities that would prevent them from fulfilling their obligations as clearing members. Section 39.12(a)(1)(iv) would prohibit a DCO from requiring that clearing members must be swap dealers. Section 39.12(a)(1)(v) would prohibit a DCO from requiring that clearing members maintain a swap portfolio of any particular size, or that clearing members meet a swap transaction volume threshold.
The access and participation requirements discussed above meet or exceed international recommendations. 21
21 In November 2004, the Task Force on Securities Settlement Systems, jointly established by the Committee on Payment and Settlement Systems (CPSS) of the central banks of the Group of Ten countries and the Technical Committee of the International Organization of Securities Commissions (IOSCO), issued Recommendations for Central Counterparties. CPSS & Technical Comm. of IOSCO Recommendations for Central Counterparties, CPSS Publ'n No. 64 (Nov. 2004), available at http://www.bis.org/publ/cpss64.pdf (CPSS-IOSCO Recommendations)
t Systems (CPSS) of the central banks of the Group of Ten countries and the Technical Committee of the International Organization of Securities Commissions (IOSCO), issued Recommendations for Central Counterparties. CPSS & Technical Comm. of IOSCO Recommendations for Central Counterparties, CPSS Publ'n No. 64 (Nov. 2004), available at http://www.bis.org/publ/cpss64.pdf (CPSS-IOSCO Recommendations). CPSS-IOSCO Recommendation 2 provides, in part, that “[a] CCP's participation requirements should be objective, publicly disclosed, and permit fair and open access.” The CPSS-IOSCO Recommendations further state that
[t]o avoid discriminating against classes of participants and introducing competitive distortions, participation requirements should be objective and avoid limiting competition through unnecessarily restrictive criteria, thereby permitting fair and open access within the scope of services offered by the CCP. [footnote omitted] Participation requirements that limit access on grounds other than risks should be avoided.
(CPSS-IOSCO Recommendations, pg. 16). The Commission notes that CPSS and IOSCO are currently reviewing the CPSS-IOSCO Recommendations, which may be revised.
(ii) Financial resources.
Core Principle C mandates that participation requirements must ensure that clearing members have “sufficient financial resources and operational capacity to meet obligations arising from participation in the [DCO].” 22 Proposed § 39.12(a)(2)(i) would require a DCO to establish participation requirements that require clearing members to have access to sufficient financial resources to meet obligations arising from participation in the DCO in extreme but plausible market conditions. The financial resources could include a clearing member's capital, a guarantee from a clearing member's parent, or a credit facility funding arrangement
(2)(i) would require a DCO to establish participation requirements that require clearing members to have access to sufficient financial resources to meet obligations arising from participation in the DCO in extreme but plausible market conditions. The financial resources could include a clearing member's capital, a guarantee from a clearing member's parent, or a credit facility funding arrangement. The proposed regulation would further specify that, for purposes of proposed § 39.12(a)(2), “capital” would mean adjusted net capital as defined in § 1.17 of the Commission's regulations, for futures commission merchants (FCMs), and net capital as defined in SEC rule 15c3-1, for broker-dealers, or any similar risk adjusted capital calculation for all other prospective clearing members.
22 Section 5b(c)(2)(C)(i)(I) of the CEA; 7 U.S.C. 7a-1(c)(2)(C)(i)(I).
The Commission invites comment regarding whether a guarantee or a credit facility funding arrangement is sufficiently reliable and liquid such that it should be considered as a resource that would be available to meet obligations arising from participation in a DCO in extreme but plausible market conditions.
Proposed § 39.12(a)(2)(ii) would require a DCO to establish capital requirements that are based on objective, transparent, and commonly accepted standards that appropriately match capital to risk. The proposed regulation would require capital requirements to be scalable so that they are proportional to the risks posed by clearing members.
With respect to persons that seek clearing membership in order to clear swaps, proposed § 39.12(a)(2)(iii) would specify that a DCO is not permitted to set a minimum capital requirement of more than $50 million.
If the capital requirement is satisfied by a prospective clearing member, the DCO is prohibited from making a determination that the prospective clearing member does not satisfy its scalable capital requirements
hat seek clearing membership in order to clear swaps, proposed § 39.12(a)(2)(iii) would specify that a DCO is not permitted to set a minimum capital requirement of more than $50 million.
If the capital requirement is satisfied by a prospective clearing member, the DCO is prohibited from making a determination that the prospective clearing member does not satisfy its scalable capital requirements. Proposed §§ 39.12(a)(2)(ii) and 39.12(a)(2)(iii), considered together, would require a DCO to admit any person to clearing membership for the purpose of clearing swaps, if the person had $50 million in capital, but would permit a DCO to require each clearing member to hold capital proportional to its risk exposure. 23 Thus, if a clearing member's risk exposure were to increase in a non-linear manner, the DCO could increase the clearing member's corresponding scalable capital requirement in a non-linear manner.
23 Conversely, as discussed, infra, in section II.B.2.g.i, proposed § 39.13(h)(1)(i) would require a DCO to impose risk limits on a clearing member to prevent a clearing member from carrying positions where the risk exposure of those positions exceeded a threshold specified by the DCO relative to the financial resources of the clearing member, the DCO, or both.
The Commission requests comment on whether establishing a capital threshold is an effective approach to promoting fair and open access. If it is, the Commission further requests views on whether the $50 million figure is an appropriate amount and, if not, what alternative amount might be more appropriate.
(iii) Operational requirements.
Proposed § 39.12(a)(3) would require a DCO to establish participation requirements that ensure that clearing members have adequate operational
ctive approach to promoting fair and open access. If it is, the Commission further requests views on whether the $50 million figure is an appropriate amount and, if not, what alternative amount might be more appropriate.
(iii) Operational requirements.
Proposed § 39.12(a)(3) would require a DCO to establish participation requirements that ensure that clearing members have adequate operational
(iv) Monitoring, reporting, and enforcement.
Strong participation requirements will not limit risk if clearing members do not satisfy the requirements on an ongoing basis. Accordingly, Core Principle C requires each DCO to “establish and implement procedures to verify, on an ongoing basis, the compliance of each participation and membership requirement of the derivatives clearing organization.” 24 Proposed § 39.12(a)(4) would codify this requirement.
24 See section 5b(c)(2)(C)(ii) of the CEA; 7 U.S.C. 7a-1(c)(2)(C)(ii). Based on context, the Commission interprets the phrase “compliance of each participation and membership requirement” to mean compliance “with” each participation and membership requirement.
A DCO cannot effectively monitor clearing members if it is not adequately informed about their financial status. Proposed § 39.12(a)(5) would address this concern. Specifically, proposed § 39.12(a)(5)(i) would require a DCO to require all of its clearing members, including non-FCMs, to file periodic financial reports with the DCO that contain any financial information that the DCO determines is necessary to assess whether participation requirements are met on an ongoing basis. A DCO would have to require its clearing members that are FCMs to file the financial reports that are specified in § 1.10 of the Commission's regulations with the DCO. The proposed regulation also would require a DCO to review these financial reports for risk management purposes
formation that the DCO determines is necessary to assess whether participation requirements are met on an ongoing basis. A DCO would have to require its clearing members that are FCMs to file the financial reports that are specified in § 1.10 of the Commission's regulations with the DCO. The proposed regulation also would require a DCO to review these financial reports for risk management purposes. Proposed § 39.12(a)(5)(i) would further require a DCO to require its clearing members that are not FCMs to make the periodic financial reports that they file with the DCO available to the Commission upon the Commission's request. Proposed § 39.12(a)(5)(ii) would require a DCO to adopt rules that require a clearing member to provide to the DCO, in a timely manner, information that concerns any financial or business developments that could materially affect the clearing member's ability to continue to comply with participation requirements.
Finally, proposed § 39.12(a)(6) would require a DCO to have the ability to enforce compliance with its participation requirements. In particular, the DCO would be required to establish procedures for the suspension and orderly removal of clearing members that no longer meet the DCO's participation requirements.
(b) Product eligibility.
Core Principle C requires each DCO to establish “appropriate standards for determining the eligibility of agreements, contracts, or transactions submitted to the [DCO] for clearing.” 25 Proposed § 39.12(b)(1) would require a DCO to establish appropriate requirements for determining the eligibility of agreements, contracts, or transactions submitted to the DCO for clearing, taking into account the DCO's ability to manage the risks associated with such agreements, contracts, or transactions
igibility of agreements, contracts, or transactions submitted to the [DCO] for clearing.” 25 Proposed § 39.12(b)(1) would require a DCO to establish appropriate requirements for determining the eligibility of agreements, contracts, or transactions submitted to the DCO for clearing, taking into account the DCO's ability to manage the risks associated with such agreements, contracts, or transactions. Factors to be considered in determining product eligibility would include, but would not be limited to: (i) trading volume; (ii) liquidity; (iii) availability of reliable prices; (iv) ability of market participants to use portfolio compression 26 with respect to a particular swap product; (v) ability of the DCO and clearing members to gain access to the relevant market for purposes of creating and liquidating positions; (vi) ability of the DCO to measure risk for purposes of setting margin requirements; and (vii) operational capacity of the DCO and clearing members to address any unique risk characteristics of a product.
25 Section 5b(c)(2)(C)(i)(II) of the CEA; 7 U.S.C. 7a-1(c)(2)(C)(i)(II).
26 Portfolio compression is a mechanism by which superfluous transactions among two or more counterparties are compressed, terminated and replaced with a smaller number of transactions of decreased notional principal value in an effort to reduce the risk, cost, and inefficiency of maintaining unnecessary transactions on the counterparties' books.
Section 2(h)(1)(B) of the CEA requires a DCO to adopt rules providing that all swaps with the same terms and conditions submitted to the DCO for clearing are economically equivalent within the DCO and may be offset with each other within the DCO. Section 2(h)(1)(B) further requires a DCO to provide for non-discriminatory clearing of a swap executed bilaterally or on or subject to the rules of an unaffiliated designated contract market (DCM) or swap execution facility (SEF). Proposed § 39.12(b)(2) would codify these requirements in the Commission's regulations
cally equivalent within the DCO and may be offset with each other within the DCO. Section 2(h)(1)(B) further requires a DCO to provide for non-discriminatory clearing of a swap executed bilaterally or on or subject to the rules of an unaffiliated designated contract market (DCM) or swap execution facility (SEF). Proposed § 39.12(b)(2) would codify these requirements in the Commission's regulations.
Proposed § 39.12(b)(3) would require a DCO to select contract unit sizes that maximize liquidity, open access, and risk management. To the extent appropriate to further these objectives, the proposed regulation would require a DCO to select contract units for clearing purposes that may be smaller than the contract units in which trades submitted for clearing were executed. The contract unit size of a particular swap executed bilaterally may reflect the immediate circumstances of the two parties to the transaction. Once submitted for clearing, it may be possible to split the trade into smaller units without compromising the interests of the two original parties. Smaller units can promote liquidity by permitting more parties to trade the product, facilitate open access by permitting more clearing members to clear the product, and aid risk management by enabling a DCO, in the event of a default, to have more potential counterparties for liquidation.
Finally, proposed § 39.12(b)(4) would require each DCO that clears swaps to have rules stating that upon acceptance of a swap by the DCO for clearing, (i) the original swap is extinguished, (ii) it is replaced by equal and opposite swaps between clearing members and the DCO, (iii) all terms of the cleared swaps must conform to templates established under DCO rules, and (iv) if a swap is cleared by a clearing member on behalf of a customer, all terms of the swap, as carried in the customer account on the books of the clearing member, must conform to the terms of the cleared swap established under the DCO's rules
and opposite swaps between clearing members and the DCO, (iii) all terms of the cleared swaps must conform to templates established under DCO rules, and (iv) if a swap is cleared by a clearing member on behalf of a customer, all terms of the swap, as carried in the customer account on the books of the clearing member, must conform to the terms of the cleared swap established under the DCO's rules.
The purpose of this provision is to encourage the standardization of swaps and to avoid any differences between the terms of a swap as carried at the DCO level and as carried at the clearing member level. Any such differences would raise both customer protection and systemic risk concerns. From a customer protection standpoint, if the terms of the swap at the customer level differ from those at the clearing level, then the customer position cannot really be said to have been cleared. If the customer position differs from the cleared position, the customer may not receive the full transparency and liquidity benefits of clearing. Similarly, from a systemic perspective, any differences could diminish overall price discovery and liquidity. Standardizing the terms of a swap upon clearing would facilitate trading and promote the mitigation of risk for all participants in the swap markets. Furthermore, standardization would support the requirement in section 2(h)(1)(B) of the CEA and proposed § 39.12(b)(2) that a DCO must adopt rules providing that all swaps with the same terms and conditions submitted to the DCO are
2. Risk Management Requirements
Core Principle D, as amended by the Dodd-Frank Act, 27 requires each DCO to ensure that it possesses the ability to manage the risks associated with discharging the responsibilities of the DCO through the use of appropriate tools and procedures. It further requires each DCO to measure its credit exposures to each clearing member not less than once during each business day and to monitor each such exposure periodically during the business day
k Act, 27 requires each DCO to ensure that it possesses the ability to manage the risks associated with discharging the responsibilities of the DCO through the use of appropriate tools and procedures. It further requires each DCO to measure its credit exposures to each clearing member not less than once during each business day and to monitor each such exposure periodically during the business day. Core Principle D also requires each DCO to limit its exposure to potential losses from defaults by clearing members, through margin requirements and other risk control mechanisms, to ensure that its operations would not be disrupted and that nondefaulting clearing members would not be exposed to losses that nondefaulting clearing members cannot anticipate or control. Finally, Core Principle D requires that the margin that the DCO requires from each clearing member must be sufficient to cover potential exposures in normal market conditions and that each model and parameter used in setting such margin requirements must be risk-based and reviewed on a regular basis. 28 The Commission is proposing to adopt § 39.13 to establish requirements that a DCO would have to meet in order to comply with Core Principle D.
27 Section 5b(c)(2)(D) of the CEA; 7 U.S.C. 7a-1(c)(2)(D) (Core Principle D).
28 Prior to amendment by the Dodd-Frank Act, Core Principle D provided that “[t]he applicant shall have the ability to manage the risks associated with discharging the responsibilities of a derivatives clearing organization through the use of appropriate tools and procedures.”
order to comply with Core Principle D.
27 Section 5b(c)(2)(D) of the CEA; 7 U.S.C. 7a-1(c)(2)(D) (Core Principle D).
28 Prior to amendment by the Dodd-Frank Act, Core Principle D provided that “[t]he applicant shall have the ability to manage the risks associated with discharging the responsibilities of a derivatives clearing organization through the use of appropriate tools and procedures.”
(a) General.
Proposed § 39.13(a) would require a DCO to ensure that it possesses the ability to manage the risks associated with discharging its responsibilities through the use of appropriate tools and procedures. The specific requirements that are addressed in the remainder of proposed § 39.13, in addition to margin requirements, describe various tools and procedures that the Commission believes are necessary to ensure that DCOs are able to effectively manage the risks that are inherent in their roles as central counterparties. Many of those requirements reflect the current practices of most or all DCOs, and others may describe enhancements that would assist existing and new DCOs in mitigating their risks as they assume new responsibilities in connection with the clearing of swaps.
(b) Risk management framework.
Proposed § 39.13(b) would require a DCO to establish and maintain written policies, procedures, and controls, approved by its Board of Directors, which establish an appropriate risk management framework that, at a minimum, clearly identifies and documents the range of risks to which the DCO is exposed, addresses the monitoring and management of the entirety of those risks, and provides a mechanism for internal audit. Those risks may include, but are not limited to, legal risk, credit risk, liquidity risk, custody and investment risk, concentration risk, default risk, operational risk, market risk, and business risk. A DCO would be required to regularly review its risk management framework and update it as necessary
ring and management of the entirety of those risks, and provides a mechanism for internal audit. Those risks may include, but are not limited to, legal risk, credit risk, liquidity risk, custody and investment risk, concentration risk, default risk, operational risk, market risk, and business risk. A DCO would be required to regularly review its risk management framework and update it as necessary.
The Commission believes that a DCO should adopt a comprehensive and documented risk management framework that addresses all of the various types of risks to which it is exposed, including the manner in which they may relate to each other. A DCO's risk management framework should be subject to the approval of its Board of Directors, as the Board is ultimately responsible for managing a DCO's risks. The Commission is proposing to leave it to the discretion of each DCO to determine the frequency with which it reviews its risk management framework as long as it is reviewed on a regular basis.
(c) Chief risk officer.
Proposed § 39.13(c) would require a DCO to have a chief risk officer who would be responsible for the implementation of the risk management framework and for making appropriate recommendations regarding the DCO's risk management functions to the DCO's Risk Management Committee or Board of Directors, as applicable. In a separate rulemaking, the Commission has proposed to adopt § 39.13(d) to require DCOs to have a Risk Management Committee with defined composition requirements and specified minimum functions. 29
29 See 75 FR at 63750. In that proposed rulemaking, the provisions relating to the Risk Management Committee were designated as § 39.13(g). In the final rulemaking, the provisions will be redesignated as § 39.13(d)
lemaking, the Commission has proposed to adopt § 39.13(d) to require DCOs to have a Risk Management Committee with defined composition requirements and specified minimum functions. 29
29 See 75 FR at 63750. In that proposed rulemaking, the provisions relating to the Risk Management Committee were designated as § 39.13(g). In the final rulemaking, the provisions will be redesignated as § 39.13(d).
DCOs generally have a chief risk officer or an individual who performs such a function, and the Commission believes this is a “best practice.” Although Core Principle D does not specifically require a DCO to have a chief risk officer, the Commission believes that given the importance of the risk management function, each DCO should have a member of senior management who is responsible for overseeing the implementation of the DCO's comprehensive risk management framework and making appropriate recommendations regarding risk management issues to the DCO's Risk Management Committee (for matters within its jurisdiction) or directly to the Board.
The CEA, as amended by the Dodd-Frank Act, requires a DCO to have a chief compliance officer with defined responsibilities. 30 These requirements have been addressed in a separate rulemaking. 31 Given the importance of the risk management function and the comprehensive nature of the responsibilities of the chief compliance officer as defined in the statute, the Commission expects that the chief risk officer and the chief compliance officer would be two different individuals.
30 See section 5b(i) of the CEA; 7 U.S.C. 7a-1(i).
31 75 FR at 77587.
n addressed in a separate rulemaking. 31 Given the importance of the risk management function and the comprehensive nature of the responsibilities of the chief compliance officer as defined in the statute, the Commission expects that the chief risk officer and the chief compliance officer would be two different individuals.
30 See section 5b(i) of the CEA; 7 U.S.C. 7a-1(i).
31 75 FR at 77587.
(d) Measurement of credit exposure.
Proposed § 39.13(e) would require a DCO to measure and monitor its credit exposures to its clearing members. The proposed regulation uses the term “credit exposure” in order to be consistent with the statutory language of Core Principle D. In this context, “credit exposure” does not refer to an extension of credit by the DCO to a clearing member. Rather, it refers to any amounts that a clearing member would owe to a DCO if the clearing member were to default in its obligations to the DCO. It includes both current exposures and potential future exposures.
Specifically, § 39.13(e) would require a DCO to: (1) Measure its credit exposure to each clearing member and mark to market such clearing member's open positions at least once each business day; and (2) monitor its credit exposure to each clearing member periodically during each business day. Proposed § 39.13(e) goes hand in hand with proposed § 39.14(b), which addresses daily settlements based on a DCO's measurement of its credit exposures to its clearing members. 32
32 See infra section II.B.3.a of this notice.
et such clearing member's open positions at least once each business day; and (2) monitor its credit exposure to each clearing member periodically during each business day. Proposed § 39.13(e) goes hand in hand with proposed § 39.14(b), which addresses daily settlements based on a DCO's measurement of its credit exposures to its clearing members. 32
32 See infra section II.B.3.a of this notice.
(e) Limitation of exposure to potential losses from defaults.
Proposed § 39.13(f) would require a DCO, through margin requirements and other risk control mechanisms, to limit its exposure to potential losses from defaults by its clearing members to ensure that: (1) Its operations would not be disrupted; and (2) nondefaulting clearing members would not be exposed to losses that nondefaulting clearing members cannot anticipate or control. The language of proposed § 39.13(f) is virtually identical to the language in
(f) Margin requirements.
(i) General.
As specified in section 5b(c)(2)(D)(iv) of the CEA, proposed § 39.13(g)(1) would require that the initial margin that a DCO requires from each clearing member must be sufficient to cover potential exposures in normal market conditions and that each model and parameter used in setting initial margin requirements must be risk-based and reviewed on a regular basis. 33 The Commission has not defined “normal market conditions” in the proposed regulation. Current international recommendations define “normal market conditions” as “price movements that produce changes in exposures that are expected to breach margin requirements or other risk control mechanisms only 1% of the time, that is, on average on only one trading day out of 100.” 34 The Commission invites comment regarding whether a definition of “normal market conditions” should be included in the proposed regulation and, if so, how normal market conditions should be defined
vements that produce changes in exposures that are expected to breach margin requirements or other risk control mechanisms only 1% of the time, that is, on average on only one trading day out of 100.” 34 The Commission invites comment regarding whether a definition of “normal market conditions” should be included in the proposed regulation and, if so, how normal market conditions should be defined.
33 The Commission has proposed to define “initial margin” as “money, securities, or property posted by a party to a futures, option, or swap as performance bond to cover potential future exposures arising from changes in the market value of the position.” See 75 FR at 77585 (proposing § 1.3(lll)).
34 CPSS-IOSCO Recommendations, pg. 21.
(ii) Methodology and coverage.
Proposed § 39.13(g)(2) would set forth requirements regarding margin methodology and coverage. First, it would require a DCO to establish initial margin requirements that are commensurate with the risks of each product or portfolio, including any unique characteristics of, or risks associated with, particular products or portfolios. In particular, proposed 39.13(g)(2)(i) would require a DCO that clears credit default swaps (CDS) to appropriately address jump-to-default risk in setting initial margins. 35 With the exception of jump-to-default risk, the Commission has not defined specific risks that a DCO should consider in light of the fact that such risks would be product-specific and portfolio-specific. In addition, there may be risks that might apply to products or portfolios that are cleared in the future that cannot be anticipated at this time. The Commission invites comment regarding whether there are specific risks that should be identified and addressed in the proposed regulation in addition to jump-to-default risk
f the fact that such risks would be product-specific and portfolio-specific. In addition, there may be risks that might apply to products or portfolios that are cleared in the future that cannot be anticipated at this time. The Commission invites comment regarding whether there are specific risks that should be identified and addressed in the proposed regulation in addition to jump-to-default risk.
35 Jump-to-default risk refers to the possibility that a CDS portfolio with large net sales of protection on an underlying reference entity could experience significant losses over a very short period of time following an unexpected event of default by the reference entity.
Proposed § 39.13(g)(2)(ii) would require a DCO to use margin models that generate initial margin requirements sufficient to cover the DCO's potential future exposures to clearing members based on price movements in the interval between the last collection of variation margin 36 and the time within which the DCO estimates that it would be able to liquidate a defaulting clearing member's positions (liquidation time). A DCO would be required to use a liquidation time that is a minimum of five business days for cleared swaps that are not executed on a DCM, whether the swaps are carried in a customer account subject to section 4d(a) or 4d(f) of the CEA, or a house account. 37 A DCO would be required to use a liquidation time that is a minimum of one business day for all other products that it clears, although it would be required to use longer liquidation times, if appropriate, based on the unique characteristics of particular products or portfolios.
36 The Commission has proposed to define “variation margin” as “a payment made by a party to a futures, option, or 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.” See 75 FR at 77585 (proposing § 1.3(ooo))
he unique characteristics of particular products or portfolios.
36 The Commission has proposed to define “variation margin” as “a payment made by a party to a futures, option, or 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.” See 75 FR at 77585 (proposing § 1.3(ooo)).
37 See infra section II.B.4.b of this notice, discussing commingling of customer futures and cleared swaps positions.
A minimum of one business day is the current standard that DCOs generally apply to futures and options on futures contracts. The Commission believes that a minimum of five business days is appropriate for cleared swaps that are not executed on a DCM in that such a time period may be necessary to close out swap positions in a cost-effective manner. 38 Several clearing organizations currently use a five-day liquidation time in determining margin requirements for certain cleared swaps. The Commission invites comment regarding whether the minimum liquidation times specified in proposed § 39.13(g)(2)(ii) are appropriate, or whether there are minimum liquidation times that are more appropriate.
38 Pursuant to section(s) 4(c) and/or 4d of the CEA, the Commission has previously issued several orders allowing funds margining cleared swaps to be commingled with funds margining futures and options on futures. In those orders, the Commission permitted such swaps to be margined using liquidation times that were less than five business days. See, e.g., 74 FR 12316 (Mar. 24, 2009) (corn, wheat and soybean swaps); 73 FR 77015 (Dec. 18, 2008) (coffee, sugar and cocoa swaps); and Order of the Commodity Futures Trading Commission, dated Sep. 26, 2008, entitled “Treatment of Funds Held in Connection with the Clearing of Over-the-Counter Products by The Chicago Mercantile Exchange,” available at http://www.cftc.gov/stellent/groups/public/@requestsandactions/documents/ifdocs/cbot4dorder9-26-08.pdf (ethanol swaps)
73 FR 77015 (Dec. 18, 2008) (coffee, sugar and cocoa swaps); and Order of the Commodity Futures Trading Commission, dated Sep. 26, 2008, entitled “Treatment of Funds Held in Connection with the Clearing of Over-the-Counter Products by The Chicago Mercantile Exchange,” available at http://www.cftc.gov/stellent/groups/public/@requestsandactions/documents/ifdocs/cbot4dorder9-26-08.pdf (ethanol swaps). The Commission intends to grandfather the swaps subject to previously issued orders, such that the relevant liquidation time periods for those swaps would continue to be governed by the terms of the orders.
Proposed § 39.13(g)(2)(iii) would require that the actual coverage of the initial margin requirements produced by a DCO's margin models, along with projected measures of the models' performance, would have to meet a confidence level of at least 99%, based on data from an appropriate historic time period with respect to: (A) Each product that is margined on a product basis; (B) each spread within or between products for which there is a defined spread margin rate, as described in proposed § 39.13(g)(3); (C) each account held by a clearing member at the DCO, by customer origin and house origin, and (D) each swap portfolio, by beneficial owner. These requirements meet or exceed international recommendations. 39
39 For example, on September 15, 2010, the European Commission (EC) proposed the European Market Infrastructure Regulation (EMIR), available at http://ec.europa.eu/internal_market/financial-markets/docs/derivatives/20100915_proposal_en.pdf, “to ensure implementation of the G20 commitments to clear standardized derivatives [which can be accessed at http://www.g20.org/Documents/pittsburgh_summit_leaders_statement_250909.pdf ], and that Central Counterparties (CCPs) comply with high prudential standards * * *,” among other things, and expressed its intent to be consistent with the Dodd-Frank Act. (EMIR, pg. 2-3)
0100915_proposal_en.pdf, “to ensure implementation of the G20 commitments to clear standardized derivatives [which can be accessed at http://www.g20.org/Documents/pittsburgh_summit_leaders_statement_250909.pdf ], and that Central Counterparties (CCPs) comply with high prudential standards * * *,” among other things, and expressed its intent to be consistent with the Dodd-Frank Act. (EMIR, pg. 2-3). The EMIR requires that margins “* * * shall be sufficient to cover losses that result from at least 99 per cent of the exposures movements over an appropriate time horizon . * * *” (EMIR, Article 39, paragraph 1, pg. 46).
The Commission recognizes that while some DCOs generally apply a 99% confidence level to some or all products that they clear, other DCOs apply a confidence level of between 95% and 99% with respect to certain products. In addition, certain DCOs may achieve an average confidence level of 99% across all products that they clear, although not every product may meet the 99% confidence level. The Commission invites comment regarding whether a confidence level of 99% is appropriate with respect to all applicable products, spreads, accounts, and swap portfolios. 40
40 For example, the CPSS-IOSCO Recommendations state that “[m]argin requirements for new and low-volume products might be set at a lower coverage level [than the major products cleared by a CCP] if the potential losses resulting from such products are minimal.” (CPSS-IOSCO Recommendations, pg. 23).
Proposed § 39.13(g)(2)(iv) does not specify the historic time period that a DCO would have to use when calculating a 99% confidence level for any particular product, account, or portfolio. Rather, it would permit each
e set at a lower coverage level [than the major products cleared by a CCP] if the potential losses resulting from such products are minimal.” (CPSS-IOSCO Recommendations, pg. 23).
Proposed § 39.13(g)(2)(iv) does not specify the historic time period that a DCO would have to use when calculating a 99% confidence level for any particular product, account, or portfolio. Rather, it would permit each
(iii) Independent validation.
Historically, many U.S. DCOs have used Chicago Mercantile Exchange's (CME) proprietary risk-based portfolio margining system, Standard Portfolio Analysis of Risk® (SPAN) as the basis for their margin models for futures and options. However, there is at least one other margin model that is currently being used for futures and options, and there are also multiple margin models that DCOs are using for swaps that are currently cleared. As DCOs begin to clear additional swaps it can be anticipated that they will develop new margin models to address the risks of particular products.
Proposed § 39.13(g)(3) would require that, on a regular basis, a DCO's systems for generating initial margin requirements, including the DCO's theoretical models, would have to be reviewed and validated by a qualified and independent party. A validation should include a comprehensive analysis to ensure that such systems and models achieve their intended goals. Although the proposed regulation does not define the term “regular basis,” the Commission would expect that, at a minimum, a DCO would obtain such an independent validation prior to implementation of a new margin model and when making any significant change to a model that is in use by the DCO. Significant changes would be those that could materially affect the nature or level of risks to which a DCO would be exposed. The Commission would expect a DCO to obtain an independent validation prior to any significant change that would relax risk management standards
dation prior to implementation of a new margin model and when making any significant change to a model that is in use by the DCO. Significant changes would be those that could materially affect the nature or level of risks to which a DCO would be exposed. The Commission would expect a DCO to obtain an independent validation prior to any significant change that would relax risk management standards. However, if a DCO needed to adopt a significant change in an expedited manner to enhance risk protections, the Commission would expect the DCO to obtain an independent validation promptly after the change was made.
The Commission has not proposed a definition of the term “qualified and independent party.” The Commission invites comment regarding whether a qualified and independent party must be a third party or whether there may be circumstances under which an employee of the relevant DCO could be considered to be independent.
(iv) Spread margins.
Proposed § 39.13(g)(4)(i) would permit a DCO to allow reductions in initial margin requirements for related positions (spread margins), if the price risks with respect to such positions were significantly and reliably correlated. Under the proposed regulation, the price risks of different positions would only be considered to be reliably correlated if there was a theoretical basis for the correlation in addition to an exhibited statistical correlation. A non-exclusive list of possible theoretical bases includes the following: (A) The products on which the positions are based are complements of, or substitutes for, each other; (B) one product is a significant input into the other product(s); (C) the products share a significant common input; or (D) the prices of the products are influenced by common external factors. An example of such an external factor might be interest rates. An offset may not be based solely on the fact that the prices of certain products have exhibited a statistical correlation in the past
r-the-counter (OTC) products if there is no continuous liquid market or if bid-ask spreads are volatile. In these circumstances, DCOs would need to ensure that they would be able to measure their credit exposures accurately through the use of sound valuation models. The nature of such valuation models would necessarily depend on the particular products and the source of any relevant pricing data.
(vi) Daily review and back tests.
Daily review and periodic back testing are essential to enable a DCO to ensure that its margin models continue to provide adequate coverage of the DCO's risk exposures to its clearing members. Proposed § 39.13(g)(6) would require a DCO to determine the adequacy of its initial margin requirements for each product, on a daily basis, with respect to those products that are margined on a product basis. Proposed § 39.13(g)(7) would require a DCO to conduct certain back tests. The Commission has proposed to define “back test” in a separate rulemaking, as “a test that compares a derivatives clearing organization's initial margin requirements with historical price changes to determine the extent of actual margin coverage.” 41 Thus, the back tests required by proposed § 39.13(g)(7), which would require a comparison of initial margin requirements with historical price changes, are distinguished from the daily review required by proposed § 39.13(g)(6), which would require a determination of whether a margin breach had occurred on the particular day under review. For purposes of proposed § 39.13(g)(7)(i) and (ii), proposed § 39.13(g)(7) specifies that, in conducting back tests, a DCO would be required to use historical price change data based on a time period that is equivalent in length to the historic time period used by the applicable margin model for establishing the minimum 99% confidence level or a longer time period. The applicable time period is separately specified for the back tests required by proposed § 39.13(g)(7)(iii), as discussed below
ducting back tests, a DCO would be required to use historical price change data based on a time period that is equivalent in length to the historic time period used by the applicable margin model for establishing the minimum 99% confidence level or a longer time period. The applicable time period is separately specified for the back tests required by proposed § 39.13(g)(7)(iii), as discussed below.
41 See 75 FR at 77585 (proposing definitions in § 39.1(b), to be redesignated as § 39.2).
Proposed § 39.13(g)(7)(i) would require a DCO, on a daily basis, to conduct back tests with respect to products that are experiencing significant market volatility. Specifically, a DCO would be required to test the adequacy of its initial margin requirements and its spread margin requirements for such products that are margined on a product basis.
Proposed § 39.13(g)(7)(ii) would require a DCO, on at least a monthly basis, to conduct back tests to test the adequacy of its initial margin requirements and spread margin requirements for each product that is margined on a product basis. The Commission requests comment regarding whether initial margin requirements for all products should be subject to back tests on a monthly basis or whether some other time period, such as quarterly, would be sufficient to meet prudent risk management standards.
Proposed § 39.13(g)(7)(iii) would require a DCO, on at least a monthly basis, to conduct back tests to test the adequacy of its initial margin
(vii) Customer margin.
Proposed § 39.13(g)(8) addresses three different proposed requirements regarding customer margin, including the collection of gross margin for customer accounts, customer initial margin levels, and withdrawals of customer initial margin. 42
42 The Commission has proposed to define “customer initial margin” as “initial margin posted by a customer with a futures commission merchant, or by a non-clearing futures commission merchant with a clearing member.” See 75 FR at 77585 (proposing § 1.3(kkk)).
ding the collection of gross margin for customer accounts, customer initial margin levels, and withdrawals of customer initial margin. 42
42 The Commission has proposed to define “customer initial margin” as “initial margin posted by a customer with a futures commission merchant, or by a non-clearing futures commission merchant with a clearing member.” See 75 FR at 77585 (proposing § 1.3(kkk)).
(1) Gross margin for customer accounts.
Proposed § 39.13(g)(8)(i) would require a DCO to collect initial margin on a gross basis for each clearing member's customer account equal to the sum of the initial margin amounts that would be required by the DCO for each individual customer within that account if each individual customer were a clearing member. A DCO would not be permitted to net positions of different customers against one another, but it could collect initial margin for its clearing members' house accounts on a net basis.
The Commission recognizes that gross margining of customer accounts would be a change from current margin practices at certain DCOs. However, the Commission believes that gross margining of customer accounts would more appropriately address the risks posed to a DCO by its clearing members' customers than margining all of a particular clearing member's customer accounts on a net basis. Gross margining would increase the financial resources available to a DCO in the event of a customer default. Moreover, with respect to cleared swaps, the requirement for gross margining of customers' portfolios supports the requirement in proposed § 39.13(g)(2)(iii) that a DCO would have to margin each swap portfolio at a minimum 99% confidence level.
The Commission recently proposed a new § 39.19(c)(1)(iv) under which a DCO would be required, on a daily basis, to report the end-of-day positions for each clearing member, by origin
ared swaps, the requirement for gross margining of customers' portfolios supports the requirement in proposed § 39.13(g)(2)(iii) that a DCO would have to margin each swap portfolio at a minimum 99% confidence level.
The Commission recently proposed a new § 39.19(c)(1)(iv) under which a DCO would be required, on a daily basis, to report the end-of-day positions for each clearing member, by origin. 43 In connection with the proposed § 39.13(g)(8)(i) requirement for DCOs to collect initial margin for customer accounts on a gross basis, the Commission is proposing to amend proposed § 39.19(c)(1)(iv) to additionally require a DCO, for the customer origin, to report the gross positions of each beneficial owner.
43 See 75 FR at 78195.
(2) Customer initial margin requirements.
Proposed § 39.13(g)(8)(ii) would require a DCO to require its clearing members to collect customer initial margin from their customers for non-hedge positions at a level that is greater than 100% of the DCO's initial margin requirements with respect to each product and swap portfolio. Such a cushion would enable clearing members to deposit additional margin with a DCO on behalf of their customers, as necessitated by adverse market movements, without the need for the clearing members to make frequent margin calls to their customers.
Historically, DCMs have mandated the amounts of customer initial margin and maintenance margin that their FCM members must collect from their customers. 44 DCMs typically impose customer initial margin requirements that are higher, by a specified percentage, than the initial margin requirements imposed upon clearing FCMs by the relevant DCO, and maintenance margin requirements that are equivalent to the DCO's initial margin requirements. Customer initial margin requirements have typically been between 125% and 140% of a DCO's initial margin requirements.
44 “Maintenance margin” refers to an amount that must be maintained on deposit at all times
age, than the initial margin requirements imposed upon clearing FCMs by the relevant DCO, and maintenance margin requirements that are equivalent to the DCO's initial margin requirements. Customer initial margin requirements have typically been between 125% and 140% of a DCO's initial margin requirements.
44 “Maintenance margin” refers to an amount that must be maintained on deposit at all times. If the equity in a customer's account drops below the level of maintenance margin because of adverse price movement, the FCM must issue a margin call to restore the customer's equity to the customer initial margin level.
The Commission believes that DCOs should determine how much margin their FCM clearing members must collect from their customers because a DCO must ensure that its clearing members are able to meet their obligations to the DCO. Moreover, although it may be appropriate for a DCM to determine the customer initial margin requirements for non-clearing FCM members of the DCM, with respect to products traded on the DCM, a DCO may be the only entity in a position to assume any responsibility for setting customer initial margin requirements for cleared swaps that may be traded on SEFs or executed bilaterally.
Proposed § 39.13(g)(8)(ii) would permit a DCO to have reasonable discretion in determining the percentage by which customer initial margins would have to exceed the DCO's initial margin requirements with respect to particular products or swap portfolios. A DCO would be familiar with the risk characteristics of particular products and swap portfolios that it clears, which should enable it to determine the extent of the cushion that a clearing member should have with respect to customer initial margins. However, under the proposed regulation, the Commission may review such percentage levels and require different percentage levels, but not specific margin amounts, if the Commission deems the levels insufficient to protect the financial integrity of the clearing members or the DCO
it to determine the extent of the cushion that a clearing member should have with respect to customer initial margins. However, under the proposed regulation, the Commission may review such percentage levels and require different percentage levels, but not specific margin amounts, if the Commission deems the levels insufficient to protect the financial integrity of the clearing members or the DCO.
The customer initial margin requirement set forth in proposed § 39.13(g)(8)(ii) would only apply with respect to customers' non-hedge positions. Hedge margins are typically equal to maintenance margins.
(3) Withdrawal of customer initial margin.
Proposed § 39.13(g)(8)(iii) would require a DCO to require its clearing members to prohibit their customers from withdrawing funds from their accounts with such clearing members unless the net liquidating value plus the margin deposits remaining in the customer's account after the withdrawal would be sufficient to meet the customer initial margin requirements with respect to the products or portfolios in the customer's account, which were cleared by the DCO. This is consistent with the definition of “Margin Funds Available for Disbursement” in the Margins Handbook prepared by the Joint Audit Committee 45 and, therefore, codifies current practices.
45 See http;//www.nfa.futures.org/NFA-compliance/publication-library/margins-handbook.pdf.
(viii) Time deadlines.
Proposed § 39.13(g)(9) would require a DCO to establish and enforce time deadlines for initial and variation margin payments. If margin payments are not made on time, DCOs and clearing members face uncollateralized risk.
(g) Other Risk Control Mechanisms
ies current practices.
45 See http;//www.nfa.futures.org/NFA-compliance/publication-library/margins-handbook.pdf.
(viii) Time deadlines.
Proposed § 39.13(g)(9) would require a DCO to establish and enforce time deadlines for initial and variation margin payments. If margin payments are not made on time, DCOs and clearing members face uncollateralized risk.
(g) Other Risk Control Mechanisms
(i) Risk limits.
Proposed § 39.13(h)(1)(i) would require a DCO to impose risk limits on each clearing member, by customer origin and house origin, in order to prevent a clearing member from carrying positions where the risk exposure of those positions exceeds a threshold set by the DCO relative to the clearing member's financial resources, the DCO's financial resources, or both. The DCO would have reasonable discretion in determining: (A) the method of computing risk exposure; (B) the applicable threshold(s); and (C) the applicable financial resources, provided however, that the ratio of exposure to capital would have to remain the same across all capital levels. The Commission could review any of these determinations and require different methods, thresholds, or financial resources, as appropriate.
Proposed § 39.13(h)(1)(ii) would allow a DCO to permit a clearing member to exceed the threshold(s) applied pursuant to paragraph (h)(1)(i) provided that the DCO required the clearing member to post additional initial margin that the DCO deemed sufficient to appropriately eliminate excessive risk exposure at the clearing member. The Commission could review the amount of additional initial margin and require a different amount, as appropriate.
permit a clearing member to exceed the threshold(s) applied pursuant to paragraph (h)(1)(i) provided that the DCO required the clearing member to post additional initial margin that the DCO deemed sufficient to appropriately eliminate excessive risk exposure at the clearing member. The Commission could review the amount of additional initial margin and require a different amount, as appropriate.
(ii) Large trader reports.
Proposed § 39.13(h)(2) would require a DCO to obtain from its clearing members, copies of all reports that such clearing members were required to file with the Commission pursuant to part 17 of the Commission's regulations, i.e., large trader reports. A DCO would be required to obtain such reports directly from the relevant reporting market if the reporting market exclusively listed self-cleared contracts, and were therefore required to file such reports on behalf of clearing members, pursuant to § 17.00(i).
Proposed § 39.13(h)(2) would require a DCO to review the large trader reports that it received from its clearing members, or reporting markets, as applicable, on a daily basis to ascertain the risk of the overall portfolio of each large trader. A DCO would be required to review large trader positions for each large trader, across all clearing members carrying an account for the large trader. A DCO would also be required to take additional actions with respect to such clearing members in order to address any risks posed by a large trader, when appropriate. Such actions would include actions specified in proposed § 39.13(h)(6), as discussed in section II.B.2(g)(vi) below.
large trader positions for each large trader, across all clearing members carrying an account for the large trader. A DCO would also be required to take additional actions with respect to such clearing members in order to address any risks posed by a large trader, when appropriate. Such actions would include actions specified in proposed § 39.13(h)(6), as discussed in section II.B.2(g)(vi) below.
(iii) Stress tests.
Proposed § 39.13(h)(3) would require a DCO to conduct certain daily and weekly stress tests. The Commission has proposed to define “stress test” in a separate rulemaking, as “a test that compares the impact of a potential price move, change in option volatility, or change in other inputs that affect the value of a position, to the financial resources of a derivatives clearing organization, clearing member, or large trader, to determine the adequacy of such financial resources.” 46 The Commission has not proposed a definition of financial resources in this context, although it would be expected to include, at a minimum, margin on deposit, and with respect to a clearing member, its capital.
46 See 75 FR at 77585-86 (proposing definitions in § 39.1(b), to be redesignated as § 39.2).
Proposed § 39.13(h)(3) would require a DCO to conduct certain types of stress tests with respect to certain large traders on a daily basis and with respect to all clearing member accounts and swap portfolios on at least a weekly basis.
Proposed § 39.13(h)(3)(i) would require a DCO to conduct daily stress tests with respect to each large trader who poses significant risk to a clearing member or the DCO in the event of default, including positions at all clearing members carrying accounts for the large trader. The DCO would have reasonable discretion in determining which traders to test and the methodology used to conduct the stress tests. However, the Commission could review the selection of accounts and the methodology and require changes, as appropriate
ant risk to a clearing member or the DCO in the event of default, including positions at all clearing members carrying accounts for the large trader. The DCO would have reasonable discretion in determining which traders to test and the methodology used to conduct the stress tests. However, the Commission could review the selection of accounts and the methodology and require changes, as appropriate.
Proposed § 39.13(h)(3)(ii) would require a DCO to conduct stress tests, at least once a week with respect to each account held by a clearing member at the DCO, by customer origin and house origin, and each swap portfolio, by beneficial owner, under extreme but plausible market conditions. The DCO would have reasonable discretion in determining the methodology used to conduct these stress tests. However, the Commission may review the methodology and require any appropriate changes. The Commission requests comment regarding whether all clearing member accounts, by origin, and all swap portfolios should be subject to such stress tests on a weekly basis or whether some other time period, such as monthly, would be sufficient to meet prudent risk management standards.
(iv) Portfolio compression.
Proposed § 39.13(h)(4)(i) would require a DCO to offer multilateral portfolio compression exercises, on a regular basis, for its clearing members that clear swaps, to the extent that such exercises are appropriate for those swaps that it clears. The Commission has not specified the frequency with which DCOs must offer multilateral portfolio compression exercises in proposed § 39.13(h)(4)(i), other than to state that they would have to be offered on a regular basis. The Commission requests comment regarding whether such exercises should be offered monthly, quarterly, or another frequency. In addition, the Commission requests comment regarding whether the frequency of such exercises should vary for different categories of swaps
rtfolio compression exercises in proposed § 39.13(h)(4)(i), other than to state that they would have to be offered on a regular basis. The Commission requests comment regarding whether such exercises should be offered monthly, quarterly, or another frequency. In addition, the Commission requests comment regarding whether the frequency of such exercises should vary for different categories of swaps.
Under proposed § 39.13(h)(4)(ii), a DCO must require its clearing members to participate in all multilateral portfolio compression exercises offered by the DCO, to the extent that any swap in the applicable portfolio is eligible for inclusion in the exercise, unless including the swap would be reasonably likely to significantly increase the risk exposure of the clearing member. Proposed § 39.13(h)(4)(iii) would permit a DCO to allow clearing members participating in such exercises to set risk tolerance limits for their portfolios, provided that the clearing member could not set such risk tolerances at an unreasonable level or use such risk tolerances to evade the requirements of proposed § 39.13(h)(4).
(v) Clearing members' risk management policies and procedures.
The Commission believes that in order for a DCO to adequately manage its own risks, it must ensure that its clearing members also have adequate risk management policies and procedures. In order to do this, a DCO must have the authority to obtain documents and information from its clearing members regarding such policies and procedures, and must review their implementation on a periodic basis.
Proposed § 39.13(h)(5) would impose several requirements upon DCOs relating to their clearing members' risk management policies and procedures
ate risk management policies and procedures. In order to do this, a DCO must have the authority to obtain documents and information from its clearing members regarding such policies and procedures, and must review their implementation on a periodic basis.
Proposed § 39.13(h)(5) would impose several requirements upon DCOs relating to their clearing members' risk management policies and procedures. Specifically, a DCO must adopt rules that: (a) Require its clearing members to maintain current written risk management policies and procedures; (b) ensure that the DCO has the authority to request and obtain information and documents from its
Proposed § 39.13(h)(5) does not define how DCOs would have to conduct clearing member risk management reviews, and has not specified a required frequency of such reviews except to state that they would have to be conducted on a periodic basis. The Commission invites comment regarding whether it should require that a DCO must conduct risk reviews of its clearing members on an annual basis or within some other time frame. The Commission also requests comment regarding whether the Commission should require that such reviews be conducted in a particular manner, e.g., whether there must be an on-site visit or whether any particular testing should be required. In addition, the Commission invites comment regarding whether, and to what extent, a DCO should be permitted to vary the method and depth of such reviews based upon the nature, risk profiles, or other regulatory supervision of particular clearing members.
The risk management reviews contemplated by proposed § 39.13(h)(5) would also support DCOs' compliance with Core Principle C and proposed § 39.12, by providing a means for the DCO and the Commission to ensure that clearing members continue to meet participation requirements relating to risk management.
on the nature, risk profiles, or other regulatory supervision of particular clearing members.
The risk management reviews contemplated by proposed § 39.13(h)(5) would also support DCOs' compliance with Core Principle C and proposed § 39.12, by providing a means for the DCO and the Commission to ensure that clearing members continue to meet participation requirements relating to risk management.
(vi) Additional authority.
Proposed § 39.13(h)(6) would require a DCO to take additional actions with respect to particular clearing members, when appropriate, based on the application of objective and prudent risk management standards. Such actions would include, but would not be limited to: (i) Imposing enhanced capital requirements; (ii) imposing enhanced margin requirements; (iii) imposing position limits; (iv) prohibiting an increase in positions; (v) requiring a reduction of positions; (vi) liquidating or transferring positions; and (vii) suspending or revoking clearing membership. The Commission believes that a DCO should have the authority to take any of the specified actions or other appropriate actions, and should take such actions, when necessary to address risks posed to the DCO by particular clearing members or their customers. However, a DCO would have the discretion to determine when to take additional actions, and what actions to take, based on its exercise of objective and prudent risk management standards.
3
he authority to take any of the specified actions or other appropriate actions, and should take such actions, when necessary to address risks posed to the DCO by particular clearing members or their customers. However, a DCO would have the discretion to determine when to take additional actions, and what actions to take, based on its exercise of objective and prudent risk management standards.
3. Settlement Procedures
Core Principle E, as amended by the Dodd-Frank Act, 47 requires a DCO to: (a) Complete money settlements on a timely basis, but not less frequently than once each business day; (b) employ money settlement arrangements to eliminate or strictly limit its exposure to settlement bank risks (including credit and liquidity risks from the use of banks to effect money settlements); (c) ensure that money settlements are final when effected; (d) maintain an accurate record of the flow of funds associated with money settlements; (e) possess the ability to comply with the terms and conditions of any permitted netting or offset arrangement with another clearing organization; (f) establish rules that clearly state each obligation of the DCO with respect to physical deliveries; and (g) ensure that it identifies and manages each risk arising from any of its obligations with respect to physical deliveries. 48 The Commission is proposing to adopt § 39.14 to establish requirements that a DCO would have to meet in order to comply with Core Principle E.
47 Section 5b(c)(2)(E) of the CEA; 7 U.S.C. 7a-1(c)(2)(E) (Core Principle E).
48 Prior to amendment by the Dodd-Frank Act, Core Principle E provided that [t]he applicant shall have the ability to—
its obligations with respect to physical deliveries. 48 The Commission is proposing to adopt § 39.14 to establish requirements that a DCO would have to meet in order to comply with Core Principle E.
47 Section 5b(c)(2)(E) of the CEA; 7 U.S.C. 7a-1(c)(2)(E) (Core Principle E).
48 Prior to amendment by the Dodd-Frank Act, Core Principle E provided that [t]he applicant shall have the ability to—
(i) complete settlements on a timely basis under varying circumstances;
(ii) maintain an adequate record of the flow of funds associated with each transaction that the applicant clears; and
(iii) comply with the terms and conditions of any permitted netting or offset arrangements with other clearing organizations.
Proposed § 39.14(a) would define “settlement” and “settlement bank” for purposes of § 39.14. In particular, “settlement” is defined in proposed § 39.14(a)(1) to include: (i) Payment and receipt of variation margin for futures, options and swap positions; (ii) payment and receipt of option premiums; (iii) deposit and withdrawal of initial margin for futures, options and swap positions; (iv) all payments due in final settlement of futures, options and swap positions on the final settlement date with respect to such positions; and (v) all other cash flows collected from or paid to each clearing member, including but not limited to, payments related to swaps such as coupon amounts. “Settlement bank” is defined in proposed § 39.14(a)(2) as “a bank that maintains an account either for the [DCO] or for any of its clearing members, which is used for the purpose of transferring funds and receiving transfers of funds in connection with settlements with the [DCO].”
from or paid to each clearing member, including but not limited to, payments related to swaps such as coupon amounts. “Settlement bank” is defined in proposed § 39.14(a)(2) as “a bank that maintains an account either for the [DCO] or for any of its clearing members, which is used for the purpose of transferring funds and receiving transfers of funds in connection with settlements with the [DCO].”
(a) Daily settlements.
The daily settlement of financial obligations arising from the addition of new positions and price changes with respect to all open positions is an essential element of the clearing process at a DCO. Proposed § 39.14(b) would require a DCO to effect a settlement with each clearing member at least once each business day, and to have the authority and operational capacity to effect a settlement with each clearing member, on an intraday basis, either routinely, when thresholds specified by the DCO were breached, or in times of extreme market volatility.
Proposed § 39.14(b) would permit DCOs to exercise their discretion regarding whether they would effect routine intraday settlements or whether they would settle positions on an intraday basis only when certain thresholds were breached or in times of extreme market volatility. Moreover, a DCO would have the discretion to establish any relevant thresholds and to define extreme market volatility in the context of the products and portfolios that it clears. These provisions are consistent with international recommendations. 49
49 See CPSS-IOSCO Recommendations, pg. 21; EMIR, Article 39, paragraph 3, pg. 46.
esholds were breached or in times of extreme market volatility. Moreover, a DCO would have the discretion to establish any relevant thresholds and to define extreme market volatility in the context of the products and portfolios that it clears. These provisions are consistent with international recommendations. 49
49 See CPSS-IOSCO Recommendations, pg. 21; EMIR, Article 39, paragraph 3, pg. 46.
(b) Settlement banks.
A DCO generally requires its clearing members to effect settlement through one of a specified set of settlement banks. In addition, a DCO itself often has a lead, concentration, or central settlement bank.
Proposed § 39.14(c) would set forth three specific requirements in furtherance of the general requirement that DCOs must employ settlement arrangements to eliminate or strictly limit their exposure to settlement bank risks. First, proposed § 39.14(c)(1) would require a DCO to have documented criteria for those banks that it would use, and that it would permit its clearing members to use, as settlement banks, including criteria addressing the capitalization, creditworthiness, access to liquidity, operational reliability, and regulation or supervision of such banks. Second, proposed § 39.14(c)(2) would require a DCO to monitor each approved 50 and assess its own and its clearing members' potential losses and liquidity pressures in the event that the settlement bank with the largest share of settlement activity were to fail. If action were reasonably necessary in order to eliminate or strictly limit exposures to settlement banks, a DCO would be required to: (i) Maintain settlement accounts at additional settlement banks; (ii) approve additional settlement banks for use by its clearing members; (iii) impose concentration limits with respect to its own or its clearing members' settlement banks; and/or (iv) take any other appropriate actions
ably necessary in order to eliminate or strictly limit exposures to settlement banks, a DCO would be required to: (i) Maintain settlement accounts at additional settlement banks; (ii) approve additional settlement banks for use by its clearing members; (iii) impose concentration limits with respect to its own or its clearing members' settlement banks; and/or (iv) take any other appropriate actions. The determination of whether any such actions were necessary would be left to the discretion of the DCO in the first instance, but such determination would have to be reasonable.
50 A DCO may have multiple exposures to a settlement bank, e.g., if the bank is also a clearing member or extends a credit facility funding arrangement to the DCO.
(c) Settlement finality.
Proposed § 39.14(d) would require that a DCO must ensure that settlement fund transfers are irrevocable and unconditional when the DCO's accounts are debited or credited. In addition, the proposed regulation would require that a DCO's legal agreements with its settlement banks would have to state clearly when settlement fund transfers would occur and a DCO would have to routinely confirm that its settlement banks were effecting fund transfers as and when required by those legal agreements.
(d) Recordkeeping.
Proposed § 39.14(e) would incorporate Core Principle E's requirement that a DCO must maintain an accurate record of the flow of funds associated with each settlement. 51
51 Section 5b(c)(2)(E)(iv) of the CEA; 7 U.S.C. 7a-1(c)(2)(E)(iv).
(e) Netting arrangements.
Proposed § 39.14(f) would incorporate Core Principle E's requirement that a DCO must possess the ability to comply with each term and condition of any permitted netting or offset arrangement with any other clearing organization. 52
52 Section 5b(c)(2)(E)(v) of the CEA; 7 U.S.C. 7a-1(c)(2)(E)(v).
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51 Section 5b(c)(2)(E)(iv) of the CEA; 7 U.S.C. 7a-1(c)(2)(E)(iv).
(e) Netting arrangements.
Proposed § 39.14(f) would incorporate Core Principle E's requirement that a DCO must possess the ability to comply with each term and condition of any permitted netting or offset arrangement with any other clearing organization. 52
52 Section 5b(c)(2)(E)(v) of the CEA; 7 U.S.C. 7a-1(c)(2)(E)(v).
(f) Physical delivery.
Proposed § 39.14(g) would set forth requirements with respect to contracts, agreements, and transactions that are settled by physical transfers of the underlying instruments or commodities. In particular, the proposed regulation would require a DCO to establish rules clearly stating each obligation that the DCO has assumed with respect to physical deliveries, including whether it has an obligation to make or receive delivery of a physical instrument or commodity, or whether it indemnifies clearing members for losses incurred in the delivery process, and to ensure that the risks of each such obligation are identified and managed. Proposed § 39.14(g) would not require DCOs to assume any particular obligations in connection with physical deliveries, in recognition of the fact that DCOs would need to determine what, if any, obligations to assume on a product-specific basis, in the exercise of prudent risk management standards.
4. Treatment of Funds
Core Principle F, as amended by the Dodd-Frank Act, 53 requires a DCO to:(a) Establish standards and procedures that are designed to protect and ensure the safety of its clearing members' funds and assets; (b) hold such funds and assets in a manner by which to minimize the risk of loss or of delay in the DCO's access to the assets and funds; and (c) only invest such funds and assets in instruments with minimal credit, market, and liquidity risks. 54 The Commission is proposing to adopt § 39.15 to establish requirements that a DCO would have to meet in order to comply with Core Principle F.
53 Section 5b(c)(2)(F) of the CEA; 7 U.S.C
manner by which to minimize the risk of loss or of delay in the DCO's access to the assets and funds; and (c) only invest such funds and assets in instruments with minimal credit, market, and liquidity risks. 54 The Commission is proposing to adopt § 39.15 to establish requirements that a DCO would have to meet in order to comply with Core Principle F.
53 Section 5b(c)(2)(F) of the CEA; 7 U.S.C. 7a-1(c)(2)(F) (Core Principle F).
54 Prior to amendment by the Dodd-Frank Act, Core Principle F provided that “[t]he applicant shall have standards and procedures designed to protect and ensure the safety of member and participant funds.”
(a) Required standards and procedures.
Proposed § 39.15(a) would require a DCO to establish standards and procedures that are designed to protect and ensure the safety of funds and assets belonging to clearing members and their customers. 55
55 Such “assets” would include any securities or property that clearing members deposit with a DCO in order to satisfy initial margin obligations, which are also sometimes referred to as “collateral.” Proposed § 39.15 uses the term “assets” rather than “securities or property” or “collateral” in order to be consistent with the statutory language.
(b) Segregation of funds and assets.
Proposed § 39.15(b)(1) would require a DCO to comply with the segregation requirements of section 4d of the CEA and Commission regulations thereunder, or any other applicable Commission regulation or order requiring that customer funds and assets be segregated, set aside, or held in a separate account. The Commission has included this language because it is an essential element of the standards and procedures described in proposed § 39.15(a). However, proposed § 39.15(b)(1) would not impose any new requirements on DCOs that are in addition to those required by section 4d of the CEA and those that are currently required, or may in the future be required, by applicable Commission regulations or orders
Commission has included this language because it is an essential element of the standards and procedures described in proposed § 39.15(a). However, proposed § 39.15(b)(1) would not impose any new requirements on DCOs that are in addition to those required by section 4d of the CEA and those that are currently required, or may in the future be required, by applicable Commission regulations or orders.
Proposed § 39.15(b)(2)(i) would permit a DCO to commingle, and a DCO to permit clearing member FCMs to commingle, customer positions in futures, options on futures, and swaps, and any money, securities, or property received to margin, guarantee, or secure such positions, in an account subject to the requirements of section 4d(f) of the CEA (cleared swap account), pursuant to DCO rules that have been approved by the Commission under § 40.5 of the Commission's regulations. The proposed regulation would establish minimum informational requirements for such rule submissions, consistent with the informational requirements the Commission has previously imposed upon petitioners requesting orders under section 4d of the CEA.
The rule filing would have to be submitted electronically to the Commission, in the form and manner required by the Commission, and would have to include, at a minimum, the following: (A) An identification of the futures, options on futures, and swaps that would be commingled, including contract specifications or the criteria that would be used to define eligible futures, options on futures, and swaps; (B) an analysis of the risk characteristics of the eligible products; (C) a description of whether the swaps would be executed bilaterally and/or executed on a DCM and/or a SEF; (D) an analysis of the liquidity of the respective markets for the futures, options on futures, and swaps that would be commingled, the ability of clearing members and the DCO to offset or mitigate the risks of such products in a timely manner, without compromising the financial integrity of the account, and, as appropriate, prop
would be executed bilaterally and/or executed on a DCM and/or a SEF; (D) an analysis of the liquidity of the respective markets for the futures, options on futures, and swaps that would be commingled, the ability of clearing members and the DCO to offset or mitigate the risks of such products in a timely manner, without compromising the financial integrity of the account, and, as appropriate, proposed means for addressing insufficient liquidity; (E) an analysis of the availability of reliable prices for each of the eligible products; (F) a description of the financial, operational, and managerial standards or requirements for clearing members that would be permitted to commingle the eligible products; (G) a description of the systems and procedures that would be used by the DCO to oversee such clearing members' risk management of the commingled positions; (H) a 56 (J) an analysis of the ability of the DCO to manage a potential default with respect to any of the commingled products; (K) a discussion of the procedures that the DCO would follow if a clearing member defaulted, and the procedures that a clearing member would follow if a customer defaulted, with respect to any of the commingled products; and (L) a description of the arrangements for obtaining daily position data from each beneficial owner of the commingled products.
56 See supra section II.B.2.f.ii of this notice, discussing the minimum liquidation time of five business days for margining cleared swaps that are not executed on a DCM.
Proposed § 39.15(b)(2)(ii) addresses situations where customer positions in futures, options on futures, and cleared swaps could be carried in a futures account subject to section 4d(a) of the CEA. In recent years, the Commission, in its discretion, has issued orders permitting cleared swaps to be carried in a futures account, on a case-by-case basis
cleared swaps that are not executed on a DCM.
Proposed § 39.15(b)(2)(ii) addresses situations where customer positions in futures, options on futures, and cleared swaps could be carried in a futures account subject to section 4d(a) of the CEA. In recent years, the Commission, in its discretion, has issued orders permitting cleared swaps to be carried in a futures account, on a case-by-case basis. 57 Proposed § 39.15(b)(2)(ii) would incorporate the informational requirements of proposed § 39.15(b)(2)(i), but would still require that the Commission issue an order granting permission to commingle customer positions in futures, options on futures, and swaps in a futures account.
57 See supra n.38.
Proposed § 39.15(b)(2)(iii)(A) would provide that the Commission may request additional information in support of a rule submission and it may approve the rules in accordance with § 40.5. 58 Proposed § 39.15(b)(2)(iii)(B) would provide that the Commission may request additional information in support of a petition and it may issue an order under section 4d of the CEA in its discretion.
58 Rules submitted for prior approval would be approved unless the rule is inconsistent with the CEA or the Commission's regulations. See section 5c(c)(5) of the CEA; 7 U.S.C. 7a-2(c)(5); and 75 FR at 67295.
In the case of a rule approval under § 39.15(b)(2)(i), as well as the issuance of an order under § 39.15(b)(2)(ii), the Commission would take action pursuant to section 4d of the CEA (permitting commingling) and section 4(c) of the CEA (exempting the DCO and clearing members from the requirement to hold customer positions in a particular account, as applicable, 4d(a) or 4d(f)). 59
59 7 U.S.C. 6(c). See infra section IV. (further discussing the 4(c) exemption and requesting comment).
The Commission requests comment on whether it should take the same approach (rule submission or petition for an order) with respect to the futures account and the cleared swap account and, if so, what that approach should be
sitions in a particular account, as applicable, 4d(a) or 4d(f)). 59
59 7 U.S.C. 6(c). See infra section IV. (further discussing the 4(c) exemption and requesting comment).
The Commission requests comment on whether it should take the same approach (rule submission or petition for an order) with respect to the futures account and the cleared swap account and, if so, what that approach should be. In addition, the Commission requests comment on whether the enumerated informational requirements fully capture the relevant considerations for making a determination on either rule approval or the granting of an order, and whether the Commission's analysis should take into consideration the type of account in which the positions would be carried, the particular type of products that would be involved, or the financial resources of the clearing members that would hold such accounts. The Commission further requests comment on what, if any, additional or heightened requirements should be imposed to manage the increased risks introduced to a futures account that also holds cleared swaps.
(c) Holding of funds and assets.
Proposed § 39.15(c) would require that a DCO must hold funds and assets belonging to clearing members and their customers in a manner that minimizes the risk of loss or of delay in the DCO's access to those funds and assets. In furtherance of this objective, the Commission has proposed certain requirements addressing types of assets that a DCO may accept, the valuation of such assets, applicable haircuts, concentration limits, and requirements that would apply if assets were pledged to a DCO but were held in the name of a clearing member, as described below.
or of delay in the DCO's access to those funds and assets. In furtherance of this objective, the Commission has proposed certain requirements addressing types of assets that a DCO may accept, the valuation of such assets, applicable haircuts, concentration limits, and requirements that would apply if assets were pledged to a DCO but were held in the name of a clearing member, as described below.
(i) Types of assets.
Proposed § 39.15(c)(1) would require a DCO to limit the assets it accepts as initial margin to those that have minimal credit, market, and liquidity risks. The proposed regulation would also state that a DCO may not accept letters of credit as initial margin. The Commission has not specified the assets that a DCO may accept, and with the exception of letters of credit, it has not specified the assets that a DCO may not accept. In general, proposed § 39.15(c)(1) would set forth the criteria of minimal credit, market, and liquidity risks and would leave it to the discretion of each DCO to determine which assets the DCO would accept, subject to their meeting those criteria. The Commission has proposed to prohibit the acceptance of letters of credit because they are unfunded financial resources with respect to which funds might be unavailable when most needed. The Commission expects that DCOs would continue their current practice of re-evaluating the types of assets that they would accept as initial margin as necessitated by changes in market conditions that could affect the credit, market, and liquidity risks of those assets.
ters of credit because they are unfunded financial resources with respect to which funds might be unavailable when most needed. The Commission expects that DCOs would continue their current practice of re-evaluating the types of assets that they would accept as initial margin as necessitated by changes in market conditions that could affect the credit, market, and liquidity risks of those assets.
(ii) Valuation.
Proposed § 39.15(c)(2) would require a DCO to use prudent valuation practices to value assets posted as initial margin on a daily basis. The Commission has not specified what such valuation practices should entail, as the nature of the valuations would depend on the nature of the particular assets. However, whatever method would be used to determine the value of margin assets, it is crucial that such assets be valued daily, because a DCO cannot evaluate the adequacy of margin coverage on a daily basis without knowing the value of the assets that are components of the margin on deposit. Such daily valuation of margin assets is currently the standard practice of DCOs.
(iii) Haircuts.
Proposed § 39.15(c)(3) would require a DCO to apply appropriate reductions in value to reflect the market and credit risk of the assets that it accepts in satisfaction of initial margin obligations. Such reductions are known as haircuts, and DCOs currently apply haircuts to the margin assets that they accept as initial margin. Haircuts are designed to mitigate the potential future exposure that could result from potential changes in the value of particular assets.
Haircut levels would be dependent on the nature of the particular assets. DCOs would be required to calculate their haircuts taking into account stressed market conditions. Incorporating stressed market conditions into the calculation of haircuts can limit the effects of procyclicality, which refers to changes that are positively correlated with business or credit cycle fluctuations and that may cause or exacerbate financial instability
nature of the particular assets. DCOs would be required to calculate their haircuts taking into account stressed market conditions. Incorporating stressed market conditions into the calculation of haircuts can limit the effects of procyclicality, which refers to changes that are positively correlated with business or credit cycle fluctuations and that may cause or exacerbate financial instability. 60 In
60 While changes in collateral values tend to be procyclical, collateral arrangements can increase procyclicality if haircut levels fall during periods of low-market stress and increase during periods of high-market stress. For example, in a stressed market, if a DCO required the posting of additional collateral due to both the decline of asset prices and an increase in haircut levels, it could exacerbate market stress and drive down asset prices further, resulting in additional collateral requirements. This cycle could exert further downward pressure on asset prices in already stressed markets. To limit the effects of this procyclicality, a DCO should establish stable and conservative haircuts that are calibrated to include periods of stressed market conditions.
(iv) Concentration limits.
Proposed § 39.15(c)(4) would require a DCO to apply appropriate limitations on the concentration of assets posted as initial margin, as necessary, in order to ensure the DCO's ability to liquidate those assets quickly with minimal adverse price effects. Any concentration limits would be set by the DCO, in its discretion, depending on the nature of the assets. The proposed regulation would require a DCO to evaluate the appropriateness of its concentration limits, on at least a monthly basis.
of assets posted as initial margin, as necessary, in order to ensure the DCO's ability to liquidate those assets quickly with minimal adverse price effects. Any concentration limits would be set by the DCO, in its discretion, depending on the nature of the assets. The proposed regulation would require a DCO to evaluate the appropriateness of its concentration limits, on at least a monthly basis.
(v) Pledged assets.
Some DCOs permit their clearing members to pledge assets for initial margin while retaining those assets in accounts in the names of the pledging clearing members. Proposed § 39.15(c)(5) would require that if such pledged assets were held in an account in the name of a clearing member, the DCO would have to ensure that the assets were unencumbered and that the pledge had been validly created and validly perfected in the relevant jurisdiction, in order to ensure that the DCO had immediate access to those assets.
(d) Permissible investments.
Proposed § 39.15(d) would require that clearing members' funds and assets that are invested by a DCO must be held in instruments with minimal credit, market, and liquidity risks. 61 The proposed regulation further adds that any investment of customer funds or assets by a DCO would have to comply with § 1.25 of the Commission's regulations, which itself is designed to ensure that such investments would be subject to minimal credit, market, and liquidity risks. Moreover, the proposed regulation would apply the limitations contained in § 1.25 to all customer funds a

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Source: Frix Law Library, https://www.frixlaw.com/law-library/statutes/FR_PRORULE_2011-690. Check the current official text before relying on it. Not legal advice.