Requirements for Derivatives Clearing Organizations, Designated Contract Markets, and Swap Execution Facilities Regarding the Mitigation of Conflicts of Interest, 63732-63753 [2010-26220]

Agencies

• Commodity Futures Trading Commission

[Federal Register Volume 75, Number 200 (Monday, October 18, 2010)]
[Proposed Rules]
[Pages 63732-63753]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2010-26220]


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COMMODITY FUTURES TRADING COMMISSION

17 CFR Parts 1, 37, 38, 39, and 40

RIN 3038-AD01


Requirements for Derivatives Clearing Organizations, Designated 
Contract Markets, and Swap Execution Facilities Regarding the 
Mitigation of Conflicts of Interest

AGENCY: Commodity Futures Trading Commission.

ACTION: Notice of proposed rulemaking.

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SUMMARY: The Commodity Futures Trading Commission (the ``Commission'') 
hereby proposes rules to implement new statutory provisions enacted by 
Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection 
Act (the ``Dodd-Frank Act''). Specifically, the proposed rules 
contained herein impose new requirements on derivatives clearing 
organizations (``DCOs''), designated contract markets (``DCMs''), and 
swap execution facilities (``SEFs'') with respect to mitigation of 
conflicts of interest.

DATES: Submit comments on or before November 17, 2010.

ADDRESSES: You may submit comments, identified by RIN number, by any of 
the following methods:
     Federal eRulemaking Portal: https://www.regulations.gov. 
Follow the instructions for submitting comments.
     Agency Web Site: https://www.cftc.gov. Follow the 
instructions for submitting comments on the Web site.
     E-mail: dcodcmsefGovernance@cftc.gov.
     Fax: 202-418-5521.
     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.

FOR FURTHER INFORMATION CONTACT: Nancy Liao Schnabel, Special Counsel, 
Division of Clearing and Intermediary Oversight (DCIO), at 202-418-5344 
or nschnabel@cftc.gov; Lois Gregory, Assistant Deputy Director for 
Market Review, the Division of Market Oversight (DMO), at 202-418-5569 
or lgregory@cftc.gov; Andrea Musalem, Special Counsel, DCIO, at 202-
418-5167 or amusalem@cftc.gov; Jordan O'Regan, Attorney-Advisor, DCIO, 
at 202-418-5984 or joregan@cftc.gov; Cody Alvarez, Attorney-Advisor, 
DMO, at 202-418-5404 or calvarez@cftc.gov; Dana Brown, Law Clerk, DMO, 
at 202-418-5093 or dbrown@cftc.gov; Jolanta Sterbenz, Counsel, Office 
of the General Counsel, at 202-418-6639 or jsterbenz@cftc.gov; David 
Reiffen, Senior Economist, Office of the Chief Economist, at 202-418-
5602 or dreiffen@cftc.gov; or Alicia Lewis, Attorney-Advisor, DCIO, at 
202-418-5862 or alewis@cftc.gov; in each case, also at the Commodity 
Futures Trading Commission, Three Lafayette Centre, 1155 21st Street, 
NW., Washington, DC 20581.

SUPPLEMENTARY INFORMATION:

I. Background

    On July 21, 2010, President Obama signed the Dodd-Frank Act.\1\ 
Title VII of the Dodd-Frank Act \2\ amended the Commodity Exchange Act 
(``CEA'') \3\ to establish a comprehensive new regulatory framework for 
swaps and certain security-based swaps. The legislation was enacted to 
reduce risk, increase transparency, and promote market integrity within 
the financial system by, among other things: (i) Providing for the 
registration and comprehensive regulation of swap dealers and major 
swap participants; \4\ (ii) imposing mandatory clearing and trade 
execution requirements on clearable swap contracts; (iii) creating 
robust recordkeeping and real-time reporting regimes; and (iv) 
enhancing the rulemaking and enforcement authorities of the Commission 
with respect to, among others, all registered entities and 
intermediaries subject to the oversight of the Commission.
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    \1\ See Dodd-Frank Act, Pub. L. 111-203, 124 Stat. 1376 (2010). 
The text of the Dodd-Frank Act may be accessed at https://www.cftc.gov./LawRegulation/OTCDERIVATIVES/index.htm.
    \2\ Pursuant to Section 701 of the Dodd-Frank Act, Title VII may 
be cited as the ``Wall Street Transparency and Accountability Act of 
2010.''
    \3\ 7 U.S.C. 1 et seq.
    \4\ In this release, the terms ``swap dealer'' and ``major swap 
participant'' shall have the meanings set forth in Section 721(a) of 
the Dodd-Frank Act, which added Sections 1a(49) and (33) of the CEA. 
However, Section 721(c) of the Dodd-Frank Act directs the Commission 
to promulgate rules to further define, among other terms, ``swap 
dealer'' and ``major swap participant.'' The Commission is in the 
process of this rulemaking. See, e.g., https://www.cftc.gov/LawRegulation/OTCDerivatives/OTC_2_Definitions.html. The 
Commission anticipates that such rulemaking will be completed by the 
statutory deadline of July 15, 2011.
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    In order to ensure the proper implementation of the comprehensive 
new regulatory framework, especially with respect to (ii) above, the 
Dodd-Frank Act requires \5\ the Commission to promulgate rules to 
mitigate conflicts of interest in the operation of certain DCOs, DCMs, 
and SEFs. First, Section 726(a) of the Dodd-Frank Act specifically 
empowers the Commission to adopt ``numerical limits * * * on control'' 
or ``voting rights'' that enumerated entities \6\ may hold with respect 
to such DCOs, DCMs, and SEFs. Second, Section 726(b) of the Dodd-Frank 
Act directs the Commission to determine the manner in which its rules 
may be deemed necessary or

[[Page 63733]]

appropriate to improve the governance of certain DCOs, DCMs, or SEFs or 
to mitigate systemic risk, promote competition, or mitigate conflicts 
of interest in connection with the interaction between swap dealers and 
major swap participants, on the one hand, and such DCOs, DCMs, and 
SEFs. Finally, Section 726(c) of the Dodd-Frank Act directs the 
Commission to consider the manner in which its rules address conflicts 
of interest in the abovementioned interaction arising from equity 
ownership, voting structure, or other governance arrangements of the 
relevant DCOs, DCMs, and SEFs. The Commission must complete a 
rulemaking under Section 726 of the Dodd-Frank Act within 180 days 
after enactment--i.e., by January 14, 2011.\7\
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    \5\ See the following colloquy between Representative Stephen 
Lynch and Representative Barney Frank on the language that became 
Section 726 of the Dodd-Frank Act:
    Madam Speaker, for the purpose of a colloquy, I would like to 
engage with the chairman of the committee and the drafter of this 
legislation. I congratulate him on the great work he has done on 
this reform bill.
    Mr. Chairman, I want to call your attention to sections 726 and 
765 of the bill. These two provisions require the CFTC and the SEC 
to conduct rulemakings to eliminate the conflicts of interest 
arising from the control of clearing and trading facilities by 
entities such as swap dealers and major swap participants.
    This problem arises because, right now, 95 percent of all of the 
clearinghouses in this country are owned by just five banks. So, 
while we are relying on the clearinghouses to reduce systemic risk, 
we have the banks now owning the clearinghouses.
    The question I have is regarding the intent of the conferees in 
retaining subsection B of these provisions. It could be loosely 
construed to leave it up to the agencies whether or not to adopt 
rules.
    Mr. Chairman, do you agree that my reading of sections 726 and 
765 affirmatively require these agencies to adopt strong conflict of 
interest rules on control and governance of clearing and trading 
facilities?
    Mr. FRANK of Massachusetts. If the gentleman would yield to me, 
he has been a leader in this important area, and he is a careful 
lawyer and understands that just saving a principle isn't enough. 
You've got to make sure it is carried out. Dealing with a conflict 
of interest that he has been a leader in identifying is essential if 
this is going to work. So I completely agree with him. Yes, we mean 
both of those subsections, and it is a mandatory rulemaking.
    I will say to my neighbor from Massachusetts that we will be 
monitoring this carefully. They can expect oversight hearings 
because, yes, this is definitely a mandate to them to adopt rules to 
deal with what would be a blatant conflict of interest in the 
efficacy rules, and we intend to follow that closely.
    156 Cong. Rec. H5217 (2010).
    \6\ The ``enumerated entities'' include: (i) Bank holding 
companies with over $50,000,000,000 in total consolidated assets; 
(ii) a nonbank financial company supervised by the Board of 
Governors of the Federal Reserve System; (iii) an affiliate of (i) 
or (ii); (iv) a swap dealer; (v) a major swap participant; or (vi) 
an associated person of (iv) or (v).
    \7\ In adopting rules to implement Section 726 of the Dodd-Frank 
Act, the Commission is also implementing Section 725(d) of the Dodd-
Frank Act. The latter states: ``[t]he Commodity Futures Trading 
Commission shall adopt rules mitigating conflicts of interest in 
connection with the conduct of business by a swap dealer or a major 
swap participant with a derivatives clearing organization, board of 
trade, or a swap execution facility that clears or trades swaps in 
which the swap dealer or major swap participant has a material debt 
or material equity investment.''
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    In carrying out Section 726 of the Dodd-Frank Act,\8\ the 
Commission identifies in Section II below the following potential 
conflicts of interest:
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    \8\ Although the Commission is proposing the rules contained 
herein to specifically carry out Section 726 of the Dodd-Frank Act 
(as well as Section 725(d) of the Dodd-Frank Act), the Commission 
notes that it has additional authority to propose such rules under 
Sections 735(b), 735(c), and 733 of the Dodd-Frank Act. See infra 
note 17 for a more extensive description of Sections 735(b), 735(c), 
and 733 of the Dodd-Frank Act.
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     Conflicts of interest that a DCO may confront when 
determining (i) whether a swap contract is capable of being cleared, 
(ii) the minimum criteria that an entity must meet in order to become a 
swap clearing member, and (iii) whether a particular entity satisfies 
such criteria; \9\ and
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    \9\ The Commission requests comment as to whether DCOs, like 
DCMs and SEFs, have (or potentially may have) other conflicts of 
interest that implicate the balance between advancement of 
commercial interests and fulfillment of self-regulatory 
responsibilities.
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     Conflicts of interest that a DCM or SEF may confront in 
balancing advancement of commercial interests and fulfillment of self-
regulatory responsibilities.

The Commission proposes in Section III below (i) structural governance 
requirements and (ii) limits on the ownership of voting equity and the 
exercise of voting power, and describes, in each case, the manner in 
which such proposals may mitigate conflicts of interest in the 
operation of a DCO, DCM, or SEF.\10\
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    \10\ Commission regulations (the ``Regulations'') referred to 
herein are found at 17 CFR Ch. 1.
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    In general, the proposed rules include strengthened versions of the 
acceptable practices that the Commission previously adopted for the DCM 
core principle on conflicts of interest.\11\ The proposed rules impose 
structural governance requirements and limits on the ownership of 
voting equity and the exercise of voting power. They impose specific 
composition requirements on DCO, DCM, or SEF Boards of Directors and 
require each DCO, DCM, or SEF to have a nominating committee and one or 
more disciplinary panels. Each DCO must have a risk management 
committee and each DCM or SEF must have a regulatory oversight 
committee and a membership or participation committee, subject to 
specific composition requirements.
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    \11\ See, generally, ``Conflicts of Interest in Self-Regulation 
and Self-Regulatory Organizations,'' 74 FR 18982 (April 27, 2009) 
(which defined ``public director''); 72 FR 6936 (Feb. 14, 2007) 
(which adopted final acceptable practices for the DCM core 
principle) (the ``DCM Conflicts of Interest Release''); 71 FR 38740 
(July 7, 2006) (which proposed acceptable practices for the DCM core 
principle).
    Currently, DCM core principle 15 addresses conflicts of 
interest. See 7 U.S.C. 7(d)(15). The Dodd-Frank Act has redesignated 
DCM core principle 15 as DCM core principle 16, but has left the 
actual language of the principle substantively unchanged.
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    The proposed rules limit DCM or SEF members (and related persons) 
from beneficially owning more than twenty (20) percent of any class of 
voting equity in the registered entity or from directly or indirectly 
voting an interest exceeding twenty (20) percent of the voting power of 
any class of equity interest in the registered entity. With respect to 
a DCO only, the proposed rules require a DCO to choose one of two 
alternative limits on the ownership of voting equity or the exercise of 
voting power. Under the first alternative, no individual member may 
beneficially own more than twenty (20) percent of any class of voting 
equity in the DCO or directly or indirectly vote an interest exceeding 
twenty (20) percent of the voting power of any class of equity interest 
in the DCO. In addition, the enumerated entities, whether or not they 
are DCO members, may not collectively own on a beneficial basis more 
than forty (40) percent of any class of voting equity in a DCO, or 
directly or indirectly vote an interest exceeding forty (40) percent of 
the voting power of any class of equity interest in the DCO.
    Under the second alternative, no DCO member or enumerated entity, 
regardless of whether it is a DCO member, may own more than five (5) 
percent of any class of voting equity in the DCO or directly or 
indirectly vote an interest exceeding five (5) percent of the voting 
power of any class of equity interest in the DCO.
    Notwithstanding the foregoing, the proposed rules recognize that 
circumstances may exist where neither alternative would be appropriate 
for a DCO. Consequently, the proposed rules provide a procedure for the 
DCO to apply for, and the Commission to grant, a waiver of the limits 
specified in the first and second alternative.
    The proposed rules reflect consultation with staff of the following 
agencies: (i) The Securities and Exchange Commission (the ``SEC''); 
\12\ (ii) the Board of Governors of the Federal Reserve, (iii) the 
Office of the Comptroller of the Currency; (iv) the Federal Deposit 
Insurance Corporation; and (v) the Treasury Department. Staff from each 
of these agencies has provided verbal and/or written comments, and the 
proposed rules incorporate elements of the comments provided. The 
proposed rules have been further informed by (i) the joint roundtable 
that Commission and SEC staff conducted on August 20, 2010 (the 
``Roundtable'') \13\ and (ii) public comments posted to the Web site of 
the Commission.\14\ Finally, mindful of the importance of international 
harmonization,\15\ the proposed rules incorporate certain elements of: 
(i) The Proposal for a Regulation of the European Parliament and of the 
Council on OTC Derivatives, Central Counterparties, and Trade 
Depositories (the ``European Commission Proposal''); \16\ and (ii) the 
latest draft of the Principles for Financial Market Infrastructures, 
which would ultimately be reviewed by the Committee on Payment and 
Settlement Systems of the Bank for International Settlements and the 
Technical Committee of the

[[Page 63734]]

International Organization of Securities Commissions.
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    \12\ Section 765 of the Dodd-Frank Act requires the SEC to 
promulgate rules to mitigate conflicts of interest in the operation 
of (i) a clearing agency that clears security-based swaps, (ii) a 
security-based swap execution facility, or (iii) a national 
securities exchange that posts or makes available for trading 
security-based swaps.
    \13\ The transcript from the roundtable (the ``Roundtable Tr.'') 
is available at: https://www.cftc.gov/ucm/groups/public/@newsroom/documents/file/derivative9sub082010.pdf.
    \14\ Such comments are available at: https://www.cftc.gov/LawRegulation/DoddFrankAct/OTC_9_DCOGovernance.html.
    \15\ Currently, the Commission regulates certain entities based 
outside of the United States (e.g., LCH.Clearnet Limited and ICE 
Clear Europe Limited (``ICE Clear Europe''), each of which is based 
in the United Kingdom).
    \16\ COM(2010) 484/5.
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    The Commission anticipates conducting at least one other rulemaking 
that may impose requirements on DCOs, DCMs, and SEFs with respect to 
governance and mitigation of conflicts of interest.\17\ The Commission 
expects to finish such rulemaking by the statutory deadline of July 15, 
2011.
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    \17\ Such rulemaking would implement Sections 735(b) and 725(c) 
of the Dodd-Frank Act, which amends Sections 5(d) and 5b(c) of the 
CEA to add new core principles, or to supplement existing core 
principles, regarding the governance of DCMs and DCOs, and the 
mitigation of conflicts of interest in the operation of such 
entities. Such core principles would apply to all DCMs and DCOs, 
regardless of whether they clear or list swap contracts or only 
commodity futures or options. Such rulemaking would also implement 
Section 733 of the Dodd-Frank Act, which inserts new Section 5h of 
the CEA to create a registration category for SEFs, and to impose 
core principles that include the mitigation of conflicts of 
interest. The Commission is considering the proposals set forth 
below, among others, with respect to the second rulemaking: (1) 
Requiring each DCO, DCM, or SEF to have a regulatory program to (i) 
identify, on an ongoing basis, existing and potential conflicts of 
interest, and (ii) to make decisions in the event of such conflict; 
(2) mandating that each DCO, DCM, or SEF (i) prescribe limits on use 
of non-public information, and (ii) afford transparency with respect 
to governance arrangements; (3) requiring each DCO, DCM, or SEF to 
report to the Commission whenever (i) the Board of Directors rejects 
a recommendation or supersedes an action of the DCM or SEF 
Regulatory Oversight Committee, DCM or SEF Membership or 
Participation Committee, or DCO Risk Management Committee, as 
applicable, or (ii) the DCO Risk Management Committee rejects or 
supersedes an action of the DCO Risk Management Subcommittee, if 
applicable; (4) mandating minimum governance fitness standards for 
DCO and DCM members and participants; and (5) prescribing minimum 
standards regarding (i) DCM consideration of market participant 
views and (ii) the diversity of DCM Board of Directors, if the DCM 
is publicly-listed.
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    The Commission requests comment on all aspects of this release.

II. Conflicts of Interest

    As mentioned above, Title VII of the Dodd-Frank Act amended the CEA 
to establish a comprehensive new framework for swaps and security-based 
swaps. This framework imposes mandatory clearing and trade execution 
requirements with respect to clearable swap contracts. Some market 
participants, investor advocates, and academics have expressed a 
concern that the enumerated entities have economic incentives to 
minimize the number of swap contracts subject to mandatory clearing and 
trading. They contend that control of a DCO by the enumerated entities, 
whether through ownership or otherwise, constitutes the primary means 
for keeping swap contracts out of the mandatory clearing requirement, 
and therefore also out of the trading requirement. The Commission 
addresses these arguments below. The Commission also examines the 
contention that sustained competition between DCMs or SEFs with respect 
to the same swap contracts may exacerbate certain structural conflicts 
of interest, as the DCM Conflicts of Interest Release defines such 
term.\18\
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    \18\ According to the DCM Conflicts of Interest Release, ``[t]he 
presence of potentially conflicting demands within a single entity--
regulatory authority coupled with commercial incentives to misuse 
such authority--constitutes the new structural conflict of interest 
addressed by the acceptable practices adopted herein.'' 72 FR at 
6937.
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a. DCOs

    In general, in the commodity futures and options markets, the DCM 
decides which contracts to list, whereas the DCO manages the risk of 
guaranteeing such contracts. Clearing members exercise significant 
control over the manner in which a DCO manages risk, whether the 
members own the DCO or not.\19\ Based on Commission experience, such 
control has generally permitted the DCO to serve the purposes of the 
CEA, especially with respect to ``ensur[ing] the financial integrity of 
all transactions subject to [the CEA] and the avoidance of systemic 
risk.'' \20\ Clearing members contribute substantial financial 
resources to the DCO default or guarantee fund. If a clearing member 
defaults, and the DCO holds insufficient performance bond from such 
member to cover its losses, then the DCO would access the default or 
guarantee fund. Thus, the DCO spreads its losses across all clearing 
members. This mechanism creates an incentive for each clearing member 
to ensure that (i) other clearing members meet certain financial 
requirements and (ii) the DCO adopt a conservative approach towards 
risk management, especially in determining whether a particular 
contract would be acceptable for clearing.
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    \19\ The CME Group, Inc. (the ``CME Group''), a publicly-listed 
corporation, wholly owns the Chicago Mercantile Exchange, Inc. 
(``CME''). However, CME Clearing House, a division of CME, has a 
Risk Committee that is composed of: (i) Two members of the CME Board 
of Directors; (ii) five clearing member representatives; and (iii) 
two additional individuals, one of whom cannot be a clearing member 
representative. See CME Rule 403.A, available at: https://www.cmegroup.com/rulebook/CME/I/4/03.html.
    \20\ See Section 3(b) of the CEA, 7 U.S.C. 5(b).
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    This same mechanism also creates a disincentive for clearing 
members to act collectively (i) to exclude other entities from becoming 
clearing members or (ii) to bar a DCO from accepting new commodity 
futures or options contracts. After all, each new clearing member must 
contribute to the default or guarantee fund. Such contribution would 
result in a pro rata decrease in the potential exposure of each other 
clearing member to a default. Moreover, clearing members generally had 
little incentive to prevent the DCO from accepting a particular 
contract, absent a risk-based objection. In fact, the more different 
types of contracts that a DCO accepts, the more the intermediation 
services that such clearing member offers would likely be in demand.
    The regulated market structure that the Dodd-Frank Act contemplates 
for swap contracts is, in many ways, the mirror image of the market 
structure for commodity futures and option contracts. Currently, most 
swap contracts are privately negotiated between two parties, and are 
generally not cleared.\21\ Section 723 of the Dodd-Frank Act requires: 
(i) Swap contracts meeting certain criteria to be cleared with a DCO; 
and (ii) such contracts to be executed on a DCM or SEF (unless no DCM 
or SEF lists such contracts). Therefore, a DCO has unprecedented 
influence over the manner in which a swap contract can be executed.
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    \21\ See, e.g., Darrel Duffie, Ada Li, Theo Lubke, ``Policy 
Perspectives on OTC Derivatives Market Infrastructure,'' Federal 
Reserve Bank of New York Staff Report No. 424, dated January 2010, 
as revised March 2010 (the ``FRBNY Staff Report''). According to 
Section II of the FRBNY Staff Report, ``[a]n over-the-counter trade 
is privately negotiated between the buyer and seller.'' According to 
Section VII(A)(i) of the FRBNY Staff Report, ``[o]nly some types of 
OTC derivatives are now cleared. These include, for example, certain 
actively traded credit derivatives, some common forms of interest-
rate swaps, and some energy derivatives. Of these `eligible' types 
of OTC derivatives, those for which clearing has been set up, not 
all positions are actually cleared; the decision of which positions 
to clear has to this point been left to the discretion of market 
participants.''
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    Certain market participants and academics believe that Section 723 
of the Dodd-Frank Act does not introduce any new incentives for 
clearing members to act collectively (i) to exclude other entities from 
becoming clearing members or (ii) to bar a DCO from accepting new 
contracts. First, they argue that clearing does not make a bilateral 
swap contract less profitable.\22\ Second, they contend that, because 
clearing does not impact the profitability of a bilateral swap 
contract, swap clearing members that are

[[Page 63735]]

enumerated entities have specific, risk-based justifications for (i) 
setting membership criteria that exclude certain entities \23\ and (ii) 
determining that certain swap contracts cannot be cleared.\24\ Third, 
they assert that such swap clearing members must have the right to 
cause the DCO to act on such justifications, since ultimately, the 
capital of such clearing members (i.e., their contributions to the 
default or guarantee fund) may be accessed if a fellow clearing member 
defaults.\25\
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    \22\ See, e.g., Comments from James Hill, Managing Director and 
Global Credit Derivatives Officer, Morgan Stanley, representing the 
Securities Industry and Financial Markets Association (``Hill'') 
(``I think there's a bit of a misconception that somehow clearing 
makes trades less profitable. That's clearly not the case. In fact, 
I think most of the large systemically important participants in 
this market prefer clearing. And I think that's not just a 
statement; there is significant anecdotal evidence to support that 
perhaps the most important of which is LCH''), Roundtable Tr. at 21-
22.
    \23\ See, e.g., Comments from Hill (``as a general rule, the 
clearing member needs to be able to absorb losses, a default by 
another clearing member, number one; and, number two, they need to 
be able to absorb the economic transaction risk in the portfolio of 
a defaulting member * * * And so the way these clearinghouses set up 
their risk, you know, their admission or their membership criteria, 
is both of those things. So, A, they have to have a capital base 
sufficient to absorb losses and add in more capital to the 
clearinghouse if a member defaults. And B, they have to be able to 
in a situation where a clearing member has defaulted, which is 
probably the time of most economic stress, you know, in the economy, 
be able to take down the economic transaction risk of the swaps that 
were otherwise, the defaulting member was otherwise a party to, 
those trades need to be allocated among the surviving clearing 
members * * * And so the way these clearinghouses developed their 
criteria is they look at both of those prongs and they set 
thresholds to make sure that the members who are admitted can do 
those things. Because, remember, if you admit a member who can't do 
both of those things, then what happens is the clearinghouse will 
have insufficient capital in a situation where a member has 
defaulted, which is the time of the highest economic stress''), 
Roundtable Tr. at 28 to 29.
    \24\ See, e.g., Comments from Hill (``In evaluating what trades 
should be cleared, there's a balance that needs to be struck between 
the goal of increasing clearing, obviously, but, B, you don't want 
to put trades in the clearinghouse that can't be appropriately risk-
managed. So if you put trades in the clearinghouse that are illiquid 
and can't be valued properly, what will happen is when a clearing 
member defaults, there will be insufficient collateral with respect 
to that trade because it wasn't properly valued in the 
clearinghouse, and the surviving clearing members will be stressed 
from an economic perspective in taking positions the value of which 
cannot be readily ascertained. So it's critical that only trades 
that can be appropriately risk-managed be put into the 
clearinghouse. And I think what you'll see is that most of the 
clearinghouses look to their clearing members to help them valuate 
which trades are appropriate from a clearing perspective, and that 
is completely consistent with the economic incentives because the 
clearing members are the ones who have the overwhelming 
preponderance of the capital in the clearinghouse. So it's their 
capital that's at risk. They should certainly have a say in helping 
the clearinghouse evaluate which trades are acceptable for clearing 
and which trades are too risky or can't be valued, or are too 
illiquid or not standardized and, therefore, shouldn't be 
cleared''), Roundtable Tr. at 43 to 45.
    \25\ Id. See, also, e.g., Comments from Lee Olesky, Chief 
Executive Officer and Co-Founder, TradeWeb (``Olesky'') (``And I 
second Mr. Hill's comments. I think that it's very important that 
the people who bear the risk and supply the capital should have a 
substantial voice in how that risk gets managed, and that includes 
what contracts are accepted for clearing''), Roundtable Tr. at 46.
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    Others do not agree. They maintain that certain enumerated entities 
are active in the over-the-counter swap markets \26\ and that they earn 
significant revenues from this line of business.\27\ Such entities may 
experience substantial decreases in revenues if swap contracts were 
required to be (i) cleared with a DCO and (ii) executed on a DCM or 
SEF.\28\ Therefore, some contend that such entities may have an 
incentive to represent that certain swap contracts do not meet the 
mandatory clearing criteria under Section 723 of the Dodd-Frank 
Act.\29\ Such swap contracts would also not be subject to the trading 
requirement under Section 723 of the Dodd-Frank Act.
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    \26\ For example, according to the Office of the Comptroller of 
the Currency (``OCC''), as of the second quarter of 2009, U.S. 
commercial banks held derivatives with $203.5 trillion in notional 
value. Of that $203.5 trillion, the top five commercial banks held 
approximately $197 trillion. The top five commercial banks were: (i) 
JPMorgan Chase Bank N.A.; (ii) Goldman Sachs Bank USA; (iii) Bank of 
America N.A.; (iv) Citibank N.A.; and (v) Wells Fargo Bank N.A. The 
sixth commercial bank, holding approximately $3 trillion, was HSBC 
Bank USA N.A. See OCC's Quarterly Report on Bank Trading and 
Derivatives Activities, Second Quarter 2009.
    \27\ Id. (stating that ``U.S. commercial banks reported revenues 
of $5.2 billion trading cash and derivative instruments in the 
second quarter of 2009, compared to a record $9.8 billion in the 
first quarter'').
    \28\ According to Section VI of the FRBNY Staff Report, ``[e]ven 
after an OTC derivatives product has achieved relatively active 
trading, and would be suitable for exchange trading, dealers have an 
incentive to maintain the wider bid-ask spreads that they can obtain 
in the OTC market relative to the spreads that might apply to the 
same product on an exchange, where buyers and sellers can more 
directly compete for the same trade. Further, exchanges are more 
likely to match ultimate buyers to sellers, reducing the fraction of 
trades intermediated by dealers. Thus, from the viewpoint of their 
profits, dealers may prefer to reduce the migration of derivatives 
trading from the OTC market to central exchanges.''
    \29\ See, e.g., Comments of Heather Slavkin, Senior Legal and 
Policy Advisor, Office of Investment, AFL-CIO (``Slavkin'') (``If 
there's an interest among the people who own the clearinghouse, or a 
conflict of interest that would create incentives for them to also 
favor, you know, [not] allowing certain types of swaps to clear 
because they may be more profitable for the institution generally if 
they remain over the counter, then that can create perverse 
incentives to maintain the OTC, nontransparent, systemically risky 
markets when the goal needs to be to prevent those conflicts of 
interest to ensure that anything that can be cleared does, in fact, 
clear''), Roundtable Tr. at 21; Comments of Darrell Duffie, Dean 
Witter Distinguished Professor of Finance at the Graduate School of 
Business, Stanford University (``Duffie'') (``We talked earlier 
about how the members of the clearinghouse should determine what 
gets traded, and we also have conflicts of interest arising from the 
incentives of the dealers to profit from bid versus ask on products 
that are not traded on swap execution facilities. So the interaction 
effect here is effectively if one gets cleared as one gets traded on 
a swap execution facility, then we want to be very careful that the 
members of a central clearing counterparty that determine what gets 
cleared and, therefore, have control over what gets traded on swap 
execution facilities are the members that have, you know, the right 
social incentives to create competition''); Comments of Michael 
Greenberger, Professor, University of Maryland School of Law 
(``Greenberger'') (``If you have one clearinghouse dominated by the 
major swaps dealers, they have several conflicting incentives. One 
is, I reject the idea that somehow they do not want to keep a large 
and vibrant over-the-counter market. We're told that clearing is 
very profitable. If it was that profitable, where were these people 
when we were aggressively arguing for mandatory clearing and 
exchange trading? They were on the opposite side of that. The 
transaction fees and the spreads still make an unregulated market 
very, very profitable, probably more profitable than the profits 
that would derive from clearing. So, if you have the swaps dealers 
in control of a clearing facility, they have that incentive''), 
Roundtable Tr. at 111.
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    Although Section 723 of the Dodd-Frank Act grants the Commission 
ultimate authority to determine whether a swap contract must be cleared 
with a DCO, it also anticipates that the Commission would consider the 
risk assessment of DCOs. Currently, DCOs that clear large volumes of 
swap contracts tend to have swap clearing members that consist 
exclusively of enumerated entities.\30\ Therefore, some argue that the 
risk assessment of such DCOs may be compromised.\31\

[[Page 63736]]

Moreover, some contend that the swap clearing members of such DCOs may 
exclude non-enumerated entities from becoming clearing members, because 
non-enumerated entities may influence risk assessments of DCOs in favor 
of clearing more swap contracts.\32\ Some market participants maintain 
that such practices may have systemic implications.\33\
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    \30\ For example, as of July 2, 2010, ICE Clear Europe cleared 
approximately $3.3 trillion in European credit default swap 
(``CDS'') indices and an additional $501 billion in European CDS 
single-name instruments. See ``ICE Surpasses $10 Trillion Milestone 
in Global CDS Clearing,'' available at: 
http:[sol][sol]ir.theice.com/releasedetail.cfm?ReleaseID=485527.
    As of September 20, 2010, all CDS clearing members of ICE Clear 
Europe are banks, bank holding companies, or affiliates thereof. 
Such members are: (i) Banc of America N.A.; (ii) Barclays Bank PLC; 
(iii) BNP Paribas; (iv) Citigroup Global Markets Limited; (v) Credit 
Suisse International; (vi) Deutsche Bank AG; (vii) Goldman Sachs 
International; (viii) HSBC Bank PLC; (ix) JPMorgan Chase Bank, N.A.; 
(x) Morgan Stanley Capital Services, Inc.; (xi) Nomura International 
PLC; (xii) Soci[eacute]t[eacute] G[eacute]n[eacute]rale; (xiii) The 
Royal Bank of Scotland PLC; (xiv) UBS AG, London Branch; and (xv) 
UniCredit Bank AG. See ICE Clear Europe, Clearing Members, available 
at: https:[sol][sol]www.theice.com/publicdocs/clear_europe/ICE_
Clear_Europe_Clearing_Member_List.pdf, and the release updating 
such list, available at https:[sol][sol]www.theice.com/publicdocs/
clear_europe/circulars/C10080.pdf.
    ICE Trust U.S. LLC (``ICE Trust''), an affiliate of ICE Clear 
Europe, cleared approximately $6 billion in North American CDS 
indices and $272 billion in North American single-name indices. The 
CDS clearing members of ICE Clear Europe and ICE Trust generally 
overlap (counting affiliated entities), except that Merrill Lynch 
International is a clearing member of ICE Trust and 
Soci[eacute]t[eacute] G[eacute]n[eacute]rale and UniCredit Bank AG 
are not. See ICE Trust, Participant List, available at: 
https:[sol][sol]www.theice.com/publicdocs/ice_trust/ICE_Trust_
Participant_List.pdf. ICE Trust is currently not a DCO.
    \31\ See note 29 above. See, also, Comments from Slavkin (``I 
think that there's the risk that anything that could be made to 
appear to be something that is a bilateral * * * contract, you could 
have the spurious customization issues, if there's the opportunity 
to get additional profits within the big dealer banks, and those 
same dealer banks are running and controlling the clearinghouses, 
then, you know, the potential for spurious customization becomes a 
real issue and becomes a possibility''), Roundtable Tr. at 40.
    In addition to noting that the enumerated entities may have 
incentives to influence DCO risk assessments in favor of considering 
fewer contracts to be suitable for mandatory clearing, certain 
academics have observed that, for those contracts that nonetheless 
are cleared, the enumerated entities may have incentives to lower 
risk management standards. See, e.g., Comments from Greenberger (``* 
* * yes, certain products will be cleared because they are 
profitable and [the enumerated entities] may over calculate and be 
over enthused about clearing things that are too risky''), 
Roundtable Tr. at 112. For example, the enumerated entities may not 
accurately calculate the amount of performance bond and/or guarantee 
or default fund contributions necessary to clear a particular swap 
contract.
    \32\ See, e.g., Comments from Jason Kastner, Vice Chairman, 
Swaps and Derivatives Markets (``Kastner'') (``Let me give you a 
specific example. One of the members of this SDMA currently clears 
13 percent of the business at a large exchange in Chicago. That 
large, independent FCM is clearly qualified to become a swap 
clearing member. But because of various conflicts of interest, the 
risk committee of said exchange is precluding that firm, which is 
clearly qualified and has the capital, from becoming a swap clearing 
member * * * this goes back to the governance point and transparency 
about who's making that decision and why, because a lot of times 
what happens is people will swallow themselves in the cloak of risk 
management or financial stability or whatever really to make an 
anti-competitive stand. In other words, you can never say that you 
don't want to let somebody in. But you could probably find an excuse 
or a reason in the interest of systematic--you know, systemic 
stability and the rest of it to put an asterisk on the application 
or just delay it for awhile''), Roundtable Tr. at 90-91.
    See, also, infra note 67 on the potential non-availability of 
arrangements whereby a non-clearing futures commission merchant may 
present a customer trade to a swap clearing member for clearing with 
a DCO.
    \33\ In Lessening Systemic Risk: Removing Final Hurdles to 
Clearing OTC Derivatives, the Swaps and Derivatives Market 
Association states: ``[r]estricted access leads to reduced clearing 
which leads to systemic risk.''
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    The framers of the Dodd-Frank Act observe that the clearing of swap 
contracts constitutes a key means for managing systemic risk, because 
clearing removes the type of interconnectedness between financial 
institutions that contributed to the financial crisis resulting from 
the failure and bankruptcy of firms such as Bear Stearns, Lehman 
Brothers, and AIG.\34\ Therefore, it is important to mitigate potential 
conflicts of interest that may prevent clearable swap contracts from 
becoming subject to mandatory clearing. At the same time, the 
Commission recognizes that the safety and soundness of a DCO should not 
be compromised. A DCO must not only have the ability to appropriately 
manage the risk associated with each and every contract that it 
guarantees, it must be able to decline accepting contracts for clearing 
if they pose unacceptable risks. In addition, DCO members must have 
input in setting membership criteria, because they bear the risk of 
loss in the event of member default. Nevertheless, the Commission does 
not believe that (i) subjecting more swap contracts to mandatory 
clearing is incompatible with (ii) DCO safety and soundness.\35\ 
Rather, the Commission intends to ensure, through the proposed rules 
below, that a DCO takes action to achieve both (i) and (ii), and that 
the private, competitive interests of certain DCO members do not 
capture DCO risk assessments.
---------------------------------------------------------------------------

    \34\ See, e.g., the letter from Senators Christopher Dodd and 
Blanche Lincoln, respective chairs of the Senate Banking and 
Agriculture Committee, to Representatives Barney Frank and Collin 
Peterson, respective chairs of the House Financial Services and 
Agriculture Committees, dated June 30, 2010 (stating that ``Congress 
determined that clearing is at the heart of reform--bringing 
transactions and counterparties into a robust, conservative and 
transparent risk management framework'').
    \35\ Certain Roundtable participants agree. See Comments from 
Duffie (``I don't think there's a conflict between the incentives 
for competition, increasing competition in this market on the one 
hand and the incentives for improving financial stability on the 
other, or I don't think there's a problem between those two. You can 
* * * have both. The incentives to watch for on competition are that 
we've got enough access by multiple market * * * participants, and 
that the oligopolistic nature of the market is, to some extent, 
watched carefully by regulators''), Roundtable Tr. at 104.
---------------------------------------------------------------------------

b. DCMs and SEFs

    The main function of a DCM, as well as a SEF, is to provide a 
facility for: (i) The discovery of prices; and (ii) the execution of 
transactions. However, in order to obtain and maintain a license to 
perform such a function, each DCM and SEF must fulfill self-regulatory 
obligations under the CEA and the Dodd-Frank Act.\36\ Therefore, 
although each DCM or SEF \37\ is a commercial enterprise, the fact that 
each entity has self-regulatory obligations means that each entity ``is 
not simply a corporation, but a corporation charged with the public 
trust.'' \38\ Section 3(b) of the CEA confers on the Commission the 
responsibility for ensuring that each DCM or SEF appropriately 
prioritizes its self-regulatory obligations. Such obligations include 
appropriately implementing the comprehensive new framework that the 
Dodd-Frank Act sets forth, as well as meeting existing requirements 
under the CEA.
---------------------------------------------------------------------------

    \36\ Section 3(a) of the CEA defines the ``national public 
interest'' that transactions in commodity futures and options and 
swaps serve. It states, ``[t]he transactions subject to this Act are 
entered into regularly in interstate and international commerce and 
are affected with a national public interest by providing a means 
for managing and assuming price risks, discovering prices, or 
disseminating pricing information through trading in liquid, fair 
and financially secure trading facilities.'' 7 U.S.C. 5(a). The 
importance of transactions in commodity futures and options, as well 
as swaps, forms the basis for Commission regulation of DCMs and 
SEFs.
    Section 3(b) of the CEA describes the system of regulation that 
Congress has directed the Commission to implement to achieve the 
abovementioned purposes. It states: ``[i]t is the purpose of this 
chapter to serve the public interests * * * through a system of 
effective self-regulation of trading facilities, clearing systems, 
market participants and market professionals under the oversight of 
the Commission.'' 7 U.S.C. 5(a). The Commission has interpreted the 
``self-regulation'' referenced in Section 3(b) of the CEA as 
encompassing both (i) the registered entity ensuring that members 
meet applicable statutory requirements, and (ii) the registered 
entity having systems to ensure that it continues to meet applicable 
statutory requirements. For example, as the Commission previously 
stated in the DCM Conflicts of Interest Release, ``Core Principle 15 
requires DCMs to maintain systems to minimize structural conflicts 
of interest inherent in self-regulation, as well as individual 
conflicts of interest faced by particular persons. The acceptable 
practices are rationally related to the purposes of Core Principle 
15.'' 72 FR at 6937, 6940.
    \37\ As mentioned above, the SEF is a new registration category 
that the Dodd-Frank Act created. Therefore, the Commission has never 
opined as to whether a SEF is a ``self-regulatory organization'' 
within the meaning of Regulation 1.3(ee). However, a SEF has self-
regulatory obligations under the Dodd-Frank Act, as the Commission 
has interpreted such obligations in the DCM Conflicts of Interest 
Release. For example, to the extent that a SEF determines that it 
must impose requirements on members in order to comport with a core 
principle (e.g., with respect to position limits), a SEF must 
monitor member compliance with such requirement, and must have the 
authority and ability to enforce such requirement. See Section 
5h(f)(2)(A) of the CEA, as added by Section 733 of the Dodd-Frank 
Act.
    \38\ Preamble to proposed acceptable practices on ``Conflicts of 
Interest in Self-Regulation and Self-Regulatory Organizations,'' 71 
FR 38740, 38741 (July 7, 2006).
---------------------------------------------------------------------------

    As the DCM Conflicts of Interest Release notes, increased 
competition may exacerbate conflicts of interest, causing a DCM to (i) 
prioritize commercial interests over self-regulatory responsibilities; 
\39\ and (ii) restrict access or impose burdens on access in a 
discriminatory manner.\40\

[[Page 63737]]

The Dodd-Frank Act attempts to create conditions favorable to sustained 
competition between DCMs and SEFs with respect to the same swap 
contract. For example, the Dodd-Frank Act contemplates that either a 
DCM or a SEF may list swap contracts.\41\ It also contemplates that 
multiple DCMs or SEFs may list the same swap contract, and that such 
swap contracts may be offset at the same DCO.\42\ Also, in requiring 
certain swap contracts to be listed on a DCM or SEF,\43\ the Dodd-Frank 
Act may encourage competition between standardized swap contracts and 
commodity futures and options.\44\
---------------------------------------------------------------------------

    \39\ See, generally, the DCM Conflicts of Interest Release.
    \40\ See, infra note 67 for a specific example of DCM or SEF 
restrictions or burdens on access. Also, clauses (i) and (ii) are 
not mutually exclusive. As the DCM Conflicts of Interest Release 
notes, ``[s]elf-regulation's traditional conflict--that members will 
fail to police their peers with sufficient zeal--has been joined by 
the possibility that competing DCMs could abuse their regulatory 
authority to gain competitive advantage or to satisfy commercial 
imperatives.'' 72 FR at 6938. In its Concept Release Concerning 
Self-Regulation, the SEC identified one method that national 
securities exchanges have used to gain a competitive advantage: 
``abus[ing] SRO status by overregulating members that operate 
markets that compete with the SROs.'' Release No. 34-50700 (Nov. 18, 
2004), 69 FR 71256 (Dec. 8, 2004).
    Also, similar to the incentives that the enumerated entities may 
have with respect to the mandatory clearing requirement, if the 
enumerated entities control a DCM or SEF, they may cause such DCM or 
SEF to not list a swap contract for trading, if it would be more 
profitable to keep such contract bilaterally negotiated. However, 
the Commission notes that nothing would prevent another DCM or SEF 
from listing such contract, and that Section 723 of the Dodd-Frank 
Act would require that a DCO clearing such contract provide non-
discriminatory access to such DCM or SEF.
    \41\ See Section 2(h)(8) of the CEA, as added by Section 723 of 
the Dodd-Frank Act.
    \42\ See Section 2(h)(1)(B) of the CEA, as added by Section 733 
of the Dodd-Frank Act. Whereas DCMs have competed in the past, and 
are currently competing, to list commodity futures and options 
contracts with the same economic terms and conditions, such 
contracts have not been, and currently are not, fungible. In other 
words, such contracts cannot be offset in the same DCO.
    \43\ See Section 2(h)(8) of the CEA, as added by Section 723 of 
the Dodd-Frank Act.
    \44\ For example, two DCMs (i.e., the NASDAQ OMX Futures 
Exchange and CME), as well as one exempt board of trade (i.e., Eris 
Exchange), offer interest rate futures products. Currently, interest 
rate swap contracts constitute a large percentage of the bilateral 
swaps market. See, e.g., OCC's Quarterly Report on Bank Trading and 
Derivatives Activities, First Quarter 2010, Executive Summary, 
available at: http:[sol][sol]www.occ.treas.gov/ftp/release/2010-
71a.pdf. (stating that ``[d]erivative contracts remain concentrated 
in interest rate products, which comprise 84% of total derivative 
notional values'').
---------------------------------------------------------------------------

    Such sustained competition, if it occurs,\45\ would constitute an 
increase to the competition that most DCMs currently face with respect 
to commodity futures and options. As described below, the Commission 
intends to ensure through the proposed rules that each DCM or SEF 
implements appropriate systems to manage such conflicts.
---------------------------------------------------------------------------

    \45\ As discussed above, whether such competition occurs depends 
in part on the manner in which Section 723 of the Dodd-Frank Act is 
implemented.
---------------------------------------------------------------------------

c. Questions on Conflicts of Interest

    The Commission seeks comment on the questions set forth below on 
potential conflicts of interest.
     Has the release correctly identified the conflicts of 
interest that a DCO, DCM, or SEF may confront?
     Has the release accurately specified the possible effects 
of such conflicts of interest on DCO, DCM, or SEF operations? What are 
other possible effects?
     What other conflicts of interest may exist? What are the 
effects of such conflicts?

III. Mitigation of Conflicts of Interest

    To mitigate, on a prophylactic basis, the conflicts of interest 
identified above, the Commission sets forth below proposed (i) 
structural governance requirements and (ii) limits on the ownership of 
voting equity and the exercise of voting power. As explained in greater 
detail below, the Commission views (ii) as a method of enhancing (i), 
in that (ii) limits the influence that certain shareholders may exert 
over the DCO, DCM, or SEF Board of Directors. The Commission believes 
that such influence may affect, among other things, the independent 
perspective of public directors. The Commission does not believe that 
stricter structural governance requirements (e.g., a higher percentage 
of public directors) justify more lenient limits on the ownership of 
voting equity and the exercise of voting power, or vice versa. However, 
the Commission requests comment on the proper relationship between such 
requirements and limits. The Commission also requests comment on 
whether both (i) structural governance requirements and (ii) limits on 
the ownership of voting equity and the exercise of voting power are 
necessary or appropriate to mitigate the conflicts of interest 
described in Section II, or whether one or the other (or neither) would 
be effective.
    In applying such requirements and limits, the Commission does not 
propose to distinguish between DCMs and SEFs listing swap contracts. As 
mentioned above, such DCMs and SEFs may experience sustained 
competition with respect to the same swap contract, and therefore would 
face the same pressures on self-regulation. Additionally, the 
Commission does not propose to distinguish between (i) DCMs listing 
swap contracts and (ii) DCMs listing only commodity futures and 
options. As mentioned above, clearable swap contracts may share 
sufficiently similar characteristics with certain commodity futures and 
options as to compete with respect to execution. Therefore, a DCM 
listing only commodity futures and options may face competition from a 
SEF with fewer self-regulatory requirements, in the same manner as a 
DCM listing swap contracts. Given that the same conflicts of interest 
\46\ may concern both types of DCM, it would appear that the same (i) 
structural governance requirements and (ii) limits on the ownership of 
voting equity and the exercise of voting power should apply.
---------------------------------------------------------------------------

    \46\ Namely, (i) prioritizing commercial interests over self-
regulatory responsibilities and (ii) restricting access or imposing 
burdens on access in a discriminatory manner, in each case, because 
of increased competition.
---------------------------------------------------------------------------

    In addition, the Commission does not propose to distinguish between 
(i) DCOs clearing swap contracts and (ii) DCOs clearing only commodity 
futures and options. Certain standardized swap contracts have 
sufficiently similar risk profiles to commodity futures and options 
that the Commission has, on occasion, permitted such products to be 
commingled and margined within the segregated customer account under 
Section 4d of the CEA.\47\ If the Commission applied differential (i) 
structural governance requirements and (ii) limits on the ownership of 
voting equity and the exercise of voting power, the Commission risks 
creating an incentive for regulatory arbitrage between the two types of 
DCO.
---------------------------------------------------------------------------

    \47\ 7 U.S.C. 6d.
---------------------------------------------------------------------------

    The Commission requests comment on holding the two types of (i) 
DCMs and (ii) DCOs to the same requirements regarding the mitigation of 
conflicts of interest. The Commission also requests comment on holding 
DCMs and SEFs listing swap contracts to the same requirements. The 
Commission is specifically interested in the costs and benefits of its 
approach.

a. Structural Governance Requirements

i. Independence
    In general, the structural governance requirements mitigate 
conflicts of interest at a DCO, DCM, or SEF by introducing a 
perspective independent of competitive, commercial, or industry 
considerations to the deliberations of governing bodies (i.e., the 
Board of Directors and committees). Such independent perspective would 
more likely encompass regulatory considerations, and to accord such 
considerations proper weight. Such independent perspective also would 
more likely contemplate the manner in which a decision might affect all 
constituencies, as opposed to concentrating on the manner in which a 
decision affects the interests of one constituency.\48\
---------------------------------------------------------------------------

    \48\ See, e.g., the DCM Conflicts of Interest Release (stating 
that ``the public interest will be furthered if the boards and 
executive committees of all DCMs are at least 35% public. Such 
boards and committees will gain an independent perspective that is 
best provided by directors with no current industry ties or other 
relationships which may pose a conflict of interest. These public 
directors, representing over one-third of their boards, will 
approach their responsibilities without the conflicting demands 
faced by industry insiders. They will be free to consider both the 
needs of the DCM and of its regulatory mission, and may best 
appreciate the manner in which vigorous, impartial, and effective 
self-regulation will serve the interests of the DCM and the public 
at large. Furthermore, boards of directors that are at least 35% 
public will help to promote widespread confidence in the integrity 
of U.S. futures markets and self-regulation''). 72 FR 6946.

---------------------------------------------------------------------------

[[Page 63738]]

    In the DCM Conflicts of Interest Release, the Commission emphasized 
the importance of independent decision-makers in protecting DCM self-
regulatory functions from DCM commercial interests and that of its 
constituencies. However, the Commission notes that participants in the 
Roundtable raised the possibility that conflicts of interest may also 
be mitigated by providing for fair representation of all constituencies 
in the governance of a DCO, DCM, or SEF.\49\ Theoretically, all 
constituencies would act in their own commercial, competitive, or 
industry interests, but no one interest would dominate. The Commission 
specifically requests comment regarding whether fair representation 
would be preferable to, or would complement, director independence in 
mitigating the DCO, DCM, and SEF conflicts of interest described in 
Section II. The Commission would particularly welcome factual examples. 
The Commission also requests comment on how the proposed structural 
governance requirements should change if the Commission adopts a fair 
representation standard as either an alternative to, or a complement 
of, rules emphasizing an independent perspective.
---------------------------------------------------------------------------

    \49\ See, e.g., Comment from Hal Scott, Nomura Professor of 
International Financial Systems and Director of Program on 
International Financial Systems, Harvard Law School (``Scott'') 
(``When I spoke, I was saying I opposed ownership restrictions, I 
was not talking about voting restrictions which I think is a 
different issue, and the way I would put it is not a voting 
restriction. I would turn it around to a duty of fair 
representation, which the SEC is quite familiar with, and is applied 
to their regulated entities which ensures that the users, more 
broadly defined of the exchange. And maybe if you translated this 
into the clearinghouse, the users, but not necessarily the members 
of the clearinghouse, would have representation in terms of 
governance * * * Independent directors, to me, are most needed with 
public companies as under SOX when there was a broad duty to 
shareholders. But I think what's needed in this context is more the 
expert, and we heard before that it's very important that people 
that know what they're doing have input into those, and clearly 
major users of these clearinghouses, that is customers who clear 
through a member. Major hedge funds, for instance, have a lot of 
expertise, okay, in these areas, they're big traders * * *''), 
Roundtable Tr. at 130-131; Richard Prager, Managing Director, Global 
Head of Fixed Income Trading, Blackrock (``as the [sole] fiduciary 
on this panel * * * we would be in support of a very inclusive 
participation and governance with teeth''), Roundtable Tr. at 131-
132; Lynn Martin, Chief Operating Officer, NYSE Liffe U.S. (``You 
may be aware that NYSE Euronext's U.S. Future Exchange--NYSE Life 
U.S., is a semi-neutralized structure whereby we balance the views 
of both the independence criteria as required by core principle 15 
in the CFTC-DCM requirements, as well as the views of NYSE Euronext 
and our external investor firms' views, such that no one board 
action may be enacted based on the views of any one of those 
constituents * * * So, it's our belief that a more balanced board 
structure, a more balanced governance structure, is the proper way 
to handle or potentially mitigate conflicts of interest''), 
Roundtable Tr. at 121.
---------------------------------------------------------------------------

ii. Board Requirements
1. Composition
    As the DCM Conflicts of Interest Release states, ``the governing 
board * * * is [the] ultimate decision maker and therefore the logical 
place to begin to address conflicts.'' \50\ The Commission proposes (i) 
maintaining the requirement that DCM Boards of Directors be composed of 
at least 35 percent ``public directors'' \51\ and (ii) extending this 
requirement to SEF and DCO Boards of Directors. In the DCM Conflicts of 
Interest Release, the Commission stated that the 35 percent requirement 
struck an appropriate balance between (i) the need to minimize 
conflicts of interest in DCM decision-making processes with (ii) the 
need for expertise and efficiency in such processes. Such rationale 
would appear to apply to SEF and DCO Boards of Directors as well.\52\
---------------------------------------------------------------------------

    \50\ 72 FR at 6940.
    \51\ See Section III(a)(iv) of this release for more detail 
regarding the definition of ``public director.''
    The Commission notes that such percentage harmonizes with 
Article 25(2) of the European Commission Proposal, which requires a 
central counterparty (``CCP'') to have ``a board of which at least 
one third, but no less than two, of its members are independent.''
    \52\ 72 FR at 6946.
---------------------------------------------------------------------------

    In addition to the 35 percent composition requirement, the 
Commission proposes specifying that DCO, DCM, and SEF Boards of 
Directors may not have less than two public directors. Such a 
requirement is also contained in the European Commission Proposal.\53\ 
As the Commi